Financial Management Principles and Applications 13E Sheridan Titman Solution Manual

Financial Management Principles and Applications 13E By Sheridan Titman

Email: Richard@qwconsultancy.com

Part One Instructor’s Manual

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Chapter 1 Getting Started—Principles of Finance ◼ Chapter Orientation Finance is the study of how people and businesses evaluate investments and raise capital to fund these investments. Key principles guide the process of evaluating investment decisions. This chapter lays the foundation for understanding the principles that underpin financial decision making. Financial decisions permeate every aspect of the business world and of our personal lives. Understanding basic financial concepts is critical to making informed decisions concerning the use of financial resources.

This chapter describes the three types of business organizations--sole proprietorships, partnerships, and corporations—and compares and contrasts the similarities and differences among these types of business organization. Further, the role of finance is discussed relative to the overall structure of the organization.

The overriding goal of finance is to maximize shareholder wealth. Ethical errors in judgment tend to destroy trust in management thereby preventing management from working toward that goal.

Finance encompasses five basic principles: Money has a time value; there is a risk-return tradeoff; cash flows are the source of value; market prices reflect information; and individuals respond to incentives.

◼ Chapter Outline 1.1 Overview of Finance A. Finance is the study of how people and businesses evaluate investments and raise capital for these investments.

B. Finance concerns the study of the management of money, as well as the interpretation of information.

1.2 Three Types of Business Organization A. A sole proprietorship is a business owned by a single individual.

B. A general partnership is an association of two or more persons who come together as owners for the purpose of operating a business for profit.

C. A corporation is a business organization that legally functions separately and apart from its owners (shareholders).

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1.3 The Goal of the Financial Manager: Maximize Shareholder Wealth A. Because shareholders are the owners of the firm, the goal of the financial manager is the maximize shareholder wealth.

B. Maximizing shareholders wealth is achieved by maximizing stock price.

C. The Sarbanes-Oxley Act attempts to safeguard the interests of shareholders by providing protection against agency problems related to accounting fraud and financial misconduct.

1.4 Financial concepts can be classified into four general principles.

A. Principle 1: Money has a time value B. Principle 2: There is a Risk-Return tradeoff C. Principle 3: Cash flows are the source of value D. Principle 4: Market prices reflect information E. Principle 5: Individuals respond to incentives

◼ Learning Objectives 1.1. Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make.

1.2. Identify the key differences between three major legal forms of business.

1.3. Understand the role of the financial manager within the firm and the goal for making financial choices.

1.4. Explain the five principles of finance that form the basis of financial management for both businesses and individuals.

◼ End-of-Chapter Problem Complexity Rating and Spreadsheet Solutions The end-of-chapter problems are sorted below, according to their level of complexity.

Simple

Average

Complex

There are no problems in this chapter.

◼ Lecture Tips 1. Identify various investments that individuals make that require knowledge of finance: a) going to college b) purchasing a car c) buying a home d) rent versus owning a home

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Chapter 1

Getting Started—Principles of Finance

2. Use real-world, non-financial situations to describe the relationship between risk and return; for example, choice of career, travels, etc.

◼ Further Questions for Class Discussion 1. When managers act in an unethical manner, it can have a long-term impact on the value of the firm.

Use the example of Enron’s board of directors temporarily suspending its own “code of ethics” to describe how that impact may be negative and permanent.

2. Explain the difference between cash flow and profit.

◼ Internet Resources None

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Chapter 2 Firms and the Financial Market ◼ Chapter Overview This chapter provides an overview of U.S. financial markets. Financial markets consist of the institutions that facilitate the transfer of money from investors to companies and individuals. The three principal players in the financial markets are borrowers, savers (i.e., investors), and financial institutions (i.e., intermediaries). There is a wide variety of financial institutions that make up our financial markets including: commercial banks, financial services corporations, insurance companies, investment banks, investment companies, mutual funds and exchange traded funds, hedge funds, and private equity firms.

The purpose of each of these institutions is to bring borrowers and investors together. Borrowers and investors are linked together through the buying and selling of a variety of securities that are traded on financial markets. While there are innumerable types of financial instruments traded on financial markets, most are some form of debt or equity security.

◼ Chapter Outline 2.1. The Basic Structure of U.S. Financial Markets A. A financial market is any place where money and credit is exchanged.

B. The three principal sets of players in financial markets are borrowers, savers (investors), and financial institutions (intermediaries).

2.2. The Financial Marketplace—Financial Institutions A. The financial institutions that make up the financial marketplace facilitate the movement of money from savers to borrowers.

1. The money market refers to transactions in short-term debt instruments.

2. Capital markets are markets for long-term financial instruments.

B. Non-Bank financial intermediaries provide financial services to businesses. There are a variety of non-bank financial intermediaries.

1. Financial services corporations are in the lending or financing business, but they are not commercial banks.

2. Insurance companies are in the business of selling insurance to individuals businesses to protect their investments.

3. Investment banks are specialized financial intermediaries that help companies and governments raise money and provide advisory services to client firms.

4. Investment companies are financial institutions that pool the savings of individual savers and invest the money in the securities issued by other companies purely for investment purposes.

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Chapter 2 Firms and the Financial Market

5.

6.

7.

Mutual funds and exchange traded funds (ETFs) are special types of intermediaries through which individuals can invest in virtually all of the securities offered in the financial markets.

Hedge funds are like mutual funds, but are less regulated and tend to take on greater risk.

Private equity firms include venture capital firms and leveraged buyout funds.

2.3. The Financial Marketplace—Securities Markets A. A security is a negotiable instrument that represents a financial claim and can take the form of ownership (stocks) or a debt agreement.

B. A primary market is a market in which new securities are bought and sold for the first time.

C. A secondary market is where all subsequent trading of previously issued securities takes place.

D. Firms borrow money by issuing debt securities. These can be either short-term (i.e., notes) or long-term securities (i.e., bonds).

E. Equity securities represent ownership of the corporation.

1. Common stock is a security that represents equity ownership, provides voting rights, and entitles the holder to a share of the company’s earnings in the form of dividends or capital appreciation.

2. Preferred stock is an equity security without voting rights but with a defined dividend payment. Preferred stock dividends must be paid before common stock dividends can be distributed.

F.

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Stock markets consist of both physical trading areas (i.e., organized security exchanges) and electronic trading areas (i.e., over-the-counter markets).

G. While many factors contributed to the financial crisis of 2008, one large factor was the collapse of the real estate market and the resulting defaults on subprime mortgages.

◼ Learning Objectives 1. Describe the structure and functions of financial markets 2. Distinguish between commercial banks and other financial institutions in the financial marketplace.

3. Describe the different securities markets for bonds and stock.

◼ End-of-Chapter Problem Complexity Rating and Spreadsheet Solutions Simple

Average

There are no problems in this chapter.

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Complex

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◼ Lecture Tips 1. Bring in a copy of the Wall Street Journal and have the students look at the various tables relevant to the security markets. Discuss the meaning of the information and how the numbers and terms relate to the chapter.

2. Simulate the start-up of a corporation with various class members playing the role of creditors and shareholders of the firm.

◼ Further Questions for Class Discussion 1. Why is it important to distinguish between depository and non-depository financial institutions?

2. Why are secondary markets important?

◼ Internet Resources http://www.sec.gov/answers/mutfund.htm www.sec.gov/investor/tools/mfcc/mfcc-int.htm http://www.mckensey.com/mgi/reports/pdfs/Mapping_Global/MGI_Global_full_Report.pdf

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Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows ◼ Chapter Overview This chapter focuses on accounting and financial statements. Understanding the financial health of a business by reviewing its financial statements is an important function of financial management. The accounting and regulatory authorities mandate the following four types of financial statements: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity.

Financial statement analysis is important for a number of reasons. First, the study of these accounting statements aids in assessing the financial condition of a business. Second, financial statements are a tool for managers to use in monitoring and controlling the firm’s operations. Third, financial planning and forecasting often is done through the medium of financial statements.

◼ Chapter Outline 3.1

An Overview of the Firm’s Financial Statements A. The four basic financial statements are: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity.

B. Accountants use three fundamental principles when preparing a firm’s financial statements: 1. The revenue recognition principle 2. The matching principle 3. The historical cost principle

3.2

The Income Statement A. The income statement can be expressed as: Revenue − Expenses = Profits.

B. The income statement recognizes both cash and noncash expenses.

C. Firms must adhere to GAAP in constructing the income statement.

D. Corporate executives have an incentive to manage the firm’s earnings through earnings management.

3.3

Corporate Taxes A. Taxable income is referred to in the income statement as earnings before taxes which is equal to a firm’s net operating income less interests expenses.

B. When firms analyze the tax consequences of a new business venture, it is important to use the marginal tax rate rather than the average tax rate.

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3.4

The Balance Sheet

• Financial Management, Thirteenth Edition

A. The balance sheet is defined as: Total Assets = Total Liabilities + Total Shareholders’ Equity.

B. Total liabilities represent the total amount of money the firm owes to creditors.

C. Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

D. The balance sheet reflects the book value of the firm’s assets. This is usually not equal to the market value of the firm’s assets.

E. Assets: The lefthand side of the balance sheet shows what the firm owns. a. Total assets = current assets + fixed assets F.

Sources of Financing: The righthand side of the balance sheet shows where the funds came from to purchase assets. a. Liabilities = accounts payable + notes payable + long-term debt b. Stockholders’ equity = par value + paid-in capital + retained earnings

G. Net working capital is a simple measure of the firm’s liquidity. a. Working capital = current assets − current liabilities 3.5

The Cash Flow Statement A. Change in Cash Balance = Ending Cash Balance − Beginning Cash Balance.

B. A source of cash is any activity that brings cash into the firm.

C. A use of cash in any activity that causes cash to leave the firm.

D. Sources and uses of cash are classified into three broad categories: operating activities, investment activities, and financing activities.

E. A popular indication of earnings quality is the quality of earnings ratio. a. Quality of earnings ratio = cash flow from operations / net income.

◼ Learning Objectives 3-1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager.

3-2. Evaluate firm profitability using the income statement.

3-3. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

3-4. Use the balance sheet to describe a firm’s investments in assets and the way it has financed them.

3-5. Identify the sources and uses of cash flow for a firm using the firm’s cash flow statement.

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Chapter 3

Understanding Financial Statements, Taxes, and Cash Flows

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◼ Lecture Tips 1.

Have the students complete the Business of Life: Your Personal Balance Sheet and Income Statement.

Use this as an introduction to the discussion of financial statements.

2.

Describe some of the alternatives to GAAP.

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Questions for Further Class Discussion

1.

What is the significance of a positive net working capital? Of a negative net working capital? Of a zero net working capital?

2.

Discuss the ways in which managers can “manage the firm’s earnings.” Should earnings management always be viewed negatively?

3.

Discuss some of the ways that a firm’s quality of earnings might be low.

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End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 3, 9, 10

4, 5, 7, 8, 11, 12, 16

6, 13, 14, 15, 17

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 3-1—3-16

◼ Internet Resources http://finance.yahoo.com http://money.cnn.com http://www.smartmoney.com www.fool.com www.google.com/finance

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Chapter 4 Financial Analysis—Sizing Up Firm Performance ◼ Chapter Overview Financial statements analysis involves the process of extracting information from a firm’s financial statements in order to evaluate the firm’s financial performance. Analyzing past performance of a firm is a valuable tool in predicting future performance and cash flows. Financial analysis is important to a variety of constituencies, including managers, lenders, suppliers, credit-rating agencies, and investors.

This chapter will develop a number of key types of statements and measures that are valuable in performing a financial analysis. Common-size statements standardize financial statements to allow for comparison. Financial ratios are developed to assess a firm’s liquidity, leverage, asset management efficiency, profitability, and market performance. The DuPont Method provides a way of analyzing the relationship among a number of key ratios and identifying key factors that affect firm performance. Two main types of benchmarks are used in analyzing a firm’s financial performance: trend analysis and peer group comparisons.

◼ Chapter Overview 4.1

Why Do We Analyze Financial Statements?

A. Financial analysis provides an internal tool to assess employee performance and to make interdivisional comparisons.

B. Financial analysis is performed by external parties to assess a firm’s credit standing and to provide input for investment decisions.

4.2

Common Size Statements: Standardizing Financial Information A. A common-size income statement expresses all entries in an income statement as a percent of sales.

B. A common-size balance sheet expresses all entries on a balance sheet as a percent of total assets.

4.3

Using Financial Ratios A. Financial ratios provide another method for standardizing the financial information in the income statement and balance sheet.

B. Liquidity ratios assess a firm’s ability to pay its bills as they come due.

1. The Current Ratio and Quick Ratio are measures of the firm’s overall liquidity.

2. Several ratios assess the liquidity of specific asset categories. These include: a. Average Collection Period b. Accounts Receivable Turnover Ratio c. Inventory Turnover Ratio d. Days’ Sales in Inventory 12 .

Chapter 4 Financial Analysis—Sizing Up Firm Performance

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C. Capital Structure Ratios indicate how the firm has financed the purchase of its assets using debt and equity funds.

1. The Debt Ratio measures the percentage of the firm’s assets that were financed using current plus long-term liabilities.

2. The Times Interest Earned Ratio measures a firm’s ability to service its debt.

D. Asset Management Efficiency Ratios analyze how efficient the firm’s management has been in utilizing its assets to generate sales.

1. Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in the firm’s assets.

2. Fixed Asset Turnover Ratios measures the amount of sales generated per dollar invested in the firm’s fixed assets.

E. Profitability Ratios determine if the firm has earned adequate returns on its investments.

1. Gross Profit Margin assesses the cost of goods sold and markups of the firm.

2. Operating Profit Margin tells managers how much profit they generated from each dollar of sales after accounting for both costs of goods sold and operating expenses.

3. Net Profit Margin identifies how much of each dollar of sales the firm has after paying all of its expenses.

4. Operating Return on Assets Ratio considers management’s success in controlling expenses and its efficient use of assets to generate firm sales.

5. Return on Equity determines the earnings available for distribution to the firm’s shareholders.

6. The DuPont Method is a way to decompose Return on Assets and Return on Equity into component parts.

F.

4.4

Market Value Ratios examine how a firm’s shares are valued in the stock market.

1. Price-Earnings Ratio indicates how much investors have been willing to pay for $1 of reported earnings.

2. Market-to-Book Ratio compares the market’s valuation of the firm to the accumulated investment made by the shareholders in the firm.

Selecting a Performance Benchmark A. Trend analysis compares a firm’s recent financial ratios with its past financial ratios and provides insight into whether the firm is improving or deteriorating in its financial performance over time.

B. Peer firm comparisons compare a firm’s performance to that of a relevant peer group of firms.

This is often done using industry average financial ratios.

4.5

Limitations of Ratio Analysis A. Financial analysts must be aware of a number of limitations in performing financial analysis for a firm.

◼ Learning Objectives 4-1. Explain what we can learn by analyzing a firm’s financial statements.

4-2. Use common size financial statements as a tool of financial analysis.

4-3. Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.

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4-4. Select an appropriate benchmark for use in performing a financial ratio analysis.

4-5. Describe the limitations of financial ratio analysis.

◼ Lecture Tips 1.

Use a flowchart to show how the DuPont Method incorporates all ratios.

2.

Rather an using the example in the book, select a real-world firm and give students a copy of the income statement and balance sheet for this firm. As a class, calculate the ratios from these statements. An example is the Mini Case at the very end of the chapter.

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Questions for Further Class Discussion

1.

Discuss which ratios would be particularly useful to creditors, managers, shareholders, and bondholders.

2.

How would one use industry ratios and peer comparisons when the firm you are analyzing is the industry leader? When the firm you are analyzing is an average-size firm in this market?

3.

Discuss the difficulty in using published industry average when analyzing a firm that competes in multiple industries.

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

6, 13, 14, 15, 16, 18

1, 2, 3, 4, 5, 7, 8, 9, 10, 11, 12, 17, 19, 20, 21, 22, 23, 25, 29

24, 26, 27, 28, 30, 31, 32, 33, 34, 35, 36

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 4-1—4-36

◼ Internet Resources www.google.com/finance www.finance.yahoo.com

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Chapter 5 Time Value of Money—The Basics ◼ Chapter Overview Time value of money is one of the most important concepts in finance. The basic premise of time value of money problems is that time impacts the value of a dollar. That is, a dollar received today is worth more than one received in the future. The principles of time value of money are used in a variety of applications in finance, including capital budgeting, capital structure, cost of capital, and working capital management decisions.

This chapter explores time value of money concepts as they apply to a lump sum or single cash flow.

Future value is the value of a sum of money compounded at a given interest rate for a specific period of time. Present value is the current value of a sum of money to be received at a specified time in the future, given a stated rate of interest.

◼ Chapter Outline 5.1

Using Timelines to Visualize Cash Flows A. A timeline identifies the timing and amount of a stream of payments, along with the interest rate it earns.

B. Timelines are the first step in visualizing and solving time value of money problems.

5.2

Compounding and Future Value A. Simple versus Compound Interest 1. Simple interest is the interest earned on the principal amount.

2. Compound interest is the interest earned on both the initial principal amount and on reinvested interest from previous periods.

B. Future Value is the value of a current sum of money at a time in the future, given a specified compound interest rate.

1. The future value of an investment grows with the number of periods it is compounded; the longer the time, the larger the future value.

2. The future value increases with the level of the rate of interest; the higher the interest rate, the larger the future value.

C. Compounding principles can be applied to things other than money.

1. Compounding applies to anything that grows.

2. Examples include sales, population, inflation rates, etc.

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Titman/Keown/Martin

5.3

Discounting and Present Value A. Present value is the value today of a future cash flow.

1. The process of discounting involves determining the present value of an expected future cash flow, given a specified rate of interest.

2. Present value decreases as the number of periods until the payment is received is increased.

3. Present value decreases as the interest rate increases.

B. Present value techniques can be used to solve problems for either the number of periods or interest rate to reach a future value.

5.4

Making Interest Rates Comparable A. Annual Percentage Rate (APR) is the amount of interest rate paid or earned without compounding.

APR = Interest Rate per Period  Compounding Periods B

Effective Annual Rate (EAR) is the annual compounded rate that produces the same return as the nominal, or stated, rate.

EAR = (1 + Quoted Annual Rate/Compounding Periods per year)m − 1

C. Continuous Compounding occurs when the time intervals between when interest is paid is infinitely small.

◼ Learning Objectives 5-1. Construct cash flow timelines to organize your analysis of problems involving the time value of money 5-2. Understand compounding and calculate the future value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet.

5-3. Understand discounting and calculate the present value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet.

5-4. Understand how interest rates are quoted and know how to make them comparable.

◼ Lecture Tips 1.

Introduce Future Value by looking at a variety of examples: a. Population growth b. Weight change c. Salary over a lifetime d. Prices given a constant inflation rate

2.

Use the Rule of 72 to explore how the growth rate significantly affects the time for a quantity to double.

Vary the growth rate to see how doubling is affected for such examples as population, sales, prices, etc.

3.

Use ads from various financial institutions showing interest rates on CDs to illustrate the concepts of APR and EAR.

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Chapter 5

Time Value of Money—The Basics

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Questions for Further Class Discussion

1.

What is the relationship between present value and future value?

2.

Explain what is meant by continuous compounding? How can compounding occur continuously?

3.

When you graduate from college, you are offered the choice between a job with a starting salary of $30,000 per year which grows annually at 6% or a job with a starting salary of $40,000 per year which grows annually at 4%. How would you determine which is the best job to take if you assume you will stay in this position for 5 years? At what growth rate would you be indifferent between the two positions?

◼

End-of-Chapter Problem Complexity Rating

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The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1,2, 4, 5,10, 17, 19-22, 29-30

3,6-9, 11, 13-16, 18, 23-24, 26, 27, 29-38

12, 25, 28,39,40

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 5-1—5-40

◼ Internet Resources http://antwrp.gsfc.nasa.gov/htmltest/gifcity/e.5mil http://tr.im/fabcam www.kiplinger.com/tools/index.html www.dinkytown.net www.bankrate.com/calculators.aspx www.interest.com www.predatorylendingassociation.com www.responsiblelending.org/payday-lending

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Chapter 6 The Time Value of Money—Annuities and Other Topics ◼ Chapter Overview An annuity is a regular cash payment that occurs over a period of time. An ordinary annuity is a series of equal dollar payments that are made at the end of equidistant points in time. An annuity due is an annuity in which all the cash flows occur at the beginning of the period. The future value of an annuity reflects the value in the future of a constant stream of payments. The present value of an annuity represents the current value of a stream of payments to be made in the future. An amortized loan is a loan paid off in equal payments. Therefore, the loan payments are an annuity. A perpetuity is a cash flow stream that continues forever and has no maturity or end date.

◼ Chapter Outline 6.1

Annuities A. An annuity in which the payments are made at the end of each period is known as an ordinary annuity.

1. The future value of an annuity reflects the value in the future of a constant stream of payments.

2. The present value of an annuity reflects the current value of a constant stream of payments.

3. An annuity can be solved using mathematical formulas, a financial calculator, or an Excel spreadsheet.

B. An amortized loan is a loan paid off in equal payments; therefore, the loan payments are an annuity.

C. An annuity due is an annuity in which all the cash flows occur at the beginning of the period.

6.2

Perpetuities A. A perpetuity is simply an annuity that continues forever or has no maturity.

1. In a level perpetuity, the payments are constant over time.

2. A growing perpetuity is one in which the payments grow at a constant rate from period to period over time.

B. Most often, one is concerned with the present value of a perpetuity.

6.3

Complex Cash Flow Streams A. Actual investment cash flows are often more complex and may consist of multiple sets of annuities or different cash flow amounts mixed in with annuities.

B. In general, all cash flows must be brought to a common timeframe in order to be compared.

In most cases the common timeframe is the present.

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Chapter 6

The Time Value of Money—Annuities and Other Topics

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◼ Learning Objectives 6-1. Distinguish between an ordinary annuity and an annuity due, and calculate present and future values of each.

6-2. Calculate the present value of a level perpetuity and a growing perpetuity.

6-3. Calculate the present and future value of complex cash flow streams.

◼ Lecture Tips 1.

As an in-class exercise, develop a “class retirement” plan. Decide on a consensus retirement income, a reasonable rate of return, a retirement age, and number of years in retirement. Have the class solve this problem together. As an alternative perhaps work through the Mini-Case at the end of the chapter.

2.

Illustrate the power of making more frequent payments when paying off a mortgage or student loans.

For example, how many years will it take to pay off a student loan if payments are made semi-monthly rather than monthly? Another example would be to explore how adding an extra amount to each payment can significantly reduce the payback period for a mortgage or other loan.

◼

Questions for Further Class Discussion

1.

What are some examples of growing annuities or growing perpetuities?

2.

What are some examples of annuities due?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 3, 5, 6, 7, 8, 10, 11, 15, 17, 19, 25, 29, 30, 34, 42, 43, 44, 45

4, 9, 12, 13, 14, 16, 18, 20, 21, 24, 26, 27, 28, 31, 32, 35, 36, 37, 38, 41, 46, 47, 48, 49, 50, 51, 58, 59

22, 23, 33, 39, 40, 52, 53, 54, 55, 56, 57, 60

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 6-1—6-16, 6-33—6-41, 6-48—6-57

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Chapter 7 An Introduction to Risk and Return—History of Financial Market Returns ◼ Chapter Overview This chapter introduces the concepts of risk and return as used in finance. In general, there is a risk-return tradeoff; that is, more risky investments are expected to realize higher returns on average. Various statistical measures aid in developing measures of risk and return.

Realized return is the gain or loss we actually experience on a stock during a period. Expected return is an average over the range of possible realized returns. Risk is measured by the variability in the returns on the stock. As such, this variability is captured by the standard deviation or variance of returns over the range of possible realized returns.

Historical returns offer insight into the risk-return tradeoff. In general, riskier investments have historically realized higher returns. Further, the historical returns of the higher-risk investment classes have higher standard deviations—i.e., risk.

The Efficient Markets Hypothesis states that security prices accurately reflect future expected cash flows and are based on all information available to investors. Three forms of market efficiency are explored: Weak-Form Efficiency, Semi-Strong-Form Efficiency, and Strong-Form Efficiency.

◼ Chapter Overview 7.1

Realized and Expected Rates of Return and Risk A. The gain or loss on a stock that we actually experience during a period is called the realized rate of return.

1. This return consists of both dividend payments and capital gains (loss).

2. This can be positive or negative for any period.

B. The expected rate of return is the weighted average of the possible returns where each possible return is weighted by the probability that it occurs.

C. Risk is measured by calculating the variance of the possible rates of return.

7.2

A Brief History of Financial Market Returns A. The riskiest investment class is comprised of International stocks followed by U.S. stocks, then corporate bonds, U.S. government bonds, and Treasury bills.

B. The historical returns of the higher-risk investment classes have higher standard deviations.

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Chapter 7

7.3

An Introduction to Risk and Return—History of Financial Market Returns

21

C. A similar risk-return tradeoff is found in international investing: Returns and risk are higher for emerging markets stocks compared to equities of developed countries.

Geometric vs. Arithmetic Average Rates of Return A. To find the arithmetic average of rates of return, add the rates together and divide by the number of observations.

1. The arithmetic average should be used to determine the rate of return to expect for the next year.

2. This measure is only appropriate when we are considering future periods that are equal in duration to the past periods used in calculating this measure.

B. The geometric average answers the questions, “What was the growth rate of your investment?”

1. The geometric average is used to answer the question, “What annual rate of return can we expect over a multi-year horizon?”

7.4

What Determines Stock Prices?

A. An efficient market is a market in which all the available information is fully incorporated into the prices of the securities, and the returns investors earn on their investments cannot be predicted.

B. There are three types of market efficiency: 1. Weak-Form Efficiency asserts that all past security market information is fully reflected in security prices.

2. Semi-Strong Form Efficiency asserts that all publicly available information is fully reflected in security prices.

3. Strong-Form Efficiency asserts that all information, public and private, is fully reflected in security prices.

◼ Learning Objectives 7-1. Calculate realized and expected rates of return and risk.

7-2. Describe the historical pattern of financial market returns.

7-3. Compute geometric (or compound) and arithmetic average rates of return.

7-4. Explain the efficient market hypothesis and why it is important to stock prices.

◼ Lecture Tips 1.

Use real-world information on a variety of stocks to calculate the holding-period returns over a given timeframe. This could be done by accessing an internet site during class.

2.

Discuss some ways that investors can invest in international stocks.

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◼

Questions for Further Class Discussion

1.

Looking at Figure 7-4, analyze the comparative levels of risk and return for the various areas of the world. Can the risk-return tradeoff fully explain the magnitude of the differences in return for these various regions?

2.

As an investor, what would you see as the pros and cons of international investment?

3.

What does the financial crisis of 2008 suggest about market efficiency?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 3, 4, 5

2, 6, 7, 8, 9

10

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 7-1—10

◼ Internet Resources http://www.rce.rutgers.edu/money/riskquiz

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Chapter 8 Risk and Return—Capital Market Theory ◼ Chapter Overview A key principle explained in this chapter is that with appropriate diversification, an investor can lower the risk of his/her portfolio without lowering the portfolio’s expected rate of return. The expected return for a portfolio is the weighted average of the expected rates of return of the individual investments in that portfolio. However, the risk of a portfolio is not simply the weighted average of the standard deviations of the individual investments. Rather, diversification—i.e., combining investments which are less than perfectly positively correlated—can result in a decrease in overall risk.

Risk can be divided into diversifiable and nondiversifiable risk. Investors are assumed to combine securities into a portfolio in such a way as to diversify away all diversifiable risk. They are left then with only nondiversifiable risk. The Capital Asset Pricing Model (CAPM) is a major theory in finance.

This theory suggests that beta is the appropriate measure of a stock’s nondiversifiable or systematic risk.

Further, the higher the stock’s beta, the higher rate of return will be for this security.

◼ Chapter Outline 8.1

Portfolio Returns and Portfolio Risk A. The expected rate of return for a portfolio of investments is a simple weighted average of the expected rates of return of the individual investments in the portfolio.

B. Portfolio risk depends on the standard deviation of the returns of the investments in a portfolio and on the correlation among these investments.

1. Diversification encompasses combining investments into a portfolio that are not perfectly positively correlated.

2. The correlation coefficient measures the degree to which the returns on two investments are correlated.

3. The correlation coefficient measures the strength of the linear relationship between two assets and takes on a range between +1.0 and −1.0.

8.2

Systematic Risk and the Market Portfolio A. The Capital Asset Pricing Model (CAPM) asserts that investors choose to hold the optimally diversified portfolio that includes all risky investments—i.e., the market portfolio.

1. Systematic risk measures the component of risk that contributes to the risk of the market.

This is nondiversifiable risk.

2. Unsystematic risk is the element of risk that does not contribute to the risk of the market.

This is diversifiable risk.

3. Beta is the measure of a stock’s systematic risk.

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8.3

The Security Market Line and the CAPM A. A key insight of the CAPM is that investments with the same beta have the same expected rate of return.

B. The security market line expresses the relationship between a security’s beta and its required rate of return: Expected return = rrisk-free + beta (rmarket − rrisk-free).

C. Since systematic risk cannot be eliminated through diversification and must be borne by the investor, this is the source of risk that is reflected in expected returns.

◼ Learning Objectives 8-1. Calculate the expected rate of return and volatility for a portfolio of investments and describe how diversification affects the returns to a portfolio of investments.

8-2. Understand the concept of systematic risk for an individual investment and calculate portfolio systematic risk (beta).

8-3. Estimate an investor’s required rate of return using the Capital Asset Pricing Model.

◼ Lecture Tips 1.

Often students have difficulty understanding how diversification leads to a reduction in risk without a change in return. It is helpful to go through an extended two-stock example. Keep the returns, weights, and standard deviations all constant and vary only the correlation coefficient. This helps students understand the actual dynamics of diversification.

2.

Explain why the beta of the market is 1.0. That is, how beta captures the covariance of a security relative to the market.

◼

Questions for Further Class Discussion

1.

Discuss some of the limitations of the CAPM.

2.

Identify and describe some of the alternatives to the CAPM—e.g., Arbitrage Pricing Model and the Fama/French Model.

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple

Average

Complex

1, 2, 12, 13, 16, 17

3, 4, 5, 6, 7, 8, 9, 10, 11, 14, 15, 18, 20, 22, 23, 24, 26, 27

19, 21, 25

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Risk and Return—Capital Market Theory

25

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 8-1—8-12, 8-15—8-16, 8-19—8-20, 8-22—8-27

◼ Internet Resources www.yahoofinance.com www.moneycentral.com www.MSN.com

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Chapter 9 Debt Valuation and Interest Rates ◼ Chapter Overview Debt financing is an important source of funds for businesses. Firms borrow from commercial banks and also sell their debt publicly on capital markets. This chapter explores two major topics: the valuation of bonds and other debt instruments, and the determinants of interest rates.

Debt can be obtained in private financial markets and on public exchanges. There is a wide variety of debt instruments, differing in terms of maturity, seniority, ratings, special provisions, and interest payments.

The value of any debt instrument is the present value of its future cash flows. For most bonds, future cash flows consist of the maturity value and, in the case of coupon bonds, periodic interest payments. There are four key relationships in bond valuation: 1) the value of a bond is inversely related to changes in the yieldto-maturity; 2) changes in interest rates over time affect the current value of a bond; 3) as the maturity date approaches, the market value of a bond approaches its par value; and 4) long-term bonds have greater interest rate risk than short-term bonds.

A variety of factors affect interest rates. First, the real rate of interest and the level of inflation are determinants of interest rates. Second, interest rates are affected by the risk of default. Third, the term to maturity is a key factor affecting interest rates.

◼ Chapter Overview 9.1

Overview of Corporate Debt A. Firms can borrow money in private financial markets through various types of financial institutions.

1. These can be floating-rate loans or fixed-rate loans.

2. Funds can be used for working capital or transactions.

3. Debt can be secured or unsecured.

B. Firms can borrow in the public financial market by issuing corporate bonds. These bonds differ on a variety of features.

1. A bond indenture is the legal agreement between the firm and the bond trustee who represents the bondholders.

2. Bondholders have a claim on the firm’s assets that must be honored before those of the shareholders.

3. The par value of a bond is the amount that must be repaid to the bondholder at maturity.

4. The coupon rate of interest indicates the percentage of the par value of the bond that will be paid out annually in the form of interest.

5. The bond’s maturity is the time until the bondholders receive the par value back and the bond is terminated.

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6.

7.

Debt Valuation and Interest Rates

27

Some bonds have special features, including a call provision or conversion feature.

Bond ratings reflect the bond’s risk of default.

B. Firms usually issue public debt through an investment banker who specializes in underwriting, distributing new securities and advising issuers on a number of issuance matters.

9.2

Valuing Corporate Debt A. The value of a bond is the present value of the principal and interest payments (i.e., cash flow) discounted back to the present using the market’s required yield.

9.3

Bond Valuation: Four Key Relationships B. There are four key relationships in bond valuation.

1. The value of a bond is inversely related to changes in the yield to maturity.

2. The market value of a bond will be less than the par value if the yield to maturity is above the coupon interest rate and will be valued above par value if the yield to maturity is below the coupon interest rate.

3. As the maturity date approaches, the market value of a bond approaches its par value.

4. Long-term bonds have greater interest rate risk than short-term bonds.

9.4

Types of Bonds A. There are a variety of types of bonds depending on their characteristics.

9.5

Determinants of Interest Rates A. Interest rates are affected by the real rate of interest and the inflation premium.

B. The risk of default is the possibility that the bond issuer will fail to repay the borrowed amount.

A premium is added to interest rates to reflect the risk of default.

C. The longer the bond’s maturity, the more the bond price fluctuates when interest rates change.

A maturity premium reflects this risk.

1. The Term Structure of Interest Rates reflects the relationship between time to maturity and interest rates, holding all other variables constant.

2. The shape of the yield curve can be a barometer of expectations concerning the economy.

◼ Learning Objectives 9-1. Identify the key features of bonds and describe the difference between private and public debt markets.

9-2. Calculate the value of a bond and relate it to the yield to maturity on the bond.

9-3. Describe the four key bond valuation relationships.

9-4. Identify the major types of corporate bonds.

9-5. Explain the effects of inflation on interest rates and describe the term structure of interest rates.

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◼ Lecture Tips 1.

Often students have difficulty with the concept of coupon rate and yield to maturity and understanding causes of interest rate changes over time. It might be useful to explore various conditions that would cause interest rates to change; for example, changes in the economy, changes in monetary policy, supply/demand conditions in credit markets, factors specific to the firm, etc.

2.

Describe and discuss some of the types of covenants that might be put into an indenture agreement.

◼ Further Questions for Class Discussion 1.

In what type of economic circumstances would a call feature be beneficial to a firm? In what ways does it increase risk for the bondholder?

2.

When would a convertibility feature be exercised by a bondholder?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple 3, 4, 5, 23, 24, 25

◼

Average

Complex

1, 2, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 20, 21, 22

18, 19

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 9-1—9-25

◼ Internet Resources www.bondsonline.com/Todays_Market/Corporate_bond_Spreads.php

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Chapter 10 Stock Valuation ◼ Chapter Overview Common stock represents ownership of the corporation. The characteristics of common stock include that it is permanent—i.e., it has no maturity date; its dividends are not set but can vary; common stockholders have voting rights; and the claim of stockholders on the firm’s assets is junior to other stakeholders.

There are several ways in which the value of common stock can be determined. One approach is the Discounted Dividend Model. Using this approach, common stock is valued by discounting the dividend stream that the firm is expected to pay to its shareholders. Alternative methods of common stock valuation involve a comparables approach. One such model is the P/E Ratio Valuation Model.

Preferred stock is a hybrid security that shares some of the features of bonds and common stock. For preferred stock, the dividend is fixed and owners of this type of security have no voting rights. Claims on the firm’s assets for preferred stockholders are junior to debt securities but senior to common stock. Since the dividend for preferred stock can be viewed as a perpetuity, valuation of preferred stock is found by finding the present value of this constant dividend stream.

◼ Chapter Outline 10.1 Common Stock A. There are a number of characteristics of common stock.

1. Common stock has no maturity date—i.e., it is a form of permanent financing.

2. Dividends for common stock can vary.

3. Common stockholders have voting rights.

4. Claims of common stockholders are junior to those of bondholders and preferred stockholders.

B. Agency problems often exist between the firm’s stockholders and the managers of the firm.

C. Several methods of valuation can be used for common stock.

1. Using the Discounted Dividend Model, the value of common stock is equal to the present value of the dividend stream that the firm is expected to pay to its shareholders. a. Dividends are discounted at the investor’s required rate of return. b. Dividends are sometimes assumed to grow at a constant rate.

2. The Comparables Approach to Valuing Common Stock is used when some inputs are not known. a. One frequently used comparables approach is the P/E Ratio Valuation Model.

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10.2 The Comparables Approach to Valuing Common Stock A. The basis of the Comparables Approach is to estimate common stock value when some inputs necessary for other methods are not known.

B. This method estimates the value of the firm’s stock as a multiple of some measure of firm performance.

1. One frequently used comparables approach is the P/E Ratio Valuation Model.

2. Other measures used to determine the value of common stock using this approach include: EPS, book value per share, sales per share, or cash flow per share.

10.3 Preferred Stock A. Preferred stock is a hybrid security that shares some of the features of bonds and common stock.

1. Preferred stock pays a contractually stated cash dividend.

2. Preferred stock has no maturity date.

3. There are no voting rights for preferred stock holders.

4. Claims of preferred stockholders are junior to bondholders, but senior to those of common stockholders.

B. Since preferred stocks are perpetuities and the cash dividend is the same every period, preferred stock can be valued as the present value of a level perpetuity.

◼ Learning Objectives 10-1.

Identify the basic characteristics and features of common stock and use the discounted cash flow model to value common shares.

10-2.

Use the price to earnings (P/E) ratio to value common stock.

10-3.

Identify the basic characteristics and features of preferred stock and value preferred shares.

◼ Lecture Tips 1.

Real-world data concerning the growth rates for firms and the growth in dividends would be useful for helping students understand the various components of the Discounted Dividend Model. One might access this information from various sources including: www.yahoofinance.com, www.valueline.com, www.reuters.com, etc.

2.

When introducing preferred stock, include a discussion of why firms would choose to issue preferred stock rather than common stock.

◼

Questions for Further Class Discussion

1.

Introduce the topic of stock valuation when a firm is not expected to grow and its dividend is constant.

2.

The Comparables approach can be used for valuation of small firms that are not publically traded.

Explore how this technique could be used for in these situations.

.

Chapter 10

◼

Stock Valuation 31

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple 1, 2, 3, 15, 16, 17, 19

◼

Average

Complex

4, 5, 6, 7, 8, 12, 18

9, 10, 11, 13, 14

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 10-3—10-14

◼ Internet Resources www.wsj.com www.smartmoney.com www.marketwatch.com

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Chapter 11 Investment Decision Criteria ◼ Chapter Overview Capital Budgeting is the term used to refer to the process used to evaluate a firm’s long-term investment opportunities. A number of steps are involved in the capital budgeting process. These include identifying promising investment opportunities and evaluating the value-creating potential of these opportunities. Net Present Value (NPV) is the “holy grail” of criteria for evaluating new investment opportunities. It incorporates the four principles of finance: 1) cash flows are a course of value; 2) money has time value; 3) there is a risk-reward tradeoff; and 4) market prices reflect information. Other investment criteria include the Profitability Index (PI), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Payback Period, and Discounted Payback Period.

◼ Chapter Outline 11.1 An Overview of Capital Budgeting A. Capital investment projects can be classified into three broad categories.

1. Revenue-enhancing investments often involve the expansion of existing businesses.

2. Cost-reduction investments are aimed at reducing the cost of doing business.

3. Mandated investments are often require capital investments to meet safety and environmental regulations.

11.2 Net Present Value A. Net Present Value (NPV) is the difference between the present value of the cash inflows and the cash outflows from an investment project.

1. NPV estimates the value or wealth created by investment in a project.

2. A project is accepted if NPV is positive and rejected if NPV is negative.

B. Since NPV is an estimate of the impact of the investment opportunity on the value of the firm, it is the right criterion for evaluating a project.

1. The following steps are used to determine the NPV of a project: a. Determine the initial cash flow for the project. b. Determine the expected cash flows for the project over its expected life. c. Determine the discount rate to calculate the present value of the project’s expected future cash flows. d. Find the difference between the initial cash flow and the present value of the expected future cash flows. e. Accept the project if NPV > 0; reject if NPV < 0. f. Note that a zero NPV project earns the required rate of return on a project.

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33

C. Investment projects can be classified as either Independent or Mutually Exclusive.

1. An independent project can stand alone and can be undertaken without influencing the acceptance or rejection of any other project.

2. Acceptance of a mutually exclusive project prevents another project from being accepted.

Mutally exclusive projects often arise in two situations: a. Projects are substitutes. b. Firm constraints (e.g., limited managerial time, limited financial capital) limit the ability to take every project that has a positive NPV. 11.3 Other Investment Criteria A. The Profitability Index (PI) is a cost-benefit ratio equal to the present value of an investment’s future cash flows divided by its initial cost.

1. A PI greater than one indicates that the present value of the investment’s future cash flows exceeds the cost of making the investment, and the investment should be accepted.

B. Internal Rate of Return (IRR) is the discount rate that results in a zero NPV for a project.

1. Accept the project if the IRR is greater than the discount rate used to calculate the NPV of the project; reject it otherwise.

2. Complications can arise from using the IRR when multiple rates of return exist.

3. IRR is often used to select between mutually exclusive investments.

4. The Modified Internal Rate of Return was developed to overcome some of the problems encountered with the IRR. C. The Payback Period for an investment opportunity is the number of years needed to recover the initial cash outlay required to make the investment.

1. The decision criteria for the payback method is to accept the project if the payback period is less than a pre-specified maximum number of years.

2. The payback method has a number of fundamental limitations that are addressed by using the Discounted Payback Decision Criteria.

11.4 A Glance at Actual Capital Budgeting Practices A. IRR and the NPV are the most widely used methods by chief financial officers.

B. Smaller firms often use the Payback method.

◼ Learning Objectives 11-1.

Understand how to identify the sources and types of profitable investment opportunities.

11-2.

Evaluate investment opportunities using net present value and describe why net present value is the best measure to use.

11-3.

Use the profitability index, internal rate of return, and payback criteria to evaluate investment opportunities.

11-4.

Understand current business practice with respect to the use of capital-budgeting criteria.

.

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◼ Lecture Tips 1.

Bring in a number of examples of independent and mutually exclusive projects that involve real firms.

2.

Estimate the NPV of a college education by estimating the future earning with and without a college education.

◼

Questions for Further Class Discussion

1.

Explore situations where a firm would want to use the Payback method. Can this method ever be justified as a valid criterion for making investment decisions?

2.

Examine the relationship between NPV and the PI.

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 3, 6, 7, 9, 10, 24

2, 4, 5, 8, 11, 12, 14, 15, 16, 17, 19, 20, 21, 22, 24, 25, 26

13, 18, 23, 27, Mini Cases

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 11-1—11-26

◼ Internet Resources www.infoplease.com

.

Chapter 12 Analyzing Project Cash Flows ◼ Chapter Overview This chapter describes and discusses the methods that can be used to develop cash flow forecasts. Incremental cash flows reflect the additional cash flow a firm receives from taking on a new project. This is the relevant cash flow when assessing a project for investment purposes. There are four steps in the procedure for calculating project cash flows. First, estimate a project’s operating cash flows. Second, calculate a project’s working capital requirements. Third, calculate a project’s capital expenditure requirements. Fourth, calculate a project’s free cash flow. Once all relevant cash flows are determined, one can compute the project’s NPV and determine if the project should be accepted.

◼ Chapter Outline 12.1 Project Cash Flows A. The cash flows from an investment project can be organized into one of three categories.

1. The initial outlays which are associated with launching a project.

2. The operating period cash flows which include all of the cash flows up until project termination.

3. The terminal cash flows which occur when a project is terminating.

B. The relevant cash flow from an investment project is the incremental cash flow—i.e., the additional cash flow a firm receives from taking on a new project.

C. There are a number of guidelines for determining the incremental cash flows.

1. Sunk costs are not incremental cash flows.

2. Overhead costs are generally not incremental cash flows.

3. If synergistic effects can be identified, their costs and benefits are relevant to the project analysis.

4. Opportunity costs must be considered in determining incremental cash flows.

5. Changes in working capital requirements are included as incremental cash flows.

6. Interest payments and other financing costs are ignored in determining incremental cash flows.

12.2 Forecasting Project Cash Flows A. Since depreciation is a non-cash outflow, it is added back into net operating income when calculating cash flows.

B. To estimate project cash flows for future periods, a four-step procedure is used.

1. Estimate a project’s operating cash flows. a. Estimate cash flow the firm earned from its operations and determine its tax liability based on net operating income. b. Add back depreciation expense since this is a non-cash outflow.

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2.

3.

4.

• Financial Management, Thirteenth Edition

Calculate a project’s working capital requirements. a. Examine the levels of accounts receivable, inventory, and accounts payable with and without the project.

Calculate a project’s capital expenditure requirements.

Calculate a project’s free cash flow.

C. Once all incremental cash flows are identified, the next step is to determine the Net Present Value of the project.

12.3 Inflation and Capital Budgeting A. Nominal cash flows are cash flows that account for future inflation.

B. These should be discounted at the nominal interest rate.

12.4 Replacement Project Cash Flows A. A replacement investment is an acquisition of a new projective asset that replaces an older, less projective asset.

1. Often a distinctive feature of a replacement investment is that the principal source of investment cash flows comes from cost savings, not new revenues.

B. The steps in determining the incremental cash flows for a replacement decision are the following.

1. Determine the initial outlay for the project. a. The cost of the replacement asset is included. b. Determine any tax effects from the sale of the existing asset.

2. Determine the annual cash flows associated with the replacement asset. a. Include in these cash flows any changes in depreciation and taxes. b. Include in these cash flows any changes in working capital. c. Include in these cash flows any additional capital spending.

◼ Learning Objectives 12-1.

Identify incremental cash flows that are relevant to project valuation.

12-2.

Calculate and forecast project cash flows for expansion-type investments.

12-3.

Evaluate the effect of inflation on project cash flows.

12-4.

Calculate the incremental cash flows for replacement-type investments.

◼ Lecture Tips 1.

Work through an example capital budgeting project using first straight-line depreciation and then an accelerated method. Discuss the differences in the cash flows and the effect on NPV. Can the choice of depreciation method affect whether or not a project is accepted?

2.

Use an example that students can relate to—for example, the decision of whether to repair a car or purchase a new car. What would the incremental cash flows be with each of these decisions?

.

Chapter 12

Analyzing Project Cash Flows

◼

Questions for Further Class Discussion

1.

Ask students to contact businesses in the region to determine how they make capital investment decisions. What criteria do they use? How do they determine incremental cash flows?

◼

End-of-Chapter Problem Complexity Rating

37

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 3, 4, 5, 6, 7, 12, 13, 26, 27

2, 8-11, 14-21, 25-32

22-25, Mini Cases

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 12-6—12-28, 12-30—12-32

.

Chapter 13 Risk Analysis and Project Evaluation ◼ Chapter Overview Often projects have risk levels that are different from that of the overall firm. Further, the projected cash flows for projects are estimates and can vary greatly for actual cash flows. For these reasons, it is useful to analyze the risk of project cash flows. There are a number of tools for analyzing this risk. Sensitivity analysis is designed to identify the most important forces that ultimately determine the success or failure of an investment. Scenario analysis is a second tool in which multiple scenarios are examined to determine a number of possible value drivers. Finally, simulation provides a robust approach to analyze a large number of possible scenarios.

Project risk can also be assessed using Break-Even Analysis. Real Options provides a way to analyze opportunities to change a project’s cash flow stream after it has begun.

◼ Chapter Outline 13.1 The Importance of Risk Analysis A. Risk Analysis is important because project cash flows are risky.

B. Risk Analysis is important because forecasts are made by humans who can be either too optimistic or too pessimistic when making their cash flow forecasts.

13.2 Tools for Analyzing the Risk of Project Cash Flows A. There are two concepts of importance in Risk Analysis.

1. The expected value of a future cash flow is a probability weighted average of all the possible cash flows that might occur.

