Corporate Finance, Fifth Canadian Edition, 5E Jonathan Berk Inatructor Manual

Type:

Instructor Manual

Resource:

Corporate Finance

Edition:

5th Edition

Author(s):

Jonathan Berk Peter DeMarzo David A. Stangeland

Instructor’s Resource Manual (IRM) Therese Trainor

Corporate Finance Fifth Canadian Edition Jonathan Berk Stanford University

Peter DeMarzo Stanford University

David Stangeland University of Manitoba

Contents Preface

iii

Part I: Introduction Chapter 1 Chapter 2

The Corporation and Financial Markets Introduction to Financial Statement Analysis

1-1 2-1

Part II: Tools Chapter 3 Chapter 4 Chapter 5

Arbitrage and Financial Decision Making The Time Value of Money Interest Rates

3-1 4-1 5-1

Part III: Basic Valuation Chapter 6 Valuing Bonds Chapter 7 Valuing Stocks Chapter 8 Investment Decision Rules Chapter 9 Fundamentals of Capital Budgeting

6-1 7-1 8-1 9-1

Part IV: Risk and Return Chapter 10 Capital Markets and the Pricing of Risk Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model Chapter 12 Estimating the Cost of Capital Chapter 13 Investor Behaviour and Capital Market Efficiency

10-1 11-1 12-1 13-1

Part V: Options Chapter 14 Chapter 15 Chapter 16

14-1 15-1 16-1

Financial Options Option Valuation Real Options

Part VI: Capital Structure and Dividend Policy Chapter 17 Capital Structure in a Perfect Market Chapter 18 Debt and Taxes Chapter 19 Financial Distress, Managerial Incentives, and Information Chapter 20 Payout Policy

17-1 18-1 19-1 20-1

Part VII: Valuation Chapter 21 Chapter 22

21-1 22-1

Capital Budgeting and Valuation with Leverage Valuation and Financial Modelling: A Case Study

Part VIII: Long-Term Financing Chapter 23 The Mechanics of Raising Equity Capital Chapter 24 Debt Financing Chapter 25 Leasing

23-1 24-1 25-1

Part IX: Short-Term Financing Chapter 26 Working Capital Management Chapter 27 Short-Term Financial Planning

26-1 27-1

Part X: Special Topics Chapter 28 Chapter 29 Chapter 30 Chapter 31

28-1 29-1 30-1 31-1

Mergers and Acquisitions Corporate Governance Risk Management International Corporate Finance .

Preface The instructor’s resource manual (IRM) is designed to aid instructors in their course delivery preparation. Each IRM chapter contains a list of that chapter’s learning objectives, a summary of the chapter’s salient topics, a grid highlighting the MyLab Finance (MLF) questions sorted by chapter section and objective, and a reference to the Excel spreadsheet solutions for that end-ofchapter’s Excel problems and data case. The Excel spreadsheet solutions can be downloaded from the Instructor’s Resources area of the MyLab Finance.

Every problem in the textbook has been recreated as a MyLab Finance (MLF) problem. To arrive at an acceptable MLF answer, you have a choice of methods: (1) Each MFL question contains specific rounding instructions within it to guide student and instructor alike in calculating the exact MFL solution shown. Following these instructions precisely requires you round interim calculations to a set number of decimal places. Doing so will propagate the rounding error, but the arrived at solution will match the MFL calculation shown.

(2) ALTERNATIVELY, each MFL problem will also accept the most accurate solution – that which uses a very large number of decimal places for each interim calculation (such as found in software programs like Microsoft’s Excel). These solutions can be replicated by setting a hand-held financial calculator’s decimal places to free floating, or the largest number permitted by the manufacturer which is usually 9 places. Instructions for changing decimal place settings can be found in the calculator’s manual.

MFL will accept an answer based on either of the above methods. However, the solution shown throughout the MFL question will always match the one obtained by following the rounding instructions provided within that question. When no rounding instructions are provided, it is presumed at least four decimal places will be used.

The MFL questions have been restructured to provide students with help as needed. For each question that requires calculations, a guided solution as well as a sample problem has been created to support the original question. The guided solution breaks the original question into smaller parts and provides detailed supporting feedback for each step, whereas the sample problem resolves the original question using different numbers while showing supporting calculations.

Instructors will welcome the addition of more data cases to many chapters. These practical aids provide students with real world practice because they require in-depth analysis to solve business problems, some in real time. Each case contains questions, to guide the student through the analysis. Many cases utilize the internet, forcing the student to understand from where data comes. Doing so ensures the student’s readiness to enter the business world.

Therese Trainor Providence Bay, Ontario

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Chapter 1 The Corporation and Financial Markets I. Learning Objectives 1-1 List and define the three major types of firms in Canada by considering the major characteristics of each type, including the means for distributing income to owners.

1-2 Distinguish between limited and unlimited liability and list firm types that are subject to each type of liability.

1-3 Describe taxation consequences for corporations, income and other trusts.

1-4 Discuss the division of corporate ownership into shares of stock; evaluate the implications of that division for corporate decision making including the firm’s role within society.

1-5 Explain how corporate bankruptcy can be viewed as a change in firm ownership.

1-6 Compare and contrast the characteristics of shares that are publically traded and those that are not.

1-7 Describe the major changes that stock markets have gone through in the last decade.

1-8 Differentiate between trading on an exchange and trading in a dark pool.

1-9 Describe the impact of various types of Fintech, such as telecommunications, security, automation and big data on the field of finance.

1-A Calculate the taxes owed on Canadian investment income.

II. Chapter Overview Chapter 1 begins by discussing the “birth” of the modern corporation. The chapter examines important characteristics of the three major types of firms in Canada with an emphasis on the corporation. Section 1.2 defines the agency relationships that sometimes occur within a corporation. Section 1.3 focuses on the stock market and its advantages in raising capital while Section 1.4 explores finance and technology.

1.1 The Three Types of Firms The three major types of firm in Canada are the sole proprietorship, the partnership (including limited liability partnerships), and the corporation. The section begins by defining each type then highlights the differences among them. Particular emphasis is placed on the following areas that distinguish the three types: 1. Ease of formation; 2. Separation between the firm and the owner from the perspective of the owner’s personal liability; 3. Lifespan of the firm; 4. Ease of transference of ownership.

The text emphasizes the corporate form. In this chapter, the authors focus on the fact that, although corporations take a great deal of effort to form, they have some distinct advantages: the life of the firm is not limited by the life of any particular individual, ownership in the corporation is very easy to transfer via purchase or sale of shares of stock and corporations often can raise substantial amounts of capital from anonymous outside investors. However there are some disadvantages as well: Each shareholder is likely to own only a small percentage of total shares and agency problems can be pretty serious.

Corporations are taxed in a very different way than other firm types. Example 1.1 shows the double taxation of corporate earnings by considering dividends paid and shares held both inside and .

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outside a tax-free savings account (TFSA). Example 1.2 shows how taxation will differ if the corporation is now a real- estate investment trust (REIT) and you hold the trust units both inside and outside a TFSA. 1.2 Ownership Versus Control of Corporations.

Section 1.2 highlights the separation of ownership and control in the corporation, with particular emphasis on principal-agent problems. The chapter emphasizes the market for corporate control as the primary means for encouraging managers and boards of directors to act in the best interest of shareholders.

An important stakeholder in the corporation will be its debt holders; a corporation that fails to repay its debt holders will be forced into bankruptcy.

1.3 The Stock Market An important feature of equity investment is its liquidity. Stock markets improve liquidity for investors by enabling investors to trade shares of public corporations in the primary and secondary markets. The TSX is the largest exchange in Canada and the 11th largest in the world (end of 2018), as measured by total market capitalization. It is an electronic exchange where investors can post orders into the TSX trading system from anywhere in the world. Stock prices are quoted in terms of bid and ask. The NYSE is the world’s largest stock market (Figure 1.3). The NASDAQ (National Association of Security Dealers Automated Quotations) is an electronic network where prices are posted so that they can be viewed by all participants.

Stock markets have undergone tremendous change over the last decade and remain in a state of flux. Dark pools offer investors the ability to trade at a better price, but there is no guarantee the trade will be made.

Researchers estimate as many as 50 venues, including dark pools, are available for stock trading just in the United States.

1.4 Fintech: Finance and Technology The relation between financial innovation and technological innovation is known as Fintech. The field of finance has been very important in technological advancement, and the converse is also true. Security and verification are very important in the financial world, and blockchain technology is a form of advanced cryptography that allows transactions to be recorded in a verifiable way without the intervention of a trusted third party.

Another advance in fintech is automated transactions, such as ATMs and smartphone apps. One new development is the recent growth in robo-advisors, which provide investment recommendations and other financial advice via computer programs. One of the first examples of “big data” was financial information, which is now stored electronically by companies such as Bloomberg, which collects and disseminates data all over the world. Computer investing algorithms use big data in an attempt to find patterns that will allow them to predict future prices. This strategy has been successful for short periods of time, but as computer algorithms compete with one another and traders adjust their strategies to make them less predictable, a technological arms race has ensued. Fintech has also enabled financial services firms to improve their product offerings and make improved lending decisions. Finally, nonfinancial organizations, such as Google, Apple, and Paypal, provide payment services that had typically been provided by banks.

Online Appendix 1A Calculation of Taxes on Investment Income in Canada Taxation of investment income in Canada differs depending on whether an individual is being taxed on personal income or a corporation is being taxed on corporate income and the type of account being taxed. The appendix is divided into 4 subsections: 1A.1 Classifications of Investment Income and Tax Payers, 1A.2 CRA Tax-Sheltered Accounts for Individual Investments, 1A.3 Calculation of Taxes on Non-Tax-Sheltered Personal Investment Income and 1A.4 Calculation of Taxes on Corporate Investment Income.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Text Page Objectives Reference Covered

1.1

The Three Types of Firms

1 to 7

1.1 to 1.3

3-8

1.2

Ownership Versus Control of Corporations

8 to 16

1.4 and 1.5 8 - 15

1.3

The Stock Market

17 to 21

1.6 to 1.8

15 - 19

1.4

Fintech: Finance and Technology

22 and 23

1.9

19 - 22

1A

Calculation of Taxes on Investment Income in Canada

None

3.A

Online

IV. Spreadsheet Solutions in Excel There are no spreadsheet solutions for this chapter.

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Chapter 2 Introduction to Financial Statement Analysis I. Learning Objectives 2-1 Define the periodic reports required by the provincial securities commissions and the SEC; describe where they can be found (SEDAR); briefly describe GAAP and the auditor’s role along with listing the major financial statements required under IFRS for publicly traded firms; compare IFRS to US GAAP. 2-2 Describe the balance sheet and define depreciation, book value, and goodwill. Discuss the difference between book value of shareholders’ equity and market value of shareholders’ equity; explain why the two numbers are almost never the same. Compute market-to-book and enterprise value.

2-3 Describe the components of the Income Statement and compute the following measures: gross profit, operating expenses, operating income, EBIT and EPS. 2-4 Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement. Describe the three sections of the statement of cash flows: Operating, Investment and Financing activities.

2-5 Explain what is included in the other financial statement information, including the notes.

2-6 Perform ratio analysis and describe each ratio’s usefulness in assessing firm performance. Discuss the uses of the DuPont Identity in disaggregating ROE and the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator.

2-7 List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud.

II. Chapter Overview This chapter reviews the five main financial statements and discusses some useful financial ratios.

The chapter closes with a look at some financial scandals of the early 2000s.

2.1 The Disclosure of Financial Information This section briefly describes the interim financial reports required by provincial securities commissions and the SEC. It provides the SEDAR web address to access these reports. It defines GAAP, the role of an auditor and the five statements IFRS requires public companies to produce: a balance sheet, statement of comprehensive income (income statement), statement of cash flows, the statement of changes in equity and notes including accounting policy. It includes a summary of steps taken toward standardizing financial statements across countries via International Financial Reporting Standards (IFRS) while comparing US GAAP to IFRS. 2.2 The Balance Sheet The balance sheet, or statement of financial position, lists the firm’s assets and liabilities. This section describes current assets, long-term assets, current liabilities and long-term liabilities, and shareholders’ equity and provides the major account names within each component. The authors emphasize the difference

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between book value of equity and market capitalization and use Example 2.1 to demonstrate. Next, they introduce us to enterprise value and show us how to compute it in Example 2.2.

2.3 The Income Statement The income statement lists the firm’s revenues and expenses over a period of time. The earnings calculations can be broken apart as we move down the income statement into: gross profit, operating expenses, earnings before interest and taxes (EBIT), and earnings before taxes and net income. Earnings per share (and diluted earnings per share) are often calculated to assess the size of net income relative to that of similar firms.

2.4 The Statement of Cash Flows The statement of cash flows converts accrual-based income into cash flow by utilizing the income statement and balance sheet. Cash flows are separated into operating activities, investment activities, and financing activities. Example 2.3 shows the impact of depreciation on cash flows.

2.5 Other Financial Statement Information The management discussion and analysis (MD&A) section of the financial statements provides management’s interpretation of the planned activities of the firm. The statement of shareholders’ equity provides detailed information about additions to or reductions in the shareholders’ equity accounts. The statement of comprehensive income combines the income statement information with other pertinent information not reported there. Notes to the financial statements are an integral part of the statements as they provide details on subsidiaries and product line, stock-based compensation plans, types of debt including leases and principal payments, acquisitions, taxes and risk management, all of which are necessary for correct interpret of the statements. Example 2.4 uses the sales by business segment note to report sales by product category and find the sales unit with the highest growth.

2.6 Financial Statement Analysis Investors use financial statements to find out how a company has changed over time or how it compares with others in its industry. Ratios, segmented into categories of Profitability, Liquidity, Working Capital, Interest Coverage, Leverage, Valuation and Operating Returns help investors reveal the state of the company.

Profitability ratios, such as gross margin, operating margin and net profit margin, are often used to measure the fraction of revenue available to common shareholders. Examples of ratios that use both income statement and balance sheet items are asset turnover and working capital ratios, such as accounts receivable days (or average collection period) and accounts payable days. EBITDA is often used to express how much cash a firm generates from operations while leverage ratios such as interest coverage, which is also a mixed ratio, are used to reflect the relationship between earnings and interest payments.

Investment returns are measured by return on equity (ROE) or return on assets, although both these measures are flawed because of their reliance on book value measures. The Dupont identity expresses ROE in terms of the firm’s profitability, efficiency and leverage. It can be restated as the return on assets times the equity multiplier. Example 2.5 and 2.6 examine liquidity and interest coverage, respectively while Example 2.7 computes profitability and valuation ratios, including the price-earnings ratio and Example 2.9 uses the Dupont identity to compare the ROE of Wal-Mart to Target. Table 2.4 summarizes the financial ratios discussed throughout the chapter applied to large U.S. firms.

2.7 Financial Reporting in Practice Abuse of financial reporting rules does occur, Enron and WorldCom being two of the most notorious examples from the past decade. Enron sold assets at inflated prices to other firms, together with a promise to buy back assets at an even higher future price. Worldcom reclassified $3.85 billion in expenses as longterm investment. The U.S. Sarbanes-Oxley Act, passed in 2002, holds CFOs and CEOs accountable for the firm’s financial statements. Canadian regulators adopted similar measures in 2005. A callout box describes Bernie Madoff’s Ponzi scheme, another financial scandal in the early 2000s that caused mistrust in the financial system. .

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

2.1

The Disclosure of Financial Information

1 to 3

2.1

28

2.2

The Balance Sheet

4 to 10

2.2

29 - 34

2.3

The Income Statement

11 to 18

2.3

35 - 36

2.4

The Statement of Cash Flows

19 to 25

2.4

37 - 39

2.5

Other Financial Statement Information

26 and 27

2.5

39 - 41

2.6

Financial Statement Analysis

28 - 43

2.6

42 - 53

2.7

Financial Reporting in Practice

44 and 45

2.7

54 - 56

IV. Spreadsheet Solutions in Excel The following problems for Chapter 2 have spreadsheet versions of the problem solutions available: 210, 2-11, 2-13, 2-15, 2-16, 2-17 and 2-20. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 3 Arbitrage and Financial Decision Making I. Learning Objectives 3-1

Identify the costs and benefits of making a decision.

3-2

Define the term “competitive market,” giving examples of markets that are competitive and those that are not. Discuss the importance of a competitive market in determining the value of a good.

3-3

Use an appropriate interest rate to find present and future values.

3-4

Assess the relative merits of two-period projects using net present value and explain why maximizing NPV is always the correct decision rule.

3-5

Define arbitrage, and discuss its role in asset pricing. How does it relate to the Law of One Price?

3-6

Calculate the no-arbitrage price of an investment opportunity.

3-7

Describe the Separation Principle.

3-8

Show how value additivity can be used to help managers maximize the value of the firm.

3-9

Calculate the value of a risky asset, using the Law of One Price.

3-10 Describe the relationship between a security’s risk premium and its correlation with returns of other securities.

3-11 Describe the effect of transactions costs on arbitrage and the Law of One Price.

3-A.1 Use a system of equations and matrix algebra to solve for a security’s price.

3-A.2 Use primitive securities to solve for a security’s price.

II. Chapter Overview The chapter opens with consideration of the decisions faced by management when undergoing acquisitions.

These considerations have one thing in common; they each involve identifying and comparing the expected costs and benefits resulting from a decision. In this chapter, the authors introduce the concept of valuation. In particular, they focus on how to compare costs and benefits that occur at different points in time using NPV. At this juncture, coverage of this analysis is very simple since time value of money and NPV analysis are both covered in detail in later chapters.

The central theme of this textbook is the Law of One Price; a distinct point of departure from the typical Corporate Finance text. Its emphasis begins with the concept of valuation in Chapter 3. The conceptual framework revealed here continues throughout the remainder of the textbook.

3.1 Valuing Decisions The most accurate way to identify costs and benefits is to use the market value of the cash flows—the price at which a good or service could be bought and sold readily. Whenever a good trades in a competitive market, the valuation principle holds that the market prices should be used to evaluate the costs and benefits of any decision. However, there are cases in which competitive market prices are not available; we must then use one-sided prices to estimate the maximum or minimum price for a good or service.

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3.2 Interest Rates and the Time Value of Money Cash inflows and outflows do not usually occur at the same point in time. To compare them, we must find their equivalent cash values by converting them to the same point in time. Since we are often called upon to make decisions today, we most often convert the cash flows to today’s date, using some interest rate.

We can consider the interest rate as the exchange rate of the currency over time. At this point, the authors only discuss risk-free rates of interest. What happens to this rate when cash flows of differing risk are compared is discussed later. This section assumes there are only two cash flows—one now and one a year from now. The future or later cash flow is converted into today’s dollars by dividing by (1 + r) while today’s cash flow in converted into the future by multiplying by (1 + r).

3.3 Present Value and the NPV Decision Rule Net present value = PV(Benefits) – PV(Costs)

(Equation 3.1)

Net present value (NPV) is introduced as the decision criterion most recommended by the finance profession. The text emphasizes that this procedure works even when people have different individual preferences regarding the timing of cash flows. As long as the project with the highest NPV is chosen, the pattern of cash flows for lesser opportunities can be replicated, with cash left over. We can shift the cash flows if we need to, by borrowing and lending. The NPV technique is revisited at many other points in the text.

3.4 Arbitrage and the Law of One Price The practice of buying and selling equivalent goods in different markets to take advantage of a price difference is known as arbitrage: “If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets.” The authors call a competitive market in which there are no arbitrage opportunities a normal market. The Law of One Price states that if equivalent goods or securities trade simultaneously in different competitive markets, they will trade for the same price in each market. Because of this law, when evaluating projects we only need to consider the costs and benefits in one market. The same is true of security valuation. We can use this knowledge to compute the no-arbitrage price of a security, given its cash flows. We can also work backward to compute the interest rate on a security, given its cash flows and price.

3.5 No-Arbitrage and Security Prices The NPV of buying a security equals the present value of the cash flows paid by the security minus the cost of the security. In normal (competitive, no-arbitrage) markets, this NPV will be zero. From this we can derive the separation principle, which says that security transactions in a normal market neither create nor destroy value on their own. Hence, we can evaluate investment decisions independently of how the firm raised the capital to invest in the opportunity. The Law of One Price also has implications for packages of securities or projects. In particular, because of value additivity (equation 3.5), if Project C has the same cash flows as Projects A and B combined, then the price of C must equal the price of A plus the price of B. Otherwise, an arbitrage opportunity would exist.

3.6 The Price of Risk Up to this point, the authors have considered risk-free cash flows, only. Risk aversion results from the fact that the personal cost of losing a dollar in bad times is greater than the benefit of an extra dollar in good times. By definition, a risky asset has more than one possible outcome. The price must be determined based on the expected return; its actual return could be higher or lower. The risk premium is introduced here as the difference between the return investors expect on a risky asset and the return the risk-free asset is paying.

The risk premium is determined by investors’ attitudes toward risk. The authors emphasize that viewed in isolation, we can’t tell much about a particular security’s risk premium - it must be compared to other risk premiums in the market. Example 3.11 shows how the Law of One Price is used to value a risky asset.

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3.7 Arbitrage with Transactions Costs With transactions costs, prices may deviate. However they will not deviate by more than the transactions cost of the arbitrage because people would take advantage of the arbitrage opportunity causing prices to adjust until the profit is eliminated.

Online Appendix 3A.1 Using a System of Equations and Matrix Algebra to Solve for a Security’s Price With two possible states of the economy one period in the future and today’s prices of two securities whose payoffs are unique from each other are known, we can solve for the price of any other security as long as its payoffs one year in the future are known. We determine this “replicating” portfolio’s composition by solving a system of two equations and two unknowns using matrices.

Online Appendix 3A.2 Using Primitive Securities to Solve for a Security’s Price Once the price of all relevant primitive securities (unique securities with a non-zero payoff in one state of the economy) is known it becomes relatively easy to price any other security without resorting to using systems of equations or matrix algebra. Table 3A.2 and Example 3A.2 demonstrate this logic.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

3.1

Valuing Decisions

1-5

3.1 and 3.2

69 - 73

3.2

Interest Rates and the Time Value of Money

6-8

3.3

73 - 76

3.3

Present Value and the NPV Decision Rule

9 - 11

3.4

76 - 80

3.4

Arbitrage and the Law of One Price

12 - 14

3.5

80 - 82

3.5

No-Arbitrage and Security Prices

15 - 19

3.6 to 3.8

82 - 89

3.6

The Price of Risk

20 - 23

3.9 and 3.10

89 - 94

3.7

Arbitrage with Transactions Costs

24 and 25

3.11

94 - 97

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3A.1

Using a System of Equations and Matrix Algebra to Solve for a Security’s Price

A1

3.A1

Online

3A.2

Using Primitive Securities to Solve for a Security’s Price

A2 and A3

3.A2

Online

IV. Spreadsheet Solutions in Excel The following problems for Chapter 3 have spreadsheet versions of the problems available: 3-6, 3-9, 3-10, 315, 3-17, 3-19, 3A.1, 3A.2 and 3A.3. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 4 The Time Value of Money I. Learning Objectives 4-1 Draw a timeline illustrating a given set of cash flows.

4-2 List and describe the three rules of time travel.

4-3 Calculate the future value of a. A single sum b. An uneven stream of cash flows, starting either now or sometime in the future c. An annuity, starting either now or sometime in the future d. Several cash flows occurring at regular intervals, which grow at a constant rate each period 4-4 Calculate the present value of a. A single sum b. An uneven stream of cash flows, starting either now or sometime in the future c. An infinite stream of identical cash flows d. An annuity, starting either now or sometime in the future e. An infinite stream of cash flows that grow at a constant rate each period f. Several cash flows occurring at regular intervals, which grow at a constant rate each period 4-5 Calculate the NPV and interpret its results.

4-6 Use an excel spreadsheet (and excel’s annuity spreadsheet) to compute (a) present value, (b) future value, (c) number of periods, (d) periodic interest rate.

4-7 Adjust any problem to solve for non-annual time intervals 4-8 Solve for the cash flows in an annuity stream.

4-9 Solve for the Internal Rate of Return for a series of cash flows.

4-10 Solve for the number of periods in an annuity stream.

4-A.1 Use a financial calculator to perform any of the above computations.

4-A.2 Derive the perpetuity formula.

II. Chapter Overview The introduction to Chapter 4 draws on the discussion of NPV in Chapter 3. The text puts a great deal of emphasis on drawing a timeline when approaching every problem, so that students may better visualize the problems they are solving. Another distinguishing feature of this text is that this chapter puts virtually everything in the context of present value. Hence all future value problems are illustrated as they relate to present value. The chapter covers present and future values of a single sum, an uneven stream of cash flows, and an annuity; present value of a perpetuity; present value of a growing perpetuity; and present and future value of a growing annuity. While the chapter focuses on using Excel, using a financial calculator is covered in its appendix. An accompanying Excel spreadsheet contains an annuity spreadsheet for student practice.

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4.1 Timeline Drawing a timeline as the first step in solving a problem will often clarify any confusion about amount and/or timing of cash flows, making problems much clearer. The timeline is a very important part of calculating the time value of money.

4.2 The Three Rules of Time Travel The three rules of time travel allow us to compare and combine cash flows that occur at different points in time. They are: 1.

