Ross 9e FCF Case Solutions

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Fundamentals of Corporate Finance

Ross, Westerfield, and Jordan

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CHAPTER 1

THE McGEE CAKE COMPANY

1. The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may mean that more expenses can be considered business expenses and be deducted from the company’s income. 3) Improved credibility. The business may have increased credibility in the business world compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life, while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer ownership in a corporation through the sale of stock.

The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively small. There are also other potential costs, including more expansive record-keeping.

2. Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be higher.

3. As a small company, changing to a LLC is probably the most advantageous decision at the current time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be less expensive than forming a corporation.

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CASH FLOWS AND FINANCIAL

STATEMENTS AT SUNSET BOARDS

Below are the financial statements that you are asked to prepare.

1. The income statement for each year will look like this:

Income statement

2008 2009

Sales

$247,259

$301,392

Cost of goods sold

126,038

159,143

Selling & administrative

24,787

32,352

Depreciation

35,581

40,217

EBIT

$60,853

$69,680

Interest

7,735

8,866

EBT

$53,118

$60,814

Taxes

10,624

12,163

Net income

$42,494

$48,651

Dividends $21,247 $24,326

Addition to retained earnings 21,247 24,326

2. The balance sheet for each year will be:

Balance sheet as of Dec. 31, 2008

Cash $18,187 Accounts payable $32,143

Accounts receivable 12,887 Notes payable 14,651

Inventory 27,119 Current liabilities $46,794

Current assets $58,193

Long-term debt $79,235

Net fixed assets $156,975 Owners' equity 89,139

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C-2 CASE SOLUTIONS

In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total liabilities & equity is equal to total assets, equity can be calculated as:

Equity = $215,168 – 46,794 – 79,235 Equity = $89,139

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Balance sheet as of Dec. 31, 2009

Cash $27,478 Accounts payable $36,404

Accounts receivable 16,717 Notes payable 15,997

Inventory 37,216 Current liabilities $52,401

Current assets $81,411

Long-term debt $91,195

Net fixed assets $191,250 Owners' equity 129,065

Total assets $272,661 Total liab. & equity $272,661

The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained earnings, plus the new equity, so:

Equity = $89,139 + 24,326 + 15,600 Equity = $129,065

3. Using the OCF equation:

OCF = EBIT + Depreciation – Taxes The OCF for each year is:

OCF2008 = $60,853 + 35,581 – 10,624 OCF2008 = $85,180

OCF2009 = $69,680 + 40,217 – 12,163 OCF2009 = $97,734

4. To calculate the cash flow from assets, we need to find the capital spending and change in net

working capital. The capital spending for the year was:

Capital spending

Ending net fixed assets $191,250

– Beginning net fixed assets 156,975

+ Depreciation 40,217

Net capital spending $74,492

And the change in net working capital was:

Change in net working capital

Ending NWC $29,010

– Beginning NWC 11,399

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C-4 CASE SOLUTIONS

So, the cash flow from assets was:

Cash flow from assets

Operating cash flow $97,734

– Net capital spending 74,492

– Change in NWC 17,611

Cash flow from assets $ 5,631

5. The cash flow to creditors was:

Cash flow to creditors

Interest paid $8,866

– Net new borrowing 11,960

Cash flow to creditors –$3,094

6. The cash flow to stockholders was:

Cash flow to stockholders

Dividends paid $24,326

– Net new equity raised 15,600

Cash flow to stockholders $8,726

Answers to questions

1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from

operations. The firm invested $17,611 in new net working capital and $74,492 in new fixed assets. The firm gave $5,631 to its stakeholders. It raised $3,094 from bondholders, and paid $8,726 to stockholders.

2. The expansion plans may be a little risky. The company does have a positive cash flow, but a large

portion of the operating cash flow is already going to capital spending. The company has had to raise capital from creditors and stockholders for its current operations. So, the expansion plans may be too aggressive at this time. On the other hand, companies do need capital to grow. Before investing or loaning the company money, you would want to know where the current capital spending is going, and why the company is spending so much in this area already.

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RATIOS ANALYSIS AT S&S AIR

1. The calculations for the ratios listed are:

Current ratio = $2,186,520 / $2,919,000 Current ratio = 0.75 times

Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000 Quick ratio = 0.39 times

Cash ratio = $441,000 / $2,919,000 Cash ratio = 0.15 times

Total asset turnover = $30,499,420 / $18,308,920 Total asset turnover = 1.67 times

Inventory turnover = $22,224,580 / $1,037,120 Inventory turnover = 21.43 times

Receivables turnover = $30,499,420 / $708,400 Receivables turnover = 43.05 times

Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920 Total debt ratio = 0.45 times

Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920 Debt-equity ratio = 0.82 times

Equity multiplier = $18,308,920 / $10,069,920 Equity multiplier = 1.82 times

Times interest earned = $3,040,660 / $478,240 Times interest earned = 6.36 times

Cash coverage = ($3,040,660 + 1,366,680) / $478,420 Cash coverage = 9.22 times

Profit margin = $1,537,452 / $30,499,420 Profit margin = 5.04%

Return on assets = $1,537,452 / $18,308,920 Return on assets = 8.40%

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C-6 CASE SOLUTIONS

Return on equity = $1,537,452 / $10,069,920 Return on equity = 15.27%

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2. Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense industry, as well as Boeing Capital, which finances airplanes.

Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting amphibious aircraft and also provides defense-related services. It is the third largest commercial aircraft manufacturer in the world. Embraer is a Brazilian manufacturer than manufactures commercial, military, and corporate airplanes. Additionally, the Brazilian government is a part owner of the company. Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products and manufacture of larger aircraft.

Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft. Its SR22 is the world's best selling plane in its class. The company is noted for its innovative small aircraft and is a good aspirant company.

Cessna is a well known manufacturer of small airplanes. The company produces business jets, freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons. It may be a good aspirant company, however, its products could be considered too broad and diversified since S&S Air produces only small personal airplanes.

3. S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash ratio is lower than the industry median.

The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are above the upper quartile. This may mean that S&S Air is more efficient than the industry.

The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than comparable companies, but still within the normal range.

The profit margin, ROA, and ROE are all slightly below the industry median, however, not dramatically lower. The company may want to examine its costs structure to determine if costs can be reduced, or price can be increased.

Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.

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C-8 CASE SOLUTIONS

Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the industry. Note that the list is not exhaustive, but merely one possible explanation for each ratio.

Ratio Good Bad

Current ratio Better at managing current

accounts.

May be having liquidity problems.

Quick ratio Better at managing current

accounts.

May be having liquidity problems.

Cash ratio Better at managing current

accounts.

May be having liquidity problems.

Total asset turnover Better at utilizing assets. Assets may be older and

depreciated, requiring extensive investment soon.

Inventory turnover Better at inventory management,

possibly due to better procedures.

Could be experiencing inventory shortages.

Receivables turnover Better at collecting receivables. May have credit terms that are too strict. Decreasing receivables turnover may increase sales.

Total debt ratio Less debt than industry median

means the company is less likely to experience credit problems.

Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.