2. Value drivers are the basic determinants of an investment’s cash flows and consequently its performance.

B. Sensitivity Analysis is the first tool for analyzing the risk of project cash flows.

1. Sensitivity Analysis occurs when a financial manager evaluates the effect of each value driver on the investment’s NPV. 2. Sensitivity Analysis involves changing only one value driver at a time and analyzing its effect on the investment NPV. C. Scenario Analysis is a second tool for analyzing the risk of project cash flows.

1. Scenario Analysis allows a financial manager to simultaneously consider the effects of changes in the estimates of multiple value drivers on the investment’s NPV. 2. Each scenario consists of a different set of estimates for the project value drivers.

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D. Simulation Analysis is the third tool for analyzing the risk of project cash flows.

1. Simulation Analysis provides the analyst with a powerful tool for generating thousands of estimates of NPV that are built upon thousands of values for each of the investment’s value drivers.

13.3 Break-Even Analysis A. Using Break-Even Analysis, managers are able to determine the minimum level of output or sales that the firm must achieve in order to avoid losing money.

B. Accounting Break-Even Analysis involves determining the level of sales necessary to cover total fixed costs; that is, both cash fixed costs and depreciation.

1. Fixed costs do not vary directly with sales revenues.

2. Variable costs vary with firm sales.

C. NPV Break-Even Analysis identifies the level of sales necessary to produce a zero level of NPV. 1. It focuses on cash flows, not accounting profits, to determine the break-even level.

D. The Degree of Operating Leverage (DOL) measures the impact of fixed and variable operating costs on the firm’s income.

1. Operating leverage results from the use of fixed costs in the operations of the firm and measures the sensitivity of changes in operating income to the change in sales.

2. The DOL is a measure of how a percentage change in sales results in a percentage change in NOI. 13.4 Real Options in Capital Budgeting A. Real Options are opportunities to alter the project’s cash flow stream after the project has begun.

B. There are several types of real options.

1. One Real Option involves delaying the launch of a project.

2. A second Real Option involves the option to expand a project.

3. A third Real Option concerns reducing the scale and scope of a project.

◼ Learning Objectives 13-1.

Explain the importance of risk analysis in the capital-budgeting decision-making process.

13-2.

Use sensitivity, scenario, and simulation analyses to investigate the determinants of project cash flows.

13-3.

Use break-even analysis to evaluate project risk.

13-4.

Describe the types of real options.

◼ Lecture Tips 1.

It is often difficult for students to understand the process for determining a probability distribution associated with a particular event. Begin the discussion of expected values by using examples students can relate to—e.g., the salary from their first job.

2.

When introducing the topic of simulation, discuss types of simulation models including Monte Carlo processes, Crystal Ball, etc.

.

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Questions for Further Class Discussion

1.

How might the size of the NPV of a project or the magnitude of a project’s IRR be interpreted as an offset to a project’s risk?

2.

Find a real-world example of a situation in which a firm had a real option for a project, and discuss the implications of this for the NPV of the project.

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 8, 12, 13

2, 3, 4, 5, 6, 9, 10, 11, 14, 15, 16

7, Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 13-1—13-3, 13-5—13-12, 13-14

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Chapter 14 The Cost of Capital ◼ Chapter Overview The cost of capital for a firm is a weighted average of the required returns of the securities that are used to finance the firm. Determining the weighted average cost of capital for a firm involves a three-step process.

First, the firm’s capital structure is defined. Second, the cost of each component’s sources of financing is estimated. Third, the cost of each component is weighted by its percent in the firm’s capital structure. If a firm has multiple divisions with different risk level, the weighted-average cost of capital is adjusted to reflect the risk characteristics of each particular unit.

◼ Chapter Outline 14.1 The Cost of Capital: An Overview A. The Weighted-Average Cost of Capital (WACC) is a weighted average of the required returns of the securities that are used to finance the firm.

B. A three-step procedure is used to estimate the WACC. 1. Define the firm’s capital structure.

2. Estimate the opportunity cost of each of the sources of financing.

3. Calculate the weighted average of the costs of each source of financing.

14.2 Determining the Firm’s Capital Structure Weights A. In theory, the weights used to calculate the WACC should be based on observed market prices for each of the firm’s securities multiplied by the number of outstanding securities.

B. In practice, capital structure weights are often calculated using market values for equity securities and book values for debt securities.

14.3 Estimating the Cost of Individual Sources of Capital A. The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm.

1. An estimate of the market’s required rate of return on a firm’s debt is provided by the yield to maturity on the firm’s outstanding debt.

2. A proxy for the yield to maturity on a firm’s debt is a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

3. Since interest payments are tax deductable, the cost of debt is adjusted to an after-tax basis.

B. The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock.

1. Since preferred stock pays a fixed dividend each period, the cost of preferred stock is the dividend as a percent of the current price for the firm’s preferred stock.

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• Financial Management, Thirteenth Edition

Since preferred stock dividends are not tax deductable, there is no adjustment to an aftertax basis.

C. The cost of equity capital is the rate of return investors expect to receive from investing in the firm’s stock.

1. There are two primary methods for determining the cost of equity. a. One approach is to use the Dividend Growth Model to determine the required rate of return on the firm’s equity. b. A second approach is to use the Capital Asset Pricing Model (CAPM) to determine the expected or required rate of return for a firm’s stock.

14.4 Summing up: Calculating the Firm’s WACC A. Market sourced data should be used for the weights and expected rate of return for debt, preferred equity, and common equity in the WACC calculation.

14.5 Estimating Project Costs of Capital A. Since finance theory suggests that the appropriate discount rate should take into account the opportunity cost of capital, it is appropriate that this cost should reflect the risk of the investment.

B. Divisional WACCs reflect the unique levels of risk of investment projects for that division.

1. The Pure Play approach to determining divisional WACCs involves identifying comparison firms to the firm’s division that operate only in this particular business area.

14.6 Flotation Costs and Project NPV A. Flotation costs will increase the firm’s WACC. B. An increase in the firm’s WACC will decrease the NPV of an investment project.

◼ Learning Objectives 14-1.

Understand the concepts underlying the firm’s overall cost of capital and the purpose for its calculation.

14-2.

Evaluate a firm’s capital structure, and determine the relative importance (weight) of each source of financing.

14-3.

Calculate the after-tax cost of debt, preferred stock, and common equity.

14-4.

Calculate a firm’s weighted average cost of capital.

14-5.

Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe the divisional cost of capital as a viable alternative for firms with multiple divisions.

14-6.

Adjust NPV for the costs of issuing new securities when analyzing new investment opportunities.

◼ Lecture Tips 1. Much of the discussion for determining the WACC is theoretical. A good exercise in class is to walk students through finding real data to determine the WACC for a firm. This would involve going to various Web sites that provide the inputs for the WACC.

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The Cost of Capital 43

2. The concept of the Pure Play approach may seem a bit complicated to the students without an example. It may be helpful to discuss a firm that anticipates opening a new division in the soft drink beverage industry and will therefore need to find the cost of capital for the firm’s new soft drink division.

◼

Questions for Further Class Discussion

1.

Discuss the concept of a firm’s “target” capital structure. How might this be determined?

2.

Why do retained earnings have a cost?

3.

What is the appropriate tax rate to use for a firm? How would this be determined?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 7, 9, 10, 11, 13, 14, 15, 16, 20, 21, 22, 23, 24

3, 4, 5, 6, 8, 12, 17, 18, 19, 25, 26, 27, 28, 29

Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 14-1—14-21, 14-23—14-29

.

Chapter 15 Capital Structure Policy ◼ Chapter Overview A firm’s capital structure is the mix of different sources of capital that it uses to finance its investments.

It is a critical determinant of both the rate of return earned from investing in the firm’s shares of common stock as well as the riskiness of the investment. Under very strict assumptions of the Modigliani and Miller Capital Structure Theorem, capital structure should be irrelevant to firm value. However, in reality capital structure does affect firm value. As the assumptions of the Modigliani and Miller (M&M) model are relaxed, the financing mix of the firm can affect its value.

◼ Chapter Outline 15.1 A Glance at Capital Structure Choices in Practice A. One of the primary duties of a financial manager is to raise capital to finance the firm’s investment.

B. A firm’s capital structure consists of owner’s equity and its interest-bearing debt.

1. Financial leverage refers to the amount of debt financing a firm uses in its capital structure.

2. Borrowing a portion of the firm’s capital at a fixed rate of interest provides the firm an opportunity to “leverage” the rate of return it earns on its total capital into an even higher rate of return on its equity capital.

15.2 Capital Structure Theory A. The Modigliani and Miller Capital Structure Theorem showed that under some ideal conditions, capital structure is irrelevant to firm value.

1. The assumptions of the M&M model are the following: a. The cash flows that a firm generates are not affected by how the firm is financed. b. Financial markets are perfect—i.e., there are no transactions costs, taxes, etc.

2. Since there are no taxes, the weighted average cost of capital is not affected by its capital structure.

3. Since the WACC is not affected by capital structure decisions, firm value will also not be affected by capital structure decisions.

B. In reality, capital structure does matter because the assumptions of the M&M model are violated.

1. Transactions costs can be important and can affect the component costs of capital.

2. In the real world, taxes exist and do affect to cost of debt. a. Since interest payments are tax deductible, the cost of debt is decreased because of this tax effect. b. In the absence of bankruptcy, the optimal capital structure would be 100% debt.

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3.

Consideration of the possibility of bankruptcy which can result from excessive debt financing and the potential costs of bankruptcy suggests that capital structure does impact firm value.

C. The managerial implications of capital structure theory are twofold.

1. High levels of debt can benefit firms by providing tax-deductible interest, which lowers the cost of capital, and the use of debt can align the incentives of managers with shareholders.

2. Higher levels of debt will increase the probability that a firm becomes financially distressed or bankrupt.

15.3 Why Do Capital Structures Differ across Industries?

A. Firms in industries that generate high levels of taxable income will benefit from debt financing more than firms in industries with low levels of taxable income.

B. Financial distress and bankruptcy costs differ in importance across industries.

15.4 Making Financing Decisions A. Financial managers will often benchmark or compare the firm’s capital structure to others in similar lines of business.

B. Managers will want to determine the effects of capital structure decisions on the level and volatility of the firm’s reported earnings per share (EPS).

1. This involves determining the financial leverage effect.

2. Increasing financial leverage, holding everything else the same, leads to greater volatility in EPS. C. Managers often adhere to a Pecking Order when they raise capital.

D. Managers need to assess whether or not the firm can afford more debt.

1. Times Interest Earned ratios are a tool for determining serviceable debt loads.

E. Leasing has the same effect on the firm’s capital structure as issuing debt to finance an asset.

◼ Learning Objectives 15-1.

Describe a firm’s capital structure.

15-2.

Explain why firms have different capital structures and how capital structure influences a firm’s weighted average cost of capital.

15-3.

Describe some fundamental differences in industries that drive differences in the way they finance their investments.

15-4.

Use the basic tools of financial analysis to analyze a firm’s financing decisions.

◼ Lecture Tips 1.

Often students will question whether the M&M theory is a relevant starting point for discussing capital structure theory. It is useful to help students understand how it is important to first explore this ideal situation before moving on to the situation in the real world.

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Questions for Further Class Discussion

1.

How can changes in a firm’s capital structure provide signals to investors in a market?

2.

Explore the upsides and downsides to the use of financial leverage.

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

2, 4, 7, 9

1, 3, 5, 6, 11, 12, 13, 14

8, Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 15-1—15-10

.

Chapter 16 Dividend Policy and Share Repurchase Policy

◼ Chapter Overview Cash distributions by a firm to its shareholders can take the form of either cash dividends or a share repurchase. A firm’s dividend policy determines how much cash will be distributed to shareholders and when these distributions will be made. Dividends are paid to all shareholders. On the other hand, only those shareholders who sell their shares have a cash inflow from share repurchase.

Dividends can also take the form of stock—i.e., a stock dividend. Stock dividends and stock splits have the same effect. That is, both increase the number of shares outstanding, and therefore decrease the share price.

Neither the timing of the payment of cash dividends nor the form of the payment has an effect on firm value. In most cases, firms opt for a stable dividend payout ratio.

◼ Chapter Overview 16.1 How Do Firms Distribute Cash to Their Shareholders?

A. Cash dividends are a direct payment of cash to shareholders.

1. The dividend payout ratio is the fraction of firm earnings paid in the form of cash dividends.

2. For the most part, firms follow a stable dividend payout policy over time.

3. Dividends are generally paid on a quarterly basis.

B. Stock repurchases on the part of a firm occurs when a firm uses its cash to buy back its own shares from the marketplace, thereby reducing the number of shares outstanding.

1. Most often, share repurchase is done through open market repurchase.

2. A second method of share repurchase is a tender offer in which a firm buys a specified number of shares at a stated price.

C. A stock dividend is a pro-rata distribution of additional shares of stock to a firm’s current stockholders.

D. A stock split is a very large stock dividend in which the existing number of shares is increased by some set multiple.

16.2 Does Dividend Policy Matter?

A. Dividends are irrelevant under a certain set of circumstances.

1. If there are not taxes, dividends do not matter.

2. It there are not transactions costs, dividends are irrelevant.

3. Dividends are irrelevant if the firm’s operating and investment policies are fixed.

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B. Whether the dividend payment comes in the form of a cash dividend or a share repurchase is irrelevant.

1. Tax policy can influence an investor’s preference for capital gains income through the repurchase of shares compared to dividend income from a cash dividend.

C. Dividend policy is important for a number of reasons.

1. There is a clientele effect from dividends; different dividend policies attract different groups of investors who prefer the firm’s cash distribution policy.

2. Information is conveyed to the market by dividend and share repurchase announcements.

16.3 Cash Distribution Policies in Practice A. Executives try to maintain a stable dividend payout from year to year.

B. Various factors affect a firm’s dividend payout policy.

1. The liquidity position of the firm is important in determining dividend payout.

2. The availability of other sources of funds is an important determinant of a firm’s dividend payout policy.

3. A firm’s future earnings are important in determining dividend policy.

◼ Learning Objectives 16-1.

Distinguish between the use of cash dividends and share repurchase.

16-2.

Understand the tax treatments of dividends and capital gains, stock dividends and stock splits, and the conditions under which dividend policy is an important determinant of stock value.

16-3.

Describe corporate dividend policies that are commonly used in practice.

◼ Lecture Tips 1.

Ask students to use information from the WSJ or other business publication to identify firms that are currently paying dividends. Determine if these firms have had a stable dividend payout policy or if dividends have varied substantially.

2.

Discuss industries that have higher proportions of their firms that pay dividends. Explore possible reasons for any patterns that are identified.

3.

Discuss any clientele effects that should be considered when a firm evolves from a high growth firm to a slower growth firm that wants to begin paying regular cash dividends.

◼

Questions for Further Class Discussion

1.

The “baby boomer” generation is getting close to retirement. Will this have any impact on investors’ preferences for dividends? How might firms respond to this?

2.

Ask students under what circumstances they would have a preference for dividends.

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End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 3, 5

4, 6, 7, 8, 9, 10, 11

12, 13, Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 16-1—16-2, 16-5, 16-8—16-13

◼ Internet Resources www.wellsfargo.com/com/shareownder_services/services_for_shareholders/investment_plans

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Chapter 17 Financial Forecasting and Planning ◼ Chapter Overview The primary objective of financial planning is to estimate the future financing requirements of a firm in advance of when the financing is needed. Financial planning also forces management to think systematically about the future and to develop contingency plans that allow them to respond to challenges and opportunities.

Financial planning can be either short-term or long-term in perspective. The long-term financial planning process spans a three- to five-year planning horizon and estimates future income statements and balance sheets for a firm. The short-term financial plan spans a one-year period. The primary short-term planning tool is the cash budget.

◼ Chapter Outline 17.1 An Overview of Financial Planning 17.2 Developing a Long-Term Financial Plan A. A long-term financial plan spans three to five years and serves as the basis for developing the short-term financial plan.

B. Forecasting a firm’s future financing needs using the long-term financial plan includes three basic steps: 1. Construct a sales forecast.

2. Prepare pro forma financial statements.

3. Estimate the firm’s financing needs.

17.3 Developing a Short-Term Financial Plan A. There are two basic differences between the short- and long-term financial plans.

1. The planning horizon for the short-term plan spans one year or less; the long-term plan spans a three- to five-year planning horizon.

2. The short-term financial plan usually is structured in terms of a cash budget; a long-term financial plan is prepared using pro forma financial statements.

B. The cash budget represents a detailed plan of future cash flows and is composed of four elements: cash receipts, cash disbursements, net change in cash for the period, and new financing needed.

C. The cash budget serves two primary roles in financial forecasting and planning.

1. The cash budget is a tool for predicting the amount and timing of the firm’s future financing requirements.

2. The cash budget serves as a tool to monitor and control the firm’s operations.

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◼ Learning Objectives 17-1.

Understand the goals of financial planning.

17-2.

Use the percent of sales method to forecast the financing requirements of a firm, including its discretionary financing needs.

17-3.

Prepare a cash budget and use it to evaluate the amount and timing of a firm’s short-term financing requirements.

◼ Lecture Tips 1.

A major concept to stress in discussing long-term planning and the use of the percent-of-sales forecasting method is that growth will change the financial ratios of a firm. Therefore, part of the planning process needs to address the “automatic” financial changes that occur as a result of growth.

2.

The Percent-of-Sales method assumes that sales are the driving force in financial planning. Other methods could be introduced (e.g., internal growth rate and sustainable growth rate) as alternative approaches.

◼

Questions for Further Class Discussion

1.

How might “lumpy” capital investments and economies of scale considerations affect how one uses the Percent-of-Sales forecasting method?

2.

Is it ever possible that a financial plan would call for a decline in sales and thus contraction of a firm’s current operations? How would a firm plan for this case?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

5

1, 2, 3, 4, 6, 7, 8, 9, 10,

11, 12, Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 17-1—17-12

.

Chapter 18 Working Capital Management ◼ Chapter Overview Working capital management encompasses the day-to-day activities of managing the firm’s current assets and current liabilities. Working capital choices are critical determinants of a firm’s liquidity. One component of working capital management encompasses determining the level of investment in current assets accounts. Further, managing the firm’s net working capital involves deciding on the investment strategy for financing the firm’s current assets and current liabilities.

◼ Chapter Outline 18.1 Working Capital Management and the Risk-Return Tradeoff A. The firm’s working capital choices are critical determinants of its liquidity and its ability to pay its bills on time.

1. The current ratio is closely linked to the firm’s net working capital.

B. Managing working capital involves balancing the firm’s investment in current assets in relation to its current liabilities.

1. Efficient use of inventories and accounts receivable is a key part of managing working capital.

2. Seeking favorable accounts payable terms and monitoring short-term borrowing is a crucial part of managing the firm’s working capital.

C. The working capital decision involves a risk-return trade-off.

18.2 Working Capital Policy A. The Principle of Self-Liquidating Debt states that the maturity of the source of financing should be matched with the length of time that the financing is needed.

B. Assets and liabilities can be classified into temporary or permanent categories.

1. Temporary assets are composed of current assets that will be liquidated or not replaced within the current years.

2. Permanent assets are composed of investments in assets that the firm expects to hold for a period of longer than one year.

3. Spontaneous sources of financing arise naturally out of day-to-day operations.

4. Temporary sources of financing consist of current liabilities the firm incurs on a discretionary basis.

5. Permanent sources of financing include intermediate-term loans, long-term debt, preferred stock, and common equity.

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18.3 Operating and Cash Conversion Cycles A. The operating cycle measures the time period that elapses from the date that an item of inventory is purchased until the firm collects the cash from its sale.

B. The cash conversion cycle is similar to the operating cycle but nets out the sum total of the operating cycle the number of days the firm has to pay its accounts payable.

18.4 Managing Current Liabilities A. The firm’s current liabilities include all of its debt obligations that must be repaid in one year or less.

B. It is important that the cost of all forms of short-term financing be determined.

18.5 Managing the Firm’s Investment in Current Assets A. Cash and marketable securities are funds that are used to pay the firm’s bills on a timely basis.

Two problems arise in the management of cash and marketable securities.

1. An adequate amount of cash must be maintained to meet the firm’s needs.

2. The composition of a firm’s marketable securities portfolio must be determined to provide liquidity and return.

B. Several issues arise in the management of accounts receivables.

1. A firm must determine the size of investment in accounts receivable.

2. Customer quality is a second decision variable involved in the accounts receivable management.

3. A third policy variable encompasses the collection policies of the firm.

C. Inventory management involves the control of the assets that are produced to be sold in the normal course of the firm’s operations.

◼ Learning Objectives 18-1.

Describe the risk-return tradeoff involved in managing a firm’s working capital.

18-2.

Explain the principle of self-liquidating debt as a tool for managing firm liquidity.

18-3.

Use the cash conversion cycle to measure the efficiency with which a firm manages its working capital.

18-4.

Evaluate the cost of financing as a key determinant of the management of a firm’s use of current liabilities.

18-5.

Understand the factors underlying a firm’s investment in cash and marketable securities, accounts receivable, and inventory.

◼ Lecture Tips 1.

Discuss how credit terms and inventory methods affect the firm’s cash conversion cycle.

2.

Use a number of financial statements from firms in different industries to discuss how industry factors impact the cash conversion cycle of firms.

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Questions for Further Class Discussion

1.

Is a zero or negative cash conversion cycle a positive or negative for a firm? Why?

2.

How have just-in-time inventory systems impacted the cash conversion cycle for firms?

◼

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 3, 4, 13, 14

5, 6, 7, 8, 9, 10, 11, 12

Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 18-1—18-2, 18-5—18-14

◼ Internet Resources www.annualcreditreport.com

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Chapter 19 International Business Finance ◼ Chapter Overview International business poses particular financial challenges for firms. International business results in risks associated with transacting business in multiple currencies. Thus a large part of the discussion in this chapter will include strategies for reducing foreign exchange risk. Also, the international environment presents issues concerning working capital management and capital structure decisions.

◼ Chapter Outline 19.1 Foreign Exchange Markets and Currency Exchange Rates A. Foreign currency values can be quite volatile and that cause some firms to alter their business plans in foreign countries B. The Foreign Exchange (FX) market is an over-the-counter market where currencies are bought and sold.

C. There are a number of participants in the FX markets, including importers and exporters, investors and portfolio managers, and currency traders.

D. An exchange rate is the price of one currency stated in terms of another.

E. Arbitrage opportunities exist when FX quotes in two different countries are not consistent with each other.

F.

A cross rate is the exchange rate for a currency determined using the exchange rates of two other currencies.

G. There are a number of types of foreign exchange transactions.

1. Exchange rates for immediate delivery of a currency involve spot exchange rates.

2. A forward exchange rate is one that is agreed upon today but which calls for delivery of the currency at the agreed rate at some future date.

19.2 Interest Rate and Purchasing-Power Parity A. Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries.

B. Purchasing-power parity (PPP) is a theory that suggests that exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased.

C. The International Fisher Effect suggests that nominal interest rates reflect the expected inflation rate and a real rate of return.

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19.3 Capital Budgeting for Direct Foreign Investment A. Direct foreign investment occurs when a company from one country makes a physical investment into building a factory in another country.

1. To evaluate these investment projects, firms discount the cash flows that are expected to be repatriated to the parent firm.

2. Exchange rates are important in converting the value of cash flows into a domestic currency.

B. Foreign investment risks include business risk and financial risk, as well as political risk and exchange rate risk.

1. Political risk can arise if the foreign subsidiary conducts its business in a politically unstable country.

2. Exchange rate risk is the risk that the value of a firm’s operations and investments will be adversely affected by changes in exchange rates.

◼ Learning Objectives 19-1.

Understand the nature and importance of the foreign exchange market and learn to read currency exchange rate quotes.

19-2.

Describe interest rate and purchasing-power parity.

19-3.

Discuss the risks that are unique to the capital budgeting analysis of direct foreign investments.

◼ Lecture Tips 1.

Bring in currencies from different countries and compare the value of the different denominations.

2.

Identify the types of goods for which purchasing-power parity would most likely hold. Identify products for which purchasing-power parity would most likely not be true.

◼

Questions for Further Class Discussion

1.

Does the FX market ever “sleep”? That is, are there times when these markets are not active?

2.

Is the foreign exchange market an example of a perfectly competitive market? Why or why not?

3.

Is arbitrage good or bad for markets and investors? Why?

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◼

International Business Finance

57

End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

◼

Simple

Average

Complex

1, 2, 3, 7, 8, 9, 15, 16

4, 5, 6, 10, 11, 12, 13, 14, 17, 18,19, 20

Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 19-1—19-20

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Chapter 20 Corporate Risk Management ◼ Chapter Overview The business environment is inherently risky. However, a number of risks faced by firms are at least partially controllable. One way that firms can alter their exposure to risk is through the use of financial contracts.

In dealing with risk, firms must first assess the nature of their risk and decide on a strategy to manage risk.

Next, the firm will determine what type of contract will best provide a way of managing risk. The main types of contracts used to manage risk include insurance contracts, various types of hedging contracts, and exchange-traded financial derivatives including options and swaps.

◼ Chapter Outline 20.1 Five-Step Corporate Risk Management Process A. Step 1: Identify and understand the firm’s major risks.

B. Step 2: Decide which types of risks to keep and which to transfer.

C. Step 3: Decide how much risk to assume.

D. Step 4: Incorporate risk into all the firm’s decisions and processes.

E. Step 5: Monitor and manage the risks the firm assumes.

20.2 Managing Risk with Insurance Contracts A. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another in exchange for a premium.

B. There are a number of types of insurance contracts including property insurance, business interruption insurance, key person life insurance, directors, and officers, insurance, and workers’ compensation insurance.

20.3 Managing Risk by Hedging with Forward Contracts A. Hedging refers to a strategy designed to offset the exposure to price risk.

B. Commodity price risk can be hedged using forward contracts.

C. Currency and exchange rate risk can be hedged using forward contracts.

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20.4 Managing Risk with Exchange-Traded Financial Derivatives A. A derivative contract is a security whose value is derived from the value of another asset or security.

B. A futures contract is a derivative instrument which represents a contract to buy or sell a stated commodity or financial claim at a specified price at some future specified time.

C. There are two types of options contracts.

1. A call option gives its owner the right (but not the obligation) to purchase a given number of shares of stock or an asset at a specified price over a given period.

2. A put option gives its owner the right (but not the obligation) to sell a given number of shares of common stock or an asset at a specified price within a given period.

20.5 Valuing Options and Swaps A. One of the most widely used methods to value options is the Black-Scholes Option Pricing Model.

B. A swap contract involves the swapping or trading of one set of payments for another.

◼ Learning Objectives 1.

Define risk management in the context of the five-step risk management process.

2.

Understand how insurance contracts can be used to manage risk.

3.

Use forward contracts to hedge commodity price risk.

4.

Understand the advantages and disadvantages of using exchange-traded futures and option contracts to hedge price risk.

5.

Understand how to value options and how swaps work.

◼ Lecture Tips 1.

Often it is difficult for students to understand the perspective of the various participants in options transactions. Discuss the motivation of a person who writes a call or put option compared to the motivation of the individual who buys a call or put option.

2.

Go the various Web sites that have options calculators to illustrate how easy it is for individual investors to have access to and to use the Black-Scholes option pricing model.

(One Web site would be Robert’s Online Option Pricer; www.intrepid.com/robertl/index.html)

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Questions for Further Class Discussion

1.

Obtain current exchange rate information. Discuss how the forward currency rates can be an indication of future movement in current exchange rates.

2.

Discuss the upside and the downside potential of options from both the perspective of the writer of the option and the buyer of the option. How and why are these the same or different?

3.

Discuss the potential for regulating credit default contracts as insurance products.

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End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple 1, 2, 4

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Average

Complex

3, 5, 6, 7, 8, 9, 10, 11, 13

12, Mini Case

Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.

Problems: 20-1—20-3, 20-5—20-8, 20-10—20-13

◼ Internet Resources www.intrepid.com/robertl/index.html

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Chapter 1 Solutions to Study Questions 1-1. The solution to this problem is dependent upon the student’s experiences.

1-2. There are three basic types of issues that are addressed by the study of finance: a. What long-term investments should the firm undertake? This area of finance is generally referred to as capital budgeting. b. How should the firm raise money to fund these investments? The firm’s funding choices are generally referred to as capital structure decisions. c. How can the firm best manage its cash flows as they arise in its day-to-day operations?

This area of finance is generally referred to as working capital management.

1-3. First, investors demand a minimum return for delaying consumption that must be greater than the anticipated rate of inflation. If they didn’t receive enough to compensate for anticipated inflation, investors would purchase whatever goods they desired ahead of time.

There isn’t much incentive to postpone consumption if your savings are going to decline in terms of purchasing power.

Investment alternatives have different amounts of risk and expected returns. Investors sometimes choose to put their money in risky investments because these investments offer higher expected returns. The more risk an investment has, the higher will be its expected return – that’s because risk investors don’t like risk, in particular, they don’t like the chance that they might lose their money. That makes risky investments less attractive, which means that to attract investors, riskier investments must be priced to offer investors a higher expected rate of return. This relationship between risk and expected return is shown in Figure 1.3.

Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns for investing will be, but we can’t peer into the future and see what those returns are actually going to be. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest induces some investors to take on the added risk of purchasing a General Motors bond.

1-4. When evaluating an investment opportunity it is the cash flows, not accounting profits, that determine its value. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning more money on it. As a personal investor or a financial manager, you must remember, it is the cash flows, not profits, which are actually received by the firms and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand. As a result, a firm’s cash flows and accounting profits may not be the same. For example, a capital expense, such as the purchase of new equipment or a building, is depreciated over several years, with the annual depreciation subtracted from profits. However, the cash flow, or actual dollars, associated with this expense generally occurs immediately. Therefore cash inflows and outflows involve the actual receiving and payout of money— when the money hits or leaves your hands. As a result, cash flows correctly reflect the timing of the benefits and costs. .

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1-5. The three business forms are: 1. Sole Proprietorship.

2. Partnership.

3. Corporation.

1. Sole Proprietorship: Advantage: • Forming a sole proprietorship is very easy; there are no forms to file and no partners to consult since the founder of the business is the sole owner.

Disadvantage : • These organizations typically have limited access to the alternative sources of financing. The owners of a sole proprietorship typically raise money by investing their own funds, and by borrowing from a bank.

2. Partnership Advantage : • An important advantage of the partnership is that it provides access to equity, or ownership, financing from multiple owners in return for partnership shares, or units of ownership.

Disadvantage : • Conflict on division of profits between partners.

3. Corporation.

Advantages : • The shareholders’ liability is confined to the amount of their investment in the company. In other words, if the corporation goes under, the owners can only lose their investment.

• The life of the business is not tied to the life of the founding owners. For example, the inventor Thomas Edison founded General Electric (GE) over a century ago. Edison died in 1931, but the corporation lives on.

Disadvantage : • Though management is expected to make ethical decisions that reflect the best interests of the firm’s owners, this is not always the case. Indeed, managers often face situations where their own personal interests differ from the interests of shareholders.

If you were to start a lawn mowing business for the summer, you’d probably form a sole proprietorship. That is the simplest one to form – you don’t have to do anything. Moreover, with a lawn mowing business the probability of a law suit is quite low, so the advantage of limited liability is not particularly important.

1-6. The shareholders are the owners of the corporation. The management should run business so as to maximize the shareholder wealth without being greedy for quick money generation by unethical conducts and practices.

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1-7. Shareholder wealth maximization isn’t the goal of every firm. Privately owned Newman’s Own, the makers of salad dressing, spaghetti sauces, and other food products, was established in 1982 with the goal of making money for educational and charitable purposes.

Paul Newman’s estate and the Newman’s Own Foundation donate all profits and royalties after taxes for educational and charitable purposes.

1-8. In microeconomics courses, profit maximization is frequently cited as the goal of the firm.

Profit maximization stresses the efficient use of capital resources, but it is not specific with respect to the time frame over which profits are to be measured. Do we maximize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating the firm’s research and development expenditures and cutting down on routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base our financial decisions on a goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the real world.

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Chapter 2 Solutions to Study Questions 2-1. The “Regardless of Your Major” box describes two types of retirement plans: defined contribution and defined benefit. The “defined” part of each name means that benefits are specified, or defined; the difference between the two plans is in when those benefits are defined. Defined benefit (DB) plans specify the amounts to be paid in retirement—that is, the benefits the retiree will receive are specified. Thus, the sponsor of the plan promises to make specific payments to the retiree, and then the sponsor accepts the responsibility for investing a pool of assets now (or at least, before the covered person retires) to ensure that those benefits in fact can be paid in the future. Managing pension assets to ensure future payments is complicated, and companies these days prefer to offer defined contribution plans, like 401(k) plans, instead of defined benefit plans. Defined contribution (DC) plans specify the contributions that will be made to the plan (now), not the benefits that will be paid at retirement. It’s a lot easier to specify an amount to be paid today than it is to ensure that one will be made in the future. With defined contribution plans, employees accept the responsibility of investing their funds to ensure adequate resources in retirement, removing that burden from employers. It’s therefore not surprising that employers prefer defined contribution plans, while employees who have defined benefit plans count themselves lucky.

2-2. The three players who interact in the financial markets are borrowers, savers, and financial intermediaries.

Borrowers need money to help finance some specific purpose—a student loan to help pay for college, an auto loan for a car, or a mortgage for a house. Savers have money that they don’t need for consumption today, so they set this money aside to use in the future.

Financial intermediaries bring the two together, channeling the savers’ “extra” money to the borrowers for their immediate use. If the borrowers and savers could get together themselves somehow, they could “cut out the middleman” and save the intermediation costs. This might sound good—but is it feasible? Financial intermediaries specialize in evaluating the creditworthiness of borrowers, so they help ensure that savers’ money is channeled to borrowers who will repay. They also allow efficient aggregation of small amounts of individual savings into blocks of loanable funds large enough to be useful to borrowers.

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lenders

$

FINANCIAL INTERMEDIARIES

$

borrowers

2-3. As outlined in section 2.2 of the text, a financial intermediary is a firm that collects money from savers, bundles it into attractive sizes with attractive terms, and lends it to borrowers.

The principal types of financial intermediaries in the United States are: COMMERCIAL BANKS Commercial banks are depository institutions that take deposits (such as checking or savings deposits) and make loans (such as mortgage loans or auto loans). Commercial banks are also integral parts of our national payment system. Their importance to the functioning of our economy has led to their being heavily regulated and subject to extensive oversight (for example, by the FDIC, which insures their deposits, and by the Fed, which mandates their reserve requirements).

NONBANK FINANCIAL INTERMEDIARIES While these businesses channel money from those who have it to those who need it, they do not both take deposits and make loans, as a depository institution does. financial services corporations: Financial services corporations, like GE Capital, provide loans and credit to businesses and individuals (including credit card services). Some of these companies are charged with ensuring financing for the expensive products of large manufacturing companies (for example, Ford Motor Credit). These institutions do not take deposits, so they are missing one of the two elements of a depository institution’s job description. insurance companies: Insurance companies insure individuals and businesses against certain types of risks (for example, the risk that your automobile will be damaged in a collision, and/or cause damage or injury to someone else; the risk that your house will burn down; the risk that you will die unexpectedly, leaving your heirs without their major breadwinner).

Insurance companies are major players in the financial markets, because they must invest the .

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premiums they collect until the money is needed to pay claims. The type of insurance a firm provides tends to determine the type of market in which they invest most frequently. For example, life insurers often have decades between premium collection and claim payments, so they are large players in the capital markets. On the other hand, property and casualty companies (like auto and home insurers) must stay closer to their money, since their claims may come much sooner; they are larger players in the money markets. investment banks: Investment banks like Goldman Sachs and Morgan Stanley advise firms about their financing needs and act as intermediaries when the firms float new securities.

For example, an investment banker may advise a client about the most favorable terms for a new bond issue (e.g., covenants, term, options, coupon), then underwrite the issuance of the bonds (buying the bonds from the issuer, then selling them to investors, taking inventory risk in return for a spread).

INVESTMENT COMPANIES These companies take savings and invest them in other companies’ securities. As the text puts it, they are “financial institutions that pool the savings of individual savers and invest the money, purely for investment purposes, in the securities issued by other companies.”

Perhaps the most familiar type of investment company is the mutual fund. mutual funds: Mutual funds collect money from investors, then invest that money into specific types of financial assets. Each mutual fund has a prospectus that describes the particular type of assets that the fund may buy: for example, the fund may buy bonds, or stocks, or money market assets, or some combination. Mutual fund investors own shares of the fund that entitle them to a proportional share of the assets held by the fund.

Be careful to distinguish mutual fund shares from the shares of stock that a mutual fund may own. Say an equity mutual fund has 10 investors who each put $1,000 into the fund.

The fund’s size is therefore $10,000, and each investor owns 1/10th of the fund. Let’s assume that the fund issues 1,000 mutual fund shares—100 to each investor. Now, say the fund takes its $10,000 and buys 1 share of stock (a very expensive, $10,000/share stock!).

Each investor has 100 mutual fund shares, representing a 1/10th interest in a single share of the fund’s chosen (very expensive) stock. exchange-traded funds (ETFs): ETFs are like mutual funds that trade on exchanges, as stocks do. Investors trade mutual funds shares with the fund itself—they send money to the fund, receiving mutual fund shares in return; they submit sell requests to the mutual fund, receiving cash in return. In contrast, investors who wish to divest themselves of their ETF shares can simply enter a sell order with their brokers. They can also do the other types of things that one can do with shares of stock: for example, buy ETF shares on margin, or sell ETF shares short. Nonetheless, investors who wish to make small, periodic contributions to a diversified fund may want to stick with mutual funds, since ETFs require brokerage commissions with every trade. hedge funds: Hedge funds are intermediaries like mutual funds, gathering money from investors, then using those pooled funds to buy assets. However, hedge funds are less regulated than mutual funds, and therefore may engage in various strategies that are not allowed to mutual funds. For example, short positions are important parts of many hedge fund strategies. .

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There are many types of hedge fund strategies; for example, funds following merger arbitrage strategies might short stock in acquiring firms and buy stock in targets; equity market neutral funds would match their long positions with shorts, ending up “neutral” to the direction of the market. private equity funds: These funds collect money from investors, then deploy it into equity that is not publicly traded. The two most important types of private equity funds are venture capital (VC) funds, which finance start-up firms, and leveraged buyout (LBO) funds, which use debt (leverage) to buy up the public stock of poorly performing firms, taking them private.

Here’s a schematic laying out these various types of companies:

financial services companies

NONBANK FINANCIAL INTERMEDIARIES

insurance companies investment banks

COMMERCIAL BANKS mutual funds

ETFs

INVESTMEN T COMPANIE S

private equity funds

LBO hedge funds

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2-4. Investment bankers advise clients on raising money (for example, what type of securities to issue, and what the features of those securities should be). They also perform underwriting services (buying the securities from the issuer, then selling them to investors). Investments bankers also provide merger and acquisition advice.

2-5. The primary market is the market for newly issued securities. In this market, the issuer (for example, a corporation like General Electric) creates a new financial asset and sells it to an investor. GE does this to raise money to finance a new project. The asset it creates can be either a debt security (like a bond), or an equity security (like a new share of stock). Every asset must trade in the primary market once (and only once), because every asset must be “born.” The primary market transaction is the only point at which the issuer receives cash for the security. Note that this is Step 1 in Figure 2.2 from the text.

(The investment bankers we considered in problem 2-4 above may play a role in this primary market transaction. They often underwrite a firm’s securities, meaning that they are the ones who actually buy the securities from the issuer [so that the issuer receives cash from the investment bankers, not the investors], then sell those securities to the initial public investors. The underwriters therefore bear the risk of inventory, and will be on the hook if they cannot sell the securities. Investment bankers typically charge about 7% of the value of the issue for performing the underwriting function.)

The secondary market is the market for investor-to-investor trading (step 4 from Figure 2.2).

The markets that we hear about every day—the New York Stock Exchange, the American Stock Exchange, the Nasdaq—are all secondary markets. Secondary markets allow investors to trade out of securities that they have purchased (or to buy new ones); that is, they provide liquidity. Investors are more willing to buy securities in the first place if they know they can sell them easily. Thus, securities are more attractive to investors—and therefore are less costly to issuers—if they are backed by a large, liquid secondary market.

Assets may trade many times in the secondary market (think of the number of times a Google share could change hands on the Nasdaq), or they may never trade there at all (for example, a bond may be held to maturity by its initial investor).

2-6. A mutual fund provides intermediated investing. Investors pool their investments together, then hire a manager to deploy those funds into an approved asset class or classes. For example, investors might pool their funds to buy equity, to buy debt, or to buy some combination of the two. Pooling their investments allows investors to achieve diversification simply, and with a minimum investment. (For example, it would be virtually impossible to create a meaningfully diversified portfolio of equity with the $3,000 it might take to open a mutual fund account, and the fees associated with any such attempt would be prohibitive.)

Some of the benefits of mutual fund investing include: ♦ ease of diversification (as just discussed) ♦ access to asset classes (some are more easily, or only, accessible to institutional investors, requiring retail investors to use an intermediary like a mutual fund) ♦ ability to establish ongoing, automated investment programs (taking money from each month’s paycheck, for example, and having it automatically invested in your funds). .

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(Many people believe that access to professional management is another benefit to intermediated investing. However, there is disagreement about the efficacy of paying higher fees for active management, as noted in the text’s “Business of Life” box.)

An ETF also allows investors access to a basket of assets. However, ETF shares trade on an exchange. They therefore can be traded multiple times per day, while mutual fund shares can be traded only once. (Investors who wish to trade mutual fund shares place orders with the fund directly, which then performs the trades once, at the end of the day.) Since ETFs trade like stocks, they can be sold short and bought on margin. There may also be certain tax advantages to ETFs over mutual funds. However, each transaction incurs a brokerage commission, so that investors desiring to set up an automatic investment program would be better off using mutual funds for those programs.

2-7. The primary difference between debt and equity is that debt has a contract: the amounts and the timing of its cash flows are contractually specified. For example, with a bond, you know that you will receive coupon payments equal to [coupon rate*par/2] twice a year, on specific dates, plus $1,000 (the par value) at maturity (another specified date). Failure to make a promised payment on time and in full constitutes default, for which there are ramifications for the issuer (of varying severity, depending upon the severity of the default).

However, cash flows to equity may not be specified at all (for example, a company makes no assertions about the dividends it may or may not pay to common stock, and certainly cannot specify the price an investor will receive when she sells the stock), or, if they are specified, do not trigger default when not made (for example, preferred dividends may be skipped if the firm so chooses 1). Equity funding provides much more flexibility for the issuer, and is therefore less risky for it. However, this comes at the cost of higher required returns to investors. Debt investors are willing to accept a lower return in exchange for contractual cash flows. However, less risk for investors means more risk for the issuer, which introduces leverage—risk—into its capital structure when issuing debt.

2-8. Preferred stock is “preferred” over common because: ♦ it has priority in liquidation—preferred shareholders must be paid in full before common shareholders can receive any of the proceeds from the liquidated assets of the firm. ♦ it has priority in dividend payment—common dividends cannot be paid before preferred dividends are paid. If the preferred is cumulative, then there can be no common dividends before all accrued preferred dividends are paid.

Thus, the preferences relate to priority of payment. However, preferred stock does not dominate common. For example, common shares come with voting rights, while preferred shares usually do not. In addition, preferred shares are not residual claims, and will not enjoy the unlimited upside that common shareholders prize. (Some preferred shares have a feature that lets them participate in any upside potential, but they still are not residual claimants.)

1

Of course, skipping a dividend may not be the end of the story, since the skipped dividends may accrue if the preferred is cumulative, as noted in the text. And, of course, no dividends may be paid to common if there are preferred dividends in arrears.

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2-9. Using the web address http://apps.finra.org/fundanalyzer/1/fa.aspx, led us to the comparable fund analyzer. Comparing this funds prescribed by the text, we get the following results: Here is the initial screen, where we specify the funds we’d like to compare:

The first results screen allows us to enter the initial amount (whose default is our $10,000), the annual return (whose default is 5%, so we need to change that to 8%), and the investment horizon (whose default is our ten years).

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We can see from the results page that the Vanguard fund, which costs us $238.78, leaves us with a profit of $11,246.61. This beats the American Beacon fund (which costs us $1,891.70, with profit of $8,448.54) and the American Growth fund (cost = $8,498.88; loss = $1,677.51). We can also see Vanguard’s domination in the chart below, where the blue bars, representing the value in the Vanguard fund, tower over the yellow and red bars.

On the next two pages are the rest of the results from this search. The first picture shows the data underlying the chart above, and gives comparable results for numerous investment horizons. It makes it clear that Vanguard’s outperformance is not only at the 10-year mark, but at any horizon. The next picture describes the funds’ fee structures, and defines their asset-class mandate using the standard Morningstar 9-box style/size taxonomy. The final picture summarizes recent returns.

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2-10. According to the data presented in the “Finance in a Flat World” box, in 2010 the U.S. financial markets incorporated $64 trillion of the world’s financial assets; the European market held about $28.4 trillion; Asia had $26.3 trillion; and the U.K. had $21 trillion.

Investors should consider this when confronting the tendency for “home country bias,” the predilection of investors for assets from their own countries. For example, it’s not uncommon for U.S. investors to hold all of their equity assets in stocks from the U.S. Given that the U.S. market is far less than 100% of the total global equity market, this introduces a source of bias (and loss of potentially useful diversification) into such targeted portfolios.

2-11. A hedge fund is a pool of assets, like a mutual fund. However, hedge funds are much less regulated than are mutual funds, which allows hedge fund managers to use many strategies forbidden to mutual fund managers. For example, hedge fund managers often employ significant leverage, invest in illiquid assets (and restrict investors’ ability to access their funds, sometimes for years), and utilize short strategies and derivatives. Hedge funds are not open to all investors; they are targeted at wealthy, sophisticated, “accredited” investors (whom the SEC deems able to take care of themselves). The fee structures of hedge funds are also different from mutual funds’, often involving both an annual fee of 2% of assets, plus 20% of profits (a “2-and-20” scheme).

2-12. The two types of private equity funds discussed in the text are venture capital (VC) funds and leveraged buyout (LBO) funds. VC funds collect money from investors, then use it to finance start-up businesses. Thus, these funds invest very early in a business’s life, perhaps funding research and/or product development. (For example, VCs are very important in the funding of drug R&D.) LBO firms target underperforming businesses, using leverage (debt) to finance the buyout of the firm’s public shareholders—taking the firm private. The idea

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is to restructure the business without the distraction of public oversight, then take the firm public again. Investors in private equity make money when their incubated firms are bought out or have their IPO (VC funds), or when the firms are taken public again (LBO funds).

2-13. According to Yahoo! Finance (http://finance.yahoo.com/q?s=goog, accessed 2/6/17), we have the following results for Alphabet: price of last trade: length of time since last trade: day’s price range: $0.15 closing change in percent: 52-week price range:

$80.334 last trade time: 4:00 PDT (trade was at close; data accessed after close) $795.25-$801.66 closing change in dollars:down down 0.02% $663.06-$841.95

Here’s what the screen looked like:

At the top of the page, there are numerous links to more data about Alphabet: Summary: summary, real-time, options, historical prices profile, key statistics, SEC filings, competitors, industry, components key executives income statement, balance sheet, cash flow major holders, insider transactions, insider roster: interactive, basic charts, basic technical analysis analyst opinion, analyst estimates, research, star analysis

Statistics: Profile: Financials: Holders: Historical data: Analyst:

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2-14. The Market Watch website has many interesting personal finance articles, and a student should have no trouble finding at least one that will interest her. On 5/26/10, there was an “Ask the Expert” article titled “Dirty Tricks Financial Advisors Play,” written by Walter Updegrave. He was responding to a question regarding the efficacy of a strategy of using an interest-only mortgage to buy a house, then combining the payment savings from that loan (versus a fixed-rate mortgage), plus the proceeds of a home equity line of credit, to invest in an equity-indexed universal life insurance policy. The author does not like this strategy, for these reasons: ♦ there is a cap on the earnings that are possible from the policy, despite its link to equity index returns ♦ borrowing from such policies, while tax-free as long as the policy is in force, leads to taxable earnings if the policy lapses (which can be inconvenient if the policyholder is close to retirement) ♦ the strategy is very risky ♦ the advisor may be motivated by his own desire for commissions The author suggests to sticking with tax-advantaged retirement plans such as 401(k)s, and with traditional investments for deployment of any funds remaining after these retirement vehicles are maxed out.

