FUNDAMENTALS

OF FINANCIAL
MANAGEMENT
TENTH EDITION
 Digitized by the Internet Archive
in 2022 with funding from
Kahle/Austin Foundation

https://archive.org/details/blueprintsforbri0000unse
 Blue Prints

Fundamentals of Financial Management

Tenth Edition

Eugene F. Brigham
University of Florida

Joel F. Houston
University of Florida

THOMSON

SOUTH-VVESTERN

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 THOMSON
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Blue Prints for Fundamentals of Financial Management, 10e

Eugene F. Brigham and Joel F. Houston

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 PREFACE

Blueprints has become an integral part of the material we provide to students. At the University of
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Instructors can use Blueprints in conjunction with the computer slide show, which is based on
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behind some of the numbers and to provide different examples. Our students end up with lots of
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One thing has become crystal clear over the years—the best lecture notes, and materials related
thereto, are instructor-specific. It is difficult to use someone else's notes verbatim. However, there is
no point in reinventing the wheel, and if the Blueprints wheel fits a particular instructor's wagon, he
or she might do well to use it, spending time adapting it to his or her own style and coverage rather
than taking the time to develop lecture notes de novo. Therefore, you are encouraged to look over
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will change things from semester to semester—there is no such thing as static optimality!

ill
 If you do use the package, and find some modifications that work well for you, we would very
much appreciate hearing from you—your modifications might well help us and others.

Eugene F. Brigham
Joel F. Houston

Houston & Associates

4723 NW 53" Ave., Suite A
Gainesville, Florida 32606
e-mail address: [email protected]

February 2003
 SUGGESTIONS FOR STUDENTS USING BLUEPRINTS

Read the textbook chapter first, going through the entire chapter rapidly. Don't expect to
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You could also read the Blueprints chapter material before class, but that is not necessary.

Blueprints was designed as the basis for a lecture—the most important material in each chapter
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You could read Blueprints, in connection with the text, and get a reasonably good idea of what
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discuss various points raised in Blueprints and elaborate on different issues. Also, he or she
will explain how formulas are used, where data in tables come from, and the like. You will
end up with lots of marginal notes on your copy if you use Blueprints as it is supposed to be
used. Indeed, these marginal notes will constitute your class notes.
 BLUEPRINTS

Table of Contents

CHAPTER An Overview of Financial Management

CHAPTER Financial Statements, Cash Flow, and Taxes

CHAPTER Analysis of Financial Statements

CHAPTER The Financial Environment: Markets,
Institutions, and Interest Rates

CHAPTER Risk and Rates of Return

CHAPTER Time Value of Money
CHAPTER Bonds and Their Valuation
CHAPTER Stocks and Their Valuation
CHAPTER NN
HD
NIN
OH
Co The Cost of Capital
CHAPTER The Basics of Capital Budgeting
CHAPTER Cash Flow Estimation and Risk Analysis
CHAPTER Other Topics in Capital Budgeting
CHAPTER Capital Structure and Leverage
CHAPTER Distributions to Shareholders: Dividends and
Share Repurchases
CHAPTER Managing Current Assets
CHAPTER Financing Current Assets
CHAPTER Financial Planning and Forecasting
CHAPTER Derivatives and Risk Management
CHAPTER Multinational Financial Management
CHAPTER Hybrid Financing: Preferred Stock, Leasing,
Warrants, and Convertibles 20-1
CHAPTER Mergers and Acquisitions Zien

vi
 BLUEPRINTS: CHAPTER 1
AN OVERVIEW OF FINANCIAL MANAGEMENT

1-1 Kato Summers opened Take a Dive 17 years ago; the store is located in Malibu,
California, and sells surfing-related equipment. Today, Take a Dive has 50
employees including Kato and his daughter Amber, who works part time in the store
to help pay for her college education.
Kato’s business has boomed in recent years, and he is looking for new ways to take
advantage of his increasing business opportunities. Although Kato’s formal
business training is limited, Amber will soon graduate with a degree in finance. Kato
has offered her the opportunity to join the business as a full-fledged partner. Amber
is interested, but she is also considering other career opportunities in finance.
Right now, Amber is leaning toward staying with the family business, partly because
she thinks it faces a number of interesting challenges and opportunities. Amber is
particularly interested in further expanding the business and then incorporating it.
Kato is intrigued by her ideas, but he is also concerned that her plans might change
the way in which he does business. In particular, Kato has a strong commitment to
social activism, and he has always tried to strike a balance between work and
pleasure. He is worried that these goals will be compromised if the company
incorporates and brings in outside shareholders.
Amber and Kato plan to take a long weekend off to sit down and think about all of
these issues. Amber, who is highly organized, has outlined a series of questions for
them to address:

a. What kinds of career opportunities are open to finance majors?

b. What are the primary responsibilities of a corporate financial staff?

c. What are the most important financial management issues today?

d. (1) What are the alternative forms of business organization?

(2) What are their advantages and disadvantages?

e. What is the primary goal of the corporation?

(1) Do firms have any responsibilities to society at large?
(2) Is stock price maximization good or bad for society?
(3) Should firms behave ethically?

BLUEPRINTS: CHAPTER 1 Page 1-1

 What is an agency relationship?
(1) What agency relationships exist within a corporation?
(2) What mechanisms exist to influence managers to act in shareholders’ best
interests?
(3) Should shareholders (through managers) take actions that are detrimental to
bondholders?

. Is maximizing stock price the same thing as maximizing profit?

. What factors affect stock prices?

What factors affect the level and riskiness of cash flows?

eee

Page 1-2
BLUEPRINTS: CHAPTER 1
 CHAPTER 1
An Overview of Financial
p Management
Career Opportunities
Issues of the New Millennium)
Forms of Businesses 1 &
Goals of the Corporation
Agency Relationships

Career Opportunities in ,,
& : Fi nance Z Hi. eaiV. } \ id

=» Money and capital markets

« Investments
« Financial management

Responsibility of the Financial ielolder vole |

i

Staff
e by:
» Forecasting and planning
» Investment and financing decisions ;
= Coordination and control (Ayaan
» Transactions in the financial markets
» Managing risk_1(1p0¢ AY ty MAK Sv7¢ff

1-3

BLUEPRINTS: CHAPTER 1 Page 1-3

 Role of Finance in a Typical
Business Organization

Financial Management Issues

of the New Millennium
= The effect of

) changing
technology > '
ZL’ AYOONO
L Bi ae
HM )¢ Wn
RE /
~a_The globalization
‘() of business
Le

Percentage of Revenue and Net Income

from Overseas Operations for 10 Well-
AIOWD COMO repos, 200!
Company % of Revenue % of Net Incorre
from overseas from overseas
Coca-Cola 60.8
Exxon Mobil 69.4
General Electric 32.6
General Motors 26.1
IBM 57.9

*t
JP Morgan Chase & 35.5
McDonald's 63.1
Merck 18,3
3M 52.9
Sears, Roebuck 10.5

Page 1-4 BLUEPRINTS: CHAPTER 1

 = Sole proprietorship
= Partnership ia
» Corporation |> 2q jut Yl pes

pate che re AW AE d
nl
Cora Lf

Sole proprietorships S
Partnerships 7+ pe
» Advantages
~) «Ease of formation. SEH aie"
» Subject to few regulations
» No corporate income taxes
s Disadvantages
(7)
=
« Difficult to raise capital
« Unlimited liability
= Limited life = an Oils will Ole PRooni2 orshi p to
Ori, 40 wir Ao Ger }lof Sov igor’ CASE CButr ASSCEE CIA
iri GodFy
(OT BAsED on how wll

5 Op COuivac
wip Corporation _
. Advantages COCO) (KA 4r Vian j en al 4o
= Unlimited life API \ ' V aed
PTT Tik,Deleote
At f | Vy

« Easy transfer of serene (DSI A she § OF SRA) (NON HAM

» Limited liability (0 ur ARE veil
Soe
» Ease of raising pital
« Disadvantages
» Double taxation
YY/ « Cost of set-up and report filing

BLUEPRINTS: CHAPTER 1 Page 1-5

 1.2,
LT
CAM VWDAMETTAL

wa: Financial Goals of the Corporation he |dvw

[eer
Theprimaryfinancial
een goats

wichranetertmaxming sock

, ie
» DO have any responsibilities to
‘society at large? Ox,
» «= Is stock price maximization good or bad
for society?
2, a Should firms behave ethically?

ZANICS — MNVESI ir tne

— Y JromMbatd” OF inn
\( A\KIR now tyien

Is stock price maximization the

same as profiItmaximization?
» No, despite a generally high correlation
amongst stock price, EPS, and cash flow.
_.= Current stock price relies upon current
' earnings, as well as future earnings and
cash flow.
=» Some actions may cause an increase in
earnings, yet cause the stock price to
decrease (and vice versa).

UO Tuo tees
» An agency /elationship exists whenever
a principal hires an agent to act on their
behalf.
» Within a corporation, agency
relationships exist between:
» Shareholders and managers
» Shareholders and creditors

Page 1-6 BLUEPRINTS: CHAPTER 1

 Shareholders versus Managers
» Managers are naturally inclined to act in
their own best interests.
» But the following factors affect
managerial behavior:
» Managerial compensation plans
» Direct intervention by shareholders
e The threat of firing ..____ —_-
» The threat of takeover

. Shareholders versus Creditors

» Shareholders (through managers) could
take actions to maximize stock price
that are detrimental to creditors.
= In the long run, such actions will raise
the cost of debt and ultimately lower
stock price.
Hon m

Projected cash
flows to
shareholders
” a Timing of the
(2 cash flow stream
» Riskiness of the
(2%) cash flows

BLUEPRINTS: CHAPTER 1 Page 1-7

 Basic Valuation Model
Cr CF CF
Value = n

ye rt
eek.
= TO estimate an asset’s value, one estimates the
cash flow for each period t (CF,), the life of the
asset (n), and the appropriate discount rate (k)
« Throughout the course, we discuss how to
estimate the inputs and how financial management
is used to improve them and thus maximize a
firm’s value. 1-16

Factors that Affect the Level

and Riskiness of Cash Flows
» Decisions made by financial managers:
» Investment decisions
a Finandng decisions (the relative use of
debt financing)
» Dividend policy decisions
» The external environment

Serene ee

Page 1-8
BLUEPRINTS: CHAPTER 1
 EXAM-TYPE PROBLEMS

1-1. _Which of the following statements is most correct?

a. A proxy fight is the main method of transferring ownership interest in a
corporation.
The corporation is a legal entity created by the state and is a direct extension of
the legal status of its owners and managers, that is, the owners and managers
are the corporation.
Unlimited liability and limited life are two key advantages of the corporate form
over other forms of business organization.
Due in large part to limited liability and ease of ownership transfer, corporations
have less trouble raising money in financial markets than other organizational
forms.
The stockholders of the corporation are insulated by limited legal liability, and
the legal status of the corporation protects the firm’s managers from civil and
criminal charges arising from business operations.

1-2. Which of the following statements is most correct?

a. The proper goal of the financial manager should be to maximize the firm’s
expected cash flow, because this will add the most wealth to each of the
individual shareholders (owners) of the firm.
One way to state the decision framework most useful for carrying out the firm’s
objective is as follows: “The financial manager should seek that combination of
assets, liabilities, and capital which will generate the largest expected projected
after-tax income over the relevant time horizon.”
The riskiness inherent in a firm’s earnings per share (EPS) depends on the
characteristics of the projects the firm selects, which means it depends upon the
firm’s assets, but EPS does not depend on the manner in which those assets
are financed.
Since large, publicly-owned firms are controlled by their management teams,
and typically, ownership is widely dispersed, managers have great freedom in
managing the firm. Managers may operate in stockholders’ best interests, but
they may also operate in their own personal best interests. As long as
managers stay within the law, there simply aren't any effective controls over
managerial decisions in such situations.
Agency problems exist between stockholders and managers, and between
stockholders (through managers) and creditors.