Debt-equity ratio Less debt than industry median

means the company is less likely to experience credit problems.

Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.

Equity multiplier Less debt than industry median

means the company is less likely to experience credit problems.

Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.

TIE Higher quality materials could be

increasing costs.

The company may have more difficulty meeting interest payments in a downturn.

Cash coverage Less debt than industry median

means the company is less likely to experience credit problems.

Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.

Profit margin The PM is slightly below the

industry median. It could be a result of higher quality materials or better manufacturing.

Company may be having trouble controlling costs.

ROA Company may have newer assets

than the industry.

Company may have newer assets than the industry.

ROE Lower profit margin may be a

result of higher quality.

Profit margin and EM are lower than industry, which results in the lower ROE.

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PLANNING FOR GROWTH AT S&S AIR

1. To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so: ROA = NI / TA ROA = $1,537,452 / $18,309,920 ROA = .0840 or 8.40% b = Addition to RE / NI b = $977,452 / $1,537,452 b = 0.64

Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)] Internal growth rate = .0564 or 5.64%

To find the sustainable growth rate, we need the ROE, which is: ROE = NI / TE

ROE = $1,537,452 / $10,069,920 ROE = .1527 or 15.27%

Using the retention ratio we previously calculated, the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)] Sustainable growth rate = .1075 or 10.75%

The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure.

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C-10 CASE SOLUTIONS

2. Pro forma financial statements for next year at a 12 percent growth rate are:

Income statement Sales $ 34,159,350 COGS 24,891,530 Other expenses 4,331,600 Depreciation 1,366,680 EBIT $ 3,569,541 Interest 478,240 Taxable income $ 3,091,301 Taxes (40%) 1,236,520 Net income $ 1,854,780 Dividends $ 675,583 Add to RE 1,179,197 Balance sheet

Assets Liabilities & Equity

Current Assets Current Liabilities

Cash $ 493,920 Accounts Payable $ 995,680

Accounts rec. 793,408 Notes Payable 2,030,000

Inventory 1,161,574 Total CL $ 3,025,680 Total CA $ 2,448,902 Long-term debt $ 5,320,000 Shareholder Equity Common stock $ 350,000

Fixed assets Retained earnings 10,899,117

Net PP&E $ 18,057,088 Total Equity $ 11,249,117

Total Assets $ 20,505,990 Total L&E $ 19,594,787

So, the EFN is:

EFN = Total assets – Total liabilities and equity EFN = $20,505,990 – 19,594,797

EFN = $911,193

The company can grow at this rate by changing the way it operates. For example, if profit margin increases, say by reducing costs, the ROE increases, it will increase the sustainable growth rate. In general, as long as the company increases the profit margin, total asset turnover, or equity multiplier, the higher growth rate is possible. Note however, that changing any one of these will have the effect of changing the pro forma financial statements.

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3. Now we are assuming the company can only build in amounts of $5 million. We will assume that the company will go ahead with the fixed asset acquisition. To estimate the new depreciation charge, we will find the current depreciation as a percentage of fixed assets, then, apply this percentage to the new fixed assets. The depreciation as a percentage of assets this year was:

Depreciation percentage = $1,366,680 / $16,122,400 Depreciation percentage = .0848 or 8.48%

The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16,122,400 + 5,000,000 = $21,122,400 So, the pro forma depreciation will be:

Pro forma depreciation = .0848($21,122,400) Pro forma depreciation = $1,790,525

We will use this amount in the pro forma income statement. So, the pro forma income statement will be: Income statement Sales $ 34,159,350 COGS 24,891,530 Other expenses 4,331,600 Depreciation 1,790,525 EBIT $ 3,145,696 Interest 478,240 Taxable income $ 2,667,456 Taxes (40%) 1,066,982 Net income $ 1,600,473 Dividends $ 582,955 Add to RE 1,017,519

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C-12 CASE SOLUTIONS

The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The fixed asset account will increase by $5 million, rather than the growth rate of sales.

Balance sheet

Assets Liabilities & Equity

Current Assets Current Liabilities

Cash $ 493,920 Accounts Payable $ 995,680

Accounts rec. 793,408 Notes Payable 2,030,000

Inventory 1,161,574 Total CL $ 3,025,680 Total CA $ 2,448,902 Long-term debt $ 5,320,000 Shareholder Equity Common stock $ 350,000

Fixed assets Retained earnings 10,737,439

Net PP&E $ 21,122,400 Total Equity $ 11,087,439

Total Assets $ 23,571,302 Total L&E $ 19,433,119

So, the EFN is:

EFN = Total assets – Total liabilities and equity EFN = $23,581,302 – 19,433,119

EFN = $4,138,184

Since the fixed assets have increased at a faster percentage than sales, the capacity utilization for next year will decrease.

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THE MBA DECISION

1. Age is obviously an important factor. The younger an individual is, the more time there is for the (hopefully) increased salary to offset the cost of the decision to return to school for an MBA. The cost includes both the explicit costs such as tuition, as well as the opportunity cost of the lost salary.

2. Perhaps the most important nonquantifiable factors would be whether or not he is married and if he has any children. With a spouse and/or children, he may be less inclined to return for an MBA since his family may be less amenable to the time and money constraints imposed by classes. Other factors would include his willingness and desire to pursue an MBA, job satisfaction, and how important the prestige of a job is to him, regardless of the salary.

3. He has three choices: remain at his current job, pursue a Wilton MBA, or pursue a Mt. Perry MBA. In this analysis, room and board costs are irrelevant since presumably they will be the same whether he attends college or keeps his current job. We need to find the aftertax value of each, so:

Remain at current job :

Aftertax salary = $55,000(1 – .26) = $40,700

His salary will grow at 3 percent per year, so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $40,700{[1 – [(1 +.065)/(1 + .03)]38} / (.065 – .03)

PV = $836,227.34

Wilton MBA:

Costs:

Total direct costs = $63,000 + 2,500 + 3,000 = $68,500 PV of direct costs = $68,500 + 68,500 / (1.065) = $132,819.25

PV of indirect costs (lost salary) = $40,700 / (1.065) + $40,700(1 + .03) / (1 + .065)2 = $75,176.00

Salary:

PV of aftertax bonus paid in 2 years = $15,000(1 – .31) / 1.0652 = $9,125.17

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His salary will grow at 4 percent per year. We must also remember that he will now only work for 36 years, so the present value of his aftertax salary is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $67,620{[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)

PV = $1,554,663.22

Since the first salary payment will be received three years from today, so we need to discount this for two years to find the value today, which will be:

PV = $1,544,663.22 / 1.0652

PV = $1,370,683.26

So, the total value of a Wilton MBA is:

Value = –$75,160 – 132,819.25 + 9,125.17 + 1,370,683.26 = $1,171,813.18

Mount Perry MBA :

Costs:

Total direct costs = $78,000 + 3,500 + 3,000 = $86,500. Note, this is also the PV of the direct costs since they are all paid today.