It is only possible to compare or combine values at the same point in time.

2.

To move a cash flow forward in time, you must compound it.

3.

To move a cash flow backward in time, you must discount it.

In order to compare or combine cash flows, they must be compounded or discounted. To compound cash flows, multiply the amount by (1 + r)n (Equation 4.1) where r is the periodic interest rate and n is the number of compounding periods. To discount cash flows, divide the amount by (1 + r)n (Equation 4.2), where r and n are as defined previously. Figure 4.1 Show the composition of interest over time.

4.3 Valuing a Stream of Cash Flows Since most investment opportunities have cash flows occurring at various points in time, the rules of time travel must be applied to streams of cash flows. This section shows how to calculate the present value or future value of an uneven cash flow stream. Note that FV can be solved by calculating the present value (discounting each cash flow), then compounding that total, n periods into the future. Example 4.5 demonstrates this process, using Equations 4.3 and 4.4:

Using this process makes it easier to find the FV of an uneven cash flow stream with a financial calculator.

4.4 Calculating the Net Present Value The logic developed in Chapter 3 is re-examined here in the context of the time value of money. Calculating present values using Excel is introduced.

4.5 Perpetuities and Annuities Several alternatives to the formulas developed earlier are addressed at this point in the chapter. In every case, the formula is derived using algebra: 1.

Present value of a perpetuity.

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2. If we have several cash flows of the same size occurring at regular intervals, starting either now or sometime in the future, this is present value or future value of an annuity. Annuities due are treated as ordinary annuities with one extra period of interest.

3. The authors introduce the concept of valuing an infinite stream of cash flows that grow at a constant rate each period, using the formula for present value of a growing perpetuity. This development is particularly useful in later chapters.

4. A growing annuity occurs when the cash flows in an annuity grow at a constant rate each period over regular intervals. The present value of a growing annuity can be found as:

The future value of a growing annuity is found by adjusting Equation 4.10 by (1 + r)n, so that the equation, once simplified, becomes:

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4.6 Solving Problems with a Spreadsheet Time value of money problems lend themselves well to spreadsheet solutions. The following functions are mentioned in the chapter: NPV, FV, PV, PMT, IRR, and NPER. Example 4.12 uses the annuity spreadsheet available on the textbook’s website to solve for future value and Example 4.13 uses the annuity spreadsheet to solve for the amount of money left in an account after periodic withdrawals are made.

4.7 Non-Annual Time Intervals All the same rules will apply if we use another time interval, say a quarter or a month or a day as long as: 1. The interest rate used corresponds to the specific time interval.

2. The number of periods used corresponds to the specific time interval.

In general, any time interval with corresponding interest rate and number of periods can be used for a time value calculation for one single cash flow. However, for annuities or perpetuities it is necessary that both the interest rate and number of periods correspond to the time period between cash flows.

4.8 Solving for the Cash Flows When the present value or future value and the rate and time period are known, the cash flows can be solved for as an unknown. The most common example of this is finding the periodic payment in for a bank loan.

4.9 The Internal Rate of Return When the present value and cash flows of an investment opportunity are known, the interest rate that equates them can be found. This interest rate is called the internal rate of return (IRR). It is defined as the interest rate that sets the net present value of the cash flows equal to zero.

4.10 Solving for the Number of Periods When the present value, future value, cash flows and interest rate are known, the amount of time it will take a sum of money to grow can be found using both spreadsheets and logarithms.

Appendix 4.A Using a Financial Calculator Use a financial calculator to solve equations, in place of excel.

Appendix 4.A Online: Derivation of the Perpetuity Formula

III. MyLab Finance Activities Text Section

Text Section Title

Problem s

Learning Objectives Covered

Text Page Reference

4.1

The Timeline

1 and 2

4.1

105 - 106

4.2

The Three Rules of Time Travel

3 - 10

4.2

106 - 112

4.3

Valuing a Stream of Cash Flows

11 - 13

4.3 and 4.4

112 - 114

.

4

4.4

Calculating the Net Present Value

14 and 15

4.5

115 - 117

4.5

Perpetuities and Annuities

16 - 29

4.3 and 4.4

117 - 129

4.6

Solving Problems with a Spreadsheet

30

4.6

129 - 131

4.7

Non-Annual time Intervals

31 and 32

4.7

131 - 132

4.8

Solving for the Cash Flows

33 – 40

4.8

132- 134

4.9

The Internal Rate of Return

41 - 44

4.9

134 - 138

4.10

Solving for the Number of Periods

45 and 46

4.10

138 - 140

4-A

Using a Financial Calculator

None

4-A1

148 - 150

4-A

Derivation of the Perpetuity Formula

None

4-A2

Online

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IV. Spreadsheet Solutions in Excel The following problems for Chapter 4 have spreadsheet versions of the problems available: 4-12, 4-13, 4-14, 415, 4-23, 4-24, 4-27, 4-28, 4-29, 4-30, 4-36, 4-37, 4-39, 4-40, 4-44 and 4-46. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication.

These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 5 Interest Rates I. Learning Objectives 5-1

Define effective annual rate and annual percentage rate.

5-2

Given an effective annual rate, compute the n-period effective annual rate.

5-3

Convert an annual percentage rate into an effective annual rate, given the number of compounding periods.

5-4

Describe the compounding rule for Canadian mortgages and mortgage rate quotations and construct the payments for loans and mortgages.

5-5

Describe the relation between nominal and real rates of interest.

5-6

Given two of the following, compute the third: nominal rate, real rate, and inflation rate.

5-7

Describe the effect of higher interest rates on net present values in the economy.

5-8

Explain how to choose the appropriate discount rate for a given stream of cash flows, according to the investment horizon.

5-9

Discuss the determinants of the shape of the yield curve.

5-10 Explain why Treasury securities are considered risk free, and describe the impact of default risk on interest rates.

5-11 Given the other two, compute the third: after-tax interest rate, tax rate, and before-tax interest rate.

5-12 Describe what is meant by the opportunity cost of capital and how it should be used.

5.A1 Discount cash flows when interest is paid, or cash received, on a continuous basis.

II. Chapter Overview Chapter 4 introduced the time value of money using risk-free rates of interest. Chapter 5 begins the discussion of how risk is incorporated into interest rates. It also compares effective annual rate, annual percentage rate, and effective periodic rate.

5.1 Interest Rate Quotes and Adjustments This section discusses Effective Annual Rate (EAR), Annual Percentage Rate (APR), and the rate per compounding period and conversions between those rates. Example 5.1 shows how to use a monthly EAR. Example 5.2 shows the future value of annuity deposits using different payment frequencies.

5.2 Application: Discount Rates and Loans In this section the lessons of section 5.1 are applied into real world examples. Example 5.3 shows how to convert a Canadian mortgage APR to an effective periodic rate while Example 5.4 demonstrates how to compute an outstanding loan balance on a Canadian mortgage.

5.3 The Determinants of Interest Rates Factors that may influence the willingness of individuals to borrow and lend are inflation, government policy, and expectations of future growth. The text uses the multiplicative form of the Fisher equation:

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Rearranging Equation 5.4 allows us to solve for the real rate of interest and an approximation:

The text also emphasizes that when interest rates are low, there are more positive NPV projects in the economy. The Bank of Canada and other central banks use this information to stimulate investment or to reduce investment when the economy is “overheating,” which can lead to inflation.

This section also discusses the yield curve. Because later chapters show students how to adjust their analysis when interest rates are not constant, the authors begin their discussion of that concept here by saying that when we use annuity and perpetuity formulas, we assume a flat yield curve. Example 5.6 shows how students can use a sloping yield curve to compute the PV. Important factors that influence the term structure are the overnight rate and expectations of future interest rates.

5.4 Risk and Taxes Two additional factors are important in determining interest rates: risk and taxes. All interest rates that have any risk are higher than the risk-free rate. When comparing rates among various investments, the after-tax rate is the relevant measure. Equation 5.8 shows how to adjust for taxes:

5.5 The Opportunity Cost of Capital In summary, interest rates vary based on quoting conventions, the term of the investment, and risk. The actual return investors keep depends on how the interest is taxed. The opportunity cost of capital is “the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.”

Appendix 5.A Continuous Rates and Cash Flows The Appendix demonstrates how to discount cash flow when interest is paid or received on a continuous basis.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

5.1

Interest Rate Quotes and Adjustments

1 – 11

5.1 to 5.3

152-158

5.2

Application: Discount Rates and Loans

12 – 24

5.4

158-160

5.3

The Determinants of Interest Rates

25 – 32

5.5 to 5.9

160-167

5.4

Risk and Taxes

33 - 36

5.10 and 5.11

167-170

5.5

The Opportunity Cost of Capital

37 – 38

5.12

170 - 171

5A

Continuous Rates and Cash Flows

None

5.A1

177 - 178

IV. Spreadsheet Solutions in Excel The following problems for Chapter 5 have spreadsheet versions of the problems available: 5-2, 5-3, 5-10, 5-18, 5-19, 5-21, 5-22, 5-29, 5-30, 5-31, 5-32.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 6 Valuing Bonds I. Learning Objectives 6-1

Identify the cash flows for both coupon bonds and zero-coupon bonds, and calculate the value for each type of bond.

6-2

Calculate the yield to maturity for both coupon and zero-coupon bonds, and interpret its meaning for each.

6-3

Given coupon rate and yield to maturity, determine whether a coupon bond will sell at a premium or a discount; describe the time path the bond’s price will follow as it approaches maturity, assuming prevailing interest rates remain the same over the life of the bond.

6-4

Illustrate the change in bond price that will occur as a result of changes in interest rates; differentiate between the effect of such a change on long-term versus short-term bonds.

6-5

Discuss the effect of coupon rate to the sensitivity of a bond price, to changes in interest rates.

6-6

Define duration, and discuss its use by finance practitioners.

6-7

Calculate the price of a coupon bond using the Law of One Price and a series of zero-coupon bonds.

6-8

Discuss the relation between a corporate bond’s expected return and the yield to maturity; define default risk and explain how these rates incorporate default risk.

6-9

Assess the creditworthiness of a corporate bond using its bond rating; define default risk.

6-10 Describe Sovereign Bonds and discuss inflating away debt versus default.

6-A.1 Use the Law of One Price to calculate forward rates.

II. Chapter Overview Chapter 6 examines basic types of bonds and their valuation and relies on the Law of One Price in many of its discussions. It describes how bond prices change dynamically over time and when interest rates change.

The chapter also examines the effect of changes in coupon payment on bond prices and the relationship between prices and returns of different bonds, including those with default risk. It concludes with a look at Sovereign Debt and the impact of “inflating away” debt.

6.1 Bond Cash Flows, Prices, and Yields Terminology is an important part of understanding bonds. The authors devote much of the chapter to using zero coupon bonds. Yield to maturity for a zero-coupon bond is:

Example 6.1 shows how to calculate yields for different maturities of zero-coupon bonds. The authors revisit their discussion of the yield curve from Chapter 5, renaming it the zero-coupon yield curve. Much of the remaining discussion in the chapter draws on the zero-coupon yield curve. Note that the authors

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often use face values of $100 instead of $1000, making prices look more like those that are quoted in the financial press.

The yield to maturity on a coupon bond can be calculated using equation 6.5, using trial and error, or by using an Excel spreadsheet. Example 6.3 shows how to use a spreadsheet to compute the yield to maturity. Example 6.4 shows how to calculate a bond price, given its yield to maturity.

Later in the chapter, the authors show how to replicate a coupon bond with zero-coupon bonds and calculate the price that way.

6.2 Dynamic Behaviour of Bond Prices The authors begin with a discussion of discount and premium bonds. Table 6.1 summarizes the properties of coupon bond prices. The rest of the section examines the effect of time and interest rates on bond prices. Figure 6.1 shows the pattern of bond prices as they approach maturity, assuming the yield remains constant. The graph is a little different from the common illustration, in that it includes lines illustrating the actual price path of the bond between coupon payments. A box on page 191 describes clean and dirty prices.

The effect of interest rate changes is shown in Example 6.7. Duration is defined, but readers are referred to Chapter 30 for thorough coverage of that topic. Figure 6.2 shows the effect of changes in yields during the life of the bond.

6.3 The Yield Curve and Bond Arbitrage This section shows how the yield curve relates to the valuation of coupon bonds. The Law of One Price dictates that the price of a coupon bond must equal the sum of the prices of a series of zero-coupon bonds. The yield to maturity can be calculated once that price is derived. In Example 6.8, the authors show the effect of changing the coupon on bond price, keeping time to maturity constant.

The authors point out that most of the time, when bond traders mention the yield curve, they’re referring to the coupon-paying yield curve; by convention, they plot the most recently issued bonds (termed on-the-run bonds).

6.4 Corporate Bonds In this section, the authors use the two extremes of no default and certain default to show that the yield to maturity is not equal to the expected return of a defaultable bond, since we used promised cash flows to calculate the yield to maturity and expected cash flows to calculate the expected return. The authors then show how the two extremes can be used to value a bond with a risk (not a guarantee) of default. Table 6.3 summarizes the results, showing that the yield to maturity is an increasing function of risk, but that expected return is not. So “the bond’s expected return, which is equal to the firm’s debt cost of capital, is less than the yield to maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected return is higher.”

The remainder of this section discusses bond ratings and the corporate yield curve. Table 6.4 shows Dominion Bond Rating Service, Moody’s and Standard and Poor’s bond ratings, while Figure 6.3 shows the yield curves for Province of Ontario bonds (rated AA) and Bell Canada bonds (rated BBB) compared to the Government of Canada bonds (rated AAA). Figure 6.4 shows yield spreads before, during and after the 2008 financial crisis, the 2011 European Debt Crisis and 2016 global economic growth concerns.

6.5 Sovereign Bonds Most Sovereign Bonds (bonds issued by national governments) are risky and so yields behave like that of corporate bonds. However, rather than default on its debt, a country may opt to “inflate it .

2

away” by printing more money. The 2012 default of Greece served as a wake-up call to many investors. Figure 6-5 shows the percentage of debtor country in default or restructuring their debt for the period 1800 – 2006 while Figure 6-6 displays European Government Bond yields between 1976 and 2018.

Appendix 6.A Forward Interest Rates and Theories of the Term Structure of Interest Rates Corporate managers require tools to help them cope with interest rate risk. One such tool is an interest rate forward contract - a contract today that fixes the interest rate for a loan or investment in the future.

Forward rates are derived from zero-coupon yields. The Law of One Price is used to calculate the forward rate from the zero-coupon yield curve’s spot rate of interest. How to get the expected future spot rate using forward rates is also demonstrated.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

6.1

Bond Cash Flows, Prices, and Yields

1-7

6.1 and 6.2

181 - 187

6.2

Dynamic Behaviour of Bond Prices

8 - 16

6.3 to 6.6

187 - 192

6.3

The Yield Curve and Bond Arbitrage

17 - 25

6.7

193 - 197

6.4

Corporate Bonds

26 – 32

6.8 and 6.9

197 - 202

6.5

Sovereign Bonds

33 – 34

6.10

203 - 206

6A

Forward Interest Rates and Theories of the Term Structure of Interest Rates

A.1 – A.5

6-A1

214 - 218

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IV. Spreadsheet Solutions in Excel The following problems for Chapter 6 have spreadsheet versions of the problems available: 6-3, 6-4, 6-13, 6-14, 6-25, 6-30. An excel suggested solution can also be found for the Case Study, “The 2012 Greek Default and Subsequent Debt Restructuring.”

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 7 Valuing Stocks I. Learning Objectives 7-1 Describe, in words, the Law of One Price value for a common stock, including the discount rate that should be used.

7-2 Calculate the total return of a stock, given the dividend payment, the current price, and the previous price.

7-3 Use the dividend-discount model to compute the value of a dividend-paying company’s stock, whether the dividends grow at a constant rate starting now or at some time in the future.

7-4 Discuss the determinants of future dividends and growth rate in dividends, and the sensitivity of the stock price to estimates of those two factors.

7-5 Given the retention rate and the return on new investment, calculate the growth rate in dividends, earnings, and share price.

7-6 Describe circumstances in which cutting the firm’s dividend will raise the stock price.

7-7 Assuming a firm has a long-term constant growth rate after time N+1, use the constant growth model to calculate the terminal value of the stock at time N. 7-8 Compute the stock value of a firm that pays dividends as well as repurchasing shares.

7-9 Use the discounted free cash flow model to calculate the value of stock in a company with leverage.

7-10 Use comparable firm multiples to estimate stock value and understand the challenges faced in Canada to find comparable firms.

7-11 Explain why several valuation models are required to value a stock.

7-12 Describe the impact of efficient markets hypothesis on positive-NPV trades by individuals with no inside information.

7-13 Discuss why investors who identify positive-NPV trades should be skeptical about their findings, unless they have inside information or a competitive advantage. As part of that, describe the return the average investor should expect to get.

7-14 Assess the impact of stock valuation on recommended managerial actions.

II. Chapter Overview This chapter shows how to use the Law of One Price to compute the value of a stock. The chapter begins by discussing the dividend-discount model. Next, the authors use time value tools learned in Chapter 4, to value the firm using a discounted free cash flow model. Finally, the valuation multiples as a method of valuation are examined. The authors conclude the chapter with a discussion of the role of competition and efficient markets in determining stock price. An accompanying Excel spreadsheet contains Examples 7.5 and 7.7

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7.1

The Dividend-Discount Model

The authors begin by showing that a one-period investor will be willing to pay the same stock price as a twoperiod investor. From there, they develop the dividend-discount model, showing that the price of the stock is equal to the present value of the expected future dividends it will pay, no matter the time horizon of each individual investor.

7.2 Applying the Dividend-Discount Model The section begins with the assumption that dividends will grow at a constant rate. The constant dividend growth model is given as equation 7.6:

Because the constant growth model assumes that dividends grow at the same rate as the share price, Equation 7.7 solves for the equity cost of capital:

Since g is the same for share price as it is for dividends, the firm must increase its dividend in order for stock price to increase. There are three ways to increase dividends: (1) increase earnings, (2) increase payout ratio, and (3) decrease shares outstanding. Suppose the number of shares outstanding is fixed. The authors show that in this case, the earnings growth rate = retention rate × return on new investment.

Equations 7.8 through 7.12 develop this relationship. Equation 7.12 shows that a firm can increase its growth rate by retaining more earnings. In order to do so, it must cut its dividend, which reduces the stock price.

Examples 7.3 and 7.4 show that if the firm’s investments are profitable (NPV), cutting the dividend will increase stock price.

The section continues with a discussion of changing growth rates, illustrated by Example 7.5 which is solved using both an Excel spreadsheet and the formulas. Finally, the authors mention the limitations of the dividenddiscount model.

7.3 Total Payout and Free Cash Flow Valuation Models The total payout method is summarized in Equation 7.16:

The discounted free cash flow model begins by estimating the firm’s enterprise value as defined in Chapter 2 and repeated in equation 7.17. To estimate the value of the firm’s equity, we begin with free cash flow, given in equation 7.18:

(Note: CCA should replace depreciation for tax purposes). Equation 7.19 is used to define net investment and Equation 7.20 shows an alternative way of computing Free Cash Flow. From there, we compute enterprise value. To solve for market value of equity, add back cash and subtract debt. Divide by shares outstanding to get stock price, as in equation 7.22:

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Note that the discount rate should be the weighted average cost of capital, rather than equity cost of capital, since it is the total firm value being computed. Example 7.7 shows how to compute the value of equity using free cash flow where CCA = depreciation, once again.

The authors discuss the relationship between capital budgeting and the discounted free cash flow model.

Included is a summary of using sensitivity analysis for stock valuation, resulting in a range of possible stock prices. Figure 7.1 summarizes the discounted cash flow models of stock valuation.

7.4 Valuation Based on Comparable Firms The use of comparables analysis is also based on the Law of One Price because a new firm that is identical to an existing publicly traded company should be priced the same. The multiples discussed in this chapter are the price-earnings ratio and enterprise value multiples. Examples 7.9 and 7.10 show how firms can be valued using these multiples.

The authors discuss the limitations of multiples analysis, stressing how differences in accounting conventions are especially problematic for Canadian firms. Table 7.1 shows the dispersion among multiples in the footwear industry. In addition, the authors point out that these are relative measures, so that they don’t tell us when an entire industry is over or under valued. Figure 7.2 shows the range of valuations for Kenneth Cole Productions using alternative valuation methods.

7.5 Information, Competition, and Stock Prices The first part of this section discusses the fact that the only way that two investors will come up with an identical value for a given stock is if they both use the same inputs and valuation method. This seldom happens, but with many transactions occurring every day on the stock market, a market price is agreed upon.

The idea that competition among investors works to eliminate all positive-NPV trading opportunities is introduced in this section. If new information becomes available, its impact depends on if the information is public and easily interpretable, or private or difficult-to-interpret. If the information is public and easily interpretable, investors can trade on the information and the stock price will react very quickly. People who obtain private information or who are able to interpret difficult-to-interpret information can sometimes trade profitably on that information, if the market for the stock is sufficiently liquid (lack of liquidity is the norm for smaller Canadian companies’ stock). These scenarios are illustrated in examples 7.12 and 7.13.

The section continues with a brief discussion of implications for investors and corporate managers. The major consequence for investors is that there are seldom positive-NPV trading opportunities. The major consequence for corporate managers is that they should focus on raising the stock price by maximizing the present value of the free cash flow from the firm’s investments, rather than accounting illusions. They should also use financial transactions, like equity offerings, to support investment in positive-NPV projects, since participants in efficient financial markets will always be willing to buy securities that are fairly priced.

Finally, the chapter distinguishes between the efficient markets hypothesis and no-arbitrage requirements. The efficient markets hypothesis states that securities with equivalent risk should have the same expected return. The efficient markets hypothesis is best viewed as an idealized approximation for highly competitive markets. The next part of the text deals with defining that relationship.

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III. MyFinanceLab Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

7.1

The Dividend-Discount Model

1-4

7.1 and 7.2

220 - 223

7.2

Applying the Dividend-Discount Model

5 - 15

7.3 to 7.7

223 - 229

7.3

Total Payout and the Free Cash Flow Valuation Models

16 - 23

7.8 and 7.9

229 - 236

7.4

Valuation Based on Comparable Firms

24 - 28

7.10 and 7.11

237 - 243

7.5

Information, Competition, and Stock Prices

29 - 34

7.12 to 7.14

243 - 255

IV. Spreadsheet Solutions in Excel The following problems for Chapter 7 have spreadsheet versions of the problems available: 7-19, 7-21, 7-22, 7-25, 7-26, 7-27. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 8 Investment Decision Rules I. Learning Objectives 8-1 Define the net present value (NPV). Given cash flows compute the NPV and describe the NPV decision rule for a stand-alone project.

8-2 Define the internal rate of return (IRR) and describe the IRR decision rule for a stand-alone project.

8-3 Given conventional and unconventional cash flows compute the IRR(s). Discuss why the IRR might be nonexistent and the problem with the IRR rule.

8-4 Define and apply the payback rule. Discuss pitfalls of the payback rule.

8-5 Contrast the NPV and IRR for mutually exclusive projects.

8-6 Describe and apply the incremental IRR Rule. Discuss the shortcomings of the incremental IRR. 8-7 Explain how the profitability index can be used in project selections when resources are constrained.

8-8 Describe capital rationing.

II. Chapter Overview This chapter introduces the techniques firms use to evaluate investments and make a decision on which projects to pursue. The techniques include the NPV, internal rate of return, payback period, incremental IRR and profitability index. For reasons provided, the emphasis is on NPV. The chapter then covers choosing between projects when they are mutually exclusive, and finally choosing between projects when there is a resource constraint using the profitability index.

8.1 NPV and Stand-Alone Projects The text emphasizes NPV as the only reliable way to make capital budgeting decisions. The internal rate of return can provide a measure of the sensitivity of the NPV to changes in the opportunity cost of capital.

Since the IRR is the point at which NPV equals zero, it can be used to measure the maximum estimation error in the cost of capital that can exist without changing the decision.

8.2 The Internal Rate of Return Rule This section defines IRR and gives the IRR decision rule. The authors then discuss reasons that NPV and IRR can result in conflicting decisions. They describe how delayed investment can cause a faulty decision and how multiple IRRs and nonexistent IRRs can happen. Example 8.1 shows NPV profiles for four projects: a normal project, one with multiple IRRs, a delayed investment, and one with nonexistent IRR. 8.3 The Payback Rule The Payback period is discussed as being easy to compute, but the procedure ignores time value of money and cash flows that occur after the payback period. Example 8.2 shows how to compute payback. Because the payback provides information as to how long capital will be committed it can be useful.

8.4 Choosing Between Projects The previous discussion addressed only stand-alone projects. Sometimes firms must decide among mutually exclusive projects. The manager must rank the projects and choose the best one. In this case, NPV again yields the correct decision.

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Suppose a project with a positive NPV is being compared with another project that is identical in all respects, except that the size is double. Then the larger project will have an NPV that is double that of the first, meaning it is clearly the better project. However, the IRRs for the two projects will be the same.