2-15. The Motley Fool retirement site has sections for “13 Retirement Steps,” IRAs, “401(k)s etc,” and asset allocation. The main page has a selection of relevant articles (e.g., “How to Salvage Your Retirement Plan Now”), retirement calculators (e.g., “Should I Convert My IRA to a Roth IRA?”), and some related links (e.g., “Discuss: Retirement Investing”). The IRA page has discussions about the basics of IRAs, the differences between Roth and traditional IRAs, and the best way to open an IRA (“follow these three simple steps!”).

Their thirteen retirement steps are these: 1. change your life with one calculation 2. trade wisdom for foolishness 3. treat every dollar as an investment 4. open and fund your accounts 5. avoid the biggest mistake investors make 6. discover great businesses 7. buy your first stock 8. cover your assets 9. invest like the masters 10. don’t sell too soon 11. retire in style 12. pay it forward 13. make friends and influence fools Students should enjoy reading the details of these accessibly named topics.

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Chapter 3 Solutions to Study Questions 3-1. The balance sheet represents an enumeration of a firm’s resources (assets) along with its liabilities and owners’ equity at a given date. The income statement summarizes the net results of the operation of a firm over a specified time interval.

The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time.

3-2. Gross profits is sales less the cost of producing or acquiring the firm’s product or service usually known as cost of goods sold. Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business.

Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes.

3-3. Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense is computed as the interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receive dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or cease paying a dividend.

3-4. Net working capital is the firm’s liquid assets (current assets) less its short-term debt.

Accountants include all short-term debt when computing net working capital; however, in computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts payables and accruals. With this latter method, we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business— beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer.

The amount of net working capital is important to a company’s lenders who are always concerned about a company’s ability to repay its loans.

3-5. A firm’s accounts receivable are the amounts owed to the firm by its customers who buy on credit. Thus, Meriwhether Chemicals is lending its cash to its customers when they purchase goods and services from the firm.

3-6. The firm’s accounts payable represents the credit suppliers have extended the firm when it purchased inventories. As such, it is a source of funding – in effect, when a firm buys on trade credit (and as a result accounts receivable increase), they are borrowing money from their supplier. .

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3-7. There would be an immediate cash outflow of $1.5 million when the new machine is purchased. Then, in future years there would be an increase in depreciation as the new capital purchase is depreciated. But depreciation is not a cash flow, but depreciation is an expense and as a result reduces earnings before taxes – but again, that’s not a cash flow item. But taxes are calculated as a percent of earnings before taxes, and as a result, the more depreciation, the lower the taxes, and taxes are a cash flow item.

3-8. A cash flow statement tells us how changes in balance sheet and income statement affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. In effect, it looks at how money flows in and out of the firm.

It can be used to determine whether there will be money left over to pay bills and personnel, the potential of the firm to repay loans, and whether the firm is fundamentally sound.

3-9. Net worth represents the value of the assets less the value of the liabilities. In this case the assets (the 2003 Corolla, the checking account, and the savings account) total $6,365.77, while the liabilities (what you owe on the Corolla and your school loan) total $14,591.22 – thus, your net worth is $6,365.77 - $14,591.22 = -$8,225.45. In effect, you owe more than the value of all your assets.

3-10. The AICPA IFRS Resources website (http://www.ifrs.com/ifrs_faqs.html) does an excellent job of keeping an up-to-date monitoring of the adoption of IFRS around the world.

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Chapter 4 Solutions to Study Questions 4-1. Financial statements of firms are analyzed for vital signs from both within the firm and by the firm’s external constituents. Internal financial analysis is performed by a firm’s own employees, while external financial analysis is performed by bankers and investors outside the firm.

Internal financial analyses are review for vital signs reflecting: • The performance of employees and determine their pay raises and bonuses.

• The comparison of the financial performance of the firm’s different divisions.

• Financial projections, such as those associated with the launch of a new product.

• Evaluation of the financial performance of the firm in light of its competitors and determine how the firm might improve its own operations.

• Evaluation of the financial well-being of an important supplier so that if the supplier is facing the risk of failure the firm can move quickly to line up alternative sources of supply.

External financial analyses are undertaken by a variety of firms and individuals who have an economic interest in the vital signs of the firm’s financial performance. These include: • Banks and other lenders who are trying to decide whether to loan money to the company.

• Suppliers trying to decide whether to grant credit to the company.

• Credit-rating agencies who are trying to determine the firm’s creditworthiness.

• Professional analysts who work for investment companies that may be considering investing in the firm or advising others about investing.

• Individual investors trying to decide whether to invest in the company.

4-2. A common size financial statement is a standardized financial statement in which all entries are presented in percentages. To create a common size income statement we simply divide each entry in its income statement by the company’s sales. The common size balance sheet is created the same way except that you divide each entry in the balance sheet by the firm’s total assets. Once these entries are converted to percentages, we can compare them with other firms that may have higher or lower sales and assets.

4-3. Five basic questions used to discuss financial statement analysis are: • How liquid is the firm? Will it be able to pay its bills as they come due?

• How liquid is the firm? Will it be able to pay its bills as they come due?

• How efficient has the firm’s management been in utilizing its assets to generate sales?

• Has the firm earned adequate returns on its investments?

• Are the firm’s managers creating value for shareholders?

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4-4. The term liquidity is used in the context of financial statement analysis as an indication of the ability of a firm to pay its bills in a timely manner. Therefore, liquidity ratios are used to address a very basic question about the firm’s financial health: How Liquid Is the Firm— Can It Pay Its Bills?

4-5. Two ratios used to measure how a firm has financed its assets are the debt ratio and the times interest earned ratio.

4-6. The gross profit margin looks at how well the firm’s management controls its expenses, and is the ratio of gross profits to sales. In effect, it shows the percent of sales that go toward gross profits. The operating profit ratio is the firm’s operating income divided by its sales and tells managers how much profit they generated from each dollar of sales after accounting for both costs of good sold and operating expenses. The net profit margin looks at the bottom line of the income statement and tells us what percent of sales is makes it to net profit.

4-7. The operating return on assets is a product of the operating profit margin (which is EBIT/Sales) times the total asset turnover ratio (which is Sales/Total Assets).

4-8. The DuPont ratio decomposes the firm’s Return on Equity into three basic determinants related to profitability, asset management efficiency, and the use of financial leverage (an equity multiplier) as follows:

From there we can further analyze the return on equity equation by looking at the determinants of each of these three components. For example the net profit margin is determined by net income and sales; net income reflects the difference in the firm’s sales and its total costs which, in turn, consist of cost of goods sold, operating expenses, interest expense and taxes. Similarly, the total asset turnover ratio is determined by the firm’s sales and total assets where total assets can be broken down into current and fixed assets, and so forth.

4-9. Market value ratios are used to address the basic question: How are the firm’s shares valued in the stock market? These two market value ratios that indicate what investors think of both the managers’ past performance and the firm’s future prospects.

4-10. Some of the more significant limitations of industry averages include: 1. Picking an industry benchmark can sometimes be difficult. It is sometimes difficult to determine the industry to which a firm belongs when the firm engages in multiple lines of business. This problem is particularly difficult if the firm you are analyzing operates in multiple lines of business and consequently in multiple industries. In this case, you must select your own set of peer firms and construct your own norms. For example, General Electric Company (Ticker: GE) operates as a technology, media, and financial services company worldwide.

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2. Published peer-group or industry averages are not always representative of the firm being analyzed. The data published provide the user with general guidelines rather than scientifically determined averages of the ratios for all, or even a representative sample, of the firms within an industry. For example, some sources of peer group financial ratios report averages of the firms that report to a particular industry trade group (e.g., companies that apply to banks for loans).

3. An industry average is not necessarily a desirable target ratio or norm. There is nothing magical about an industry norm. At best, an industry average provides an indication of the financial position of the average firm within the industry. It does not mean it is the ideal or best value for the ratio. For various reasons, a well-managed company might be above the average, whereas another equally good firm might choose to be below the average. For example, one firm might use a just-in-time inventory approach, and as a result might have a very high inventory turnover ratio. By contrast, another firm in the same industry might be a supplier to companies like Dell that employ just-in-time inventory approaches. If this is the case, the firm will have to keep a large amount of inventory on hand and will have a lower inventory turnover ratio. Both firms might be successful companies but just approach inventory differently.

4-11. Your savings ratio, which is the ratio of your income available for savings divided by your after-tax income:

Personal Savings Ratio =

Personal savings Income available for living expenses

It can be used to calculate exactly how much of your available income is being saved. Once you’ve calculated it, you can compare your anticipated monthly savings with your target savings level. If it doesn’t look as if you’ll be able to fund all your goals, then you must earn more, spend less, or downsize your goals.

4-12. When comparing the price-earnings ratios of companies from the U. S. and Hong Kong we must be aware of differences in how earnings are calculated in the different countries and the impact of these differences on reported earnings. U. S. firms amortize the goodwill created by the acquisition of another firm over time if the value of the acquisition appears to have fallen. However, in Hong Kong firms write off goodwill immediately in the year of the acquisition. This difference can have a significant impact on the reported earnings per share of two otherwise similar firms. Consequently, the price-earnings ratios would differ simply because of the difference in accounting conventions.

Goodwill is an intangible asset, and if there’s goodwill, the assets are more than they would be otherwise. When goodwill is “written off” it is being expensed, and as a result, profits drop.

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Chapter 5 Solutions to Study Questions 5-1. The concept of time value of money is recognition that a dollar received today is worth more than a dollar received a year from now or at any future date. It exists because there are investment opportunities on money, that is, we can place our dollar received today in a savings account and one year from now have more than a dollar.

New investment projects generally involve an initial outlay at the beginning of the project, which results in cash inflows in future years. The time value of money can make those cash flows comparable. A firm may sign a contract to rent a sales location for a number of years.

If the payments are constant, they are actually going down in terms of their present value.

Firms try to postpone taxes because the further off the taxes are postponed, the less their present value is.

5-2. Compounding and discounting are inverse processes of each other. In compounding, money is moved forward in time, while in discounting money is moved back in time. This can be shown mathematically in the compounding equation: FVn = PV (1 + i)n We can derive the discounting equation by multiplying each side of this equation by PV = FVn

1 and we get: (1 + i) n

1 (1 + i) n

5-3. As interest is compounded more frequently per year, interest is earned on past interest more frequently – thus, the effective interest rate increases.

To make interest rates comparable, we calculate their equivalent rate using an annual compounding period. We do this by calculating the effective annual rate (EAR), the annual compounded rate that produces the same return as the nominal, or stated, rate. The EAR can be calculated using the following equation: To make them comparable, we calculate their equivalent rate using an annual compounding period. We do this by calculating the effective annual rate (EAR), the annual compounded rate that produces the same return as the nominal, or stated, rate. The EAR can be calculated using the following equation:

As you can see, as m, the number of times compounding occurs per year increases, the EAR increases.

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5-4. We know that FVn = PV(1 + i)n Thus, an increase in i will increase FVn and a decrease in n will decrease FVn. 5-5. We know that PV = FVn

1 (1 + i) n

Thus an increase in i will decrease FVn and an increase in n will decrease FVn. 5-6. This is a subjective question and whatever the student chooses is correct as long as they have a reason for liking that calculator.

5-7. This question would be answered differently by different students.

5-8. Although Payday loans are described by the lenders as a quick fix for short-term, the actual experience is a much longer term loan. These loans tend to put the borrower in greater difficulty with each loan flip or loan rollover. There the website describes the loans as a debt trap fraught with bank overdraft fees and other expenses that can make the borrower’s cash flow problem even greater and possibly lead to bankruptcy. Research supports that supposition as well as the practice of automobile title loans which upon default, the borrower loses their automobile making it more difficult to earn a living and escape the debt trap.

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Chapter 6 Solutions to Study Questions 6-1. An annuity is a series of equal dollar payments for a specified number of years.

Examples of annuities include mortgage payments, interest payments on bonds, fixed lease payments, and any fixed contractual payment.

6-2. Future Value of an Annuity = the sum of the future value of the individual cash flows that make up the annuity,

This can be simplified to,

Note that there are n payments in the ordinary annuity. However, since the first payment is received at the end of the first period, it is compounded for only n-1 periods until the end of the nth period. In addition, the last payment is received at the end of the nth period so it is compounded for n – n or zero periods.

6-3. The present value of an annuity is actually derived from the sum of present value of each of the individual cash flows making up the annuity. For example, the present value of a fiveyear annuity of $500 discounted back to present at 6 percent would be,

6-4. Every month you would be paying off a portion of the principle along with the interest accrued for that month. You also know that to calculate your monthly mortgage payment you simply enter the amount of the loan as PV, n as the number of periods, i as the interest rate per period, and enter 0 for FV, because at the end of the mortgage you will have your mortgage paid off – then solve for PMT. To find out how much you still have to pay, you first need to calculate what your mortgage payment is. Then, enter that as PMT, enter n as the number of periods left, i as the interest rate per period, n as the number of periods left, FV as 0, and solve for PV. 6-5. An ordinary annuity is an annuity in which payments are made at equidistant points in time .

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at the end of a period. An annuity due is an annuity in which all the cash flows occur at the beginning of the period. For example, rent payments on apartments are typically annuities due since the payment for the month’s rent occurs at the beginning of the month.

6-6. There are two basic types of perpetuities that we will encounter in our study of finance.

The first is a level perpetuity in which the payments are constant over time. The second is a growing perpetuity in which the payments grow at a constant rate from period to period over time.

6-7. The formula for the present value of an annuity is: 1   1 − (1 + i ) n  PV = PMT   i      

The formula for perpetuity is: PV =

PMT i

The formula for growing perpetuity is: 𝑃𝑉 =

𝑃𝑀𝑇𝑝𝑒𝑟𝑖𝑜𝑑 1 𝑖−𝑔

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Chapter 7 Solutions to Study Questions 7-1. Because financial markets provide rich sources of data, it is no surprise that the tools used by statisticians are so widely used in finance. We also know from Principle 2: There Is a Risk-Return Tradeoff. Specifically, although investing in higher risk investments does not always result in higher realized rates of return (that’s why they call it risk), higher risk investments are expected to realize higher returns, on average. As such, we use the basic tools of descriptive statistics, such as the mean and measures of dispersion, to analyze the riskiness of potential investments, giving use a picture of the historical risk and return on an investment.

7-2. The realized rate of return tells us how much you’ve made over some period both from appreciation (or loss) in the value of your asset (for example, how much your stock went up or down in price) and how much money was distributed to you as a result of holding the asset (for example, how much you got in terms of interest or dividends).

7-3. Dividends are money that you receive from owning common stock, and are one of the two ways investors receive returns from owning stock – the other is from capital appreciation, that is, when the value of the stock rises.

7-4. We call the gain or loss we actually experienced on a stock during a period the realized rate of return for that period. However, the risk-return tradeoff that investors face is not based on realized rates of return; it is instead based on what the investor expects to earn on an investment in the future. We can think of the rate of return that will ultimately be realized from making a risky investment in terms of a range of possible return outcomes, much like the distribution of grades for a class at the end of the term. To describe this range of possible returns, investors use the average of the possibilities, which is known as the expected rate of return. To be more precise, the expected rate of return is the average of the possible returns, where each possible return is weighted by the probability that it occurs.

7-5. When you invest money, you do so because you want to make your money grow.

Unfortunately, no one really knows what will happen in the future. You may have an idea or expectation of what will happen in the future, but nothing is ever for certain. The return that you think you will get in the future is your expected rate of return. It may not actually happen, but when you invest it is what you think will happen.

7-6. There are two methods financial analysts can use to quantify the variability of an investment’s returns. The first is the variance in investment returns and the second is the standard deviation, which is the square root of the variance. Both of these measures give us an idea of the width of the distribution of possible outcomes – the wider the distribution, the more risk there is. Why don’t investors like a wide distribution of possible returns? While it is always nice to receive more than you expect, it is more painful to receive less than you expect – that’s the idea of diminishing marginal utility of wealth that you learned in your

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economics classes. Because the pain of missing (negative utility) is more than the positive utility gained from a miss of the same size, investors don’t like variability of possible returns. Moreover, it is much easier to plan into the future if you know how much money you’ll have to work with.

7-7. Step 1: Calculate the expected rate of return using Equation (7-3).

Step 2: Subtract the expected rate of return calculated in Step 1 from each of the possible rates of return and square the difference.

Step 3: Multiply the squared differences calculated in Step 2 by the probability that those outcomes will occur.

Step 4: Sum all the values calculated in Step 3 together. The sum is the variance of the distribution of possible rates of return. Note that the variance is actually the average squared difference between the possible rates of return and the expected rate of return.

Step 5: Take the square root of the variance calculated in Step 4 to calculate the standard deviation of the distribution of possible rates of return. Note that the standard deviation (unlike the variance) is measured in rates of return.

7-8. The returns and standard deviations of the investments in Figure 7.3 are given as: Small stocks, 11.9%; large stocks, 9.8%; government bonds, 5.4%; treasurey bills, 3.7%, and inflation, 3.0%. Clearly, stocks have outperformed bonds over the long run, but they also carry a high standard deviation. In spite of the fact that historically stocks have been the better investment for investors with a long-term investment time horizon, very risk adverse investors may have avoided them because their volatility.

7-9

The riskier investments have historically realized higher returns. The riskiest investment class is comprised of the stocks of the smallest set of firms followed by the stocks of large companies, then corporate bonds, long-term U.S. government bonds, and finally Treasury bills. The difference between the returns of the riskier stock investments and the less risky investments in government securities is called the equity risk premium. For example, referring to the previous compound annual return table, the premium of large company common stocks over long-term government bonds averages 9.8% - 5.4% = 4.4%. A similar comparison to short-term Treasury bills reveals an average risk premium of 9.8% 3.7% = 6.1 %.

7-10. Figure 7.4 shows that U.S. stocks underperformed relative to stocks in the United Kingdom as well as the Emerging-Market stocks however U.S. Stocks exhibited lower standard deviations than both of those groups suggesting lower risk. Relative to Japan, U.S. stocks outperformed Japanese stocks and did so with slightly lower risk as well.

7-11. From Figure 7.4 U.S. stocks exhibited about the same level of variability relative to stocks in Japan. However, the U.S. stocks outperformed that same group measured by average return. During that time period, it appears that the Japanese market was quite risky and without an appropriate rate of return.

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7-12. The easiest way to answer this question is with an example. Let’s look at an example.

Suppose you invest $100 in a particular stock. After one year, your investment rises to $150. But unfortunately, in the second year it falls to $75. What was the average return on this investment? In this first year, the stock realized a rate of return of 50% and in the second year, it realized a rate of return of -50%. If we took the simple average of these two rates, we get 0%, suggesting our investment return is 0% over the two-year period. This doesn’t look like a 0% rate of return because we began with $100 and ended two years later with only $75! In actuality, over the two-year investment period, the $100 investment lost the equivalent of -13.4%. So which average rate of return is correct?

Actually, both rates of return are correct. The 0% rate is the arithmetic average rate of return, while the -13.4% rate is the geometric or compound average rate. The arithmetic average is the simple average we have already learned to calculate in this chapter. The geometric average is different because it takes compounding into account. For example, a 50% increase in value from $100 is $50, but a 50% decrease in value from $150 is $75. The geometric average rate of return answers the question, “What was the growth rate of your investment?” while the arithmetic average rate of return answers the question, “What was the average of the yearly rates of return?”

7-13. If you are trying to determine what annual rate of return can you expect over a multi-year horizon, then the geometric mean is better.

7-14. This is a subjective question and the student’s answer would be dependent upon their answers to the risk tolerance quiz.

7-15. The efficient markets hypothesis states that securities prices accurately reflect future expected cash flows and are based on all information available to investors. An efficient market is a market in which all the available information is fully incorporated into securities prices, and the returns investors will earn on their investments cannot be predicted.

7-16. Taking this concept of an efficient market further, we can distinguish between weak-form efficient markets, semi-strong form efficient markets, and strong-form efficient markets, depending on the degree of efficiency: 1. The Weak-Form Efficient Market Hypothesis asserts that all past security market information is fully reflected in securities prices. This means that all price and volume information is already reflected in a security’s price.

2. The Semi-Strong Form Efficient Market Hypothesis asserts that all publicly available information is fully reflected in securities prices. This is a stronger statement because it isn’t limited to price and volume information, but includes all public information. Thus, the firm’s financial statements, news and announcements about the economy, industry, or company, analysts’ estimates on future earnings, or any other publicly available information is already reflected in the security’s price. As a result, taking an investments class won’t be of any value to you in picking a winner.

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3. The Strong-Form Efficient Market Hypothesis asserts that all information, regardless of whether this information is public or private, is fully reflected in securities prices.

This form of the efficient market hypothesis encompasses both the weak-form and semi-strong form efficient market hypotheses. It asserts that there isn’t any information that isn’t already embedded into the prices of all securities. In other words, even insider information—that is, material information that isn’t available to any other investor—is of no use.

7-17. This answer will differ from student to student because it is based upon how they feel about the validity of efficient markets.

7-18. If we believe that investors do not rationally process information, then market prices may not accurately reflect even public information. As an example, economists have suggested that overconfident investors tend to under- react when a company’s management announces earnings or makes other statements that are relevant to the value of the firm’s stock. This is because investors have too much confidence in their own views of the company’s true value and tend to place too little weight on new information provided by management.

As a result, this new information, even though it is publicly and freely available, is not completely reflected in stock prices.

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Chapter 8 Solutions to Study Questions 8-1. Vanguard, one of the leading mutual fund families, identifies four key guidelines you should consider when making personal investment decisions: 1. Select investment products suited to your objective.

2. Find a comfortable balance between risk and return.

3. Diversify wisely to help manage risks.

4. Evaluate your portfolio periodically.

8-2. He is talking about the difference between expectations and outcome. Will Rogers was concerned about how much his investment would actually earn rather than what people told him it would return.

8-3. The expected rate of return for a portfolio of investments is simply a weighted average of the expected rates of return of the individual investments in that portfolio. To calculate a portfolio’s expected rate of return we weight each individual investment’s expected rate of return using the fraction of the portfolio which is invested in that particular investment. For instance, if you put half your money in the stock of ExxonMobil, with an expected rate of return of 12%, and the other half in General Electric (GE) stock, with an expected rate of return of 8%, then we can calculate the expected rate of return of the portfolio as follows: (½ x 12%) + (½ x 8%) = 10%.

8-4. The idea behind diversification is to find things that don’t move precisely together, that why when one goes down, the other won’t necessarily go down (hopefully it will go up), and as a result some of the variability will be eliminated. When you pick two stocks in the same industry to diversify with, much of the variability may be associated with that industry. In this case, when the auto industry suffers, both Ford and Toyota may suffer together and as a result, the value of diversification may be less than it would have been if your grandfather had picked stocks in different industries.

8-5. This statement is false. The amount of risk reduction that takes place as a result of diversification is a function of the correlation coefficient. The higher the correlation coefficient between two assets, the less benefit, or risk reduction, there is from diversification. For example, if you can find stocks that are extremely risky, but move in an opposite direction from your portfolio, you could add those very risky stocks to your portfolio and end up with less risk than you had before.

8-6. Unsystematic risk is the variability in a firm’s stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence. On the other hand, systematic risk is the variability in a firm’s stock price that is the result of general influences within the industry or resulting from overall market or economic influences. A general change in interest rates charged by banks is an example of systematic risk. Since beta measures the extent to which a particular

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investment’s returns vary with the returns of the market portfolio, and the market is, by definition, diversified to the point that there is no unsystematic risk, beta only measures systematic risk.

8-7. The beta of a portfolio is simply the weighted average of the betas that make up the portfolio.

8-8. The straight line relationship between the betas and expected returns in Figure 8-4 is called the security market line, and its slope is often referred to as the reward-to-risk ratio. Note that the security market line is simply a graphical representation of the Capital Asset Pricing Model. We can measure the slope of the security market line by computing the ratio of the change in expected rate of return measured along the vertical axis divided by the corresponding change in the beta for the portfolios with these two expected returns. The intercept is the risk free rate of return.

8-9. The capital asset pricing model (CAPM) provides an intuitive framework for understanding the risk-return relationship. It basically says that investors receive a return for delaying consumption (the risk-free rate of return) and then a return for taking on added risk as measured by the investment’s systematic risk.

8-10. If the reward-to-risk relationship is not the same for all assets, individuals would sell securities that did not have the reward-to-risk relationship available on other securities and buy securities with higher reward-to-risk relationships – the end result would be to push the price of underachieving stocks down – making them more attractive, and pushing the price of overachieving stocks up – making them less attractive. This would continue until all stocks have the same reward-to-risk relationship.

8-11. The key to reducing risk through diversification is to combine investments whose returns do not move together and thus are not perfectly positively correlated – thus, as long as investments are not perfectly correlated with each other there will be some value to diversification (like investments A and B). If assets are negatively correlated, the impact of diversification will be much more dramatic. Keep in mind, diversification does not impact the expected return, it is simply the weighted average expected return of the assets making up the portfolio.

8-12. False. The standard deviation measures total risk – both systematic and unsystematic, whereas the beta is a measure of unsystematic risk. Just because the beta is low (that is, the stock tends to mute the market’s ups and downs), the total variability may be high because the company has a lot of unique risk – perhaps it is simply a very risky venture on in its own right where that risk has nothing to do with what’s happening to other stocks or in the market.

8-13. No, assuming the risk-free rate is 4% and the market risk premium is 5%, if the beta jumps from 1.5 to 4.5, then the expected return would go from 12.5% to 27.5%, keep in mind only the return for taking on added risk jumps, not the return for delaying consumption (the riskfree rate) jumps.

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Chapter 9 Solutions to Study Questions 9-1. This is a subjective question and every student, depending upon their individual circumstance, will have a different answer.

9-2. When a corporation borrows money to finance its operations it can choose to either take out a loan from a financial institution, such as a bank or insurance company, or sell bonds.

When debt is incurred through a loan from a financial institution, it is often referred to as private debt, since the debt is not publicly traded. In contrast, bonds are referred to as public debt since they can be traded in the public financial markets.

9-3. Loans made in the private financial market are typically floating rate loans, which means that either every month or every quarter the rate of interest charged by the lender adjusts up or down depending on the movements of an agreed-upon benchmark rate of interest.

9-4. The clean price for a bond is the price of a bond using the bond pricing equation whereas the dirty price of a bond is equal to the clean price plus accrued interest. Accrued interest is equal to the coupon payment times (#days since the last coupon payment / #days in this coupon period).

9-5. This is the first of the four bond valuation relationships - The value of a bond is inversely related to changes in the yield to maturity. When market interest rates increase, the value of the bond decreases, and vice versa. When the market rate of interest goes up, the yield to maturity of the bonds must also go up. However, because the interest payments on a bond are fixed, the only way for the yields to maturity to increase is if the bond’s value declines.

9-6. If you are buying a house and do not expect to be there very long, you may want an adjustable rate mortgage because adjustable rate mortgages generally have a lower interest rate on them than do fixed rate mortgages and if you are going to move soon, the adjustable rate mortgage may not have time to “reset” before you sell your house and move on.

9-7. The par or face value of a bond is the amount that must be repaid to the bondholder at maturity. In general, corporate bonds are issued in denominations of $1,000 although there are some exceptions to this rule. Also, when bond prices are quoted, either by financial managers or in the financial press, prices are generally expressed as a percentage of the bond’s par value. For example, General Electric has a bond issue outstanding that was recently quoted as selling for 100.65. That does not mean you can buy the bond for $100.65. It means that this bond is selling for 100.65 percent of its par value of $1,000.

Hence, the market price of this bond is actually is $1,006.50.

What the bond sells for is a function of the risk of the bond and the current level of interest rates relative to the coupon interest rate on the bond. In effect, the return an investor receives is a function of the interest the bond pays plus or minus the capital appreciation or depreciation on the bond as the price of the bond moves towards its par value (at maturity).

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9-8. Bond par value: The par value of a bond, also known as its face value, is the principal that must be repaid to the bondholder at maturity. In general, corporate bonds are issued with par values in increments of $1,000. Also, when bond prices are quoted in the financial press, prices are generally expressed as a percentage of the bond’s par value.

Current Yield: The current yield on a bond refers to the ratio of the annual interest payment to the bond’s current market price. If, for example, we have a bond with an 8 percent coupon interest rate, a par value of $1,000, and a market price of $700, it would have a current yield of 11.4 percent ($80/$700 = 11.4%).

Yield to maturity: The yield to maturity (YTM) on a bond is the discount rate that equates the present value of the bond’s contractual cash flows (interest and principal at maturity) with the current market price of the bond. This is also the return the investor will earn on the bond if the investor is paid everything that is contractually promised by the issuing firm and the bond is held until maturity.

9-9. The yield to maturity calculation assumes that the bond performs according to the terms in the bond contract or indenture. Thus, the yield to maturity that we calculated above is actually the promised YTM for the bond. Since corporate bonds are subject to the risk of default, the promised yield to maturity can be an optimistic estimate of the yield that the bondholder will actually earn.

9-10. Bond ratings are extremely important to the financial manager. The rating provides an indicator of default risk and therefore it affects the rate of return that lenders require of the firm and the firm’s cost of borrowing. In keeping with Principle 2: There Is a Risk-Return Tradeoff, the rating a bond receives affects the rate of return demanded on the bond by the investors. The lower the bond rating, the higher the risk of default and the higher is the rate of return demanded in the capital markets.

9-11. a. Debentures and mortgage bonds. The term debenture applies to any unsecured long-term debt whereas a mortgage bond is a bond secured by a lien on real property. b. Eurobonds, zero coupon bonds, and junk bonds. Eurobonds are bonds issued in a country different from the one in which the currency of the bond is denominated. Junk, or highyield, bonds have a below-investment grade bond rating.

Bonds with a zero or very low coupon are called zero coupon bonds. The firm issues these bonds at a substantial discount from their $1,000 par value and promises to pay a zero or very low coupon rate of interest each year the bonds are outstanding. With these bonds the investor receives most (or with zero coupon bonds, all) of their return from the appreciation of the bonds.

Originally, the term “junk bonds” was used to describe bonds issued by “fallen angels,” that is, firms with sound financial histories that were facing severe financial problems and suffering from poor credit ratings.

9-12. Bonds sell for less than their par value when the yield to maturity on the bond exceeds the coupon rate. For example, if market rates of interest are such that the bonds of company had a yield to maturity of 10% but the bonds pay interest based on a coupon rate of only 8%, then the bonds will sell for a discount or less than par value. Likewise, if the market rate of interest is such that the bond is priced to yield a 10% rate of return and the bond has an 8% coupon rate of interest, then the bond will sell for more than its par value. .

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9-13. Longer maturity bonds experience greater price changes in response to changes in interest rates than do shorter-term bonds. This means that the prices of longer-term bonds fluctuate more when interest rates change than do the prices of shorter-term bonds. The reason longterm bond prices fluctuate more than short-term bond prices in response to interest rate changes can be explained as follows. If an investor bought a 10-year bond yielding a 12% interest rate, and then the current interest rate for bonds of similar risk increased to 15%, the investor would be receiving a below market coupon for 10 years. If, however, a shorterterm bond had been purchased—say, one maturing in one month— the investor would have to accept the below market rate for only one month. At the end of one month, the investor would get paid his original investment, which could then be invested at the new market rates. Thus, interest rate risk is determined, at least in part, by the length of time an investor is required to commit to an investment 9-14. The nominal rate of interest is the one observed in financial markets. It is the rate of interest that will be earned from holding a bond until maturity where the bond pays the holder the promised interest and principal in accordance with what is promised. This rate is NOT adjusted for the loss of purchasing power resulting from inflation. The real rate of increase in purchasing power experienced over time. This rate of interest is the nominal rate of interest after adjusting for the effects of inflation. Thus, while inflation does not impact the real rate of return, it does impact the nominal return which is observed in the market – the higher anticipated inflation, the higher the nominal rate of return.

9-15. One benefit from buying foreign bonds is diversification. Since interest rate movements differ from country to country, adding international bonds to your portfolio may provide added diversification. On the other hand, financial information used to analyze the foreign company may be less reliable, and is often more difficult to obtain.

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Chapter 10 Solutions to Study Questions 10-1. This is a student opinion response, but typical answers include how will Google take its product and make money off it. How much might it make per year. What are the costs associated with the business. What is the potential for this line of business to create new lines of business? How much risk is there associated with this investment?

10-2. We referred to preferred stock as a hybrid security that shares some of the features of bonds and common stock. For example, like bonds that pay a contractually set interest payment, preferred stock has a contractually stated cash dividend that is paid to the preferred stockholder. Like common stock, and unlike bonds, there is no maturity for a preferred stock issue.

10-3. As we noted earlier, preferred stock has characteristics of both common stock and bonds.

First, like common stock, preferred stock has no fixed maturity date. Also like common stock, the nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. Because a firm can pass on its preferred stock dividends without throwing the firm into bankruptcy, preferred stock is not considered to be a liability, but rather a lower form of equity than common stock. On the other hand, like debt, preferred stock dividends are fixed in amount similar to interest payments. In addition, although in theory preferred stock does not have a set maturity associated with it, many issues of preferred stock require that money be set aside regularly to retire the preferred stock issue, in effect resulting in a maturity date.

10-4. A cumulative feature requires all past unpaid preferred stock dividends be paid before any common stock dividends are declared. A stockholder would like preferred stock to have a cumulative dividend feature because without it there would be no reason why preferred stock dividends would not be omitted or passed when common stock dividends were passed. Since preferred stock does not have the dividend enforcement power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred stockholders.

Other frequent protective features serve to allow for voting rights in the event of nonpayment of dividends or to restrict the payment of common stock dividends if sinkingfund payments are not met or if the firm is in financial difficulty. In effect, the protective features included with preferred stock are similar to the restrictive provisions included with long-term debt.

10-5. Many times the financial media reports focus on the returns of stocks like the dotcoms in an enthusiastic manner that highlights the possibility that a new investor in that stock might also generate high returns in the near future. While that may or may not be the case it does tend to further fuel the herd behavior effect of investing. Perhaps a greater focus on the fundamental valuation prospects for the stock in question would help check some of the unintended consequences of diligently reporting on stocks or investments that have produced high returns of late. .

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10-6. Both values are based on future cash flows to be received by stockholders. Preferred stock typically has a predetermined constant dividend. For common stock, thedividend is based on the profitability of the firm and on management’s decision to pay dividends or to retain the profits for reinvestment purposes. Thus, the growth of future dividends is a prime distinguishing feature of common stock.

10-7. In the previous chapter we learned that the yield to maturity (YTM) used to value a bond is not the same thing as the expected rate of return on the bond. The reason for this is that the bond interest and principal payments used to value the bond are promised payments that are received only if the borrowing firm makes all the interest and principal payments on time (i.e., the firm does not default). The same idea is applied to the valuation of preferred stock. Preferred stock dividends are promised dividends that are only paid if the firm earns sufficient income to pay them. This causes no problem for valuing the preferred stock since we simply discount the promised dividends back to the present using the market yield or promised rate of return for similar shares of preferred stock in the financial marketplace. In other words, we value preferred shares by discounting the contractually promised dividend payments using a promised rate of return to the preferred shareholders.

10-8. The two types of return are dividend income and capital gains. The dividend income for common stockholders differs from preferred stockholders, in that no specified dividend amount is to be received. However, the common stockholders are permitted to participate in the growth of the company. As a result of this growth, their second source of return, price appreciation, is realized.

10-9. Prior to going public, Google’s stock could not have traded in a public market and therefore could not have had a market determined price for its shares at that time. However, that should not take away from the idea that a “value” for Google’s shares would have still existed based upon the present value of the future cash flow expected to be generated by Google’s shares.

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Chapter 11 Solutions to Study Questions 11-1. Over your career you will be faced with investment opportunities that require some type of evaluation and analysis. Whether the decision is to purchase a piece of property that you hope to develop and resell or it involves starting and running a business, capital budgeting analysis will help you make the right decision. In the introduction we described a very simple real estate investment opportunity. More typically such an investment would require substantial investments to improve the property, with renovations over an extended period of time (perhaps as much as a year). Having completed the renovation you might consider at least two alternatives: selling the property to someone else to rent and manage or keep the property and managing the rentals yourself. The tools we develop in this chapter will help you evaluate the initial property investment as well as the decision of whether or not to keep and manage the property.

11-2. Investment ideas can come from a variety of sources. For example, ideas often come from the management and employees of the firm. Employees who work closely with the firm’s customers (generally, the marketing department) and run the firm’s operations (the production management department) are often the idea generators.

11-3. Revenue Enhancing Investments Investments that lead to higher revenues often involve the expansion of existing businesses, such as Apple’s (APPL) decision to add the smaller Nano iPods. Alternatively, when Apple originally decided to begin selling MP3 players with its iPod line of products they created an entirely new line of business.

Cost-Reduction Investments The majority of a firm’s capital expenditure proposals are aimed at reducing the cost of doing business. For example, when WalMart (WMT) decided to locate a regional distribution center in San Marcos, Texas, this investment probably did not expand firm revenues since the region was already populated with WalMart stores. Instead, the primary benefit derived from the distribution center came from lower costs of supporting stores within the region.

Other types of cost-reducing investments arise when equipment either wears out or becomes obsolete due to the development of new and improved equipment. For example, Intel’s (INTC) semiconductor manufacturing plants (called fabs) utilize equipment called handlers that move microprocessors from one processing station to another and test their functionality. Since the technology involved in the manufacture of these processors is always evolving, the handlers also change and evolve. This means that Intel is continually evaluating the replacement of existing equipment.

Mandated Investments Companies frequently find that they must make capital investments to meet safety and environmental regulations. These investments are not revenue producing or cost reducing but are required for the company to continue doing business. An example would be the scrubbers that are installed on the smoke stacks of coal-fired power plants. The scrubbers reduce airborne emissions in order to meet government pollution guidelines.

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11-4. Finding good investment projects can be a daunting task, particularly when the firm faces substantial competition from other firms that are also looking for similar investment opportunities. Recall from your introductory economics class that firms tend to be more profitable when they operate in markets that have less competition. So, the search for good investments is largely a search for opportunities where the firm can exploit some competitive advantage over its competitors. For example, the firm may have a proprietary production process that uses fewer inputs and results in a lower cost of production.

External competition from other firms is an obvious source of competition. However, sources of competition sometimes crop up from within the firm. For example, when the Frito Lay division of Pepsico, Inc. (PEP) considers the development of a new Doritos flavor, Frito Lay’s analysis of future cash flows must take into account competition from other manufacturers of salty snack products as well as competition from their existing line of Doritos flavors. Since shelf space devoted to Doritos is generally fixed, the creation of a new flavor means that the space devoted to existing flavors must be reduced (this is often referred to as cannibalization or erosion of existing product revenues). 1 As a consequence, good investments are most likely to be found in markets that are less competitive. These are markets where barriers to new entrants are sufficiently high to keep out would-be competitors. For example, the strong brand reputation of the Doritos and Frito Lay that results from an ongoing barrage of advertising make it more difficult for new brands to enter the salty snack food category.

11-5. As we discussed in Chapter 1, one of the primary goals of a corporation is to improve the wealth of its shareholders. Since the NPV of an investment is an estimate of the impact of the investment opportunity on the value of the firm, NPV is the holy grail of criteria for evaluating new investment opportunities. In simplified terms, NPV is equal to the present value of the benefits of a project less the present value of the costs of the project.

However, it is not the only investment criterion that is used. In the pages that follow, we will describe other criteria that are used in practice and compare each of them to the NPV criteria.

In the pages that follow, we will first describe in more detail how NPV is used to evaluate investment projects. We will then discuss the case where a firm is interested in choosing just one of many projects. When this is the case, managers do not necessarily choose the project with the highest NPV. We will then describe other criteria that are used in practice and compare each of them to the NPV criteria.

11-6. As we discussed in Chapter 1, one of the primary goals of a corporation is to improve the wealth of its shareholders. Since the NPV of an investment is an estimate of the impact of the investment opportunity on the value of the firm, NPV is the holy grail of criteria for evaluating new investment opportunities. However, it is not the only investment criterion that is used. In the pages that follow, we will describe other criteria that are used in practice and compare each of them to the NPV criteria.

1

We will return to the discussion of revenue cannibalization in Chapter 12 where we discuss cash flow estimation.

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11-7. The payback criterion measures how quickly the project will return its original investment, which is a very useful piece of information to know when evaluating a risky investment.

Specifically, the longer the firm has to wait to recover its investment, the more things can happen that might reduce or eliminate the benefits of making the investment. The principal advantage of the payback method relates to its simplicity and intuitive appeal. However, using the payback period as the sole criterion for evaluating whether to undertake an investment has three fundamental limitations.

Limitation #1: The payback period calculation ignores the time value of money, treating for example cash flows three years from now the same as cash flows in one year.

Limitation #2: The payback period ignores cash flows that are generated by the project beyond the end of the payback period.

Limitation #3: There is no clear-cut way to define the cutoff criterion for the payback period that is tied to the value creation potential of the investment.

11-8.

Investment Criteria Net Present Value

Profitability Index (PI)

Internal Rate of Return (IRR)

Definition

Decision Rule

Present value of expected cash inflows minus the present value of cash outflows.

Accept investments that have a positive NPV.

Present value of expected future cash flows divided by the initial cash investment.

When the PI is greater than one, the NPV will be positive, so the project should be accepted. When PI is less than one, which indicates a bad investment, NPV will be negative and the project should be rejected.

Accept the project if the IRR is greater than the discount rate used to calculate the net present value of the project, and reject it otherwise.

The discount rate that makes NPV equal to zero.

Advantages

Disadvantages

Theoretically correct in that it measures directly the increase in value that the project is expected to produce.

Measures the increase in shareholder wealth expected from undertaking the project being analyzed.

Somewhat complicated to compute (requires an understanding of the time value of money).

Theoretically correct in that it measures directly the increase in value that the project is expected to produce. Useful when rank ordering positive NPV projects where capital is being rationed.

Not as familiar to managers as NPV and does not add any additional information.

Provides a rate of return metric, which many managers prefer.

Cannot always be estimated.

Not familiar to managers without formal business education.

Sometimes provides multiple rates of return for projects with multiple changes in the sign of their cash flows over time.

Can provide conflicting indications to NPV were mutually exclusive projects are compared.

Modified Internal rate of Return (MIRR)

The discount rate that makes the NPV of the modified cash flow stream equal to zero.

Accept the project if the MIRR is greater than the discount rate used to calculate the net present value of the project, and reject it otherwise.

Always produces a single rate of return estimate.

The rate of return produced by the MIRR is not unique to the project since it is influenced by the discount rate used to discount the negative cash flows.

Payback

Time until the initial cash outlay has been recovered.

If the project payback is less than the maximum the firm will accept, the project is acceptable.

Easy to understand and calculate.

Does not consider the time value of money.

An indication of risk (how long it takes to recover the investment.)

Ignores cash flows beyond the payback period.

No rational way to determine the cutoff value for payback.

Discounted Payback

The number of years required to recover the initial investment out of project discounted future cash flows. .

If the project payback is less than the maximum the firm will accept, the project is acceptable

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Same as payback. Plus, by discounting the cash flows, this measure takes into account the time value of money.

Same as the last two items above.

Also, since cash inflows must be discounted it is more complicated to compute than payback.

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11-9. No. To illustrate, consider an investment that costs $100,000 and has cash flows of $50,000 per year for two years. If the firm’s minimum payback is two years then the project is acceptable. Of course, the project will have a negative NPV for any positive discount rate.

To see why this is true, compute the NPV where the discount rate is 10% and you will get a NPV of -$13,223.

11-10. The MIRR represents an attempt to overcome the problem of multiple IRRs for a project.

To accomplish this we essentially eliminate the source of multiple IRRs (i.e., multiple changes in the signs of the cash flows over time). We do this by compounding the interim cash flows forward to the final year of the project’s life using the cost of capital. Having done this then we have only two cash flows to deal with, the initial outlay and the terminal cash flow. By definition this cash flow stream produces only one sign change and therefore only one IRR. The problem we encounter when doing this type of analysis is that we are compounding interim cash flows using the cost of capital (not the project’s IRR—which we are trying to estimate). Consequently, the MIRR is affected by the cost of capital. The correct way to deal with the problem of multiple IRRs is to use NPV! It isn’t that MIRR gives an incorrect accept/reject signal but that it really is not the compound annual rate of return the project is expected to earn.

11-11. Your education expenses are spread over the years you are in college and include the obvious items such as tuition, books, room and board but also include the lost income from working over your college years. The cash inflows from your investment come after college and include the your earnings over your lifetime less the income you would have earned had you not attended college. This analysis focuses on the explicit economic costs and benefits of your college education. There are many other non-economic benefits, however, related to the quality of life you experience as a result of your education.

11-12. The difference in payback and discounted payback, as the names imply, relates to the fact that the future cash flows are discounted to the present in the latter case. Consequently, the two methods produce identical payback measures only where the discount rate is zero (i.e., where the discounting process does not reduce the present value of the future cash flows).

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11-13. These survey results are based on the survey responses of 392 chief financial officers of large US firms. CFOs were asked if they used any of the following standard techniques.

Specifically, they were asked how frequently they used different capital budgeting techniques on a scale of 0 to 4 (with 0 meaning “never,” 1 “almost never,” 2 “sometimes,” 3 “almost always,” and 4 “always”). The results below are the percentage of the CFOs who said they always or almost always used a particular method.

Profitability Index Discounted Payback Payback NPV IRR 0%

10%

20%

30%

40%

50%

60%

70%

80%

Source: John Graham and Campbell Harvey, “How do CFOs make capital budgeting and capital structure decisions?” Journal of Applied Corporate Finance, Volume 15, Number 1 (Spring 2002), 8 - 23.

11-14. The idea, very simply, is that the longer it takes you to get your money back out of an investment, other things being the same, the greater the chance that something will not work out as planned. Consequently, the longer the payback for an investment, the riskier the investment.

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Chapter 12 Solutions to Study Questions 12-1. One obvious possibility is that Toyota is being paid for the technology. Although we do not know the specifics of the financial arrangement between the two auto makers, there probably is some type of royalty payment involved. This means that every time Ford sells a hybrid Fusion it has to pay Toyota a fee for the use of its technology. Moreover, if the technology becomes the dominant technology in the industry with other auto makers making similar arrangements then Toyota makes money each time a hybrid is used.

12-2. For the airline to analyze the decision to include in-flight Internet access, it needs a team that includes technical staff such as engineers to address the cost of installing and maintaining the service, marketing personnel to estimate customer acceptance rates and revenues, and a financial analyst to combine the various cost and revenue estimates into a project evaluation.

12-3. Overhead expenses such as the cost of heat, light, and rent occur regardless of whether we accept or reject a particular project. For this reason, overhead expenses are generally not a relevant consideration when evaluating project cash flows. Note, however, that there are some instances in which overhead expenses may change with a new investment. For example, if the firm adds a new shift to the firm’s operations then its energy costs will increase during the new shift and would therefore be a relevant “incremental” expense of the decision.

12-4. Many times a new project involves an additional investment in working capital. Additional working capital arises out of the fact that cash inflows and outflows from the operations of an investment are often mismatched. That is, inventory is purchased and paid for before it is sold. For example, this may take the form of new inventory to stock a sales outlet or an additional investment in accounts receivable resulting from additional credit sales. Some of the funds needed to finance the increase in inventory and accounts receivable may come from an increase in accounts payable that arises when the firm buys goods on credit. As a result, the actual amount of new investment required by the project is determined by the difference in the sum of the increase in accounts receivables plus inventories less the increase in accounts payable. We will refer to this quantity as net operating working capital. You may recall that in Chapter 3 we defined net working capital as the difference in current assets and current liabilities. Net operating working capital is very similar but focuses on the firm’s accounts receivable and inventories compared to accounts payable.

12-5. Although interest payments are incremental to the investments that are partly financed by borrowing, we do not include the interest payments in the computation of project cash flows. The reason, as we will discuss more fully in Chapter 14, is that the cost of capital for the project incorporates consideration as to how the project is financed, including the after-tax cost of any debt that is used in financing the investment. Consequently, when we discount the incremental cash flows back to the present using the cost of capital, we are implicitly accounting for the cost of raising funds to finance the new project (including the after-tax interest expense). To include interest expense in the computation of the project’s cash flows and in the discount rate would amount to counting interest twice. .

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12-6. The annual free cash flow for an investment project is calculated using Equation (12-2):

Net Operating Profit after Taxes or NOPAT

Operating Cash Flow Note that operating cash flow includes the sum of NOPAT plus depreciation expense.

However, Free Cash Flow adjusts the firm’s operating cash for the effects of any net new investments in capital equipment and working capital.