PV of indirect costs (lost salary) = $40,700 / (1.065) = $38,215.96 Salary:

PV of aftertax bonus paid in 1 year = $10,000(1 – .29) / 1.065 = $6,666.67 Aftertax salary = $81,000(1 – .29) = $57,510

His salary will grow at 3.5 percent per year. We must also remember that he will now only work for 37 years, so the present value of his aftertax salary is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $57,510{[1 – [(1 +.065)/(1 + .035)]37} / (.065 – .035)

PV = $1,250,991.81

Since the first salary payment will be received two years from today, so we need to discount this for one year to find the value today, which will be:

PV = $1,250,991.81 / 1.065 PV = $1,174,640.20

So, the total value of a Mount Perry MBA is:

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C-16 CASE SOLUTIONS

4. He is somewhat correct. Calculating the future value of each decision will result in the option with the highest present value having the highest future value. Thus, a future value analysis will result in the same decision. However, his statement that a future value analysis is the correct method is wrong since a present value analysis will give the correct answer as well.

5. To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the current job, we need to take the PV of his current job, add the costs of attending Wilton, and the PV of the bonus on an aftertax basis. So, the necessary PV to make the Wilton MBA the same as his current job will be:

PV = $836,227.34 + 132,819.25 + 75,176.00 – 9,125.17 = $1,035,097.42

This PV will make his current job exactly equal to the Wilton MBA on a financial basis. Since his salary will still be a growing annuity, the aftertax salary needed is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

$1,035,097.42 = C {[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)

C = $45,021.51

This is the aftertax salary. So, the pretax salary must be: Pretax salary = $45,021.51 / (1 – .31) = $65,248.57

6. The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the source of the funds. Therefore, whether he can pay cash or must borrow is irrelevant. This is an important concept which will be discussed further in capital budgeting and the cost of capital in later chapters.

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FINANCING S&S AIR’S EXPANSION

PLANS WITH A BOND ISSUE

A rule of thumb with bond provisions is to determine who benefits by the provision. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate.

1. A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell the asset used as collateral, and they will generally have to keep the asset in good working order.

2. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds.

3. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. This means the company must be able to generate these cash flows.

4. A provision with a specific call date and prices would increase the coupon rate. The call provision would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call provision cost.

5. A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the company cannot call the bond for a specified period. This offers the bondholders protection for this period. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. Interest rates could potentially fall to the point where it would be beneficial for the company to call the bond, yet the company is unable to do so.

6. A make-whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make-whole call repays the bondholder the present value of the future cash flows. However, a make-whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain vanilla bond and a make-whole bond. If a bond with a make-whole provision is called, bondholders receive the market value of the bond, which they can reinvest in another bond with similar

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CASE 3 C-18

characteristics. If we compare this to a bond with a specific call price, investors rarely receive the full market value of the future cash flows.

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7. A positive covenant would reduce the coupon rate. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. Examples of positive covenants would be: the company must maintain audited financial statements; the company must maintain a minimum specified level of working capital or a minimum specified current ratio; the company must maintain any collateral in good working order. The negative side of positive covenants is that the company is restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake.

8. A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of negative covenants would be: the company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral. The downside of negative covenants is the restriction of the company’s actions.

9. Even though the company is not public, a conversion feature would likely lower the coupon rate. The conversion feature would permit bondholders to benefit if the company does well and also goes public. The downside is that the company may be selling equity at a discounted price.

10. The downside of a floating-rate coupon is that if interest rates rise, the company has to pay a higher

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CHAPTER 8

STOCK VALUATION AT RAGAN, INC.

1. The total dividends paid by the company were $126,000. Since there are 100,000 shares outstanding, the total earnings for the company were:

Total earnings = 100,000($4.54) = $454,000 This means the payout ratio was:

Payout ratio = $126,000/$454,000 = 0.28 So, the retention ratio was:

Retention ratio = 1 – .28 = 0.72

Using the retention ratio, the company’s growth rate is:

g = ROE × b = .28(.72) = .1806 or 18.06%

The dividend per share paid this year was: D0 = $63,000 / 50,000

D0 = $1.26

Now we can find the stock price, which is: P0 = D1 / (R – g)

P0 = $1.26(1.1806) / (.20 – .1806)

P0 = $76.75

2. Since Expert HVAC had a write off which affected its earnings per share, we need to recalculate the industry EPS. So, the industry EPS is:

Industry EPS = ($0.79 + 1.38 + 1.06) / 3 = $1.08 Using this industry EPS, the industry payout ratio is: Industry payout ratio = $0.40/$1.08 = .3715 or 37.15% So, the industry retention ratio is

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C-22 CASE SOLUTIONS

This means the industry growth rate is: Industry g = .1233(.6285) = .0775 or 7.75%

The company will continue to grow at its current pace for five years before slowing to the industry growth rate. So, the total dividends for each of the next six years will be:

D1 = $1.26(1.1806) = $1.49 D2 = $1.49(1.1806) = $1.76 D3 = $1.76(1.1806) = $2.07 D4 = $2.07(1.1806) = $2.45 D5 = $2.45(1.1806) = $2.89 D6 = $2.89(1.0849) = $3.11

The stock price in Year 5 with the industry required return will be: Stock value in Year 5 = $3.11 / (.1167 – .0775) = $79.54

This means the total value of the stock today is:

P0 = $1.149/1.1167 + $1.76/1.11672 + $2.07/1.11673 + $2.45/1.11674 + ($2.89 + 79.54) / 1.11675

P0 = $53.28

3. Using the revised industry EPS, the industry PE ratio is: Industry PE = $13.09 / $1.08 = 12.15

Using the original stock price assumption, Ragan’s PE ratio is: Ragan PE (original assumptions) = $76.75 / $4.54 = 16.90

Using the revised assumptions, Ragan’s PE = $53.28 / $4.54 = 11.74

Obviously, using the original assumptions, Ragan’s PE is too high. The PE using the revised assumptions is close to the industry PE ratio. Using the industry average PE, we can calculate a stock price for Ragan, which is:

Stock price implied by industry PE = 12.15($4.32) = $55.18

4. If the ROE on the company’s projects exceeds the required return, the company should retain earnings and reinvest. If the ROE on the company’s projects is lower than the required return, the company should pay dividends. This makes logical sense. Consider a company with a 10 percent required return. If the company can keep retained earnings and reinvest those earnings at 15 percent, shareholders would be better off since the dividends in future years would be more than needed for the required return.

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5. Again, we will assume the results in Question 2 are correct. The growth rate of the company we calculated in this question was the industry growth rate of 7.75 percent. Since the growth rate is: g = ROE × b

If we assume the payout ratio remains constant, the ROE is: .0775 = ROE(.72)

ROE = .1073 or 10.73%

6. The most obvious solution is to retain more of the company’s earnings and invest in profitable opportunities. This strategy will not work if the return on the company’s investment is lower than the required return on the company’s stock.