Hence IRR cannot be used to evaluate mutually exclusive projects of different scales. By the same token, IRR cannot be used consistently to evaluate two projects with different timing or different risk. Example 8.3 presents four companies that have positive NPV projects. Each project can be used to discuss a different problem faced by IRR and how it is solved using NPV. The incremental IRR investment rule improves usage of the IRR. It applies the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives, yielding the same answer as NPV. However, incremental IRR still has some problems: First, the incremental IRR could not exist, or there could be several.

The fact that the incremental IRR exceeds the cost of capital does not imply that the NPV of either project is positive. In addition, it is sometimes difficult to keep track of which project is the incremental project. Example 8.4 shows use of incremental IRR. 8.5 Project Selection with Resource Constraints The previous discussion has assumed that resources are unlimited. If resource constraints, like capital rationing exist, simply picking the highest NPV project will not always lead to the best decision.

Sometimes a different combination of projects will result in a higher overall NPV. In this case, the profitability index often helps. The profitability index can be computed as follows:

Note that this text treats PI a little differently than the typical text; the conventional method for computing PI is shown as a text footnote. First, NPV, rather than PV of future cash flows, is in the numerator. Also, the resource constraint need not be financial. Example 8.5 shows how to use the PI with a human resources constraint.

The result of the PI calculation can be used to rank projects. In some situations, however, PI does not give an accurate answer. For example, sometimes there are leftover resources if PI is strictly applied. If projects could be found that would use only those resources, the overall NPV would improve. Also, in some cases there is more than one resource constraint. In those cases, the only way to assess the best scenario is to sort through all the possibilities. With computer-based linear programming tools, this is not as difficult as it sounds.

III. MyFinanceLab Activities Text Section

Text Section Title

Problems Learning Objectives Covered

Text Page Reference

8.1

NPV and Stand-Alone Projects

1–7

8.1

266 - 268

8.2

The Internal Rate of Return Rule

8 - 20

8.2 - 83

269 - 275

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8.3

The Payback Rule

21 and 22 8.4

276 - 277

8.4

Choosing Between Projects

23 - 30

8.5 - 8.6

277 - 283

8.5

Project Selection with Resource Constraints

31 - 34

8.7 – 8.8

283 - 286

IV. Spreadsheet Solutions in Excel The following problems for Chapter 8 have spreadsheet versions of the problems available: 8-4, 8-5, 8-6, 8- 7, 8-11, 8-16, 8-17, 8-20, 8-24 and 8-27.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 9 Fundamentals of Capital Budgeting I. Learning Objectives 9-1 Begin the process by forecasting incremental earnings and the unlevered net income for a project.

9-2 Explain why opportunity costs, project externalities like cannibalization and net working capital must be included in cash flows, while sunk costs like fixed overheads and past research and development and interest expenses must not.

9-3 Calculate the UCC (undepreciated capital cost) for a given asset at any point in time.

9-4 Calculate the CCA (capital cost allowance) for any given project given various assumptions.

9-5 Illustrate the impact of CCA (capital cost allowance) on cash flows.

9-6 Calculate free cash flows from earnings by using the multi-step process of determining the periodic tax shield by including the CCA charge for each free cash flow period and then using the CCA tax shield equation to make a final adjustment.

9-7 Calculate free cash flows directly (using Equation 9.8) by where the last term in the formula is the CCA tax shield. This method excludes the periodic CCA charge in each free cash flow and instead uses the PV CCA tax shield formula to compute the entire CCA tax shield in one step, which students will likely prefer.

9-8 Use the appropriate cost of capital to compute the project’s Net Present Value and make the decision.

9-9 Understand that when choosing between alternatives only the free cash flows of each alternative need be analyzed.

9-10 Consider if any further adjustments to free cash flows, such as relevant non-cash items, timing, liquidation values, continuation values, capital gains tax, perpetual tax shields – with or without negative additions and tax loss carryforwards and carrybacks are needed.

9-11 Use breakeven analysis (and Excel’s solver), sensitivity analysis, or scenario analysis to evaluate project risk.

9-A Compute the effects of asset sales on CCA calculations II. Chapter Overview Chapter 8 described the use of NPV (and some other tools) to make investment decisions. Chapter 9 demonstrates how to derive the cash flows for a given project to determine which projects or investments a firm should undertake. An accompanying Excel spreadsheet contains the chapter’s tables.

9.1 Forecasting Earnings The chapter teaches the concept of forecasting earnings by considering a capital budgeting decision faced by managers of the hypothetical Spy Peripherals Incorporated (SPI). The development project is called the SPI Phone 86, an advanced micro-sized smartphone with superior features. The issues addressed are summarized here and in the accompanying excel spreadsheet for this chapter (Textbook Tables 9-1 to 9.14 and the solution to Example 9.5): • The company has already conducted a feasibility study, which cost $300,000.

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• • • • •

Sales are expected to be 100,000 units per year.

The project is estimated to have a four-year life.

It will sell at an expected wholesale price of $260.

Engineering and design costs will be $5 million.

Actual production will cost $110 per unit.

• • •

Software development will require 50 software engineers at $200,000 per year each.

Lab facilities are already available, but will require $7.5 million of new equipment.

The software and hardware design will be completed and the lab will be operational at the end of one year. At that time, the SPI Phone 86 will be ready to ship.

The company will spend $2.8 million per year on marketing and support.

The lab equipment falls under Class 45 and the CCA rate for that class is 45%. The half-year rule applies to Class 45.

The marginal corporate tax rate is 40%.

• • •

The net income from the project is in the Table 9.1 spreadsheet. Additional issues addressed in this section of the chapter are: • Interest income is not included—the investment decision is separate from the financing decision and thus unlevered net income is used to project earnings • Project externalities affect cash flows. These include cannibalization and opportunity costs. Opportunity cost for SPI’s Phone 86 new lab is estimated to be $200,000 per year. Cannibalization is estimated to cost 25% of the sales of the existing SPI phone.

• Sunk costs, such as the study already conducted and paid for, should not be included.

• Fixed overhead expenses should be included only if they are in addition to those that would be incurred without the project.

• CCA deductions extend beyond the life of the project when the UCC of the asset class remains positive at the end of the project.

Table 9.1 shows the incremental earnings forecast for the Phone 86 project. Table 9.2 shows the schedule of CCA and UCC for the first 5 years and Table 9.3 shows incremental earnings including cannibalization and lost rent.

9.2 Determining Free Cash Flow and NPV This section shows how to convert net income to free cash flow. Free cash flow can be calculated directly by using the following formula:

Because the CCA tax shield usually continues beyond the life of a project, students will likely find it much easier to exclude the CCA from Free Cash Flow computation. Instead of using formula 9.7, students may rewrite it and compute Free Cash Flow indirectly as:

.

2

Once the present value of the free cash flows are found using the project’s cost of capital as the discount rate, the NPV is computed by simply summing the present values of each free cash flow. Table 9.4 shows the calculation of SPI’s Phone 86 Free Cash Flow. Table 9.5 shows net working capital requirements.

Table 9.6 shows SPI’s Phone 86 NPV. 9.3 Choosing Among Alternatives Because not launching a project produces an additional NPV of zero for the firm, launching a project is the best decision for the firm, if its NPV is positive. In many situations, however, we must compare mutually exclusive alternatives, each of which has consequences for the firm’s cash flows. In such cases, we can make the best decision by choosing the alternative with the highest NPV. Table 9.7 compares the NPV of outsourcing to the NPV of in-house assembly.

9.4

Further Adjustments to Free Cash Flow

This section considers a variety of other complications that may arise because of the specifics of a project. For example, free cash flows may be computed during any time period such as weekly or monthly rather than just annually, CCA tax shields may be perpetual, salvage values may impact both the project and the CCA tax shields, capital gains from disposal of assets create a tax liability and the impact of terminal values, tax loss carryforwards and carrybacks.

Because it is easier, students may prefer to use equation 9.11 to find the project’s free cash flows:

And then break down the CCA tax shields into two perpetuities and find its present value using:

Formula 9.15 may require adjustments arising from the specific assumptions provided in the problem at hand.

For example, alternative assumptions about the timing of the asset purchase or sale can be easily accommodated: if the asset is purchased at the end of tax-year 0 rather than the beginning of tax-year 1, the first term of equation 9.15 would have to be multiplied by (1+r). If the asset is expected to be sold at the end of taxyear t rather than the beginning of tax-year t+1, then the last term of equation 9.15 would be multiplied by (1+r).

Often business reasons drive the timing of the asset sale (rather than just the tax implications), so it is important to understand how to adjust these formulas.

When free cash flow is calculated for a period shorter than the horizon of the project, a terminal or continuation value must be calculated. This can be calculated as a constant growth perpetuity. That value must then be discounted back to the present, along with the remaining cash flows. We must also consider tax carryforwards and carrybacks when calculating NPV, which allow corporations to take losses during a current year and offset them against gains in nearby years.

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3

9.5 Analyzing the Project Finally, there are several tools to analyze the project’s sensitivity to assumptions used in deriving the cash flows. Break-even analysis can be done for each input. This involves solving for the break-even level of that input — the level that makes NPV equal zero. If there is a great deal of uncertainty regarding that input, this provides valuable information. IRR is the breakeven point for the cost of capital.

Table 9.11 shows the calculation of SPI’s IRR. Table 9.12 shows break-even levels for Phone 86 in terms of units sold, wholesale price, cost of goods, and cost of capital. Figure 9.1 shows the range of NPVs in sensitivity analysis. Table 9.14 shows scenario analysis changing price and units sold.

The chapter concludes with an illustration of several useful Excel tools that assist in conducting sensitivity analysis and scenario analysis. Excel’s solver tool makes it easy to compute the IRR, without omitting any CCA tax shields.

9.A The Effects of Asset Sales on CCA Calculations The Appendix to the chapter provides the effects of asset sales on CCA calculations.

III. MyFinanceLab Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

9.1

Forecasting Earnings

1-5

9.1 to 9.5

294 - 303

9.2

Determining Free Cash Flow and NPV

6-8

9.6 to 9.8

303 - 308

9.3

Choosing Among Alternatives

9

9.9

308 - 310

9.4

Further Adjustments to Free Cash Flow

10 - 13

9.10

310 - 318

9.5

Analyzing the Project

14 and 15

9.11

318- 323

9.A

The Effects of Asset Sales on CCA Calculations

None

9.A

331 - 335

.

4

IV. Spreadsheet Solutions in Excel The following problems for Chapter 9 have spreadsheet versions of the problems available: 9-5, 9-7, 9-9, 9- 13, 9-14, 9-15. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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5

Chapter 10 Capital Markets and the Pricing of Risk I. Learning Objectives 10-1 Define a probability distribution, the mean, the variance, the standard deviation, and the volatility.

10-2 Compute the realized or total return for an investment.

10-3 Using the empirical distribution of realized returns, estimate expected return, variance, and standard deviation (or volatility) of returns.

10-4 Use the standard error of the estimate to gauge the amount of estimation error in the average.

10-5 Discuss the volatility and return characteristics of small stocks versus large stocks and bonds.

10-6 Describe the relationship between volatility and return of individual stocks.

10-7 Define and contrast idiosyncratic and systematic risk and the risk premium required for taking each on.

10-8 Define an efficient portfolio and a market portfolio.

10-9 Discuss how beta can be used to measure the systematic risk of a security.

10-10 Use the Capital Asset Pricing Model to calculate the expected return for a risky security.

10-11 Use the Capital Asset Pricing Model to calculate the cost of capital for a particular project 10-12 Explain why in an efficient capital market the cost of capital depends on systematic risk rather than diversifiable risk.

II. Chapter Overview This chapter begins the discussion of risk and return. The authors begin with probability distributions and realized returns. They show that the expected return of individual stocks is higher for the amount of risk taken than it is for the portfolios typically examined. They then describe idiosyncratic and systematic risk. The CAPM is also introduced. Throughout the discussion the authors emphasize no-arbitrage conditions to explain idiosyncratic and systematic risk. An accompanying Excel spreadsheet contains the raw data for Ford Motor Company.

10.1 A First Look at Risk and Return This section compares returns on several types of investment. Figure 10.1 shows the returns from a $100 investment at the beginning of 1956 to 2018 in the S&P/TSX Composite Index, the S&P 500, Long-Term Government of Canada Bonds and Canadian Treasury Bills along with the CPI during the period.

10.2 Common Measures of Risk and Return This section introduces the probability distribution of returns and describes how mean, variance, and standard deviation are computed when the probability distribution is known. Example 10.1 shows how those values are calculated. The authors explain that, in most cases, we don’t have an explicit probability distribution, so we must use historical returns to learn about the relationship between risk and return.

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1

10.3 Historical Returns of Stocks and Bonds This section begins with an explanation of how to compute realized returns, including an explanation of how those returns are annualized with equations 10.4 and 10.5. Example 10.2 shows how to calculate returns using those equations for Barrick Gold Corp. stock for the years 2004 and 2008. Table 10.2 summarizes realized returns for the S&P/TSX, Barrick Gold, and the 3-month Canadian T-bills. Figure 10.4 presents histograms of some of the return series presented in Figure 10.1, identifying this plot of the probability distribution using historical data as the empirical distribution of returns.

The section next shows how average, variance, and standard deviation are computed for realized returns.

Equation 10.7 shows how variance is calculated. Example 10.3 uses data from Table 10.2 to illustrate the calculation of variance for the S&P/TSX Composite Index. The realized returns and volatilities for Canadian Stocks (the S&P/TSX), Long-term Government of Canada bonds, and Canadian Treasury Bills are summarized in Tables 10.3 and 10.4. The text then describes the estimation error faced when a sample is being used to estimate a population. Equation 10.8 shows how to calculate the standard error of the estimate of the expected return. Example 10.4 then shows how to compute a 95% confidence interval using that information. Note there is a box that addresses the difference between arithmetic and geometric means.

10.4 The Historical Tradeoff between Risk and Return The section begins by discussing the excess returns of large portfolios over Government bonds and bills. Figure 10.5 plots those returns and volatilities and the authors provide some discussion in the text about the relationship that appears. They next discuss the returns of individual stocks. They plot those returns and volatilities in Figure 10.6, along with the portfolios that appear in Figure 10.5. This graph shows that, even though risk and return are positively related and almost linear for the portfolios, the same is not true of individual stocks. So, “while volatility seems to be a reasonable measure of risk when evaluating a large portfolio, it is not adequate to explain the returns of individual securities.”

10.5 Common versus Independent Risk This section explains why the risk of an individual security is different from that of a portfolio. The authors explain this concept using an insurance company example. Suppose an insurance company offered two types of insurance: theft and earthquake. If the company insures 100,000 houses in San Francisco, the two types of insurance will have very different risk profiles for the insurance company, since the risk of theft in any one house is independent and identically distributed, while the risk of earthquake is not. The authors use this example through the remainder of the chapter to illustrate independent or idiosyncratic risk (theft) and common or systematic risk (earthquake). This example also illustrates the risk and return tradeoff, as well as the principle of diversification. Example 10.5 shows how casinos make a profit on roulette wheels, and why some casinos place limits on the amount of any individual bet.

10.6 Diversification in Stock Portfolios The authors begin with two extremes: companies (firm S) with no idiosyncratic risk and companies (firm I) with no systematic risk (or only idiosyncratic risk). Figure 10.7 shows how volatility declines with the size of the portfolio for type S and I firms. The volatility of the portfolio does not change with an increase in the number of firms for type S firms. For type I firms, as more firms are added to the portfolio, volatility declines. This example explains why, in Figure 10.6, the S&P/TSX Composite Index and the S&P 500 had so much lower volatility than any of the individual stocks.

Now consider only type I firms. The authors describe how investors who hold a large portfolio of type I firms could diversify away (nearly) all the risk of the portfolio, since the firms have only idiosyncratic risk. This concept is illustrated in Figure 10.7. Hence, in an efficient market, the portfolio must earn the risk-free rate.

Otherwise, there would be an arbitrage opportunity. From this we conclude that “the risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk.” Also, “the risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk.” This insight also provides an answer for the second puzzle in Figure 10.6; volatility is not a good measure of risk for an individual security. Example 10.6 shows volatility for 10 type S firms versus 10 type I firms. A box describes 2 .

diversification benefits during market crashes.

10.7 Measuring Systematic Risk In order to estimate the expected return, we must first measure the investment’s systematic risk, then determine the risk premium required to compensate for that amount of systematic risk. The authors then introduce the idea of efficient portfolios, one of which is the market portfolio. They do not develop the computation for beta in this chapter—they do that in Chapter 12. Here, they simply define beta as “the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio.”

In Example 10.8, the authors show how to estimate beta from type S and type I firms. Table 10.6 shows betas with respect to the S&P/TSX for individual stocks from a number of different industries.

10.8 Beta and the Cost of Capital In this section, the authors show how the CAPM can be used to calculate the cost of capital for a firm or project.

They begin by estimating the risk premium for the market, then for the investment. Example 10.9 shows how to estimate expected returns for type S firms.

III. MyFinanceLab Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

10.1

A First Look at Risk and Return

10.2

Common Measures of Risk and Return

1-3

10.1

341 - 345

10.3

Historical Returns of Stocks and Bonds

4 - 10

10.2

345 - 353

10.4

The Historical Trade-off between Risk and Return

11

10.3 and 10.4

353 - 356

10.5

Common Versus Independent Risk

12 and 13

10.5

356 - 358

10.6

Diversification in Stock Portfolios

14 - 19

10.6 to 10.8 359 - 364

.

339 - 341

3

10.7

Measuring Systematic Risk

20 - 22

10.9

364 - 367

10.8

Beta and the Cost of Capital

23 - 26

10.10 to 10.12

368 - 370

IV. Spreadsheet Solutions in Excel The following problems for Chapter 10 have spreadsheet versions of the problems available: 10-1, 10-2, 10-6, 10-7, 10-8, 10-9, 10-10, 10-19, 10-24. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

.

4

Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model I. Learning Objectives 11-1 a. b.

11-2

Given a portfolio of stocks, including the holdings in each stock and the expected return in each stock, compute the following: portfolio weight of each stock (equation 11.1) expected return on the portfolio (equation 11.3)

a. b. c. d.

Given a portfolio of stocks, including the holdings in each stock and the expected return in each stock, compute the following: covariance of each pair of stocks in the portfolio (equation 11.5) correlation coefficient of each pair of stocks in the portfolio (equation 11.6) variance of the portfolio (equation 11.8) standard deviation of the portfolio

11-3

Compute the variance of an equally weighted portfolio, using equation 11.12.

11-4

Describe the contribution of each security to the portfolio.

11-5

Use the definition of an efficient portfolio from Chapter 10 to describe the efficient frontier.

11-6

Explain how an individual investor will choose from the set of efficient portfolios.

11-7

Describe what is meant by a short sale, and illustrate how short selling extends the set of possible portfolios.

11-8

Explain the effect of combining a risk-free asset with a portfolio of risky assets, and compute the expected return and volatility for that combination.

11-9

Illustrate why the risk-return combinations of the risk-free investment and a risky portfolio lie on a straight line.

11-10 Define the Sharpe ratio, and explain how it helps identify the portfolio with the highest possible expected return for any level of volatility, and how this information can be used to identify the tangency (efficient) portfolio.

11-11 Calculate the beta of investment with a portfolio.

11-12 Use the beta of a security, expected return on a portfolio, and the risk-free rate to decide whether buying shares of that security will improve the performance of the portfolio.

11-13 Explain why the expected return must equal the required return.

11-14 List the three main assumptions underlying the Capital Asset Pricing Model (CAPM).

11-15 Explain why the CAPM implies that the market portfolio of all risky securities is the efficient portfolio.

11-16 Use the risk-free rate, the expected return on the efficient (tangency) portfolio, and the beta of a security with the efficient portfolio to calculate the risk premium for an investment 11-17 Compare and contrast the capital market line with the security market line.

11-18 Define beta for an individual stock and for a portfolio.

11.A1 Find the efficient frontier when investors face different borrowing and savings rates.

1

II. Chapter Overview This chapter expands upon the concepts developed in Chapter 10 to show risk and return in a portfolio context.

It develops a generalized model that will result in the development of the CAPM in Chapter 12. The authors conclude the chapter by describing the importance of this material for financial managers of corporations.

11.1 The Expected Return of a Portfolio The authors begin by showing how to calculate the portfolio weights, then show the calculation of portfolio return using those weights. In Example 11.1, the authors use Barrick Gold Corp. and Air Canada to show that the return on the portfolio is the weighted average of the returns of the assets in the portfolio. They also mention that, after a price change, the weights of the portfolio will change. Without rebalancing, the portfolio weights will increase for high-return stocks.

11.2 The Volatility of a Two-Stock Portfolio This section describes the statistics that can be used to quantify the diversification benefits described in Chapter 10. Table 11.1 contains annual returns for three hypothetical stocks—North Jet, South Jet, and Alberta Oil— along with their average returns and volatilities. The table also includes returns and volatilities for the two portfolios that can be constructed from combining the three stocks equally, two at a time. Although the average returns and volatilities of the three stocks are the same, the average returns and volatilities of the two portfolios are quite different from the individual stocks’ returns and from each other.

The authors then define covariance and show how to compute it. They also state that, “While the sign of the covariance is easy to interpret, its magnitude is not.” They use this fact as motivation for calculating the correlation coefficient. Table 11.2 shows the computation of covariance and correlation coefficient for the stocks in Table 11.1. Figure 11.1 displays the interpretation for any correlation coefficient. Example 11.4 shows that the variance of a stock with itself is its covariance.

Next, the authors use that fact to show how the variance of a portfolio is computed. This development relies on knowledge about the properties of the covariance. The necessary tools are given in footnote 4. Substituting in two assets, the resulting formula (equation 11.8) is the variance of a two-stock portfolio. Example 11.6 uses historical covariance in Table 11.3 to illustrate the computation of volatility of a two- asset portfolio.

11.3 The Volatility of a Large Portfolio The authors first show the generalized form of the portfolio variance formula in equation 11.11. They then simplify that formula by assuming that n stocks are equally weighted. Equation 11.12 shows the variance of an equally weighted portfolio of n stocks. They use this information to show that the variance of a large portfolio converges to the average covariance, but that market risk remains.

Example 11.8 is used to derive the result in chapter 10 that when risks are independent, all of the risk can be diversified by holding a large portfolio. The authors then show the volatility of a portfolio with arbitrary weights, and show that the volatility of a portfolio is less than the weighted average volatility.

11.4 Risk Versus Return: Choosing an Efficient Portfolio This section begins with a two-stock portfolio of Intel and Coca-Cola. Those two stocks were uncorrelated during the period examined. Table 11.4 shows the expected returns and volatility for different portfolio weights of the two stocks. Figure 11.3 is a plot of the expected returns and volatility, showing the efficient portfolios and the inefficient portfolios. The authors describe how investors will select among efficient portfolios based on their risk preferences. Figure 11.4 shows the effect on the risk and return of the portfolio when the correlation coefficient changes.

Next, the authors discuss short sales. Example 11.10 shows how short selling can be advantageous even when the stock price increases, as long as the portfolio has a long position in a stock with a higher realized return. It also shows that the ability to short sell impacts volatility; in this example the volatility increases above that of 2

the individual stocks. Figure 11.5 shows the plot of various combinations of Intel and Coca-Cola when short sales are allowed. Shorting Coca-Cola to buy Intel results in efficient portfolios, while shorting Intel to buy Coca-Cola does not.

The authors next tackle the more complicated problem of portfolios with many assets. They begin by including a third stock (Bore Industries) in their analysis. Figure 11.6 shows the risk-return graphs of various combinations of those three stocks, two at a time. Figure 11.7 expands the graph to show the efficient frontier with all three stocks without short sales, with short sales and the efficient frontier. Figure 11.8 shows the effect of adding seven more stocks.

11.5 Risk-Free Saving and Borrowing This section starts by showing the expected return on a portfolio that combines the risk-free asset with a risky portfolio. Equation 11.5 shows that calculation with a risk premium explicitly included.

The volatility is shown in equation 11.16, with the special case that the covariance of the risk-free asset with any portfolio is zero and the variance of the risk-free asset is zero. Figure 11.9 shows the resulting line—in this case, the portfolio chosen is not the tangency portfolio. The next part of the section shows how to find the tangent portfolio using the Sharpe ratio. The efficient portfolio is the tangent portfolio, the one with the highest Sharpe ratio in the economy. Figure 11.10 shows the tangent portfolio. Example 11.12 shows how an individual investor can choose the optimal portfolio.

11.6 The Efficient Portfolio and Required Returns This section begins by examining how to determine whether the addition of a particular security, i, to a portfolio will improve its Sharpe ratio. Equations 18 and 19 show that increasing the amount invested in i will increase the Sharpe ratio expected return, which exceeds the required return given by equation 11.20. The required return is the expected return that is necessary to compensate for the risk investment i will contribute to the portfolio.

11.7 The Capital Asset Pricing Model The CAPM uses actions of investors as input and identifies the efficient portfolio as the market portfolio— the portfolio of all stocks and securities in the market.

The authors identify the three main assumptions of the CAPM as: (1) investors can borrow and lend at the riskfree rate, (2) investors hold only efficient portfolios, (3) investors have homogeneous expectations.