BLUEPRINTS: CHAPTER 1 Page 1-9

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 BLUEPRINTS: CHAPTER 2
FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

2-19 Donna Jamison, a 1997 graduate of the University of Florida with four years of
banking experience, was recently brought in as assistant to the chairman of the
board of D’Leon Inc., a small food producer that operates in north Florida and
whose specialty is high-quality pecan and other nut products sold in the snack-foods
market. D’Leon’s president, Al Watkins, decided in 2001 to undertake a major
expansion and to “go national” in competition with Frito-Lay, Eagle, and other major
snack-food companies. Watkins felt that D’Leon’s products were of a higher quality
than the competition’s, that this quality differential would enable it to charge a
premium price, and that the end result would be greatly increased sales, profits, and
stock price.
The company doubled its plant capacity, opened new sales offices outside its home
territory, and launched an expensive advertising campaign. D’Leon’s results were
not satisfactory, to put it mildly. Its board of directors, which consisted of its
president and vice-president plus its major stockholders (who were all local
business people), was most upset when directors learned how the expansion was
going. Suppliers were being paid late and were unhappy, and the bank was
complaining about the deteriorating situation and threatening to cut off credit. Asa
result, Watkins was informed that changes would have to be made, and quickly, or
he would be fired. Also, at the board’s insistence Donna Jamison was brought in
and given the job of assistant to Fred Campo, a retired banker who was D’Leon’s
chairman and largest stockholder. Campo agreed to give up a few of his golfing
days and to help nurse the company back to health, with Jamison’s help.
Jamison began by gathering the financial statements and other data given in Tables
IC2-1, |C2-2, |C2-3, and |C2-4. Assume that you are Jamison’s assistant, and you
must help her answer the following questions for Campo. (Note: We will continue
with this case in Chapter 3, and you will feel more comfortable with the analysis
there, but answering these questions will help prepare you for Chapter 3. Provide
clear explanations, not just yes or no answers!)

nn

BLUEPRINTS: CHAPTER 2 Page 2-1

 TABLE IC2-1. Balance Sheets

__2002 _ 2001
Assets:
Cash $ 7,282 $ 57,600
Accounts receivable 632,160 351,200
Inventories 1,287,360 715,200
Total current assets $1,926,802 $1,124,000
Gross fixed assets 1,202,950 491,000
Less accumulated depreciation 263,160 146,200
Net fixed assets $ 939,790 $_344,800
Total assets $2,866,592 $1,468,800

Liabilities and Equity:

Accounts payable $ 524,160 $ 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total current liabilities $1,650,568 $ 481,600
Long-term debt 723,432 323,432
Common stock (100,000 shares) 460,000 460,000
Retained earnings 32,992 203,768
Total equity $ 492,592 $ 663,768
Total liabilities and equity $2,866,592 $1,468,800

eee

Page 2-2
BLUEPRINTS: CHAPTER 2
 TABLE IC2-2. Income Statements

2002 2001
Sales $6,034,000 $3,432,000
Cost of goods sold 5,528,000 2,864,000
Other expenses 519,988 358,672
Total operating costs excluding
Depreciation and amortization $6,047,988 $3,222,672
EBITDA ($ 13,988) $ 209,328
Depreciation and amortization 116,960 18,900
EBIT ($ 130,948) $ 190,428
Interest expense 136,012 43,828
EBT ($ 266,960) $ 146,600
Taxes (40%) (106,784)* 58,640
Net income ($__160,176) $__87,960

EPS ($1.602) $0.880

DPS $0.110 $0.220
Book value per share $4.926 $6.638
Stock price $2.25 $8.500
Shares outstanding 100,000 100,000
Tax rate 40.00% 40.00%
Lease payments 40,000 40,000
Sinking fund payments 0 0

Note:
* The firm had sufficient taxable income in 2000 and 2001 to obtain its full tax refund in
2002.

TABLE IC2-3. Statement of Retained Earnings, 2002

Balance of retained earnings, 12/31/01 $203,768

Add: Net income, 2002 (160,176)
Less: Dividends paid (11,000)
Balance of retained earnings, 12/31/02 $ 32,592

BLUEPRINTS: CHAPTER 2 Page 2-3

 TABLE IC2-4. Statement of Cash Flows, 2002

OPERATING ACTIVITIES
Net income ($ 160,176)
Additions (Sources of Cash):
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Subtractions (Uses of Cash):
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provided by operating activities ($ 164,176)

LONG-TERM INVESTING ACTIVITIES

Cash used to acquire fixed assets ($ 711,950)

FINANCING ACTIVITIES
Increase in notes payable 436,808
increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $ 825,808

Sum: Net decrease in cash ($ 50,318)

Plus: Cash at beginning of year 97,600

Cash at end of year $ 7,282

SS ee eee
Page 2-4
BLUEPRINTS: CHAPTER 2
 a. What effect did the expansion have on sales, net operating profit after taxes
(NOPAT), net operating working capital (NOWC), total investor-supplied
Operating capital, and net income?

b. What effect did the company’s expansion have on its net cash flow, operating
cash flow, and free cash flow?

c. Jamison also has asked you to estimate D’'Leon’s EVA. She estimates that the
after-tax cost of capital was 10 percent in 2001 and 13 percent in 2002.

d. Looking at D’Leon’s stock price today, would you conclude that the expansion
increased or decreased MVA?

e. D’Leon purchases materials on 30-day terms, meaning that it is supposed to pay

for purchases within 30 days of receipt. Judging from its 2002 balance sheet, do
you think D’Leon pays suppliers on time? Explain. If not, what problems might
this lead to?

f. D’Leon spends money for labor, materials, and fixed assets (depreciation) to
make products, and still more money to sell those products. Then, it makes
sales that result in receivables, which eventually result in cash inflows. Does it
appear that D’Leon’s sales price exceeds its costs per unit sold? How does this
affect the cash balance?

g. Suppose D’Leon’s sales manager told the sales staff to start offering 60-day
credit terms rather than the 30-day terms now being offered. D’Leon’s
competitors react by offering similar terms, so sales remain constant. What
effect would this have on the cash account? How would the cash account be
affected if sales doubled as a result of the credit policy change?

h. Can you imagine a situation in which the sales price exceeds the cost of
producing and selling a unit of output, yet a dramatic increase in sales volume
causes the cash balance to decline?

i. Did D’Leon finance its expansion program with internally generated funds
(additions to retained earnings plus depreciation) or with external capital? How
does the choice of financing affect the company’s financial strength?

j. Refer to Tables |C2-2 and IC2-4. Suppose D’Leon broke even in 2002 in the
sense that sales revenues equaled total operating costs plus interest charges.
Would the asset expansion have caused the company to experience a cash
shortage that required it to raise external capital?

BLUEPRINTS: CHAPTER 2 Page 2-5

 k. If D’Leon started depreciating fixed assets over 7 years rather than 10 years,
would that affect (1) the physical stock of assets, (2) the balance sheet account
for fixed assets, (3) the company’s reported net income, and (4) its cash
position? Assume the same depreciation method is used for stockholder
reporting and for tax calculations, and the accounting change has no effect on
assets’ physical lives.

|. Explain how earnings per share, dividends per share, and book value per share
are calculated, and what they mean. Why does the market price per share not
equal the book value per share?

m. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest
earned and dividends received, (3) capital gains, and (4) tax loss carry-back and
carry-forward. How might each of these items impact D’Leon’s taxes?

ATIYV

eee

Page 2-6 BLUEPRINTS: CHAPTER 2

 CHAPTER 2
Financial Statements, Cash __ ae
ee a
Flow, and Taxes) 7"
| SOUCESOt FES i a ayaa
Balance sheet
Income statement
Statement of cash flows
Accounting income vs. cash flow .
MVA and EVA ee ¢ WS ELOonmic
Federal tax system

= Balance sheet — provides a snapshot of a é

firm’s financial position at one point in time. --
= Income statement — summarizes a firm’s
revenues and expenses over a given period of
time. (MoT?)
=» Statement of retained earnings — shows how
much of the firm’s earnings were retained,
rather than paid out as dividends.
[ } reports the impact
of a firm’s activities on cash flows over a
given period of time.

57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800

BLUEPRINTS: CHAPTER 2 Zs \\\4 | ss aaa Page 2-7

 Balance sheet:
=a Liabilities and Equity
2002 __2001
Accts payable 524,160 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings _ 32,592 203,768
Total Equity 492,592 663,768
Total L&E 2,866,592 1,468,800
2-4

Sales
COGS 5,528,000
Other expenses 519,988
EBITDA (13,988)
Depr. & Amort. 116,960
EBIT (130,948)
Interest Exp. 136,012
EBT (266,960)
Taxes 4 £106,784)
Net income / (160,176)

Other data
=
2002, , 2001
2.
No. of shares 100,000 100,000
~ EPS -$1.602 $0.88
y/DPS $0.11 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000

Page 2-8 BLUEPRINTS: CHAPTER 2

 Statement of Retained
Earnings (2002) |

Balance of retained
earnings, 12/31/01 $203,768
Add: Net income, 2002 (160,176)
Less: Dividends paid _(11,000)
Balance of retained
earnings, 12/31/02 $32,592

Statement of Cash Flows

(2002)
OPERATING ACTIVITIES
Net income : _(160,176)
Add (Sources of cash):
Depreciation ____________116,960 |
Increase in A/P- ee — 378,560
Increase in accruals ---—--—353,600
Subtract (Uses of cash):
Increase in A/R (280,960)
Increase in inventories (572,160)
Net cash provided by ops.

Statement of Cash Flows

(2002)
~ L-T INVESTING ACTIVITIES
Investment in fixed assets (711,950)
FINANCING ACTIVITIES
Increase in notes payable-—436,808
Increase in long-term debt 400,000
Payment of cash dividend — —(11,000
Net cash from financing. 825,808
NET CHANGE IN CASH (50,318)
Plus: Cash at beginning of year 57,600
Cash at end of year 7202
2-9

\h_/} y~
Page 2-9
ai ty \}\ + ==

BLUEPRINTS: CHAPTER2 Mme My 7 [ on

4 wal | (
 What can you conclude about
D’Leon’s financial condition from
its statement of CFs?

» Net cash from operations = -$164,176,

mainly because of negative NI.
» The firm borrowed $825,808 to meet
its cash requirements.
» Even after borrowing, the cash
account fell by $50,318.

Did the expansion create additional

net operating after taxes (NOPAT):

NOPAT,, = -$130,948(1 - 0.4)

= -$130,948(0.6)
= -$78,569
NOPAT,, = $114,257

What effect did the expansion have

on net operating working capital?

‘NOwC assets _—bearing CL . \\

Sal
et RNX'S Ny
Z, ps y
NOWC,, = ($7,282 + $632,160 + $1,287,360)
mae oe + $489,600),
= $913,042 ww
A\? ath
\l {‘\

NOWC,, = $842,400

Page
2 - 10 BLUEPRINTS: CHAPTER 2
 What effect did the expansion have
on operating capital?

Operating Capital), = $913,042 + $939,790

= $1,852,832

Operating Capital),= $1,187,200

What is your assessment of the

-expansion’s effect on operations?
ie 2002 ey C2 2001
Sales $6,034,000 $3,432,000
NOPAT -$78,569 $114,257
NOWC $913,042 $842,400
Operating capital $1,852,832 $1,187,200
Net Income -$160,176 $87,960

|ONCF ) = NI + Dep = ($160,176)+ $116,960

(ve CAH 4/ow= -$43, 216
NCFp, = $87,960 + $18,900= $106, cn
how CfcAvel is|p!\/ Pf LNGBianec a ahagett otei
= ($78,569) + $116,960
= $38,391
OCF, = $114,257 + $18,900
= $133,157

BLUEPRINTS: CHAPTER 2 Page 2-11

rear
\ CyN
 FCF = OCF — Gross capital investment
ORe
FCFy, = NOPAT — Net capital investment
= -$78,569 — ($1,852,832 - $1,187,200)
= -$744,201

Is negative free cash flow always a bad sign?