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CHAPTER 9

BULLOCK GOLD MINING

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Note, there is no Excel function to directly calculate the payback period. We used “If” statements in our spreadsheet. The IF statement we used is:

=IF(-D8>(D9+D10+D11+D12+D13+D14),"Greater than 6 years",IF(-

D>(D9+D10+D11+D12+D13),(5+(-D8-D9-D10-D11-D12-D13)/D14),IF(- D8>(D9+D10+D11+D12),(4+(-D8-D9-D10-D11-D12)/D13),IF(-D8>(D9+D10+D11),(3+(-D8-D9- D10-D11)/D12),IF(-D8>(D9+D10),(2+(-D8-D9-D10)/D11),IF(-D8>D9,(1+(-D8-D9)/D10),IF(-D8<D9,-D8/D9," ")))))))

2. Since the NPV of the mine is positive, the company should open the mine. We should note, it may be advantageous to delay the mine opening because of real options, a topic covered in more detail in a later chapter.

3. There are many possible variations on the VBA code to calculate the payback period. Below is a VBA program from http://www.vbaexpress.com/kb/getarticle.php?kb_id=252.

Function PAYBACK(invest, finflow) Dim x As Double, v As Double Dim c As Integer, i As Integer x = Abs(invest) i = 1 c = finflow.Count Do x = x - v v = finflow.Cells(i).Value If x = v Then PAYBACK = i Exit Function ElseIf x < v Then P = i - 1 Z = x / v PAYBACK = P + Z Exit Function End If i = i + 1 Loop Until i > c

PAYBACK = "no payback" End Function

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CHAPTER 10

CONCH REPUBLIC ELECTRONICS,

PART 1

This is an in-depth capital budgeting problem. The initial cash outlay at Time 0 is simply the cost of the new equipment, $21,500,000. The sales each year are a combination of the sales of the new PDA, the lost sales each year, and the lost revenue. In this case, the lost sales are 15,000 units of the old PDA each year for two years at a price of $290 each. The company will also be forced to reduce the price of the old PDA on the units they will still sell for the next two years. So, the total change in sales is:

Sales = New sales – Lost sales – Lost revenue

Year 1 = (74,000 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] = $20,015,000 Year 2 = (95,000 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] = $28,275,000

Sales Year 1 Year 2 Year 3 Year 4 Year 5

New $26,640,000 $34,200,000 $45,000,000 $37,800,000 $28,800,000 Lost sales –4,350,000 –4,350,000 Lost revenue –2,275,000 –1,575,000 Net sales $20,015,000 $28,275,000 $45,000,000 $37,800,000 $28,800,000 VC New $11,470,000 $14,725,000 $19,375,000 $16,275,000 $12,400,000 Lost sales –1,800,000 –1,800,000 $9,670,000 $12,925,000 $19,375,000 $16,275,000 $12,400,000 Sales $20,015,000 $28,275,000 $45,000,000 $37,800,000 $28,800,000 VC 9,670,000 12,925,000 19,375,000 16,275,000 12,400,000 Fixed costs 4,700,000 4,700,000 4,700,000 4,700,000 4,700,000 Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 EBT $2,572,650 $5,384,650 $17,164,650 $14,139,650 $9,780,050 Tax 900,428 1,884,628 6,007,628 4,948,878 3,423,018 NI $1,672,223 $3,500,023 $11,157,023 $9,190,773 $6,357,033 + Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 OCF $4,744,573 $8,765,373 $14,917,373 $11,876,123 $8,276,983

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NWC Beg $0 $4,003,000 $5,655,000 $9,000,000 $7,560,000 End 4,003,000 5,655,000 9,000,000 7,560,000 0 NWC CF –$4,003,000 –$1,652,000 –$3,345,000 $1,440,000 $7,560,000 Net CF $741,573 $7,113,373 $11,572,373 $13,316,123 $15,836,983 BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650

Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828

CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828 So, the cash flows of the project are:

Time Cash flow

0 –$21,500,000 1 741,573 2 7,113,373 3 11,572,373 4 13,316,123 5 20,180,810

1. The payback period is:

Payback period = 3 + ($2,072,683 / $13,316,123) Payback period = 3.156 years

2. The profitability index is:

Profitability index = [($741,573 / 1.12) + ($7,113,373 / 1.122) + ($11,572,373 / 1.123) +

($13,316,123 / 1.124) + ($20,180,810 / 1.125)] / $21,500,000

Profitability index = 1.604

3. The project IRR is:

IRR: –$21,500,000 = $741,573 / (1 + IRR) + $7,113,373 / (1 + IRR)2 + $11,572,373 / (1 + IRR)3 +

$13,316,123 / (1 + IRR)4 + $20,180,810 / (1 + IRR)5

IRR = 27.62%

4. The project NPV is:

NPV = –$21,500,000 + $741,573 / 1.12 + $7,113,373 / 1.122 + $11,572,373 / 1.123 +

$13,316,123 / 1.124 + $20,180,810 / 1.125

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CHAPTER 11

CONCH REPUBLIC ELECTRONICS,

PART 2

1. Here we want to examine the sensitivity of NPV to changes in the price of the new PDA. The

calculations for sensitivity to changes in price are similar to the original cash flows. The only difference is that we will change the price of the PDA. We will use a price of $370 per unit, but remember that the price we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one dollar change in price will be the same no matter what price we use. The projections with the new prices are:

The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or:

Sales = New sales – Lost sales – Lost revenue

Year 1 sales = (74,000 × $370) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,755,000

Year 2 sales = (95,000 × $370) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $29,225,000

Sales Year 1 Year 2 Year 3 Year 4 Year 5

New $27,380,000 $35,150,000 $46,250,000 $38,850,000 $29,600,000 Lost sales 4,350,000 4,350,000 Lost revenue 2,275,000 1,575,000 Net sales $20,755,000 $29,225,000 $46,250,000 $38,850,000 $29,600,000 VC New $11,470,000 $14,725,000 $19,375,000 $16,275,000 $12,400,000 Lost sales 1,800,000 1,800,000 $9,670,000 $12,925,000 $19,375,000 $16,275,000 $12,400,000

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Sales $20,755,000 $29,225,000 $46,250,000 $38,850,000 $29,600,000 VC 9,670,000 12,925,000 19,375,000 16,275,000 12,400,000 Fixed costs 4,700,000 4,700,000 4,700,000 4,700,000 4,700,000 Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 EBT $3,312,650 $6,334,650 $18,414,650 $15,189,650 $10,580,050 Tax 1,159,428 2,217,128 6,445,128 5,316,378 3,703,018 NI $2,153,223 $4,117,523 $11,969,523 $9,873,273 $6,877,033 + Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 OCF $5,225,573 $9,382,873 $15,729,873 $12,558,623 $8,796,983 NWC Beg $0 $4,151,000 $5,845,000 $9,250,000 $7,770,000 End 4,151,000 5,845,000 9,250,000 7,770,000 0 NWC CF –$4,151,000 –$1,694,000 –$3,405,000 $1,480,000 $7,770,000 Net CF $1,074,573 $7,688,873 $12,324,873 $14,038,623 $16,566,983 BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650

Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828

CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828 So, the cash flows of the project under this price assumption are:

Time Cash flow

0 –$21,500,000 1 1,074,573 2 7,688,873 3 12,324,873 4 14,038,623 5 20,910,810

The NPV with this sales price is:

NPV = –$21,500,000 + $1,074,573 / 1.12 + $7,688,873 / 1.122 + $12,324,873 / 1.123 +

$14,038,623 / 1.124 + $20,910,810 / 1.125

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C-30 CASE SOLUTIONS

And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($15,148,716.18 – 12,983,611.62) / ($370 – 360) ΔNPV/ΔP = $216,510.46

For every dollar change in price of the new PDA, the NPV of the project changes $216,510.46 in the same direction.