11.8 Determining the Risk Premium Equation 11.22 gives the equation of the SML and equation 11.23 shows how beta is calculatedExample 11.16 shows the calculation of beta for Finning International Inc. Next, Figure 11.12 plots the Security Market Line

(SML) and the capital market line side by side. The authors point out the differences—in particular, there is no clear relationship between a stock’s volatility and its expected return. They then discuss the calculation of the beta of a portfolio.

3

Appendix 11A The CAPM with Differing Interest Rates The appendix examines changes to the CAPM when borrowing and lending rates differ. Figures 11A.1 and 11A.2 show the effect of changing this assumption on the tangent portfolio and the investors’ optimal portfolio choice. The market portfolio must lie between the tangent portfolio implied by the borrowing rate and the tangent portfolio implied by the lending rate. The implication for the SML is that it still holds in the following form:

Where r* is some rate between the borrowing and lending risk-free rate.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

11.1

The Expected Return of a Portfolio

1-4

11.1

377-379

11.2

The Volatility of a Two-Stock Portfolio

5 - 14

11.2

379 - 386

11.3

The Volatility of a Large Portfolio

15 - 20

11.3 and 11.4

386 - 390

11.4

Risk Versus Return: Choosing an Efficient Portfolio

21 - 32

11.5 to 11.7

390 - 398

11.5

Risk-Free Saving and Borrowing

33 - 37

11.8 to 11.10

398 - 402

11.6

The Efficient Portfolio and Required Returns

38 - 42

11.11 to 11.13 402 - 407

11.7

The Capital Asset Pricing Model

43 - 46

11.14 and 11.15

407 - 409

4

11.8

Determining the Risk Premium

47 - 50

11.16 to 11.18 409 - 414

11A

The CAPM with Differing Interest Rates

None

11.A1

427 - 429

IV. Spreadsheet Solutions in Excel The following problems for Chapter 11 have spreadsheet versions of the problems available: 11-6, 11-7, 11-8, 11-9, 11-14, 11-26 and 11-48. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

5

Chapter 12 Estimating the Cost of Capital I. Learning Objectives 12-1

Estimate a company’s cost of capital using the CAPM equation for the Security Market Line.

12-2

Describe the market portfolio and how it is constructed in practice.

12-3

Discuss the attributes of a value-weighted portfolio.

12-4

Describe common proxies for the market return and the risk-free rate.

12-5

Define alpha and beta and explain how they are generally estimated.

12-6

Compare the use of average return versus beta and the SML to estimate cost of equity capital.

12-7

Estimate the cost of debt, given a company’s yield to maturity, probability of default, and expected loss rate.

12-8

Discuss the difference between the yield to maturity and the cost of debt when there is low versus high default risk.

12-9

Calculate the cost of debt given a company’s debt beta, the risk free rate, and the market risk premium.

12-10 Illustrate the use of comparable companies’ unlevered betas or unlevered cost of capital to estimate project cost of capital.

12-11 Discuss the advantages of using several companies’ betas to estimate a project beta.

12-12 Define operating leverage and discuss its influence on project risk.

12-13 Calculate the weighted average cost of capital.

12-14 Discuss strengths and weaknesses of the CAPM. 12A

Describe the practical considerations when estimating beta

II. Chapter Overview This chapter introduces the additional assumptions of the CAPM and describes the CAPM. It then shows how to estimate equity and debt cost of capital and introduces the weighted-average cost of capital. An accompanying Excel spreadsheet contains the raw data for Nike and HP stocks returns.

12.1 The Equity Cost of Capital This section reviews the use of the CAPM’s SML for cost of equity estimation. Example 12.1 shows two companies with their volatility and beta estimates, contrasting the two. The company with a higher beta (Husky Energy) has a higher cost of equity capital (than Brookfield Business Partners) even though it has a lower volatility.

12.2 The Market Portfolio This section shows how a value-weighted portfolio is constructed and describes common market indexes and their weighting schemes. A call-out box shows how a value-weighted portfolio is passive so that no rebalancing is required. The ability to invest in market indexes using index funds or ETFs is also discussed.

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1

12.3 The Market Risk Premium In order to estimate security returns, the risk-free rate and the market risk premium must also be estimated.

CAPM states the risk-free rate corresponds to the risk-free rate at which investors can both borrow and save.

Most firms use the yields on long-term bonds to determine the risk-free rate by extending CAPM to allow for differing investment horizons. An average should be used. The market risk premium is typically based on historical excess returns over the risk-free asset. There is some evidence that the premium is declining, as demonstrated in Table 12.1. Because historical estimates are flawed, the authors introduce an alternative “fundamental” approach to risk premium estimation. Based on estimates and studies, most practitioners use a rate between 3% and 5%.

12.4 Beta Estimation This section describes the use of historical returns to calculate beta. Figure 12.1 shows monthly returns for Suncor stock and the S&P/TSX, while Figure 12.2 shows the scatterplot of those returns and discusses the “eyeball” estimate of the beta. The final part of the section describes the use of linear regression to estimate beta. Example 12.2 illustrates calculation of 95% confidence intervals for beta.

12.5 The Debt Cost of Capital This section discusses main methods for estimating debt cost of capital. The most common method for doing so is to use the company’s yield to maturity on existing debt. However, as the authors show, in the presence of default risk, the YTM is overstated. Example 12.3 shows a method for adjusting the YTM when a high degree of default risk is present. A second way to calculate debt cost of capital is to use the debt beta. However, debt betas are hard to find so we can approximate them using bond ratings, whose average betas are shown in Table 12.3. Chapter 15 develops a method for estimating debt betas from stock price data.

12.6 A Project’s Cost of Capital Calculating the project cost of capital can be done using all-equity comparable firms (Example 12.4) or by using levered firms and removing the effects of leverage to arrive at the asset beta. The unlevered cost of capital can be calculated as the weighted average of the equity and debt costs of capital. A formula for unlevering beta is presented, and Example 12.5 illustrates its use. Example 12.6 shows the effect of excess cash on the unlevered beta. A final way to estimate a project’s beta is to use the industry-average asset beta.

12.7 Project Risk Characteristics and Financing This section of the chapter discusses the differences in market risk across projects within a firm due to differences in operating leverage. It then introduces financial risk and adds the effect of debt financing to the unlevered cost of capital equation, resulting in the weighted average cost of capital. Equations 12.12 and 12.13 give alternative ways to calculate the WACC. Example 12.9 illustrates this concept.

12.7 Final Thoughts on Using the CAPM The CAPM uses several assumptions and approximations. This section discusses its reliability. The authors offer several thoughts on this. First, the types of approximations used to estimate cost of capital are the same as those used to estimate cash flows but have far less impact on project value than errors in the estimates used for cash flows. Second, the CAPM is practical, straightforward, and very robust. Third, the CAPM imposes a disciplined process on managers with little room for manipulation without justification. Finally, the CAPM gets managers to think about risk correctly.

Chapter 12 Appendix: Practical Considerations When Forecasting Beta The Appendix discusses some practical issues about beta calculation, such as choosing a market proxy and the time interval to use for estimation. It introduces a common method for adjusting beta, as well as discussing treatment of outliers. Finally, the authors discuss the concept that firm conditions and betas may change over time.

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2

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

12.1

The Equity Cost of Capital

1-3

12.1

431 - 432

12.2

The Market Portfolio

4-8

12.2 and 12.3

432 - 436

12.3

The Market Risk Premium

9 - 11

12.4

437 - 439

12.4

Beta Estimation

12 - 15

12.5 and 12.6

439 - 444

12.5

The Debt Cost of Capital

16 - 18

12.7 to 12.9

444 - 447

12.6

A Project’s Cost of Capital

19 - 23

12.10 and 12.11

447 - 453

12.7

Project Risk Characteristics and Financing

24 - 28

12.12 and 12.13

453 - 456

12.8

Final Thoughts on Using the CAPM

12.14

457

12A

Practical Considerations when Forecasting Beta

12A.1

465 -468

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3

IV. Spreadsheet Solutions in Excel The following problems for Chapter 12 have spreadsheet versions of the problems available: 12-4, 12-5, 12-13, 12-14, and 12-15. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 13 Investor Behaviour and Capital Market Efficiency I. Learning Objectives 13-1

Compute a stock’s alpha using equation 13.2.

13-2

Explain how investors’ attempts to “beat the market” should keep the market portfolio efficient.

13-3

Describe the effect of homogeneous expectations on a security’s alpha.

13-4

Explain why holding the market portfolio does not depend on the quality of an investor’s information or trading skills.

13-5

Understand what the CAPM requires about investors’ expectations.

13-6

Evaluate under what conditions the market portfolio would be inefficient.

13-7

Explain diversification bias and familiarity bias.

13-8

Discuss why uninformed investors trade too much.

13-9

Assess how uninformed investors’ behaviour deviates from the CAPM in systematic ways.

13-10 Explain the disposition effect.

13-11 Review why investors, on average, earn negative alphas when they invest in managed mutual funds.

13-12 Assess the strategy of an investor “holding the market.”

13-13 Discuss the size effect.

13-14 Describe the momentum trading strategy.

13-15 Explain how the choice of the market proxy may lead to nonzero alphas.

13-16 Discuss how systematic behavioural biases may affect the efficiency of the market portfolio.

13-17 Assess how a preference for stocks with a positively skewed return distribution would impact the market portfolio’s efficiency.

13-18 Describe the Arbitrage Pricing Theory using equation 13.4.

13-19 Discuss the expected return on a self-financing portfolio using equation 13.5.

13-20 Discuss the Fama-French-Carhart model using equation 13.6.

II. Chapter Overview This chapter expands upon the concepts developed in Chapters 11 and 12 to show risk and return in a portfolio context. It develops a generalized model that will result in development of the CAPM equilibrium discussed in Chapter 11. The authors conclude the chapter by describing the importance of this material for financial managers of corporations.

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13.1 Competition and Capital Markets The chapter begins by revisiting the efficient and inefficient portfolios in Figure 13.1. Alpha is defined as:

Figure 13.1 shows the consequences of choosing a market portfolio that is not the efficient portfolio. Figure 13.2 shows how a stock’s alpha is reflected in its deviation from the security market line. As investors trade to improve their portfolios, they raise the price and lower the expected return of the positive-alpha stocks, and they depress the price and raise the expected return of the negative-alpha stocks, until the stocks are once again on the SML and the market portfolio is efficient.

13.2 Information and Rational Expectations This section points out that an important conclusion of the CAPM is that all investors, informed and uniformed, should hold the market portfolio (combined with risk-free investments), and this investment advice does not depend on the quality of an investor’s information or trading skill. This concept is illustrated in Example 13.1.

The section concludes with the following statement: The market portfolio can be inefficient (so it is possible to beat the market) only if a significant number of investors either 1.

Do not have rational expectations so that they misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or

2.

Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities.

13.3 The Behaviour of Individual Investors This section begins by examining whether individual investors hold the market portfolio. Despite the benefits, many do not because of behavioural biases. Investors suffer from a familiarity bias, so they favor investments in companies with which they are familiar. Investors also care most about the performance of their portfolio relative to that of their peers. Investors also exhibit an overconfidence bias regarding their investment decision making skills. Many investors overtrade, as shown in Figure 13.4. The section ends by asking whether the conclusions of the CAPM are invalid given investors’ actions. This question is answered in the following section.

13.4 Systematic Trading Biases For the behaviour of individual investors to affect market prices, there must be systematic patterns in the types of errors individual investors make. For example, investors tend to hold on to stocks that have lost value and sell stocks that have risen in value (the disposition effect). Studies have also shown that investors are more likely to buy stocks that have recently been in the news. Investor mood also has an impact on investor behaviour.

Investors often try to imitate the actions of others (herd behaviour). If individual investors are engaging in strategies that earn negative alphas, it may be possible for more sophisticated investors to take advantage of this behaviour and earn positive alphas. This is addressed in the following section.

13.5 The Efficiency of the Market Portfolio This section examines evidence as to whether or not investors can outperform the market without taking on additional risk. Figure 13.5 shows the average response to takeover announcements, showing the target stock’s cumulative abnormal return. Jim Cramer’s recommendations on Mad Money are also examined. Figure 13.6 shows the results of a recent study that analyzed the average stock price reaction to these recommendations, based on whether the recommendation coincided with a news story about the company. Investors appear to be subject to an overconfidence bias, trusting too much in Cramer’s recommendations. Figure 13.7 shows the average annual alphas for mutual fund managers, illustrating that mutual funds have, on average, negative alphas. Finally, this section concludes that investors should simply “hold the market.” .

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13.6 Style-Based Techniques and the Market Efficiency Debate Several characteristics can be used to pick stocks that produce high average returns, including size, book- tomarket, and momentum. Each of these characteristics is examined in this section.

Figure 13.9 shows the average excess return of portfolios formed in deciles by size. The evidence suggests that small firms outperform the SML’s predictions. Recent studies show that when the market portfolio is not efficient, the size effect is expected. This effect is illustrated in Example 13.2. Over the years since the discovery of the CAPM, practitioners and researchers have realized that by forming portfolios based on market capitalization, book-to-market ratios, and past returns, it is possible to construct trading strategies with positive alphas. This observation leads us to conclude that either (1) investors systematically ignore positive-NPV investment opportunities or (2) the CAPM does not correctly compute the risk premium. The first conclusion does not seem likely. The second can only happen if the market portfolio is inefficient. The authors discuss reasons that this could be true.

13.7 Multifactor Models of Risk The first part of this section points out that it is not actually necessary to identify the efficient portfolio itself. All that is required is to identify a collection of portfolios from which the efficient portfolio can be constructed. For example, if we identify two portfolios that can be combined to form an efficient portfolio, we can calculate risk coefficients for each of the portfolios. The section mentions the Arbitrage Pricing Theory as one example of this type of model. One way to implement a multifactor model is called a smart beta strategy by practitioners. This strategy over-weights risk factors that investors do not care about. Another way is to construct self-financing portfolio.

The next part of this section describes Fama-French-Carhart factor specification and shows how to calculate the cost of capital using that specification. As with the CAPM, we must use historical data to estimate the factors and the factor betas. Example 13.3 shows how to use FFC factor specifications to calculate the cost of capital.

13.8 Methods Used in Practice Figure 13.11 summarizes Graham and Harvey’s results about how firms actually calculate cost of capital. The chapter concludes with the point that, “All the techniques we covered are imprecise.” That is, there is no clear answer to the question of which technique is used to measure risk in practice—it very much depends on the organization and the sector. Practitioners must apply the techniques that best suit their particular circumstances.

As for investors, we can actually observe their actions and infer what type of risk model they use to assess investment opportunities. According to a recent study by Berk and van Binsbergen, based on mutual fund inflows, investor behavior is most consistent with the CAPM. Chapter 13 Appendix: Building a Multifactor Model The Appendix examines how derive a two-factor model of expected returns from a collection of portfolios.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems Learning Objectives Covered

Text Page Reference

13.1

Competition and Capital Markets

1-3

13.1 and 13.2

470-472

13.2

Information and Rational Expectations

4-7

13.3 to 13.6

472-474

13.3

The Behaviour of Individual Investors

8 - 10

13.7 and 13.8

474-478

13.4

Systematic Trading Biases

11 - 13

13.6 and 13.7

478-481

13.5

The Efficiency of the Market Portfolio

14 - 16

13.9 and 13.10

481-488

13.6

Style-Based Techniques and the Market Efficiency Debate

17 - 26

13.11 and 13.12

488-494

13.7

Multifactor Models of Risk

27 - 29

13.13 to 13.16

494-499

13.8

Methods Used in Practice

None

13.17 to 13.20

499-501

13A

Building a Multi-Factor Model

None

13A.1

508

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IV. Spreadsheet Solutions in Excel The following problems for Chapter 13 have spreadsheet versions of the problems available: 13-2, 13-19, 13-20, 13-21, 13-27, 13-28 and 13-29 along with Table 13.1.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 14 Financial Options I. Learning Objectives 14-1

Define the following terms: call option, put option, exercise price, strike price, exercising the option, expiration date, American option, European option, in-the-money, and out-of-the-money.

14-2

Compute the value of a call or a put option at expiration.

14-3

List the rights and obligations of both the buyer and seller of the option.

14-4

Use put-call parity to solve for the call premium, the put premium, the stock price, the strike price, or dividend.

14-5

Discuss the following factors that influence call and put option values: stock price, strike price, and volatility.

14-6

Describe arbitrage bounds for option prices.

14-7

Explain why it is never optimal to exercise an American call option early on a non-dividend-paying stock, and why it is sometimes optimal to exercise an American put option early.

14-8

Explain the use of option modeling to value equity.

14-9

Describe how corporate debt can be viewed as a portfolio of riskless debt and a short position in a put option.

14-10 Define and describe credit default swaps.

II. Chapter Overview This chapter gives an overview of financial options and describes payoffs to various option strategies. The factors that affect option prices are also discussed. Finally, the equity and debt of the firm are modeled as options.

14.1 Option Basics This section defines important option-related terms and illustrates how options are listed and quoted. Table 14.1 gives quotes on Bow.com options from www.cboe.com. This section also distinguishes between hedging and speculating, as they apply to stock index options.

14.2 Option Payoffs at Expiration Option payoffs and payoff diagrams are the focus of this section. In equation 14.1, the call value at expiration is shown, while Figure 14.1 graphs that value. Equation 14.2 shows the value of a put at expiration, and Example 14.2 graphs the value of a put on Onex Corporation. Next, short positions in calls and puts are discussed. Finally, the profits for holding an option to expiration are graphed in Figure 14 .3 and Example 14.4. Those graphs include the option premium and adjust for time value of money (by assuming the funds are borrowed by shorting bonds). Several expirations appear on those graphs, to show the difference between payoffs for different strike prices. Figure 14.4 shows the returns from holding a put or a call to expiration.

This section also shows some common combinations of options—namely, a straddle, a strangle and a butterfly spread. Portfolio insurance is also discussed briefly and used to introduce protective puts. Figure 14.7 illustrates portfolio insurance.

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14.1 Put-Call Parity Portfolio insurance is used in this section to derive put-call parity, which appears in equation 14.3. Example 14.6 shows how an options dealer might use put-call parity. Put-call parity on a dividend paying stock is shown in equation 14.4. Example 14.6 also shows how to use put-call parity to determine a break-even call option price.

14.4 Factors Affecting Option Prices This section discusses the factors that affect option prices, starting from the relationship between the strike price, the stock price, and option value. They define three arbitrage bounds on option prices.

First, an American option cannot be worth less than its European counterpart. Second, a put option cannot be worth more than its strike price, nor can a call option be worth more than the stock itself.

Finally, an American option cannot be worth less than its intrinsic value.

The section also discusses the relation between option value and time to maturity. Example 14.8 illustrates the positive relationship between option prices and stock volatility. Option valuation itself is covered in Chapter 15.

14.5 Exercising Options Early This section shows that, for a non-dividend paying stock, it is never optimal to exercise a call option early. However, it is sometimes optimal to exercise a put option early. In addition, as Example 14.10 shows, it is sometimes optimal to exercise early on a dividend-paying stock.

14.6 Options and Corporate Finance In this section, the authors show how equity can be modelled as a call option on the assets of the firm with the strike price equal to the value of debt outstanding. Figure 14.8 is a graph showing how the payoffs of equity resemble the payoffs of a call option. The text discussion describes how the equity holders have an incentive to take negative-NPV, high-volatility investments.

The next part of the section discusses two ways that debt can be viewed as an option portfolio. The first way is to model debt holders as owning the firm and selling a call option with a strike price equal to the required debt payment. The second method is to view this is as a portfolio of riskless debt and a short position in a put on the firm’s assets with strike price equal to the required debt payment. The put option in the latter method is called a credit default swap because it can insure a firm’s credit risk.

Both alternatives are graphed in Figure 14.9. Example 14.11 shows how viewing debt as an option portfolio is useful in providing insight into credit spreads on risky debt. The section then describes credit default swaps and provides a brief description of their contribution to the financial crisis.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

14.1

Option Basics

1-3

14.1

511 - 514

14.2

Option Payoffs at Expiration

4 – 16

14.2 and 14.3

514 - 523

14.3

Put-Call Parity

17 - 20

14.4

523 - 525

14.4

Factors Affecting Option Prices

21 – 23

14.5 and14.6

525 - 528

14.5

Exercising Options Early

24 - 29

14.7

528 - 533

14.6

Options and Corporate Finance

30 - 33

14.8 to 14.10

533 - 537

IV. Spreadsheet Solutions in Excel The following problems for Chapter 14 have spreadsheet versions of the problems available: 14-6, 14-7, 14-8 and 14-9 along with the graphs for buying and selling a call and buying and selling a put. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 15 Option Valuation I. Learning Objectives 15-1

Illustrate the use of the Binomial Option Pricing Model to value an option.

15-2

Define the replicating portfolio for the Binomial Option Pricing Model.

15-3

Use the Law of One Price to explain how the Binomial Option Pricing Model provides the correct value under the assumptions made by the model.

15-4

Use the Black-Scholes Option Pricing formula to calculate the value of a call option on a non- dividendpaying stock.

15-5

Use the Black-Scholes Option Pricing formula to calculate the price of a European put option on a nondividend paying stock.

15-6

Compute the value of a European option on a dividend-paying stock.

15-7

Define the Black-Scholes replicating portfolio for a call option on a non-dividend paying stock or a European put option on a non-dividend paying stock.

15-8

Discuss what is meant by risk-neutral probabilities, and show how these probabilities can be used to price any other asset for which the payoffs in each state are known.

15-9

Define and calculate the risk-neutral probability that the stock price will increase in a binomial tree.

15-10 Calculate and interpret the beta of an option.

15-11 Use the Black-Scholes formula to unlever the equity beta of a firm and find the beta of debt.

15-12 Use option theory to measure the extent of the debt overhang problem.

II. Chapter Overview The chapter discusses how options are valued using the Binomial Option Pricing Model, the Black-Scholes formula, and risk-neutral probabilities. The authors emphasize the reliance of these formulas on the Law of One Price.

15.1 The Binomial Option Pricing Model This section begins with a two-state single-period model. The authors show how to form a replicating portfolio, and show that the price is not a function of the probabilities of the states in the binomial tree. They continue with the illustration and solve for the price of the call option with Equation 15.6. Example 15.1 shows how to use a binomial tree to value a put option. Next, the authors extend the problem to a two-period model for both a call and a put.

Figure 15.2 shows a binomial stock price path, which looks very much like stock price charts. By decreasing the length of each period and increasing the number of periods, a simple model for the stock price can be constructed. As a result, practitioners typically use this method to calculate the prices of options and other types of derivate securities.

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1

15.2 The Black-Scholes Option Pricing Model Rather than deriving the Black-Scholes formula, the authors state it (equation 15.7) and discuss its implications.

Example 15.3 shows how to value a call option with the Black-Scholes formula. The authors then show how to compute the price of a European put on a non-dividend-paying stock using put-call parity. Example 15.4 shows how the formula can be used to calculate the lower bound on a put option’s value. Figure 15.4 shows the BlackScholes value of the option relative to its intrinsic value. The calculated value is always above the intrinsic value. Figure 15.5 show that this is not always true for puts.

Next, the authors show that the price of a dividend-paying European Call is given by the standard formula, but with the stock price replaced throughout with the stock price minus the discounted value of dividends. Again, the option value can be lower than its intrinsic value. The authors briefly discuss implied volatility. The final part of the section shows the replicating portfolio for a call and a put, with mention of the option delta.

15.3 Risk-Neutral Probabilities In this section, the authors discuss how to find risk-neutral probabilities and the implications of those probabilities. They show how they are used in option pricing, via Example 15.8. They also mention their use in Monte Carlo simulation.

15.4 Risk and Return of an Option This section discusses the beta of an option, using the fact that, for a call option, the replicating portfolio sells bonds. Because the weight of bonds in the portfolio is negative, the beta of the call option (the weighted average of the beta of the stock with the beta of the bond) must be smaller than the beta of the stock.

Figure 15.7 illustrates leverage ratios. It shows that the magnitude of the leverage ratio for options can be very large, especially for out-of-the-money options.

15.5 Corporate Applications The final section of this chapter shows how the previous information can be used to calculate the beta of risky debt. Figure 15.9 shows the beta of debt and the beta of equity. It shows how to measure the debt overhang of an investment by adjusting NPV using the betas of debt and equity.

III. MyLab Finance Activities Text Section

Text Section Title

15.1

Learning Objectives Covered

Text Page Reference

The Binomial Option Pricing Model 1 - 10

15.1 to 15.3

545 - 553

15.2

The Black-Scholes Option Pricing Model

11 - 18

15.4 to 15.7

553 - 564

15.3

Risk-Neutral Probabilities

19 - 24

15.8 and 15.9

565 - 568

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Problems

2

15.4

Risk and Return of an Option

25 - 26

15.10

568 - 570

15.5

Corporate Applications

27 - 29

5.11 and 5.12

570 - 573

IV. Spreadsheet Solutions in Excel There are no spreadsheet solutions for this chapter.

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Chapter 16 Real Options I. Learning Objectives 16-1

Define the term “real option”.

16-2

Draw decision trees to represent alternative decisions and potential outcomes in an uncertain economy.

16-3

Illustrate how, given the option to wait, an investment that currently has a negative NPV can have a positive value.

16-4

Describe situations in which the option to delay is most valuable.