Important definitions and concepts: Net Operating Income is the profit after deducting the cost of goods sold and all operating expenses (including depreciation expense). Net operating income or net operating profit is also equal to earnings before interest and taxes (EBIT) for capital investment projects since projects do not have other (non-operating) sources of income or expense. For firms that have both operating and non-operating income and expenses EBIT differs from net operating income by the amount of these non-operating sources of income and expense.

Net Operating Profit after Taxes (NOPAT) is equal to the firm’s net operating profit times one minus the corporate tax rate. Note that we do not deduct interest expense before computing the corporate income taxes owed because the tax deductibility of interest is accounted for in the computation of the discount rate or the weighted average cost of capital which is discussed in detail in Chapter 14.

Depreciation Expense is allocation of the cost of fixed assets to the period when the assets are used.

Capital Expenditures (CAPEX) is the periodic expenditure of money for new capital equipment that generally occurs at the time the investment is undertaken (i.e. in year 0).

However, many investments require periodic expenditures over the life of the investment to repair or replace worn out capital equipment. Finally, if the equipment has a salvage value then this becomes a cash inflow in the final year of the project’s life.

Change in Net Operating Working Capital (NOWC) represents changes in the balance of accounts receivable plus inventories less accounts payable. Any changes in this quantity represent either the need to invest more cash or an opportunity to extract cash from the project.

12-7. Depreciation expense represents the allocation of the cost of a long-lived piece of equipment or a building over the life of that item. The actual expenditure might have been made several years prior but the expensing of that cost is “matched” to the revenues the firm generates from that equipment. Since the IRS requires the depreciating of long- lived assets for tax purposes these expenses reduce the firm’s taxes in the year in which the depreciation is taken thus depreciation expense is important as it reduces the firm’s tax liability. However, since there is no cash outflow in the year of the expensing we add depreciation back to determine cash flow. .

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12-8. When a firm invests in a new project, it often leads to an increase in sales that require the firm to extend credit, which means that the firm’s accounts receivable balance will grow. In addition, new projects often lead to a need to increase the firm’s investment in inventories. Both the increase in accounts receivable and in inventories mean that the firm must invest more cash in the business. This is a cash outflow. However, if the firm is able to finance some or all of its inventories using trade credit this offsets the effects of the increased investment in receivables and inventories. The difference in the increased accounts receivable plus inventories, less the 12-9. What are sunk costs and how should they be considered when evaluating an investment’s cash flows?

Sunk costs consist of expenditures that have already been made by the firm and cannot be undone should the firm decide not to make an investment. One such example is R&D expenditures that have been made in past years. Since these expenditures have already been made they are not “incremental” to the investment being considered and are therefore irrelevant to the analysis.

12-10. To be a relevant expense for considering an investment the expenditure must result directly from the decision to accept the investment opportunity. Generally, overhead expenses such as managerial salaries, office expenses, etc. are sunk and therefore irrelevant to the analysis of most new investments. However, if an investment requires that the firm increase sources of overhead (hiring new managers, increasing utilities for extra shifts, etc.) then these expenses are indeed incremental and should be considered when computing the firm’s investment cash flows.

12-11. In calculating the cash flows of an investment it is important to account for what economists refer to as opportunity costs, the cost of passing up the next best choice when making a decision. To illustrate, consider the convenience store example we introduced earlier. Remember that we were considering whether to open a second location just a few blocks from our first very successful store. Let’s now assume that you have purchased the building in which the second store is to be located and it has space for two businesses.

One of the spaces is occupied by a tanning salon and you are considering opening a second convenience store in the open space. Since you already own the building and the space needed for the convenience store is currently unused, should you charge the second convenience store business for use of the open space? The answer is no if you have no other foreseeable use for the space. However, what if a local restaurant owner approaches you with a proposal to rent the space for $2,000 a month? If you open the second convenience store then you will forego the $2,000 per month in rent, and this becomes a very relevant incremental expense since it represents an opportunity cost of putting in a convenience store.

12-12. In a word, yes. Anticipated inflation effects on both revenue and expense should be incorporated into the analysis. There are two basic approaches that can be taken. The first uses inflated or nominal cash flows discounted using nominal discount rates. The second uses real (not adjusted for the effects of future inflation) cash flows that are discounted using real interest rates. The former method is, for most analysts, the preferred methodology. .

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12-13. This is an interesting case study for on the surface one would not expect a hamburger chain to be successful in an environment dominated by Hindu’s and vegetarians. However, there are a number of possibilities. First, the chain does have a wide variety of products that are not made of beef. Second, the small market for beef products may be sufficient in the second most populous country in the world.

12-14. Responses to this question are going to vary from individual to individual and from year to year. However, new consumer electronics products are a very obvious choice.

12-15. In point of fact, when a buyer purchased a Pontiac it may well be that their alternative might have been an Oldsmobile (now defunct) or Chevrolet. Not considering the incremental impact of developing and selling a new model could well lead to overinvestment in different models. For example, a new model of Chevrolet might offer an anticipate revenue of $100 million per year if we fail to consider that 50% of the new model sales came from Pontiac models that were not purchased. Considering the incremental (non-cannibalized) revenues then leads to better company-wide decisions.

12-16. The answer here is no. Consider the assets that comprise a firm’s working capital: accounts receivable and inventory. Both these assets are subject to “shrinkage”. Some credit accounts may end up being uncollectable and some inventory items may spoil, be stolen, or simply become unsalable with the passage of time.

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Chapter 13 Solutions to Study Questions 13-1. Although responses to this question will vary, a primary source of risk relates to demand for the firm’s products and/or services which will incorporate consideration for the nature of the competitive environment. In addition, the firm will face cost control issues including staffing the firm and effectively motivating them to act in concert to achieve the firm’s goals.

13-2. There are two fundamental reasons to perform a project risk analysis of NPV before making the final accept/reject decision: o The first is that project cash flows are risky. Our NPV calculation is based on estimates of future cash flows, and the future probably will not look like our estimate.

So, it is very helpful to explore the nature of the risks the project entails so that we can be better prepared to manage the project if it is accepted. o The second is that forecasts are made by humans, and they can be either too optimistic or too pessimistic when making their cash flow forecasts. The fact that the analyst may not be totally objective about the analysis injects a source of bias into the investment decision-making process. Overly optimistic behavior can result in the acceptance of investments that fail to produce the optimistic forecasts, and pessimistic bias can result in the firm passing up worthwhile projects. Both types of bias are costly to the firm’s shareholders, and a careful risk analysis of projects is one way to guard against such bias.

13-3. Sensitivity analysis entails an exploration of the effect of individual value drivers of an investment on the final outcome of the project (i.e., NPV). Scenario analysis involves selecting a set of specific assumptions about project value drivers and computing the resulting NPV. Simulation analysis utilizes “overwhelming force” to solve for the effect of value drivers on project NPV. Specifically, with simulation we do not analyze a limited number of scenarios but literally thousands.

13-4. The risking value of the Yen relative to the dollar meant that Japanese exports looked more expensive to US buyers. As a result, a rising value of your home country generally results in falling exports and rising imports.

13-5. The simulation process is illustrated in Figure 13-1 and can be thought of in terms of a five-step process: Step 1: Probability distributions are estimated for each of the investment’s key value drivers, (i.e., the variables or factors that determine the project’s cash flows). In this example the value drivers include the cost required to launch the investment and its associated residual value at the end of the project’s life; the factors that determine project revenues (the size of the market for the drug, the market share that Merck thinks it can capture, the rate of growth in the size of the market, and the price of the drug); and the factors underlying the cost of manufacturing and selling the drug (operating costs and fixed costs). .

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Randomly select one value for each of the value drivers from their respective probability distributions.

Combine the values selected for each of the value drivers to estimate project cash flows for each year of the project’s life and calculate the project’s IRR. Store or save the calculated value of the IRR and repeat Steps 2 and 3.

Simulations are easily carried out using readily available computer software that allows one to easily repeat steps 2 and 3 thousands of times.

Use the stored values of the project IRR to construct a histogram or probability distribution of IRR.

13-6. Accounting breakeven analysis focuses on the level of revenue or unit sales that provide an operating earnings equal to zero. To the contrary, NPV breakeven focuses on the level of revenue or units sole that produces a zero NPV. These two quantities are different not only because of differences in the breakeven metric (operating earnings versus NPV) but also due to the fact that with NPV we discount the future cash flows.

13-7. Three of the most common sources of flexibility that can add value to an investment opportunity include the following: o Timing options—the option to delay a project until the future cash flows are more favorable—this option is common when the firm has exclusive rights, perhaps a patent, to a product or technology; o Expansion options—the option to increase the scale and scope of an investment in response to realized demand; and o Contract, Shut-down, and Abandonment options—the option to slow down production, halt production temporarily, or stop production permanently (abandonment).

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Chapter 14 Solutions to Study Questions 14-1. We can think of the cost of capital for a firm as a weighted average of the required returns of the securities that are used to finance the firm. We refer to this as the firm’s Weighted Average Cost of Capital, or WACC. WACC not only incorporates the required rates of return of the firm’s lenders and investors but also accounts for the particular mix of financing sources that the firm uses. Most firms raise capital to fund investments with a combination of debt, equity, and hybrid securities that have attributes of both debt and equity. The firm’s WACC is simply a weighted average of the cost of these sources of capital to the firm. As such, a firm’s WACC is a blend of the costs of borrowing money (after-taxes) and cost of raising capital from common stockholders.

14-2. We can summarize the mechanics of calculating the firm’s WACC using Equation (14-1) in the three-step procedure illustrated in Figure 14-2. The steps are as follows: Step 1: Define the firm’s capital structure. Evaluate the firm’s mix of debt and equity financing (commonly referred to as its capital structure) and determine the relative importance of each component in the mix listed in column (1) of Figure 14-2. In column (2), we can see the importance (weight) of each source of capital, which is based on the current market value of each source of capital.

Step 2: Estimate the opportunity cost of each of the sources of financing. These costs are equal to the investor’s required rates of return after adjusting the cost of debt for the effects of taxes, as shown in column (3). To estimate these costs, we’ll use the current market value of each source of capital based on its current, not historical, costs.

Step 3: Calculate a weighted average of the costs of each source of financing. Finally, in column (4) we calculate the product of the after-tax costs of each capital source used by the firm and the weights associated with each source. The sum of these products is the weighted average cost of capital at the bottom of column (4). Consequently, the firm’s WACC is nothing but a weighted average of the costs of each source of capital used by the firm where the weights capture the relative importance of each source of capital to the firm’s capital structure.

14-3. We need to be a bit careful here when talking about invested capital, for it does not include everything on the right-hand side of the firm’s balance sheet. A firm’s capital structure includes the firm’s interest-bearing debt (both short-term and long-term), preferred equity, and common equity. Interest-bearing debt includes things like bank loans (short- and longterm) as well as any bonds the firm has issued. However, accounts payable and accrued expenses are excluded from the capital structure components even though they do have a cost to the firm; however, their costs are included in the prices the firm pays for the goods and services that give rise to the creation of the accounts payable and accrued expenses. So to include the cost of accounts payable and accrued expenses in the calculation of the WACC and include them in the calculation of the firm’s cash flow would effectively count them twice.

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14-4. The key thing to think about is that the risk of the investment opportunity, not the source of financing, should drive the discount rate decision. This means, for example, if the investment is to come from your friend’s savings account on which he is earning 5% then it might seem that the opportunity cost foregone for using the savings to buy the restaurant is the 5% in lost interest. However, this is incorrect for the restaurant is a far more risky use of your friend’s savings than depositing them in a bank account. In addition, should your friend decide to borrow some part of the funds then the cost of borrowing for the investment must be considered. Preferably we want the loan rate to the project (not the rate to your friend who might personally guarantee payment and who might have sufficient funds in the bank to guarantee repayment of the note). Finally, one would compute the WACC of the opportunity cost of the funds used to purchase the franchise to use as the appropriate discount rate for valuing it.

14-5. Using the firm’s WACC to evaluate new investment is, in theory, only appropriate if the firm only considers new projects that are identical in risk to the investments it has already made. If the firm has several divisions with different risk levels, the discount rate they should use to evaluate individual investment projects should be different than the WACC. Finance theory suggests that the appropriate discount rate takes into account the opportunity cost of capital, which in turn reflects the risk of the investment. The appropriate opportunity cost can be viewed as the expected rate of return on publicly traded stocks and bonds with equivalent risk. One would not initiate an investment project with expected returns that are less than the returns that can be generated from investments in publicly traded stocks and bonds with equivalent risk since an investment in the stocks and bonds would clearly dominate the project. Hence, less risky investments, whose cash flows resemble the cash flows of a bond, will have an opportunity cost of capital that is lower than more risky investments, whose cash flows resemble the cash flows of a more risky stock.

There are at least two important reasons for sticking with a single discount rate. First, there are technical issues that can potentially make the use of multiple discount rates more trouble than it is worth. For example, individual investment projects, unless they are very large ones, do not have their own capital structure, nor are the sources of capital for the project easily identified or their market prices easily observed. Instead, the firm issues equity, and the price of the firm’s stock combined with its volatility reflects the average risk of all the firm’s investments, not any one particular project.

The second issue that arises with the use of project costs of capital is more subtle and relates to something we will refer to as influence costs. These added costs arise as a result of the extra time and effort someone in charge of trying to get a project approved for funding by the firm’s upper management spends trying to justify a lower discount rate, as well as the time spent by the firm’s managers charged with evaluating the project. In spite of these added costs, some firms do allow for limited flexibility in determining the project cost of capital.

14-6. The approach taken by most firms that undertake investments with very different risk characteristics is to try and isolate their costs of capital for each of their business units or divisions by estimating divisional WACCs. The idea here is that the divisions take on investment projects with unique levels of risk and, consequently, the WACC used in each division is potentially unique to that division. Generally, divisions are defined either by .

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geographical regions (e.g., the Latin American division) or industry (e.g., pipelines, refining, and exploration and production for a large integrated oil company). The procedure used to estimate a divisional WACC are very similar to those used to calculate a firm’s WACC except that the opportunity costs of funds and weights now correspond to those of the division.

The advantages of using a divisional WACC include the following: • It provides different discount rates that reflect differences in the systematic risk of the projects evaluated by the different divisions.

• It entails only one cost of capital estimate per division (as opposed to unique discount rates for each project), thereby minimizing the time and effort of estimating the cost of capital.

The use of a common discount rate throughout the division limits managerial latitude and the attendant influence costs.

14-7. Flotation costs of raising new financing constitute a part of the initial outlay of the investment and should be treated as such. That is, we simply add the total cost of raising the money needed to finance the investment to the project’s initial cash outlay.

Alternatively, the cost of each source of financing can be adjusted to reflect flotation costs. In the end both methods work. It just seems simpler to recognize flotation costs for what they are, a cash outflow in the year in which funds are raised from the capital markets.

14-8. The cost of borrowing short-term funds is lower only for firms that can qualify for borrowing! Moreover, even if you are able to borrow money or issue stock at current low rates, you may be unwilling to invest due to the high degree of uncertainty you face in your product or service markets.

14-9. The guiding principle for selecting a cost of capital is that the cost follows the risk of the investment opportunity. This would argue for using the cost of capital for Seattle’s Best in valuing the company. However, Seattle’s Best may have used a significant amount of debt in its capital structure that Starbucks does not plan to use. In the latter case we would want to estimate the WACC for Seattle’s Best “using” the proposed capital structure.

14-10. Interest rates in different countries are nominal rates and nominal rates (as we learned in previous chapters) reflect the effects of both real rates of interest in the economy and the effect of anticipated inflation. To the extent that the expected rates of inflation differ among countries we should also expect that their nominal rates of interest would also differ.

14-11. Based upon the average yields for the first quarter of 2016, the yield for a 10-year Acorporate bond was 2.92% while the 10-year Treasury yield was 1.59%. That means the spread for 10-year corporate bonds was 1.33% (2.92% - 1.59%).

A basis point (bp) is 1/100th of a percentage point so 10.01% is 1-bp higher than 10.00%.

The yield for a 30-year BB- corporate bond was 8.00% while the 30-year Treasury yield was 2.76%. That means the spread for 30-year corporate bonds was 5.24% or 524 bps.

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Chapter 15 Solutions to Study Questions 15-1. The dominant form of retirement program in the U.S. involves what is known as a defined contribution program. This means that your employer agrees to provide you with a specified sum of money (usually a percent of your pay check) that is deposited into your retirement fund. The investment of this fund then is directed by you to different types of investment funds. It is at this point that the failures of GM and Lehman Brothers might impact you personally since the majority of these firm’s shares is held in various mutual funds.

15-2. A firm’s capital structure consists of owner’s equity and its interest-bearing debt, including short-term bank loans. You may recall from Chapter 14 that the firm’s capital structure does not include everything listed on the liabilities and owners’ equity side of the balance sheet. We call the combination of capital structure plus the firm’s non-interest bearing liabilities such as accounts payable and accrued expenses as the firm’s financial structure.

15-3. Non-interest bearing liabilities are liabilities incurred by a firm for which no explicit interest payment is specified. An example is accounts payable which is incurred by the firm when it purchases new items of inventory. Although there is a cost of money included in such liabilities, it is implicit or hidden in the cost of the items being purchased. So to include accounts payable (or any non-interest bearing liability) in the firm’s capital structure would result in double counting the implicit interest which is already in the computation of firm cash flows.

15-4. The term financial leverage is often used to describe a firm’s capital structure. This terminology arises from the fact that borrowing a portion of the firm’s capital at a fixed rate of interest provides the firm an opportunity to “leverage” the rate of return it earns on its total capital into an even higher rate of return on the firm’s equity. We will look into this phenomenon much closer in the final section, however, it should be noted that if the firm is earning 15% on its investments and paying only 9% on borrowed money, the 6% differential goes to the firm’s owners. As a result, the firm’s return on equity will be much higher than 15%. This is what is known as favorable financial leverage. If the firm earns only 9% on its investments and must pay 15% then the 6% differential here must come out of the owner’s share of the investment return and they suffer unfavorable financial leverage. The key determinant of whether the use of financial leverage is favorable or not relates to whether the firm is able to invest the borrowed money at a rate of return that exceeds its cost.

15-5. The term relevant is used here to mean that the financing choices made by the firm are or are not important in determining the value of the firm to its shareholders. Where financing decisions are not relevant then managers should treat the financing choice between debt and equity as a matter of indifference.

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15-6.

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Assumption 1: The cash flows that a firm generates are not affected by how the firm is financed. As we will discuss later, this is the case when there are no taxes, no costs associated with bankruptcy and when the firm’s debt obligations do not in any way affect its ability to operate its business.

Assumption 2: Financial markets are perfect. This means that securities can be traded without cost and individuals can borrow and lend at the same rate as the firm.

15-7. This figure suggests that the cash flow “pie” is the same regardless of the financing mix. If this is true then the financing decision is not relevant to value maximization and therefore to the financial manager.

15-8. The firm’s cost of capital is fixed (constant) for all capital structure alternatives. Since the weight attached to debt increases with more debt financing and debt is less costly than equity, the cost of equity must increase such that the weighted average cost of capital remains constant.

15-9. In reality, financial managers care a great deal about how their firms are financed. Indeed, there can be negative consequences for firms that select an inappropriate capital structure, which means that, in reality, at least one of the two M&M assumptions is violated.

Violations of Assumption 2 Assumption 2 is clearly violated in reality. Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. When this is the case, firm values may depend on how they are financed because individuals cannot substitute their individual borrowing for corporate borrowing to achieve a desired level of financial leverage. For example, if firms can borrow more cheaply than individuals, it might be better to have firms take on more financial leverage.

This would increase both the risk and return of the stocks, and allow individuals who want to take substantial risk in their own portfolios to do so without borrowing. However, these violations of the Modigliani and Miller Theorem provide very little in the way of insights about why some firms include much more debt in their capital structures than other firms, since the transaction costs that cause differences between the borrowing rates of corporations and the rates faced by individuals tend to affect all firms equally.

Violations of Assumption 1 are much more fundamental and provide important insights about why different firms choose different capital structures. As we will discuss, the cash flows generated by firms are in fact influenced by how the firm is financed.

Violations of Assumption 1 Why might the extent to which the firm is financed by debt or equity affect the total aftertax cash flows generated by a firm? As we discuss below, there are three important reasons why capital structure affects the total cash flows available to its debt and equity holders.

1. Under the U.S. tax code, interest is a tax-deductible expense, while dividends paid to stockholders are not. Thus, after taxes, firms have more money to distribute to their debt and equity holders if they use more debt financing. 1 2. Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the creditors can force the firm into bankruptcy and the firm will incur the added costs that this process entails.

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This is not the case in all countries. The taxing authorities in a number of countries have made changes in their tax laws that reduced or eliminated the tax preference for debt financing.

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The threat of bankruptcy can influence the behavior of a firm’s executives as well as its employees and customers. On one hand, it can focus managerial attention on improving firm performance. On the other hand, too much debt can lead to changes that make a firm a less desirable employer and supplier.

15-10. In the United States, interest payments are tax deductible, but dividend payments are not.

So if the before-tax cash flows are unaffected by how the firm is financed, the after-tax cash flows will be higher if the firm’s capital structure includes more debt and less equity.

This tax deductibility of interest expense leads firms to include more debt in their capital structures. In essence, corporate income taxes subsidize the firm’s use of debt financing by allowing interest to be deducted before corporate taxes are calculated. So if a firm pays a tax rate of 25%, it gets a $0.25 tax refund for every dollar it pays in interest but nothing for the dividends it pays to the firm’s common stockholders.

15-11. If taxes were the only reason that capital structure affects cash flows, the firm would simply use enough debt financing to generate a tax deduction that is sufficient to eliminate its tax liability. However, the downside of using debt financing quickly becomes apparent when the firm’s debt obligations exceed its ability to generate cash. When this is the case, the firm will need to work out a deal with its bankers and bondholders to restructure its debt or they might be forced into bankruptcy. In either case, a failure to meet one’s debt obligations can generate substantial costs to the firm that we collectively refer to as financial distress costs.

In both a mild and deep recession, firms that use financial leverage will be subject to what economists call deadweight costs that reduce the total amount of the cash flows that the firm can distribute to its debt and equity holders. These costs of financial distress arise because the firm’s financial troubles will distract the managers, forcing them to spend their time negotiating with bankers rather than developing new products. They are also likely to generate large legal bills.

While being forced into bankruptcy is obviously costly to the firm, it is also true that just the threat of bankruptcy, or what we will call financial distress, can cause problems for a firm long before the firm finds itself filing for bankruptcy. A firm that is close to bankruptcy is likely to be viewed by its customers and its suppliers as an unreliable business partner. Firms that are experiencing financial distress are likely to lose sales as customers seek out more reliable suppliers, find it difficult to get competitive quotes from their suppliers who are increasingly worried about being repaid, and find it difficult to attract the best quality employees as prospective workers worry more about future layoffs.

15-12. There are two factors that can have a material impact on the role of capital structure in determining firm value.

• Interest expense is tax deductible. This fact makes the use of debt financing less costly, and lowers the firm’s weighted average cost of capital.

• Debt makes it more likely that firms will experience financial distress costs.

The contractual interest and principal payments that accompany the use of debt financing increase the likelihood that the firm will go into bankruptcy at some time in the future, which can lead to losses that reduce the cash flows of the firm.

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When firms make financing decisions they must tradeoff the pluses and minuses of both these factors. On one hand, firms with substantial amounts of taxable income that they can eliminate by taking on debt while facing relatively modest risk of incurring the costs of financial distress will tend to choose relatively high debt ratios. On the other hand, firms that are not generating a lot of taxable income, and which would be subject to substantial costs of financial distress if they have financial difficulties, will want relatively low debt ratios.

The tradeoff between the positive effects of interest tax savings and the expected costs of financial distress produces a saucer shaped cost of capital curve that has a minimum cost of capital for the optimal mix of financing sources. Unfortunately it is not possible to determine the optimal capital structure precisely since the expected costs of financial distress are very difficult to estimate.

15-13. As we discussed in Chapter 1, public corporations are managed by professional managers who do not own all the shares of the firm they manage. When the managers who control the firm’s operations own only a small fraction of its shares there will be times when their self-interest is not the same as that of the firm’s stockholders who own the majority of the firm’s shares. When this is the case, the managers may make choices that are not in the shareholders’ interests resulting in what economists call agency costs. It is sometimes possible to reduce these agency costs through the use of debt financing. For example, it is often argued that managers of firms that have high levels of cash flow tend to become complacent about controls over spending that cash and may engage in wasteful spending practices like buying expensive company buildings, airplanes, and so forth. Corporate executives may also invest in new lines of business, which provide opportunities for themselves and their employees but may not be particularly profitable for the firm’s stockholders.

One way to limit these choices and to get managers to focus more narrowly on stockholder interests is to increase the firm’s debt obligations, thereby reducing the firm’s discretionary control over its cash flow. For example, in 2009 a financially distressed Citigroup canceled its planned delivery of a new corporate jet. As we discussed above, financial distress generally has negative consequence, however, the threat of financial distress can provide a source of discipline that restrains managers who might otherwise make choices that are not in their shareholders’ best interest.

15-14. By benchmarking a firm’s capitals structure, we compare the firm’s current and proposed capital structures to a set of firms that are considered to be in similar lines of business and consequently subject to the same types of risks.

The objective of the benchmarking is not to simply copy what the firm’s competitors are doing. Instead, we use benchmarking to determine a starting point for our analysis. For example, consider the situation where the firm being analyzed currently has a debt ratio of 45%, and raising additional funds with debt will push the debt ratio to 50%. If other firms in similar businesses all have debt ratios less than 30%, we would probably want to be extremely cautious about engaging in additional borrowing.

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15-15. Benchmarking is a tool for analyzing financing decisions by comparing the effects of the financing alternatives on the firm’s financial ratios. The benchmarking process involves calculating a set of financial leverage ratios for the firm for three scenarios: (i) prior to any new financing episode (the firm as it exists today), (ii) with common equity financing, and (iii) with debt financing. The resulting ratios are then compared to these same ratios for similar firms.

Two types of financial ratios are typically used including balance sheet based measures of the extent to which debt financing has been used by the firm (the Debt Ratio and Interestbearing Debt Ratio found below) and coverage ratios that indicate the ability of the firm to meet the financial requirements of its debt (i.e., the Times Interest Earned Ratio and the EBITDA Coverage Ratio found below): These financial leverage ratios are then used to compare a firm’s capital structure to the financial leverage ratios of similar firms (the final column): 15-16. The firm’s capital structure decisions affect both the level and the volatility of the firm’s reported earnings per share (EPS). Firms that use more debt financing, other things remaining the same, will experience greater swings in their earnings per share in response to changes in firm revenues and operating earnings. This is generally referred to as the financial leverage effect.

Financial leverage can sometimes make a firm’s earnings per share higher and at other times lower. The key determinant of the effect of financial leverage on the level of earnings per share is the rate of return earned by the firm on its assets. For example, if the firm is borrowing at 8% and earns 10% on the borrowed money, then the additional 2% the firm earns over the cost of borrowing goes to the common shareholders. This increases both the rate of return earned on the common shareholders’ equity and earnings per share.

When this happens the firm is said to benefit from the use of favorable financial leverage since the use of debt financing results in higher EPS and an increase in the firm’s return on equity.

15-17. Based solely on the level of EPS the firm is expected to earn in the future we could easily make a case for incorporating a higher level of debt financing. However, this recommendation must be tempered by the fact that higher use of financial leverage leads to more volatile EPS in response to fluctuations in firm operating earnings. So the tradeoff the firm’s CFO must consider is the prospect of reporting higher but more volatile EPS in the future if the firm chooses to increase its reliance on debt financing.

15-18. Industry norms are averages of ratios used to compare one firm’s use of debt (financial leverage) to another. Typically, two types of ratios are used: income statement based coverage ratios such as times interest earned that indicate the firm’s ability to service its outstanding debt, and balance sheet debt ratios that indicate the proportion of the firm’s investments that have been financed with debt.

15-19. In general, firms that have very stable earnings are able to sustain a higher proportion of debt in their capital structure. The reason is that with stable earnings the risk of financial distress and its attendant costs is reduced.

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15-20. Financial flexibility refers to the ease with which a firm can raise capital when needed. For example, many firms hold substantial cash reserves in anticipation of an investment opportunity that may arise unexpectedly. What this does is reduce the firm’s dependence on the capital markets which can be both fickle and expensive to access.

15-21. Investments that increase fixed operating costs relative to variable expenses result in an increase in the firm’s degree of operating leverage. What this means is that the firm’s operating earnings will fluctuate much more wildly in response to changes in revenues than they did prior to making the investment. Consequently, other things being the same, the robotics investment increases operating risk and would probably be financed using equity which reduces financial risk such that the combined effects of operating and financial leverage do not get out of hand.

15-22. The principal source of differences in interest rates across countries relate to risk exposure in the different economies that leads to differences in the real rate of interest and differences in inflationary expectations which results in different inflation premiums.

15-23. In the case of the capital lease, the lessor borrows to purchase the asset and subsequently owns the title to the asset thus giving the tax depreciation benefits of ownership to the lessor. The lessor pays the loan used to finance the asset with the payments received from the lessee. In the case of the purchase of the asset by the user of the asset, the user borrows to finance the asset and then makes the debt payments. The tax depreciation benefits of ownership are given to the user of the asset in that case.

15-24. If the user of a potential asset is in a low effective tax rate then by purchasing the asset the user will not be able to completely utilize the depreciation tax shield of owning that asset.

Leasing provides an avenue for a firm in a higher effective tax rate to purchase the asset and more effectively utilize the depreciation tax shield and then share some of those benefits with the user (lessee) of the asset through a payment stream that has the potential to create a lower present value of after-tax payments for use of the asset than through purchasing the asset.

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Chapter 16 Solutions to Study Questions 16-1. EMR’s cash dividend in 2012 was $1.60 per share and the stock was selling for $46.49 on July 26, 2012 which provided a dividend yield of 3.5%.

16-2. The firm increased its dividend from $0.45 per quarter in 2013 to $0.47 per quarter in 2014. Since then they have maintained the dividend through 2014, 2015, and even through 2016. This all took place during a period when oil prices were lower relative to a reasonably long period of time preceding 2014. Shell understood the significance of maintaining its dividend during that time as a reduction in the dividend could signal management’s concern about the level of cash flow expected to be produced by the firm going forward.

16-3. When companies earn a profit they have a choice to make as to what to do with those profits. One alternative is to give the profit back to the firm’s shareholders in cash payments called dividends. Alternatively, the company could keep the profits and reinvest them in the firm’s new investments in the hopes of increasing the value of the firm’s common stock. Dividend policy describes how much of the firm’s profits to retain and how much to pay out in cash dividends.

16-4. A firm’s dividend policy determines how much cash it will distribute to its shareholders and when these distributions will be made. We can characterize a firm’s dividend policy in terms of two fundamental attributes: 1. The fraction of firm earnings paid in dividends. This first attribute is typically described in terms of the dividend payout ratio, which indicates the amount of dividends paid relative to the company’s earnings. For instance, if the dividend per share is $2 and the earnings per share is $4, the payout ratio is 50 percent ($2 ÷ $4).

2. The pattern of payments followed by the firm over time. As will be observed later in the chapter, dividend stability may be almost as important to the investor as the amount of dividends received.

16-5. A stock dividend is a pro-rata distribution of additional shares of stock to the firm’s current stockholders. These distributions are generally defined in terms of a fraction paid per share. A stock split is essentially a very large stock dividend. For example, a 2-for-1 split would entail issuing two new shares of stock to each shareholder in exchange for each old share they currently hold. Thus the 2 for 1 stock split is equivalent to a 100% stock dividend since both will result in the number of shares outstanding doubling while the share price drops in half.

16-6. Unfortunately Aunt Mary is not right. The number of shares has increased but nothing else changed so that the price of each share will decrease proportionately. That is, 100 shares times $20 means her holdings were worth $2,000. Now that she has 110 shares but the total value of the firm’s equity has not changed, the price per share will drop to only $18.18 such that the total value of Aunt Mary’s stock is still $2,000 = 110 x $18.18. .

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16-7. Generally, companies pay dividends on a quarterly basis. To illustrate, on September 13, 2007, Intel announced that holders of record as of November 7, 2007, would receive a $0.10 dividend. The dividend payment was to be made on December 1. September 13 is the declaration date—the date when the dividend is formally declared by the board of directors. The date of record, November 7, designates when the stock transfer books are closed. Investors who own the stock on this date receive the dividend. However, because in the past it was difficult to record stock sales on a timely basis, stock brokerage companies decided to terminate the right of ownership to the dividend two working days before the date of record. This prior date is the ex-dividend date. Therefore, any acquirer of Intel stock on or after November 5 does not receive the dividend. Finally, the company mails the dividend check to each investor on December 1, the payment date.

16-8. Under a dividend reinvestment plan, you’re allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees.

16-9. Very simply, if cousin Harold decides to sell his shares (tender them) to the company, they will pay the announced price for the shares and his holdings in the company stock will decline by 10%.

16-10. Paying a constant dollar amount in dividends per share is popular with both companies and investors who depend on dividends for their income. The reason companies like it is due to the fact that investors watch the firm’s dividend payout and any change is viewed as an indication as to whether the firm is prospering (increased dividend) or not (decreased dividend). By paying out a stable amount the firm can set the dividend sufficiently below anticipated earnings so they can continue paying the dividend even if firm earnings were to decline.

16-11. The firm’s dividend policy is a matter of irrelevance under the following conditions (or assumptions): 1. There are no taxes.

2. No transaction costs are incurred in either buying or selling shares of stock.

3. The firm’s operating and investment policies are fixed.

In other words, under the conditions where the Modigliani and Miller capital structure irrelevancy theorem holds, the distribution choice is also irrelevant.

16-12. This preference for a stable history of paying dividends is ingrained in the investment strategies of a number of investors. However, the popularity of this strategy tends to be counter cyclical. That is, when the economy is booming and investment opportunities are everywhere, investors tend to like high growth stocks that tend to pay little or no dividend.

In times of uncertainty and bad economic times there tends to be a preference for cash dividend paying companies.

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16-13. Prior to the passage of the 2003 tax law, dividends were taxed as ordinary income while capital gains were taxed at the capital gains tax rate. In addition, the capital gains tax rate was lower than the ordinary income tax rate for long-term capital gains, (gains from the sale of securities held for more than one year). Under this tax scenario investor preference for share repurchases over cash dividends as a means of distributing corporate cash flow was even stronger. This is a result of the fact that the capital gains tax is based on the gain realized from the sale of shares not the total value of the cash distribution, and the tax rate on the capital gains was lower than the rate on ordinary income. The tax treatment of capital gains and dividends has changed several times in recent years.

The 2003 tax law calls for the same tax rate to be applied to dividend and capital gains income.

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Chapter 17 Solutions to Study Questions 17-1. Although the functions of marketing and accounting are quite different within the organization they each play a critical role in financial planning. Marketing largely contributes to the revenue estimation requirement which drives the financial forecast while accounting provides the template or set of guidelines within which the financial forecast is prepared. Once a plan has been formulated then the two functional disciplines (marketing and accounting) play a similar role in evaluating the reasonableness of the forecast and in coming up with appropriate target goals for the firm’s performance.

17-2. To prepare the firm for an uncertain future.

17-3. Forecasting a firm’s future sales is the key element in developing a financial plan, yet forecasting can be extremely difficult in some industries. If forecast accuracy is very poor, does this mean the financial planning process is not worthwhile? Explain your answer.

Although forecasts are inherently imperfect, one cannot run a business without making forecasts and thinking about the future. Indeed, forecasting can be viewed as the first step in coming up with a financial plan, that allows firms to come up with the required financing for upcoming investment projects as well as to develop contingency plans when the future does not unfold as expected. While many CEOs still rely on their “gut- feeling,” businesses are increasingly using more systematic approaches to forecasting, which has the added benefit of giving them a more structured approach to planning. Of course plans, based on imperfect forecasts, are by definition imperfect. However, with a systematic approach to think about what the future might be like, firms are better positioned to come up contingency plans that can be used to improve their ability to respond to adverse events and take advantage of opportunities as they arise.

17-4. The percent of sales method utilizes historical ratios of different variables that are relevant to building a financial plan (e.g., the level of inventories the firm might need) divided by firm sales to forecast the variable of interest.

17-5. Most firms engage in three types of planning activities that vary in their objective and degree of detail. For example the firm’s strategic plan defines, in very general terms, how the firm plans to make money in the future. The strategic plan will answer very general questions about the company, such as the following: • Who are we and what do we do?

• Who are our customers?

• Who are our competitors and how do we compete (price, quality, features, etc.)?

For the purposes of this chapter, we assume that the firm has such a plan already in place.

This strategic plan serves as a guide to the preparation of long- and short-term financial plans.

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The long-term financial plan generally encompasses a period of three to five years and incorporates estimates of the firm’s income statements and balance sheets for each year of the planning horizon. These forecasts of the firm’s financial statements are referred to as pro forma financial statements which we defined earlier in Chapter 12 when we discussed cash flow forecasting for capital budgeting.

The short-term financial plan spans a period of one year or less and is a very detailed description of the firm’s anticipated cash flows. The format typically used for the short- term financial plan is a cash budget. The cash budget is highly disaggregated and contains detailed revenue projections and expenses in the month (or even week) in which they are expected to occur for each operating unit of the company.

The long-term financial plan, by comparison, has less detail as it aggregates individual operating unit data to the division or firm level.

17-6. Spontaneous sources of short-term financing arise naturally out of the firm’s operating decisions. For example, when the firm orders new items for its inventories these purchases generate seller financing in accordance with the terms offered by the firm’s vendors. A discretionary source of financing, on the other hand, requires an explicit act by the firm’s management in order to generate the needed sources of funds. For example, when the firm makes a purchase of a piece of capital equipment and does not have the cash to pay for it, then the firm must make a decision as to how best to raise the money and go out and negotiate the terms of financing. An example would be a bank loan to purchase a new forklift truck.

17.7

a. A new advertising campaign that results in more rapidly rising sales—An immediate cash outflow that will be followed later by cash inflows as sales are made and money is collected. b. A delay in the payment of the firm’s accounts payable—A reduction in planned cash expenditures but no change in the firm’s cash balance. c. Offering a more liberal credit policy (to the firm’s customers)—As credit sales are made cash will not flow in as rapidly as before so there will be a reduction in the firm’s cash balance. d. Holding larger inventories in an attempt to reduce the probability of being out of stock—this requires a cash outflow to acquire the additional inventory (unless trade credit can be arranged, thus a reduction in the firm’s cash balance.

17-8. Firms can have too little or too much cash. So, even when the firm has adequate cash on hand it should plan for its cash needs so that it can invest the excess cash to earn a positive return.

17-9. No solution provided as the answer will be unique to each student's particular circumstances.

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Chapter 18 Solutions to Study Questions 18-1. The management at Dell Computer Corporation (DELL) recognized early in the firm’s history that it could improve company performance by following a policy of minimizing its investment in net working capital, (the difference in the firm’s investment in current assets and current liabilities). At the time, Dell’s sales were dominated by retail customers who used credit cards to purchase computers. This meant that the firm’s investment in accounts receivable was minimal, so the firm focused its attention on reducing inventories and expanding its use of trade credit, which is a type of account payable that arises when one firm provides goods or services to a customer with an agreement to bill them later.

Dell used a two-pronged attack. First, to reduce inventories, Dell convinced its suppliers to leave truckloads of the items that Dell needed at the back door of Dell’s plants. The trucks’ contents belonged to the supplier until they were needed by Dell, at which time Dell moved the items from the trailers to its plant. At the same time, Dell’s management took full advantage of the trade credit terms by making their payments at the latest possible date. In combination, these actions not only reduced but eliminated the firm’s investment in working capital! Without the drag of working capital on firm performance the company’s profits soared and its stock price rose dramatically.

18-2. The sales force will push for lenient repayment terms as a method for enticing customers to buy the firm’s products and services. However, offering more lenient payment terms will mean that the firm will need to make a larger investment in accounts receivables.

18-3. The rationale for using the current ratio as a measure of liquidity is as follows: the ability of the firm to pay on time is roughly related to the firm’s current assets, which are by definition those assets that will be converted to cash within one year or less. Similarly, the firm’s debts that must be repaid over the coming year are included in its current liabilities.

Therefore, by comparing the firm’s current assets to its current liabilities we get an indication of the firm’s liquidity.

18-4. Working capital management encompasses the day-to-day activities of managing the firm’s current assets and current liabilities. Because cash, accounts receivable, inventory, and accounts payable can change on a daily and even hourly basis, financial managers may spend more time on working capital management than any other part of their job. Working capital management decisions include, “How much inventory should we carry?,” “Who should credit be extended to?,” Should the firm purchase items for its inventories on credit or pay cash?,” and “If credit is used, when should payment be made?”

18-5. The decisions firms make that affect their net working capital changes the firm’s liquidity or ability to pay its bills on time. Thus, working capital decisions involve a risk–return trade-off. For example, the firm can enhance its profitability by reducing its cash and marketable securities balance since these assets typically earn very low rates of return.

However, the increased profitability comes at a price for the firm is now exposed to a higher risk of not being to pay its bills on time should an unexpected need for cash arise since it has lower cash and marketable securities.

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18-6. Short-term debt must, by definition, be repaid in a period less than a year while long-term debt is due in a period longer than a year. Thus, by definition, using short-term debt creates a greater risk of illiquidity.

18-7. This principle of self-liquidating debt states that the maturity of the source of financing should be matched with the length of time that the financing is needed 18-8. Define the following terms: a. Permanent asset investments Permanent investments are composed of investments in assets that the firm expects to hold for a period longer than one year. These include the firm’s minimum level of current assets such as accounts receivable and inventories, as well as fixed assets. b. Temporary asset investments Temporary investments in assets or simply temporary assets are composed of current assets that will be liquidated and not replaced within the current year. These include cash and marketable securities, accounts receivable, and seasonal fluctuation in inventories. c. Permanent sources of financing Permanent sources of financing include intermediate-term loans, long-term debt (such as installment loans and bonds), preferred stock, and common equity. These sources are considered permanent since the financing is available for a longer period of time than a current liability. d. Temporary sources of financing Temporary sources of financing typically consist of current liabilities the firm incurs on a discretionary basis. Unlike spontaneous sources of financing, the firm’s management must make an overt decision to use one of the various sources of temporary financing. e. Spontaneous sources of financing In Chapter 17 we learned that spontaneous sources of financing arise naturally or spontaneously out of the day-to-day operations of the business and consist of trade credit and other forms of accounts payable.

18-9. The national median credit score is 723, but the cutoff to get the best rate requires a score of 760 or higher. A score of around 620 is often a cutoff point for receiving credit at any rate.

18-10. We solve this expression for rate which is then used to compare the cost of alternative sources of short-term credit.

18-11. The first two numbers, (e.g., 2/10) represent the cash discount of 2% for paying within 10 days) while the net 30 refers to the length of the credit period at which point 100% of the credit extended is due and payable.

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18-12. The size of the investment in accounts receivable is determined by several factors. The first is the level of credit sales as a percentage of total sales. The nature of the business tends to determine the blend between credit sales and cash sales. A large grocery store tends to sell exclusively on a cash basis, whereas most construction-lumber supply firms make their sales primarily with credit. Second, the level of sales is also a factor in determining the size of the investment in accounts receivable. Very simply, the more sales, the greater accounts receivable. The third determinant of the level of investment in accounts receivable is the credit and collection policies—more specifically, the time period allowed until payment is due, any discount for early payment, the quality of customer who receive credit (i.e., the likelihood that they will pay you in a timely fashion), and the collection efforts put forth by the firm to collect its delinquent accounts.

18-13. a. Your Payment History (35 percent of your score). Since a lender is considering extending credit to you, it only makes sense that they want to know how you’ve handled your credit payments in the past. b. The Amount You Owe and Your Available Credit (30 percent of your score). The amount you owe on your credit cards, your mortgage, your car loans, and any other outstanding debt, along with whether you are close to or at your credit limit is also factored in. c. Length of Credit History (15 percent of your score). The longer your credit accounts have been open and the longer you have had accounts with the same creditors, the higher your credit score will be. d. Types of Credit Used (10 percent of your score). If you have several different types of credit outstanding( for example, credit cards, retail accounts, installment loans, auto loans, and a mortgage loan), that is taken as an indicator that you know how to handle your money. e. New Credit (10 percent of your score). Applying for lots of new credit is generally a bad sign. This is because individuals who are moving toward bankruptcy generally take one last grasp at credit, hoping it will keep them afloat. This will lower your score.

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Chapter 19 Solutions to Study Questions 19-1. Operating risks—maintaining operational control while operating in another country with different labor laws and culture can prove very challenging Financial risks—making investments using one currency while receiving cash inflows in another currency creates an exchange rate risk problem not encountered in domestic investing.

Political risks—especially when investing in underdeveloped countries the risk of expropriation can be very real.

19-2. The world has become an increasingly international place in which to live and work.

Thomas Friedman expounds on this theme in his book, The World is Flat, which looks closely at how global boundaries have collapsed, flattening the playing field for all firms worldwide. It no longer matters whether you major in accounting, engineering, economics, marketing, management or finance, you will be competing with individuals with the same training from around the world. As Thomas Friedman explains in his book, the convergence of technology and events have allowed India, China, and many other countries to become part of the global supply chain for services and manufacturing.

Let there be no doubt, there is no going back – not in terms of business or your personal life. The playing field you’ll be on the rest of your life will be an international one.

19-3. Without international investing by domestic firms it is often difficult to get the opportunity to invest in emerging economies. The domestic firms are large enough to manage the risks attendant to such investing while most individual investors are not able to do so.

19-4. Buying an undervalued asset while selling an overvalued asset to profit from coming price corrections.

19-5. Simple arbitrage eliminates exchange rate differentials across the markets for a single currency. For example, assume that in London the spot exchange rate is £ .6360/$, and in New York the exchange rate is £.6239/$. If you simultaneously bought a pound in New York for £.6239/$ and sold a pound in London for £.6360/$, you would have (1) taken a zero net investment position since you bought £1 and sold £1, (2) locked in a sure profit of £.0121/$ no matter which way the pound subsequently moves, and (3) set in motion the forces that will eliminate the different quotes in New York and London. As others in the marketplace learn of your transaction, they will attempt to do the same. The increased demand to buy pounds in New York will lead to a higher £/$ exchange rate in New York, while the increased supply of pounds in London will lead to a lower £/$ exchange rate in London. Ultimately, the workings of the market will produce a new spot rate that lies between £.6239/$ and £.6360/$ and is the same in New York and in London.

19-6. How do purchasing power parity, interest rate parity, and the International Fisher effect explain the relationships between the current spot rate, the future spot rate, and the forward rate?

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Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries’ currencies. Specifically, the interest parity condition can be stated as follows: Difference in = Ratio of the forward interest rates and spot rates According to the theory of purchasing-power parity (PPP), exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased.

The International Fisher Effect (IFE) assumes that real rates of return are the same across the world, so that the differences in nominal returns around the world arise because of different inflation rates.

19-7. Exchange rate risk arises where a firm holds an investment in a foreign country and the value of the currency of that country falls relative to the company’s host country. The loss in value of the investment denomenated in the foreign country is a result of exchange rate risk.

When a company invests resources in a foreign country and the government of that country places taxes on those assets or seizes them altogether the firm is said to have experienced political risk.

19-8. Firms can follow one of two strategies: First, they can hedge their exposure to exchange rate risk by entering into an offsetting contract today in lieu of the pending transaction in the future. Second, the firm can borrow money in the foreign market that can be repaid with revenues from the investment such that there is no need to translate the revenues back to their home currency.

19-9. You could denominate your debt in rupees such that as you receive rupees from your investment you could use them to pay down your debt. In essence, by borrowing in rupees you have hedged your foreign exchange risk.

19-10. Political risk can arise if the foreign subsidiary conducts its business in a politically unstable country. A change in a country’s political environment frequently brings a change in policies with respect to businesses—and especially with respect to foreign businesses.

An extreme change in policy might involve nationalization or even outright expropriation (government seizure) of certain businesses. For example, in 2007, Venezuela nationalized the country’s largest telecommunications company, several electrical companies, and four lucrative oil projects that were owned by Exxon Mobil, Chevron, and ConocoPhillips.

These are the political risks of conducting business abroad. Some examples of political risk are as follows: 1. Expropriation of plants and equipment without compensation.