2 ae

EVA = __ After-tax ____ After-tax

Operating Income Capital costs

= Funds Available __ _— Cost of

to Investors Capital Used

= NOPAT — After-tax Cost of Capital

2eky,

EVA Concepts _
« In order to generate positive EVA, a
firm has to more than just cover
operating costs. It must also provide
a return to those who have provided
the firm with capital.
» EVA takes into account the total cost
of capital, which includes the cost of
equity.

a
SSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSesese
ee

Page 2-12 BLUEPRINTS: CHAPTER 2

 What is the firm’s EVA? Assume the
_ firm's after-tax percentage cost of capita!
was 10% in 2000 and 13% in 2001.
NOPAT — (A-T cost of capital) (Capital)
-$78,569 — (0.13)($1,852,832)
-$78,569 - $240,868
iWOH-$319,437

= $114,257 — (0.10)($1,187,200)
= $114,257 - $118,720
= -$4,463

Did the expansion increase or

wi. decrease MVA? |
MVA = Market value __ Equity capital
of equity supplied

During the last year, the stock price has

decreased 73%. As a consequence, the
market value of equity has declined,
and therefore MVA has declined, as
well.

Does D’Leon pay its suppliers

on time?
= Probably not.
» A/P increased 260%, over the past
year, while sales increased by only
76%.
= If this continues, suppliers may cut
off D’Leon’s trade credit.

Page 2 - 13
BLUEPRINTS: CHAPTER 2
 Does it appear that D’Leon’s sales
price exceeds itscost per unit sold?
« NO, the negative NOPAT and decline
in cash position shows that D’Leon is
spending more on its operations than
it is taking in.

What if D’Leon’s sales manager decided

to offer 60-day credit terms to customers,
rather than 30-day credit terms?
If competitors match terms, and sales remain
constant ...
» A/R would 4s
» Cash would ¥
If competitors don’t match, and sales double ...
» Short-run: Inventory and fixed assets 4 to
meet increased sales. A/R 4s, Cash ¥.
Company may have to seek additional financing.
» Long-run: Collections increase and the
company’s cash position would improve.

How did D’Leon finance its

expansion?
« D’Leon financed its expansion with
external capital.
= D’Leon issued long-term debt which
reduced its financial strength and
flexibility.

Page 214 BLUEPRINTS: CHAPTER 2

 Would D’Leon have required external
capital if they had broken even in 2001
(Net Income = 0)? _

» YES, the company would still have to

finance its increase in assets. Looking
to the Statement of Cash Flows, we see
that the firm made an investment of
$711,950 in net fixed assets.
Therefore, they would have needed to
raise additional funds.

|Hrf
|
*
What happens if D’Leon depreciates OOF a | ;Q00, 0 00
fixed assets over 7 years (as opposed to
DOM % oO ' Depre by IOK/Yr
" ; 1 {fNyk i >
the current 10 years)?_
No effect on physical
assets.
= Fixed assets on the
balance sheet would
) ly
decline.
« Net income would ae
decline. ata —_~—_—_—
» Tax payments would oi)
decline. Oiurnat f! OF POG (7
« Cash position would b VOM
improve.

Page 2 - 15
BLUEPRINTS: CHAPTER 2
 _Corporate and Personal Taxes
Both have a progressive structure (the higher the
income, the higher the marginal tax rate).
Corporations
» Rates begin at 15% and rise to 35% for corporations
with income over $10 million.
« Also subject to state tax (around 5%).
Individuals
» Rates begin at 10% and rise to 38.6% for individuals
with income over $307,050.
» May be subject to state tax.

Tax treatment of various uses

and sources of funds
Interest paid — tax deductible for corporations
(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
Interest earned — usually fully taxable (an
exception being interest from a (muni”).
Dividends paid — paid out of after-tax income.
Dividends received — taxed as ordinary income
for individuals (“double taxation”). A portion of
dividends received by corporations is tax
excludable, in order to avoid “triple taxation”.
2-29

.More tax issues i

= Tax Loss Carry-Back and Carry-Forward — since
corporate incomes can fluctuate widely, the tax
code allows firms to carry losses back to offset
profits in previous years or forward to offset
profits in the future.
Capital gains — defined as the profits from the
sale of assets not normally transacted in the
normal course of business, capital gains for
individuals are generally taxed as ordinary
income if held for less than a year, and at the
capital gains rate if held for more than a year.
Corporations face somewhat different rules.
2-30

—_—
hw SSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSS

Page 2 - 16 BLUEPRINTS: CHAPTER 2

 EXAM-TYPE PROBLEMS

2-1. Purcell Corporation has operating income (EBIT) of $1,250,000. The company’s
depreciation expense is $300,000. Purcell is 100 percent equity financed, and it
faces a 40 percent tax rate. In addition, the firm’s net investment in operating
capital is $500,000.
a. What is the company’s net income? ($750,000)
. What is its net cash flow? ($1,050,000)
What is its operating cash flow? ($1,050,000)
. What is its net operating profit after taxes (NOPAT)? ($750,000)
oe
ss . What is its free cash flow (FCF)? ($250,000)
ono

Ssrrrrrsrrrrnrrrrrrrrrrn
Page 2 - 17
BLUEPRINTS: CHAPTER 2
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ny
 BLUEPRINTS: CHAPTER 3
ANALYSIS OF FINANCIAL STATEMENTS

3-26 Part! of this case, presented in Chapter 2, discussed the situation that D’Leon Inc.,
a regional snack-foods producer, was in after an expansion program. D’Leon had
increased plant capacity and undertaken a major marketing campaign in an attempt
to “go national.” Thus far, sales have not been up to the forecasted level, costs
have been higher than were projected, and a large loss occurred in 2002 rather than
the expected profit. As a result, its managers, directors, and investors are
concerned about the firm’s survival.
Donna Jamison was brought in as assistant to Fred Campo, D’Leon’s chairman,
who had the task of getting the company back into a sound financial position.
D'Leon’s 2001 and 2002 balance sheets and income statements, together with
projections for 2003, are given in Tables IC3-1 and IC3-2. In addition, Table IC3-3
gives the company’s 2001 and 2002 financial ratios, together with industry average
data. The 2003 projected financial statement data represent Jamison’s and
Campo’s best guess for 2003 results, assuming that some new financing is
arranged to get the company “over the hump.”
Jamison examined monthly data for 2002 (not given in the case), and she detected ‘
an improving pattern during the year. Monthly sales were rising, costs were falling,
and large losses in the early months had turned to a small profit by December.
Thus, the annual data look somewhat worse than final monthly data. Also, it
appears to be taking longer for the advertising program to get the message across,
for the new sales offices to generate sales, and for the new manufacturing facilities
to operate efficiently. In other words, the lags between spending money and
deriving benefits were longer than D’Leon’s managers had anticipated. For these
reasons, Jamison and Campo see hope for the company—provided It can survive in
the short run.
Jamison must prepare an analysis of where the company is now, what it must do to
regain its financial health, and what actions should be taken. Your assignment is to
help her answer the following questions. Provide clear explanations, not yes or no
answers.

e
nn BB EN a a
e
Pasecst
BLUEPRINTS: CHAPTER 3
 TABLE IC3-1. Balance Sheets

2003E 2002 2001

Assets
Cash $ 85,632 $ 1262 $55 7-600
Accounts receivable 878,000 632,160 351,200
Inventories 1,716,480 1,287,360 715,200
Total current assets $2,680,112 $1,926,802 $1,124,000

Gross fixed assets 1,197,160 1,202,950 491,000

Less accumulated depreciation 380,120 263,160 146,200
Net fixed assets $ 817,040 $939,790 $ 344,800
Total assets $3,497,152 $2,866,592 $1,468,800

Liabilities and Equity

Accounts payable $ 436,800 $ 524,160 $ 145,600
Notes payable 300,000 636,808 200,000
Accruals 408,000 489,600 136,000
Total current liabilities $1,144,800 $1,650,568 $ 481,600

Long-term debt 400,000 723,432 S2Z0:402

Common stock een my yds 460,000 460,000

Retained earnings 251.100 32,092 203,768
Total equity $1,952,352 $ 492,592 $ 663,768
Total liabilities and equity $3,497,152 $2,866,592 $1,468,800
Note: “E” indicates estimated. The 2003 data are forecasts.

en a ee ee er
Page 3-2 BLUEPRINTS: CHAPTER 3
 TABLE IC3-2. Income Statements

2003E 2002 2001

Sales $7,035,600 $6,034,000 $3,432,000
Cost of goods sold 5,875,992 5,528,000 2,864,000
Other expenses 950,000 919,988 358,672
Total operating costs
excluding depreciation $6,425,992 $6,047,988 $3,222,672
EBITDA $ 609,608 ($ 13,988) $ 209,328
Depreciation 116,960 116,960 18,900
EBIT $ 492,648 ($ 130,948) $ 190,428
Interest expense 70,008 136,042 43,828
EBT $ 422,640 ($ 266,960) $ 146,600
Taxes (40%) 169,056 (106,784)* 58,640
Net income $:°9253:584 ($_ 160,176) $__ 87,960

EPS $1.014 ($1.602) $0.880

DPS $0.220 $0.110 $0.220
Book value per share $7.809 $4.926 $6.638
Stock price $1201 7 $2.25 $8.50
Shares outstanding 250,000 100,000 100,000
Tax rate 40.00% 40.00% 40.00%
Lease payments 40,000 40,000 40,000
Sinking fund payments 0 0 0

Note: “E” indicates estimated. The 2003 data are forecasts.

*The firm had sufficient taxable income in 2000 and 2001 to obtain its full tax refund in 2002.

nnnnnne aaeeeUtEInIEEIIE NSIS SEES ESSSSSSSE SSSR!

BLUEPRINTS: CHAPTER 3 Page 3-3

 TABLE IC3-3. Ratio Analysis

Industry
2003E 2002 2001 _ Average
Current 2x 2.3x re
Inventory turnover 4.7x 4.8x GFix
Days sales outstanding (DSO)? 38.2 87.4 32.0
Fixed assets turnover 6.4x 10.0x 7.0x
Total assets turnover 24% 2.3% 20x
Debt ratio 82.8% 54.8% 50.0%
TIE -1.0x 4.3x 6.2x
EBITDA coverage Ont Do Ux 8.0x
Profit margin -2.7% 2.6% 3.5%
Basic earning power 46% 13.0% 19.1%
ROA -5.6% 6.0% 9.1%
ROE “32.5% 13.38% 18.2%
Price/earnings -1.4x 9: 7x 14.2x
Price/cash flow -5.2x 8.0x TeOx
Market/book 0.5x 13x 2.4x
Book value per share $4.93 $6.64 n.a.
Note: “E” indicates estimated. The 2003 data are forecasts.
* Calculation is based on a 365-day year.

Sasa
Page 3-4
BLUEPRINTS: CHAPTER 3
 a. Why are ratios useful? What are the five major categories of ratios?

b. Calculate D’Leon’s 2003 current ratio based on the projected balance sheet and
income statement data. What can you say about the company’s liquidity
position in 2001, 2002, and as projected for 2003? We often think of ratios as
being useful (1) to managers to help run the business, (2) to bankers for credit
analysis, and (3) to stockholders for stock valuation. Would these different types
of analysts have an equal interest in the liquidity ratio?

c. Calculate the 2003 inventory turnover, days sales outstanding (DSO), fixed
assets turnover, and total assets turnover. How does D’Leon’s utilization of
assets stack up against other firms in its industry?

d. Calculate the 2003 debt, times-interest-earned, and EBITDA coverage ratios.

How does D’Leon compare with the industry with respect to financial leverage?
What can you conclude from these ratios?

e. Calculate the 2003 profit margin, basic earning power (BEP), return on assets
(ROA), and return on equity (ROE). What can you say about these ratios?

f. Calculate the 2003 price/earnings ratio, price/cash flow ratio, and market/book
ratio. Do these ratios indicate that investors are expected to have a high or low
opinion of the company?

g. Use the extended Du Pont equation to provide a summary and overview of

D’Leon’s financial condition as projected for 2003. What are the firm’s major
strengths and weaknesses?

h. Use the following simplified 2003 balance sheet to show, in general terms, how
an improvement in the DSO would tend to affect the stock price. For example, if
the company could improve its collection procedures and thereby lower its DSO
from 45.6 days to the 32-day industry average without affecting sales, how
would that change “ripple through” the financial statements (shown in thousands
below) and influence the stock price?
Accounts receivable $ 878 Debt $1545
Other current assets 1,802
Net fixed assets 817 Equity 1-952
Total assets $3,497 Liabilities plus equity 3,497

i. Does it appear that inventories could be adjusted, and, if so, how should that
adjustment affect D’Leon’s profitability and stock price?

j. In 2002, the company paid its suppliers much later than the due dates, and it
was not maintaining financial ratios at levels called for in its bank loan

BLUEPRINTS: CHAPTER 3 Page 3-5

 agreements. Therefore, suppliers could cut the company off, and its bank could
refuse to renew the loan when it comes due in 90 days. On the basis of data
provided, would you, as a credit manager, continue to sell to D’Leon on credit?
(You could demand cash on delivery, that is, sell on terms of COD, but that
might cause D’Leon to stop buying from your company.) Similarly, if you were
the bank loan officer, would you recommend renewing the loan or demand its
repayment? Would your actions be influenced if, in early 2003, D’Leon showed
you its 2003 projections plus proof that it was going to raise over $1.2 million of
new equity capital?