16-5

Describe three types of real options— growth, expansion (timing) and abandonment—and explain why it is important to consider those options when evaluating projects.

16-6

Choose between investments of different lives by evaluating the option to replace or extend the shorterlived project at the end of its original life.

16-7

Discuss the situation in which equivalent annual benefit method results in optimal decision making.

16-8

Describe the types of investments that should be done first in a multi-stage investment decision, and calculate project rankings according to Eq. 16.3.

16-9

Define and use the profitability index and the hurdle rate rules of thumb.

16-10 Outline the key insights obtained from using real options.

II. Chapter Overview The chapter begins with a description of the capital budgeting decision of biotechnology company, Gilead Sciences Inc. There is no single methodology to evaluate real investment options. Here they focus on using general principles that govern capital budgeting and option pricing to evaluate real options. They also show how to decide between two mutually exclusive projects of different lengths and explain two rules of thumb that managers often use in real option analysis. The authors conclude by examining the key insights obtained by using real option analysis.

16.1 Real versus Financial Options The difference between a real option and a financial option is that real options, and the underlying assets on which they are based, are often not traded in competitive markets. Still, many of the principles developed for financial options also apply to real options. Previous chapters assumed that the forecast of the project’s expected future cash flows already included the effect of future decisions that could be made. Here the authors begin looking at those cash flows more explicitly, beginning with decision trees.

16.2 Decision Tree Analysis For this section of the text, the authors describe a project under consideration by United Studios, which owns the rights to produce two movies for a national best seller. The company believes shooting both movies simultaneously would allow significant cost savings, and both movies could be produced for a total budget of $525 million. If the movies are produced sequentially, the total cost will be $575 million, but by waiting to produce the second movie until after they release the first movie, the studio will have much better information about the likelihood that it will be a hit. Figure 16.1 shows the decision tree if the studio

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produces both movies at once. The NPV of the decision to make the movie is positive. However, the actual outcome has significant uncertainty. Figure 16.2 shows the uncertainty of the outcome: If the first movie is a blockbuster the NPV is positive. If it is only a moderate hit, the NPV is negative. Figure 16.3 shows the full decision tree with the real option to produce the second movie after the outcome of the first movie is observed.

The next section begins the analysis of three types of option often observed in practice: (1) the option to delay (timing) an investment opportunity, (2) the option to grow, and (3) the option to abandon an investment opportunity.

16.3 The Option to Delay an Investment Opportunity This section considers an option to open an electric car dealership immediately or in exactly one year. If you do neither, you lose the right to open the dealership. The decision tree is shown in Figure 16.4. The free cash flow is expected to be $600,000 per year, with a 2% growth rate. The cost of capital is 12%, and the project will cost $5,000,000. The NPV of the investment is $1 million, so the contract is worth at least that amount.

The NPV of waiting to open the dealership can be considered the payoff to a European call option with a strike price of $5 million and a dividend equal to the $600,000 cash flow in the first year that will be forgone. If we use a comparable company to estimate the volatility at 40%, we can value this option using the Black-Scholes formula. The value is calculated to be $1.2 million. Thus, we will pay $1.2 million for the contract and wait until next year to build the dealership. Table 16.1 shows the inputs to the Black- Scholes model.

Whether it is optimal to invest today will depend on the magnitude of lost profits compared to the benefit of the right to postpone. Figure 16.5 shows that if the current value of an operating dealership is more than $6.66 million, we should invest today. Otherwise, waiting is optimal. Example 16.1 discusses how the decision would change if the volatility of cash flows were lower or the initial amount of cash flows was affected by competition.

In both cases, the decision would be to invest now.

16.4 Growth and Abandonment Options This section introduces another example, StartUp Incorporated, whose only asset is a patent on a new drug. If produced, it will generate certain profits of $1 million per year for the life of the patent, which is 17 years. The NPV of this project is negative. However, if interest rates decrease, the NPV will be positive.

Figure 16.6 shows the decision tree. The final part of the section shows how the previous discussion applies to the expansion, or staged investment, option.

The third major type of real option is the option to shut down if the project is not valuable. The example in this section is an opportunity to open a store in the Ferry Building in Boston. The lease is cancelable after two years at no cost. The uncertainty involves how many pedestrians the store will get each day. If only morning and evening commuters visit the store, the monthly cash inflows will be half as much as if the building becomes a tourist attraction. There is a 50% chance of each. Because the risk is diversifiable, the appropriate discount rate is the risk-free rate.

In this case, the firm has an abandonment option. If it turns out that the building does not become a tourist attraction, the firm will simply close the store after two years. So the NPV of the opportunity is the 50% chance of the positive-NPV alternative (the building gets high traffic) plus the 50% chance of the negative-NPV alternative, which is abandoned after two years. Figure 16.8 shows the decision tree.

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16.5 Investments with Different Lives Consider an opportunity to replace a machine with one of two designs. The first design has a five-year life, and the second machine has a 10-year life. The NPV of the longer-lived machine is higher. As the authors point out, this is partly true because the benefits of the project last longer. Three scenarios are considered: (1) the firm does not intend to replace the five-year project; (2) replacement will be made at the same terms as the original investment; and (3) replacement can be made at improved terms. In case 1, the original evaluation stands: The longer project should be adopted. In the second case, the NPV of the longer term project is still higher. In the third case, the shorter term project provides a higher NPV by allowing managers to take advantage of improved technology. Example 16.2 shows the value of the replacement option. The equivalent annual benefit is also illustrated, with a caveat that it assumes replacement happens at identical terms as the original.

16.6 Optimally Staging Investments The text next addresses the staging problem for mutually dependent investments. In the case where development of a product happens in multiple stages, each stage must be evaluated based on its scale, time to completion, and risk. Table 16.2 gives the required time, cost and likelihood of success for an electric car development project.

Equation 16.3 gives a general rule for deciding which stage to undertake first. In general, the riskiest stage with the highest time to completion should be conducted first, so that the investment in the remaining stages will not take place unless the first stage is successful. Example 16.3 shows how the order of the stages can be decided, and Example 16.4 shows the investment decision process.

16.7 Rules of Thumb This section discusses two rules of thumb for capital budgeting: the profitability index rule and the hurdle rate rule. The profitability index rule sets a different benchmark (rather than zero) for the profitability index. When there is an option to delay, a good rule of thumb is that PI must be greater than or equal to 1. The hurdle rate rule raises the discount rate used to calculate NPV. If NPV is still higher than zero, accept the project. Equation 16.4 shows one way to calculate the hurdle rate. When cash flows are constant and perpetual, and the reason to wait derives solely from interest rate uncertainty, the rule of thumb is always exact. Otherwise, the rule of thumb only approximates the correct decision. Example 16.5 shows how to use the hurdle rate rule.

16.8 Key Insights from Real Options The chapter closes with this restatement of the rules that have been developed. The authors highlight the following conclusions: (1) out-of-the-money real options have value, (2) in-the-money real options need not be exercised immediately, (3) waiting is valuable, (4) delay investment expenses as much as possible, and (5) create value by exploiting real options.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

16.1

Real Versus Financial Options

None

16.1

580

16.2

Decision Tree Analysis

1-4

16.2

580 - 583

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3

16.3

The Option to Delay: Investment as a Call Option

5 - 12

16.3 and 16.4

583 - 590

16.4

Growth and Abandonment Options

13 - 20

16.5

590 - 596

16.5

Investments with Different Lives

21 - 22

16.6 and 16.7

596 - 599

16.6

Optimally Staging Investments

23 - 24

16.8

599 - 601

16.7

Rules of Thumb

25 - 27

16.9

602 - 605

16.7

Key Insights from Real Options

None

16.10

605

IV. Spreadsheet Solutions in Excel The following problems for Chapter 16 have spreadsheet versions of the problems available: 16-2, 16-8, and 1618.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 17 Capital Structure in a Perfect Market I. Learning Objectives 17-1

Define the types of securities usually used by firms to raise capital; define leverage.

17-2

Describe the capital structure that the firm should choose.

17-3

List the three conditions that make capital markets perfect.

17-4

Discuss the implications of MM Proposition I, and the roles of homemade leverage and the Law of One Price in the development of the proposition.

17-5

Calculate the cost of capital for levered equity according to MM Proposition II.

17-6

Illustrate the effect of a change in debt on weighted average cost of capital in perfect capital markets.

17-7

Calculate the market risk of a firm’s assets using its unlevered beta.

17-8

Illustrate the effect of increased leverage on the beta of a firm’s equity.

17-9

Compute a firm’s net debt.

17-10 Discuss the effect of leverage on a firm’s expected earnings per share.

17-11 Show the effect of dilution on equity value.

17-12 Explain why perfect capital markets neither create nor destroy value.

II. Chapter Overview In this chapter, the capital structure decision is examined in a setting of perfect capital markets in which all securities are fairly priced, there are no taxes or transactions costs, and the total cash flows of the firm’s projects are no affected by how the firm finances them.

17.1 Equity versus Debt Financing Table 17.1 presents a risky project that can be financed completely with equity or with a portion of debt and the remainder in equity. Table 17.2 shows the return under each scenario, that shareholders would get with equity alone. The expected return is 15%.

Nest, the authors examine the case where the firm can raise part of the funding using debt.

Modigliani and Miller discovered that the value of the firm in this situation would be the same as under the equity scenario, because of the increased riskiness of the firm’s equity. Table 17.5 illustrates this point, showing the increase in the risk premium on equity. As the examples in the tables show, leverage increases the risk of equity even when there is no default risk.

17.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value This section shows how MM relates to the Law of One Price. Table 17.6 shows how individuals can replicate levered equity using homemade leverage. Table 17.7 shows how investors can replicate unlevered equity by buying both the debt and equity of the firm. The market value balance sheet is also introduced, so that market value of equity is defined as market value of assets—market value of debt and other liabilities.

The section also shows a leveraged recapitalization as an application of the preceding arguments.

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17.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital This section begins with Proposition I and shows proposition II. That is, the cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

The unlevered cost of capital (pretax WACC) is given in equation 17.6. As Figure 17.1 shows, the weighted average cost of capital is independent of capital structure. Figure 17.1 also has a data table that corresponds to the text example, showing there is no change in cost of capital.

Equation 17.8 shows the unlevered beta as a weighted average of the equity beta and the debt beta.

The authors solve for the equity beta in equation 17.9.

17.4 Capital Structure Fallacies This section examines two incorrect arguments that are sometimes cited in favour of leverage: 1) leverage increases equity value because it increases earnings per share and 2) issuing new equity results in dilution. First, although leverage often increases earnings per share, it also increases the risk of the equity thus increasing the cost of equity. Example 17.9 illustrates this concept. Second, the authors show that, as long as shares are sold at a fair price, there is no such thing as dilution.

17.5 MM: Beyond the Propositions The MM propositions were important in the field not just for their findings, but for the way in which they taught finance researchers to reason. Proposition I was one of the first arguments to use the Law of One Price. The authors cite an excerpt from John Burr Williams’ 1938 book The Theory of Investment Value. They apply the concepts from that chapter to a conservation of value principle that states, “With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).”

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

17.1

Equity Versus Debt Financing

1-4

17.1 and 17.2

615 - 619

17.2

Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

5-9

17.3 and 17.4

619 - 624

17.3

Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

10 - 20

17.5 to 17.9

624 - 631

17.4

Capital Structure Fallacies

21 - 24

17.10 and 17.11

631 - 636

.

2

17.5

MM: Beyond the Propositions

None

71.12

636 - 637

IV. Spreadsheet Solutions in Excel The following problems for Chapter 17 have spreadsheet versions of the problems available: 17-5, 17-9 and 17-21. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 18 Debt and Taxes I. Learning Objectives 18-1

Explain the effect of interest payments on cash flows to investors.

18-2

Calculate the interest tax shield, given the corporate tax rate and interest payments.

18-3

Calculate the value of a levered firm.

18-4

Calculate the weighted average cost of capital with corporate taxes.

18-5

Describe the effect of a leveraged recapitalization on the value of equity.

18-6

Describe the effect of personal taxes on the corporate tax benefits of leverage.

18-7

Given corporate and personal tax rates on equity and debt, calculate the tax benefit of debt with personal taxes.

18-8

Discuss why the optimal level of leverage from a tax-saving perspective is the level at which interest equals EBIT.

18-9

Describe the relationship between the optimal fraction of debt and the growth rate of the firm.

18-10 Assess the apparent under-leveraging of corporations, both domestically and internationally.

II. Chapter Overview The motivation for this chapter is empirical observation of corporate capital structure. In particular, if capital structure is unimportant, why do we see consistent differences in capital structure across firms and industries?

Also, why do managers spend time thinking about capital structure if it’s irrelevant?

This chapter focuses on the impact of taxes on the capital structure decision. The first part considers the benefits of debt in the presence of corporate taxes. Later, personal taxes are included to show their effect on the capital structure choice.

18.1 The Interest Tax Deduction In this section the authors show the value of the interest tax shield. The calculation is shown as equation 18.1:

18.2 Valuing the Interest Tax Shield This section of the chapter shows how to calculate the value of the levered firm. Equation 18.2 is a general formula—Example 18.2 shows the calculation for risk-free ten-year maturity debt. The analysis is extended to permanent debt with equation 18.4:

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The authors then show the effect of taxes on the weighted average cost of capital, so that risk can be incorporated into the analysis. Example 18.3 shows the effect of a target debt-equity ratio on the interest tax shield.

18.3 Recapitalizing to Capture the Tax Shield The authors first compute the value of the levered firm, then subtract the debt value to show the new value of equity. If the stock is repurchased at its pre-recapitalization rate, then the stock price will increase. The authors then use an arbitrage argument to explain that the company will not be able to repurchase at the previous price, and show how to calculate the new price. They conclude that, “When securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage.” Finally, the authors show how the leveraged recapitalization impacts the market value balance sheet in Table 18.2.

18.4 Personal Taxes This section includes the consequences of the combination of personal and corporate taxes. Table 18.3 shows federal and combined federal and provincial tax rates for the top tax bracket in Canada for the year 2020. Figure 18.3 is a visual aid to understanding how taxes are paid, so that equation 18.7, showing the effective tax advantage of debt, is easily derived. Figure 18.4 shows the effective tax advantage of debt with across provinces and territories by considering investments in both tax-exempt and taxable accounts.

Equation 18.8 shows the adjustment that must be made in calculating the value of the levered firm in the presence of personal taxes. The final part of the section provides a discussion of the assumptions made to derive the results and the impact of changes in those assumptions.

18.5 Optimal Capital Structure with Taxes Figure 18.5 shows net external financing and capital expenditures of corporations in Canada from 1970- 2019.

This chart indicates that while most companies seem to prefer using debt when raising external funds, not all investment is externally financed. Figure 18.5 also shows that because capital expenditures greatly exceed firms’ external financing, most investment and growth is supported by internally generated funds such as retained earnings. Thus, even though firms have not issued as much new equity as new debt, the market value of equity has risen over time as firms have grown. In fact Figure 18.6 shows debt, as a fraction of firm value has varied in a range from 32% to 45% on aggregate for all firms. The average debt- to-value ratio is higher in times when the stock market is lower. Figure 18.7 shows debt as a fraction of firm value by industry sector and for the market. It is clear that there are large differences across industries.

There are several explanations for this difference. First, in order to receive tax benefits, a company must pay taxes. Table 18.4 shows that the optimal level of interest to pay, from a tax perspective, is the amount equal to EBIT. The consequences of regularly incurring interest charges that exceed EBIT are discussed in Chapter 19.

When EBIT is uncertain, the tax savings declines for high levels of interest, as shown in Figure 18.8.

Growth will affect the optimal leverage ratio, even for firms with positive earnings. The higher the firm’s growth rate, the lower will be the optimal proportion of debt in the capital structure. In addition, when firms have other tax shields, taxable earnings will be reduced without incurring interest payments.

The chapter concludes with a discussion of the actual levels of leverage and interest as a percent of EBIT for Canadian companies. The conclusion is that, both in Canada and internationally (as shown by Table 18.5), firms tend to be under-leveraged. This observation motivates the discussion of costs of financial distress in Chapter 19.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

18.1

The Interest Tax Deduction

1-4

18.1

645 - 647

18.2

Valuing the Interest Tax Shield

5 - 15

18.2 to 18.4

647 - 652

18.3

Recapitalizing to Capture the Tax Shield

16 - 19

18.5

653 - 656

18.4

Personal Taxes

20 – 24

18.6 and 18.7

656 - 661

18.5

Optimal Capital Structure with Taxes

25 - 27

18.8 to 18.10

661 - 669

IV. Spreadsheet Solutions in Excel The following problems for Chapter 18 have spreadsheet versions of the problems available: 18-4, 18-5, 18-7 and 18-27. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 19 Financial Distress, Managerial Incentives, and Information I. Learning Objectives 19-1

Describe the effect of bankruptcy in a world of perfect capital markets.

19-2

List and define the relevant acts for financially distressed firms in Canada

19-3

Contrast the Canadian and American acts that allow firms to file for protection or bankruptcy.

19-4

Discuss several direct and indirect costs of bankruptcy.

19-5

Illustrate why, when securities are fairly priced, the original shareholders of a firm pay the present value of bankruptcy and financial distress costs.

19-6

Calculate the value of a levered firm in the presence of financial distress costs.

19-7

Define agency costs, and describe agency costs of financial distress and agency benefits of debt.

19-8

Describe how debt can motivate managers.

19-9

Calculate the value of the firm, including financial distress costs and agency costs.

19-10 Explain the impact of asymmetric information on the optimal level of leverage.

19-11 Describe the implications of adverse selection and the lemons principle for equity issuance; describe the empirical implications.

19-12 Discuss why most changes in capital structure occur passively.

II. Chapter Overview Chapter 18 concluded that Canadian firms use less leverage than theory justifies. Chapter 19 describes imperfections that explain at least part of this result.

19.1 Default and Bankruptcy in a Perfect Market The authors begin the chapter by considering a hypothetical company (Armin Industries) that has a new project available that can save its falling revenues. If the product is a hit, the company will be worth $150 million by year end. Otherwise, it will be worth $80 million. It can finance this expansion with 100% equity or with debt with a face value of $100 million due at year-end.

This section of the chapter examines what happens if the new product succeeds or fails in a setting of perfect capital markets. Table 19.1 summarizes the outcomes. It shows that the total loss if the product fails will be the same whether the company has leverage or not. If the company has leverage, it will declare bankruptcy, but the failure of the product will cause economic distress in either case. If the company declares bankruptcy, it will also experience financial distress.

The section concludes that, as long as a firm can raise capital at a fair price, it need not default as long as the market value of its assets exceeds the market value of its liabilities.

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19.2 The Costs of Bankruptcy and Financial Distress “With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt—bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors.” In this section, the authors describe the long, complicated process of bankruptcy in both Canada and the U.S.; in Canada the Bankruptcy and Insolvency Act (BIA) and the Companies’ Creditors Arrangement Act (CCAA) are described along with a “plan of arrangement” and a “stay”. For the U.S., Chapter 7 liquidation and Chapter 11 reorganization are contrasted with the Canadian acts. The authors further describe direct and indirect costs of bankruptcy and conclude that the direct and indirect costs of financial distress may be substantial.

19.3 Financial Distress Costs and Firm Value This section begins the discussion of firm value when financial distress is costly. In the case of Armin Industries, if bankruptcy is costly, the value of the firm with leverage, in case of failure, is lower than it would be without leverage. Example 19.2 illustrates this point.

The section concludes with a discussion of who pays for bankruptcy and financial distress costs. The authors show that, when securities are fairly priced, the costs associated with bankruptcy and financial distress are paid by the original shareholders. Example 19.3 illustrates that concept.

19.4 Optimal Capital Structure: The Trade-off Theory Equation 19.1 shows the total value of the levered firm with financial distress costs. These costs are hard to calculate, since doing so involves estimating the probability of financial distress, as well as the cost. The tradeoff theory states that firms should increase their leverage until firm value is maximized, which is the point at which tax savings from increased leverage are offset by the increased probability of financial distress. Example 19.4 illustrates.

19.5 Exploiting Debt Holders: The Agency Costs of Debt In this section, the agency costs of debt are addressed. The text uses the example of a firm that will default on its debt if it does not change its strategy. Given the opportunity to invest in a risky asset that has a chance of retaining some value for shareholders, management, acting in the interest of shareholders, has the incentive to engage in this project, even if it has a negative NPV. The additional agency costs described are the underinvestment motive (debt overhang) and the incentive to liquidate assets. Example 19.5 shows how to estimate the debt overhang.

The leverage ratchet effect asserts that if the company has debt in place, shareholders may have an incentive to increase leverage (or decide not to decrease it) even if it will reduce the value of the firm. Example 19.7 illustrates this concept.

There are ways to mitigate the agency costs of debt. First, the agency costs of debt are smaller for short-term debt, though its use will require the firm to refinance its debt more frequently. Second, creditors often place covenants on the debt that are designed to reduce agency costs.

19.6 Motivating Managers: The Agency Benefits of Debt This section discusses the agency benefits of debt. In particular, debt will allow original shareholders to retain their fractional ownership without infusing capital. As a result, managers who are also shareholders may spend less on perks. High debt payments may also reduce wasteful investment, due to empire building or managerial overconfidence. Here the authors discuss the free cash flow hypothesis.

19.7 Agency Costs and the Trade-off Theory Equation 19.3 shows the value of the levered firm in the presence of financial distress costs and agency costs.

Figure 19.2 illustrates the optimal choice of leverage under these circumstances.

The trade-off theory explains how firms should choose their capital structures—not necessarily what they do in .

2

practice. Managerial entrenchment theory suggests managers choose capital structure to avoid the “discipline of debt” and maintain job security. However, they must have enough debt to satisfy shareholders.

19.8 Asymmetric Information and Capital Structure The previous discussion assumed that all parties have the same information and that securities are fairly priced.

In this section, those assumptions are relaxed. The authors use a hypothetical company with good prospects that cannot be revealed to explain the signaling theory of debt. In order to credibly signal the positive prospects, the manager must commit enough cash flow to debt that it would be costly to signal unless she is certain about the prospects. Example 19.8 shows how the credibility of the signal affects investor reactions.

The authors use the Akerlof lemon’s problem to explain adverse selection and the lemons principle, which in turn explains why firms are reluctant to issue equity. Example 19.9 shows the consequence of adverse selection.

The three major implications for equity issuance are that: 1) the stock price declines on the announcement of an equity offering, 2) the stock price tends to rise prior to the issue and that 3) firms tend to issue equity when information asymmetries are minimized, such as after earnings announcements. These implications are empirically supported.

The next topic in this section is the pecking order hypothesis, which results from information asymmetry and the adverse selection problem. Example 19.10 illustrates this hypothesis.

Finally, the market timing view of capital structure suggests that the firm’s overall capital structure depends on market conditions when funding was sought. Hence, similar firms in the same industry might wind up with different capital structures, even though each was minimizing cost of capital.

19.9 Capital Structure: The Bottom Line This section provides a summary of the previous discussion. The authors also point out that most changes in capital structure occur passively, as the market value of equity fluctuates with changes in the firm’s stock price.

III. MyLab Finance Activities Text Section

Text Section Title

Problems Learning Objectives Covered

Text Page Reference

19.1

Default and Bankruptcy in a Perfect Market

1-2

19.1

676 - 679

19.2

The Costs of Bankruptcy and Financial Distress

3–7

19.2 to 19.4

679 - 684

19.3

Financial Distress Costs and Firm Value

8 - 10

19.5

684 - 686

19.4

Optimal Capital Structure: The Tradeoff Theory

11 - 15

19.6

686 - 688

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3

19.5

Exploiting Debt Holders: The Agency Costs of Debt

16 - 20

19.7

689 - 695

19.6

Motivating Managers: The Agency Benefits of Debt

21 - 23

19.8

696 - 700

19.7

Agency Costs and the Tradeoff Theory 24 - 27

19.9

700 - 702

19.8

Asymmetric Information and Capital Structure

28 - 30

19.10 and 19.11

702 - 711

19.9

Capital Structure: The Bottom Line

None

19.12

711 - 712

IV. Spreadsheet Solutions in Excel The following problems for Chapter 19 have spreadsheet versions of the problems available: 19-1, 19-8, 19-19 and 19-22.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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4

Chapter 20 Payout Policy I. Learning Objectives 20-1

List two ways a company can distribute cash to its shareholders.

20-2

Describe the dividend payment process and the open-market repurchase process.

20-3

Define stock split and stock dividend; describe the effect of those actions on stock price.

20-4

Discuss the effect of dividend payment or share repurchase in a perfect world.

20-5

Assuming perfect capital markets, describe what Modigliani and Miller (1961) found about payout policy.

20-6

Discuss the effect of taxes on dividend policy.

20-7

Compute the effective dividend tax rate.

20-8

Provide reasons why firms might accumulate cash balances rather than pay dividends.

20-9

Describe the effect of agency costs on payout policy.

20-10 Assess the impact of information asymmetry on payout policy.

20-11 Describe the relationship between stock price and number of shares for: stock splits, reverse splits and stock dividends.