2. Here we want to examine the sensitivity of NPV to changes in the quantity sold. The calculations for

sensitivity to changes in quantity are similar to the original cash flows. The only difference is that we will change the quantity sold of the new PDA. We will increase unit sold by 100 units per year. Remember that the quantity we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one unit per year change in sales. The projections with the quantity are:

The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or:

Sales = New sales – Lost sales – Lost revenue

Year 1 sales = (74,100 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,051,000

Year 2 sales = (95,100 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $28,311,000

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Sales Year 1 Year 2 Year 3 Year 4 Year 5 New $26,676,000 $34,236,000 $45,036,000 $37,836,000 $28,836,000 Lost sales 4,350,000 4,350,000 Lost revenue 2,275,000 1,575,000 Net sales $20,051,000 $28,311,000 $45,036,000 $37,836,000 $28,836,000 VC New $11,485,500 $14,740,500 $19,390,500 $16,290,500 $12,415,500 Lost sales 1,800,000 1,800,000 $9,685,500 $12,940,500 $19,390,500 $16,290,500 $12,415,500 Sales $20,051,000 $28,311,000 $45,036,000 $37,836,000 $28,836,000 VC 9,685,500 12,940,500 19,390,500 16,290,500 12,415,500 Fixed costs 4,700,000 4,700,000 4,700,000 4,700,000 4,700,000 Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 EBT $2,593,150 $5,405,150 $17,185,150 $14,160,150 $9,800,550 Tax 907,603 1,891,803 6,014,803 4,956,053 3,430,193 NI $1,685,548 $3,513,348 $11,170,348 $9,204,098 $6,370,358 + Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950 OCF $4,757,898 $8,778,698 $14,930,698 $11,889,448 $8,290,308 NWC Beg $0 $4,010,200 $5,662,200 $9,007,200 $7,567,200 End 4,010,200 5,662,200 9,007,200 7,567,200 0 NWC CF –$4,010,200 –$1,652,000 –$3,345,000 $1,440,000 $7,567,200 Net CF $747,698 $7,126,698 $11,585,698 $13,329,448 $15,857,508 BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650

Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828

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C-32 CASE SOLUTIONS

So, the cash flows of the project under this quantity assumption are:

Time Cash flow

0 –$21,500,000 1 747,698 2 7,126,698 3 11,585,698 4 13,329,448 5 20,201,335

The NPV under this assumption is:

NPV = –$21,500,000 + $747,698 / 1.12 + $7,126,698 / 1.122 + $11,585,698 / 1.123 +

$13,329,448 / 1.124 + $20,201,335 / 1.125

NPV = $13,029,302.17

So, the sensitivity of NPV to units sold is:

ΔNPV/ΔQ = ($13,029,302.17 – 12,983,611.62) / 100 ΔNPV/ΔQ = $456.91

For a one unit per year change in quantity sold of the new PDA, the NPV of the project changes $456.91 in the same direction.

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A JOB AT S&S AIR

1. The biggest advantage the mutual funds have is instant diversification. The mutual funds have a number of assets in the portfolio.

2. Both the APR and EAR are infinite. The match is instantaneous, so the number of periods in a year is infinite.

3. The advantage of the actively managed fund is the possibility of outperforming the market, which

the fund has done six of the last eight years. The major disadvantage is the likelihood of underperforming the market. In general, most mutual funds do not outperform the market for an extended period of time, and finding the funds that will outperform the market in the future beforehand is a daunting task. One factor that makes outperforming the market even more difficult is the management fee charged by the fund.

4. The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest. This does not imply the fund is bad, just that the risk is higher, and therefore, the expected return is higher. You would want to invest in this fund if your risk tolerance is such that you are willing to take on the additional risk in expectation of a higher return.

The higher expenses of the fund are expected. In general, small cap funds have higher expenses, in large part due to the greater cost of running the fund, including researching smaller stocks.

5. Since we are given the average return for each fund over the past 10 years, we should use the

average risk-free rate over the same period. So, using the information from Table 10.1, the 10-year average risk-free rate is:

Risk-free rate = (.0486 + .0480 + .0598 + .0333 +.0161 +.0094 +.0114 + .0279 + .0497 + .0452) / 10 Risk-free rate = .0349 or 3.49%

The Sharpe ratio for each of the mutual funds and the company stocks are: Bledsoe S&P 500 Index Fund = (11.48% – 3.49) / 15.82% = .5048

Bledsoe Small-Cap Fund = (16.68% – 3.49) / 19.64% = .6714

Bledsoe Large Company Stock Fund = (11.85% – 3.49) / 15.41% = .5422 Bledsoe Bond Fund = (9.67% – 3.49) / 10.83% = .5703

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C-34 CASE SOLUTIONS

The Sharpe ratio is most applicable for a diversified portfolio, and is least applicable for the company stock.

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6. This is a very open-ended question. The asset allocation depends on the risk tolerance of the individual. However, most students will be young, so in this case, the portfolio allocation should be more heavily weighted toward stocks.

In any case, there should be little, if any, money allocated to the company stock. The principle of diversification indicates that an individual should hold a diversified portfolio. Investing heavily in company stock does not create a diversified portfolio. This is especially true since income comes from the company as well. If times get bad for the company, employees face layoffs, or reduced work hours. So, not only does the investment perform poorly, but income may be reduced as well. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. At most, 5 to 10 percent of the portfolio should be allocated to company stock.

Age is a determinant in the decision. Older individuals should be less heavily weighted toward stocks. A commonly used rule of thumb is that an individual should invest 100 minus their age in stocks. Unfortunately, this rule of thumb tends to result in an underinvestment in stocks.

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CHAPTER 13

THE BETA FOR AMERICAN STANDARD

NOTE: The example below shows the results from May 2008. The actual answer to the case will change based on current market conditions