In hindsight, what should D’Leon have done back in 2001?

What are some potential problems and limitations of financial ratio analysis?

. What are some qualitative factors analysts should consider when evaluating a
_-company’s likely future financial performance?

Seem

Page 3-6 BLUEPRINTS: CHAPTER 3

 CHAPTER 3
Analysis of Financial
» Statements

Ratio Analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors

Balance Sheet: Assets

2003E 2002
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592

Balance sheet:
Liabilities and Equity
2003E 2002
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L&E 3,497,152 2,866,592

BLUEPRINTS: CHAPTER 3
 = Income statement
2003E 2002
Sales 7,035,600 6,034,000
COGS 5,875)992 -» 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
3-4

—2003E _2002
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 G2 25
Lease pmts $40,000 $40,000

sl. Why are ratios useful?

» Ratios standardize numbers and
facilitate comparisons.
» Ratios are used to highlight
weaknesses and strengths.

Page 3.8 | BLUEPRINTS: CHAPTER 3

 What are the five major categories of
ratios, and what questions do they
answer?
Liquidity: Can we make required payments?
» Asset management: right amount of assets
vs. Sales?
Debt management: Right mix of debt and
equity?
Profitability: Do sales prices exceed unit
costs, and are sales high enougn as
reflected in PM, ROE, and ROA’
Market value: Do investors like what they
see as reflected in P/E and M/B ratios?

Calculate D’Leon’s forecasted

.current ratio for 2003.

Current ratio = Current assets/ Current liabilities

= $2,680 / $1,145
= 2.34x

Comments on current ratio

Current
ratio

« Expected to improve but still below

the industry average.
» Liquidity position is weak.

BLUEPRINTS: CHAPTER 3 Page 3-9

 What is the inventory turnover
Shpvs. the industry average?

Inv. turnover = Sales / Inventories

=%7;036/°51,716
= 4.10x

Inventory
Turnover

_, Comments on
gue Inventory Turnover
» Inventory turnover is below industry
average.
« D’Leon might have old inventory, or
its control might be poor.
« No improvement is currently
forecasted.

DSO is the average number of days after

» Making a sale before receiving cash.

DSO = Receivables / Average sales per day

= Receivables/ Sales/365
= $878 / ($7,036/365)
= 45.6

Page 3 - 10 BLUEPRINTS: CHAPTER 3

 » Appraisal of DSO-
2003 | 2002 | 2001 | Ind.
BOO oO.e O74 | MeO

» D’Leon collects on sales too slowly,

and is getting worse.
» D’Leon has a poor credit policy.

Fixed asset and total asset turnover

ratios vs. the industry average

| FA turnover= Sales / Net fixed assets

= $7,036 /.$317-=.8.61x

TA turnover= Sales / Total assets

= $7,036 / $3,497 = 2.01x

Evaluating the FA turnover and

, TA turnover ratios

10.0x | 7.0x

» FA turnover projected to exceed the industry

average.
» TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).

BLUEPRINTS: CHAPTER 3 paaesets

 Calculate the debt ratio, TIE, and
Sh EBITDA coverage ratios.

Debt ratio = Total debt / Total assets

= ($1,145 + $400) / $3,497 = 44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

Calculate the debt ratio, TIE, and

EBITDA coverage ratios.

EBITDA _ y. (EBITDA+Lease pmts)

coverage Int exp + Lease pmts + Principal pmts

$609.6 + $40
$70 + $40 + $0
5.9x

How do the debt management ratios

compare with industry averages?

D/A
ME
EBITDA
coverage
« D/A and TIE are better than the industry
average, but EBITDA coverage still trails the
industry.
3-18

Page 3-12 BLUEPRINTS: CHAPTER 3

 Profitability ratios:
» Profit margin and Basic earning power

Profit margin = Net income / Sales

= $253.6 / $7,036 = 3.6%

= EBIT / Total assets

= $492.6 / $3,497 = 14.1%

4. Appraising profitability with the profit

margin and basic earning power

« Profit margin was very bad in 2002, but is projected to

exceed the industry average in 2003. Looking good.
« BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
= BEP projected to improve, yet still below the industry
average. There is definitely room for improvement.
3-20

Profitability ratios:
Return on assets and Return on equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity

= $253.6 / $1,952 = 13.0%

eee

nn ne ttttttEEIIEESES SESS

BLUEPRINTS: CHAPTER 3 Page 3-13

 ee}. Appraising profitability with the return
Sh, on assets and return
on equity
2003
ROA ene 6.0% | 9.1%
13.0% |-32.5%

» Both ratios rebounded from the previous year,

but are still below the industry average. More
improvement is needed.
« Wide variations in ROE illustrate the effect that
leverage can have on profitability.
3-22

_Effects of debt on ROA and ROE

» ROA is lowered by debt--interest
lowers NI, which also lowers ROA =
NI/Assets.
» But use of debt also lowers equity,
hence debt could raise ROE =
NI/Equity.

Problems with ROE

» ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
» ROE does not consider risk.
» ROE does not consider the amount of capital
invested.
« Might encourage managers to make investment
decisions that do not benefit shareholders.
» ROE focuses only on return. A better
measure is one that considers both risk and
return.
3-24

SE ee ee ne ee
Flags 0/44 BLUEPRINTS: CHAPTER 3
 Calculate the Price/Earnings, Price/Cash
. flow, and Market/Book ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share

= $12.17/ [($253.6 + $117.0) + 250]
= 8.21x

Calculate the Price/Earnings, Price/Cash

flow, and Market/Book ratios.

M/B = Mkt price per share/ Book value per share

= $12.17 / ($1,952 / 250) = 1.56x

Analyzing the market value ratios

» P/E: How much investors are willing to pay
for $1 of earnings.
» P/CF: How much investors are willing to
pay for $1 of cash flow.
« M/B: How much investors are willing to
pay for $1 of book value equity.
« For each ratio, the higher the number, the
better.
» P/E and M/B are high if ROE is high and
risk is low.
3-27

BLUEPRINTS: CHAPTER 3 Page 3-15

 Extended DuPont equation:
= Breaking down Return on equity

(Profit margin) x (TA turnover) x (Equity multiplier)

3.6% Xx 2 X 1.8
13.0%

SkThe Du Pont system

Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
» Focuses on:
» Expense control (PM)
« Asset utilization (TATO)
« Debt utilization (Eq. Mult.)
» Shows how these factors combine to
determine ROE.

wt | Tre
nd analysi
s

» Analyzes a firm’s
financial ratios over
time
= Can be used to
estimate the likelihood ,.,
of improvement or
deterioration in
financial condition.

Page 3-16 BLUEPRINTS: CHAPTER 3

 An example:
The effects of improving ratios
AJR 878 Debt 1,545
Other CA 1,802 Equity 1,952
Net FA 817
TA 3,497 —‘Total L&E 3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firm’s DSO to 32

days affect the company?
3-31

_ Reducing accounts receivable and

fye the days sales outstanding
M Reducing A/R will have no effect on
sales
Old A/R = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up: $261,180

Initially shows up as addition to cash.

Effect of reducing receivables on

_ balance sheet and stock price
Added cash $261 Debt sta)
617 Equity 1952
1,802
817
Total Assets 3,497 Total L&E 3,497

What could be done with the new cash?

How might stock price and risk be affected?

Sad

BLUEPRINTS: CHAPTER 3 Page 3-17

 gp POtential usesof freed up cash
» Repurchase stock
» Expand business
» Reduce debt
« All these actions would likely improve
the stock price.

Potential problems and limitations

of financial ratio analysis
% Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.
» “Average” performance is not necessarily
good, perhaps the firm should aim
higher.
» Seasonal factors can distort ratios.
» “Window dressing” techniques can make
statements and ratios look better.

.More issues regarding ratios

« Different operating and accounting
practices can distort comparisons.
» Sometimes it is hard to tell if a ratio is
“good” or “bad”.
« Difficult to tell whether a company is,
on balance, in strong or weak position.

Page 3 - 18 BLUEPRINTS: CHAPTER 3

 Qualitative factors to be considered
when evaluating a company’s future
financial performance
« Are the firm’s revenues tied to 1 key
customer, product, or supplier?
a What percentage of the firm’s business
is generated overseas?
» Competition
» Future prospects
» Legal and regulatory environment

i
Page 3-19
BLUEPRINTS: CHAPTER 3 g
 EXAM-TYPE PROBLEMS

3-1. Automotive Supply’s ROE last year was only 2 percent, but its new owner has
developed an operating plan designed to improve things. The new plan calls for a
total debt ratio of 70 percent, which will result in interest charges of $500 per year.
Management projects an EBIT of $2,000 on sales of $20,000, and it expects to
have a total assets turnover ratio of 2.5. Under these conditions, the average tax
rate will be 30 percent. If the changes are made, what return on equity will
Automotive earn? (43.75%)

3-2. Capital Garden Supply (CGS) recently hired a new chief financial officer, Louise
Johnston, who was brought in and charged with raising the firm's profitability. CGS
has sales of $5 million, a profit margin of 5 percent, and the following balance sheet:
Cash $ 250,000 A/P $ 750,000
Receivables 2,290,000 Other C.L. 500,000
Inventories 1,750,000 Long-term debt 2,250,000
Net fixed assets 3,250,000 Common equity 4,000,000
Total assets $7,500,000 Total L/E $7,500,000
a. Ms. Johnston thinks that receivables are too high, and that they can be lowered
to the point where the firm’s DSO is equal to the industry average, 60 days,
without affecting either sales or net income. If receivables are reduced so as to
lower the DSO to 60 days (365-day basis), and if the funds generated are used
to reduce common equity (stock can be repurchased at book value), and if no
other changes occur, by how much will the ROE change? (+3.47%)
b. Suppose we wanted to modify this problem and use it on an exam, i.e., to create
a new problem that you have not seen to test your knowledge of this general
type of problem. How would your answer change under each of the following
conditions:
(1) Double all dollar amounts. (+3.47%)
(2) Set the target DSO at 70 days. (+2.98%)
(3) State that the target is to achieve a receivables turnover (Sales/Receivables)
of 6x. (+3.43%)
(4) State that the company has 250,000 shares of stock outstanding, and ask
how much the original change would increase EPS. (+$0.56)
(5) Change part 4 to state that the stock was selling for twice book value, so
common equity would not be reduced on a dollar-for-dollar basis. (+$0.22)
c. Now explain how we could have set the problem up to have you focus on
changing inventory or fixed assets, or using the funds generated to retire debt,

Apert ia
Page 3 - 20 BLUEPRINTS: CHAPTER 3
 or how the original problem could have stated that the company needed more
inventory and would finance them with new common equity, or with new debt.

3-3. Which of the following statements is most correct?

a. If two firms pay the same interest rate on their debt and have the same rate of
return on assets, and if that ROA is positive, the firm with the higher debt ratio
will also have a higher rate of return on common equity.
b. One of the problems of ratio analysis is that the relationships are subject to
manipulation. For example, we know that if we use some of our cash to pay off
some of our current liabilities, the current ratio will always increase, especially if
the current ratio is weak initially.
c. Generally, firms with high profit margins have high asset turnover ratios, and
firms with low profit margins have low turnover ratios; this result is exactly as
predicted by the extended Du Pont equation.
d. Firms A and B have identical earnings and identical dividend payout ratios. If
Firm A’s growth rate is higher than that of Firm B, Firm A’s P/E ratio must be
greater than Firm B’s P/E ratio.
e. None of the above statements is correct.