II. Chapter Overview This chapter shows that payout policy has similar constraints and motivations as capital structure. Dividend policy is shaped by market imperfections, such as taxes, agency costs, transaction costs, and asymmetric information, just as capital structure is. The chapter discusses why some firms pay dividends and some do not, and why some firms prefer share repurchases.

20.1 Distributions to Shareholders This section describes the payment process for dividends. In addition, the authors briefly touch on stock splits and stock dividends, as well as special and liquidating dividends. The alternative processes for share repurchase (open market, tender offer, Dutch auction, targeted repurchase and greenmail) are also described.

20.2 Comparison of Dividends and Share Repurchases This section introduces a hypothetical company with a large amount of cash that will increase substantially and permanently in the next year. There are three alternative forms of payout: (1) pay a dividend, (2) repurchase shares, or (3) issue equity to pay a high dividend in order to keep the dividend payment steady. The analysis shows that, in a setting of perfect capital markets, there is no difference among the three alternatives. Table 20.1 shows the Modigliani and Miller Irrelevance theorem.

20.3 The Tax Disadvantage of Dividends Because dividends are generally taxed at a higher present value rate (in Canada and the United States) than capital gains, dividends are tax disadvantaged. In fact, as Example 20.2 shows, issuing equity to pay dividends returns shareholders less money than they put in. Figure 20.4 shows the declining use of dividends over the past 30 years, and an increasing use of repurchases. Most notable is the trend away from any sort of dividend payout, which has reversed since the U.S.’s 2003 dividend tax cut. .

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20.4 Dividend Capture and Tax Clienteles This section quantifies the combined effects of dividend and capital gains taxes. Equation 20.3 gives the effective dividend tax rate. This rate will differ across investors. This section considers four different factors affecting investors— including income level, investment horizon, tax jurisdiction, and type of investor or investment accounts— and calculates the effective dividend tax rate for each. Example 20.3 shows how to calculate the effective dividend tax rate. Table 20.2 summarizes payout preferences among different types of investor.

The dividend-capture theory states that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend. An implication of this theory is that investors in low tax brackets buy the stock just before the ex-dividend date to collect the dividend then sell the stock shortly after. This contention is empirically supported by the observed increase in volume at that time (Figure 20.6) 20.5 Payout versus Retention of Cash This section explains how firms choose the amount to pay out to shareholders. It starts out with the Modigliani and Miller (1961) finding that, in perfect capital markets, the choice of payout versus retention is irrelevant. In reality, though, the firm must pay taxes on earnings from the funds retained; therefore, it is generally better to pay the funds out. Example 20.5 gives an example of the tax disadvantage to cash, while Example 20.6 provides an example in the context of Microsoft’s special dividend.

There are, however, issuance and financial distress costs if the firm pays out the funds that it could have used later. There are also agency costs associated with retaining cash, as discussed in Chapter 19, that arise if managers are tempted to spend excess cash on inefficient investments and perks. Firms should choose to retain cash for the same reasons as they use low leverage—to preserve financial slack.

20.6 Signalling with Payout Policy Firms seldom vary the size of their dividend (they smooth dividends). If this is the case, then dividend choice will contain information regarding expectations of future earnings. This dividend signalling is similar to the use of leverage described in Chapter 19. Specifically, dividend changes may reflect managers’ views about a firm’s future earnings prospects.

Share repurchases might also signal information to the market. However, there are several differences between repurchases and cash dividends. First, the actual amount spent may be far less than the amount promised, and it may take several years to finish. Second, firms do not smooth repurchase activity. Third, the cost of a share repurchase depends on the market price of the stock. Because repurchasing shares that are overvalued is a negative-NPV project, managers who do a repurchase are signaling that their stock price is undervalued.

20.7 Stock Dividends, Splits, and Spin-offs The chapter closes with a definition of stock splits, reverse splits and dividends. The authors attempt to answer the question about why firms split their stock. They conclude that the goal is to keep the stock price within a range that will allow investors to more easily trade the stock, given that fractional ownership of shares is not allowed. Figure 20.8 shows the distribution of stock prices in January of 2018.

Spin-offs are a different type of distribution. The company issues shares in a subsidiary in place of a special dividend. This action avoids transaction costs of paying dividends and the special dividend is not taxed as if it were cash. Instead, investors pay capital gains tax when they sell shares.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

20.1

Distributions to Shareholders

1-3

20.1 to 20.3

723 - 726

20.2

Comparison of Dividends and Share Repurchases

4-9

20.4 and 20.5

726 - 732

20.3

The Tax Disadvantage of Dividends

10

20.6

732 - 735

20.4

Dividend Capture and Tax Clienteles 11 - 17

20.7

735 - 739

20.5

Payout Versus Retention of Cash

18 - 24

20.8 and 20.9

739 - 745

20.6

Signalling with Payout Policy

25 - 27

20.10

745 - 750

20.7

Stock Dividends, Splits, and Spinoffs

28 - 32

20.11

750 - 755

IV. Spreadsheet Solutions in Excel The following problems for Chapter 20 have spreadsheet versions of the problems available: 20-19, 20-20, 2021, 20-27 and 20-29. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 21 Capital Budgeting and Valuation with Leverage I. Learning Objectives 21-1

Describe three methods of valuation discussed in the chapter.

21-2

List the key steps in the WACC method.

21-3

List the key steps in the APV method.

21-4

List the key steps in the Flow-to-Equity method.

21-5

Compute the unlevered and equity costs of capital, and explain how they are related.

21-6

Estimate the cost of capital for a project, even if its risk is different from that of the firm as a whole.

21-7

Estimate the cost of capital for a project, given the project’s debt-to-value ratio, assuming (1) the firm maintains a target leverage ratio, or (2) some tax shields are predetermined.

21-8

Discuss the importance of considering the overall incremental impact of the leverage of a project on the firm.

21-9

Calculate the levered value of a project if (1) the firm has a constant interest coverage policy, or (2) the firm keeps debt at a constant level.

21-10 Describe situations in which the WACC method is best to use and situations in which the APV method is advisable.

21-11 Discuss how issuance costs and mispricing costs should be included in the assessment of the project’s value.

21-12 Calculate the value of the interest tax shield if a firm adjusts its debt annually to a target level.

21-13 Describe the effects of financial distress on the use of leverage.

21-14 Adjust the APV method for personal taxes.

12A.1 Examine the relationships between levered and unlevered costs of capital and solve for leverage policy and value simultaneously.

II. Chapter Overview This chapter discusses complexities in capital budgeting that were treated as assumptions in Chapter 9. The authors address how to estimate the appropriate cost of capital, and also how the financing decision can affect the cost of capital and the cash flows. The first part of the chapter introduces the three main methods for capital budgeting with leverage and market imperfections: 1) the weighted average cost of capital (WACC) method 2) the adjusted present value (APV) method and 3) the flow-to-equity (FTE) method. The assumptions made in Chapter 9 were also made in this part. The remainder of the chapter relaxes these assumptions. Section 21.5 examines the use of the three methods when risk or debt capacity is very different from the rest of the firm.

Section 21.6 considers alternative leverage policies for the firm, and uses the APV method to analyze that situation. Section 21.7 addresses other market imperfections. Section 21.8 investigates some advanced topics.

An appendix to the chapter examines the foundations for the WACC model and the relationship between a firm’s levered and unlevered costs of capital. It also addresses how to solve for a firm’s leverage policy and value simultaneously using Excel. An accompanying Excel spreadsheet contains many of the chapter’s tables.

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21.1 Overview The three methods are introduced in Sections 21.2 through 21.4. Each method is applied to the same example, in which the following assumptions are made: 1) the project has average risk 2) the firm’s debt- to-equity ratio is constant and 3) corporate taxes are the only imperfection.

21.2 The Weighted Average Cost of Capital Method.

The project under consideration used in next three sections is by Avco, Inc., a manufacturer of custom packaging products. The company is considering a new line of packaging. The expected free cash flows are given in Table 21.1.

To summarize, the steps are: 1. Determine the free cash flow of the investment.

2. Compute the weighted average cost of capital using equation 21.1.

3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC. Example 21.1 uses the WACC method to value an acquisition. The next section of the chapter shows how debt capacity is computed, assuming a constant debt-to-equity ratio.

21.3 The Adjusted Present Value Method In the APV method, we “determine the levered value VL of an investment by first calculating its unlevered value VU, which is its value without any leverage, and then adding the value of the interest tax shield and deducting any costs that arise from other market imperfections.” Equation 21.5 gives the APV formula. This method was used in Chapter 19 to determine the optimal level of debt according to the tradeoff theory.

The steps to calculating the APV method are: 1. Determine the investment’s value without leverage by discounting its free cash flows at the unlevered cost of capital.

2. Determine the present value of the interest tax shield.

3. Add the unlevered value to the present value of the interest tax shield.

The APV method is a little more complicated than the WACC method, for several reasons. One reason is that debt and value must be solved simultaneously, as long as management intends to maintain a constant debt-toequity ratio. It is, however, easier to apply APV than WACC when the debt-to-equity ratio changes. Also, the APV approach explicitly values the market imperfections, which will allow closer examination of those.

Example 21.1 is repeated using APV in Example 21.4. This example shows that the value of the acquisition is derived largely from the interest tax shield.

21.4 The Flow-to-Equity Method This method focuses on value to shareholders. Its calculation involves computing free cash flow to equity holders, excluding all payments made to debt. The first step is to calculate the free cash flow to equity.

Table 21.6 shows this calculation for Avco’s RFX Project.

The steps in the Flow-to-Equity Method are: 1. Determine the free cash flow to equity using equation 21.9: 2. Determine the equity cost of capital.

3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital.

Example 21.5 shows the application of the FTE model to Avco’s project. Like the APV method, FTE method requires an additional calculation over and above the WACC method. Therefore, WACC is often the easiest method to use. The FTE method has an advantage primarily in that it emphasizes the value to equity holders.

21.5 Project-Based Costs of Capital This section addresses how the calculations change when the project under consideration has different characteristics than the company as a whole. For this section, the authors suggest that Avco launches a new plastics manufacturing division that is very different from its main packaging business. The first step they take .

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is to calculate the proper unlevered cost of capital. In Example 21.6, they use a comparable company method.

This cost can be used for the APV method, but for the other two methods cost of equity is required. Equation 21.10 is used for this calculation. Equation 21.11 shows a more direct method to calculate weighted average cost of capital.

It is very important to use the incremental financing to adjust the cost of capital. This is not necessarily the same as financing that is tied directly to the project. Some important factors to remember are: 1) cash is negative debt 2) a fixed payout policy implies 100% debt financing 3) optimal leverage depends on project and firm characteristics and 4) safe cash flows can be 100% debt financed. Example 21.7 gives information about Apple’s debt financing.

21.6 APV with Other Leverage Policies When the debt-equity ratio is not constant, the WACC and FTE approaches are difficult to use. The APV method is fairly easy. This section of the chapter shows how APV can be adjusted when there is a constant interest coverage ratio or predetermined debt levels. Equation 21.14 shows how to compute the levered value with a constant interest coverage ratio. Example 21.8 shows an application.

Table 21.8 shows a fixed debt schedule for Avco’s RFX project. When these levels are predetermined, we can simply use the discounted value of the interest tax shields directly in the equation, as in equation 21.15. When this is the case, the WACC will not give the same answer as APV without adjustment, as shown in Section 21.8.

21.7 Other Effects of Financing This section considers ways to adjust valuation to account for issuance costs, security mispricing, and financial distress and agency costs. Table 21.9 shows fees that are typically assessed for raising capital. These should be deducted from the investment’s NPV. Example 21.9 shows how to adjust for mispricing of a loan. Free cash flows must be adjusted to include expected distress and agency costs. Also, cost of capital will be affected.

Example 21.10 shows how this can be done.

21.8 Advanced Topics in Capital Budgeting Four complications are addressed in this section: 1) the case in which debt is periodically adjusted 2) the relationship between a firm’s equity and unlevered cost of capital for alternative leverage policies 3) when the firm’s debt-equity ratio changes over time and 4) includes the effects of personal taxes. In general, managers adjust their leverage ratio sporadically, rather than continuously. Equation 21.16 shows how the APV formula can be improved to calculate the correct interest tax shield in this case. The other two methods can also be adjusted. The new equations are 21.17 and 21.18. Example 21.11 shows the calculations.

Three different levels of frequency with which debt is assumed to adjust to growth of the investment are considered here: 1) continuously adjusted debt 2) annually adjusted debt and 3) permanent debt. Equations 21.19 through 21.21 show how these adjustments can be made using the APV method and Example 21.12 illustrates. The WACC or FTE method may also be used, but they are more complicated. Equation 21.22 shows how to adjust the WACC method—the FTE method uses the same approach.

The WACC method does not change in the presence of personal taxes. The APV method does change. The unlevered cost of capital changes, as does the interest tax shield. Example 21.13 shows how to calculate the value of an expansion including the effect of personal taxes.

Chapter 18 Appendix: Foundations and Further Details The appendix derives the WACC method starting by redefining WACC in terms of firm value. It then examines the relationship between levered and unlevered cost of capital. Next, it illustrates how to use a spreadsheet to solve for leverage and value simultaneously. Finally, the residual income valuation method and the economic value added are discussed.

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3

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

21.1

Overview

1-4

21.1

765 - 766

21.2

The Weighted Average Cost of Capital Method

5-7

21.2

766 - 771

21.3

The Adjusted Present Value Method

8 - 10

21.3

771 - 775

21.4

The Flow-to-Equity Method

11 - 12

21.4

776 - 779

21.5

Project-Based Costs of Capital

13 - 15

21.5 to 21.8

780 - 784

21.6

APV with Other Leverage Policies

16 - 19

21.9 and 21.10

784 - 787

21.7

Other Effects of Financing

20 - 23

21.11

787 - 791

21.8

Advanced Topics in Capital Budgeting

24 - 28

21.12 to 21.14

791 - 799

21.A

Foundations and Further Details

None

12A.1

809 - 815

.

4

IV. Spreadsheet Solutions in Excel The following problems for Chapter 21 have spreadsheet versions of the problems available: 21-15, 21-16, 2118, 21-21, 21-26 and 21-28. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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5

Chapter 22 Valuation and Financial Modelling: A Case Study I. Learning Objectives 22-1

Describe the use of comparables as a preliminary way to estimate firm value.

22-2

Identify the primary factors to consider when estimating the firm’s future cash flows.

22-3

Describe the use of a financial model in projecting future cash flows from an investment.

22-4

Use the CAPM to estimate the equity cost of capital for a proposed project, using betas of comparable firms.

22-5

Use a valuation multiple to estimate the continuation value for a firm or a project.

22-6

Use the discounted cash flow method to estimate a continuation value for a firm or a project.

22-7

Use the valuation methods described in Chapter 21 to calculate firm value.

22-8

Discuss the use of IRR and cash multiples as alternative valuation metrics, and discuss the drawbacks of those methods.

22-9

Calculate IRR and cash multiples for a given firm or project.

22-10 Describe the use of sensitivity analysis in evaluating the uncertainty of the value of the deal.

22-A Determine the value of incentive based managerial compensation plans.

II. Chapter Overview This chapter is an extended example of how a venture capital firm (PKK) might assess the purchase of a company, Ideko, which specializes in sports eyewear. The principals believe that the firm can be purchased for $150 million. The chapter examines multiples analysis, then goes through the APV model step by step, then evaluates the sensitivity of the estimates. An accompanying Excel spreadsheet contains many of the chapter’s tables and examples.

22.1 Valuation Using Comparables Valuation using comparables may be used as a preliminary way to estimate the value of a firm. Table 22.1 shows the estimated end-of-year income statement and balance sheet for Ideko. Financial ratios for Ideko under the current purchase proposal, as financial ratios for three competitors and the sporting goods industry appear in Table 22.2. This section provides valuation estimates using P/E, EV/Sales, and EV/EBITDA, showing a range of prices for each.

22.2 The Business Plan PKK plans to make some changes to Ideko, in order to improve their profitability. This section of the chapter discusses those changes and the use of a financial model to estimate the firm’s future cash flows. Areas to consider include operational improvements, capital expenditures if the sales increase as much as anticipated, improvements in working capital management, and capital structure changes. Each change is illustrated in a spreadsheet.

22.3 Building the Financial Model This section gives step-by-step instructions as to how to construct a pro forma income statement. The authors then use that forecast to estimate free cash flows. The final estimate of free cash flows is in Table 22.10. Example 22.4 shows the difference in the free cash flow to equity should PKK use less debt in its .

1

acquisition of Ideko. The final part of the section labelled “optional” illustrates construction of pro forma balance sheets and statement of cash flows in Tables 22.11 and 22.12.

22.4 Estimating the Cost of Capital To value the investment, we assess its risk and estimate an appropriate cost of capital using the CAPM. Using the comparable firms given before, the authors show how to estimate the equity cost of capital for PKK’s investment in Ideko. They discuss two betas of the comparable firms, one based on monthly returns and one based on 10-day returns. They estimate 95% confidence intervals, and unlever the betas so they can be relevered using PKK’s intended capital structure. The result appears in Table 22.14, where it is clear that there is a great deal of variance in the beta estimates. The authors make a decision about which beta to use, then use the SML to estimate the equity cost of capital. The authors also discuss where they found their risk-free rate and market risk premium. Example 22.5 shows how the range of unlevered cost of capital estimates can be found.

22.5 Valuing the Investment The next topic of discussion is estimating the firm’s continuation value (or terminal value). The authors show how to use comparables and the discounted cash flow approach to find this value. Table 22.16 shows how the authors come to a final conclusion about the continuation enterprise value of Ideko.

The next portion of the chapter shows how to find the adjusted present value of Ideko equity. They also discuss whether their final estimate, found in Table 22.17, is realistic. Finally, the authors discuss the use of IRR and cash multiples to determine the profitability of the project. Both are discussed because they are commonly used in practice. However, the authors point out that the cash multiple approach can only be used to compare deals with similar time horizons and risk.

22.6 Sensitivity Analysis In this final section, the authors emphasize that the analysis is based on estimates. It is important to assess the uncertainty of the estimates and to evaluate the impact of an error in the estimates on the value of the deal. The spreadsheet in Table 22.20 shows sensitivity analysis with the ending enterprise value and a change in the assumption about the unlevered cost of capital. The end-of-chapter problems in Chapter 22 continue this sensitivity analysis by requiring students to assess the impact of estimation errors in some of the other inputs.

Appendix 22.A: Compensating Management This appendix discusses motivations for offering incentive based compensation to managers, how to value that compensation, and its effect on the NPV of the project, as well as share value.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

22.1

Valuation Using Comparables

1

22.1

817 -819

22.2

The Business Plan

2-3

22.2

819 - 823

.

2

22.3

Building the Financial Model

4 - 10

22.3

823 - 832

22.4

Estimating the Cost of Capital

11 - 12

22.4

832 - 835

22.5

Valuing the Investment

13 - 19

22.5 to 22.9

835 - 842

22.6

Sensitivity Analysis

None

22.10

842 - 843

22.A

Compensating Management

None

22.A

847 - 848

IV. Spreadsheet Solutions in Excel The following problems for Chapter 22 have spreadsheet versions of the problems available: 22-2, 22-3, 22-4, 22-5, 22-6, 22-7, 22-8, 22-9, 22-10, 22-13, 22-15, 22-16, 22-17, 22-18 and 22-19.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 23 Raising Equity Capital I. Learning Objectives 23-1

Describe the ways in which a private company can raise outside capital.

23-2

Discuss the effects of a company founder selling stock to an outsider.

23-3

Identify the two main exit strategies used by equity investors in private companies.

23-4

Demonstrate the role of Sovereign Wealth Funds in the private equity market.

23-5

Define an initial public offering, and discuss their advantages and disadvantages.

23-6

Distinguish between primary and secondary offerings in an IPO.

23-7

Describe typical methods by which stock may be sold during an IPO; discuss risks for parties involved in each method.

23-8

Evaluate the role of the underwriter in an IPO.

23-9

Describe the IPO process, including the methods underwriters use to value a company before its IPO.

23-10 Identify ways in which underwriters can mitigate risk during an IPO. 23-11 List and discuss four puzzles associated with IPOs. 23-12 Define a seasoned equity offering; describe two ways in which it can be brought to market and identify the stock price reaction to its announcement.

II. Chapter Overview The chapter begins by reminding us that most Canadian companies are sole proprietorships or partnerships.

However, most economic activity (62%) is generated by large corporations. The chapter discusses how businesses gain access to capital by examining a real company, RealNetworks.

23.1 Equity Financing for Private Companies This section identifies sources of funding for private companies, including angel investors, venture capital firms, private equity firms, institutional investors, sovereign wealth funds and corporate investors. Table 23.1 shows the top venture capital firms (ranked by deals) in Canada and Figure 23.1 shows venture capital funding in Canada from 1996 through 2019 as measured by both number of deal per year versus number of dollars. A callout box describes crowdfunding.

RealNetworks was founded by Robert Glaser in 1993 with an initial investment of $1 million. The company needed outside capital, and they decided on convertible preferred. They issued $1.8 million of convertible preferred, totalling 16.4% of the company. They placed three subsequent issues, all to angel investors, institutional investors, or corporate investors. Because the company was still private, it was difficult to liquidate the shares. There are two exit strategies for this type of investor. The firm could be acquired, or it could issue an IPO.

.

1

Typical features of venture financing terms are defined in this section. Liquidation preference specifies a minimum amount venture capital investors must receive before any payments to common stockholders can be made. Most venture capital firms require seniority over investors in earlier rounds. Participation rights are often required for holders of convertible shares so that they receive their liquidation preference as well as any payments to common shareholders. Anti-dilution protection lowers the price at which investors in earlier rounds can convert their shares to common. New investors may also negotiate the right to appoint one or more members to the board of directors of the firm. Example 23.2 requires calculating the minimum sale price such that all investors will convert their shares.

There is a call-out box in this chapter that illustrates the life cycle of a typical successful start-up firm from launch to IPO. 23.2 The Initial Public Offering This section begins with a discussion of the advantages and disadvantages of going public. Next, the chapter introduces various types of offerings, such as primary versus secondary offerings and best-efforts, firm commitment, and auction IPOs. Example 23.3 shows how an auction IPO is priced.

The next part of the chapter outlines the mechanics of an IPO, from the underwriters and the syndicate to the provincial securities filings (SEC in the U.S.), to valuation. The section on valuation discusses the importance of book building. The front page of the prospectus for RealNetworks’ IPO appears in Figure 23.2. The RealNetworks offer was underwritten, and also had a greenshoe provision. The IPO price was 12.50 per share, of which 7% was an underwriter’s fee. In the case of RealNetworks, the underwriters sold the entire allotment, including the greenshoe provision. The text describes the consequence when the issue is undersold, as well as the lockup period and underwriter support for the issue. Example 23.4 shows how an IPO is valued using comparables.

This section also describes the IPO puzzles related to underpricing, cyclicality, high issuance costs, and long-run underperformance. Figure 23.3 shows international first day IPO returns. Example 23.5 illustrates the winner’s curse. Figure 23.4 shows the cyclicality of IPOs in the United States. Figure 23.5 shows the relative costs of issuing securities.

23.3 The Seasoned Equity Offering This section describes the process that companies follow in an SEO. The chapter also examines rights offers versus cash offers, illustrating rights offerings with Example 23.6.

The authors discuss the stock price reaction to a seasoned offering; this drop can be explained by adverse selection as discussed in Chapter 19. There are two empirical puzzles that remain unexplained. First, adverse selection can be mitigated by use of a rights offering. It is unclear why most Canadian and U.S. companies do not use that vehicle. Second, there is significant underperformance after an SEO, as shown in Figure 23.6. One possible explanation is provided by Carlson, Fisher, and Giammarino (2004), who conclude that this outcome is a result of the conditions that led the firm to choose an SEO. If the investment is for the exercise of growth options, they are riskier than projects themselves, so the firm’s beta will decline upon exercise of the growth options, which explains the lower returns.

One possible explanation for the disinterest in rights offerings in Canada and the United States is the decrease in asymmetric information from using an underwriter in a cash offering.

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2

III.

MyLab Finance Activities

Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

23.1

Equity Financing for Private Companies

1-8

23.1 to 23.4

851 - 862

23.2

The Initial Public Offering

9 - 17

23.5 to 23.11

862 - 876

23.3

The Seasoned Equity Offering

18 - 20

23.12

876 - 880

IV.

Spreadsheet Solutions in Excel

The following problems for Chapter 23 have spreadsheet versions of the problems available: 23-4, 23-5 and 2312. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 24 Debt Financing I. Learning Objectives 24-1

Identify typical sources of debt for corporations.

24-2

Describe the bond indenture.

24-3

Define the following terms: notes, debentures, mortgage bonds, and asset-backed bonds. Identify which of these are secured, and which are senior.

24-4

Identify and define the four broadly defined categories that comprise international bonds.

24-5

Define term loan and private placement and contrast the two forms of private debt.

24-6

Identify the different types of securities used by the Government of Canada.

24-7

Describe Sovereign Debt and Agency Securities.

24-8

Identify the characteristics of municipal bonds.

24-9

Describe what a bond covenant is and how it protects bond investors.

24-10 Define the following bond terminology: covenants, call provision, callable bond, yield to call, sinking fund, and convertible bonds.

24-11 Compare and contrast convertible and callable bonds with straight debt.