2. Expropriation with minimal compensation that is below actual market value.

3. Nonconvertibility of the subsidiary’s foreign earnings into the parent’s currency—the problem of blocked funds.

4. Substantial changes in tax rates.

5. Governmental controls in the foreign country regarding the sale price of certain products, wages and compensation paid to personnel, the hiring of personnel, transfer payments made to the parent, and local borrowing.

6. Requirements regarding the local ownership of the business.

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All of these controls and governmental actions put the cash flows of the investment to the parent company at risk. Thus, these risks must be considered before making the foreign investment decision. For example, the MNC might decide against investing in countries with risks of types 1 and 2 as mentioned above, whereas other risks can be borne— provided that the returns from the foreign investments are high enough to compensate for them. In fact, insurance against some types of political risks can be purchased from private insurance companies or from the U.S. government Overseas Private Investment Corporation. It should be noted that although an MNC cannot protect itself against all foreign political risks, political risks are also present in domestic business.

Exchange rate risk is the risk that the value of a firm’s operations and investments will be adversely affected by changes in exchange rates. For example, if U.S. dollars must be converted into euros before making an investment in Denmark, an adverse change in the value of the dollar with respect to the euro will affect the total gain or loss on the investment when the money is converted back to dollars. We will have a lot more to say about exchange rate risk in Chapter 20 where we discuss risk management.

19-11. The same net present value calculations used for domestic investments apply to direct foreign investments. However, the risks are different (see the answer to question 19-10. Since there are more “unknowns” involved in foreign investing it is naturally more complicated.

19-12. If owning the plant doesn’t make sense then the firm might consider partnering with a local company by using a joint venture agreement whereby the foreign partner builds the plant. Alternatively, the firm may license its technology to a foreign company as a means of profiting from the use of that technology in a new market.

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Chapter 20 Solutions to Study Questions 20-1. The focus of corporate risk management is on managing the factors that determine the risk of a firm’s cash flows. Very simply, this risk can be thought of as coming from forces outside the control of the firm such as competition from firms selling similar products or the overall health of the economy in general; and from factors that are under the control of the firm’s management. With respect to the latter, the biggest source of risk comes from uncertainty about the firm’s revenues, which are determined to a large extent by the successes and failures of the firm’s marketing efforts. Another important contributor to the risk of a firm’s cash flows is the firm’s production costs. For example, production cost overruns are a major source of risk that can be controlled to some extent through the use of well-designed and maintained accounting systems that are used by the firm’s operating managers to monitor and control the firm’s operations. So, even though you may not be directly involved in the risk management of your firm, your actions contribute to the underlying risk of the firm’s cash flows.

20-2. Risk management refers to the processes and procedures used by the firm to measure and assess the risks to which the firm is exposed and deciding which ones to retain and which ones to transfer to an outside party.

20-3. The most common sources include the following: 1. Demand risk—fluctuations in product or service demand driven by competitive forces and the effects of the state of the economy in general. Some of this risk is strictly focused on the firm (e.g., product quality, on- time delivery, and so forth). External competition, as well as the status of the regional and national economy, also influences a firm’s demand for its goods and services. For example, the mortgage market crisis of 2007-08 affected the demand for new home construction across the nation. However, the Arizona, California, and Florida markets were hit the hardest for reasons related to their regional economies.

2. Commodity risk—price fluctuations in commodities that are essential to your business can wreak havoc on the firm’s cash flow. For example, the dramatic price increases in the cost of fuel that occurred in 2007-08 produced huge losses for airline companies as it drove up their cost of operations substantially.

3. Country or political risk—where your firm does business can create problems related to maintaining operations in the face of political unrest or unfavorable governmental interference in the firm’s operations.

4. Operational risk—cost overruns related to the firm’s operations is another source of volatility in corporate cash flow.

5. Foreign-exchange risk—unfavorable shifts in the exchange rate between the United States and the foreign countries in which a firm does business can lead to dramatic decreases in corporate cash flow.

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20-4. On May 1, 2008 the firm had natural gas hedges, or investments that neutralize risk, in place covering 74% and 80% of the firm’s natural gas production for 2008 and 2009, respectively.

20-5.

Type of Risk Property damage to company facilities due to fire, storm, or vandalism Loss of business resulting from a temporary shutdown because of fire or other insured peril.

Loss of income resulting from the disability or death of an employee in a key position Losses suffered by the officers and directors of the firm due to alleged errors in judgment, breaches of duty, and wrongful acts related to their organizational activities.

Losses due to on-the-job injuries suffered by employees

Type of Insurance Contract Used to Hedge Property insurance Business interruption insurance

Key person life insurance

Directors and officers insurance

Workers’ compensation insurance

20-6. So when should you purchase life insurance? Here are some common sense guidelines that can help you answer this question: • You’re single and don’t have any dependents. Unless you are concerned that you may not be insurable in the future, purchasing life insurance should probably be a very low priority for you.

• You are part of a married, double-income couple, with no children. Consider life insurance only if you are concerned that a surviving spouse’s lifestyle will suffer should you die today.

• You are married but are not employed. Consider life insurance only if you have young children and your spouse would have financial problems with day care and other costs of raising a family should you die today.

• You are retired. Consider life insurance only if your spouse could not live on your savings, including Social Security and your pension, should you die today.

• You have children. You should have coverage for raising and educating your children until they are financially self-sufficient.

20-7. As discussed in Chapter 19, a forward contract is a contract wherein a price is agreedupon today for an asset to be sold in the future. These contracts are privately negotiated between the buyer and seller. The key feature to a forward contract is the fact that the price determination is made at the time of the contract but the actual purchase and sale do not occur until the maturity of the contract in the future.

Futures contracts are similar to forward contracts except that they have a limited number of terms and conditions that standardize the contract such that it can be traded on an organized exchange. .

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20-8. Consider the problem faced by Tree-Top Airlines (TTA). In six months the firm will need to purchase jet fuel that is currently selling for $100 per barrel and does not want to suffer the risks associated with future price fluctuations in the cost of fuel. (For now we will assume that the firm needs just one barrel of fuel. You can multiply the results by any number of barrels to adjust the outcome for TTA’s actual fuel needs).

The firm can enter into a forward contract today with a delivery price equal to the current price of fuel of $100 that will have the payoffs found in panel (a) of Figure 20-2. The firm that owns this position is said to have taken a long position in the forward contract. Note that if the actual price of jet fuel rises to $130, then the forward contract pays TTA $30 per barrel. Thus, in six months TTA’s cost of fuel remains $100, (the market price of fuel in six months of $130 less the payoff from the long position in the forward contract which is $30).

Now let us consider the situation faced by the Pilot Refining Company, which anticipates that it will have jet fuel refined and ready for sale in six months. However, the price it can realize from the sale of the jet fuel is subject to market fluctuations. To eliminate the risk of a drop in the price Pilot can sell a forward contract (i.e., take a short position) for the delivery in six months at a delivery price of $100. The payoff to this contract is found in Panel (b) of Figure 20-2. For example, if the price of jet fuel rises to $130 on the delivery date then Pilot can sell its jet fuel for this price but the firm suffers a loss of $30 on the forward contract such that the net price received per barrel is $100.

20-9. Generally, forward contracts are negotiated long-term contracts between the firm managing its risk exposure and a financial intermediary such as an investment bank. The primary advantage of this type of bilateral arrangement is that the contract can be tailored to the specific needs of the firm that is engaging in risk management. However, there are some potentially serious limitations of this approach.

1. Credit risk exposure. Both parties to the contract are exposed to the credit or default risk. This is the risk that the other party to the transaction might default on their obligation. For example, there were a large number of firms that had entered into various types of risk management or hedging contracts with Enron Corporation that were designed to mitigate the firms’ exposure to energy price risk. When Enron failed, these contracts were no longer effective. The point is that using bilateral negotiated contracts to manage price risk also exposes the firm to credit or default risk of the person or institution on the other side of the transaction.

2. Sharing of strategic information. Since the two parties to a forward contract know who the other party is, they learn about the specific risks that are being hedged. If the parties to the agreement were anonymous (as would be the case if exchange traded contracts were used), then no such sharing of information would occur.

3. Market values of negotiated contracts are not easily determined. Without a market value for the negotiated forward contract, it is difficult to assess the gains and losses the firm has experienced at any point in time.

The limitations noted can be addressed through the use of exchange-traded contracts.

Specifically, exchanged traded futures, options, and swap contracts, which we discuss in the next section, provide an alternative means for managing corporate risk that does not suffer from the limitations of bilateral negotiated forward contracts.

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20-10. A futures contract is a contract to buy or sell a stated commodity (such as soybeans or corn) or a financial claim (such as U.S. Treasury bonds) at a specified price at some future specified time. These contracts, like forward contracts, can be used by the financial manager to lock in future prices of raw materials, interest rates, or exchange rates.

20-11. There are two basic types of options: calls and puts. A call option gives its owner the right (but not the obligation) to purchase a given number of shares of stock or an asset at a specified price over a given period. Note a key difference between an option contract and a futures contract is that the option holder does not have to exercise the option. If the price of the underlying common stock or asset on which the option is written goes up, the owner of a call option makes money. You have the option to buy something, for example shares of common stock, at a set price even though the market price of the stock has risen above the fixed exercise price.

A put option, on the other hand, gives its owner the right (but not the obligation) to sell a given number of shares of common stock or an asset at a specified price within a given period. The owner of a put makes money when the price of the underlying common stock or asset on which the put is written drops in value. Just as with a call, a put option gives its holder the right to sell the common stock or asset at a set price, but it is not a promise to sell. Now let’s take a look at some of the terminology involved with options.

20-12. As the name swap implies, a swap contract involves the swapping or trading of one set of payments for another. Common types of swap contracts involve interest payments or currencies. For example, an interest rate swap might involve the trading of fixed interest payments for variable or floating rate interest payments between two companies. A currency swap would involve an exchange of debt obligations in different currencies.

To see how an interest rate swap works, consider the set of swap cash flows found in Figure 20-10. These cash flows correspond to a five-year fixed for floating rate swap (trading payments on a five-year fixed rate loan for the payments on a five-year floating rate loan) with semi-annual interest payments and a notional principal of $250 million.

The term notional principal is used since this is the amount used to calculate payments for the contract but this amount does not change hands. The floating rate is set to equal the six-month London Interbank Offer Rate, or Libor, and the fixed rate is 9.75% with both coupon payments paid semi-annually.

In this illustration, the firm that initiates the swap contract has a floating rate obligation so it must pay floating rate payments found in column (D) of Figure 20-10. However, after entering into the swap the firm now pays the swap counterparty the fixed coupon payments found in column (C) and receives a set of payments equal to the floating rate payments found in column (D). The floating rate payments that the firm receives as part of the swap are exactly equal to its floating rate obligations under the terms of its floating rate loan.

Thus, the firm pays the floating rate interest using the proceeds of the swap agreement and then is left with the set of fixed rate coupon payments. Consequently, the firm has converted its floating rate loan into a fixed rate loan.

20-13. Enter into a forward contract today to purchase the needed crude in the future. By doing this the firm fixes the cost of crude for its needs at a future date.

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Chapter 1 Solutions to Study Questions 1-1. The solution to this problem is dependent upon the student’s experiences.

1-2. There are three basic types of issues that are addressed by the study of finance: a. What long-term investments should the firm undertake? This area of finance is generally referred to as capital budgeting. b. How should the firm raise money to fund these investments? The firm’s funding choices are generally referred to as capital structure decisions. c. How can the firm best manage its cash flows as they arise in its day-to-day operations?

This area of finance is generally referred to as working capital management.

1-3. First, investors demand a minimum return for delaying consumption that must be greater than the anticipated rate of inflation. If they didn’t receive enough to compensate for anticipated inflation, investors would purchase whatever goods they desired ahead of time.

There isn’t much incentive to postpone consumption if your savings are going to decline in terms of purchasing power.

Investment alternatives have different amounts of risk and expected returns. Investors sometimes choose to put their money in risky investments because these investments offer higher expected returns. The more risk an investment has, the higher will be its expected return – that’s because risk investors don’t like risk, in particular, they don’t like the chance that they might lose their money. That makes risky investments less attractive, which means that to attract investors, riskier investments must be priced to offer investors a higher expected rate of return. This relationship between risk and expected return is shown in Figure 1.3.

Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns for investing will be, but we can’t peer into the future and see what those returns are actually going to be. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest induces some investors to take on the added risk of purchasing a General Motors bond.

1-4. When evaluating an investment opportunity it is the cash flows, not accounting profits, that determine its value. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning more money on it. As a personal investor or a financial manager, you must remember, it is the cash flows, not profits, which are actually received by the firms and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand. As a result, a firm’s cash flows and accounting profits may not be the same. For example, a capital expense, such as the purchase of new equipment or a building, is depreciated over several years, with the annual depreciation subtracted from profits. However, the cash flow, or actual dollars, associated with this expense generally occurs immediately. Therefore cash inflows and outflows involve the actual receiving and payout of money— when the money hits or leaves your hands. As a result, cash flows correctly reflect the timing of the benefits and costs. .

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1-5. The three business forms are: 1. Sole Proprietorship.

2. Partnership.

3. Corporation.

1. Sole Proprietorship: Advantage: • Forming a sole proprietorship is very easy; there are no forms to file and no partners to consult since the founder of the business is the sole owner.

Disadvantage : • These organizations typically have limited access to the alternative sources of financing. The owners of a sole proprietorship typically raise money by investing their own funds, and by borrowing from a bank.

2. Partnership Advantage : • An important advantage of the partnership is that it provides access to equity, or ownership, financing from multiple owners in return for partnership shares, or units of ownership.

Disadvantage : • Conflict on division of profits between partners.

3. Corporation.

Advantages : • The shareholders’ liability is confined to the amount of their investment in the company. In other words, if the corporation goes under, the owners can only lose their investment.

• The life of the business is not tied to the life of the founding owners. For example, the inventor Thomas Edison founded General Electric (GE) over a century ago. Edison died in 1931, but the corporation lives on.

Disadvantage : • Though management is expected to make ethical decisions that reflect the best interests of the firm’s owners, this is not always the case. Indeed, managers often face situations where their own personal interests differ from the interests of shareholders.

If you were to start a lawn mowing business for the summer, you’d probably form a sole proprietorship. That is the simplest one to form – you don’t have to do anything. Moreover, with a lawn mowing business the probability of a law suit is quite low, so the advantage of limited liability is not particularly important.

1-6. The shareholders are the owners of the corporation. The management should run business so as to maximize the shareholder wealth without being greedy for quick money generation by unethical conducts and practices.

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1-7. Shareholder wealth maximization isn’t the goal of every firm. Privately owned Newman’s Own, the makers of salad dressing, spaghetti sauces, and other food products, was established in 1982 with the goal of making money for educational and charitable purposes.

Paul Newman’s estate and the Newman’s Own Foundation donate all profits and royalties after taxes for educational and charitable purposes.

1-8. In microeconomics courses, profit maximization is frequently cited as the goal of the firm.

Profit maximization stresses the efficient use of capital resources, but it is not specific with respect to the time frame over which profits are to be measured. Do we maximize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating the firm’s research and development expenditures and cutting down on routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base our financial decisions on a goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the real world.

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Chapter 2 Solutions to Study Questions 2-1. The “Regardless of Your Major” box describes two types of retirement plans: defined contribution and defined benefit. The “defined” part of each name means that benefits are specified, or defined; the difference between the two plans is in when those benefits are defined. Defined benefit (DB) plans specify the amounts to be paid in retirement—that is, the benefits the retiree will receive are specified. Thus, the sponsor of the plan promises to make specific payments to the retiree, and then the sponsor accepts the responsibility for investing a pool of assets now (or at least, before the covered person retires) to ensure that those benefits in fact can be paid in the future. Managing pension assets to ensure future payments is complicated, and companies these days prefer to offer defined contribution plans, like 401(k) plans, instead of defined benefit plans. Defined contribution (DC) plans specify the contributions that will be made to the plan (now), not the benefits that will be paid at retirement. It’s a lot easier to specify an amount to be paid today than it is to ensure that one will be made in the future. With defined contribution plans, employees accept the responsibility of investing their funds to ensure adequate resources in retirement, removing that burden from employers. It’s therefore not surprising that employers prefer defined contribution plans, while employees who have defined benefit plans count themselves lucky.

2-2. The three players who interact in the financial markets are borrowers, savers, and financial intermediaries.

Borrowers need money to help finance some specific purpose—a student loan to help pay for college, an auto loan for a car, or a mortgage for a house. Savers have money that they don’t need for consumption today, so they set this money aside to use in the future.

Financial intermediaries bring the two together, channeling the savers’ “extra” money to the borrowers for their immediate use. If the borrowers and savers could get together themselves somehow, they could “cut out the middleman” and save the intermediation costs. This might sound good—but is it feasible? Financial intermediaries specialize in evaluating the creditworthiness of borrowers, so they help ensure that savers’ money is channeled to borrowers who will repay. They also allow efficient aggregation of small amounts of individual savings into blocks of loanable funds large enough to be useful to borrowers.

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lenders

$

FINANCIAL INTERMEDIARIES

$

borrowers

2-3. As outlined in section 2.2 of the text, a financial intermediary is a firm that collects money from savers, bundles it into attractive sizes with attractive terms, and lends it to borrowers.

The principal types of financial intermediaries in the United States are: COMMERCIAL BANKS Commercial banks are depository institutions that take deposits (such as checking or savings deposits) and make loans (such as mortgage loans or auto loans). Commercial banks are also integral parts of our national payment system. Their importance to the functioning of our economy has led to their being heavily regulated and subject to extensive oversight (for example, by the FDIC, which insures their deposits, and by the Fed, which mandates their reserve requirements).

NONBANK FINANCIAL INTERMEDIARIES While these businesses channel money from those who have it to those who need it, they do not both take deposits and make loans, as a depository institution does. financial services corporations: Financial services corporations, like GE Capital, provide loans and credit to businesses and individuals (including credit card services). Some of these companies are charged with ensuring financing for the expensive products of large manufacturing companies (for example, Ford Motor Credit). These institutions do not take deposits, so they are missing one of the two elements of a depository institution’s job description. insurance companies: Insurance companies insure individuals and businesses against certain types of risks (for example, the risk that your automobile will be damaged in a collision, and/or cause damage or injury to someone else; the risk that your house will burn down; the risk that you will die unexpectedly, leaving your heirs without their major breadwinner).

Insurance companies are major players in the financial markets, because they must invest the

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premiums they collect until the money is needed to pay claims. The type of insurance a firm provides tends to determine the type of market in which they invest most frequently. For example, life insurers often have decades between premium collection and claim payments, so they are large players in the capital markets. On the other hand, property and casualty companies (like auto and home insurers) must stay closer to their money, since their claims may come much sooner; they are larger players in the money markets. investment banks: Investment banks like Goldman Sachs and Morgan Stanley advise firms about their financing needs and act as intermediaries when the firms float new securities.

For example, an investment banker may advise a client about the most favorable terms for a new bond issue (e.g., covenants, term, options, coupon), then underwrite the issuance of the bonds (buying the bonds from the issuer, then selling them to investors, taking inventory risk in return for a spread).

INVESTMENT COMPANIES These companies take savings and invest them in other companies’ securities. As the text puts it, they are “financial institutions that pool the savings of individual savers and invest the money, purely for investment purposes, in the securities issued by other companies.”

Perhaps the most familiar type of investment company is the mutual fund. mutual funds: Mutual funds collect money from investors, then invest that money into specific types of financial assets. Each mutual fund has a prospectus that describes the particular type of assets that the fund may buy: for example, the fund may buy bonds, or stocks, or money market assets, or some combination. Mutual fund investors own shares of the fund that entitle them to a proportional share of the assets held by the fund.

Be careful to distinguish mutual fund shares from the shares of stock that a mutual fund may own. Say an equity mutual fund has 10 investors who each put $1,000 into the fund.

The fund’s size is therefore $10,000, and each investor owns 1/10th of the fund. Let’s assume that the fund issues 1,000 mutual fund shares—100 to each investor. Now, say the fund takes its $10,000 and buys 1 share of stock (a very expensive, $10,000/share stock!).

Each investor has 100 mutual fund shares, representing a 1/10th interest in a single share of the fund’s chosen (very expensive) stock. exchange-traded funds (ETFs): ETFs are like mutual funds that trade on exchanges, as stocks do. Investors trade mutual funds shares with the fund itself—they send money to the fund, receiving mutual fund shares in return; they submit sell requests to the mutual fund, receiving cash in return. In contrast, investors who wish to divest themselves of their ETF shares can simply enter a sell order with their brokers. They can also do the other types of things that one can do with shares of stock: for example, buy ETF shares on margin, or sell ETF shares short. Nonetheless, investors who wish to make small, periodic contributions to a diversified fund may want to stick with mutual funds, since ETFs require brokerage commissions with every trade. hedge funds: Hedge funds are intermediaries like mutual funds, gathering money from investors, then using those pooled funds to buy assets. However, hedge funds are less regulated than mutual funds, and therefore may engage in various strategies that are not allowed to mutual funds. For example, short positions are important parts of many hedge fund strategies. .

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There are many types of hedge fund strategies; for example, funds following merger arbitrage strategies might short stock in acquiring firms and buy stock in targets; equity market neutral funds would match their long positions with shorts, ending up “neutral” to the direction of the market. private equity funds: These funds collect money from investors, then deploy it into equity that is not publicly traded. The two most important types of private equity funds are venture capital (VC) funds, which finance start-up firms, and leveraged buyout (LBO) funds, which use debt (leverage) to buy up the public stock of poorly performing firms, taking them private.

Here’s a schematic laying out these various types of companies:

financial services companies

NONBANK FINANCIAL INTERMEDIARIES

insurance companies investment banks

COMMERCIAL BANKS mutual funds

ETFs

INVESTMEN T COMPANIE S

private equity funds

LBO hedge funds

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2-4. Investment bankers advise clients on raising money (for example, what type of securities to issue, and what the features of those securities should be). They also perform underwriting services (buying the securities from the issuer, then selling them to investors). Investments bankers also provide merger and acquisition advice.

2-5. The primary market is the market for newly issued securities. In this market, the issuer (for example, a corporation like General Electric) creates a new financial asset and sells it to an investor. GE does this to raise money to finance a new project. The asset it creates can be either a debt security (like a bond), or an equity security (like a new share of stock). Every asset must trade in the primary market once (and only once), because every asset must be “born.” The primary market transaction is the only point at which the issuer receives cash for the security. Note that this is Step 1 in Figure 2.2 from the text.

(The investment bankers we considered in problem 2-4 above may play a role in this primary market transaction. They often underwrite a firm’s securities, meaning that they are the ones who actually buy the securities from the issuer [so that the issuer receives cash from the investment bankers, not the investors], then sell those securities to the initial public investors. The underwriters therefore bear the risk of inventory, and will be on the hook if they cannot sell the securities. Investment bankers typically charge about 7% of the value of the issue for performing the underwriting function.)

The secondary market is the market for investor-to-investor trading (step 4 from Figure 2.2).

The markets that we hear about every day—the New York Stock Exchange, the American Stock Exchange, the Nasdaq—are all secondary markets. Secondary markets allow investors to trade out of securities that they have purchased (or to buy new ones); that is, they provide liquidity. Investors are more willing to buy securities in the first place if they know they can sell them easily. Thus, securities are more attractive to investors—and therefore are less costly to issuers—if they are backed by a large, liquid secondary market.

Assets may trade many times in the secondary market (think of the number of times a Google share could change hands on the Nasdaq), or they may never trade there at all (for example, a bond may be held to maturity by its initial investor).

2-6. A mutual fund provides intermediated investing. Investors pool their investments together, then hire a manager to deploy those funds into an approved asset class or classes. For example, investors might pool their funds to buy equity, to buy debt, or to buy some combination of the two. Pooling their investments allows investors to achieve diversification simply, and with a minimum investment. (For example, it would be virtually impossible to create a meaningfully diversified portfolio of equity with the $3,000 it might take to open a mutual fund account, and the fees associated with any such attempt would be prohibitive.)

Some of the benefits of mutual fund investing include: ♦ ease of diversification (as just discussed) ♦ access to asset classes (some are more easily, or only, accessible to institutional investors, requiring retail investors to use an intermediary like a mutual fund) ♦ ability to establish ongoing, automated investment programs (taking money from each month’s paycheck, for example, and having it automatically invested in your funds).

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(Many people believe that access to professional management is another benefit to intermediated investing. However, there is disagreement about the efficacy of paying higher fees for active management, as noted in the text’s “Business of Life” box.)

An ETF also allows investors access to a basket of assets. However, ETF shares trade on an exchange. They therefore can be traded multiple times per day, while mutual fund shares can be traded only once. (Investors who wish to trade mutual fund shares place orders with the fund directly, which then performs the trades once, at the end of the day.) Since ETFs trade like stocks, they can be sold short and bought on margin. There may also be certain tax advantages to ETFs over mutual funds. However, each transaction incurs a brokerage commission, so that investors desiring to set up an automatic investment program would be better off using mutual funds for those programs.

2-7. The primary difference between debt and equity is that debt has a contract: the amounts and the timing of its cash flows are contractually specified. For example, with a bond, you know that you will receive coupon payments equal to [coupon rate*par/2] twice a year, on specific dates, plus $1,000 (the par value) at maturity (another specified date). Failure to make a promised payment on time and in full constitutes default, for which there are ramifications for the issuer (of varying severity, depending upon the severity of the default).

However, cash flows to equity may not be specified at all (for example, a company makes no assertions about the dividends it may or may not pay to common stock, and certainly cannot specify the price an investor will receive when she sells the stock), or, if they are specified, do not trigger default when not made (for example, preferred dividends may be skipped if the firm so chooses 1). Equity funding provides much more flexibility for the issuer, and is therefore less risky for it. However, this comes at the cost of higher required returns to investors. Debt investors are willing to accept a lower return in exchange for contractual cash flows. However, less risk for investors means more risk for the issuer, which introduces leverage—risk—into its capital structure when issuing debt.

2-8. Preferred stock is “preferred” over common because: ♦ it has priority in liquidation—preferred shareholders must be paid in full before common shareholders can receive any of the proceeds from the liquidated assets of the firm. ♦ it has priority in dividend payment—common dividends cannot be paid before preferred dividends are paid. If the preferred is cumulative, then there can be no common dividends before all accrued preferred dividends are paid.

Thus, the preferences relate to priority of payment. However, preferred stock does not dominate common. For example, common shares come with voting rights, while preferred shares usually do not. In addition, preferred shares are not residual claims, and will not enjoy the unlimited upside that common shareholders prize. (Some preferred shares have a feature that lets them participate in any upside potential, but they still are not residual claimants.)

1

Of course, skipping a dividend may not be the end of the story, since the skipped dividends may accrue if the preferred is cumulative, as noted in the text. And, of course, no dividends may be paid to common if there are preferred dividends in arrears.

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2-9. Using the web address http://apps.finra.org/fundanalyzer/1/fa.aspx, led us to the comparable fund analyzer. Comparing this funds prescribed by the text, we get the following results: Here is the initial screen, where we specify the funds we’d like to compare:

The first results screen allows us to enter the initial amount (whose default is our $10,000), the annual return (whose default is 5%, so we need to change that to 8%), and the investment horizon (whose default is our ten years).

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We can see from the results page that the Vanguard fund, which costs us $238.78, leaves us with a profit of $11,246.61. This beats the American Beacon fund (which costs us $1,891.70, with profit of $8,448.54) and the American Growth fund (cost = $8,498.88; loss = $1,677.51). We can also see Vanguard’s domination in the chart below, where the blue bars, representing the value in the Vanguard fund, tower over the yellow and red bars.

On the next two pages are the rest of the results from this search. The first picture shows the data underlying the chart above, and gives comparable results for numerous investment horizons. It makes it clear that Vanguard’s outperformance is not only at the 10-year mark, but at any horizon. The next picture describes the funds’ fee structures, and defines their asset-class mandate using the standard Morningstar 9-box style/size taxonomy. The final picture summarizes recent returns.

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2-10. According to the data presented in the “Finance in a Flat World” box, in 2010 the U.S. financial markets incorporated $64 trillion of the world’s financial assets; the European market held about $28.4 trillion; Asia had $26.3 trillion; and the U.K. had $21 trillion.

Investors should consider this when confronting the tendency for “home country bias,” the predilection of investors for assets from their own countries. For example, it’s not uncommon for U.S. investors to hold all of their equity assets in stocks from the U.S. Given that the U.S. market is far less than 100% of the total global equity market, this introduces a source of bias (and loss of potentially useful diversification) into such targeted portfolios.

2-11. A hedge fund is a pool of assets, like a mutual fund. However, hedge funds are much less regulated than are mutual funds, which allows hedge fund managers to use many strategies forbidden to mutual fund managers. For example, hedge fund managers often employ significant leverage, invest in illiquid assets (and restrict investors’ ability to access their funds, sometimes for years), and utilize short strategies and derivatives. Hedge funds are not open to all investors; they are targeted at wealthy, sophisticated, “accredited” investors (whom the SEC deems able to take care of themselves). The fee structures of hedge funds are also different from mutual funds’, often involving both an annual fee of 2% of assets, plus 20% of profits (a “2-and-20” scheme).

2-12. The two types of private equity funds discussed in the text are venture capital (VC) funds and leveraged buyout (LBO) funds. VC funds collect money from investors, then use it to finance start-up businesses. Thus, these funds invest very early in a business’s life, perhaps funding research and/or product development. (For example, VCs are very important in the funding of drug R&D.) LBO firms target underperforming businesses, using leverage (debt) to finance the buyout of the firm’s public shareholders—taking the firm private. The idea

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is to restructure the business without the distraction of public oversight, then take the firm public again. Investors in private equity make money when their incubated firms are bought out or have their IPO (VC funds), or when the firms are taken public again (LBO funds).

2-13. According to Yahoo! Finance (http://finance.yahoo.com/q?s=goog, accessed 2/6/17), we have the following results for Alphabet: price of last trade: length of time since last trade: day’s price range: $0.15 closing change in percent: 52-week price range:

$80.334 last trade time: 4:00 PDT (trade was at close; data accessed after close) $795.25-$801.66 closing change in dollars:down down 0.02% $663.06-$841.95

Here’s what the screen looked like:

At the top of the page, there are numerous links to more data about Alphabet: Summary: summary, real-time, options, historical prices profile, key statistics, SEC filings, competitors, industry, components key executives income statement, balance sheet, cash flow major holders, insider transactions, insider roster: interactive, basic charts, basic technical analysis analyst opinion, analyst estimates, research, star analysis

Statistics: Profile: Financials: Holders: Historical data: Analyst:

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2-14. The Market Watch website has many interesting personal finance articles, and a student should have no trouble finding at least one that will interest her. On 5/26/10, there was an “Ask the Expert” article titled “Dirty Tricks Financial Advisors Play,” written by Walter Updegrave. He was responding to a question regarding the efficacy of a strategy of using an interest-only mortgage to buy a house, then combining the payment savings from that loan (versus a fixed-rate mortgage), plus the proceeds of a home equity line of credit, to invest in an equity-indexed universal life insurance policy. The author does not like this strategy, for these reasons: ♦ there is a cap on the earnings that are possible from the policy, despite its link to equity index returns ♦ borrowing from such policies, while tax-free as long as the policy is in force, leads to taxable earnings if the policy lapses (which can be inconvenient if the policyholder is close to retirement) ♦ the strategy is very risky ♦ the advisor may be motivated by his own desire for commissions The author suggests to sticking with tax-advantaged retirement plans such as 401(k)s, and with traditional investments for deployment of any funds remaining after these retirement vehicles are maxed out.

2-15. The Motley Fool retirement site has sections for “13 Retirement Steps,” IRAs, “401(k)s etc,” and asset allocation. The main page has a selection of relevant articles (e.g., “How to Salvage Your Retirement Plan Now”), retirement calculators (e.g., “Should I Convert My IRA to a Roth IRA?”), and some related links (e.g., “Discuss: Retirement Investing”). The IRA page has discussions about the basics of IRAs, the differences between Roth and traditional IRAs, and the best way to open an IRA (“follow these three simple steps!”).

Their thirteen retirement steps are these: 1. change your life with one calculation 2. trade wisdom for foolishness 3. treat every dollar as an investment 4. open and fund your accounts 5. avoid the biggest mistake investors make 6. discover great businesses 7. buy your first stock 8. cover your assets 9. invest like the masters 10. don’t sell too soon 11. retire in style 12. pay it forward 13. make friends and influence fools Students should enjoy reading the details of these accessibly named topics.

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Chapter 3 Solutions to Study Questions 3-1. The balance sheet represents an enumeration of a firm’s resources (assets) along with its liabilities and owners’ equity at a given date. The income statement summarizes the net results of the operation of a firm over a specified time interval.

The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time.

3-2. Gross profits is sales less the cost of producing or acquiring the firm’s product or service usually known as cost of goods sold. Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business.

Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes.

3-3. Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense is computed as the interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receive dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or cease paying a dividend.

3-4. Net working capital is the firm’s liquid assets (current assets) less its short-term debt.

Accountants include all short-term debt when computing net working capital; however, in computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts payables and accruals. With this latter method, we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business— beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer.

The amount of net working capital is important to a company’s lenders who are always concerned about a company’s ability to repay its loans.

3-5. A firm’s accounts receivable are the amounts owed to the firm by its customers who buy on credit. Thus, Meriwhether Chemicals is lending its cash to its customers when they purchase goods and services from the firm.

3-6. The firm’s accounts payable represents the credit suppliers have extended the firm when it purchased inventories. As such, it is a source of funding – in effect, when a firm buys on trade credit (and as a result accounts receivable increase), they are borrowing money from their supplier. .

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3-7. There would be an immediate cash outflow of $1.5 million when the new machine is purchased. Then, in future years there would be an increase in depreciation as the new capital purchase is depreciated. But depreciation is not a cash flow, but depreciation is an expense and as a result reduces earnings before taxes – but again, that’s not a cash flow item. But taxes are calculated as a percent of earnings before taxes, and as a result, the more depreciation, the lower the taxes, and taxes are a cash flow item.

3-8. A cash flow statement tells us how changes in balance sheet and income statement affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. In effect, it looks at how money flows in and out of the firm.

It can be used to determine whether there will be money left over to pay bills and personnel, the potential of the firm to repay loans, and whether the firm is fundamentally sound.

3-9. Net worth represents the value of the assets less the value of the liabilities. In this case the assets (the 2003 Corolla, the checking account, and the savings account) total $6,365.77, while the liabilities (what you owe on the Corolla and your school loan) total $14,591.22 – thus, your net worth is $6,365.77 - $14,591.22 = -$8,225.45. In effect, you owe more than the value of all your assets.

3-10. The AICPA IFRS Resources website (http://www.ifrs.com/ifrs_faqs.html) does an excellent job of keeping an up-to-date monitoring of the adoption of IFRS around the world.

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Chapter 4 Solutions to Study Questions 4-1. Financial statements of firms are analyzed for vital signs from both within the firm and by the firm’s external constituents. Internal financial analysis is performed by a firm’s own employees, while external financial analysis is performed by bankers and investors outside the firm.

Internal financial analyses are review for vital signs reflecting: • The performance of employees and determine their pay raises and bonuses.

• The comparison of the financial performance of the firm’s different divisions.

• Financial projections, such as those associated with the launch of a new product.

• Evaluation of the financial performance of the firm in light of its competitors and determine how the firm might improve its own operations.

• Evaluation of the financial well-being of an important supplier so that if the supplier is facing the risk of failure the firm can move quickly to line up alternative sources of supply.

External financial analyses are undertaken by a variety of firms and individuals who have an economic interest in the vital signs of the firm’s financial performance. These include: • Banks and other lenders who are trying to decide whether to loan money to the company.

• Suppliers trying to decide whether to grant credit to the company.

• Credit-rating agencies who are trying to determine the firm’s creditworthiness.

• Professional analysts who work for investment companies that may be considering investing in the firm or advising others about investing.

• Individual investors trying to decide whether to invest in the company.

4-2. A common size financial statement is a standardized financial statement in which all entries are presented in percentages. To create a common size income statement we simply divide each entry in its income statement by the company’s sales. The common size balance sheet is created the same way except that you divide each entry in the balance sheet by the firm’s total assets. Once these entries are converted to percentages, we can compare them with other firms that may have higher or lower sales and assets.

4-3. Five basic questions used to discuss financial statement analysis are: • How liquid is the firm? Will it be able to pay its bills as they come due?

• How liquid is the firm? Will it be able to pay its bills as they come due?

• How efficient has the firm’s management been in utilizing its assets to generate sales?

• Has the firm earned adequate returns on its investments?

• Are the firm’s managers creating value for shareholders?

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4-4. The term liquidity is used in the context of financial statement analysis as an indication of the ability of a firm to pay its bills in a timely manner. Therefore, liquidity ratios are used to address a very basic question about the firm’s financial health: How Liquid Is the Firm— Can It Pay Its Bills?

4-5. Two ratios used to measure how a firm has financed its assets are the debt ratio and the times interest earned ratio.

4-6. The gross profit margin looks at how well the firm’s management controls its expenses, and is the ratio of gross profits to sales. In effect, it shows the percent of sales that go toward gross profits. The operating profit ratio is the firm’s operating income divided by its sales and tells managers how much profit they generated from each dollar of sales after accounting for both costs of good sold and operating expenses. The net profit margin looks at the bottom line of the income statement and tells us what percent of sales is makes it to net profit.

4-7. The operating return on assets is a product of the operating profit margin (which is EBIT/Sales) times the total asset turnover ratio (which is Sales/Total Assets).

4-8. The DuPont ratio decomposes the firm’s Return on Equity into three basic determinants related to profitability, asset management efficiency, and the use of financial leverage (an equity multiplier) as follows:

From there we can further analyze the return on equity equation by looking at the determinants of each of these three components. For example the net profit margin is determined by net income and sales; net income reflects the difference in the firm’s sales and its total costs which, in turn, consist of cost of goods sold, operating expenses, interest expense and taxes. Similarly, the total asset turnover ratio is determined by the firm’s sales and total assets where total assets can be broken down into current and fixed assets, and so forth.

4-9. Market value ratios are used to address the basic question: How are the firm’s shares valued in the stock market? These two market value ratios that indicate what investors think of both the managers’ past performance and the firm’s future prospects.

4-10. Some of the more significant limitations of industry averages include: 1. Picking an industry benchmark can sometimes be difficult. It is sometimes difficult to determine the industry to which a firm belongs when the firm engages in multiple lines of business. This problem is particularly difficult if the firm you are analyzing operates in multiple lines of business and consequently in multiple industries. In this case, you must select your own set of peer firms and construct your own norms. For example, General Electric Company (Ticker: GE) operates as a technology, media, and financial services company worldwide.

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2. Published peer-group or industry averages are not always representative of the firm being analyzed. The data published provide the user with general guidelines rather than scientifically determined averages of the ratios for all, or even a representative sample, of the firms within an industry. For example, some sources of peer group financial ratios report averages of the firms that report to a particular industry trade group (e.g., companies that apply to banks for loans).

3. An industry average is not necessarily a desirable target ratio or norm. There is nothing magical about an industry norm. At best, an industry average provides an indication of the financial position of the average firm within the industry. It does not mean it is the ideal or best value for the ratio. For various reasons, a well-managed company might be above the average, whereas another equally good firm might choose to be below the average. For example, one firm might use a just-in-time inventory approach, and as a result might have a very high inventory turnover ratio. By contrast, another firm in the same industry might be a supplier to companies like Dell that employ just-in-time inventory approaches. If this is the case, the firm will have to keep a large amount of inventory on hand and will have a lower inventory turnover ratio. Both firms might be successful companies but just approach inventory differently.

4-11. Your savings ratio, which is the ratio of your income available for savings divided by your after-tax income:

Personal Savings Ratio =

Personal savings Income available for living expenses

It can be used to calculate exactly how much of your available income is being saved. Once you’ve calculated it, you can compare your anticipated monthly savings with your target savings level. If it doesn’t look as if you’ll be able to fund all your goals, then you must earn more, spend less, or downsize your goals.

4-12. When comparing the price-earnings ratios of companies from the U. S. and Hong Kong we must be aware of differences in how earnings are calculated in the different countries and the impact of these differences on reported earnings. U. S. firms amortize the goodwill created by the acquisition of another firm over time if the value of the acquisition appears to have fallen. However, in Hong Kong firms write off goodwill immediately in the year of the acquisition. This difference can have a significant impact on the reported earnings per share of two otherwise similar firms. Consequently, the price-earnings ratios would differ simply because of the difference in accounting conventions.

Goodwill is an intangible asset, and if there’s goodwill, the assets are more than they would be otherwise. When goodwill is “written off” it is being expensed, and as a result, profits drop.

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Chapter 5 Solutions to Study Questions 5-1. The concept of time value of money is recognition that a dollar received today is worth more than a dollar received a year from now or at any future date. It exists because there are investment opportunities on money, that is, we can place our dollar received today in a savings account and one year from now have more than a dollar.

New investment projects generally involve an initial outlay at the beginning of the project, which results in cash inflows in future years. The time value of money can make those cash flows comparable. A firm may sign a contract to rent a sales location for a number of years.

If the payments are constant, they are actually going down in terms of their present value.

Firms try to postpone taxes because the further off the taxes are postponed, the less their present value is.

5-2. Compounding and discounting are inverse processes of each other. In compounding, money is moved forward in time, while in discounting money is moved back in time. This can be shown mathematically in the compounding equation: FVn = PV (1 + i)n We can derive the discounting equation by multiplying each side of this equation by PV = FVn

1 and we get: (1 + i) n

1 (1 + i) n

5-3. As interest is compounded more frequently per year, interest is earned on past interest more frequently – thus, the effective interest rate increases.

To make interest rates comparable, we calculate their equivalent rate using an annual compounding period. We do this by calculating the effective annual rate (EAR), the annual compounded rate that produces the same return as the nominal, or stated, rate. The EAR can be calculated using the following equation: To make them comparable, we calculate their equivalent rate using an annual compounding period. We do this by calculating the effective annual rate (EAR), the annual compounded rate that produces the same return as the nominal, or stated, rate. The EAR can be calculated using the following equation:

As you can see, as m, the number of times compounding occurs per year increases, the EAR increases.

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5-4. We know that FVn = PV(1 + i)n Thus, an increase in i will increase FVn and a decrease in n will decrease FVn. 5-5. We know that PV = FVn

1 (1 + i) n

Thus an increase in i will decrease FVn and an increase in n will decrease FVn. 5-6. This is a subjective question and whatever the student chooses is correct as long as they have a reason for liking that calculator.

5-7. This question would be answered differently by different students.

5-8. Although Payday loans are described by the lenders as a quick fix for short-term, the actual experience is a much longer term loan. These loans tend to put the borrower in greater difficulty with each loan flip or loan rollover. There the website describes the loans as a debt trap fraught with bank overdraft fees and other expenses that can make the borrower’s cash flow problem even greater and possibly lead to bankruptcy. Research supports that supposition as well as the practice of automobile title loans which upon default, the borrower loses their automobile making it more difficult to earn a living and escape the debt trap.

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Chapter 6 Solutions to Study Questions 6-1. An annuity is a series of equal dollar payments for a specified number of years.

Examples of annuities include mortgage payments, interest payments on bonds, fixed lease payments, and any fixed contractual payment.

6-2. Future Value of an Annuity = the sum of the future value of the individual cash flows that make up the annuity,

This can be simplified to,

Note that there are n payments in the ordinary annuity. However, since the first payment is received at the end of the first period, it is compounded for only n-1 periods until the end of the nth period. In addition, the last payment is received at the end of the nth period so it is compounded for n – n or zero periods.

6-3. The present value of an annuity is actually derived from the sum of present value of each of the individual cash flows making up the annuity. For example, the present value of a fiveyear annuity of $500 discounted back to present at 6 percent would be,

6-4. Every month you would be paying off a portion of the principle along with the interest accrued for that month. You also know that to calculate your monthly mortgage payment you simply enter the amount of the loan as PV, n as the number of periods, i as the interest rate per period, and enter 0 for FV, because at the end of the mortgage you will have your mortgage paid off – then solve for PMT. To find out how much you still have to pay, you first need to calculate what your mortgage payment is. Then, enter that as PMT, enter n as the number of periods left, i as the interest rate per period, n as the number of periods left, FV as 0, and solve for PV. 6-5. An ordinary annuity is an annuity in which payments are made at equidistant points in time .

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at the end of a period. An annuity due is an annuity in which all the cash flows occur at the beginning of the period. For example, rent payments on apartments are typically annuities due since the payment for the month’s rent occurs at the beginning of the month.

6-6. There are two basic types of perpetuities that we will encounter in our study of finance.

The first is a level perpetuity in which the payments are constant over time. The second is a growing perpetuity in which the payments grow at a constant rate from period to period over time.

6-7. The formula for the present value of an annuity is: 1   1 − (1 + i ) n  PV = PMT   i      

The formula for perpetuity is: PV =

PMT i

The formula for growing perpetuity is: 𝑃𝑉 =

𝑃𝑀𝑇𝑝𝑒𝑟𝑖𝑜𝑑 1 𝑖−𝑔

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Chapter 7 Solutions to Study Questions 7-1. Because financial markets provide rich sources of data, it is no surprise that the tools used by statisticians are so widely used in finance. We also know from Principle 2: There Is a Risk-Return Tradeoff. Specifically, although investing in higher risk investments does not always result in higher realized rates of return (that’s why they call it risk), higher risk investments are expected to realize higher returns, on average. As such, we use the basic tools of descriptive statistics, such as the mean and measures of dispersion, to analyze the riskiness of potential investments, giving use a picture of the historical risk and return on an investment.

7-2. The realized rate of return tells us how much you’ve made over some period both from appreciation (or loss) in the value of your asset (for example, how much your stock went up or down in price) and how much money was distributed to you as a result of holding the asset (for example, how much you got in terms of interest or dividends).

7-3. Dividends are money that you receive from owning common stock, and are one of the two ways investors receive returns from owning stock – the other is from capital appreciation, that is, when the value of the stock rises.

7-4. We call the gain or loss we actually experienced on a stock during a period the realized rate of return for that period. However, the risk-return tradeoff that investors face is not based on realized rates of return; it is instead based on what the investor expects to earn on an investment in the future. We can think of the rate of return that will ultimately be realized from making a risky investment in terms of a range of possible return outcomes, much like the distribution of grades for a class at the end of the term. To describe this range of possible returns, investors use the average of the possibilities, which is known as the expected rate of return. To be more precise, the expected rate of return is the average of the possible returns, where each possible return is weighted by the probability that it occurs.

7-5. When you invest money, you do so because you want to make your money grow.

Unfortunately, no one really knows what will happen in the future. You may have an idea or expectation of what will happen in the future, but nothing is ever for certain. The return that you think you will get in the future is your expected rate of return. It may not actually happen, but when you invest it is what you think will happen.

7-6. There are two methods financial analysts can use to quantify the variability of an investment’s returns. The first is the variance in investment returns and the second is the standard deviation, which is the square root of the variance. Both of these measures give us an idea of the width of the distribution of possible outcomes – the wider the distribution, the more risk there is. Why don’t investors like a wide distribution of possible returns? While it is always nice to receive more than you expect, it is more painful to receive less than you expect – that’s the idea of diminishing marginal utility of wealth that you learned in your

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economics classes. Because the pain of missing (negative utility) is more than the positive utility gained from a miss of the same size, investors don’t like variability of possible returns. Moreover, it is much easier to plan into the future if you know how much money you’ll have to work with.

7-7. Step 1: Calculate the expected rate of return using Equation (7-3).

Step 2: Subtract the expected rate of return calculated in Step 1 from each of the possible rates of return and square the difference.

Step 3: Multiply the squared differences calculated in Step 2 by the probability that those outcomes will occur.

Step 4: Sum all the values calculated in Step 3 together. The sum is the variance of the distribution of possible rates of return. Note that the variance is actually the average squared difference between the possible rates of return and the expected rate of return.

Step 5: Take the square root of the variance calculated in Step 4 to calculate the standard deviation of the distribution of possible rates of return. Note that the standard deviation (unlike the variance) is measured in rates of return.

7-8. The returns and standard deviations of the investments in Figure 7.3 are given as: Small stocks, 11.9%; large stocks, 9.8%; government bonds, 5.4%; treasurey bills, 3.7%, and inflation, 3.0%. Clearly, stocks have outperformed bonds over the long run, but they also carry a high standard deviation. In spite of the fact that historically stocks have been the better investment for investors with a long-term investment time horizon, very risk adverse investors may have avoided them because their volatility.