3-4. Alumbat Corporation has $800,000 of debt outstanding, and it pays an interest rate
of 10 percent annually on its bank loan. Alumbat’s annual sales are $3,200,000; its
average tax rate is 40 percent; and its net profit margin on sales is 6 percent. If the
company does not maintain a TIE ratio of at least 4 times, its bank will refuse to
renew its loan, and bankruptcy will result. What is Alumbat’s current TIE ratio? (5x)

Austin & Company has a debt ratio of 0.5, a total assets turnover ratio of 0.25, and
a profit margin of 10 percent. The Board of Directors is unhappy with the current
return on equity (ROE), and they think it could be doubled. This could be
accomplished (1) by increasing the profit margin to 12 percent, and (2) by
increasing debt utilization. Total assets turnover will not change. What new debt
ratio, along with the new 12 percent profit margin, would be required to double the
ROE? (70%)

3-6. Jecko Enterprises has an ROA of 12.5 percent, a 3 percent profit margin, and a
return on equity equal to 16 percent.
a. What is the company’s total assets turnover? (4.167x)
b. What is the firm’s equity multiplier? (1.28)
c. What is the firm’s debt ratio? Assume the firm has no preferred stock. (22%)

nnn

BLUEPRINTS: CHAPTER 3 Page 3 - 21

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 BLUEPRINTS: CHAPTER 4
THE FINANCIAL ENVIRONMENT:
MARKETS, INSTITUTIONS, AND INTEREST RATES

4-17 Assume that you recently graduated with a degree in finance and have just reported
to work as an investment advisor at the brokerage firm of Smyth Barry & Co. Your
first assignment is to explain the nature of the U.S. financial markets to Michelle
Varga, a professional tennis player who has just come to the United States from
Mexico. Varga is a highly ranked tennis player who expects to invest substantial
amounts of money through Smyth Barry. She is also very bright, and, therefore,
she would like to understand in general terms what will happen to her money. Your
boss has developed the following set of questions that you must ask and answerto
explain the U.S. financial system to Varga.

a. What is a market? Differentiate between the following types of markets:

physical asset vs. financial markets, spot vs. futures markets, money vs. capital
markets, primary vs. secondary markets, and public vs. private markets.

. What is an initial public offering (IPO) market?

If Apple Computer decided to issue additional common stock, and Varga

purchased 100 shares of this stock from Merrill Lynch, the underwriter, would
this transaction be a primary market transaction or a secondary market
transaction? Would it make a difference if Varga purchased previously
outstanding Apple stock in the dealer market?

. Describe the three primary ways in which capital is transferred between savers
and borrowers.

. What are the two leading stock markets? Describe the two basic types of stock
markets.

What do we call the price that a borrower must pay for debt capital? What is the
price of equity capital? What are the four most fundamental factors that affect
the cost of money, or the general level of interest rates, in the economy?

What is the real risk-free rate of interest (k*) and the nominal risk-free rate (KrF)?
How are these two rates measured?

Define the terms inflation premium (IP), default risk premium (DRP), liquidity
premium (LP), and maturity risk premium (MRP). Which of these premiums is

BLUEPRINTS: CHAPTER 4 Page 4-1

 included when determining the interest rate on (1) short-term U.S. Treasury
securities, (2) long-term U.S. Treasury securities, (3) short-term corporate
securities, and (4) long-term corporate securities? Explain how the premiums
would vary over time and among the different securities listed above.

i. What is the term structure of interest rates? What is a yield curve?

j. Suppose most investors expect the inflation rate to be 5 percent next year, 6
percent the following year, and 8 percent thereafter. The real risk-free rate is 3
percent. The maturity risk premium is zero for bonds that mature in 1 year or
less, 0.1 percent for 2-year bonds, and then the MRP increases by 0.1 percent
per year thereafter for 20 years, after which it is stable. What is the interest rate
on 1-year, 10-year, and 20-year Treasury bonds? Draw a yield curve with these
data. What factors can explain why this constructed yield curve is upward
sloping?

k. At any given time, how would the yield curve facing an AAA-rated company
compare with the yield curve for U.S. Treasury securities? At any given time,
how would the yield curve facing a BB-rated company compare with the yield
curve for U.S. Treasury securities? Draw a graph to illustrate your answer.

|. What is the pure expectations theory? What does the pure expectations theory
imply about the term structure of interest rates?

m. Suppose that you observe the following term structure for Treasury securities:
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years G5
Assume that the pure expectations theory of the term structure is. correct. (This
implies that you can use the yield curve given above to “back out” the market's
expectations about future interest rates.) What does the market expect will be
the interest rate on 1-year securities one year from now? What does the market
expect will be the interest rate on 3-year securities two years from now?

n. Finally, Varga is also interested in investing in countries other than the United
States. Describe the various types of risks that arise when investing overseas.

ee ee
Page4s2 BLUEPRINTS: CHAPTER 4
 CHAPTER 4
The Financial Environment:
_ Markets, Institutions, and Interest Rates

Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves

What is a market?_
» A market is a venue where goods and
services are exchanged.
» A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together with
those having a surplus of funds.

» |ypes of financial markets

» Physical assets vs. Financial assets
» Money vs. Capital
= Primary vs. Secondary
= Spot vs. Futures
» Public vs. Private

Page 4-3
BLUEPRINTS: CHAPTER 4
 How is capital transferred between
savers and borrowers?
s Direct transfers
a Investment
banking house
s Finandal
intermediaries

Types of financial intermediaries

=» Commercial banks
» Savings and loan associations
« Mutual savings banks
» Credit unions
» Pension funds
« Life insurance companies
» Mutual funds

Physical location stock exchanges

vs. Electronic dealer-based markets
# Auction market vs.
Dealer market
(Exchanges vs. OTC)
a NYSE vs. Nasdaq
= Differences are
narrowing

nay BLUEPRINTS: CHAPTER 4

 The cost of money —
= The price, or cost, of debt capital is
the interest rate.
= The price, or cost, of equity capital is
the required return. The required
return investors expect is composed of
compensation in the form of dividends
and capital gains.

What four factors affect the cost

» Production
opportunities
’ a Time preferences for
consumption
a Risk
» Expected inflation

. Nominal” vs. “Real” rates

k = represents any nominal rate
k* = represents the “real” risk-free rate
of interest. Like a T-bill rate, if
there was no inflation. Typically
ranges from 1% to 4% per year.

ke = represents the rate of interest on

Treasury securities.

BLUEPRINTS: CHAPTER 4
 ,Determinants of interest rates
k = k* + IP + DRP + LP + MRP

= required return ona debt security

= real risk-free rate of interest
= inflation premium
default risk premium
= liquidity premium
maturity risk premium

Premiums added to k* for

different types of debt

J
S-T Treasury

|
L-T Treasury
—a=

S-T Corporate

L-T Corporate

Yield curve and the term

structure of interest rates
a Term structure— Interest
relationship between —_—®ate(*)
interest rates (or
yields) and maturities.
a The yield curve isa
graph of the term
structure.
« A Treasury yield curve
from October 2002
can be viewed at the
right.

Page4=6 BLUEPRINTS: CHAPTER 4

 Constructing the yield curve:
Inflation
» Step 1 — Find the average expected inflation
rate over years 1 to n:

STINFL,
IP, =
n
t=1
n

, Constructing the yield curve:

. Inflation
Suppose, that inflation is expected to be 5%
next year, 6% the following year, and 8%
thereafter.
IP, = 5% / 1 = 5.00%
IP,= [5% + 6% + 8%(8)] / 10 = 7.50%
IP,9= [5% + 6% + 8%(18)] / 20 = 7.75%
Must earn these IPs to break even vs.
inflation; these IPs would permit you to earn
k* (before taxes).
4-14

Constructing the yield curve:

Inflation
= Step 2 — Find the appropriate maturity
risk premium (MRP). For this
example, the following equation will
be used find a security's appropriate
maturity risk premium.

MRP, = 0.1% (t-1)

BLUEPRINTS: CHAPTER 4 Page 4-7

 Constructing the yield curve:
waylpMaturity Risk
Using the given equation:
MRP, = 0.1% x (1-1) = 0.0%
MRP,, = 0.1% x (10-1) = 0.9%
MRP) = 0.1% x (20-1) = 1.9%
Notice that since the equation is linear,
the maturity risk premium is increasing
in the time to maturity, as it should be.

4-16

Add the IPs and MRPs to k* to find

_the appropriate nominal rates
Step 3 — Adding the premiums to k*.

Ker, = k* + IP, + MRP,

Assume k* = 3%,
keri = 3% + 5.0% + 0.0% = 8.0%
ker, 10 = 3% + 7.5% + 0.9% = 11.4%
kee, 20 = 3% + 7.75% + 1.9% = 12.65%
4-17

=a Hypothetical yield curve

Interest » An upward sloping
Rate (%)
in Maturity risk premium
yield curve.
» Upward slope due
to an increase in
expected inflation
and increasing
maturity risk
premium.
la Years to

Page 4-8 BLUEPRINTS: CHAPTER 4

 What is the relationship between the
Treasury yield curve and the yield SS ERE ae a
urves for corporate issues?

« Corporate yield curves are higher than

that of Treasury securities, though not
necessarily parallel to the Treasury
curve.
= The spread between corporate and
Treasury yield curves widens as the
corporate bond rating decreases.

_, Illustrating the relationship between

=i... Corporate and Treasury yield curves
Interest
Rate (%)
15

BB-Rated

martray
a 6.0% vield Curve

Years to
Maturity
20
4-20

Je Pure Expectations Hypothesis

= The PEH contends that the shape of the
yield curve depends on investor's
expectations about future interest rates.
a If interest rates are expected to
increase, L-T rates will be higher than
S-T rates, and vice-versa. Thus, the
yield curve can slope up, down, or even
bow.

BLUEPRINTS: CHAPTER 4 Page 4-9

 Assumptions ofthe PEH
« Assumes that the maturity risk premium
for Treasury securities is zero.
» Long-term rates are an average of
current and future short-term rates.
= If PEH is correct, you can use the yield
curve to “back out” expected future
interest rates.

An example:
Observed Treasury rates and the PEH
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4years 6.5%
Syears 6.5%
If PEH holds, what does the market expect
will be the interest rate on one-year
securities, one year from now? Three-year
securities, two years from now?
4-23

One-year forward rate

x%
k 6.0% re . f ;
0, 1 & 4 5
6.2%

6.2% = (6.0% + x%) / 2

12.4%= 6.0% + x%
6.4% =x%
PEH says that one-year securities will yield
6.4%, one year from now.

——_—_—_—_—
LSS SSS

Pacaaatt0 BLUEPRINTS: CHAPTER 4

 = Three-year security, two years

6.5% = [2(6.2%) + 3(x%) /5

32.5% = 12.4% + 3(x%)
6.7% =x%
PEH says that one-year securities will yield
6.7%, one year from now.

Conclusions about PEH

» Some would argue that the MRP + 0, and
hence the PEH is incorrec.
s Most evidence supports the general view
that lenders prefer S-T securities, and view
L-T securities as riskier.
» Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP > 0).

Other factors that influence

interest rate levels _ |

= Federal reserve policy

» Federal budget surplus or deficit
» Level of business activity
» International factors

eereerrnenrr DEE na
Page 4-11
BLUEPRINTS: CHAPTER 4
 Risks associated with investing
overseas
a Exchange rate risk — If an
investment is denominated in a
currency other than U.S.
dollars, the investment’s value
will depend on what happens
to exchange rates.
Country risk — Arises from
investing or doing business in a
particular country and depends
on the country’s economic,
political, and social
environment.