II. Chapter Overview The chapter covers corporate as well as government debt instruments. The example of Hertz’s LBO illustrates how corporations use debt markets to raise capital. The chapter defines bond terminology.

24.1 Corporate Debt In 2005, Hertz was bought out by CDR in an LBO. Table 24.1 shows the debt portion of the deal. Figure 24.1 shows the front cover of the prospectus for the Hertz junk bond issue. This section of the chapter covers a great deal of terminology, including a description of bearer versus registered bonds and a discussion of seniority.

Table 24.3 shows the details of Hertz’s junk bond issues. One of those issues is a Euro-denominated bond, so the section discusses domestic, foreign, Eurobonds, and global bonds. Another type of debt that Hertz took out was a bank loan. This leads to a discussion of private debt, which describes two segments of the private debt market, term loans and private placements.

24.1 Other Types of Debt Sovereign debt is introduced first, with a focus on the four types of domestic debt and three types of foreign debt securities used by the Government of Canada. Example 24.1 shows the computation of the coupon on a Real Return Bond. The process of the two auctions used by the Bank of Canada (multiple price and Dutch or single priced auctions) and taxation are also topics of interest here. The authors also describe STRIPS. Agency securities and provincial and municipal bonds are the final topic of this section.

24.2 Bond Covenants This section gives a description of bond covenants, including Hertz’s junk bond issue. Those covenants limited the company’s ability to incur more debt, make dividend payments, redeem stock, make 1 .

investments, create liens, transfer or sell assets, and merge or consolidate. There was also a requirement to repurchase the bonds at 101% of face value if there is a change in control. The authors also mention the benefit of bond covenants for equity holders.

24.3 Repayment Provisions This section discusses call provisions, sinking funds and convertible provisions. Figure 24.2 compares the price of a callable to the price of a non-callable bond. Example 24.2 shows how to calculate yield to call. Figure 24.4 shows the value of a convertible bond compared to straight debt.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

24.1

Corporate Debt

1-4

24.1 to 24.6

886 - 891

24.2

Other Types of Debt

5-9

24.7 and 24.8

892 - 895

24.3

Bond Covenants

10

24.9

895 - 896

24.4

Repayment Provisions

11 - 14

24.10 and 24.11

896 - 903

IV. Spreadsheet Solutions in Excel The following problems for Chapter 24 have spreadsheet versions of the problems available: 24-11, 24-12, and 24-14. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

2 .

Chapter 25 Leasing I.

Learning Objectives

25-1 Define a lease and specify the rights and obligations of each party to the lease.

25-2 Distinguish between a sales-type lease, a direct lease, and a sale and lease-back.

25-3 Compute the cost of leasing in a perfect market.

25-4 Define the four types of options available for the lessee to obtain ownership of the asset at the end of the lease.

25-5 Distinguish between the two types of leasses recognized by the AcSB (Canadian Accounting Standards Board).

25-6 Distinguish between the two broad categories of leases recognized by the CRA (Canada Revenue Agency) and the General Anti-Avoidance Rule (GAAR).

25-7 Describe the treatment of leases in bankruptcy.

25-8 Given necessary inputs, compare the cost of leasing with the cost of financing.

25-9 Identify good reasons for leasing, including for a non-tax lease.

25-10 Identify suspect reasons for leasing.

II. Chapter Overview Leases function as an important financing method for tangible assets—leasing is the most common method of equipment financing. This chapter defines various types of leases, reviews accounting and tax treatment, shows how to evaluate the lease-versus-buy decision, and discusses common reasons for the benefits of leasing. Excel spreadsheets containing several tables and examples from the chapter are provided.

25.1 The Basics of Leasing This section defines the parties to the lease, along with various types of lease transactions. Example 25.1 shows how to calculate lease terms in a perfect market. The bottom line is that “in a perfect market, the cost of leasing and then purchasing the asset is equivalent to the cost of borrowing to purchase the asset.” Example 25.2 shows how to calculate a loan payment for the lease presented in Example 25.1.

Leases can be structured in several ways that allow the lessee to obtain ownership of the asset at the end of the lease for some price. The chapter identifies the following: • A fair market value lease, which gives the lessee the option to buy the asset at its fair market value.

•

A $1.00 out lease, where ownership of the asset transfers for a nominal cost of $1.00.

• •

A fixed price lease, where the price is set upfront.

A fair market cap lease, which sets the maximum price on a fair market value lease. End-of-lease options are explored in Example 25.3.

Leases can contain many other provisions. For example, some clauses may allow the lessee to trade in and upgrade the equipment to a newer model. Each lease agreement can be tailored to fit the precise nature of the asset and the needs of the parties. Provisions of the lease will be priced into the lease.

.

1

25.2 Accounting, Tax, and Legal Consequences of Leasing For accounting purposes, there are two types of lease: operating leases and capital leases. An operating lease is viewed as a rental—the entire lease payment is an operating expense and no depreciation is incurred. A capital lease is viewed as an acquisition. The interest portion of the lease payment is deducted and the asset is depreciated. Example 25.4 shows the effect of the lease versus loan decision on the balance sheet for both a capital lease and an operating lease.

If a lease is categorized as a capital lease, the asset and the liability will be reflected on the balance sheet. The CPA Handbook Section 3065 has four rules—if the lease satisfies any one of them, it must be classified as a capital lease. Example 25.5 shows the determination of the classification of a lease.

Regarding tax treatment, the CRA has its own classification rules; again there are two categories. In a true tax lease, the lessor deducts depreciation (the CCA charges) and the lessee deducts the lease payments as an operating expense. In a non-tax lease, the lessee receives the CCA deductions and the interest portion of the lease payments, although the asset belongs to the lessor. In 2001, the CRA announced that the legal form of the contract would be central to determining if the transaction was a sale or lease, however, if a contract were designed strictly to avoid tax, the General Anti-Avoidance Rule (GAAR) could be used to reassess the case. In addition, under the Specialized Leasing Property Rules, certain assets held under financial leases could be fully treated as a lease for tax purposes.

The final portion of this section discusses leases and bankruptcy. If the lease is deemed to be a security interest, the firm is assumed to have effective ownership of the asset and it cannot be seized. The lessor is treated as any other secured creditor. If the lease is classified as a true lease, the lessor retains ownership and the bankrupt firm must choose whether to assume or reject the lease. If it assumes the lease, it must settle all pending claims and continue to make promised payments. If it rejects the lease, the asset must be returned to the lessor. The judge makes the decision about lease classification based on the facts of the case, but the distinctions tend to be similar to accounting and tax distinctions.

25.3 The Leasing Decision This section shows how a firm makes the leasing decision in a world where markets are not perfect. It begins by showing the lease-versus-buy decision in a true tax lease, then points out that the correct comparison is lease versus borrow. Tables 25.1 through 25.3 show the cash flows from these incremental steps. The authors show how either NPV or IRR can be used to make this comparison. Example 25.6 illustrates NPV. Next, the authors evaluate a non-tax lease, as illustrated in Example 25.7.

25.4 Reasons for Leasing There are many reasons leasing can be profitable for lessor and lessee. This section analyzes those reasons to evaluate their validity. Valid reasons are tax differences, reduced resale costs, efficiency gains from specialization, reduced distress costs and increased debt capacity, transferring risk, mitigating debt overhang and improved incentives. Example 25.8 shows how tax differences can be exploited through leasing. Leasing to avoid debt overhand is illustrated in Example 25.9. Reasons that people often give that are suspect include avoiding capital expenditure controls, preserving capital, and reducing leverage through off-balance-sheet financing.

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2

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

25.1

The Basics of Leasing

1-3

25.1 to 25.4

908 - 913

25.2

Accounting, Tax and Legal Consequences of Leasing

4-5

25.5 to 25.7

914 - 918

25.3

The Leasing Decision

6-9

25.8

918 - 925

25.4

Reasons for Leasing

10 - 11

25.9 and 25.10

925 - 929

IV. Spreadsheet Solutions in Excel The following problems for Chapter 25 have spreadsheet versions of the problems available: 25-4, 25-7, 25-8, 25-9 and 25-10.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

.

3

Chapter 26 Working Capital Management I. Learning Objectives 26-1

Define working capital management, cash cycle, and operating cycle.

26-2

Compute the cost of trade credit and compare that cost to alternative sources of financing.

26-3

Discuss ways that companies provide trade credit to their customers.

26-4

List the three steps involved in establishing a credit policy, and two methods used to monitor the effectiveness of that policy.

26-5

Discuss the importance of monitoring and managing accounts payable.

26-6

Discuss the importance of monitoring and managing inventory.

26-7

Discuss the importance of monitoring and managing cash.

II. Chapter Overview The chapter focuses on the tools firms use to manage working capital in order to minimize the opportunity costs associated with holding working capital. The authors discuss why firms have working capital. In a perfect market, working capital accounts would be irrelevant. Because of market frictions, working capital accounts do affect firm value. The authors discuss tradeoffs associated with trade credit, inventory, and cash holdings.

26.1 Overview of Working Capital Working capital alters a firm’s value by affecting its free cash flow. The chapter begins with some definitions.

The firm’s cash cycle is “the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory.” The cash cycle is often measured by calculating the cash conversion cycle. The firm’s operating cycle is “the average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product. It is the same as the cash conversion cycle when the firm pays cash for its payables.”

Table 26.1 shows accounts receivable days, inventory days, accounts payable days and the cash conversion cycle for a number of firms in various industries. Example 26.1 shows how to find the NPV of the working capital requirements for a project.

26.2 Trade Credit This section of the chapter begins with some definitions, including discussing the quoting convention of trade credit terms. The cost of trade credit is discussed in Chapter 5, and the formula is repeated here. The authors discuss the benefits of trade credit from both the borrower’s and the creditor’s perspective. Example 26.2 illustrates computing the effective cost of trade credit.

The section continues with a discussion of managing float, breaking it down into collection float and disbursement float. Electronic cheque processing is also discussed; electronic cheque imaging allows for the clearing of cheques through the use of image transmissions rather than physically moving actual paper cheques.

Although this system allows cheques to clear more quickly, in 2008 Canada abandoned its 11 year old project because banks have developed and implemented their own imaging projects to gain efficiencies – such as the mobile deposit of cheques using a phone’s camera. As efficiency increases it may be possible to reduce a bank’s hold period which would in turn lower a firm’s collection float. The authors point out that the processes used to reduce collection float and increase disbursement float are not without costs.

.

1

26.3 Receivables Management Establishing a credit policy involves three steps: (1) establishing credit standards, (2) establishing credit terms, and (3) establishing a collection policy. After the credit policy is established, the firm must monitor the policy to ensure that it is working effectively. Two monitoring tools are the accounts receivable days and the aging schedule. Table 26.2 shows an aging schedule, both in number of accounts and in dollar amounts outstanding.

Example 26.3 shows how the aging schedule is calculated.

26.4 Payables Management Trade discounts are relevant for the management of payables, just as they are for receivables. Any discount sacrificed should be compared to alternative sources of funding. Example 26.4 illustrates this concept.

Some firms ignore the payment due period and stretch the payables. Example 26.5 shows how much this action can change the cost of the trade payable. The authors also discuss some practices widely considered to be unethical. For example, some firms make the payment on the last day of the terms, or even later, but pay the discounted price, to which they are not entitled. This action can have consequences, such as a poor credit rating.

26.5 Inventory Management The costs and benefits of holding inventory are discussed in this section. The main benefit of holding inventory is that stock-outs are less likely to happen. The costs of holding inventory can be classified into three categories: (1) acquisition costs, (2) order costs, and (3) carrying costs. The authors use the apparel chain, the GAP, as an example of the benefits of proper inventory management. Some firms, like Walmart, use just-in-time inventory but when demand shifts suddenly, the system can fail as it during the COVID-19 pandemic when consumers hoarded toilet paper.

26.6 Cash Management Chapter 18 showed that holding excess cash has a tax disadvantage. However, there are three reasons why a firm holds cash: (1) to meet its daily needs (transactions balance), (2) to compensate for the uncertainty associated with its cash flows (precautionary balance), and (3) to satisfy bank requirements (compensating balance). Table 26.3 shows some alternative money market investments the firm may choose from to invest any excess cash.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

26.1

Overview of Working Capital

1-4

26.1

935 - 938

26.2

Trade Credit

5-8

26.2 and 26.3

939 - 942

26.3

Receivables Management

9 - 11

26.4

942 - 945

.

2

26.4

Payables Management

12 - 15

26.5

945 - 946

26.5

Inventory Management

16

26.6

946 - 948

26.6

Cash Management

17

26.7

948 - 949

IV. Spreadsheet Solutions in Excel The following problems for Chapter 26 have spreadsheet versions of the problems available: 26-4, 26-13 and 26-15. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 27 Short-Term Financial Planning I. Learning Objectives 27-1

Show how future cash flow forecasts allow a company to determine whether it has a cash flow surplus or deficit, and whether it is a long- or short-term imbalance.

27-2

Discuss the recommendations of the matching principle with respect to long- and short-term needs for funds.

27-3

Describe three types of bank loans, and how they may be used for short-term cash needs.

27-4

Identify the factors that affect the effective annual rate of a bank loan.

27-5

Define commercial paper and discuss its advantages for large corporations.

27-6

Describe the use of inventory and accounts receivable as security for loans.

27-7

Define factoring, floating liens, trust receipts loan, and a warehouse arrangement.

II. Chapter Overview This chapter begins with a discussion of Mattel, Inc. Because the company has a highly seasonal product, shortterm financial planning is very important. The chapter examines how firms forecast their cash flows to determine short-term financing needs and policies that firms use to guide those decisions. The chapter also examines some ways a company can finance any shortfall. The accompanying excel spreadsheet contains selected Springfield Snowboards tables, as presented in this chapter.

27.1 Forecasting Short-Term Financing Needs This section focuses on Springfield Snowboards, Inc. The company is profitable, and will accumulate cash on an ongoing basis. Table 27.1 shows a spreadsheet of the firm’s projected financial statements. The firm could require short-term financing for three reasons: seasonalities, negative cash flow shocks, and positive cash flow shocks.

In discussing seasonalities, the authors address the reality that sales of snowboarding equipment are likely to be seasonal. Table 27.2 modifies the previous table to allow for seasonal sales. In the second and third quarters, the company will have negative change in cash, so the company will need to find additional short-term sources of cash. The first and fourth quarters will be positive, so the firm may choose to invest the excess cash.

Occasionally, a firm will face a negative cash flow shock, such as an unexpected need to replace a machine.

Table 27.3 presents cash flows for Springfield with level sales and an unexpected equipment breakage in the second quarter.

A positive cash flow shock can also result in a short-term financing need. For example, Table 27.4 shows a situation in which Springfield has an opportunity to increase sales, but it must spend money on marketing and on capital expenditures.

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1

27.2 The Matching Principle The matching principle states that short-term needs should be financed with short-term debt and long-term needs should be financed with long-term funding. It is necessary to distinguish between permanent and temporary working capital. Table 27.5 shows that Springfield’s net working capital varies from $2,125 in the first quarter to $5,425 in the third quarter. The minimum amount of net working capital during the year can be considered the permanent need. The remainder can be considered temporary.

The section evaluates some of the advantages and disadvantages of aggressive versus conservative funding policies.

27.3 Short-Term Financing with Bank Loans Here, the authors describe three different types of short-term bank loans: a single, end-of-period payment loan, a line of credit, and a bridge loan. Common loan stipulations and fees are commitment fees, loan origination fee, and compensating balance requirements. The authors show how to calculate the cost of each alternative.

Example 27.1 shows how to include the cost of a compensating balance in the effective annual rate on a loan.

27.4 Short-Term Financing with Commercial Paper This section defines commercial paper, including discussing the maturity requirements. The authors also distinguish between direct paper and dealer paper. Example 27.2 shows how to calculate the effective annual rate of commercial paper.

27.5 Short-Term Financing with Secured Financing This section discusses the use of accounts receivable and inventory as collateral for short-term loans.

Specifically, pledging of accounts receivable, factoring of accounts receivable, floating liens, trust receipts (or floor planning), and warehouse arrangements are discussed in this section. These arrangements vary in the extent to which specific items of inventory are identified as collateral; consequently, they vary in the amount of risk the lender faces. Example 27.3 shows how to calculate the effective annual cost of warehouse financing.

III. MyLab Finance Activities Text Section

Text Section Title

27.1

Learning Objectives Covered

Text Page Reference

Forecasting Short-Term Financing 1 - 2 Needs

27.1

957 - 962

27.2

The Matching Principle

3-5

27.2

962 - 964

27.3

Short-Term Financing with Bank Loans

6 - 10

27.3 and 27.4

964 - 967

27.4

Short-Term Financing with Commercial Paper

11 - 14

27.5

967 - 969

.

Problems

2

27.5

Short-Term Financing With Secured Financing

15 - 18

27.6 and 27.7

969 - 972

IV. Spreadsheet Solutions in Excel The following problems for Chapter 27 have spreadsheet versions of the problems available: 27-4 and 27-6.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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3

Chapter 28 Mergers and Acquisitions I. Learning Objectives 28-1

Describe trends in the global takeover market since the 1960s.

28-2

Describe the typical market reaction to the news of a takeover bid.

28-3

Identify the sources of synergies that are most commonly cited in the justification given for acquiring a firm.

28-4

Define the term “tender offer,” and discuss the premium typically paid over current share price.

28-5

Identify the gains to both acquiring and target firms upon announcement of a takeover; provide reasons for those gains to accrue.

28-6

Calculate the maximum premium that should be paid in a stock acquisition, as well as the earnings per share before and after a merger, the new price of the combined firm, and the change in percentage ownership that will happen as a result of the merger.

28-7

Identify two methods commonly used to pay for a target, and the tax and accounting consequences of each.

28-8

Discuss the role of the board of directors and shareholders of the target and the board of directors of the acquirer in the merger.

28-9

Distinguish between a friendly and a hostile takeover.

28-10 List and define several defence strategies against takeovers.

28-11 Define the free rider problem, and describe how it can be alleviated by a toehold, a leveraged buyout, or a freezeout merger.

II. Chapter Overview The topic is illustrated with a description of the merger between Anheuser-Busch and giant InBev. It describes the important events in that transaction. This chapter first provides historical background and trends in mergers and acquisitions. Next, the authors discuss both why a manager may pursue an acquisition and the takeover process. Finally, the question of who gets the value when a takeover occurs is addressed.

28.1 Background and Historical Trends The global takeover market is active and large. Table 28.1 shows the largest mergers from 1998 to 2018.

Mergers appear to occur in distinct waves, as illustrated in Figure 28.1. Those waves seem to be associated with specific types of deals. The text describes horizontal, vertical, and conglomerate mergers, as well as mergers classified by form of payment.

28.2 Market Reaction to a Takeover In Canada and most U.S. states, the law requires that shareholders forced to sell receive a fair value. In most cases, fair value is interpreted to be the share price before the merger announcement. As a result, bidders cannot pay less than the current market value for a company; in practice, they typically pay a large premium. On average, the stock price reaction to a merger announcement is 15% for the target and a gain of 1% for bidders (although in half the transactions the bidder price decreases). These facts raise three questions: 1) Why do acquirers pay a premium? 2) Why does the price of the target rise less than the premium offered? 3) Why does the acquirer not experience a price increase? .

28.3 Reasons to Acquire This section attempts to answer the first part of question 1 above. Namely, what benefits ensue from a merger that would lead a company to pay more than the market price for the acquisition? The reasons most often cited by acquirers are economies of scale and scope, vertical integration, expertise, monopoly gains, efficiency gains, operating losses, diversification, earnings growth and manager-driven reasons to merge.

One example of economies of scale and scope is Stride Rite’s acquisition of sports shoemaker Saucony in 2005.

Economies of scope were believed to be the motive in Kraft’s decision to purchase British chocolate maker Cadbury. The authors point out, however, that there may be costs associated with size.

Small firms are more responsive to changes in the economic environment than larger firms, and the small- firm CEO is typically close to the firm’s operations.

An example of vertical integration is oil companies, because they often own all stages of the production process.

Again, there is a counter-example. Microsoft makes only the operating system, while Apple makes the computer as well. Some experts argue that the success of Microsoft is due to its decision not to vertically integrate.

There are many examples of acquisition for the purpose of acquiring expertise. The chapter gives three: AXA’s purchase of Sanford C. Bernstein, UK builder Amec’s purchase in French firm Spie Batignolles, and Cisco Systems’ strategy of purchasing young startup firms.

When GE agreed to buy Honeywell, the European Commission refused to approve the deal—this was the first time a merger of two U.S. companies that had been approved by U.S. authorities was blocked by European authorities. This event shows how difficult it is to merge with or acquire a major rival, because governments are very worried about monopolistic behaviour. It is not always attractive for the firm either, because while all companies in the industry benefit from the reduction in competition, all the cost is borne by the acquiring firm.

Efficiency gains are often achieved through elimination of duplication, like in the SBC/AT&T merger. If a company is not being run efficiently, the CEO can be ousted by the shareholders. However, this seldom happens, as unhappy shareholders are more likely to simply sell their stock. As a result, the stock price will fall, and a better manager could acquire the company at a discount. However, just as a sports team may not begin winning after its coach is replaced, not all inefficiently run organizations will be more efficient following a merger.

The next topic is tax savings from operating losses. Example 28.1 shows two firms. Each year one firm will have an operating profit and the other will have an operating loss. The example shows that combining the firms will result in higher after-tax profits than the two firms’ profits added together. In Canada and the United States, however, those benefits are mitigated because companies can carry losses forward 20 years or back for 3 years in Canada. In addition, the CRA in Canada and the IRS in the United States will disallow a tax break if it can show that the principal reason for a takeover is tax avoidance.

Diversification benefits from mergers fall into three categories: risk reduction, debt capacity and borrowing costs, asset allocation and liquidity. The risk reduction argument is difficult to support, because investors can diversify their own portfolios. The only class of stockholders who benefit from the diversification are stockholders who do not hold well-diversified portfolios, such as employees. The debt capacity and borrowing costs argument suggests that a post-merger company, being larger, will incur smaller bankruptcy costs, offsetting any increased cost of running a large company. The ability to quickly reallocate assets such as managerial talent is an additional argument for the diversification motive for a merger. The final argument is a liquidity one. Shareholders of private companies are often under-diversified. When an acquirer buys a private target, the liquidity will be valuable to the target shareholders.

The earnings growth argument is illustrated in Example 28.2. In that example, a low-growth company merges with a high-growth company, and earnings per share of the merged company increases. However, since there is Copyright © 2022 Pearson Canada Inc

no economic value created by a merger, the price-earnings ratio declines, as shown in Example 28.3. The last section of the chapter discusses managerial motives to merge. Two possible explanations for the stock price drop of large bidders are conflicts of interest and overconfidence.

28.4 The Takeover Process Chapter 22 demonstrated how a bidder values a target company. That discussion is reviewed in this section.

Once the acquirer is in the position to make a tender offer, a public announcement is made of the intention to buy the company. There is no guarantee that the takeover will take place at this price.

A bidder can use either of two methods to pay for the target: cash or stock. Equation 28.4 shows how to calculate the maximum exchange ratio, using premerger target and acquirer share prices. This calculation is illustrated in Example 28.4, using the Sprint/Nextel merger.

Merger “arbitrage” is described in this chapter, using the HP/Compaq merger to illustrate how investors speculate on the outcome of deal once a tender offer is announced. Figure 28.2 shows the merger- arbitrage spread for the deal.

The tax and accounting implications of a merger depend on the terms of trade. Any cash paid triggers a tax liability for target shareholders. If the acquirer purchases the assets directly, rather than the stock, it can step up the value of the assets to the purchase price. While the method of payment selected affects how the value of the target’s assets is recorded for tax purposes, it does not affect the combined firm’s financial statements for reporting purposes. If the purchase price exceeds the fair market value of the target’s identifiable assets, then the remainder is recorded as goodwill and is examined annually by the firm’s accountants to determine whether its value has decreased.

For a merger to proceed, it must be approved by both boards of directors. Target shareholders (and sometimes acquirer shareholders) must also approve. This section defines a friendly and a hostile takeover. It also discusses cases in which the target’s board may not approve the merger.

28.5 Takeover Defences In a hostile takeover, the acquirer must bypass the board of directors and appeal directly to the target shareholders in a proxy fight. Target companies have a number of strategies to stop this process. The ones discussed here are the poison pill, staggered boards, white knights (or squires), golden parachutes, and recapitalization.

The discussion of poison pills includes a brief history of that strategy. Finance research has verified that by adopting a poison pill, a company effectively entrenches its management. Upon adoption of a pill, the stock price drops (on average). In addition, firms have below-average financial performance after the adoption.

Some companies change their capital structure in a recapitalization, in order to become less attractive targets.

Companies with a lot of cash may pay a large dividend. Those without much cash may take on debt to pay a dividend, thereby increasing their debt capacity. Occasionally, the restructuring itself can remove the principal motivation for the takeover.

Regulatory approval was introduced in Section 28.2 and the discussion continues here. In Canada, the Competition Bureau monitors potential monopoly combinations and the Investment Canada Act governs takeovers by foreigners of Canadian corporations. In the United States, antitrust enforcement is governed by three main statutes: the Sherman Act, the Clayton Act, and the Hart-Scott-Rodino Act. 28.6 Who Gets the Value Added from a Takeover?