7-9

The riskier investments have historically realized higher returns. The riskiest investment class is comprised of the stocks of the smallest set of firms followed by the stocks of large companies, then corporate bonds, long-term U.S. government bonds, and finally Treasury bills. The difference between the returns of the riskier stock investments and the less risky investments in government securities is called the equity risk premium. For example, referring to the previous compound annual return table, the premium of large company common stocks over long-term government bonds averages 9.8% - 5.4% = 4.4%. A similar comparison to short-term Treasury bills reveals an average risk premium of 9.8% 3.7% = 6.1 %.

7-10. Figure 7.4 shows that U.S. stocks underperformed relative to stocks in the United Kingdom as well as the Emerging-Market stocks however U.S. Stocks exhibited lower standard deviations than both of those groups suggesting lower risk. Relative to Japan, U.S. stocks outperformed Japanese stocks and did so with slightly lower risk as well.

7-11. From Figure 7.4 U.S. stocks exhibited about the same level of variability relative to stocks in Japan. However, the U.S. stocks outperformed that same group measured by average return. During that time period, it appears that the Japanese market was quite risky and without an appropriate rate of return.

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7-12. The easiest way to answer this question is with an example. Let’s look at an example.

Suppose you invest $100 in a particular stock. After one year, your investment rises to $150. But unfortunately, in the second year it falls to $75. What was the average return on this investment? In this first year, the stock realized a rate of return of 50% and in the second year, it realized a rate of return of -50%. If we took the simple average of these two rates, we get 0%, suggesting our investment return is 0% over the two-year period. This doesn’t look like a 0% rate of return because we began with $100 and ended two years later with only $75! In actuality, over the two-year investment period, the $100 investment lost the equivalent of -13.4%. So which average rate of return is correct?

Actually, both rates of return are correct. The 0% rate is the arithmetic average rate of return, while the -13.4% rate is the geometric or compound average rate. The arithmetic average is the simple average we have already learned to calculate in this chapter. The geometric average is different because it takes compounding into account. For example, a 50% increase in value from $100 is $50, but a 50% decrease in value from $150 is $75. The geometric average rate of return answers the question, “What was the growth rate of your investment?” while the arithmetic average rate of return answers the question, “What was the average of the yearly rates of return?”

7-13. If you are trying to determine what annual rate of return can you expect over a multi-year horizon, then the geometric mean is better.

7-14. This is a subjective question and the student’s answer would be dependent upon their answers to the risk tolerance quiz.

7-15. The efficient markets hypothesis states that securities prices accurately reflect future expected cash flows and are based on all information available to investors. An efficient market is a market in which all the available information is fully incorporated into securities prices, and the returns investors will earn on their investments cannot be predicted.

7-16. Taking this concept of an efficient market further, we can distinguish between weak-form efficient markets, semi-strong form efficient markets, and strong-form efficient markets, depending on the degree of efficiency: 1. The Weak-Form Efficient Market Hypothesis asserts that all past security market information is fully reflected in securities prices. This means that all price and volume information is already reflected in a security’s price.

2. The Semi-Strong Form Efficient Market Hypothesis asserts that all publicly available information is fully reflected in securities prices. This is a stronger statement because it isn’t limited to price and volume information, but includes all public information. Thus, the firm’s financial statements, news and announcements about the economy, industry, or company, analysts’ estimates on future earnings, or any other publicly available information is already reflected in the security’s price. As a result, taking an investments class won’t be of any value to you in picking a winner.

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3. The Strong-Form Efficient Market Hypothesis asserts that all information, regardless of whether this information is public or private, is fully reflected in securities prices.

This form of the efficient market hypothesis encompasses both the weak-form and semi-strong form efficient market hypotheses. It asserts that there isn’t any information that isn’t already embedded into the prices of all securities. In other words, even insider information—that is, material information that isn’t available to any other investor—is of no use.

7-17. This answer will differ from student to student because it is based upon how they feel about the validity of efficient markets.

7-18. If we believe that investors do not rationally process information, then market prices may not accurately reflect even public information. As an example, economists have suggested that overconfident investors tend to under- react when a company’s management announces earnings or makes other statements that are relevant to the value of the firm’s stock. This is because investors have too much confidence in their own views of the company’s true value and tend to place too little weight on new information provided by management.

As a result, this new information, even though it is publicly and freely available, is not completely reflected in stock prices.

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Chapter 8 Solutions to Study Questions 8-1. Vanguard, one of the leading mutual fund families, identifies four key guidelines you should consider when making personal investment decisions: 1. Select investment products suited to your objective.

2. Find a comfortable balance between risk and return.

3. Diversify wisely to help manage risks.

4. Evaluate your portfolio periodically.

8-2. He is talking about the difference between expectations and outcome. Will Rogers was concerned about how much his investment would actually earn rather than what people told him it would return.

8-3. The expected rate of return for a portfolio of investments is simply a weighted average of the expected rates of return of the individual investments in that portfolio. To calculate a portfolio’s expected rate of return we weight each individual investment’s expected rate of return using the fraction of the portfolio which is invested in that particular investment. For instance, if you put half your money in the stock of ExxonMobil, with an expected rate of return of 12%, and the other half in General Electric (GE) stock, with an expected rate of return of 8%, then we can calculate the expected rate of return of the portfolio as follows: (½ x 12%) + (½ x 8%) = 10%.

8-4. The idea behind diversification is to find things that don’t move precisely together, that why when one goes down, the other won’t necessarily go down (hopefully it will go up), and as a result some of the variability will be eliminated. When you pick two stocks in the same industry to diversify with, much of the variability may be associated with that industry. In this case, when the auto industry suffers, both Ford and Toyota may suffer together and as a result, the value of diversification may be less than it would have been if your grandfather had picked stocks in different industries.

8-5. This statement is false. The amount of risk reduction that takes place as a result of diversification is a function of the correlation coefficient. The higher the correlation coefficient between two assets, the less benefit, or risk reduction, there is from diversification. For example, if you can find stocks that are extremely risky, but move in an opposite direction from your portfolio, you could add those very risky stocks to your portfolio and end up with less risk than you had before.

8-6. Unsystematic risk is the variability in a firm’s stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence. On the other hand, systematic risk is the variability in a firm’s stock price that is the result of general influences within the industry or resulting from overall market or economic influences. A general change in interest rates charged by banks is an example of systematic risk. Since beta measures the extent to which a particular

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investment’s returns vary with the returns of the market portfolio, and the market is, by definition, diversified to the point that there is no unsystematic risk, beta only measures systematic risk.

8-7. The beta of a portfolio is simply the weighted average of the betas that make up the portfolio.

8-8. The straight line relationship between the betas and expected returns in Figure 8-4 is called the security market line, and its slope is often referred to as the reward-to-risk ratio. Note that the security market line is simply a graphical representation of the Capital Asset Pricing Model. We can measure the slope of the security market line by computing the ratio of the change in expected rate of return measured along the vertical axis divided by the corresponding change in the beta for the portfolios with these two expected returns. The intercept is the risk free rate of return.

8-9. The capital asset pricing model (CAPM) provides an intuitive framework for understanding the risk-return relationship. It basically says that investors receive a return for delaying consumption (the risk-free rate of return) and then a return for taking on added risk as measured by the investment’s systematic risk.

8-10. If the reward-to-risk relationship is not the same for all assets, individuals would sell securities that did not have the reward-to-risk relationship available on other securities and buy securities with higher reward-to-risk relationships – the end result would be to push the price of underachieving stocks down – making them more attractive, and pushing the price of overachieving stocks up – making them less attractive. This would continue until all stocks have the same reward-to-risk relationship.

8-11. The key to reducing risk through diversification is to combine investments whose returns do not move together and thus are not perfectly positively correlated – thus, as long as investments are not perfectly correlated with each other there will be some value to diversification (like investments A and B). If assets are negatively correlated, the impact of diversification will be much more dramatic. Keep in mind, diversification does not impact the expected return, it is simply the weighted average expected return of the assets making up the portfolio.

8-12. False. The standard deviation measures total risk – both systematic and unsystematic, whereas the beta is a measure of unsystematic risk. Just because the beta is low (that is, the stock tends to mute the market’s ups and downs), the total variability may be high because the company has a lot of unique risk – perhaps it is simply a very risky venture on in its own right where that risk has nothing to do with what’s happening to other stocks or in the market.

8-13. No, assuming the risk-free rate is 4% and the market risk premium is 5%, if the beta jumps from 1.5 to 4.5, then the expected return would go from 12.5% to 27.5%, keep in mind only the return for taking on added risk jumps, not the return for delaying consumption (the riskfree rate) jumps.

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Chapter 9 Solutions to Study Questions 9-1. This is a subjective question and every student, depending upon their individual circumstance, will have a different answer.

9-2. When a corporation borrows money to finance its operations it can choose to either take out a loan from a financial institution, such as a bank or insurance company, or sell bonds.

When debt is incurred through a loan from a financial institution, it is often referred to as private debt, since the debt is not publicly traded. In contrast, bonds are referred to as public debt since they can be traded in the public financial markets.

9-3. Loans made in the private financial market are typically floating rate loans, which means that either every month or every quarter the rate of interest charged by the lender adjusts up or down depending on the movements of an agreed-upon benchmark rate of interest.

9-4. The clean price for a bond is the price of a bond using the bond pricing equation whereas the dirty price of a bond is equal to the clean price plus accrued interest. Accrued interest is equal to the coupon payment times (#days since the last coupon payment / #days in this coupon period).

9-5. This is the first of the four bond valuation relationships - The value of a bond is inversely related to changes in the yield to maturity. When market interest rates increase, the value of the bond decreases, and vice versa. When the market rate of interest goes up, the yield to maturity of the bonds must also go up. However, because the interest payments on a bond are fixed, the only way for the yields to maturity to increase is if the bond’s value declines.

9-6. If you are buying a house and do not expect to be there very long, you may want an adjustable rate mortgage because adjustable rate mortgages generally have a lower interest rate on them than do fixed rate mortgages and if you are going to move soon, the adjustable rate mortgage may not have time to “reset” before you sell your house and move on.

9-7. The par or face value of a bond is the amount that must be repaid to the bondholder at maturity. In general, corporate bonds are issued in denominations of $1,000 although there are some exceptions to this rule. Also, when bond prices are quoted, either by financial managers or in the financial press, prices are generally expressed as a percentage of the bond’s par value. For example, General Electric has a bond issue outstanding that was recently quoted as selling for 100.65. That does not mean you can buy the bond for $100.65. It means that this bond is selling for 100.65 percent of its par value of $1,000.

Hence, the market price of this bond is actually is $1,006.50.

What the bond sells for is a function of the risk of the bond and the current level of interest rates relative to the coupon interest rate on the bond. In effect, the return an investor receives is a function of the interest the bond pays plus or minus the capital appreciation or depreciation on the bond as the price of the bond moves towards its par value (at maturity).

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9-8. Bond par value: The par value of a bond, also known as its face value, is the principal that must be repaid to the bondholder at maturity. In general, corporate bonds are issued with par values in increments of $1,000. Also, when bond prices are quoted in the financial press, prices are generally expressed as a percentage of the bond’s par value.

Current Yield: The current yield on a bond refers to the ratio of the annual interest payment to the bond’s current market price. If, for example, we have a bond with an 8 percent coupon interest rate, a par value of $1,000, and a market price of $700, it would have a current yield of 11.4 percent ($80/$700 = 11.4%).

Yield to maturity: The yield to maturity (YTM) on a bond is the discount rate that equates the present value of the bond’s contractual cash flows (interest and principal at maturity) with the current market price of the bond. This is also the return the investor will earn on the bond if the investor is paid everything that is contractually promised by the issuing firm and the bond is held until maturity.

9-9. The yield to maturity calculation assumes that the bond performs according to the terms in the bond contract or indenture. Thus, the yield to maturity that we calculated above is actually the promised YTM for the bond. Since corporate bonds are subject to the risk of default, the promised yield to maturity can be an optimistic estimate of the yield that the bondholder will actually earn.

9-10. Bond ratings are extremely important to the financial manager. The rating provides an indicator of default risk and therefore it affects the rate of return that lenders require of the firm and the firm’s cost of borrowing. In keeping with Principle 2: There Is a Risk-Return Tradeoff, the rating a bond receives affects the rate of return demanded on the bond by the investors. The lower the bond rating, the higher the risk of default and the higher is the rate of return demanded in the capital markets.

9-11. a. Debentures and mortgage bonds. The term debenture applies to any unsecured long-term debt whereas a mortgage bond is a bond secured by a lien on real property. b. Eurobonds, zero coupon bonds, and junk bonds. Eurobonds are bonds issued in a country different from the one in which the currency of the bond is denominated. Junk, or highyield, bonds have a below-investment grade bond rating.

Bonds with a zero or very low coupon are called zero coupon bonds. The firm issues these bonds at a substantial discount from their $1,000 par value and promises to pay a zero or very low coupon rate of interest each year the bonds are outstanding. With these bonds the investor receives most (or with zero coupon bonds, all) of their return from the appreciation of the bonds.

Originally, the term “junk bonds” was used to describe bonds issued by “fallen angels,” that is, firms with sound financial histories that were facing severe financial problems and suffering from poor credit ratings.

9-12. Bonds sell for less than their par value when the yield to maturity on the bond exceeds the coupon rate. For example, if market rates of interest are such that the bonds of company had a yield to maturity of 10% but the bonds pay interest based on a coupon rate of only 8%, then the bonds will sell for a discount or less than par value. Likewise, if the market rate of interest is such that the bond is priced to yield a 10% rate of return and the bond has an 8% coupon rate of interest, then the bond will sell for more than its par value. .

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9-13. Longer maturity bonds experience greater price changes in response to changes in interest rates than do shorter-term bonds. This means that the prices of longer-term bonds fluctuate more when interest rates change than do the prices of shorter-term bonds. The reason longterm bond prices fluctuate more than short-term bond prices in response to interest rate changes can be explained as follows. If an investor bought a 10-year bond yielding a 12% interest rate, and then the current interest rate for bonds of similar risk increased to 15%, the investor would be receiving a below market coupon for 10 years. If, however, a shorterterm bond had been purchased—say, one maturing in one month— the investor would have to accept the below market rate for only one month. At the end of one month, the investor would get paid his original investment, which could then be invested at the new market rates. Thus, interest rate risk is determined, at least in part, by the length of time an investor is required to commit to an investment 9-14. The nominal rate of interest is the one observed in financial markets. It is the rate of interest that will be earned from holding a bond until maturity where the bond pays the holder the promised interest and principal in accordance with what is promised. This rate is NOT adjusted for the loss of purchasing power resulting from inflation. The real rate of increase in purchasing power experienced over time. This rate of interest is the nominal rate of interest after adjusting for the effects of inflation. Thus, while inflation does not impact the real rate of return, it does impact the nominal return which is observed in the market – the higher anticipated inflation, the higher the nominal rate of return.

9-15. One benefit from buying foreign bonds is diversification. Since interest rate movements differ from country to country, adding international bonds to your portfolio may provide added diversification. On the other hand, financial information used to analyze the foreign company may be less reliable, and is often more difficult to obtain.

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Chapter 10 Solutions to Study Questions 10-1. This is a student opinion response, but typical answers include how will Google take its product and make money off it. How much might it make per year. What are the costs associated with the business. What is the potential for this line of business to create new lines of business? How much risk is there associated with this investment?

10-2. We referred to preferred stock as a hybrid security that shares some of the features of bonds and common stock. For example, like bonds that pay a contractually set interest payment, preferred stock has a contractually stated cash dividend that is paid to the preferred stockholder. Like common stock, and unlike bonds, there is no maturity for a preferred stock issue.

10-3. As we noted earlier, preferred stock has characteristics of both common stock and bonds.

First, like common stock, preferred stock has no fixed maturity date. Also like common stock, the nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. Because a firm can pass on its preferred stock dividends without throwing the firm into bankruptcy, preferred stock is not considered to be a liability, but rather a lower form of equity than common stock. On the other hand, like debt, preferred stock dividends are fixed in amount similar to interest payments. In addition, although in theory preferred stock does not have a set maturity associated with it, many issues of preferred stock require that money be set aside regularly to retire the preferred stock issue, in effect resulting in a maturity date.

10-4. A cumulative feature requires all past unpaid preferred stock dividends be paid before any common stock dividends are declared. A stockholder would like preferred stock to have a cumulative dividend feature because without it there would be no reason why preferred stock dividends would not be omitted or passed when common stock dividends were passed. Since preferred stock does not have the dividend enforcement power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred stockholders.

Other frequent protective features serve to allow for voting rights in the event of nonpayment of dividends or to restrict the payment of common stock dividends if sinkingfund payments are not met or if the firm is in financial difficulty. In effect, the protective features included with preferred stock are similar to the restrictive provisions included with long-term debt.

10-5. Many times the financial media reports focus on the returns of stocks like the dotcoms in an enthusiastic manner that highlights the possibility that a new investor in that stock might also generate high returns in the near future. While that may or may not be the case it does tend to further fuel the herd behavior effect of investing. Perhaps a greater focus on the fundamental valuation prospects for the stock in question would help check some of the unintended consequences of diligently reporting on stocks or investments that have produced high returns of late. .

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10-6. Both values are based on future cash flows to be received by stockholders. Preferred stock typically has a predetermined constant dividend. For common stock, thedividend is based on the profitability of the firm and on management’s decision to pay dividends or to retain the profits for reinvestment purposes. Thus, the growth of future dividends is a prime distinguishing feature of common stock.

10-7. In the previous chapter we learned that the yield to maturity (YTM) used to value a bond is not the same thing as the expected rate of return on the bond. The reason for this is that the bond interest and principal payments used to value the bond are promised payments that are received only if the borrowing firm makes all the interest and principal payments on time (i.e., the firm does not default). The same idea is applied to the valuation of preferred stock. Preferred stock dividends are promised dividends that are only paid if the firm earns sufficient income to pay them. This causes no problem for valuing the preferred stock since we simply discount the promised dividends back to the present using the market yield or promised rate of return for similar shares of preferred stock in the financial marketplace. In other words, we value preferred shares by discounting the contractually promised dividend payments using a promised rate of return to the preferred shareholders.

10-8. The two types of return are dividend income and capital gains. The dividend income for common stockholders differs from preferred stockholders, in that no specified dividend amount is to be received. However, the common stockholders are permitted to participate in the growth of the company. As a result of this growth, their second source of return, price appreciation, is realized.

10-9. Prior to going public, Google’s stock could not have traded in a public market and therefore could not have had a market determined price for its shares at that time. However, that should not take away from the idea that a “value” for Google’s shares would have still existed based upon the present value of the future cash flow expected to be generated by Google’s shares.

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Chapter 11 Solutions to Study Questions 11-1. Over your career you will be faced with investment opportunities that require some type of evaluation and analysis. Whether the decision is to purchase a piece of property that you hope to develop and resell or it involves starting and running a business, capital budgeting analysis will help you make the right decision. In the introduction we described a very simple real estate investment opportunity. More typically such an investment would require substantial investments to improve the property, with renovations over an extended period of time (perhaps as much as a year). Having completed the renovation you might consider at least two alternatives: selling the property to someone else to rent and manage or keep the property and managing the rentals yourself. The tools we develop in this chapter will help you evaluate the initial property investment as well as the decision of whether or not to keep and manage the property.

11-2. Investment ideas can come from a variety of sources. For example, ideas often come from the management and employees of the firm. Employees who work closely with the firm’s customers (generally, the marketing department) and run the firm’s operations (the production management department) are often the idea generators.

11-3. Revenue Enhancing Investments Investments that lead to higher revenues often involve the expansion of existing businesses, such as Apple’s (APPL) decision to add the smaller Nano iPods. Alternatively, when Apple originally decided to begin selling MP3 players with its iPod line of products they created an entirely new line of business.

Cost-Reduction Investments The majority of a firm’s capital expenditure proposals are aimed at reducing the cost of doing business. For example, when WalMart (WMT) decided to locate a regional distribution center in San Marcos, Texas, this investment probably did not expand firm revenues since the region was already populated with WalMart stores. Instead, the primary benefit derived from the distribution center came from lower costs of supporting stores within the region.

Other types of cost-reducing investments arise when equipment either wears out or becomes obsolete due to the development of new and improved equipment. For example, Intel’s (INTC) semiconductor manufacturing plants (called fabs) utilize equipment called handlers that move microprocessors from one processing station to another and test their functionality. Since the technology involved in the manufacture of these processors is always evolving, the handlers also change and evolve. This means that Intel is continually evaluating the replacement of existing equipment.

Mandated Investments Companies frequently find that they must make capital investments to meet safety and environmental regulations. These investments are not revenue producing or cost reducing but are required for the company to continue doing business. An example would be the scrubbers that are installed on the smoke stacks of coal-fired power plants. The scrubbers reduce airborne emissions in order to meet government pollution guidelines.

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11-4. Finding good investment projects can be a daunting task, particularly when the firm faces substantial competition from other firms that are also looking for similar investment opportunities. Recall from your introductory economics class that firms tend to be more profitable when they operate in markets that have less competition. So, the search for good investments is largely a search for opportunities where the firm can exploit some competitive advantage over its competitors. For example, the firm may have a proprietary production process that uses fewer inputs and results in a lower cost of production.

External competition from other firms is an obvious source of competition. However, sources of competition sometimes crop up from within the firm. For example, when the Frito Lay division of Pepsico, Inc. (PEP) considers the development of a new Doritos flavor, Frito Lay’s analysis of future cash flows must take into account competition from other manufacturers of salty snack products as well as competition from their existing line of Doritos flavors. Since shelf space devoted to Doritos is generally fixed, the creation of a new flavor means that the space devoted to existing flavors must be reduced (this is often referred to as cannibalization or erosion of existing product revenues). 1 As a consequence, good investments are most likely to be found in markets that are less competitive. These are markets where barriers to new entrants are sufficiently high to keep out would-be competitors. For example, the strong brand reputation of the Doritos and Frito Lay that results from an ongoing barrage of advertising make it more difficult for new brands to enter the salty snack food category.

11-5. As we discussed in Chapter 1, one of the primary goals of a corporation is to improve the wealth of its shareholders. Since the NPV of an investment is an estimate of the impact of the investment opportunity on the value of the firm, NPV is the holy grail of criteria for evaluating new investment opportunities. In simplified terms, NPV is equal to the present value of the benefits of a project less the present value of the costs of the project.

However, it is not the only investment criterion that is used. In the pages that follow, we will describe other criteria that are used in practice and compare each of them to the NPV criteria.

In the pages that follow, we will first describe in more detail how NPV is used to evaluate investment projects. We will then discuss the case where a firm is interested in choosing just one of many projects. When this is the case, managers do not necessarily choose the project with the highest NPV. We will then describe other criteria that are used in practice and compare each of them to the NPV criteria.

11-6. As we discussed in Chapter 1, one of the primary goals of a corporation is to improve the wealth of its shareholders. Since the NPV of an investment is an estimate of the impact of the investment opportunity on the value of the firm, NPV is the holy grail of criteria for evaluating new investment opportunities. However, it is not the only investment criterion that is used. In the pages that follow, we will describe other criteria that are used in practice and compare each of them to the NPV criteria.

1

We will return to the discussion of revenue cannibalization in Chapter 12 where we discuss cash flow estimation.

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11-7. The payback criterion measures how quickly the project will return its original investment, which is a very useful piece of information to know when evaluating a risky investment.

Specifically, the longer the firm has to wait to recover its investment, the more things can happen that might reduce or eliminate the benefits of making the investment. The principal advantage of the payback method relates to its simplicity and intuitive appeal. However, using the payback period as the sole criterion for evaluating whether to undertake an investment has three fundamental limitations.

Limitation #1: The payback period calculation ignores the time value of money, treating for example cash flows three years from now the same as cash flows in one year.

Limitation #2: The payback period ignores cash flows that are generated by the project beyond the end of the payback period.

Limitation #3: There is no clear-cut way to define the cutoff criterion for the payback period that is tied to the value creation potential of the investment.

11-8.

Investment Criteria Net Present Value

Profitability Index (PI)

Internal Rate of Return (IRR)

Definition

Decision Rule

Present value of expected cash inflows minus the present value of cash outflows.

Accept investments that have a positive NPV.

Present value of expected future cash flows divided by the initial cash investment.

When the PI is greater than one, the NPV will be positive, so the project should be accepted. When PI is less than one, which indicates a bad investment, NPV will be negative and the project should be rejected.

Accept the project if the IRR is greater than the discount rate used to calculate the net present value of the project, and reject it otherwise.

The discount rate that makes NPV equal to zero.

Advantages

Disadvantages

Theoretically correct in that it measures directly the increase in value that the project is expected to produce.

Measures the increase in shareholder wealth expected from undertaking the project being analyzed.

Somewhat complicated to compute (requires an understanding of the time value of money).

Theoretically correct in that it measures directly the increase in value that the project is expected to produce. Useful when rank ordering positive NPV projects where capital is being rationed.

Not as familiar to managers as NPV and does not add any additional information.

Provides a rate of return metric, which many managers prefer.

Cannot always be estimated.

Not familiar to managers without formal business education.

Sometimes provides multiple rates of return for projects with multiple changes in the sign of their cash flows over time.

Can provide conflicting indications to NPV were mutually exclusive projects are compared.

Modified Internal rate of Return (MIRR)

The discount rate that makes the NPV of the modified cash flow stream equal to zero.

Accept the project if the MIRR is greater than the discount rate used to calculate the net present value of the project, and reject it otherwise.

Always produces a single rate of return estimate.

The rate of return produced by the MIRR is not unique to the project since it is influenced by the discount rate used to discount the negative cash flows.

Payback

Time until the initial cash outlay has been recovered.

If the project payback is less than the maximum the firm will accept, the project is acceptable.

Easy to understand and calculate.

Does not consider the time value of money.

An indication of risk (how long it takes to recover the investment.)

Ignores cash flows beyond the payback period.

No rational way to determine the cutoff value for payback.

Discounted Payback

The number of years required to recover the initial investment out of project discounted future cash flows. .

If the project payback is less than the maximum the firm will accept, the project is acceptable

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Same as payback. Plus, by discounting the cash flows, this measure takes into account the time value of money.

Same as the last two items above.

Also, since cash inflows must be discounted it is more complicated to compute than payback.

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11-9. No. To illustrate, consider an investment that costs $100,000 and has cash flows of $50,000 per year for two years. If the firm’s minimum payback is two years then the project is acceptable. Of course, the project will have a negative NPV for any positive discount rate.

To see why this is true, compute the NPV where the discount rate is 10% and you will get a NPV of -$13,223.

11-10. The MIRR represents an attempt to overcome the problem of multiple IRRs for a project.

To accomplish this we essentially eliminate the source of multiple IRRs (i.e., multiple changes in the signs of the cash flows over time). We do this by compounding the interim cash flows forward to the final year of the project’s life using the cost of capital. Having done this then we have only two cash flows to deal with, the initial outlay and the terminal cash flow. By definition this cash flow stream produces only one sign change and therefore only one IRR. The problem we encounter when doing this type of analysis is that we are compounding interim cash flows using the cost of capital (not the project’s IRR—which we are trying to estimate). Consequently, the MIRR is affected by the cost of capital. The correct way to deal with the problem of multiple IRRs is to use NPV! It isn’t that MIRR gives an incorrect accept/reject signal but that it really is not the compound annual rate of return the project is expected to earn.

11-11. Your education expenses are spread over the years you are in college and include the obvious items such as tuition, books, room and board but also include the lost income from working over your college years. The cash inflows from your investment come after college and include the your earnings over your lifetime less the income you would have earned had you not attended college. This analysis focuses on the explicit economic costs and benefits of your college education. There are many other non-economic benefits, however, related to the quality of life you experience as a result of your education.

11-12. The difference in payback and discounted payback, as the names imply, relates to the fact that the future cash flows are discounted to the present in the latter case. Consequently, the two methods produce identical payback measures only where the discount rate is zero (i.e., where the discounting process does not reduce the present value of the future cash flows).

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11-13. These survey results are based on the survey responses of 392 chief financial officers of large US firms. CFOs were asked if they used any of the following standard techniques.

Specifically, they were asked how frequently they used different capital budgeting techniques on a scale of 0 to 4 (with 0 meaning “never,” 1 “almost never,” 2 “sometimes,” 3 “almost always,” and 4 “always”). The results below are the percentage of the CFOs who said they always or almost always used a particular method.

Profitability Index Discounted Payback Payback NPV IRR 0%

10%

20%

30%

40%

50%

60%

70%

80%

Source: John Graham and Campbell Harvey, “How do CFOs make capital budgeting and capital structure decisions?” Journal of Applied Corporate Finance, Volume 15, Number 1 (Spring 2002), 8 - 23.

11-14. The idea, very simply, is that the longer it takes you to get your money back out of an investment, other things being the same, the greater the chance that something will not work out as planned. Consequently, the longer the payback for an investment, the riskier the investment.

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Chapter 12 Solutions to Study Questions 12-1. One obvious possibility is that Toyota is being paid for the technology. Although we do not know the specifics of the financial arrangement between the two auto makers, there probably is some type of royalty payment involved. This means that every time Ford sells a hybrid Fusion it has to pay Toyota a fee for the use of its technology. Moreover, if the technology becomes the dominant technology in the industry with other auto makers making similar arrangements then Toyota makes money each time a hybrid is used.

12-2. For the airline to analyze the decision to include in-flight Internet access, it needs a team that includes technical staff such as engineers to address the cost of installing and maintaining the service, marketing personnel to estimate customer acceptance rates and revenues, and a financial analyst to combine the various cost and revenue estimates into a project evaluation.

12-3. Overhead expenses such as the cost of heat, light, and rent occur regardless of whether we accept or reject a particular project. For this reason, overhead expenses are generally not a relevant consideration when evaluating project cash flows. Note, however, that there are some instances in which overhead expenses may change with a new investment. For example, if the firm adds a new shift to the firm’s operations then its energy costs will increase during the new shift and would therefore be a relevant “incremental” expense of the decision.

12-4. Many times a new project involves an additional investment in working capital. Additional working capital arises out of the fact that cash inflows and outflows from the operations of an investment are often mismatched. That is, inventory is purchased and paid for before it is sold. For example, this may take the form of new inventory to stock a sales outlet or an additional investment in accounts receivable resulting from additional credit sales. Some of the funds needed to finance the increase in inventory and accounts receivable may come from an increase in accounts payable that arises when the firm buys goods on credit. As a result, the actual amount of new investment required by the project is determined by the difference in the sum of the increase in accounts receivables plus inventories less the increase in accounts payable. We will refer to this quantity as net operating working capital. You may recall that in Chapter 3 we defined net working capital as the difference in current assets and current liabilities. Net operating working capital is very similar but focuses on the firm’s accounts receivable and inventories compared to accounts payable.

12-5. Although interest payments are incremental to the investments that are partly financed by borrowing, we do not include the interest payments in the computation of project cash flows. The reason, as we will discuss more fully in Chapter 14, is that the cost of capital for the project incorporates consideration as to how the project is financed, including the after-tax cost of any debt that is used in financing the investment. Consequently, when we discount the incremental cash flows back to the present using the cost of capital, we are implicitly accounting for the cost of raising funds to finance the new project (including the after-tax interest expense). To include interest expense in the computation of the project’s cash flows and in the discount rate would amount to counting interest twice. .

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12-6. The annual free cash flow for an investment project is calculated using Equation (12-2):

Net Operating Profit after Taxes or NOPAT

Operating Cash Flow Note that operating cash flow includes the sum of NOPAT plus depreciation expense.

However, Free Cash Flow adjusts the firm’s operating cash for the effects of any net new investments in capital equipment and working capital.

Important definitions and concepts: Net Operating Income is the profit after deducting the cost of goods sold and all operating expenses (including depreciation expense). Net operating income or net operating profit is also equal to earnings before interest and taxes (EBIT) for capital investment projects since projects do not have other (non-operating) sources of income or expense. For firms that have both operating and non-operating income and expenses EBIT differs from net operating income by the amount of these non-operating sources of income and expense.

Net Operating Profit after Taxes (NOPAT) is equal to the firm’s net operating profit times one minus the corporate tax rate. Note that we do not deduct interest expense before computing the corporate income taxes owed because the tax deductibility of interest is accounted for in the computation of the discount rate or the weighted average cost of capital which is discussed in detail in Chapter 14.

Depreciation Expense is allocation of the cost of fixed assets to the period when the assets are used.

Capital Expenditures (CAPEX) is the periodic expenditure of money for new capital equipment that generally occurs at the time the investment is undertaken (i.e. in year 0).

However, many investments require periodic expenditures over the life of the investment to repair or replace worn out capital equipment. Finally, if the equipment has a salvage value then this becomes a cash inflow in the final year of the project’s life.

Change in Net Operating Working Capital (NOWC) represents changes in the balance of accounts receivable plus inventories less accounts payable. Any changes in this quantity represent either the need to invest more cash or an opportunity to extract cash from the project.

12-7. Depreciation expense represents the allocation of the cost of a long-lived piece of equipment or a building over the life of that item. The actual expenditure might have been made several years prior but the expensing of that cost is “matched” to the revenues the firm generates from that equipment. Since the IRS requires the depreciating of long- lived assets for tax purposes these expenses reduce the firm’s taxes in the year in which the depreciation is taken thus depreciation expense is important as it reduces the firm’s tax liability. However, since there is no cash outflow in the year of the expensing we add depreciation back to determine cash flow. .

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12-8. When a firm invests in a new project, it often leads to an increase in sales that require the firm to extend credit, which means that the firm’s accounts receivable balance will grow. In addition, new projects often lead to a need to increase the firm’s investment in inventories. Both the increase in accounts receivable and in inventories mean that the firm must invest more cash in the business. This is a cash outflow. However, if the firm is able to finance some or all of its inventories using trade credit this offsets the effects of the increased investment in receivables and inventories. The difference in the increased accounts receivable plus inventories, less the 12-9. What are sunk costs and how should they be considered when evaluating an investment’s cash flows?

Sunk costs consist of expenditures that have already been made by the firm and cannot be undone should the firm decide not to make an investment. One such example is R&D expenditures that have been made in past years. Since these expenditures have already been made they are not “incremental” to the investment being considered and are therefore irrelevant to the analysis.

12-10. To be a relevant expense for considering an investment the expenditure must result directly from the decision to accept the investment opportunity. Generally, overhead expenses such as managerial salaries, office expenses, etc. are sunk and therefore irrelevant to the analysis of most new investments. However, if an investment requires that the firm increase sources of overhead (hiring new managers, increasing utilities for extra shifts, etc.) then these expenses are indeed incremental and should be considered when computing the firm’s investment cash flows.

12-11. In calculating the cash flows of an investment it is important to account for what economists refer to as opportunity costs, the cost of passing up the next best choice when making a decision. To illustrate, consider the convenience store example we introduced earlier. Remember that we were considering whether to open a second location just a few blocks from our first very successful store. Let’s now assume that you have purchased the building in which the second store is to be located and it has space for two businesses.

One of the spaces is occupied by a tanning salon and you are considering opening a second convenience store in the open space. Since you already own the building and the space needed for the convenience store is currently unused, should you charge the second convenience store business for use of the open space? The answer is no if you have no other foreseeable use for the space. However, what if a local restaurant owner approaches you with a proposal to rent the space for $2,000 a month? If you open the second convenience store then you will forego the $2,000 per month in rent, and this becomes a very relevant incremental expense since it represents an opportunity cost of putting in a convenience store.

12-12. In a word, yes. Anticipated inflation effects on both revenue and expense should be incorporated into the analysis. There are two basic approaches that can be taken. The first uses inflated or nominal cash flows discounted using nominal discount rates. The second uses real (not adjusted for the effects of future inflation) cash flows that are discounted using real interest rates. The former method is, for most analysts, the preferred methodology. .

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12-13. This is an interesting case study for on the surface one would not expect a hamburger chain to be successful in an environment dominated by Hindu’s and vegetarians. However, there are a number of possibilities. First, the chain does have a wide variety of products that are not made of beef. Second, the small market for beef products may be sufficient in the second most populous country in the world.

12-14. Responses to this question are going to vary from individual to individual and from year to year. However, new consumer electronics products are a very obvious choice.

12-15. In point of fact, when a buyer purchased a Pontiac it may well be that their alternative might have been an Oldsmobile (now defunct) or Chevrolet. Not considering the incremental impact of developing and selling a new model could well lead to overinvestment in different models. For example, a new model of Chevrolet might offer an anticipate revenue of $100 million per year if we fail to consider that 50% of the new model sales came from Pontiac models that were not purchased. Considering the incremental (non-cannibalized) revenues then leads to better company-wide decisions.

12-16. The answer here is no. Consider the assets that comprise a firm’s working capital: accounts receivable and inventory. Both these assets are subject to “shrinkage”. Some credit accounts may end up being uncollectable and some inventory items may spoil, be stolen, or simply become unsalable with the passage of time.

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Chapter 13 Solutions to Study Questions 13-1. Although responses to this question will vary, a primary source of risk relates to demand for the firm’s products and/or services which will incorporate consideration for the nature of the competitive environment. In addition, the firm will face cost control issues including staffing the firm and effectively motivating them to act in concert to achieve the firm’s goals.

13-2. There are two fundamental reasons to perform a project risk analysis of NPV before making the final accept/reject decision: o The first is that project cash flows are risky. Our NPV calculation is based on estimates of future cash flows, and the future probably will not look like our estimate.

So, it is very helpful to explore the nature of the risks the project entails so that we can be better prepared to manage the project if it is accepted. o The second is that forecasts are made by humans, and they can be either too optimistic or too pessimistic when making their cash flow forecasts. The fact that the analyst may not be totally objective about the analysis injects a source of bias into the investment decision-making process. Overly optimistic behavior can result in the acceptance of investments that fail to produce the optimistic forecasts, and pessimistic bias can result in the firm passing up worthwhile projects. Both types of bias are costly to the firm’s shareholders, and a careful risk analysis of projects is one way to guard against such bias.

13-3. Sensitivity analysis entails an exploration of the effect of individual value drivers of an investment on the final outcome of the project (i.e., NPV). Scenario analysis involves selecting a set of specific assumptions about project value drivers and computing the resulting NPV. Simulation analysis utilizes “overwhelming force” to solve for the effect of value drivers on project NPV. Specifically, with simulation we do not analyze a limited number of scenarios but literally thousands.

13-4. The risking value of the Yen relative to the dollar meant that Japanese exports looked more expensive to US buyers. As a result, a rising value of your home country generally results in falling exports and rising imports.

13-5. The simulation process is illustrated in Figure 13-1 and can be thought of in terms of a five-step process: Step 1: Probability distributions are estimated for each of the investment’s key value drivers, (i.e., the variables or factors that determine the project’s cash flows). In this example the value drivers include the cost required to launch the investment and its associated residual value at the end of the project’s life; the factors that determine project revenues (the size of the market for the drug, the market share that Merck thinks it can capture, the rate of growth in the size of the market, and the price of the drug); and the factors underlying the cost of manufacturing and selling the drug (operating costs and fixed costs). .

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Step 5:

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Randomly select one value for each of the value drivers from their respective probability distributions.

Combine the values selected for each of the value drivers to estimate project cash flows for each year of the project’s life and calculate the project’s IRR. Store or save the calculated value of the IRR and repeat Steps 2 and 3.

Simulations are easily carried out using readily available computer software that allows one to easily repeat steps 2 and 3 thousands of times.

Use the stored values of the project IRR to construct a histogram or probability distribution of IRR.

13-6. Accounting breakeven analysis focuses on the level of revenue or unit sales that provide an operating earnings equal to zero. To the contrary, NPV breakeven focuses on the level of revenue or units sole that produces a zero NPV. These two quantities are different not only because of differences in the breakeven metric (operating earnings versus NPV) but also due to the fact that with NPV we discount the future cash flows.

13-7. Three of the most common sources of flexibility that can add value to an investment opportunity include the following: o Timing options—the option to delay a project until the future cash flows are more favorable—this option is common when the firm has exclusive rights, perhaps a patent, to a product or technology; o Expansion options—the option to increase the scale and scope of an investment in response to realized demand; and o Contract, Shut-down, and Abandonment options—the option to slow down production, halt production temporarily, or stop production permanently (abandonment).

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Chapter 14 Solutions to Study Questions 14-1. We can think of the cost of capital for a firm as a weighted average of the required returns of the securities that are used to finance the firm. We refer to this as the firm’s Weighted Average Cost of Capital, or WACC. WACC not only incorporates the required rates of return of the firm’s lenders and investors but also accounts for the particular mix of financing sources that the firm uses. Most firms raise capital to fund investments with a combination of debt, equity, and hybrid securities that have attributes of both debt and equity. The firm’s WACC is simply a weighted average of the cost of these sources of capital to the firm. As such, a firm’s WACC is a blend of the costs of borrowing money (after-taxes) and cost of raising capital from common stockholders.

14-2. We can summarize the mechanics of calculating the firm’s WACC using Equation (14-1) in the three-step procedure illustrated in Figure 14-2. The steps are as follows: Step 1: Define the firm’s capital structure. Evaluate the firm’s mix of debt and equity financing (commonly referred to as its capital structure) and determine the relative importance of each component in the mix listed in column (1) of Figure 14-2. In column (2), we can see the importance (weight) of each source of capital, which is based on the current market value of each source of capital.

Step 2: Estimate the opportunity cost of each of the sources of financing. These costs are equal to the investor’s required rates of return after adjusting the cost of debt for the effects of taxes, as shown in column (3). To estimate these costs, we’ll use the current market value of each source of capital based on its current, not historical, costs.

Step 3: Calculate a weighted average of the costs of each source of financing. Finally, in column (4) we calculate the product of the after-tax costs of each capital source used by the firm and the weights associated with each source. The sum of these products is the weighted average cost of capital at the bottom of column (4). Consequently, the firm’s WACC is nothing but a weighted average of the costs of each source of capital used by the firm where the weights capture the relative importance of each source of capital to the firm’s capital structure.

14-3. We need to be a bit careful here when talking about invested capital, for it does not include everything on the right-hand side of the firm’s balance sheet. A firm’s capital structure includes the firm’s interest-bearing debt (both short-term and long-term), preferred equity, and common equity. Interest-bearing debt includes things like bank loans (short- and longterm) as well as any bonds the firm has issued. However, accounts payable and accrued expenses are excluded from the capital structure components even though they do have a cost to the firm; however, their costs are included in the prices the firm pays for the goods and services that give rise to the creation of the accounts payable and accrued expenses. So to include the cost of accounts payable and accrued expenses in the calculation of the WACC and include them in the calculation of the firm’s cash flow would effectively count them twice.

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14-4. The key thing to think about is that the risk of the investment opportunity, not the source of financing, should drive the discount rate decision. This means, for example, if the investment is to come from your friend’s savings account on which he is earning 5% then it might seem that the opportunity cost foregone for using the savings to buy the restaurant is the 5% in lost interest. However, this is incorrect for the restaurant is a far more risky use of your friend’s savings than depositing them in a bank account. In addition, should your friend decide to borrow some part of the funds then the cost of borrowing for the investment must be considered. Preferably we want the loan rate to the project (not the rate to your friend who might personally guarantee payment and who might have sufficient funds in the bank to guarantee repayment of the note). Finally, one would compute the WACC of the opportunity cost of the funds used to purchase the franchise to use as the appropriate discount rate for valuing it.

14-5. Using the firm’s WACC to evaluate new investment is, in theory, only appropriate if the firm only considers new projects that are identical in risk to the investments it has already made. If the firm has several divisions with different risk levels, the discount rate they should use to evaluate individual investment projects should be different than the WACC. Finance theory suggests that the appropriate discount rate takes into account the opportunity cost of capital, which in turn reflects the risk of the investment. The appropriate opportunity cost can be viewed as the expected rate of return on publicly traded stocks and bonds with equivalent risk. One would not initiate an investment project with expected returns that are less than the returns that can be generated from investments in publicly traded stocks and bonds with equivalent risk since an investment in the stocks and bonds would clearly dominate the project. Hence, less risky investments, whose cash flows resemble the cash flows of a bond, will have an opportunity cost of capital that is lower than more risky investments, whose cash flows resemble the cash flows of a more risky stock.

There are at least two important reasons for sticking with a single discount rate. First, there are technical issues that can potentially make the use of multiple discount rates more trouble than it is worth. For example, individual investment projects, unless they are very large ones, do not have their own capital structure, nor are the sources of capital for the project easily identified or their market prices easily observed. Instead, the firm issues equity, and the price of the firm’s stock combined with its volatility reflects the average risk of all the firm’s investments, not any one particular project.

The second issue that arises with the use of project costs of capital is more subtle and relates to something we will refer to as influence costs. These added costs arise as a result of the extra time and effort someone in charge of trying to get a project approved for funding by the firm’s upper management spends trying to justify a lower discount rate, as well as the time spent by the firm’s managers charged with evaluating the project. In spite of these added costs, some firms do allow for limited flexibility in determining the project cost of capital.

14-6. The approach taken by most firms that undertake investments with very different risk characteristics is to try and isolate their costs of capital for each of their business units or divisions by estimating divisional WACCs. The idea here is that the divisions take on investment projects with unique levels of risk and, consequently, the WACC used in each division is potentially unique to that division. Generally, divisions are defined either by .

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geographical regions (e.g., the Latin American division) or industry (e.g., pipelines, refining, and exploration and production for a large integrated oil company). The procedure used to estimate a divisional WACC are very similar to those used to calculate a firm’s WACC except that the opportunity costs of funds and weights now correspond to those of the division.

The advantages of using a divisional WACC include the following: • It provides different discount rates that reflect differences in the systematic risk of the projects evaluated by the different divisions.

• It entails only one cost of capital estimate per division (as opposed to unique discount rates for each project), thereby minimizing the time and effort of estimating the cost of capital.

The use of a common discount rate throughout the division limits managerial latitude and the attendant influence costs.

14-7. Flotation costs of raising new financing constitute a part of the initial outlay of the investment and should be treated as such. That is, we simply add the total cost of raising the money needed to finance the investment to the project’s initial cash outlay.

Alternatively, the cost of each source of financing can be adjusted to reflect flotation costs. In the end both methods work. It just seems simpler to recognize flotation costs for what they are, a cash outflow in the year in which funds are raised from the capital markets.

14-8. The cost of borrowing short-term funds is lower only for firms that can qualify for borrowing! Moreover, even if you are able to borrow money or issue stock at current low rates, you may be unwilling to invest due to the high degree of uncertainty you face in your product or service markets.

14-9. The guiding principle for selecting a cost of capital is that the cost follows the risk of the investment opportunity. This would argue for using the cost of capital for Seattle’s Best in valuing the company. However, Seattle’s Best may have used a significant amount of debt in its capital structure that Starbucks does not plan to use. In the latter case we would want to estimate the WACC for Seattle’s Best “using” the proposed capital structure.

14-10. Interest rates in different countries are nominal rates and nominal rates (as we learned in previous chapters) reflect the effects of both real rates of interest in the economy and the effect of anticipated inflation. To the extent that the expected rates of inflation differ among countries we should also expect that their nominal rates of interest would also differ.

14-11. Based upon the average yields for the first quarter of 2016, the yield for a 10-year Acorporate bond was 2.92% while the 10-year Treasury yield was 1.59%. That means the spread for 10-year corporate bonds was 1.33% (2.92% - 1.59%).

A basis point (bp) is 1/100th of a percentage point so 10.01% is 1-bp higher than 10.00%.

The yield for a 30-year BB- corporate bond was 8.00% while the 30-year Treasury yield was 2.76%. That means the spread for 30-year corporate bonds was 5.24% or 524 bps.

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Chapter 15 Solutions to Study Questions 15-1. The dominant form of retirement program in the U.S. involves what is known as a defined contribution program. This means that your employer agrees to provide you with a specified sum of money (usually a percent of your pay check) that is deposited into your retirement fund. The investment of this fund then is directed by you to different types of investment funds. It is at this point that the failures of GM and Lehman Brothers might impact you personally since the majority of these firm’s shares is held in various mutual funds.

15-2. A firm’s capital structure consists of owner’s equity and its interest-bearing debt, including short-term bank loans. You may recall from Chapter 14 that the firm’s capital structure does not include everything listed on the liabilities and owners’ equity side of the balance sheet. We call the combination of capital structure plus the firm’s non-interest bearing liabilities such as accounts payable and accrued expenses as the firm’s financial structure.