Factors that cause exchange rates to

fluctuate
s Changes in
relative inflation
a Changes in
country risk

ae
ee ee aSO
Page 4-12 BLUEPRINTS: CHAPTER 4
 EXAM-TYPE PROBLEMS

4-1. Which of the following statements is most correct?

a. Since the default risk premium (DRP) and the liquidity premium (LP) are both
essentially zero for U.S. Treasury securities, the Treasury yield curve is
influenced more heavily by expected inflation than corporate bonds’ yield curves,
i.e., we Can be sure that a given amount of expected inflation will have more
effect on the slope of the Treasury yield curve than on the corporate yield curve.
b. Yield curves for government and corporate bonds can be constructed from data
that exist in the marketplace. If the yield curves for several companies were
plotted on a graph, along with the yield curve for U.S. Treasury securities, the
company with the largest total of DRP plus LP would have the highest yield
curve.
c. An upward-sloping yield curve is the normal situation, because long-term
securities have less interest rate risk than shorter-term securities, hence smaller
MRPs. Therefore, long-term rates are normally lower than short-term rates.
d. All of the statements above are true.
e. All of the above statements are false.

4-2. Assume that the real risk-free rate, k*, is 4 percent, and inflation is expected to be 9
percent in Year 1, 6 percent in Year 2, and 4 percent thereafter. Assume also that
all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year
Treasury bonds both yield 12 percent, what is the difference in the maturity risk
premiums (MRPs) on the two bonds, i.e., what is MRPs — MRP2? (+2.1%)

4-3. A Treasury bond that matures in 8 years has a yield of 6.6 percent. An 8-year
corporate bond has a yield of 9.3 percent. Assume that the liquidity premium on the
corporate bond is 0.6 percent. What is the default risk premium on the corporate
bond? (2.1%)

Sr

CHAPTER 4 Page 4 - 13
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 BLUEPRINTS: CHAPTER 5
RISK AND RATES OF RETURN

5-23 Assume that you recently graduated with a major in finance, and you just landed a
job as a financial planner with Merrill Finch Inc., a large financial services
corporation. Your first assignment is to invest $100,000 for a client. Because the
funds are to be invested in a business at the end of 1 year, you have been
instructed to plan for a 1-year holding period. Further, your boss has restricted you
to the following investment alternatives in the table below, shown with their
probabilities and associated outcomes. (Disregard for now the items at the bottom
of the data; you will fill in the blanks later.)
Returns on Alternative Investments
Estimated Rate of Return
State of the T- High Collec- U.S. Market 2-stock
Economy Prob. Bills Tech tions Rubber Portfolio Portfolio
Recession 0.1 8.0% (22.0%) 28.0% 10.0%* (13.0%) 3.0%
Below avg 0.2 8.0 (2.0) 14.7 -10.0 1.0
Average 0.4 8.0 20.0 0.0 7.0 15.0 10.0
Above avg 0.2 8.0 35.0 (10.0) 45.0 29.0
Boom 0.1 8.0 50.0 (20.0) 30.0 43.0 15.0
k 1.7% 13.8% 15.0%
o 0.0 13.4 18.8 15.3 3.3
CV 7.9 1.4 1.0 0.3
b -0.87 0.89

* Note that the estimated returns of U.S. Rubber do not always move in the same direction as the overall
economy. For example, when the economy is below average, consumers purchase fewer tires than they would
if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers
who were planning to purchase a new car may choose to wait and instead purchase new tires for the car they
currently own. Under these circumstances, we would expect U.S. Rubber’s stock price to be higher if there is a
recession than if the economy was just below average.

Merrill Finch’s economic forecasting staff has developed probability estimates for
the state of the economy, and its security analysts have developed a sophisticated
computer program, which was used to estimate the rate of return on each
alternative under each state of the economy. High Tech Inc. is an electronics firm;
Collections Inc. collects past-due debts; and U.S. Rubber manufactures tires and
various other rubber and plastics products. Merrill Finch also maintains a “market
portfolio” that owns a market-weighted fraction of all publicly traded stocks; you can
invest in that portfolio, and thus obtain average stock market results. Given the
situation as described, answer the following questions.

a. (1) Why is the T-bill’s return independent of the state of the economy? Do
T-bills promise a completely risk-free return?

BLUEPRINTS: CHAPTER 5 Baden’

 (2) Why are High Tech's returns expected to move with the economy whereas
Collections’ are expected to move counter to the economy?

b. Calculate the expected rate of return on each alternative and fill in the blanks on
the row for k in the table above.

c. You should recognize that basing a decision solely on expected returns is only
appropriate for risk-neutral individuals. Since your client, like virtually everyone,
is risk averse, the riskiness of each alternative is an important aspect of the
decision. One possible measure of risk is the standard deviation of returns.
(1) Calculate this value for each alternative, and fill in the blank on the row for o
in the table above.
(2) What type of risk is measured by the standard deviation?
(3) Draw a graph that shows roughly the shape of the probability distributions for
High Tech, U.S. Rubber, and T-bills.

d. Suppose you suddenly remembered that the coefficient of variation (CV) is

generally regarded as being a better measure of stand-alone risk than the
standard deviation when the alternatives being considered have widely differing
expected returns. Calculate the missing CVs, and fill in the blanks on the row for
CV in the table above. Does the CV produce the same risk rankings as the
standard deviation?

e. Suppose you created a 2-stock portfolio by investing $50,000 in High Tech and
$50,000 in Collections.
(1) Calculate the expected return (k,), the standard deviation (c, ), and the
coefficient of variation (CV,) for this portfolio and fill in the appropriate blanks
in the table above.
(2) How does the riskiness of this 2-stock portfolio compare with the riskiness of
the individual stocks if they were held in isolation?

f. Suppose an investor starts with a portfolio consisting of one randomly selected

stock. What would happen (1) to the riskiness and (2) to the expected return of
the portfolio as more and more randomly selected stocks were added to the
portfolio? What is the implication for investors? Draw a graph of the two
portfolios to illustrate your answer.

g. (1) Should portfolio effects impact the way investors think about the riskiness of
individual stocks?
(2) If you decided to hold a 1-stock portfolio, and consequently were exposed to
more risk than diversified investors, could you expect to be compensated for

Page 5-2 BLUEPRINTS: CHAPTER 5

 all of your risk; that is, could you earn a risk premium on that part of your risk
that you could have eliminated by diversifying?

h. The expected rates of return and the beta coefficients of the alternatives as
supplied by Merrill Finch’s computer program are as follows:

Security Return(k) Risk (Beta)

High Tech 17.4% 1.30
Market 15.0 1.00
U.S. Rubber 13.8 0.89
T-bills 8.0 0.00
Collections ed -0.87
(1) What is a beta coefficient, and how are betas used in risk analysis?
(2) Do the expected returns appear to be related to each alternative’s market
risk?
(3) Is it possible to choose among the alternatives on the basis of the
information developed thus far? Use the data given at the start of the
problem to construct a graph that shows how the T-bill’s, High Tech’s, and
the market's beta coefficients are calculated. Then discuss what betas
measure and how they are used in risk analysis.

i. The yield curve is currently flat, that is, long-term Treasury bonds also have an 8
percent yield. Consequently, Merrill Finch assumes that the risk-free rate is 8
percent.
(1) Write out the Security Market Line (SML) equation, use it to calculate the
required rate of return on each alternative, and then graph the relationship
between the expected and required rates of return.
(2) How do the expected rates of return compare with the required rates of
return?
(3) Does the fact that Collections has an expected return that is less than the
T-bill rate make any sense?
(4) What would be the market risk and the required return of a 50-50 portfolio of
High Tech and Collections? Of High Tech and U.S. Rubber?

j. (1) Suppose investors raised their inflation expectations by 3 percentage points

over current estimates as reflected in the 8 percent risk-free rate. What
effect would higher inflation have on the SML and on the returns required on
high- and low-risk securities?
(2) Suppose instead that investors’ risk aversion increased enough to cause the
market risk premium to increase by 3 percentage points. (Inflation remains
constant.) What effect would this have on the SML and on returns of high-
and low-risk securities?

CHAPTER 5 Page 5-3

BLUEPRINTS:
 CHAPTER 5
f Risk and Rates of Return

» Stand-alone risk
s Portfolio risk
a Risk & return: CAPM / SML

8 Investment returns
The rate of return on an investment can be
calculated as follows:
Amount received — Amount invested)

For example, if $1,000 is invested and $1,100 is

retumed after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.

What is investment risk?

= Two types of investment risk
= Stand-alone risk
» Portfolio risk
iplclemialabapialnads babilit
of earning a low or negative actual return.,
a The greater the chance of lower than
expected or negative returns, the riskier the
investment.

Page 5-4 BLUEPRINTS: CHAPTER 5

 probability of each occurrence.
» Can be shown graphically.

Rate of
100 Return (%)

Expected Rate of Return Gh

£0

Selected Realized Returns,

1926 -— 2001
~ Average Standard)
Return \ Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12,7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds By, 9.4
~=t35. ae bill 3.9 3:2

Source: Basedon Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates 2002), 28.

\ (4 VJ

natives ~0——

Economy

Recession
 Why is the T-bill return independent
of the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 8%, regardless of
the economy.
No, T-bills do not provide a risk-free retum, as
they are still exposed to inflation. Although, very
little unexpected inflation is likely to occur over
such a short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the
word.

How do the returns of HT and Coll.

behave in relation to the market?

» HT — Moves with the economy, and has

a positive correlation. This is typical.
= Coll. — Is countercyclical with the
economy, and has a negative
correlation. This is unusual.

Return: Calculating the expected

return for each alternative

k = expected rate of return

Q |
es
a I
+ {tk

kur = (-22.%) (0.1) + (-2%) (0.2)

+ (20%) (0.4) + (35%) (0.2)
+ (50%) (0.1) =17.4%

Page 5-6 BLUEPRINTS: CHAPTER 5

 : {c/™

HT has the highest expected return, and appears

to be the best investment alternative, but is it
really? Have we failed to account for risk?

Risk: Calculating the standard

deviation for each alternative

o = Standard deviation

o = VVariance = Vo?

= (2 (k,-kyP,

Standard deviation calculation

(8.0 - 8.0)2(0.1) +(8.0 - 8.0)(0.2)

Or~pbils ==| + (8.0 - 8.0)?(0.4) + (8.0 - 8.0)7(0.2)
+ (8.0 - 8.0)2(0.1)

Tris = 0-0% Ce toave

Ge 20.0% Oysa = 18.8%
op, Sls

BLUEPRINTS: CHAPTER 5
 2 _Comparing standard deviations

Prob.

Rate of Return (%)

5-13

Standard deviation (0,) measures total, or

stand-alone, risk.
The larger o, is, the lower the probability that
actual returns will be closer to expected
returns.
Larger 0; is associated with a wider probability
distribution of returns.
Difficult to compare standard deviations,
because return has not been accounted for.

Comparing risk and return

Expected Risk, o
return |
T-bills 8.0% he
0.0%
HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* | 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place

Tene

Page 5-8 BLUEPRINTS: CHAPTER 5

 A standardized measure of dispersion about
the expected value, that shows the risk per
unit of return.

Stddev _o
CV =
Mean /

Risk rankings, ¥V Snows NW ky STOUR SS

“| by coefficient of variation ( ait Pi te oa

0.000
TL49.
7.882
1.362
1.020
» Collections has the highest degree of risk per unit
of return.
« HT, despite having the highest standard deviation
of returns, has arelatively average CV.
5-17

Illustrating the CV as a
| measure of relative risk

Rate of Return (%)

0, = Oz, but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by o) for less returns.
5-18

BLUEPRINTS: CHAPTER 5 Page 5-9

 « Risk aversion — assumes investors
dislike risk and require higher rates
of return to encourage them to hold
riskier securities.
« Risk premium — the difference
between the return on a risky asset
and less risky asset, which serves as
compensation for investors to hold
riskier securities.