Target shareholders capture the value added by the acquirer. The discussion of the free rider problem illustrates this concept through a hypothetical example. The next part of the section explains how toeholds can help acquirers mitigate the free rider problem. However, most of the value added accrues to the target shareholders. .

The reason that investors should care about this is that acquirers perform an important service. Managers are more likely to act in the best interest of shareholders if they know that failing to act that way could result in the loss of their job via acquisition.

Acquirers can avoid the free rider problem and capture a larger piece of the gain from the acquisition via a leveraged buyout or freezeout merger. Example 28.5 illustrates a leveraged buyout. The laws on tender offers allow the acquiring company to force non-tendering shareholders to sell their shares for the tender offer price.

A final question is why acquirers are willing to pay such a premium for the acquisition. The most likely explanation is the competition in the takeover market. If there is no bidding war, it is often because acquirers offered a price large enough to discourage competitive offers

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

28.1

Background and Historical Trends

1-3

28.1

979 - 981

28.2

Market Reaction to a Takeover

4

28.2

981 - 982

28.3

Reasons to Acquire

5 - 11

28.3

983 - 990

28.4

Valuation and the Takeover Process

12 - 15

28.4 to 28.9

990 - 995

28.5

Takeover Defences

16

28.10

995 - 1000

28.6

Who Gets the Value Added from a Takeover?

17 - 18

28.11

1000 - 1006

Copyright © 2022 Pearson Canada Inc

IV. Spreadsheet Solutions in Excel The following problems for Chapter 28 have spreadsheet versions of the problems available: 28-9, 28-10, 28-14 and 28-16.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 29 Corporate Governance I. Learning Objectives 29-1

Define corporate governance, and describe its role in the successful reduction of agency problems.

29-2 Describe the roles of the following in corporate governance: a. The board of directors b. The market for corporate control c. Regulation 29-3

Define the term “captured board” and describe situations in which a board is most likely to be captured.

29-4

Discuss the costs and benefits of having managers as shareholders, in terms of proper corporate governance.

29-5

Discuss the costs and benefits of having managerial compensation tied to firm performance, in terms of proper corporate governance.

29-6

Identify alternatives available to shareholders if the board fails to act in their interests.

29-7

Identify the methods that boards can use to entrench themselves.

29-8

Describe the provisions of the Exchange Acts of 1933 and 1934, the Sarbanes-Oxley Act of 2002, and the Dodd-Frank Act of 2010, which attempt to improve shareholder protections.

29-9 Compare corporate governance practices across countries. Specifically address the following: a. Common-law vs. civil-law countries b. Pyramidal ownership structures c. Dual class shares d. The role of employees in governance e. Cross-holdings 29-10 Describe the corporate governance trade-off.

II. Chapter Overview The chapter begins with a brief description of recent corporate scandals, and the apparent lack of corporate governance that allowed them to happen. Firm value can be increased if good governance is in place. The chapter discusses various governance mechanisms and regulations that are designed to prevent certain acts that are not in the best interest of shareholders. The chapter concludes with a discussion of international corporate governance and the corporate governance trade-off.

29.1 Corporate Governance and Agency Costs Here the authors define corporate governance and describe how it is necessitated by agency conflicts. Aligning the interests of managers with those of shareholders comes at a cost, particularly to managers. The corporate governance system attempts to provide incentives for taking the right actions and punishments for taking the wrong action.

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1

29.2 Monitoring by the Board of Directors and Others A great deal of academic research has been devoted to corporate governance. This section summarizes the most widely accepted views. The authors first define inside, grey, and outside directors. Some evidence indicates that the proportion of outside directors (labelled board independence) matters for major activities such as firing CEOs and making acquisitions. Board independence doesn’t seem to lead to better firm performance. The nature of the role of an independent director is also tenuous. Many independent directors sit on multiple boards, and even the most active spend only one or two days per month on firm business.

Because their wealth is less sensitive to performance than that of inside and grey directors, they have less incentive to monitor managerial actions closely. When a board’s monitoring duties appear to have been compromised, it is said to be a captured board. Theoretical and empirical research finds that the longer a CEO has served; especially when the CEO is also the chairman, the more likely the board is to become captured.

Researchers have also found that smaller boards provide greater firm value and performance than larger boards.

Boards tend to grow over time.

Other monitors help align managers’ incentives with those of shareholders. Securities analysts produce independent valuations of the firm by collecting and evaluating as much information as they can. They tend to uncover irregularities first. Lenders also monitor firms they lend to and also require covenants designed to mitigate default risk. Employees of the firm are most likely to detect fraud because of their inside knowledge.

Some juridictions have whistle-blower statutes to protect employees who report fraud to the authorities.

29.3 Compensation Policies Again, there is a great deal of academic research in this area, so this chapter mentions the most widely accepted findings. The premise is that incentive-based compensation will alleviate agency problems between managers and owners.

During the 1990s, most companies adopted compensation policies that included grants of stock or stock options to executives. Figure 29.1 shows the dramatic increase in median CEO pay during the 1990s through 2014, mostly as a result of stock- and option-based compensation. Lately, the fraction of stock and option grants has been reduced some, suggesting that sensitivity of pay to performance might have been too high. Recently, some negative effects have been associated with increasing the sensitivity of pay to performance. For example, evidence suggests widespread manipulation of the timing of information releases to increase the value of CEO options. In addition, the practice of options backdating has been detected.

29.4 Managing Agency Conflict Evidence has shown that greater managerial ownership results in fewer value-reducing actions by managers.

However, it also makes managers harder to fire. If all else fails, shareholders may take direct action to mitigate agency problems. That action can take the form of a shareholder resolution. Such resolutions are rarely adopted, but they can be embarrassing if backed by large shareholders. Some large institutional shareholders take an activist role in governance. Studies show that they are usually successful in achieving their goals without taking matters public. Recently, shareholders have been refusing to approve a slate of nominees for the board.

Shareholder approval is required for many corporate actions.

However, approval is usually perfunctory. In the extreme, shareholders can launch a proxy contest and introduce a rival slate of directors. This action gives the shareholders a choice about the board. In recent years, activist hedge funds have played a role in shaping management strategy. Empirical evidence suggest that the market values this activism.

Over time, managers can sometimes become entrenched, especially as the tools that enable that entrenchment have evolved. The Investor Responsibility Research Center has been measuring that entrenchment, and researchers have begun to use their index. Managerial entrenchment seems to have explanatory power in performance, CEO compensation, and value of acquisitions made.

An active takeover market is another mechanism by which poorly performing managers can be disciplined. .

2

Research has found that boards are more likely to fire managers for poor performance during active takeover markets than during slow ones.

29.5 Regulation The four major pieces of U.S. legislation that are discussed in this section are the Exchange Acts of 1933 and 1934, the Sarbanes-Oxley Act (SOX), and the Dodd-Frank Act. The discussion of SOX centers on three ways the legislation is meant to improve the accuracy of information: (1) overhauling incentives and independence in the auditing process, (2) stiffening penalties for providing false information, and (3) forcing companies to validate their internal financial control processes. The annual costs to corporations due to SOX appear to have been grossly underestimated. Current estimates are between $20 and $35 billion. Five provisions of the DoddFrank Act are discussed: the independent compensation committee, nominating directors, vote on executive pay and golden parachutes, clawback provisions, and pay disclosure (ratio of CEO pay to median employee pay).Similar regulations were enacted in Canada.

A similar attempt in the UK to institute SOX-type rules happened with the Cadbury Commission. That commission made recommendations that were voluntary—firms that did not adopt them were required to explain why in their annual reports. Empirical findings are mixed. Insider trading laws are discussed, as well.

They were introduced in the Exchange Act of 1934 and strengthened by the Insider Trading Sanctions Act in 1984.

29.6 Corporate Governance Around the World This section contains several governance issues in other countries. In particular, the authors point out that the degree to which investors are protected in the United States is among the best in the world. Some researchers claim that the country’s legal regime determines its level of investor protection. They found that common law countries typically offered more protection, while civil law countries offered less protection. Other researchers argue that investor protection is a relatively recent development in Great Britain.

In many countries, the central agency conflict is between controlling shareholders and minority shareholders.

Controlling shareholders are often members of the founding family. Families can gain control over firms even when they do not own a majority of the shares by issuing dual class shares. These shares are common in Canada and Europe but are rare in the United States. In some countries, they are illegal.

In a pyramid structure, a family creates a company in which it owns a majority of the stock, and that company owns a controlling interest in another company. Even though the family owns only 25% of the second company, it controls the shares. Figure 29.3 shows the pyramid controlled by the Pesenti family in Italy, which effectively controls five companies primarily in the construction industry, even though it does not have more than 50% ownership in any of them. A conflict of interest can arise because the family has the incentive to move profits up the pyramid. They do pay for this control, however, as studies have shown that shares in companies controlled by a pyramid structure trade at a discount.

The stakeholder model, which gives explicit consideration to other stakeholders like rank-and-file employees, is common in much of the world. Cross-holdings are the norm for many countries as well. In Japan, such groups also have a common relation to a bank and are known as keiretsu. In Korea, chaebol are similar, except that they have no common relation to a bank. Table 29.1 summarizes employee participation in corporate governance for OECD countries.

29.7 The Tradeoff of Corporate Governance No one structure works for all firms. The costs and benefits of a governance system depend on cultural norms, as well. Good governance is value enhancing and so investors should strive for it.

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III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objective Covered

Text Page Reference

29.1

Corporate Governance and Agency Costs

1-3

29.1

1011 - 1012

29.2

Monitoring by the Board of Directors and Others

4-8

29.2 and 29.3

1012 - 1015

29.3

Compensation Policies

9

29.4 and 29.5

1015 - 1017

29.4

Managing Agency Conflict

10 - 14

29.6 and 29.7

1017 - 1021

29.5

Regulation

15 - 19

29.8

1021 - 1027

29.6

Corporate Governance Around the World

20 - 21

29.9

1027 - 1031

29.7

The Trade-off of Corporate Governance

None

29.10

1031

IV. Spreadsheet Solutions in Excel There are no spreadsheet solutions for this chapter.

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Chapter 30 Risk Management I. Learning Objectives 30-1

Explain what is meant by the statement, “In a perfect market, insurance is actuarially fair.”

30-2

Compute the value of an actuarially fair insurance premium.

30-3

Explain why, for large risks that are difficult to diversify, insurance has a negative beta; evaluate the impact of that beta on price.

30-4

Discuss six market imperfections that are sources of value for insurance.

30-5

List and define three costs of insurance.

30-6

Describe three risk management strategies firms use to hedge their exposure to commodity price movements.

30-7

Discuss the use of currency forwards and options contracts to hedge exchange rate risk.

30-8

Discuss the use of the cash-and-carry strategy in currency hedging.

30-9

Describe situations in which a firm would prefer currency options to futures for hedging.

30-10 Use the Black-Scholes formula to compute the value of a currency option.

30-11 Define interest rate risk and discuss tools to manage that risk.

30-12 Define and compute duration of a single asset and of a portfolio.

30-13 Use duration to measure the change in value attributable to a change in yields.

30-14 Explain the use of equity duration to manage interest rate risk.

30-15 Describe the use of swaps in managing interest rate risk; explain how the use of swaps separates the risk of interest changes from the risk of changes in the firm’s credit quality.

II. Chapter Overview All firms are subject to various forms of risk. This risk should be managed to minimize the effect on firm value.

Insurance and financial markets allow some risk associated with changes in commodity prices, exchange rate fluctuations, and interest rate movements to be traded and some risks to be alleviated for debt and equity holders. This chapter discusses insurance and financial market hedges. It also identifies ways to measure risk, such as duration.

30.1 Insurance Companies use four common types of insurance to reduce risk: property insurance, business liability insurance, business interruption insurance and key personnel insurance. This section explains the role of insurance in reducing risk by examining pricing and potential costs and benefits.

The section begins with an illustration of the expected loss from fire each year for a hypothetical firm.

Next, the actuarially fair fire insurance premium is computed (equation 30.1). Since this risk is diversifiable, the appropriate discount rate is the risk-free rate. This is not true for all insurable risks: because insurance for nondiversifiable hazards is usually a negative beta asset, the risk-adjusted rate for losses is less than the risk-free rate, leading to a higher insurance premium. Example 30.1 shows the application of the CAPM to insurance pricing. .

1

In order for insurance to add value to the firm, since it’s priced to earn an NPV of zero, some market imperfections must result in benefits to insurance. The imperfections considered here are those addressed in Part VI of the text, namely, bankruptcy and financial distress costs, issuance costs, tax rate fluctuations, debt capacity, managerial incentives, and risk assessment.

Example 30.2 shows how financial distress and issuance costs can cause insurance to be beneficial. To illustrate the effect of tax rate fluctuations, the authors use the example of a canola grower subject to graduated income tax rates. If the grower’s crop fails, he will be in a lower tax bracket. The NPV from purchasing insurance will be positive, because of his lower tax rate.

Some costs of insurance raise the premiums above the actuarially fair price. These include three main frictions: administrative and overhead costs, adverse selection, and agency costs, such as moral hazard. To address the problem of adverse selections, insurance companies screen applicants to assess their risk as accurately as possible. To deter moral hazard, insurance companies examine claims for signs of fraud or deliberate intent.

Insurance companies also place deductibles and policy limits on their policies, in order to reduce the costs of market imperfections. Example 30.3 shows the use of policy limits to mitigate the adverse selection problem.

Because market imperfections are likely to raise the premiums charged by insurers, insurance is “most likely to be attractive to firms that are currently financially healthy, do not need external capital, and are paying high current tax rates. They will benefit most from insuring risks that can lead to cash shortfalls or financial distress, and that insurers can accurately assess and monitor to prevent moral hazard.”

30.2 Commodity Price Risk This section shows ways firms can hedge their exposure to commodity price movements.

The most common strategies to hedge risk are vertical integration and storage. However, while vertical integration can reduce risk, it does not always increase value, because investors can do their own vertical integration. Because acquirers often pay a premium over the current share price, it is generally cheaper for shareholders to diversify on their own. Vertical integration can add value if there are synergies. However, the more likely outcome is diseconomies, since the combined firm would often lack a strategic focus.

Finally, vertical integration is not a perfect hedge because suppliers are exposed to other risks. Long-term storage of inventory is typically very costly, leaving that option unrealistic.

Another option is to hedge with long-term contracts. The authors use Southwest Airlines’ oil futures hedging as an example. Figure 30.1 graphs the futures contract Southwest owned, and Example 30.4 shows a different hedge. The remainder of the section discusses futures and options hedges, including the use of margin and marking to market to eliminate credit risk. Table 30.1 shows an example of marking to market for oil futures while Table 30.2 shows future and options hedging strategies. Example 30.5 contrasts a futures with an options hedge.

This section also considers when to hedge commodity price risk. Since commodity markets are not very vulnerable to adverse selection and moral hazard, and administrative costs are low, hedging in those markets is typically cheaper than insurance. However, trading in those markets can result in a loss. Also, firms may speculate rather than hedging, which will add risk instead of reducing it.

30.3 Exchange Rate Risk The section begins with a brief discussion of exchange rate determination and a definition of exchange rate risk.

Example 30.6 shows the effect of exchange rate risk on a hypothetical company.

The chapter then defines currency forwards and forward exchange rates, and explains their use in hedging exchange rate risk. The cash-and-carry strategy is also defined, and the Law of One Price is used in its derivation, resulting in covered interest parity. Example 30.8 shows how to compute the no-arbitrage forward exchange rate, and Example 30.9 shows how to use the cash-and-carry strategy. Forward contracts have several advantages over the cash-and-carry strategy. In particular, the forward contract is simpler, may cost less in .

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transaction fees, and some firms may not be able to borrow in the foreign currency without paying a very high rate. The cash-and-carry method is most often used by banks to offset their currency risk.

Currency options can also be used to hedge. The chapter compares options to forwards. Figure 30.6 provides a graph comparing hedging using a forward, an option, or no hedge. Example 30.10 shows the use of options to hedge a conditional exposure, including graphing both contingencies. The section also shows how to price call options on a currency using the Black-Scholes model in equation 30.4. Example 30.11 shows how implied volatility of exchange rates is calculated.

30.4 Interest Rate Risk This section begins with an illustration of a duration calculation (using equation 30.6), for a ten-year coupon bond. Example 30.12 shows the duration calculation. The example is extended to show, in Example 30.13, how to estimate interest rate sensitivity using duration.

A discussion of duration-based hedging follows, using the example of a typical bank – Northland Bank.

The example shows that the firm has a duration mismatch. Equation 30.9 shows how to calculate equity duration. The ensuing discussion shows how the company can make its portfolio duration neutral, or immunized. Equation 30.10 shows how much the company must exchange (how much in mortgages to sell) to immunize the portfolio. Table 30.6 shows the company’s market-value balance sheet after immunization. The equity duration is now zero.

The chapter concludes with an explanation of swap-based hedging by firms to modify their interest rate risk exposure without buying or selling assets and the use of a swap to change duration. Table 30.7 shows the cash flows for a fixed-for-floating interest rate swap. Example 30.14 shows how interest rate swaps are used to take advantage of declining interest rates without changing the firm’s credit rating. Example 30.15 shows how Northland Bank can use a swap, rather than selling mortgages, to hedge interest rate exposure.

III. MyLab Finance Activities Text Section

Text Section Title

Problems

Learning Objectives Covered

Text Page Reference

30.1

Insurance

1-4

31.1 to 30.5

1036-1043

30.2

Commodity Price Risk

5-9

30.6

1043-1056

30.3

Exchange Rate Risk

10 - 12

30.7 to 30.10

1056-1068

30.4

Interest Rate Risk

13 - 16

30.11 to 30.15 1068-1078

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IV. Spreadsheet Solutions in Excel The following problems for Chapter 30 have spreadsheet versions of the problems available: 30-6, 30-10, 30-11, 30-14 and 30-15.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Chapter 31 International Corporate Finance I. Learning Objectives 31-1

Discuss the condition necessary for internationally integrated capital markets.

31-2

Describe two methods that can be used to value foreign currency cash flows; use those methods to value those flows.

31-3

Calculate foreign and domestic WACCs, using equation 31.7, given three out of the four inputs.

31-4

Identify which tax rate (the foreign or the domestic) a Canadian corporation will pay on its foreign project.

31-5

Discuss the implications of the possibility that capital markets are internationally segmented.

31-6

Value a project when it has inputs and outputs in different currencies.

II. Chapter Overview Starbucks Coffee Japan Ltd. is used to introduce this chapter. Three major issues when considering an investment in a foreign project: 1) foreign currency cash flows will likely result from the project, although the firm cares only about the home currency value 2) interest rates and costs of capital will likely be different in the foreign country 3) the firm will probably face a different tax rate in the foreign country, and will face two tax codes.

This chapter examines the conditions required for markets to be internationally integrated. It next shows how to value a foreign project and address the major issues. The chapter then uses two valuation methods to value foreign currency cash flows. Finally, the authors explore the implications of internationally segmented markets. An accompanying Excel spreadsheet contains this chapter’s tables.

31.1 Internationally Integrated Capital Markets This section begins with the development of covered interest parity for risky cash flows instead of riskless cash flows, as was developed in Chapter 30. The authors are careful to point out that the implicit assumption is that markets are internationally integrated, so that the value does not depend on the currency (home or foreign) used in the analysis. Example 31.1 shows that present value is the same whether the foreign currency or the home currency perspective is used.

31.2 Valuation of Foreign Currency Cash Flows Two methods can be used to calculate the NPV of a foreign project in an internationally integrated capital market. Either we can calculate the NPV in the foreign country and convert it to local currency at the spot rate, or we can convert the cash flows into the local currency and then calculate the NPV. The text emphasizes the first approach throughout, so the second approach is emphasized in this section.

Table 31.1 begins the example in which foreign free cash flows are converted into Canadian (CAD) dollars and then the NPV is calculated. This example uses a manufacturer of custom packaging products headquartered in Canada called Ityesi. The company wants to use the WACC method to value a project that is completely selfcontained in the United Kingdom, such that all revenues are generated there and all costs are incurred there. The first step is to calculate the forward exchange rates, using covered interest parity. Next, the free cash flows are converted into dollars using the forward rates (shown in Table 31.2). The WACC is calculated using the market value balance sheet in Table 31.3, and the NPV is calculated. .

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The Law of One Price can be used as a robustness check of the NPV. In order to use this method, the foreign cost of capital must be computed. Example 31.2 shows that calculation using equation 31.7. The same example shows the NPV calculation in pounds, then the conversion at the spot rate, resulting in the same NPV found using the first method (with a slight rounding error difference).

31.3 Valuation and International Taxation The assumption used thus far was that Ityesi pays a corporate tax rate of 40% no matter where its earnings are generated. In fact, the true tax calculation is far more complicated because corporate income taxes must be paid to two national governments: the host (The U.K. in this example) and the home (Canada). If a foreign project is a separately incorporated subsidiary of the parent, the amount of taxes paid depends on the profits repatriated and whether a tax treaty exists.

Canadian tax policy requires Canadian corporations to pay taxes on their foreign income at the same rate as Canadian profits if the income is passive or without a tax treaty; however, a full tax credit is given for foreign taxes paid up to the amount of the Canadian tax liability. If the foreign rate exceeds the Canadian tax rate, companies must pay the higher rate there, but they pay no income taxes in Canada.

If a Canadian corporation receives active income from a subsidiary located in a country that has a tax treaty, that income is not taxed when it is returned to Canada. This territorial approach to taxation contrasts sharply with America’s worldwide approach to taxation. Firms can lower their taxes by pooling multiple foreign projects and deferring the repatriation income that would be taxable at home.

31.4 Internationally Segmented Capital Markets The previous discussion has assumed internationally integrated capital markets. This section explores the implication when this is not the case. The authors begin with a brief discussion of the main reasons for segmentation of capital markets.

In some cases firms face differential access to markets. For example, if Ityesi is not well known in the U.K., it may have difficulty borrowing in the pound capital markets. This would make the pound WACC higher than the WACC computed using parity conditions. Differential access is probably the best explanation for the popularity of currency swaps.

Markets for risk-free securities may also be segmented. Capital controls and foreign exchange controls create barriers to international capital flows. Some countries restrict who can hold financial securities.

Political, social, legal, and cultural characteristics may require a country risk premium. If that is the case, then the risk-free rate used in covered interest arbitrage may not truly be risk free. Example 31.3 shows the effect of risky government bonds on covered interest parity.

A segmented financial market can have an important implication for international corporate finance: depending on the source of the segmentation, some corporations may have a competitive advantage by taking advantage of the imbalance. Example 31.4 illustrates valuing a foreign acquisition in a segmented market. It should be noted that the size of any imbalance will be limited to the ease with which it can be taken advantage of.

31.5 Capital Budgeting with Exchange Risk Thus far, the chapter has assumed that free cash flows are uncorrelated with the spot exchange rates. If, for example, Ityesi imports some of its raw materials from Canada, the pound free cash flows will be correlated with exchange rates. To correctly value such projects, the foreign and domestic cash flows should be valued separately. The most convenient approach to follow is to separate the cash flows according to the currency they depend on, as the authors do in Table 31.4. In practice, determining the sensitivities is sometimes difficult.

Regression analysis can provide further insight when historical data are available.

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III.

MyLab Finance Activities Text Section

Text Section Title

Problem s

Learning Objectives Covered

Text Page Reference

31.1

Internationally Integrated Capital Markets

1-2

31.1

1088-1090

31.2

Valuation of Foreign Currency Cash Flows

3-8

31.2 and 31.3

1090-1094

31.3

Valuation and International Taxation

9 - 11

31.4

1094-1096

31.4

Internationally Segmented Capital Markets

12

31.5

1096-1099

31.5

Capital Budgeting with Exchange Risk

13

31.6

1099-1103

IV. Spreadsheet Solutions in Excel The following problems for Chapter 31 have spreadsheet versions of the problems available: 31-3, 31-4, 31-8 and 31-13, along with various spreadsheet Tables. An excel suggested solution can also be found for the Data Case, but of course these solutions are time dependent — on the time of publication. These values are not likely to match the real time prices students will use when they perform their Data Case projects.

The Excel solution spreadsheets can be downloaded from the MyLab Finance.

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Etext Bug Report Author: Berk/DeMarzo/Stangeland Title: Corporate Finance Edition: 5th Canadian edition • This report documents known Etext bugs.

• The dates shown indicate when the bug was reported. Note that this bug report is not updated as bugs are resolved, so some bugs may no longer be active.

• The Impact field indicates whether a bug is universal and appears in all platforms/operating systems or if it is specific to certain platforms/operating systems only.

Bug description Jira ticket # (for internal use only) Date reported Impact Location

The variable "i" is misplaced and appears next to "∑" rather than below it.

CCQA-239573 08/19/2021 All platforms Chapter 11, Section 11.8, under heading Beta of a Portfolio

Bug description Jira ticket # (for internal use only) Date reported Impact Location

Heading 11.8 appears alone on the screen. The associated content follows on the next screen.

CQDS-119826 04/06/2021 All platforms Chapter 11, Section 11.8