1. The information used for the analysis is presented below. Note that the risk-free rate (3-month T-bill

rate) is expressed as an annual rate. It is necessary to find the monthly rate, so this rate is divided by 12. Risk-free Monthl y Risk-free Stock price Return S&P 500 S&P 500 return Stock risk premium S&P risk premium May-03 $53.91 963.59 Jun-03 0.0107 0.00089 $52.40 -0.0280 974.5 0.0113 -0.0289 0.0104 Jul-03 0.0092 0.00077 $49.58 -0.0538 990.31 0.0162 -0.0546 0.0155 Aug-03 0.009 0.00075 $50.20 0.0125 1008.01 0.0179 0.0118 0.0171 Sep-03 0.0095 0.00079 $50.75 0.0110 995.97 -0.0119 0.0102 -0.0127 Oct-03 0.0094 0.00078 $48.50 -0.0443 1050.71 0.0550 -0.0451 0.0542 Nov-03 0.0092 0.00077 $47.87 -0.0130 1058.2 0.0071 -0.0138 0.0064 Dec-03 0.0093 0.00078 $45.64 -0.0466 1111.92 0.0508 -0.0474 0.0500 Jan-04 0.009 0.00075 $46.97 0.0291 1131.13 0.0173 0.0284 0.0165 Feb-04 0.0088 0.00073 $50.80 0.0815 1144.94 0.0122 0.0808 0.0115 Mar-04 0.0093 0.00078 $50.48 -0.0063 1126.21 -0.0164 -0.0071 -0.0171 Apr-04 0.0094 0.00078 $53.25 0.0549 1107.3 -0.0168 0.0541 -0.0176 May-04 0.0094 0.00078 $52.63 -0.0116 1120.68 0.0121 -0.0124 0.0113 Jun-04 0.0102 0.00085 $53.78 0.0219 1140.84 0.0180 0.0210 0.0171 Jul-04 0.0127 0.00106 $49.16 -0.0859 1101.72 -0.0343 -0.0870 -0.0353 Aug-04 0.0133 0.00111 $49.90 0.0151 1104.24 0.0023 0.0139 0.0012 Sep-04 0.0148 0.00123 $41.75 -0.1633 1114.58 0.0094 -0.1646 0.0081 Oct-04 0.0165 0.00138 $41.45 -0.0072 1130.2 0.0140 -0.0086 0.0126 Nov-04 0.0176 0.00147 $42.73 0.0309 1173.82 0.0386 0.0294 0.0371 Dec-04 0.0207 0.00173 $47.53 0.1123 1211.92 0.0325 0.1106 0.0307 Jan-05 0.0219 0.00183 $49.05 0.0320 1181.27 -0.0253 0.0302 -0.0271 Feb-05 0.0233 0.00194 $49.40 0.0071 1203.6 0.0189 0.0052 0.0170 Mar-05 0.0254 0.00212 $48.70 -0.0142 1180.59 -0.0191 -0.0163 -0.0212 Apr-05 0.0274 0.00228 $46.74 -0.0402 1156.85 -0.0201 -0.0425 -0.0224

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May-05 0.0278 0.00232 $46.91 0.0036 1191.5 0.0300 0.0013 0.0276 Jun-05 0.0284 0.00237 $46.85 -0.0013 1191.33 -0.0001 -0.0036 -0.0025 Jul-05 0.0297 0.00248 $49.98 0.0668 1234.18 0.0360 0.0643 0.0335 Aug-05 0.0322 0.00268 $49.56 -0.0084 1220.33 -0.0112 -0.0111 -0.0139

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C-38 CASE SOLUTIONS Sep-05 0.0344 0.00287 $49.84 0.0056 1228.81 0.0069 0.0028 0.0041 Oct-05 0.0342 0.00285 $50.28 0.0088 1207.01 -0.0177 0.0060 -0.0206 Nov-05 0.0371 0.00309 $51.76 0.0294 1249.48 0.0352 0.0263 0.0321 Dec-05 0.0388 0.00323 $52.07 0.0060 1248.29 -0.0010 0.0028 -0.0042 Jan-06 0.0389 0.00324 $52.39 0.0061 1280.08 0.0255 0.0029 0.0222 Feb-06 0.0424 0.00353 $52.00 -0.0074 1280.66 0.0005 -0.0110 -0.0031 Mar-06 0.0443 0.00369 $54.50 0.0481 1294.87 0.0111 0.0444 0.0074 Apr-06 0.0451 0.00376 $56.75 0.0413 1310.61 0.0122 0.0375 0.0084 May-06 0.046 0.00383 $57.92 0.0206 1270.09 -0.0309 0.0168 -0.0348 Jun-06 0.0472 0.00393 $57.50 -0.0073 1270.2 0.0001 -0.0112 -0.0038 Jul-06 0.0479 0.00399 $57.23 -0.0047 1276.66 0.0051 -0.0087 0.0011 Aug-06 0.0495 0.00413 $57.75 0.0091 1303.82 0.0213 0.0050 0.0171 Sep-06 0.0496 0.00413 $59.92 0.0376 1335.85 0.0246 0.0334 0.0204 Oct-06 0.0481 0.00401 $62.05 0.0355 1377.94 0.0315 0.0315 0.0275 Nov-06 0.0492 0.0041 $63.10 0.0169 1400.63 0.0165 0.0128 0.0124 Dec-06 0.0494 0.00412 $63.28 0.0029 1418.3 0.0126 -0.0013 0.0085 Jan-07 0.0485 0.00404 $66.57 0.0520 1438.24 0.0141 0.0479 0.0100 Feb-07 0.0498 0.00415 $65.70 -0.0131 1406.82 -0.0218 -0.0172 -0.0260 Mar-07 0.0503 0.00419 $65.10 -0.0091 1420.86 0.0100 -0.0133 0.0058 Apr-07 0.0494 0.00412 $66.38 0.0197 1482.37 0.0433 0.0155 0.0392 May-07 0.0487 0.00406 $65.62 -0.0114 1530.62 0.0325 -0.0155 0.0285 Jun-07 0.0473 0.00394 $63.55 -0.0315 1503.35 -0.0178 -0.0355 -0.0218 Jul-07 0.0461 0.00384 $65.02 0.0231 1455.27 -0.0320 0.0193 -0.0358 Aug-07 0.0482 0.00402 $65.34 0.0049 1473.99 0.0129 0.0009 0.0088 Sep-07 0.042 0.0035 $70.26 0.0753 1526.75 0.0358 0.0718 0.0323 Oct-07 0.0389 0.00324 $75.51 0.0747 1549.38 0.0148 0.0715 0.0116 Nov-07 0.039 0.00325 $79.28 0.0499 1481.14 -0.0440 0.0467 -0.0473 Dec-07 0.0327 0.00273 $77.18 -0.0265 1468.36 -0.0086 -0.0292 -0.0114 Jan-08 0.03 0.0025 $76.10 -0.0140 1378.55 -0.0612 -0.0165 -0.0637 Feb-08 0.0275 0.00229 $75.70 -0.0053 1330.63 -0.0348 -0.0075 -0.0371 Mar-08 0.0212 0.00177 $77.51 0.0239 1322.7 -0.0060 0.0221 -0.0077 Apr-08 0.0126 0.00105 $70.70 -0.0879 1385.59 0.0475 -0.0889 0.0465 May-08 0.0129 0.00108 $72.15 0.0205 1394.35 0.0063 0.0194 0.0052

Using the Excel functions for the average return and standard deviation, the table below shows the averages and standard deviations for each of the series.

Last 60 months Risk-free Coach S&P 500

Average return 0.25% 0.58% 0.65%

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2. Jensen’s alpha represents the excess return not explained by the beta of the stock. A positive alpha

plots above the Security Market Line and has a return in excess of its systematic risk. The residual is the error in the estimation, and is the portion of the return not explained by the market model.