Portfolio construction:
_Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
» Expected return of a portfolio is a
weighted average of each of the
component assets of the portfolio.
Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.
5-20

Kp is a weighted average:

Kp = yw, ki
j=1

kp = 0.5 (17.4%) + 0.5 (1.7%) = 9.6%

Page 5-10
BLUEPRINTS: CHAPTER 5
 An alternative method for determining
. portfolio expected return

Economy | Prob.
Recession | 0.1 3.0%
Below avg | 0.2 6.4%
Average 0.4 10.0%
Above avg | 0.2 12.5%
Boom o1 | 15.0%
a
Kp = 0.10 (3.0%) + 0.20 (6.4%) + 0.40 (10.0%)
+ 0.20 (12.5%) + 0.10 (15.0%) = 9.6%

Ds
Calculating portfolio standard
deviation and CV

0.10 (3.0-9.6)2 72
+0.20 (6.4 - 9.6)?
+0.40 (10.0 - 9.6)? | =3.3%
+0.20 (12.5 - 9.6)?
+0.10 (15.0 - 9.6)2
3.3%

Comments on portfolio risk

_measures
0, = 3.3% is much lower than the 9; of
either stock Gy = 20.0%; O¢oy, = 13.4%).
p = 3.3% is lower than the weighted
average of HT and Coll.’s o (16.7%).
. Portfolio provides average return of
component stocks, but bwer than average
risk.
Why? Negative correlation between stocks.

5-24

BLUEPRINTS: CHAPTER 5 Page

5- 11
 *e Most stocks are positively correlated
with the market (P,,~ 0.65).
« 0 x 35% for an average stock.
« Combining stocks in a portfolio
generally lowers risk.

Returns distribution for two perfectly

_negatively correlated stocks (p = -1.0)

Stock W Stock M Portfolio WM

Returns distribution for two perfectly

positively correlated stocks (p = 1.0)

Stock M’ Portfolio MM’

Page 5542
BLUEPRINTS: CHAPTER 5
 = O, decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
« Expected return of the portfolio would remain
relatively constant.
« Eventually the diversification benefits of
adding more stocks dissipates (after about 10
stocks), and for large stock portfolios, Op
tends to converge to ~ 20%.

Illustrating diversification effects of

.oy (%) Company-Specific Risk

Stand-Alone Risk, Op,

40 ; 2,000+
# Stocks in Portfolio
5-29

Stand-alone risk = Market risk + Firm-specific risk

» Marketlrisk — portion of a security's stand-alone

risk that cannot be eliminated through
diversification. Measured by beta. (4
« @Firmespecific
risk — portion of a security’s
stand-alone risk that can be eliminated through
proper diversification.

BLUEPRINTS: CHAPTER 5 Page 5-13

 ilure to diversify
= If an investor chooses to hdd a one-stock
portfolio (exposed to more risk than a
diversified investor), would the investor be
compensated for the risk they bear?
» NO!
» Stand-alone risk is not important to a well-
diversified investor.
« Rational, risk-averse investors are concerned
with o,, which is based upon market risk.
« There can be only one price (the market return)
for a given security.
« No compensation should be earned for holding
unnecessary, diversifiable risk. 5-31

apital Asset Pricing Model

(CAPM)

» Model based upon concept that a stock's

required rate of return is equal to the risk-
free rate of return piusa risk premium that
reflects the riskiness of the stock after
diversification.
» Primary concluson: The relevant riskiness of
a stock is its contribution to the riskiness of a
well-diversified portfolio.

Page 5-14 he ied me ey a Se ne BLUEPRINTS: CHAPTER5

? \ h

Say Oe ase S
Vie / A ‘
 » Run a regression of past returns of a
security against past returns on the
market.
« The slope of the regression line
(sometimes called the security’s
characteristic line) is defined as the
beta coefficient for the security.

18%
-10
16

Regression line:
k, = -2.59 + 1.44 ky

If beta = 1.0, the security is just as risky as

the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than ue sy
average. Oh SAFE S4F)b)A FPA KS
Most stocks have betas in the range of 6.5to
( 1.5. a

BLUEPRINTS: CHAPTER 5 (IMEC EIS Aine J APTA) Page 5-15

 Can the beta of a security be
_| negative?
Yes, if the correlation between Stock i and
the market is negative (i.€., Pim < 0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly
unlikely.

Beta coefficients for

HT, Coll, and T-Bills

_ Comparing expected return

mind beta coefficients
, Security

Riskier securities have higher returns, so the

rank order is OK.

Page5-16 / .\ V\\ LL fh
 ' w Assume Kp, = 8% and ky = 15%.
» The market (or equity) risk premium is
RPx, = ky—Kee = 15% — 8% = 7%.
)
ASK prumiuny
i

a Additional return over the risk-free rate

needed to compensate investors for
assuming an average amount of risk.
« [té"Siz@"depends on the perceived risk of
the stock market and investors’ degree of
risk aversion.
« Vareés"from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.

, Calculating required rates of return

= kyr = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
ky = 8.0% +(7.0%)(1.00) = 15.00%
kyca = 8.0% +(7.0%)(0.89) = 14.23%
kei = 8.0% +(7.0%)(0.00) = 8.00%
Keon = 8.0% +(7.0%)(-0.87) = 1.91%

BLUEPRINTS: CHAPTER 5 Page 5-17

 HT 17.4% 17.1% Undervalued (k > k)
Market 15.0 15.0 _ Fairly valued (k =k)
USR 13.8 14.2. ~—Overvalued (k <k)
T-bills 8.0 8.0 _ Fairly valued (k =k)
Coll. LZ. 1,9 Overvalued (k <k)
5-43

Illustrating the
a. oecurity Market Line
SML: k, = 8% + (15% — 8%) B,
SML

|
T-bills |
Seen
5 Risk, B,
5-44

An example:
Equally-weighted two-stock portfolio
« Create a portfolio with 50% invested in
HT and 50% invested in Collections.
» The beta of a portfolio is the weighted
average of each of the stock’s betas.

Bp = War Bur + Woon Boot

B, = 0.5 (1-30) + 0.5 (-0.87)
Bp = 0.215

Page 5 - 18 BLUEPRINTS: CHAPTER 5

 Calculating portfolio required returns
« The required return of a portfolio is the weighted
average of each of the stock’s required returns.
Kp = War Kur + Woon Keon
kp = 0.5 (17.1%) + 0.5 (1.9%)
kp = 9.5%
« Or, using the portfolio’s beta, CAPM can be used
to solve for expected return.

kp = Kee+ (Ky— Kee) Bp

kp = 8.0% + (15.0%— 8.0%) (0.215)
kp = 9.5%

Factors that change the SML

= What if investors raise inflation expectations
by 3%, what would happen to the SML?
k; (%)
/ Al=3% —— SML,
SML,

Factors that change the SML

« What if investors’ risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?
k, (%) SML,
SML,

Risk, B,

Page 5-19
BLUEPRINTS: CHAPTER 5
 e CAPM empirically
» The CAPM has not been verified
completely.
« Statistical tests have problems that
make verification almost impossible.
«» Some argue that there are additional
risk factors, other than the market risk
premium, that must be considered.

More thoughts on the CAPM

: « Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate of k;.

Ki = Kpp + (Ky— Kee) Bi + 22?

» CAPM/SML concepts are based upon
expectations, but betas are calculated using
historical data. A company’s historical data
may not reflect investors’ expectations about
future riskiness.

ss
SSSSSSSS
a eSeeeeeeeeeeeeeeeeeeSSsSsSSSSSSSSSSSSSeSeEee

Page 5 - 20 BLUEPRINTS: CHAPTER 5

 EXAM-TYPE PROBLEMS

9-1. For markets to be in equilibrium (that is, for there to be no strong pressure for prices
to depart from their current levels),
a. The expected rate of return must be equal to the required rate of return; that is,
kK=k.
The:past realized rate of return must be equal to the expected rate of return; that
is, k=k.

The required rate of return must equal the realized rate of return; thatis, k =k .
. All three of the above statements must hold for equilibrium to exist; that is,
a _—

k=k=k.
e. None of the above statements is correct.

5-2. Which of the following statements is most correct?

a. According to CAPM theory, the required rate of return on a given stock can be
found by use of the SML equation:
ki = Krr + (Ku — Krr)bi.
Expectations for inflation are not reflected anywhere in this equation, even
indirectly, and because of that the text notes that the CAPM may not be strictly
correct.
. If the required rate of return is given by the SML equation as set forth in answer
a, there is nothing a financial manager can do to change his or her company’s
cost of capital, because each of the elements in the equation is determined
exclusively by the market, not by the type of actions a company’s management
can take, even in the long run.
Assume that the required rate of return on the market is currently ky = 15%, and
that ky remains fixed at that level. If the yield curve has a steep upward slope,
the calculated market risk premium would be larger if the 30-day T-bill rate were
used as the risk-free rate than if the 30-year T-bond rate were used as kerr.
d. Statements a and b are true.
e. Statements a and c are true.

5-3. You hold a diversified portfolio consisting of a $5,000 investment in each of 20

different common stocks. The portfolio beta is equal to 1.15. You have decided to
sell one of your stocks, a lead mining stock whose b = 1.0, for $5,000 net and to use
the proceeds to buy $5,000 of stock in a steel company whose b = 2.0. What will
be the portfolio’s new beta? (1.20)

BLUEPRINTS: CHAPTER 5 Page 5 - 21

 5-4. Electro Inc. has a beta of 1.7, Flowers Galore has a beta of0.6, the expected rate of
return on an average stock is 14 percent, and the risk-free rate of return is 7.8
percent. By how much does the required return on the riskier stock exceed the
required return on the less risky stock? (+6.82%)

eee

Page 5 - 22 BLUEPRINTS: CHAPTER 5

 BLUEPRINTS: CHAPTER 6
TIME VALUE OF MONEY

6-50 Assume that you are nearing graduation and that you have applied for a job with a
local bank, First National Bank. As part of the bank’s evaluation process, you have
been asked to take an examination that covers several financial anaes
techniques. The first section of the test addresses time value of money ana ysis.
ee how you would do by > es eins questions. ie
= I
4. Draw aie lines for (1) a $100 lump sum cash flow at the end of Year 2, (2) an
ordinary annuity of $100 per year for 3 years, and (3) an uneven cash flow
stream of -$50, $100, $75, and $50 at the end of Years 0 through 3.

b. (1) What is the future value of an initial $100 after 3 elt, if itis invested inan _
account paying 10 percent, annual compounding? |/=2, £ = 10 , P¥= 12°) 7%
(2) What is the present value of $100 to be received in 3 years ifthe sppropriat
interest rate is 10 percent, annual compounding? {\|,~ (Pico a
N22Wl YWeja0 |
c. We sometimes need to find how long it will take a sum of money (or anything
else) to grow to some specified amount. For example, if a company’s sales are
growing at~707
a rateof 20 percent per year, how long will it take sales to double?

‘4) What is the difference between an ordinary annuity and an annuity due? What
type of annuity is shown below? How would you change it to the other type of
annuity? pete”
4 :
0
pt 4 ring Anis:
[__- $$ 100 100 V
100

e. (1) What is the future value of a 3-year ordinary annuity of $100 if the
appropriate interest rate is 10 percent, annual compounding?
(2) What is the present value of the annuity? {V=
(3) What would the future and present values be if the annuity were an annuity
due? =
; \v
N W? FV

Page 6-1
BLUEPRINTS: CHAPTER 6
 f. What is the present value of the following uneven cash flow stream? The
appropriate interest rate is 10 percent, compounded annually.
0 1 2 3 4 Years
-———-———___
0 100 300 300 -50

g. What annual interest rate will cause $100 to grow to $125.97 in 3 years?

h. A 20-year-old student wants to begin saving for her retirement. Her plan is to
save $3 a day. Every day she places $3 in a drawer. At the end of each year,
she invests the accumulated savings ($1,095) in an online stock account that
has an expected annual return of 12 percent.
(1) If she keeps saving in this manner, how much will she have accumulated by
age 65?
(2) If a 40-year-old investor began saving in this manner, how much would he
have by age 65?
(3) How much would the 40-year-old investor have to save each year to
accumulate the same amount at age 65 as the 20-year-old investor
described above?
i. (1) Will the future value be larger or smaller if we compound an initial amount
more often than annually, for example, every 6 months, or semiannually,
holding the stated interest rate constant? Why?
(2) Define (a) the stated, or quoted, or nominal, rate, (b) the periodic rate, and
(c) the effective annual rate (EAR).
(3) What is the effective annual rate corresponding to a nominal rate of
10 percent, compounded semiannually? Compounded quarterly? Com-
pounded daily? |
(4) What is the future value of $100 after 3 years under 10 percent semiannual
compounding? Quarterly compounding?

j. When will the effective annual rate be equal to the nominal (quoted) rate?

k. (1) What is the value at the end of Year 3 ofthe following cash flow stream if the
quoted interest rate is 10 percent, compounded semiannually?
0 2 4 6 Periods
b——————+——_
+h YP>9 ++
100 100 100
(2) What is the PV of the same stream?
(3) Is the stream an annuity?