15-3. Non-interest bearing liabilities are liabilities incurred by a firm for which no explicit interest payment is specified. An example is accounts payable which is incurred by the firm when it purchases new items of inventory. Although there is a cost of money included in such liabilities, it is implicit or hidden in the cost of the items being purchased. So to include accounts payable (or any non-interest bearing liability) in the firm’s capital structure would result in double counting the implicit interest which is already in the computation of firm cash flows.

15-4. The term financial leverage is often used to describe a firm’s capital structure. This terminology arises from the fact that borrowing a portion of the firm’s capital at a fixed rate of interest provides the firm an opportunity to “leverage” the rate of return it earns on its total capital into an even higher rate of return on the firm’s equity. We will look into this phenomenon much closer in the final section, however, it should be noted that if the firm is earning 15% on its investments and paying only 9% on borrowed money, the 6% differential goes to the firm’s owners. As a result, the firm’s return on equity will be much higher than 15%. This is what is known as favorable financial leverage. If the firm earns only 9% on its investments and must pay 15% then the 6% differential here must come out of the owner’s share of the investment return and they suffer unfavorable financial leverage. The key determinant of whether the use of financial leverage is favorable or not relates to whether the firm is able to invest the borrowed money at a rate of return that exceeds its cost.

15-5. The term relevant is used here to mean that the financing choices made by the firm are or are not important in determining the value of the firm to its shareholders. Where financing decisions are not relevant then managers should treat the financing choice between debt and equity as a matter of indifference.

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15-6.

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Assumption 1: The cash flows that a firm generates are not affected by how the firm is financed. As we will discuss later, this is the case when there are no taxes, no costs associated with bankruptcy and when the firm’s debt obligations do not in any way affect its ability to operate its business.

Assumption 2: Financial markets are perfect. This means that securities can be traded without cost and individuals can borrow and lend at the same rate as the firm.

15-7. This figure suggests that the cash flow “pie” is the same regardless of the financing mix. If this is true then the financing decision is not relevant to value maximization and therefore to the financial manager.

15-8. The firm’s cost of capital is fixed (constant) for all capital structure alternatives. Since the weight attached to debt increases with more debt financing and debt is less costly than equity, the cost of equity must increase such that the weighted average cost of capital remains constant.

15-9. In reality, financial managers care a great deal about how their firms are financed. Indeed, there can be negative consequences for firms that select an inappropriate capital structure, which means that, in reality, at least one of the two M&M assumptions is violated.

Violations of Assumption 2 Assumption 2 is clearly violated in reality. Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. When this is the case, firm values may depend on how they are financed because individuals cannot substitute their individual borrowing for corporate borrowing to achieve a desired level of financial leverage. For example, if firms can borrow more cheaply than individuals, it might be better to have firms take on more financial leverage.

This would increase both the risk and return of the stocks, and allow individuals who want to take substantial risk in their own portfolios to do so without borrowing. However, these violations of the Modigliani and Miller Theorem provide very little in the way of insights about why some firms include much more debt in their capital structures than other firms, since the transaction costs that cause differences between the borrowing rates of corporations and the rates faced by individuals tend to affect all firms equally.

Violations of Assumption 1 are much more fundamental and provide important insights about why different firms choose different capital structures. As we will discuss, the cash flows generated by firms are in fact influenced by how the firm is financed.

Violations of Assumption 1 Why might the extent to which the firm is financed by debt or equity affect the total aftertax cash flows generated by a firm? As we discuss below, there are three important reasons why capital structure affects the total cash flows available to its debt and equity holders.

1. Under the U.S. tax code, interest is a tax-deductible expense, while dividends paid to stockholders are not. Thus, after taxes, firms have more money to distribute to their debt and equity holders if they use more debt financing. 1 2. Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the creditors can force the firm into bankruptcy and the firm will incur the added costs that this process entails.

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This is not the case in all countries. The taxing authorities in a number of countries have made changes in their tax laws that reduced or eliminated the tax preference for debt financing.

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The threat of bankruptcy can influence the behavior of a firm’s executives as well as its employees and customers. On one hand, it can focus managerial attention on improving firm performance. On the other hand, too much debt can lead to changes that make a firm a less desirable employer and supplier.

15-10. In the United States, interest payments are tax deductible, but dividend payments are not.

So if the before-tax cash flows are unaffected by how the firm is financed, the after-tax cash flows will be higher if the firm’s capital structure includes more debt and less equity.

This tax deductibility of interest expense leads firms to include more debt in their capital structures. In essence, corporate income taxes subsidize the firm’s use of debt financing by allowing interest to be deducted before corporate taxes are calculated. So if a firm pays a tax rate of 25%, it gets a $0.25 tax refund for every dollar it pays in interest but nothing for the dividends it pays to the firm’s common stockholders.

15-11. If taxes were the only reason that capital structure affects cash flows, the firm would simply use enough debt financing to generate a tax deduction that is sufficient to eliminate its tax liability. However, the downside of using debt financing quickly becomes apparent when the firm’s debt obligations exceed its ability to generate cash. When this is the case, the firm will need to work out a deal with its bankers and bondholders to restructure its debt or they might be forced into bankruptcy. In either case, a failure to meet one’s debt obligations can generate substantial costs to the firm that we collectively refer to as financial distress costs.

In both a mild and deep recession, firms that use financial leverage will be subject to what economists call deadweight costs that reduce the total amount of the cash flows that the firm can distribute to its debt and equity holders. These costs of financial distress arise because the firm’s financial troubles will distract the managers, forcing them to spend their time negotiating with bankers rather than developing new products. They are also likely to generate large legal bills.

While being forced into bankruptcy is obviously costly to the firm, it is also true that just the threat of bankruptcy, or what we will call financial distress, can cause problems for a firm long before the firm finds itself filing for bankruptcy. A firm that is close to bankruptcy is likely to be viewed by its customers and its suppliers as an unreliable business partner. Firms that are experiencing financial distress are likely to lose sales as customers seek out more reliable suppliers, find it difficult to get competitive quotes from their suppliers who are increasingly worried about being repaid, and find it difficult to attract the best quality employees as prospective workers worry more about future layoffs.

15-12. There are two factors that can have a material impact on the role of capital structure in determining firm value.

• Interest expense is tax deductible. This fact makes the use of debt financing less costly, and lowers the firm’s weighted average cost of capital.

• Debt makes it more likely that firms will experience financial distress costs.

The contractual interest and principal payments that accompany the use of debt financing increase the likelihood that the firm will go into bankruptcy at some time in the future, which can lead to losses that reduce the cash flows of the firm.

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When firms make financing decisions they must tradeoff the pluses and minuses of both these factors. On one hand, firms with substantial amounts of taxable income that they can eliminate by taking on debt while facing relatively modest risk of incurring the costs of financial distress will tend to choose relatively high debt ratios. On the other hand, firms that are not generating a lot of taxable income, and which would be subject to substantial costs of financial distress if they have financial difficulties, will want relatively low debt ratios.

The tradeoff between the positive effects of interest tax savings and the expected costs of financial distress produces a saucer shaped cost of capital curve that has a minimum cost of capital for the optimal mix of financing sources. Unfortunately it is not possible to determine the optimal capital structure precisely since the expected costs of financial distress are very difficult to estimate.

15-13. As we discussed in Chapter 1, public corporations are managed by professional managers who do not own all the shares of the firm they manage. When the managers who control the firm’s operations own only a small fraction of its shares there will be times when their self-interest is not the same as that of the firm’s stockholders who own the majority of the firm’s shares. When this is the case, the managers may make choices that are not in the shareholders’ interests resulting in what economists call agency costs. It is sometimes possible to reduce these agency costs through the use of debt financing. For example, it is often argued that managers of firms that have high levels of cash flow tend to become complacent about controls over spending that cash and may engage in wasteful spending practices like buying expensive company buildings, airplanes, and so forth. Corporate executives may also invest in new lines of business, which provide opportunities for themselves and their employees but may not be particularly profitable for the firm’s stockholders.

One way to limit these choices and to get managers to focus more narrowly on stockholder interests is to increase the firm’s debt obligations, thereby reducing the firm’s discretionary control over its cash flow. For example, in 2009 a financially distressed Citigroup canceled its planned delivery of a new corporate jet. As we discussed above, financial distress generally has negative consequence, however, the threat of financial distress can provide a source of discipline that restrains managers who might otherwise make choices that are not in their shareholders’ best interest.

15-14. By benchmarking a firm’s capitals structure, we compare the firm’s current and proposed capital structures to a set of firms that are considered to be in similar lines of business and consequently subject to the same types of risks.

The objective of the benchmarking is not to simply copy what the firm’s competitors are doing. Instead, we use benchmarking to determine a starting point for our analysis. For example, consider the situation where the firm being analyzed currently has a debt ratio of 45%, and raising additional funds with debt will push the debt ratio to 50%. If other firms in similar businesses all have debt ratios less than 30%, we would probably want to be extremely cautious about engaging in additional borrowing.

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15-15. Benchmarking is a tool for analyzing financing decisions by comparing the effects of the financing alternatives on the firm’s financial ratios. The benchmarking process involves calculating a set of financial leverage ratios for the firm for three scenarios: (i) prior to any new financing episode (the firm as it exists today), (ii) with common equity financing, and (iii) with debt financing. The resulting ratios are then compared to these same ratios for similar firms.

Two types of financial ratios are typically used including balance sheet based measures of the extent to which debt financing has been used by the firm (the Debt Ratio and Interestbearing Debt Ratio found below) and coverage ratios that indicate the ability of the firm to meet the financial requirements of its debt (i.e., the Times Interest Earned Ratio and the EBITDA Coverage Ratio found below): These financial leverage ratios are then used to compare a firm’s capital structure to the financial leverage ratios of similar firms (the final column): 15-16. The firm’s capital structure decisions affect both the level and the volatility of the firm’s reported earnings per share (EPS). Firms that use more debt financing, other things remaining the same, will experience greater swings in their earnings per share in response to changes in firm revenues and operating earnings. This is generally referred to as the financial leverage effect.

Financial leverage can sometimes make a firm’s earnings per share higher and at other times lower. The key determinant of the effect of financial leverage on the level of earnings per share is the rate of return earned by the firm on its assets. For example, if the firm is borrowing at 8% and earns 10% on the borrowed money, then the additional 2% the firm earns over the cost of borrowing goes to the common shareholders. This increases both the rate of return earned on the common shareholders’ equity and earnings per share.

When this happens the firm is said to benefit from the use of favorable financial leverage since the use of debt financing results in higher EPS and an increase in the firm’s return on equity.

15-17. Based solely on the level of EPS the firm is expected to earn in the future we could easily make a case for incorporating a higher level of debt financing. However, this recommendation must be tempered by the fact that higher use of financial leverage leads to more volatile EPS in response to fluctuations in firm operating earnings. So the tradeoff the firm’s CFO must consider is the prospect of reporting higher but more volatile EPS in the future if the firm chooses to increase its reliance on debt financing.

15-18. Industry norms are averages of ratios used to compare one firm’s use of debt (financial leverage) to another. Typically, two types of ratios are used: income statement based coverage ratios such as times interest earned that indicate the firm’s ability to service its outstanding debt, and balance sheet debt ratios that indicate the proportion of the firm’s investments that have been financed with debt.

15-19. In general, firms that have very stable earnings are able to sustain a higher proportion of debt in their capital structure. The reason is that with stable earnings the risk of financial distress and its attendant costs is reduced.

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15-20. Financial flexibility refers to the ease with which a firm can raise capital when needed. For example, many firms hold substantial cash reserves in anticipation of an investment opportunity that may arise unexpectedly. What this does is reduce the firm’s dependence on the capital markets which can be both fickle and expensive to access.

15-21. Investments that increase fixed operating costs relative to variable expenses result in an increase in the firm’s degree of operating leverage. What this means is that the firm’s operating earnings will fluctuate much more wildly in response to changes in revenues than they did prior to making the investment. Consequently, other things being the same, the robotics investment increases operating risk and would probably be financed using equity which reduces financial risk such that the combined effects of operating and financial leverage do not get out of hand.

15-22. The principal source of differences in interest rates across countries relate to risk exposure in the different economies that leads to differences in the real rate of interest and differences in inflationary expectations which results in different inflation premiums.

15-23. In the case of the capital lease, the lessor borrows to purchase the asset and subsequently owns the title to the asset thus giving the tax depreciation benefits of ownership to the lessor. The lessor pays the loan used to finance the asset with the payments received from the lessee. In the case of the purchase of the asset by the user of the asset, the user borrows to finance the asset and then makes the debt payments. The tax depreciation benefits of ownership are given to the user of the asset in that case.

15-24. If the user of a potential asset is in a low effective tax rate then by purchasing the asset the user will not be able to completely utilize the depreciation tax shield of owning that asset.

Leasing provides an avenue for a firm in a higher effective tax rate to purchase the asset and more effectively utilize the depreciation tax shield and then share some of those benefits with the user (lessee) of the asset through a payment stream that has the potential to create a lower present value of after-tax payments for use of the asset than through purchasing the asset.

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Chapter 16 Solutions to Study Questions 16-1. EMR’s cash dividend in 2012 was $1.60 per share and the stock was selling for $46.49 on July 26, 2012 which provided a dividend yield of 3.5%.

16-2. The firm increased its dividend from $0.45 per quarter in 2013 to $0.47 per quarter in 2014. Since then they have maintained the dividend through 2014, 2015, and even through 2016. This all took place during a period when oil prices were lower relative to a reasonably long period of time preceding 2014. Shell understood the significance of maintaining its dividend during that time as a reduction in the dividend could signal management’s concern about the level of cash flow expected to be produced by the firm going forward.

16-3. When companies earn a profit they have a choice to make as to what to do with those profits. One alternative is to give the profit back to the firm’s shareholders in cash payments called dividends. Alternatively, the company could keep the profits and reinvest them in the firm’s new investments in the hopes of increasing the value of the firm’s common stock. Dividend policy describes how much of the firm’s profits to retain and how much to pay out in cash dividends.

16-4. A firm’s dividend policy determines how much cash it will distribute to its shareholders and when these distributions will be made. We can characterize a firm’s dividend policy in terms of two fundamental attributes: 1. The fraction of firm earnings paid in dividends. This first attribute is typically described in terms of the dividend payout ratio, which indicates the amount of dividends paid relative to the company’s earnings. For instance, if the dividend per share is $2 and the earnings per share is $4, the payout ratio is 50 percent ($2 ÷ $4).

2. The pattern of payments followed by the firm over time. As will be observed later in the chapter, dividend stability may be almost as important to the investor as the amount of dividends received.

16-5. A stock dividend is a pro-rata distribution of additional shares of stock to the firm’s current stockholders. These distributions are generally defined in terms of a fraction paid per share. A stock split is essentially a very large stock dividend. For example, a 2-for-1 split would entail issuing two new shares of stock to each shareholder in exchange for each old share they currently hold. Thus the 2 for 1 stock split is equivalent to a 100% stock dividend since both will result in the number of shares outstanding doubling while the share price drops in half.

16-6. Unfortunately Aunt Mary is not right. The number of shares has increased but nothing else changed so that the price of each share will decrease proportionately. That is, 100 shares times $20 means her holdings were worth $2,000. Now that she has 110 shares but the total value of the firm’s equity has not changed, the price per share will drop to only $18.18 such that the total value of Aunt Mary’s stock is still $2,000 = 110 x $18.18. .

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16-7. Generally, companies pay dividends on a quarterly basis. To illustrate, on September 13, 2007, Intel announced that holders of record as of November 7, 2007, would receive a $0.10 dividend. The dividend payment was to be made on December 1. September 13 is the declaration date—the date when the dividend is formally declared by the board of directors. The date of record, November 7, designates when the stock transfer books are closed. Investors who own the stock on this date receive the dividend. However, because in the past it was difficult to record stock sales on a timely basis, stock brokerage companies decided to terminate the right of ownership to the dividend two working days before the date of record. This prior date is the ex-dividend date. Therefore, any acquirer of Intel stock on or after November 5 does not receive the dividend. Finally, the company mails the dividend check to each investor on December 1, the payment date.

16-8. Under a dividend reinvestment plan, you’re allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees.

16-9. Very simply, if cousin Harold decides to sell his shares (tender them) to the company, they will pay the announced price for the shares and his holdings in the company stock will decline by 10%.

16-10. Paying a constant dollar amount in dividends per share is popular with both companies and investors who depend on dividends for their income. The reason companies like it is due to the fact that investors watch the firm’s dividend payout and any change is viewed as an indication as to whether the firm is prospering (increased dividend) or not (decreased dividend). By paying out a stable amount the firm can set the dividend sufficiently below anticipated earnings so they can continue paying the dividend even if firm earnings were to decline.

16-11. The firm’s dividend policy is a matter of irrelevance under the following conditions (or assumptions): 1. There are no taxes.

2. No transaction costs are incurred in either buying or selling shares of stock.

3. The firm’s operating and investment policies are fixed.

In other words, under the conditions where the Modigliani and Miller capital structure irrelevancy theorem holds, the distribution choice is also irrelevant.

16-12. This preference for a stable history of paying dividends is ingrained in the investment strategies of a number of investors. However, the popularity of this strategy tends to be counter cyclical. That is, when the economy is booming and investment opportunities are everywhere, investors tend to like high growth stocks that tend to pay little or no dividend.

In times of uncertainty and bad economic times there tends to be a preference for cash dividend paying companies.

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16-13. Prior to the passage of the 2003 tax law, dividends were taxed as ordinary income while capital gains were taxed at the capital gains tax rate. In addition, the capital gains tax rate was lower than the ordinary income tax rate for long-term capital gains, (gains from the sale of securities held for more than one year). Under this tax scenario investor preference for share repurchases over cash dividends as a means of distributing corporate cash flow was even stronger. This is a result of the fact that the capital gains tax is based on the gain realized from the sale of shares not the total value of the cash distribution, and the tax rate on the capital gains was lower than the rate on ordinary income. The tax treatment of capital gains and dividends has changed several times in recent years.

The 2003 tax law calls for the same tax rate to be applied to dividend and capital gains income.

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Chapter 17 Solutions to Study Questions 17-1. Although the functions of marketing and accounting are quite different within the organization they each play a critical role in financial planning. Marketing largely contributes to the revenue estimation requirement which drives the financial forecast while accounting provides the template or set of guidelines within which the financial forecast is prepared. Once a plan has been formulated then the two functional disciplines (marketing and accounting) play a similar role in evaluating the reasonableness of the forecast and in coming up with appropriate target goals for the firm’s performance.

17-2. To prepare the firm for an uncertain future.

17-3. Forecasting a firm’s future sales is the key element in developing a financial plan, yet forecasting can be extremely difficult in some industries. If forecast accuracy is very poor, does this mean the financial planning process is not worthwhile? Explain your answer.

Although forecasts are inherently imperfect, one cannot run a business without making forecasts and thinking about the future. Indeed, forecasting can be viewed as the first step in coming up with a financial plan, that allows firms to come up with the required financing for upcoming investment projects as well as to develop contingency plans when the future does not unfold as expected. While many CEOs still rely on their “gut- feeling,” businesses are increasingly using more systematic approaches to forecasting, which has the added benefit of giving them a more structured approach to planning. Of course plans, based on imperfect forecasts, are by definition imperfect. However, with a systematic approach to think about what the future might be like, firms are better positioned to come up contingency plans that can be used to improve their ability to respond to adverse events and take advantage of opportunities as they arise.

17-4. The percent of sales method utilizes historical ratios of different variables that are relevant to building a financial plan (e.g., the level of inventories the firm might need) divided by firm sales to forecast the variable of interest.

17-5. Most firms engage in three types of planning activities that vary in their objective and degree of detail. For example the firm’s strategic plan defines, in very general terms, how the firm plans to make money in the future. The strategic plan will answer very general questions about the company, such as the following: • Who are we and what do we do?

• Who are our customers?

• Who are our competitors and how do we compete (price, quality, features, etc.)?

For the purposes of this chapter, we assume that the firm has such a plan already in place.

This strategic plan serves as a guide to the preparation of long- and short-term financial plans.

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The long-term financial plan generally encompasses a period of three to five years and incorporates estimates of the firm’s income statements and balance sheets for each year of the planning horizon. These forecasts of the firm’s financial statements are referred to as pro forma financial statements which we defined earlier in Chapter 12 when we discussed cash flow forecasting for capital budgeting.

The short-term financial plan spans a period of one year or less and is a very detailed description of the firm’s anticipated cash flows. The format typically used for the short- term financial plan is a cash budget. The cash budget is highly disaggregated and contains detailed revenue projections and expenses in the month (or even week) in which they are expected to occur for each operating unit of the company.

The long-term financial plan, by comparison, has less detail as it aggregates individual operating unit data to the division or firm level.

17-6. Spontaneous sources of short-term financing arise naturally out of the firm’s operating decisions. For example, when the firm orders new items for its inventories these purchases generate seller financing in accordance with the terms offered by the firm’s vendors. A discretionary source of financing, on the other hand, requires an explicit act by the firm’s management in order to generate the needed sources of funds. For example, when the firm makes a purchase of a piece of capital equipment and does not have the cash to pay for it, then the firm must make a decision as to how best to raise the money and go out and negotiate the terms of financing. An example would be a bank loan to purchase a new forklift truck.

17.7

a. A new advertising campaign that results in more rapidly rising sales—An immediate cash outflow that will be followed later by cash inflows as sales are made and money is collected. b. A delay in the payment of the firm’s accounts payable—A reduction in planned cash expenditures but no change in the firm’s cash balance. c. Offering a more liberal credit policy (to the firm’s customers)—As credit sales are made cash will not flow in as rapidly as before so there will be a reduction in the firm’s cash balance. d. Holding larger inventories in an attempt to reduce the probability of being out of stock—this requires a cash outflow to acquire the additional inventory (unless trade credit can be arranged, thus a reduction in the firm’s cash balance.

17-8. Firms can have too little or too much cash. So, even when the firm has adequate cash on hand it should plan for its cash needs so that it can invest the excess cash to earn a positive return.

17-9. No solution provided as the answer will be unique to each student's particular circumstances.

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Chapter 18 Solutions to Study Questions 18-1. The management at Dell Computer Corporation (DELL) recognized early in the firm’s history that it could improve company performance by following a policy of minimizing its investment in net working capital, (the difference in the firm’s investment in current assets and current liabilities). At the time, Dell’s sales were dominated by retail customers who used credit cards to purchase computers. This meant that the firm’s investment in accounts receivable was minimal, so the firm focused its attention on reducing inventories and expanding its use of trade credit, which is a type of account payable that arises when one firm provides goods or services to a customer with an agreement to bill them later.

Dell used a two-pronged attack. First, to reduce inventories, Dell convinced its suppliers to leave truckloads of the items that Dell needed at the back door of Dell’s plants. The trucks’ contents belonged to the supplier until they were needed by Dell, at which time Dell moved the items from the trailers to its plant. At the same time, Dell’s management took full advantage of the trade credit terms by making their payments at the latest possible date. In combination, these actions not only reduced but eliminated the firm’s investment in working capital! Without the drag of working capital on firm performance the company’s profits soared and its stock price rose dramatically.

18-2. The sales force will push for lenient repayment terms as a method for enticing customers to buy the firm’s products and services. However, offering more lenient payment terms will mean that the firm will need to make a larger investment in accounts receivables.

18-3. The rationale for using the current ratio as a measure of liquidity is as follows: the ability of the firm to pay on time is roughly related to the firm’s current assets, which are by definition those assets that will be converted to cash within one year or less. Similarly, the firm’s debts that must be repaid over the coming year are included in its current liabilities.

Therefore, by comparing the firm’s current assets to its current liabilities we get an indication of the firm’s liquidity.

18-4. Working capital management encompasses the day-to-day activities of managing the firm’s current assets and current liabilities. Because cash, accounts receivable, inventory, and accounts payable can change on a daily and even hourly basis, financial managers may spend more time on working capital management than any other part of their job. Working capital management decisions include, “How much inventory should we carry?,” “Who should credit be extended to?,” Should the firm purchase items for its inventories on credit or pay cash?,” and “If credit is used, when should payment be made?”

18-5. The decisions firms make that affect their net working capital changes the firm’s liquidity or ability to pay its bills on time. Thus, working capital decisions involve a risk–return trade-off. For example, the firm can enhance its profitability by reducing its cash and marketable securities balance since these assets typically earn very low rates of return.

However, the increased profitability comes at a price for the firm is now exposed to a higher risk of not being to pay its bills on time should an unexpected need for cash arise since it has lower cash and marketable securities.

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18-6. Short-term debt must, by definition, be repaid in a period less than a year while long-term debt is due in a period longer than a year. Thus, by definition, using short-term debt creates a greater risk of illiquidity.

18-7. This principle of self-liquidating debt states that the maturity of the source of financing should be matched with the length of time that the financing is needed 18-8. Define the following terms: a. Permanent asset investments Permanent investments are composed of investments in assets that the firm expects to hold for a period longer than one year. These include the firm’s minimum level of current assets such as accounts receivable and inventories, as well as fixed assets. b. Temporary asset investments Temporary investments in assets or simply temporary assets are composed of current assets that will be liquidated and not replaced within the current year. These include cash and marketable securities, accounts receivable, and seasonal fluctuation in inventories. c. Permanent sources of financing Permanent sources of financing include intermediate-term loans, long-term debt (such as installment loans and bonds), preferred stock, and common equity. These sources are considered permanent since the financing is available for a longer period of time than a current liability. d. Temporary sources of financing Temporary sources of financing typically consist of current liabilities the firm incurs on a discretionary basis. Unlike spontaneous sources of financing, the firm’s management must make an overt decision to use one of the various sources of temporary financing. e. Spontaneous sources of financing In Chapter 17 we learned that spontaneous sources of financing arise naturally or spontaneously out of the day-to-day operations of the business and consist of trade credit and other forms of accounts payable.

18-9. The national median credit score is 723, but the cutoff to get the best rate requires a score of 760 or higher. A score of around 620 is often a cutoff point for receiving credit at any rate.

18-10. We solve this expression for rate which is then used to compare the cost of alternative sources of short-term credit.

18-11. The first two numbers, (e.g., 2/10) represent the cash discount of 2% for paying within 10 days) while the net 30 refers to the length of the credit period at which point 100% of the credit extended is due and payable.

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18-12. The size of the investment in accounts receivable is determined by several factors. The first is the level of credit sales as a percentage of total sales. The nature of the business tends to determine the blend between credit sales and cash sales. A large grocery store tends to sell exclusively on a cash basis, whereas most construction-lumber supply firms make their sales primarily with credit. Second, the level of sales is also a factor in determining the size of the investment in accounts receivable. Very simply, the more sales, the greater accounts receivable. The third determinant of the level of investment in accounts receivable is the credit and collection policies—more specifically, the time period allowed until payment is due, any discount for early payment, the quality of customer who receive credit (i.e., the likelihood that they will pay you in a timely fashion), and the collection efforts put forth by the firm to collect its delinquent accounts.

18-13. a. Your Payment History (35 percent of your score). Since a lender is considering extending credit to you, it only makes sense that they want to know how you’ve handled your credit payments in the past. b. The Amount You Owe and Your Available Credit (30 percent of your score). The amount you owe on your credit cards, your mortgage, your car loans, and any other outstanding debt, along with whether you are close to or at your credit limit is also factored in. c. Length of Credit History (15 percent of your score). The longer your credit accounts have been open and the longer you have had accounts with the same creditors, the higher your credit score will be. d. Types of Credit Used (10 percent of your score). If you have several different types of credit outstanding( for example, credit cards, retail accounts, installment loans, auto loans, and a mortgage loan), that is taken as an indicator that you know how to handle your money. e. New Credit (10 percent of your score). Applying for lots of new credit is generally a bad sign. This is because individuals who are moving toward bankruptcy generally take one last grasp at credit, hoping it will keep them afloat. This will lower your score.

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Chapter 19 Solutions to Study Questions 19-1. Operating risks—maintaining operational control while operating in another country with different labor laws and culture can prove very challenging Financial risks—making investments using one currency while receiving cash inflows in another currency creates an exchange rate risk problem not encountered in domestic investing.

Political risks—especially when investing in underdeveloped countries the risk of expropriation can be very real.

19-2. The world has become an increasingly international place in which to live and work.

Thomas Friedman expounds on this theme in his book, The World is Flat, which looks closely at how global boundaries have collapsed, flattening the playing field for all firms worldwide. It no longer matters whether you major in accounting, engineering, economics, marketing, management or finance, you will be competing with individuals with the same training from around the world. As Thomas Friedman explains in his book, the convergence of technology and events have allowed India, China, and many other countries to become part of the global supply chain for services and manufacturing.

Let there be no doubt, there is no going back – not in terms of business or your personal life. The playing field you’ll be on the rest of your life will be an international one.

19-3. Without international investing by domestic firms it is often difficult to get the opportunity to invest in emerging economies. The domestic firms are large enough to manage the risks attendant to such investing while most individual investors are not able to do so.

19-4. Buying an undervalued asset while selling an overvalued asset to profit from coming price corrections.

19-5. Simple arbitrage eliminates exchange rate differentials across the markets for a single currency. For example, assume that in London the spot exchange rate is £ .6360/$, and in New York the exchange rate is £.6239/$. If you simultaneously bought a pound in New York for £.6239/$ and sold a pound in London for £.6360/$, you would have (1) taken a zero net investment position since you bought £1 and sold £1, (2) locked in a sure profit of £.0121/$ no matter which way the pound subsequently moves, and (3) set in motion the forces that will eliminate the different quotes in New York and London. As others in the marketplace learn of your transaction, they will attempt to do the same. The increased demand to buy pounds in New York will lead to a higher £/$ exchange rate in New York, while the increased supply of pounds in London will lead to a lower £/$ exchange rate in London. Ultimately, the workings of the market will produce a new spot rate that lies between £.6239/$ and £.6360/$ and is the same in New York and in London.

19-6. How do purchasing power parity, interest rate parity, and the International Fisher effect explain the relationships between the current spot rate, the future spot rate, and the forward rate?

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Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries’ currencies. Specifically, the interest parity condition can be stated as follows: Difference in = Ratio of the forward interest rates and spot rates According to the theory of purchasing-power parity (PPP), exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased.

The International Fisher Effect (IFE) assumes that real rates of return are the same across the world, so that the differences in nominal returns around the world arise because of different inflation rates.

19-7. Exchange rate risk arises where a firm holds an investment in a foreign country and the value of the currency of that country falls relative to the company’s host country. The loss in value of the investment denomenated in the foreign country is a result of exchange rate risk.

When a company invests resources in a foreign country and the government of that country places taxes on those assets or seizes them altogether the firm is said to have experienced political risk.

19-8. Firms can follow one of two strategies: First, they can hedge their exposure to exchange rate risk by entering into an offsetting contract today in lieu of the pending transaction in the future. Second, the firm can borrow money in the foreign market that can be repaid with revenues from the investment such that there is no need to translate the revenues back to their home currency.

19-9. You could denominate your debt in rupees such that as you receive rupees from your investment you could use them to pay down your debt. In essence, by borrowing in rupees you have hedged your foreign exchange risk.

19-10. Political risk can arise if the foreign subsidiary conducts its business in a politically unstable country. A change in a country’s political environment frequently brings a change in policies with respect to businesses—and especially with respect to foreign businesses.

An extreme change in policy might involve nationalization or even outright expropriation (government seizure) of certain businesses. For example, in 2007, Venezuela nationalized the country’s largest telecommunications company, several electrical companies, and four lucrative oil projects that were owned by Exxon Mobil, Chevron, and ConocoPhillips.

These are the political risks of conducting business abroad. Some examples of political risk are as follows: 1. Expropriation of plants and equipment without compensation.

2. Expropriation with minimal compensation that is below actual market value.

3. Nonconvertibility of the subsidiary’s foreign earnings into the parent’s currency—the problem of blocked funds.

4. Substantial changes in tax rates.

5. Governmental controls in the foreign country regarding the sale price of certain products, wages and compensation paid to personnel, the hiring of personnel, transfer payments made to the parent, and local borrowing.

6. Requirements regarding the local ownership of the business.

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All of these controls and governmental actions put the cash flows of the investment to the parent company at risk. Thus, these risks must be considered before making the foreign investment decision. For example, the MNC might decide against investing in countries with risks of types 1 and 2 as mentioned above, whereas other risks can be borne— provided that the returns from the foreign investments are high enough to compensate for them. In fact, insurance against some types of political risks can be purchased from private insurance companies or from the U.S. government Overseas Private Investment Corporation. It should be noted that although an MNC cannot protect itself against all foreign political risks, political risks are also present in domestic business.

Exchange rate risk is the risk that the value of a firm’s operations and investments will be adversely affected by changes in exchange rates. For example, if U.S. dollars must be converted into euros before making an investment in Denmark, an adverse change in the value of the dollar with respect to the euro will affect the total gain or loss on the investment when the money is converted back to dollars. We will have a lot more to say about exchange rate risk in Chapter 20 where we discuss risk management.

19-11. The same net present value calculations used for domestic investments apply to direct foreign investments. However, the risks are different (see the answer to question 19-10. Since there are more “unknowns” involved in foreign investing it is naturally more complicated.

19-12. If owning the plant doesn’t make sense then the firm might consider partnering with a local company by using a joint venture agreement whereby the foreign partner builds the plant. Alternatively, the firm may license its technology to a foreign company as a means of profiting from the use of that technology in a new market.

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Chapter 20 Solutions to Study Questions 20-1. The focus of corporate risk management is on managing the factors that determine the risk of a firm’s cash flows. Very simply, this risk can be thought of as coming from forces outside the control of the firm such as competition from firms selling similar products or the overall health of the economy in general; and from factors that are under the control of the firm’s management. With respect to the latter, the biggest source of risk comes from uncertainty about the firm’s revenues, which are determined to a large extent by the successes and failures of the firm’s marketing efforts. Another important contributor to the risk of a firm’s cash flows is the firm’s production costs. For example, production cost overruns are a major source of risk that can be controlled to some extent through the use of well-designed and maintained accounting systems that are used by the firm’s operating managers to monitor and control the firm’s operations. So, even though you may not be directly involved in the risk management of your firm, your actions contribute to the underlying risk of the firm’s cash flows.

20-2. Risk management refers to the processes and procedures used by the firm to measure and assess the risks to which the firm is exposed and deciding which ones to retain and which ones to transfer to an outside party.

20-3. The most common sources include the following: 1. Demand risk—fluctuations in product or service demand driven by competitive forces and the effects of the state of the economy in general. Some of this risk is strictly focused on the firm (e.g., product quality, on- time delivery, and so forth). External competition, as well as the status of the regional and national economy, also influences a firm’s demand for its goods and services. For example, the mortgage market crisis of 2007-08 affected the demand for new home construction across the nation. However, the Arizona, California, and Florida markets were hit the hardest for reasons related to their regional economies.

2. Commodity risk—price fluctuations in commodities that are essential to your business can wreak havoc on the firm’s cash flow. For example, the dramatic price increases in the cost of fuel that occurred in 2007-08 produced huge losses for airline companies as it drove up their cost of operations substantially.

3. Country or political risk—where your firm does business can create problems related to maintaining operations in the face of political unrest or unfavorable governmental interference in the firm’s operations.

4. Operational risk—cost overruns related to the firm’s operations is another source of volatility in corporate cash flow.

5. Foreign-exchange risk—unfavorable shifts in the exchange rate between the United States and the foreign countries in which a firm does business can lead to dramatic decreases in corporate cash flow.

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20-4. On May 1, 2008 the firm had natural gas hedges, or investments that neutralize risk, in place covering 74% and 80% of the firm’s natural gas production for 2008 and 2009, respectively.

20-5.

Type of Risk Property damage to company facilities due to fire, storm, or vandalism Loss of business resulting from a temporary shutdown because of fire or other insured peril.

Loss of income resulting from the disability or death of an employee in a key position Losses suffered by the officers and directors of the firm due to alleged errors in judgment, breaches of duty, and wrongful acts related to their organizational activities.

Losses due to on-the-job injuries suffered by employees

Type of Insurance Contract Used to Hedge Property insurance Business interruption insurance

Key person life insurance

Directors and officers insurance

Workers’ compensation insurance

20-6. So when should you purchase life insurance? Here are some common sense guidelines that can help you answer this question: • You’re single and don’t have any dependents. Unless you are concerned that you may not be insurable in the future, purchasing life insurance should probably be a very low priority for you.

• You are part of a married, double-income couple, with no children. Consider life insurance only if you are concerned that a surviving spouse’s lifestyle will suffer should you die today.

• You are married but are not employed. Consider life insurance only if you have young children and your spouse would have financial problems with day care and other costs of raising a family should you die today.

• You are retired. Consider life insurance only if your spouse could not live on your savings, including Social Security and your pension, should you die today.

• You have children. You should have coverage for raising and educating your children until they are financially self-sufficient.

20-7. As discussed in Chapter 19, a forward contract is a contract wherein a price is agreedupon today for an asset to be sold in the future. These contracts are privately negotiated between the buyer and seller. The key feature to a forward contract is the fact that the price determination is made at the time of the contract but the actual purchase and sale do not occur until the maturity of the contract in the future.

Futures contracts are similar to forward contracts except that they have a limited number of terms and conditions that standardize the contract such that it can be traded on an organized exchange. .

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20-8. Consider the problem faced by Tree-Top Airlines (TTA). In six months the firm will need to purchase jet fuel that is currently selling for $100 per barrel and does not want to suffer the risks associated with future price fluctuations in the cost of fuel. (For now we will assume that the firm needs just one barrel of fuel. You can multiply the results by any number of barrels to adjust the outcome for TTA’s actual fuel needs).

The firm can enter into a forward contract today with a delivery price equal to the current price of fuel of $100 that will have the payoffs found in panel (a) of Figure 20-2. The firm that owns this position is said to have taken a long position in the forward contract. Note that if the actual price of jet fuel rises to $130, then the forward contract pays TTA $30 per barrel. Thus, in six months TTA’s cost of fuel remains $100, (the market price of fuel in six months of $130 less the payoff from the long position in the forward contract which is $30).

Now let us consider the situation faced by the Pilot Refining Company, which anticipates that it will have jet fuel refined and ready for sale in six months. However, the price it can realize from the sale of the jet fuel is subject to market fluctuations. To eliminate the risk of a drop in the price Pilot can sell a forward contract (i.e., take a short position) for the delivery in six months at a delivery price of $100. The payoff to this contract is found in Panel (b) of Figure 20-2. For example, if the price of jet fuel rises to $130 on the delivery date then Pilot can sell its jet fuel for this price but the firm suffers a loss of $30 on the forward contract such that the net price received per barrel is $100.

20-9. Generally, forward contracts are negotiated long-term contracts between the firm managing its risk exposure and a financial intermediary such as an investment bank. The primary advantage of this type of bilateral arrangement is that the contract can be tailored to the specific needs of the firm that is engaging in risk management. However, there are some potentially serious limitations of this approach.

1. Credit risk exposure. Both parties to the contract are exposed to the credit or default risk. This is the risk that the other party to the transaction might default on their obligation. For example, there were a large number of firms that had entered into various types of risk management or hedging contracts with Enron Corporation that were designed to mitigate the firms’ exposure to energy price risk. When Enron failed, these contracts were no longer effective. The point is that using bilateral negotiated contracts to manage price risk also exposes the firm to credit or default risk of the person or institution on the other side of the transaction.

2. Sharing of strategic information. Since the two parties to a forward contract know who the other party is, they learn about the specific risks that are being hedged. If the parties to the agreement were anonymous (as would be the case if exchange traded contracts were used), then no such sharing of information would occur.

3. Market values of negotiated contracts are not easily determined. Without a market value for the negotiated forward contract, it is difficult to assess the gains and losses the firm has experienced at any point in time.

The limitations noted can be addressed through the use of exchange-traded contracts.

Specifically, exchanged traded futures, options, and swap contracts, which we discuss in the next section, provide an alternative means for managing corporate risk that does not suffer from the limitations of bilateral negotiated forward contracts.

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20-10. A futures contract is a contract to buy or sell a stated commodity (such as soybeans or corn) or a financial claim (such as U.S. Treasury bonds) at a specified price at some future specified time. These contracts, like forward contracts, can be used by the financial manager to lock in future prices of raw materials, interest rates, or exchange rates.

20-11. There are two basic types of options: calls and puts. A call option gives its owner the right (but not the obligation) to purchase a given number of shares of stock or an asset at a specified price over a given period. Note a key difference between an option contract and a futures contract is that the option holder does not have to exercise the option. If the price of the underlying common stock or asset on which the option is written goes up, the owner of a call option makes money. You have the option to buy something, for example shares of common stock, at a set price even though the market price of the stock has risen above the fixed exercise price.

A put option, on the other hand, gives its owner the right (but not the obligation) to sell a given number of shares of common stock or an asset at a specified price within a given period. The owner of a put makes money when the price of the underlying common stock or asset on which the put is written drops in value. Just as with a call, a put option gives its holder the right to sell the common stock or asset at a set price, but it is not a promise to sell. Now let’s take a look at some of the terminology involved with options.

20-12. As the name swap implies, a swap contract involves the swapping or trading of one set of payments for another. Common types of swap contracts involve interest payments or currencies. For example, an interest rate swap might involve the trading of fixed interest payments for variable or floating rate interest payments between two companies. A currency swap would involve an exchange of debt obligations in different currencies.

To see how an interest rate swap works, consider the set of swap cash flows found in Figure 20-10. These cash flows correspond to a five-year fixed for floating rate swap (trading payments on a five-year fixed rate loan for the payments on a five-year floating rate loan) with semi-annual interest payments and a notional principal of $250 million.

The term notional principal is used since this is the amount used to calculate payments for the contract but this amount does not change hands. The floating rate is set to equal the six-month London Interbank Offer Rate, or Libor, and the fixed rate is 9.75% with both coupon payments paid semi-annually.

In this illustration, the firm that initiates the swap contract has a floating rate obligation so it must pay floating rate payments found in column (D) of Figure 20-10. However, after entering into the swap the firm now pays the swap counterparty the fixed coupon payments found in column (C) and receives a set of payments equal to the floating rate payments found in column (D). The floating rate payments that the firm receives as part of the swap are exactly equal to its floating rate obligations under the terms of its floating rate loan.

Thus, the firm pays the floating rate interest using the proceeds of the swap agreement and then is left with the set of fixed rate coupon payments. Consequently, the firm has converted its floating rate loan into a fixed rate loan.

20-13. Enter into a forward contract today to purchase the needed crude in the future. By doing this the firm fixes the cost of crude for its needs at a future date.

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Problem 3-5 Given Sales Revenue COGS Cash Operating Expenses Depreciation Expense Interest Expense Dividend Income Dividends Paid Solution 3-5 Sales Revenue $0.00 Dividend Income taxable $0.00 Total Revenues $0.00 COGS $0.00 Cash Operating Expenses $0.00 Depreciation Expenses $0.00 Total Expense $0.00 Net Operating Income $0.00 Interest Expense $0.00 Income before Income Taxes $0.00 Income Tax (Tax Liability) $0.00 Net Income $0.00 Marginal Tax rate 34.00% Average tax rate #DIV/0!

Problem 3-6 Robbins Corporation Given Sales Revenue COGS Cash Operating Expenses Depreciation Expense Interest Expense Dividend Income Dividends Paid Solution 3-6 Sales Revenue Dividend Income Total Revenues COGS Cash Operating Expenses Depreciation Expenses Total Expense Net Operating Income Interest Expense Income before Income Taxes Income Tax Marginal tax rate Average tax rate

$0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 -$5,000.00 25.00% #DIV/0!

Problem 3-11 Given Current Assets Net Fixed Assets Long-term debt Current Liabilities Accounts Payable Short Term Debt

Solution a b c

Stockholder's Equity Net Working Capital Net Working Capital

$0.00 $0.00 $0.00

Problem 3-13 Given

Depreciation Expense Cash Long-Term debt Sales Accounts Payable General & Administrative Expense Buildings & Equipment Notes Payable Accounts Receivable Interest Expense Accrued Expenses Common Stock Cost of Goods Sold Inventory Taxes Accumulated Depreciation Taxes payable Retained Earnings Solution 3-13 a TNT, Inc. Income Statement

Sales Revenue Cost of Goods Sold Gross Profit Expenses General & Administrative Expense Depreciation Expense Total Expenses Net Operating Income / Profit Interest Expense Earnings Before Taxes Taxes Net Income

$0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 Solution 3-13-b TNT, Inc. Balance Sheet

ASSETS Current Assets Cash Inventory Accounts Receivable Total Current Assets

$0.00 $0.00 $0.00 $0.00

Fixed Assets Buildings & Equipment Less : Accumulated Depreciation Buildings & Equipment, net Total Assets Liabilities Current Liabilities Accounts Payable Taxes Payable Accrued Expenses Notes Payable Total Current Liabilities Long-Term debt Total Liabilities Shareholder's Equity Common Stock Retained Earnings Total Shareholder's Equity Total Liabilities & Shareholder's Equity

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00 $0.00

$0.00 $0.00

$0.00 $0.00 $0.00 $0.00

Problem 4-25

Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Step 7 Step 8 Step 9 Step 10 Step 11

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells In Cell E52, Calculate Current ratio using formula "Current Assets / Current Liabilities" In Cell E53, Calculate Times interest earned using formula "Net Operating Income/ Interest E In Cell E54, Calculate Inventory Turnover using formula "Cost of goods sold/ Inventory" In Cell E55, Calculate Total Asset turn Over using formula "Net Sales / Total Assets" In Cell E56, Calculate Operating Profit Margin using formula "Net Operating Income / Net Sa In Cell E57, Calculate Operating Return on Assets using formula "Net Operating Income / Tot In Cell E58, Calculate Debt Ratio using formula "( Current Liabilities + Long-term debt) / Tota In Cell E59, Calculate Average Collection Period using formula "( Accounts Receivable * 365 ) In Cell E60, Calculate Fixed Asset Turnover using formula "Net Sales / Net Fixed Assets " In Cell E61, Calculate Return on Equity using formula "Net Income / Owner's Equity"

Given J. P. Robard Mfg., Inc. Balance Sheet ($000) Cash Accounts receivable Inventories Current assets Net fixed assets Total assets Accounts payable Accrued expenses Short-term notes payable Current liabilities Long-term debt Owners’ equity Total liabilities and owners’ equity J. P. Robard Mfg., Inc. Income Statement ($000) Net sales (all credit) Cost of goods sold Gross profit Operating expenses (includes $500 depreciation) Net operating income Interest expense Earnings before taxes Income taxes (40%) Net income

Solution Current ratio Times interest earned Inventory turnover Total asset turnover Operating profit margin Operating return on assets Debt ratio Average collection period Fixed asset turnover Return on equity

Problem 4-25

tions to use the Solution Template below yellow colored cells a "Current Assets / Current Liabilities" g formula "Net Operating Income/ Interest Expense" ormula "Cost of goods sold/ Inventory" g formula "Net Sales / Total Assets" ing formula "Net Operating Income / Net Sales" s using formula "Net Operating Income / Total Assets" ( Current Liabilities + Long-term debt) / Total Assets" using formula "( Accounts Receivable * 365 ) / Credit Sales " formula "Net Sales / Net Fixed Assets " mula "Net Income / Owner's Equity"

Given

Solution

Problem 4-27

Step 1

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Carver Industries Balance Sheet for December 31, 2012 and 2013 Cash Accounts receivable Inventories Total current assets Land Buildings and equipment Less: Accumulated depreciation Total fixed assets Total assets Accounts payable Short-term bank notes Total current liabilities Long-term debt Common stock Retained earnings Common Equity Total debt and equity Carver Industries Income Statements Years Ending December 31, 2012 and 2013 Sales (all credit) Cost of goods sold Gross profit Operating expenses Fixed cash operating expenses Variable operating expenses Depreciation

Total operating expenses Earnings before interest and taxes Interest expense Earnings before taxes Taxes Net income Shares of Common Stock Outstanding Market price per share No. of shares in common Stock outstanding Market price per share

Solution a.

Current ratio Acid Test Ratio Average collection period Inventory turnover Debt ratio Times interest earned Operating profit margin Total asset turnover Fixed asset turnover Operating return on assets Return on equity

c.