3. The relevant output from Excel for this period is:

SUMMARY OUTPUT Regression Statistics Multiple R 0.143856 R Square 0.020695 Adjusted R Square -0.00811 Standard Error 0.032 Observations 36 ANOVA df SS MS F Significance F Regression 1 0.000736 0.000736 0.718487 0.402568 Residual 34 0.034816 0.001024 Total 35 0.035552

Coefficients Standard Error t Stat P-value

Intercept 0.008954 0.005341 1.676392 0.102834 X Variable 1 0.180843 0.213349 0.847636 0.402568

The α is barely insignificant at 10%, while the β estimate 0.18 and is insignificant. The residual plot is:

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C-40 CASE SOLUTIONS

4. The relevant output from Excel for this period is:

SUMMARY OUTPUT Regression Statistics Multiple R 0.084631 R Square 0.007162 Adjusted R Square -0.00996 Standard Error 0.043074 Observations 60 ANOVA df SS MS F Significance F Regression 1 0.000776 0.000776 0.418416 0.52028 Residual 58 0.10761 0.001855 Total 59 0.108386

Coefficients Standard Error t Stat P-value

Intercept 0.002744 0.005635 0.486983 0.628106 X Variable 1 0.147156 0.227495 0.646851 0.52028

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5. The beta for Colgate-Palmolive on Yahoo! Finance at the time was 0.16, which is similar to these estimates. Possible reasons for the difference could be different data. For example Yahoo! Finance uses 36 months of returns, but they do not specify the risk-free rate, or the market proxy the use.

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CHAPTER 14

THE COST OF CAPITAL FOR HUBBARD

COMPUTER, INC.

NOTE: The example below shows the results during June, 2008. The actual answer to the case will change based on current market conditions.

1. The book value of the company’s liabilities and equity can be found from a number of sources. We went to http://www.sec.gov and found Dell’s Form 10q, dated May 2, 2008. Dell’s Form 10k showed the following:

Dell has one outstanding bond issue as of June 2008, maturing in 2028. The book value of debt is the book value of this issue, or $300 million.

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2. We need various pieces of information to estimate the cost of equity. We can use the dividend growth model or the CAPM, so we will attempt to use both. The following information is necessary for our calculations. We gathered all the information from finance.yahoo.com. The screen shots below show this information.

Market price = $23.06

Market capitalization = $47.10 billion Book value per share = $1.813 Shares outstanding = 2.05 billion Most recent dividend = $0 Beta = 1.53

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C-44 CASE SOLUTIONS

Dell has never paid a dividend so we cannot use the dividend growth model to estimate the cost of equity. We do have the information to estimate the cost of equity with the CAPM. Using the market risk premium of 7 percent from the textbook, we get:

RE = Rf + β[E(RM) – Rf]

RE = .0183 + 1.53[.07]

RE = 12.54%

3. To get the yield to maturity on Dell’s bonds, we went to www.finra.org/marketdata. We gathered the following information:

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So, the weighted average cost of debt for Dell using both the book value and the market value is: Coupon Rate Book value (face value, in millions) Percentage of total Market value (in millions) Percentage of total Yield to maturity Weighted book values Weighted market values 7.10 $300 1.00 $305.43 1.00 6.93% 6.93% 6.93% Total $300 1.00 $305.43 1.00 6.93% 6.93%

It is irrelevant whether we use book or market values to calculate the cost of debt for Dell since the company has only one bond issue outstanding.

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C-46 CASE SOLUTIONS

4. Using book value weights, the total value of Dell is: V = $300M + $3.717B

V = $4.017B

So, the WACC based on book value weights is: WACC = RE(E/V) + RD(D/V)(1 – t)

WACC = (.1254)($3.717/$4.017) + (.0693)($0.300/$4.017)(1 – .35) WACC = 11.94%

Using the market value weights, the total value of Dell is: V = $305.43M + $47.10B

V = $47.41B

So, the WACC based on market value weights is: WACC = RE(E/V) + RD(D/V)(1 – t)

WACC = (.1254)($47.10/$47.41) + (.0693)($0.305/$47.41)(1 – .35) WACC = 12.49%

The cost of capital for Dell using Book value weights and market value weights is similar because Dell has such a small portion of debt in its capital structure. The difference in this case is 0.55 percent.

5. The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that

generate the company’s sales. Dell generates sales almost exclusively from its internet site. This could potentially be a risk factor that affects the cost of capital. Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company, while Hubbard Computer is private.

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S&S AIR GOES PUBLIC

1. The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. As to which is better, we don’t actually know. In theory, the Dutch auction should be better since it should eliminate underpricing. However, as Google shows, underpricing can still exist in a Dutch auction. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown.

2. There is no way to calculate the optimum size of the IPO, so whether Mark is correct or Kim is correct will only be told in time. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash. The extra cash may encourage management to act carelessly. The extra cash will also earn a small return unless invested in income producing assets. At best, cash and short-term investments are a zero NPV investment. The advantages of the increased IPO size include the increased liquidity for the company, and the lower probability that the company will have to go back to the primary market in the near term future. The increased size will also reduce the costs of the IPO on a percentage of funds raised, although this may not be a large advantage.

3. The underwriter fee is 7 percent of the amount raised, or:

Underwriter fee = $75,000,000(.07) Underwriter fee = $5,250,000

Since the company must currently provide audited financial statements due to the bond covenants, the audit costs are not incremental costs and should not be included in the calculation of the fees. So, the sum of the other fees is:

Total other fees = $1,800,000 + 12,000 + 15,000 + 100,000 + 6,500 + 520,000 + 110,000 Total other fees = $2,563,500

This means the total fees are: Total fees = $5,250,000 + 2,563,500 Total fees = $7,813,500

The net amount raised is the IPO offer size minus the underwriter fee, or: Net amount raised = $75,000,000 – 5,250,000

Net amount raised = $69,750,000

So, the fees as a percentage of the net amount to the company are: Fee percentage = $7,813,500 / $69,750,000

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

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CHAPTER 16

STEPHENSON REAL ESTATE

RECAPITALIZATION

1. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $110 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm.

2. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding, worth $35.20 per share, the market value of the firm is:

Market value of equity = $35.20(15,000,000) Market value of equity = $528,000,000

So, the market value balance sheet before the land purchase is:

Market value balance sheet

Assets $528,000,000 Equity $528,000,000

Total assets $528,000,000 Debt & Equity $528,000,000

3. a. As a result of the purchase, the firm’s pre-tax earnings will increase by $27 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by:

Earnings increase = $27,000,000(1 – .40) Earnings increase = $16,200,000

Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity, so the NPV of the purchase is:

NPV = –$110,000,000 + ($16,200,000 / .125) NPV = $19,600,000

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b. After the announcement, the value of Stephenson will increase by $20 million, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Therefore, the market value of Stephenson’s equity after the announcement will be:

Equity value = $528,000,000 + 19,600,000 Equity value = $507,500,000

Market value balance sheet

Old assets $528,000,000

NPV of project 19,600,000 Equity $507,500,000

Total assets $547,600,000 Debt & Equity $547,600,000

Since the market value of the firm’s equity is $547,600,000 and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be:

New share price = $547,600,000 / 15,000,000 New share price = $36.51

Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth $36.51 per share, Stephenson must issue:

Shares to issue = $110,000,000 / $36.51 Shares to issue = 3,013,148

c. Stephenson will receive $110 million in cash as a result of the equity issue. This will increase the firm’s assets and equity by $110 million. So, the new market value balance sheet after the stock issue will be:

Market value balance sheet

Cash $110,000,000

Old assets 528,000,000

NPV of project 19,600,000 Equity $657,600,000

Total assets $657,600,000 Debt & Equity $657,600,000

The stock price will remain unchanged. To show this, Stephenson will now have: Total shares outstanding = 15,000,000 + 3,031,148

Total shares outstanding = 18,013,148 So, the share price is:

Share price = $657,600 / 18,013,148 Share price = $36.51

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C-52 CASE SOLUTIONS

d. The project will generate $27 million of additional annual pretax earnings forever. These earnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases the annual earnings of the firm by $16.2 million. So, the aftertax present value of the earnings increase is:

PVProject = $16,200,000 / .125

PVProject = $129,600,000

So, the market value balance sheet of the company will be:

Market value balance sheet

Old assets $528,000,000

PV of project 129,600,000 Equity $648,000,000

Total assets $657,600,000 Debt & Equity $657,600,000

4. a. Modigliani-Miller Proposition I states that in a world with corporate taxes: VL = VU + tCB

As was shown in Question 3, Stephenson will be worth $657.6 million if it finances the purchase with equity. If it were to finance the initial outlay of the project with debt, the firm would have $110 million worth of 8 percent debt outstanding. So, the value of the company if it financed with debt is:

VL = $657,600,000 + .40($110,000,000)

VL = $701,600,000

b. After the announcement, the value of Stephenson will immediately rise by the present value of the project. Since the market value of the firm’s debt is $110 million and the value of the firm is $692 million, we can calculate the market value of Stephenson’s equity. Stephenson’s market-value balance sheet after the debt issue will be:

Market value balance sheet

Value unlevered $657,600,000 Debt $110,000,000

Tax shield 44,000,000 Equity 591,600,000

Total assets $701,600,000 Debt & Equity $701,600,000

Since the market value of the Stephenson’s equity is $591.6 million and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the debt issue will be: Stock price = $591,600,000 / 15,000,000

Stock price = $39.44

5. If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $36.51 per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to $39.44 per share. Therefore, debt financing maximizes the per share stock price of the firm’s equity.

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ELECTRONIC TIMING, INC.

1. The value of the company will decline by the amount of the dividend. Ignoring taxes, shareholders wealth will not be affected because the stock price will drop by the amount of the dividend payment.

2. The value of the company could increase or decrease. If the company is over-levered, paying off debt can lower the interest rate on debt, and decrease financial distress costs. If there are no financial distress costs, capital structure theory argues that increasing debt can increase the value of the company because of the interest tax shield.

3. The PE ratio will fall and the ROA and ROE will increase, but the changes are irrelevant.

4. A regular dividend payment is something the company should probably not undertake. A company rarely begins regular dividend payments that it will be unable to continue in the future. Cessation of dividend payments is viewed a negative signal by the market.

5. The implication is that the company should not retain earnings unless the ROE of the new project is greater than the shareholders required return on equity. This is an intuitive result. Shareholders want the company to retain earnings for future growth if the earnings will earn a greater return than shareholders require. If the return on the retained earnings is lower than shareholders required return, the company is lowering shareholder value.

6. The decision does depend on the organizational form of the company. Money paid to shareholders of a corporation are dividends, and currently taxed at the lower dividend tax rate. Money paid to the owners of a LLC is considered income, and taxed at the applicable personal income tax rate.

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CHAPTER 18

PIEPKORN MANUFACTURING

WORKING CAPITAL MANAGEMENT

1. The cash flow each quarter will consist of the sales collection, minus the suppliers paid, expenses,

dividends, interest, and capital outlays. The individual cash flows are calculated as follows: Accounts receivable collected from the previous quarter:

For the 1st quarter, this is simply 90 percent of the beginning A/R balance. For the remaining

quarters, the company will collect (53 / 90) percent of the previous quarter sales since this is the balance remaining at the end of the quarter.

Accounts receivable from current quarter sales:

The company will collect ((90 – 53) / 90) percent of the current quarter sales. Purchases last quarter paid this quarter:

The company purchases one-half of next quarter sales in the current quarter and takes 42 days to pay the accounts payable. So, the accounts payable balance at the beginning of each quarter will be:

Payments for purchases from last quarter = (42 / 90)(Current quarter sales)(.50) Purchases for next quarter paid this quarter:

Using the same payables period, the company will pay part of the current quarter orders. The current quarter orders are based on next orders sales, so:

Purchase paid for next quarter = ((90 – 42) / 90)(Current quarter sales)(.50)

Expenses are simply 30 percent of gross sales, while interest is constant. The cash flows for each quarter will be:

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Net cash inflow

Q1 Q2 Q3 Q4

A/R at beginning of Q collected $484,000.00 $532,944.44 $606,555.56 $683,111.11

Sales collection in current Q 372,055.56 423,444.44 476,888.89 509,777.78

Purchases last Q paid this Q –211,166.67 –240,333.33 –270,666.67 –289,333.33

Purchase for next Q paid this Q –274,666.67 –309,333.33 –330,666.67 –269,333.33

Expenses –271,500.00 –309,000.00 –348,000.00 –372,000.00

Interest and dividends –95,000.00 –95,000.00 –95,000.00 –95,000.00

Outlay –370,000.00

Net cash inflow $3,722.22 $2,722.22 $39,111.11 –$202,777.78

So, the cash balance each quarter is:

Cash Balance

Q1 Q2 Q3 Q4

Beginning cash balance $190,000.00 $193,722.22 $196,444.44 $235,555.56

Net cash inflow 3,722.22 2,722.22 39,111.11 –202,777.78

Ending cash balance $193,722.22 $196,444.44 $235,555.56 $32,777.78

Minimum cash balance 100,000.00 100,000.00 100,000.00 100,000.00

Cumulative surplus (deficit) $93,722.22 $96,444.44 $135,555.56 –$67,222.22

The short-term financial plan looks like this:

Short-term Financial Plan

Target cash balance $100,000.00 $100,000.00 $100,000.00 $100,000.00

Net cash inflow 3,722.22 2,722.22 39,111.11 –202,777.78

New short-term investments –4,622.22 –3,668.44 –40,094.02 0

Income on short-term investments 900.00 946.22 982.91 1,383.85

Short-term investments sold 0 0 0 98,290.67

New short-term borrowing 0 0 0 103,103.26

Interest on short-term borrowing 0 0 0 0

Short-term borrowing repaid 0 0 0 0

Ending cash balance $100,000.00 $100,000.00 $100,000.00 $100,000.00

Minimum cash balance –100,000.00 –100,000.00 –100,000.00 –100,000.00

Cumulative surplus (deficit) $0 $0 $0 $0

Beginning short-term investments $90,000.00 $94,622.22 $98,290.67 $138,384.68

Ending short-term investments 94,622.22 98,290.67 138,384.68 40,094.02

Beginning short-term debt 0 0 0 0

Figure

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