Earnings per share P-E ratio Market to Book Ratio

Problem 4-27

Instructions to use the Solution Template the below yellow colored cells

Given

2012

2013

Solution 2012 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

#DIV/0! #DIV/0! #DIV/0!

2013 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Industry Averages 2.00 0.80 37.00 2.50 58.00% 3.80 10.00% 1.14 1.40 11.40% 9.50%

Problem 5-16

Step 1

Instructions to use the Solution Templat Enter the given values from the textbook in the below yellow colored cells

Given Cost of Ring after 7 years Number of years from present to 30-year anniversary Money available for investing now

Solution Interest Rate at which the money should be invested

Problem 5-16

Instructions to use the Solution Template elow yellow colored cells

ed

Solution #NUM!

Problem 5-20

Step 1 Step 2 Step 3 Step 4 Step 5 Step 6

Instructions to use the Solution T Enter the given values from the textbook in the below yellow colored cells Enter the rate function( RATE) in cell "E16" ( tan colored cell) For the argument "nper" enter the number of years from given values marked in yellow or s For the argument "pmt" enter the value"0" as there were no payments For the argument "PV" enter the value of statue seven years ago from given values marked i For the argument "FV" enter current value of statue from given values marked in yellow or s

Given Current Value of the statue (FV) Number of Years Value of statue seven years ago

Solution Annual Rate of return

ns to use the Solution Template d cells

s marked in yellow or select the cell that contains number of years value nts m given values marked in yellow or select that particular cell es marked in yellow or select that particular cell

Problem 5-33

Step 1

Instructions to use the Solution Templa Enter the given values from the textbook in the below yellow colored cells

Given Annual Interest Rate Number of years Money available for investing

solution Value of investment after 7 years

Problem 5-33

nstructions to use the Solution Template w yellow colored cells

solution $0.00

Step 1

Problem 5-34 Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Cost of Vacation home Number of years Money available for investing

solution Annual Interest Rate

blem 5-34 to use the Solution Template

solution #NUM!

Problem 6-9

Step 1

Instructions to use the Solution Templa Enter the given values from the textbook in the below yellow colored cells

Given Current price of the house Rate at which house would grow Rate of interest per year Number of Years

Solution - Template Price of the house after 10 years Annual Payment

$0.00 #NUM!

to use the Solution Template olored cells

ate

Problem 6-18

Step 1

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Loan Amount Payment Number of Years to repay remaining amount(n)

Interest rate

Solution Template #NUM!

8

e Solution Template olored cells

ate

Problem 6-25

Step 1 Step 2 Step 3 Step 4 Step 5

Instructions to use the Soluti Enter the given values from the textbook in the below yellow color cells Enter the payment function( PMT) in cell "E21" ( tan colored cell) For the argument "rate" enter the rate of interest from given values marked in yellow or sele For the argument "nper" enter the number of years from given values marked in yellow or s For the argument "PV" enter the loan amount from given values marked in yellow or select t

Given Loan amount Rate of interest Number of Years (n)

Solution -Template Payment

structions to use the Solution Template olor cells ) lues marked in yellow or select the cell that contains rate of interest value values marked in yellow or select the cell that contains number of years value marked in yellow or select the cell that contains loan amount value

te

Problem 6-32

Step 1

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Loan amount Rate of interest Number of years Month number for Portion of Monthly payment toward interest calculation

Solution - Template Number of periods Monthly Interest rate Payment Interest amount in the 48th payment Principal amount in the 48th payment

Problem 6-32 Instructions to use the Solution Template textbook in the below yellow colored cells

Given

Solution - Template 0 0.00% #NUM! #NUM! #NUM!

Problem 7-1

Given Price of stock on 24 dec 2007 Price of stock after 1 yr

Solution Rate of return= (ending price + dividend - beginning price)/ beginning price)=(298.02+0-700.

Growth rate #DIV/0!

nning price)=(298.02+0-700.73)/700.73

Problem 7-10

Given TIME 1 2 3 4

a

BARRIS Solution Annual rate of return for year(1-2)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(2-3)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(3-4)=(ending price - beginning price)/ beginning price)= CARSON Solution Annual rate of return for year(1-2)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(2-3)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(3-4)=(ending price - beginning price)/ beginning price)=

b

BARRIS Solution Arithmetic average rate of return = CARSON Solution Arithmetic average rate of return = BARRIS Solution Geometric average rate of return = CARSON Solution Geometric average rate of return =

c

BARRIS Solution Three year rate of return = CARSON Solution

Three year rate of return = d BARRIS Solution Annual rate of return = CARSON Solution Annual rate of return =

e

Problem 7-10

Given BARRIS

CARSON

BARRIS Solution ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)=

#DIV/0! #DIV/0! #DIV/0!

CARSON Solution ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)=

#DIV/0! #DIV/0! #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution

#DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

Problem 7-1

Given Price of stock on 24 dec 2007 Price of stock after 1 yr

Solution Rate of return= (ending price + dividend - beginning price)/ beginning price)=(298.02+0-700.

Growth rate #DIV/0!

nning price)=(298.02+0-700.73)/700.73

Problem 7-10

Given TIME 1 2 3 4

a

BARRIS Solution Annual rate of return for year(1-2)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(2-3)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(3-4)=(ending price - beginning price)/ beginning price)= CARSON Solution Annual rate of return for year(1-2)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(2-3)=(ending price - beginning price)/ beginning price)= Annual rate of return for year(3-4)=(ending price - beginning price)/ beginning price)=

b

BARRIS Solution Arithmetic average rate of return = CARSON Solution Arithmetic average rate of return = BARRIS Solution Geometric average rate of return = CARSON Solution Geometric average rate of return =

c

BARRIS Solution Three year rate of return = CARSON Solution

Three year rate of return = d BARRIS Solution Annual rate of return = CARSON Solution Annual rate of return =

e

The annual rate of return calculated in part d is nothing but geometric average rate of re describes the average annual rate of return over a period because it compounds at the sam

Problem 7-10

Given BARRIS

CARSON

BARRIS Solution ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)=

#DIV/0! #DIV/0! #DIV/0!

CARSON Solution ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)= ing price - beginning price)/ beginning price)=

#DIV/0! #DIV/0! #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution

#DIV/0!

BARRIS Solution #DIV/0!

CARSON Solution #DIV/0!

n part d is nothing but geometric average rate of return calculated in a different way. Geometric best eturn over a period because it compounds at the same rate and is useful over a period while arithmetic

Problem 8-10 a Step 1

Instructions to use the solution template Enter the given values from the textbook in the below yellow colored cells

Given MONTH 1 2 3 4 5 6

Sugita Corp.

Solution Sugita Corp.

0.00% 0.00%

Average return Standard deviation

b Step 1

Instructions to use the solution template Enter the given values from the textbook in the below yellow colored cells

Given Sugita's beta Risk free rate

Market's expected return Expected return

c

Solution 0.00% 0.00%

Solution Sugita's historical Average Sugita's Expected return from CAPM and the firm's systematic risk

em 8-10

o use the solution template olored cells

Given MARKET

lution Market 0.00% 0.00%

o use the solution template olored cells

lution

lution 0.00% 0.00%

Problem 8-20 a Step 1

Instructions to use the solution te Enter the given values from the textbook in the below yellow colored cells

Given STOCK 1 2 3 4 5

PERCENTAGE OF PORTFOLIO

a

Solution 0.00%

Expected return of portfolio

b

Solution Portfolio beta

Step 1

Instructions to use the solution te Enter the given values from the textbook in the below yellow colored cells Given Beta Risk-free rate Market Portfolio

0 1

120% 100%

Expected Return

c

0

80%

EXPECTED RETURN

60% 40%

SECURITY MARKET Line

20%

Linear (SECURITY MARKET Line)

0% 0

0.5

1 Beta

1.5

em 8-20

ctions to use the solution template olored cells

Given BETA

lution

lution

ctions to use the solution template olored cells Given Expected Rate

EXPECTED RETURN SECURITY MARKET Linear (SECURITY MARKET Line)

EXPECTED RETURN

Problem 8-23 a Step 1

Instructions to use the solution template Enter the given values from the textbook in the below yellow colored cells

Step 2 Step 3

Calculate the beta of First portfolio in cell " E18 " (Tan colored cell) using the formula: Weight of Asset A in first portfolio * Beta of Asset A + Weight of Asset B in first portfolio * B Weight of Asset C in first portfolio * Beta of Asset C + Weight of Asset D in first portfolio * Be Apply the same formula to calculate the Beta of the second portfolio in cell "F18" (Tan color Given Beta

Asset A B C D

Solution First Portfolio Portfolio beta

c Step 1

Instructions to use the solution template Enter the given values from the textbook in the below yellow colored cells

Step 2 Step 3 Step 4 Step 5

Calculate the Expected return of first portfolio using the formula below in cell "E40" (Tan col = risk free rate + beta of the portfolio * risk premium Enter the value of risk free rate from given values Enter the risk premium from given values Enter the Beta of the first portfolio from the above calculated values (Cell "F18")

Step 6

Apply the same formula to calculate the Beta of second portfolio, expect fro select the beta values in cell "F18")

Given Risk free rate Risk premium

Solution First Portfolio Expected rate of return of the portfolio

the solution template lored cells

ll) using the formula: Asset B in first portfolio * Beta of Asset B + Asset D in first portfolio * Beta of Asset D folio in cell "F18" (Tan colored cell)

iven First Portfolio

Second Portfolio

Second Portfolio

the solution template lored cells

below in cell "E40" (Tan colored cell):

alues (Cell "F18")

, expect fro select the beta of second portfolio from calculated

Second Portfolio

Problem 9-1

Given Loan floating rate over LIBOR Maximum rate Minimum rate

Solution Date Week 1 Week 2 Week 3 Week 4 Week 5 Week 6 Week 7 Week 8 Week 9 Week 10

LIBOR 1.98% 1.66% 1.52% 1.35% 1.60% 1.63% 1.67% 1.88% 1.93%

Libor + spread rate

Loan Rate

1.98% 1.66% 1.52% 1.35% 1.60% 1.63% 1.67% 1.88% 1.93%

1.98% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.88% 1.93%

Problem 9-16

a

Given Market price Coupon rate Number of years to maturity Par value

Solution Coupon payments Yield to maturity

b

$0.00 #NUM!

Problem 9-23

Given Real rate of interest expected inflation rate

Solution Nominal rate of interest

0.00%

Problem 9-1

Given Loan floating rate over LIBOR Maximum rate Minimum rate

Solution Date Week 1 Week 2 Week 3 Week 4 Week 5 Week 6 Week 7 Week 8 Week 9 Week 10

LIBOR 1.98% 1.66% 1.52% 1.35% 1.60% 1.63% 1.67% 1.88% 1.93%

Libor + spread rate

Loan Rate

1.98% 1.66% 1.52% 1.35% 1.60% 1.63% 1.67% 1.88% 1.93%

1.98% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.88% 1.93%

Problem 9-16

a

Given Market price Coupon rate Number of years to maturity Par value

Solution Coupon payments Yield to maturity

b

$0.00 #NUM!

As the required yield to maturity for comparable risk bond is 9%, the price of this bond shou equal to $713.57. As the price is greater than $713.57 you should not buy it

%, the price of this bond should be less than or d not buy it

Problem 9-23

Given Real rate of interest expected inflation rate

Solution Nominal rate of interest

0.00%

Problem 10-9

a

Given Retention per share ROE Earnings per share

Solution Retention percentage Growth rate

#DIV/0! #DIV/0!

b Given growth rate Dividend Rate of return

Solution Value of common stock

#DIV/0!

c Given Retention per share Earnings per share Dividend Rate of return

Solution Retention percentage Growth rate= Value of common stock

d

#DIV/0! #DIV/0! #DIV/0!

Given Retention per share Earnings per share Dividend

Rate of return

Solution Retention percentage Growth rate

#DIV/0! #DIV/0!

Problem 10-9

Solution

Solution

Solution

Solution

Problem 10-13

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return a

Solution Growth rate

b

Solution P/E ratio (for comparable firm)

c

Solution Stock price

d Solution Value of common stock e

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price P/E1 ratio Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price = P/E1 ratio

f

Problem 10-13

Given

Solution 0.00%

Solution 0 Solution $0.00

Solution #DIV/0!

Given

Solution #DIV/0! #DIV/0!

Given

Solution #DIV/0! #DIV/0!

Problem 10-14

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return a

Solution Growth rate

b

Solution P/E ratio (for comparable firm)

c

Solution Stock price

d Solution Value of common stock e

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price P/E1 ratio

f

Problem 10-14

Given

Solution 0.00%

Solution 0 Solution $0.00

Solution #DIV/0!

Given

Solution #DIV/0! #DIV/0!

Problem 10-9

a

Given Retention per share ROE Earnings per share

Solution Retention percentage Growth rate

#DIV/0! #DIV/0!

b Given growth rate Dividend Rate of return

Solution Value of common stock

#DIV/0!

c Given Retention per share Earnings per share Dividend Rate of return

Solution Retention percentage Growth rate= Value of common stock

#DIV/0! #DIV/0! #DIV/0!

As the value of the common stock is decreasing, Solarpower should not make this change

d

Given Retention per share Earnings per share Dividend

Rate of return

Solution

Retention percentage #DIV/0!

Growth rate #DIV/0!

Note that since the value of growth rate is greater than required return, the dividend growth

Problem 10-9

Solution

Solution

Solution

uld not make this change

Solution

d return, the dividend growth model doesn't apply for this case

Problem 10-13

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return a

Solution Growth rate

b

Solution P/E ratio (for comparable firm)

c

Solution Stock price

d Solution Value of common stock e

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price P/E1 ratio Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price = P/E1 ratio

f

As the retention ratio increases, P/E ratio increases and vice versa

Problem 10-13

Given

Solution 0.00%

Solution 0 Solution $0.00

Solution #DIV/0!

Given

Solution #DIV/0! #DIV/0!

Given

Solution #DIV/0! #DIV/0!

Problem 10-14

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return a

Solution Growth rate

b

Solution P/E ratio (for comparable firm)

c

Solution Stock price

d Solution Value of common stock e

Given P/E ratio of similar stock ROE Retention ratio Expected earnings at end of year Required rate of return Solution Price P/E1 ratio

f

As ROE increases growth rate increase there by increasing the P/E ratio and vice versa

Problem 10-14

Given

Solution 0.00%

Solution 0 Solution $0.00

Solution #DIV/0!

Given

Solution #DIV/0! #DIV/0!

ncrease there by increasing the P/E ratio and vice versa

Problem 11-12

a

Project A Given Year 0 1 2 3 4 5

cashflows

Solution IRR

Project B Given Year 0 1 2 3 4 5

cashflows

Solution IRR

Project C Given Year 0 1 2 3 4 5

cashflows

Solution IRR

b

c

Project A

Discount rate=10% Solution

NPV Project B Solution NPV Project C Solution NPV Project A

Discount rate=20% Solution

NPV Project B Solution NPV Project C Solution NPV

lem 11-12

olution #NUM!

olution #NUM!

olution #NUM!

olution $0.00

olution $0.00

olution $0.00

olution $0.00

olution $0.00

olution $0.00

Problem 11-18

Given Cash outlay at years 0,5,10,15 Discount rate Yearly inflow Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

a Solution NPV

Solution MIRR (Modified Cash Flows)

Solution IRR (Project's actual cash flows)

Note: The IRR found above is might be only one of the multiple IRRS. In Unconventional cash flow stream there is a possibility of multiple IRRS.

Problem 11-18

ven

Cash Outflows

Cash Inflows $0 -

$0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

Solution $0.00

Solution #NUM!

Solution #NUM!

Modified Cash Flows Cash Flows $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

of the multiple IRRS. ssibility of multiple IRRS.

Problem 11-23

Barnett Shale Given Required rate of return Year 0 1 2 3 4 5 6 7 8 9 10

20.00% Net cash outflow schedule cash outflow

Gulf Coast Given Required rate of return Year 0 1 2 3 4

20.00% Net cash outflow schedule cash outflow

Barnett Shale a

Solution Payback period Gulf Coast Solution Payback period

Barnett Shale c

Solution NPV Gulf Coast Solution NPV

Cumulative Cash Flows $ -

Cumulative Cash Flows $ -

4

1.875

$0.00

$0.00

Problem 11-12

a

Project A Given Year 0 1 2 3 4 5

cashflows

Solution IRR

Project B Given Year 0 1 2 3 4 5

cashflows

Solution IRR

Project C Given Year 0 1 2 3 4 5

cashflows

Solution IRR

b

If discount rate is 10%, We would accept project A & project C

c

Project A

Discount rate=10% Solution

NPV Project B Solution NPV Project C Solution NPV Project A

Discount rate=20% Solution

NPV Project B Solution NPV Project C Solution NPV

lem 11-12

olution #NUM!

olution #NUM!

olution #NUM!

olution $0.00

olution $0.00

olution $0.00

olution $0.00

olution $0.00

olution $0.00

Problem 11-18

Given Cash outlay at years 0,5,10,15 Discount rate Yearly inflow Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

a Solution NPV

Solution MIRR (Modified Cash Flows)

The project is worthwhile investment because NPV is positive or the cost of capital is less th Solution IRR (Project's actual cash flows)

Note: The IRR found above is might be only one of the multiple IRRS. In Unconventional cash This is a good investment because NPV is positive

Problem 11-18

ven

Cash Outflows

Cash Inflows $0 -

$0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

Solution $0.00

Solution #NUM!

PV is positive or the cost of capital is less than MIRR of project Solution #NUM!

Modified Cash Flows Cash Flows $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

of the multiple IRRS. In Unconventional cash flow stream there is a possibility of multiple IRRS

Problem 11-23

Barnett Shale Given Required rate of return Year 0 1 2 3 4 5 6 7 8 9 10

20.00% Net cash outflow schedule cash outflow

Gulf Coast Given Required rate of return Year 0 1 2 3 4

20.00% Net cash outflow schedule cash outflow

Barnett Shale a

Solution Payback period Gulf Coast Solution Payback period

Barnett Shale c

Solution NPV Gulf Coast Solution NPV

Cumulative Cash Flows $ -

Cumulative Cash Flows $ -

4

1.875

$0.00

$0.00

Problem 13-3

a

Given Probability

Expected Cash Flow

Revenue

$

Solution -

roblem 13-3

Solution

Problem 13-4

Scenario I Probability High Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Medium Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Low Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Total Revenues from each scenario

$0.00

Solution Expected Revenue

$

-

m 13-4

Scenario II

Scenario III

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Problem 13-5

a

Given Probability

Expected NPV

NPV estimate

Solution -

$

b

Given Probability High Medium Low

State of Demand 1 -Pb - .5 50% Pb

Solution

Let probability be "Pb", so the sum of the probabilities of all possible states is equal to one 1.00 = Pb(low demand state) + .50 + Pb(high demand state) such that Pb(High demand state Setting the expected NPV equal to zero using the above probabilities and solving for the pb(l Pb (low demand state)

#DIV/0!

roblem 13-5

Solution

Given NPV Estimate

Solution

e states is equal to one and the probability of the medium state is .5 , i.e., t Pb(High demand state)= .5 - Pb (low demand state) s and solving for the pb(low demand state) results in the following probability:

P

Given Initial cost of equipment Project and equipment life Salvage value of equipment Working capital requirement Depreciation method Depreciation expense Discount rate Tax rate

Base case Unit sales Price per unit Variable cost per unit Fixed costs Best Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV Worst Case

Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense

Assuming the negative tax credit obtained here can used s Solution $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0!

Net income Cash flow

NPV=PV(E12,E7,D50)-E6 NPV

#DIV/0! #DIV/0!

Problem 13-6

Given

Straight-Line #DIV/0!

Worst case 0 $0.00 $0.00 $0.00

Best Case 0 $0.00 $0.00 $0.00

Solution Excel formula in previous column F17*F18 F17*F19 F20 D25-D26-D27 E11 D28-D29 D30* E13 D30-D31 D32+D29

#DIV/0!

e tax credit obtained here can used somewhere else or carried forward Solution Excel formula in previous column E17*E18 E17*E19 E20 D42-D43-D44 E11 D45-D46 D47*E13

D47-D48 D32+D29

#DIV/0!

Proble

Given Initial cost of equipment Project and equipment life Salvage value of equipment Working capital requirement Depreciation method Depreciation expense Discount rate Expected units of sale Sale price per unit Variable cost per unit Fixed costs Tax rate

a Base case Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV NPV % decrease in NPV=(D39-D36)/D36

#DIV/0!

NPV % decrease in NPV NPV

#DIV/0!

% decrease in NPV=(D50-D36)/D36 e

#DIV/0!

NPV=PV($E$12,$E$7,-I32,-$E$9)-$E$6-$E$9 NPV % decrease in NPV

#DIV/0!

f

Base case Unit sales Price per unit Variable cost per unit Fixed costs Base Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 #VALUE! #DIV/0! #VALUE! #VALUE! #VALUE! #VALUE!

NPV

#VALUE!

Best Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV

#DIV/0!

Worst Case Solution

Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV

#DIV/0!

Problem 13-7

Given

Straight-Line #DIV/0!

Excel formula in previous column E13*E14 E13*E15 E16 D25-D26-D27 E11 D28-D29 D29* E17 D30-D31 D32+D29

#DIV/0! #DIV/0!

#DIV/0!

#DIV/0!

Solution 10% decrease in units sold 10% decrease in cost per unit $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

#DIV/0!

Worst case

Best Case

10% increase in variable cost per unit 10% increase in fixed cost $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 13-11

Given Price per an hour Variable cost per hour Depreciation expenses Fixed costs

Solution a b

Accounting break-even Cash break-even units of production

Problem 13-11

#DIV/0! #DIV/0!

Problem 13-3

a

Given Probability

Expected Cash Flow

Revenue

$

Solution -

roblem 13-3

Solution

Problem 13-4

Scenario I Probability High Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Medium Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Low Priced Boats Category Unit Sales Avg Price per Unit Total Revenues

$0.00

Total Revenues from each scenario

$0.00

Solution Expected Revenue

$

-

m 13-4

Scenario II

Scenario III

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Problem 13-5

a

Given Probability

Expected NPV

NPV estimate

Solution -

$

The expected NPV is the weighted average of the NPV for the MRI machine. The expected va being negative b

Given Probability High Medium Low

State of Demand 1 -Pb - .5 50% Pb

Solution

Let probability be "Pb", so the sum of the probabilities of all possible states is equal to one 1.00 = Pb(low demand state) + .50 + Pb(high demand state) such that Pb(High demand state Setting the expected NPV equal to zero using the above probabilities and solving for the pb(l Pb (low demand state)

#DIV/0!

roblem 13-5

Solution

machine. The expected value is good, but there is 20% probability of NPV

Given NPV Estimate

Solution

e states is equal to one and the probability of the medium state is .5 , i.e., t Pb(High demand state)= .5 - Pb (low demand state) s and solving for the pb(low demand state) results in the following probability:

P

Given Initial cost of equipment Project and equipment life Salvage value of equipment Working capital requirement Depreciation method Depreciation expense Discount rate Tax rate

Base case Unit sales Price per unit Variable cost per unit Fixed costs Best Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV Worst Case

Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense

Assuming the negative tax credit obtained here can used s Solution $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0!

Net income Cash flow

NPV=PV(E12,E7,D50)-E6 NPV

#DIV/0! #DIV/0!

Problem 13-6

Given

Straight-Line #DIV/0!

Worst case 0 $0.00 $0.00 $0.00

Best Case 0 $0.00 $0.00 $0.00

Solution Excel formula in previous column F17*F18 F17*F19 F20 D25-D26-D27 E11 D28-D29 D30* E13 D30-D31 D32+D29

#DIV/0!

e tax credit obtained here can used somewhere else or carried forward Solution Excel formula in previous column E17*E18 E17*E19 E20 D42-D43-D44 E11 D45-D46 D47*E13

D47-D48 D32+D29

#DIV/0!

Proble

Given Initial cost of equipment Project and equipment life Salvage value of equipment Working capital requirement Depreciation method Depreciation expense Discount rate Expected units of sale Sale price per unit Variable cost per unit Fixed costs Tax rate

a Base case Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV NPV % decrease in NPV=(D39-D36)/D36

#DIV/0!

NPV % decrease in NPV NPV

#DIV/0!

% decrease in NPV=(D50-D36)/D36 e

#DIV/0!

NPV=PV($E$12,$E$7,-I32,-$E$9)-$E$6-$E$9 NPV % decrease in NPV

#DIV/0!

f

Base case Unit sales Price per unit Variable cost per unit Fixed costs Base Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 #VALUE! #DIV/0! #VALUE! #VALUE! #VALUE! #VALUE!

NPV

#VALUE!

Best Case Solution Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV

#DIV/0!

Worst Case Solution

Revenues Variable cost Fixed Expenses Gross margin Depreciation Net operating income Income tax expense Net income Cash flow

$0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

NPV

#DIV/0!

Problem 13-7

Given

Straight-Line #DIV/0!

Excel formula in previous column E13*E14 E13*E15 E16 D25-D26-D27 E11 D28-D29 D29* E17 D30-D31 D32+D29

#DIV/0! #DIV/0!

#DIV/0!

#DIV/0!

Solution 10% decrease in units sold 10% decrease in cost per unit $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

#DIV/0!

Worst case

Best Case

10% increase in variable cost per unit 10% increase in fixed cost $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 13-11

Given Price per an hour Variable cost per hour Depreciation expenses Fixed costs

Solution a b

Accounting break-even Cash break-even units of production

Problem 13-11

#DIV/0! #DIV/0!

Problem 14-2

Given Book values ST Debt LT Debt Common Equity Total

Solution As market values have to be considered for calculating weights Weight of Debt Weight of Equity

Problem 14-2

Given Market Values

Solution

considered for calculating weights #DIV/0! #DIV/0!

Problem 14-6

a

Given Yield Rate Tax rate

Solution Cost of debt capital

b

Given Last year dividend Market price of stock Dividend growth rate

Solution Cost of capital Equity Capital c

Given Face value Market Value Number of years Coupon rate Tax rate

Solution Yield to Maturity After-tax Cost of Debt d

Given Par Value Market Value Dividend rate

Solution Cost of capital =(7%*100)/85=8.24%

Problem 14-6

Given

Solution 0.00%

Given

Solution #DIV/0!

Given

Solution #NUM! #NUM! Given

Solution #DIV/0!

Problem 14-22

Given Weight of common stock Weight of preferred stock Weight of debt Cost of common stock Cost of preferred stock Tax rate Cost of debt

Solution WACC

Problem 14-22

Given

Solution 0.00%

Problem 14-29

Given Planned borrowing amount Capital raised from retention of earnings Total Cost of New Investments Investment bankers fee (basis points) 1 basis point

Solution Floatation cost adjusted initial outlay

Problem 14-29

Given

0.01%

Solution $0.00

Problem

Instructions to use Step 1

Enter the given values from the textbook in the below yellow colored cells

Given Current equity financing Current debt financing Equity financing after taking debt Debt financing after taking debt Interest rate Tax rate Income Statement EBIT Interest expense Earnings before taxes Taxes Net Income

Solutio a

EBIT Less : Interest expense EBT Income tax Net Income

Amount distributed to share holders Amount distributed to bond holders

b

Solutio Interest tax savings

c

Solutio Amount Received from dividends by shareholders per $1 of equity held before debt financing Amount Received from dividends by shareholders per $1 of equity held after debt financing

d

Solutio Income Statement Before debt financing with out corporate taxes EBIT Less : Interest expense EBT Net Income

Solutio Income Statement after debt financing with out corporate taxes EBIT Less : Interest expense EBT Net Income

Solutio Amount Received from dividends by shareholders per $1 of equity held before debt financing without Amount Received from dividends by shareholders per $1 of equity held after debt financing without c

Problem 15-8

Instructions to use the Solution Template

m the textbook in the below yellow colored cells

Given

vidends by shareholders per $1 of equity held before debt financing vidends by shareholders per $1 of equity held after debt financing

Solution $0.00 $0.00 $0.00 $0.00 $0.00

$0.00 $0.00

Solution

Solution

Solution

e debt financing with out corporate taxes $0.00 $0 $0.00 $0.00 Solution

debt financing with out corporate taxes

Solution vidends by shareholders per $1 of equity held before debt financing without corporate taxes vidends by shareholders per $1 of equity held after debt financing without corporate taxes

$0.00 $0 $0.00 $0.00

mplate

$0.00

#DIV/0! #DIV/0!

#DIV/0! #DIV/0!

Problem 15-9

Step 1 Step 2 Step 3 Step 4

Instructions to use the Solutio Enter the given values from the textbook in the below yellow color cells

In Cell F23, Calculate the Times Interest Earned ratio for 2006 using formula EBIT/ interest expense from given Values In Cell F23, Calculate the Times Interest Earned ratio for 2007 using formula EBIT/ interest expense from given Values

In Cell F23, Calculate the Times Interest Earned ratio for 2008 using formula EBIT/ interest expense from given Values From the three ratios asses the firm's ability to service debt obligations

Given EBIT Less : Interest expense EBT Income tax Net Income

Solution Times Interest earned ratio 2006 Times Interest earned ratio 2007 Times Interest earned ratio 2008

Problem 15-9

Instructions to use the Solution Template he textbook in the below yellow color cells

es Interest Earned ratio for 2006 using formula EBIT/Interest Expense.. Enter/ Select the values of EBIT and Values es Interest Earned ratio for 2007 using formula EBIT/Interest Expense. Enter/ Select the values of EBIT and Values

es Interest Earned ratio for 2008 using formula EBIT/Interest Expense. Enter/ Select the values of EBIT and Values he firm's ability to service debt obligations

006 007 008

Given 2008

Solution

2007

2006

Problem 15-12

Step 1

Instructions to use the So Enter the given values from the textbook in the below yellow colored cells

Given Equity Debt Number of shares Income tax Interest rate

Solution a

EBIT indifference level

Solution b

EBIT Less : Interest expense EBT Income tax Net Income EPS

Problem 15-12

Instructions to use the Solution Template he textbook in the below yellow colored cells

Given Plan B

Solution

Solution Plan B #DIV/0! $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0!

tion Template

Plan A

#DIV/0!

Plan A #DIV/0! $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 15-13

Step 1

Instructions to use the Solution Enter the given values from the textbook in the below yellow colored cells

Given Equity Debt Price of each share Income tax Interest rate

Solution a

Number of shares issues in plan B Number of shares issues in plan A EBIT indifference level

b

Solution EBIT Less : Interest expense EBT Income tax Net Income EPS

Problem 15-13

Instructions to use the Solution Template he textbook in the below yellow colored cells

Given Plan B

Solution

an B an A

Solution Plan B #DIV/0! $0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!

tion Template

Plan A

#DIV/0! #DIV/0! #DIV/0!

Plan A #DIV/0! $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 16-1

Given EMR INTC WMT

Solution Cash dividend per share for EMR Cash dividend per share for INTC Cash dividend per share for WMT

Problem 16-1

Given Dividend payout ratio

Earning per share

Solution 0 0 0

Problem 16-9 Cash Accounts Receivable Inventories Current Assets Fixed Assets Total Assets

Cash dividend Number of shares

Total cash outflow New Balance sheet(Book Values and Market Values) Cash Accounts Receivable Inventories Current Assets Fixed Assets Total Assets

Market value of the equity decreases as the dividend is paid

ecreases as the dividend is paid

Problem 16-9 Accounts Payable Notes Payable Current Liabilities Long-term Debt Equity Total

$0.00

$0 Accounts Payable 0 Notes Payable 0 Current Liabilities $0 Long-term Debt 130,000 Equity $130,000 Total

$0 0 0 0 0 $0

Problem 16-12

Given Current dividends Investors required rate of return Dividends after 1 yr

a

Solution Value of equity

Problem 16-12

Given

Solution $0.00

Problem 17-1

Given Next Year Net Income Last year Sales Projected Sales for Next Year Dividends

Balance Sheet Current Assets Net Fixed assets Total Assets Liabilities and Owner's Equity Accounts Payable Long-Term Debt Total Liabilities Common stock Paid-in-capital Retained Earnings Common Equity Total Liabilities and Owner's Equity

$0.00

$0.00

$0.00 $0.00

Solution Retained Earnings for next year Total Financing Requirements= Projected Total Assets(From the Excel)

Discretionary Financing Required= Pro Forma Total Assets - Accounts Payable - Lo Common Stock - Paid-in-Capital - Retained Earnings

% of Sales #DIV/0! #DIV/0!

Projected Values #DIV/0! #DIV/0! #DIV/0!

#DIV/0!

#DIV/0! $0.00 $0.00 $0.00

Solution

From the Excel)

$0.00 #DIV/0!

ets - Accounts Payable - Long Term debt #DIV/0!

Problem 17-3

Given Net Income/Sales Current Assets Common Equity Current Sales Projected Sales for Next Year Fixed assets Accounts Payable Lon-Term Debt Projected Increase in Fixed Assets Dividends

a

Solution

Total Financing Requirements= Current Assets * Proportion increase in Sales+ La Assets + Projected Increase in Fixed Assets

b

Solution

Discretionary Financing Required= Pro Forma Total Assets - Accounts Payable - Lo Common equity - Addition to Retained Earnings

c

Solution

Direct Proportion Increase in Sales= ((- Fixed Assets - Increase in Fixed Assets + Lo Common Equity - Dividends)/ (Current Assets - Accounts Payable- % of Net incom Sales) -1)

Solution

ortion increase in Sales+ Last Year Fixed #DIV/0!

Solution

ets - Accounts Payable - Long Term debt #DIV/0!

Solution

ncrease in Fixed Assets + Long Term debt + ts Payable- % of Net income of Sales * #DIV/0!

Problem 17-4

Given Total asset turnover Average collection period (assume a 365-day year) Fixed asset turnover Inventory turnover (based on cost of goods sold) Current ratio Sales (all on credit) Cost of goods sold Debt ratio

Solution Total Assets= Sales/ Total Asset turnover Fixed Assets= Sales/Fixed Asset Turnover Cash + Accounts Receivables + Inventory= Total Assets - Fixed Assets Accounts Receivable=(Sales *Avg Collection Period)/365 Inventory= COGS/Inventory turnover Cash= Total assets - Fixed Assets - Accounts Receivable- Inventory Current Liabilities= Current Assets( Sum of Cash, A/R and Inventory)/ Current Rati Long Term Debt= Debt Ratio * Total Assets - Current Liabilities Common Stock plus Retained Earnings= (1- Debt Ratio) * Total Assets

Balance Sheet Cash Inventory Accounts Receivable Net Fixed Assets Total Assets Liabilities and Owner's Equity Current Liabilities Long-Term Debt Common stock Plus Retained Earnings Total Liabilities and Owner's Equity

Solution

ets - Fixed Assets )/365

able- Inventory R and Inventory)/ Current Ratio

atio) * Total Assets

#DIV/0! #DIV/0! $0.00 #DIV/0! #DIV/0!

#DIV/0! #DIV/0! #DIV/0! #DIV/0!

#DIV/0! #DIV/0! #DIV/0! $0.00 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 17-6

Given Sales for the Year Ended on 12/31/13 Anticipated Sales

a

Balance Sheet Current Assets Net Fixed Assets Total Assets Accounts Payable Notes Payable Bonds Payable Common Equity Total Liabilities and Owner's Equity

b

Solution Retained Earnings for next year= Last Year Retained Earnings + Net Income - Divid Total Financing Requirements= Projected Total Assets Discretionary Financing Required

17-6

n

New Balance Sheet #DIV/0! $0.00 $0.00 #DIV/0! #DIV/0! #DIV/0! $0.00 $0.00 $0.00

Solution r Retained Earnings + Net Income - Dividends Total Assets

#DIV/0!

#DIV/0! #DIV/0!

Problem 17-8

Given Amount invested in assets for 1 dollar in sales Ratio of spontaneous liabilities Additional Sales Profits per each additional $ of sales Amount reinvested in firm for each $ in sales

Solution

Total additional Financing Requirements= Amount invested in assets for $ 1 of sa Discretionary financing required= Additional investment in sales - Increase in spon in retained earnings(Reinvested amount)

17-8

n

Solution

Amount invested in assets for $ 1 of sales * Additional Sales nal investment in sales - Increase in spontaneous liabilities -increase

$0.00 $0.00

Problem 17-11

Given Purchases (% of sales) Cash Collection(% of sales) Cash collections one month after sales Cash Collections two months after sales Rent Quarterly Taxes Yearly Interest rate Minimum Cash Balance Other Expenditures

November Sales (forecasted) Purchases( 60% of Sales price)

$0.00

December $0.00

January $0.00

Cash receipts Collections: On month after sale (10%) One month after sale (60%) Second month after sale (30%) Total cash receipts

$0.00 $0.00 $0.00 $0.00

Cash disbursements Payments Rent Other expenses Taxes Total cash disbursements

$0.00 $0.00 $0.00 0 $0.00

Net change in cash for the period Plus: Beginning cash balance Less: Interest on short-term borrowing Equals: Ending cash balance before shortterm borrowing

$0.00 $22,000.00 $0.00

New financing needed Cash balance before repayment Repayment Ending Cash Balance Cumulative borrowing

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$22,000.00

February

March

April

May

June

July

August

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $0.00 $0.00 0 $0.00

$0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00

$22,000.00

$22,000.00

$22,000.00

$22,000.00

$22,000.00

$22,000.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

$0.00 $22,000.00 $0.00 $22,000.00 $0.00

Problem 18-2

Step 1

Instructions to use the So Enter the given values from the textbook in the below yellow colored cells

Step 2

To find out the current state of Microsoft liquidity calculate the current ratio.

In cell G28, calculate current ratio of Microsoft in 2008 using formula = Current as

Step 3 Step 4 Step 5 Step 6 Step 7

To find out the current state of Microsoft liquidity calculate Net working capital in In cell G29, calculate Net working capital of Microsoft in 2008 using formula = Cu To observe the recent changes in Microsoft liquidity, Calculate the Current ratio a In cell G30, calculate current ratio of Microsoft in 2007 using formula = Current as In cell G31, calculate Net working capital of Microsoft in 2007 using formula = Cu In cell G32, calculate current ratio of Microsoft in 2006 using formula = Current as In cell G33, calculate Net working capital of Microsoft in 2006 using formula = Cu From the calculations infer the Microsoft liquidity position

Given Total Current Liabilities for Year 2008 Total Current Liabilities for Year 2007 Total Current Liabilities for Year 2006 Total Current Assets for Year 2008 Total Current Assets for Year 2007 Total Current Assets for Year 2006

Solution Current Ratio for 2008 Net Working Capital for 2008 Current Ratio for 2007 Net Working Capital for 2007 Current Ratio for 2006 Net Working Capital for 2006

tructions to use the Solution Template llow colored cells

te the current ratio. ing formula = Current assets in 2008/ Current liabilities in 2008

te Net working capital in 2008.

2008 using formula = Current assets in 2008 - Current liabilities in 2008 ulate the Current ratio and net working capital for Microsoft in 2007 and 2006 ing formula = Current assets in 2007/ Current liabilities in 2007 2007 using formula = Current assets in 2007 - Current liabilities in 2007 ing formula = Current assets in 2006/ Current liabilities in 2006 2006 using formula = Current assets in 2006 - Current liabilities in 2006 n

Solution #DIV/0! $0.00 #DIV/0! $0.00 #DIV/0! $0.00

Step 1

a

Step 1

b

Problem 18-6

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Inventory conversion period in days Average Collection period (Credits collection period) in days Accounts payable deferral period in days

Solution Operating cycle Cash conversion cycle

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells

Given Inventory conversion period in days Average Collection period ( Credits collection period) in days Accounts payable deferral period in days

90 30 45

Solution Cash conversion cycle

0 0

75

Problem 18-12

Step 1

Instructions to use the So Enter the given values from the textbook in the below yellow colored cells

Given Principal loan amount Interest rate over prime Prime Interest rate per annum % of loan amount as minimum balance Current balance Duration of loan in months

Assuming Mr Hale wants to maintain his initial balance after 3 months a

Solution Loan amount Jimmy Hale has to take in order for him to have $240,000 in hand a Total Rate of interest = Prime interest rate + Interest over prime Interest paid Amount Mr. Hale would pay after 3 months The annualized cost of the bank loan

Assuming Mr Hale wants to maintain his initial balance after 3 months a

Solution Loan amount Jimmy Hale has to take in order for him to have $240,000 in hand a Interest paid Amount Mr. Hale would pay after 3 months The annualized cost of the bank loan

18-12

Instructions to use the Solution Template k in the below yellow colored cells

n

initial balance after 3 months

Solution order for him to have $240,000 in hand and maintain 20% balance te + Interest over prime

$0.00 0.00% $0.00 $0.00

ths #DIV/0!

initial balance after 3 months

Solution order for him to have $240,000 in hand and maintain 20% balance

$0.00 $0.00 $0.00

ths #DIV/0!

Problem 19-7

Step 1 Step 2 Step 3

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells In Cell D16, Subtract Spot exchange rate from 6 month forward contract rate to obtain Premium/Discount In Cell D17, Use this formula "((Forward rate - Spot Rate)/Spot rate)*12/n" to obtain Premium/ Discount Perc Given Spot Rate of 1 Australian Dollar in terms of US dollars 6 Month forward rate of 1 Australian Dollar in terms of US dollars

Solution Premium/ Discount Premium/ Discount Percentage Per annum= ((Forward rate - Spot Rate)/Spot rate)*12/n

olution Template

tain Premium/Discount n Premium/ Discount Percentage Per annum

*12/n

Problem 19-14

Step 1 Step 2 Step 3

Instructions to use the Solution Template Enter the given values from the textbook in the below yellow colored cells In Cell D16, Subtract Spot exchange rate from 6 month forward contract rate to obtain Premium/Discount In Cell D17, Use this formula "((Forward rate - Spot Rate)/Spot rate)*12/n" to obtain Premium/ Discount Perc Given Spot Rate of 1 Swiss franc in terms of US dollars 6 Month forward rate of 1 Swiss franc in terms of US dollars

Solution Premium/ Discount Premium/ Discount Percentage Per annum= ((Forward rate - Spot Rate)/Spot rate)*12/n

em 19-14

s to use the Solution Template cells ct rate to obtain Premium/Discount 2/n" to obtain Premium/ Discount Percentage Per annum

Given

Solution

e)/Spot rate)*12/n

Problem 19-19

Step 1

Instructions to use the So Enter the given values from the textbook in the below yellow colored cells

Given Year 0 1 2 3 4 Discount rate Current spot exchange rate (Tab/ $) 1 Year forward Exchange (rate Tab/ $)

Solution 1 Year interest rate differential Year 0 1 2 3 4 NPV

oblem 19-19

Instructions to use the Solution Template book in the below yellow colored cells

Given Cash Flow in TABS

Solution #DIV/0!

Cash Flow in US Dollars #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 19-20

Step 1

Instructions to use the Solut Enter the given values from the textbook in the below yellow colored cells

Given Year 0 1 2 3 4 Discount rate Current exchange spot rate (Tab/ $) 1 Year forward Exchange rate (Tab/ $)

Solution 1 Year interest rate differential Year 0 1 2 3 4 NPV

Problem 19-20

Instructions to use the Solution Template e textbook in the below yellow colored cells

Given Cash Flow in BLA

Solution #DIV/0!

Cash Flow in US Dollars #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!

Problem 20-1

Given Delivery Price Underlying Asset (Min) Underlying Asset (Max)

With a Range of 5 Profit and Loss Solution Price of Asset $40 $45 $50 $55 $60 $65 $70 $75 $80

Problem 20-1

Given

Solution Profit/Loss $ $ $ $ $ $ $ $ $

40 45 50 55 60 65 70 75 80

Problem 20-5

Given Call Exercise Price Call Premium

Solution Stock Price $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70

Solution Break-Even Point=Exercise Price+Premium From the graph also you can observe the same break even point(where the blue l Maximum Losses= Premium From the graph also, you can observe the same Maximum Loss Maximum Profit for a call option is unlimited(theoretically) as the stock price rise

Given Call Exercise Price Call Premium

Solution Stock Price $0 $6 $12 $18 $24 $30 $36 $42 $48 $54 $60 $66 $72 $78

Solution Break-Even Point=Exercise Price+Premium From the graph also you can observe the same break even point(where the blue l Maximum Losses= Premium From the graph also, you can observe the same Maximum Loss Maximum Profit for a call option is unlimited(theoretically) as the stock price rise

$84 $78 $72

$84 $78 $72 $66 $60 $54 $48 $42 $36 $30 $24 $18 $12 $6 $0

Maximum Loses $6

$0

$6

$12

$18

$24

$30

Problem 20-5

Given

Solution Profit before Premium 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70

Profit after Premium $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70

Solution

$0 ame break even point(where the blue line meets X axis) $0 same Maximum Loss ed(theoretically) as the stock price rises the profit also rises

Profit before Premium 0 6 12 18 24 30 36 42 48 54 60 66 72 78

Profit after Premium $0 $6 $12 $18 $24 $30 $36 $42 $48 $54 $60 $66 $72 $78

$0 ame break even point(where the blue line meets X axis) $0 same Maximum Loss ed(theoretically) as the stock price rises the profit also rises

Profits

Break-even point

Maximum profits unlimited

Exercise Price Exercise Price

$30

$36

$42

$48

$54

$60

$66

$72

$78

a

b

c

Problem 20-10

Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2) Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2)

Given Current stock price Exercise Price

Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2) Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2)

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Problem 20-1

Given Delivery Price Underlying Asset (Min) Underlying Asset (Max)

With a Range of 5 Profit and Loss Solution Price of Asset $40 $45 $50 $55 $60 $65 $70 $75 $80

$90 $80

Profit/Loss

$70 $60 $50 $40

$40

$30

$45

$55

$50

$60

$65

Loss

$20 $10 $$40

$45

$50

$55

$60

$65

Price of Asset

$70

Problem 20-1

Given

Solution Profit/Loss $ $ $ $ $ $ $ $ $

40 45 50 55 60 65 70 75 80

$70

$65

$75

$80 Profits

Profit/Loss Delivery Price

$70

$75

$80

Problem 20-5

Given Call Exercise Price Call Premium

Solution Stock Price $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70

$75 $70 $65 $60 $55 $50 $45 $40 $35 $30 $25 $20 $15 $10 $5 $0

Maximum Loses $5

$0

$5

$10

$15

$20

$25

Solution Break-Even Point=Exercise Price+Premium From the graph also you can observe the same break even point(where the blue l Maximum Losses= Premium From the graph also, you can observe the same Maximum Loss Maximum Profit for a call option is unlimited(theoretically) as the stock price rise

Given Call Exercise Price Call Premium

Solution Stock Price $0 $6 $12 $18 $24 $30 $36 $42 $48 $54 $60 $66 $72 $78

Solution Break-Even Point=Exercise Price+Premium From the graph also you can observe the same break even point(where the blue l Maximum Losses= Premium From the graph also, you can observe the same Maximum Loss Maximum Profit for a call option is unlimited(theoretically) as the stock price rise

$84 $78 $72

$84 $78 $72 $66 $60 $54 $48 $42 $36 $30 $24 $18 $12 $6 $0

Maximum Loses $6

$0

$6

$12

$18

$24

$30

Problem 20-5

Given

Solution Profit before Premium 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70

Profit after Premium $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70

Profits

Break-even point

Maximum profits

Exercise Price

$25

$30

$35

$40

$45

$50

$55

$60

$65

$70

Solution

$0 ame break even point(where the blue line meets X axis) $0 same Maximum Loss ed(theoretically) as the stock price rises the profit also rises

Profit before Premium 0 6 12 18 24 30 36 42 48 54 60 66 72 78

Profit after Premium $0 $6 $12 $18 $24 $30 $36 $42 $48 $54 $60 $66 $72 $78

$0 ame break even point(where the blue line meets X axis) $0 same Maximum Loss ed(theoretically) as the stock price rises the profit also rises

Profits

Break-even point

Maximum profits unlimited

Exercise Price Exercise Price

$30

$36

$42

$48

$54

$60

$66

$72

$78

a

b

c

Problem 20-10

Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2) Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2)

Given Current stock price Exercise Price

Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2) Given Current stock price Exercise Price Maturity of the option in years Variance of the returns of the stock Risk free rate

Solution d1=(ln(stock price today/Exercise price) + (Risk Free rate + Variance in stock/2)* times of Expiration)/Sqrt(Variance * Time o expiration) d2=d1-sqrt(variance * time of expiration) N(d1)= Normsdist(d1) N(d2)=Normsdist(d2) Value of Call option= Current Stock Price * N(d1) - exercise price * exp(-risk free rate * time of expiration)*N(d2)

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