—
SS

Page 6-2 BLUEPRINTS: CHAPTER 6

 (4) An important rule is that you should never show a nominal rate on a time line
or use it in calculations unless what condition holds? (Hint: Think of annual
compounding, when inom = EAR = iper.) What would be wrong with your
answer to parts k(1) and k(2) if you used the nominal rate, 10 percent, rather
than the periodic rate, inom/2 = 10%/2 = 5%?

. (1) Construct an amortization schedule for a $1,000, 10 percent, annual

compounding loan with 3 equal installments.
(2) What is the annual interest expense for the borrower, and the annual interest
income for the lender, during Year 2?
m. Suppose a house is on the market for $250,000, and a bank agrees to lend the
potential home buyer $220,000 secured by a mortgage on the house. Thus, the
buyer must come up with $30,000 to complete the transaction. For purposes of
this question, ignore any additional closing costs. Suppose the buyer has only
$7,500 cash, and the seller agrees to take a note with the following terms: a
face value of $22,500, a 7.5 percent annual interest rate, and payments at the
end of the year based on a 20-year amortization schedule, but with the loan
maturing at the end of the 10" year.
(1) What is the balloon portion of the payment due at the end of the 10" year?
(2) What is the total payment that will be due at the end of the “ee year?

es SS
Page 6 -3
BLUEPRINTS: CHAPTER 6
 See
Se ee

a
eeWO oe
CHAPTER 6
| Time Value of Money Eta ee 2 ee ee
SOAOSEAESLMURAH ARERR

Future value LS
TT STL Re eT ee
Present value
~az ORS ee Se Ge s* eee
Annuities
Rates of return ee ee ol i SS eee ae
Amortization
yd peel ot os i Se ee

| Time lines

= Show the timing of cash flows.

= Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the
first period (year, month, etc.) or the
beginning of the second period.

Drawing time lines:

$100 lump sum due in 2 years;
Be 3-year $100 ordinary annuity

$100 lump sum due in 2 years

0 1 2
tJ 7 \ :

(100
3 year $100 ordinary annuity

a
0 1 2
| 3

100 100 100

pageione BLUEPRINTS: CHAPTER 6

 Drawing time lines:
Uneven cash flow stream; CF, = -$50,
CF, = $100, CF, = $75, and CF, = $50

Uneven cash flow stream

What is the future value (FV) of an initial

$100 after 3 years, if I/YR = 10%?

« Finding the FV of a cash flow or series of

cash flows when compound interest is
applied is called compounding.
= FV can be solved by using the arithmetic, _
financial calculator, and spreadsheet ag
methods. oe
0 1 \\0
10%

100 We? >

Ene
® - o ae

Solving for FV:

The arithmetic method
» After 1 year:
» FV, = PV(1+/i)= $100 (1.10)
= $110.00
a After 2 years:
=» FV, = PV(1+i)?= $100 (1.10)?
=$121.00
a After 3 years:
« FV; = PV(1+i)3 = $100 (1.10)
=Slooml”)
» After n years (general case):
oFV,=PV (11

ee

BLUEPRINTS: CHAPTER 6 ee f Page 6-5

am Wt a vera\CAle ie
yn A Jw J
 Solving for FV:
The calculator method
= Solves the general FV equation.
» Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and
END moce.)

What is the present value (PV) of $100

_,. due in 3 years, if I/YR = 10%?
Finding the PV of a cash flow or series of
cash flows when compound interest is
applied is called discounting (the reverse of
compounding).
» The PV shows the value of cash flows in
terms of today’s purchasing power.
0 1 2 3
| 10% | | |

100
6-8

Solving for PV:

.|. The arithmetic method
tte Solve the general FV equation for PV:
« PV=FV,/(1+i)
= PV=FV3/(1+i)3
= $100/ (1.10 }
= $75.13

Se

Page 6-6 BLUEPRINTS: CHAPTER 6

 Solving for PV:
The calculator method
= Solves the general FV equation for PV.
» Exactly like solving for FV, except we
have different input information and are
solving for a different variable.

Solving for N:
If sales grow at 20% per year, how long
_before sales double? “sy eras
» Solves the general FV equation for N.
» Same as previous problems, but now
solving for N.

What is the difference between an

ordinary annuity and an annuity due?
1f/
Ordinary Annuity ph Vill]
;
| i% |

Annuity Due

6 . ; Page 6-7
BLUEPRINTS: CHAP er

\ Dry
KY) A
(yy! |
ae rN
Non
Vd DMI
ee)
Ne - ‘ ‘
, ae eee
+X )
 vE|
A

eee
ae A th ih. A
Solving for FV: , JC
3-year ordinary annuity of $100 at 10%
ee
ee
s $100 payments occur at the end of
each period, but there is no PV. Se
er ee een

SS

S's .¢¢, eee se © ee + 2 ee

2S
eeeae = Ee

— —————————————

Solving for PV: —————————————— SSS

3-year ordinary annuity of $100 at 10%

» $100 payments still occur at the end of

each period, but now there is no FV.

Solving for FV:

3-year annuity due of $100 at 10%

= Now, $100 payments occur at the

beginning of each period. pe
ee oe ee eee
» Set calculator to “BEGIN” mode.
et eS ee RS Pe a ee |

eS Dy ee eet ee es SS.

ee ee ee, ee eee! 2 Ae.

ee
ee Nee ee

Page 6-8 BLUEPRINTS: CHAPTER 6

 Solving for PV:
3 year annuity due of $100 at 10%

» Again, $100 payments occur at the

beginning of each period.
= Set calculator to “BEGIN” mode.

What is the PV of this uneven

«|. cash flow stream?

0 ay 1 2
jOoD.
> AO aot
90.91 -——
247.93
225.39
-34.15
530.08 = PV

Solving for PV:

Uneven cash flow stream
» Input cash flows in the calculator’s “CFLO”
register:
« CF, =0
s CF, = 100

= CF, = 300
= CF; = 300
» CF, = -50
a Enter I/YR = 10, press NPV button to get
NPV = $530.09. (Here NPV = PV.)
6-18

eee
eee

BLUEPRINTS: CHAPTER 6 Page 6-9

 Solving for I:
What interest rate would cause $100 to
row to $125.97 in 3 years?

» Solves the general FV equation for I.

The Power of Compound

Interest
A 20-year-old student wants to start saving for
retirement. She plans to save $3 a day. Every
day, she puts $3 in her drawer. At the end of
the year, she invests the accumulated savings
($1,095) inan online stock account. The stock
account has an expected annual return of 12%.

How much money will she have when she is 65

years old?

Solving for FV:

Savings problem
» If she begins saving today, and sticks to
her plan, she will have $1,487,261.89
when she is 65.

Page 6 - 10 BLUEPRINTS: CHAPTER 6

 Solving for FV:
Savings problem, if you wait until you are
40 years old to start
= If a 40-year-old investor begins saving
today, and sticks to the plan, he or she will
have $146,000.59 at age 65. This is $1.3
million less than if starting at age 20.
» Lesson: It pays to start saving early.

Solving for PMT:

How much must the 40-year old deposit
annually to catch the 20-year old?
= 10 find the required annual contribution,
enter the number of years until retirement
and the final goal of $1,487,261.89, and
solve for PMT.

Will the FV of a lump sum be larger or

smaller if compounded more often,
holding the stated I%constant?
» LARGER, as the more frequently compounding
occurs, interest is earned on interest more often.
2 3

Annually: FV, = $100(1.10)° = $133.10

0 1 2 3
1 2 3 4 5 6

Sy.
be Semiannually: FV, = $100(1.05)° = $134.01 134.01
6-24

U © Qafo) (op) ' =x an

BLUEPRINTS: CHAPTER 6
 ifications of interest rates
Nominal rate (iyo™) — also called the quoted or
state rate. An annual rate that ignores
compounding effects.
= iyom is stated in contracts. Periods must also be
given, e.g. 8% Quarterly or 8% Daily interest.
» Periodic rate (ipez) — amount of interest
charged each period, e.g. monthly or quarterly.
» jpeg = inom /mM, Where m is the number of
compounding periods per year. m = 4 for
quarterly and m = 12 for monthly
compounding.

Classifications of interest rates

Effective (or equivalent) annual rate (EAR =
EFF%) — the annual rate of interest actually
being earned, taking into account
compounding.
» EFF% for 10% semiannual investment
EFF% .
=(1+0.10/2)?-1= 10.25%
» An investor would be indifferent between
an investment offering a 10.25% annual
return and one offering a 10% annual
return, compounded semiannually.

Why is it important to consider

effective rates of return?
An investment with monthly payments is
different from one with quarterly payments.
Must put each return on an EFF% basis to
compare rates of return. Must use EFF% for
comparisons. See following values of EFF%
rates at various compounding levels.

EARaynuan 10.00%
EAR Gidome 10.38%
BAR cy 10.47%
EAR Saye 10.52%

Page 6 - 12 BLUEPRINTS: CHAPTER 6

 Can the effective rate ever be
equal to the nominal rate?
» Yes, but only if annual compounding
is-used,.e.,1f.mo=1,
« If m > 1, EFF% will always be greater
than the nominal rate.

When is each rate used?

® inom Written into contracts, quoted by
banks and brokers. Not used in
calculations or shown on time lines.
= ipcr Used in calculations and shown on
time lines. If m = 1, inom = iper =
EAR.
» EAR Used to compare returns on
investments with different payments
per year. Used in calculations when
annuity payments don’t match
compounding periods. a

What is the FV of $100 after 3 years under

10% semiannual compounding? Quarterly
ompounding?
FV, =PV (1+ Nom
m
ym

FV;, = $100 (1+ “8 yee

FV,¢ = $100 (1.05)° = $134.01

FV3q = $100 (1.025)? = $134.49

BLUEPRINTS: CHAPTER 6 Page 6-13

 What's the FV of a 3-year $100
annuity, if the quoted interest rate is
g 10%, compounded semiannually?

» Payments occur annually, but compounding

occurs every 6 months.
» Cannot use normal annuity valuation
techniques.
as \ /
\\

Method 1:
Compound each cash flow

110.25
121.55
331.80

FV; = $100(1.05)* + $100(1.05)2 + $100

FV; = $331.80
6-32

Method 2:
Financial calculator
» Find the EAR and treat as an annuity.
» EAR=(1+0.10/2 )2-1 = 10.25%.

Page 6 - 14 BLUEPRINTS: CHAPTER 6

 Find the PV of this 3-year
ordinary annuity.
» Could solve by discounting each cash
flow, or ...
» Use the EAR and treat as an annuity to
solve for PV.

Loan amortization
s Amortization tables are widely used for
home mortgages, auto loans, business
loans, retirement plans, etc.
« Finandal calculators and spreadsheets are
great for setting up amortization tables.

s EXAMPLE: Construct an amortization

scheduk for a $1,000, 10% annual rate
loan with 3 equal payments.

Step 1:
Find the required annual payment
# All input information is already given,
just remember that the FV = 0 because
the reason for amortizing the loan and
making payments is to retire the loan.

NN —$——

BLUEPRINTS: CHAPTER 6 Page 6- 15

 Step 2:
Find the interest paid in Year 1
= The borrower will owe interest upon the
initial balance at the end of the first
year. Interest to be paid in the first
year can be found by multiplying the
beginning balance by the interest rate.

INT, = Beg bal, (i)

INT, = $1,000 (0.10) = $100

principal repaid in Year 1

= If a payment of $402.11 was made at
the end of the first year and $100 was
paid toward interest, the remaining
value must represent the amount of
principal repaid.

PRIN= PMT — INT

= $402.11 - $100 = $302.11

6-38

Step 4:
Find the ending balance after Year 1
» TO find the balance at the end of the
period, subtract the amount paid
toward principal from the beginning
balance.

END BAL = BEG BAL — PRIN

= $1,000 - $302.11
= $697.89

Page 6 - 16 BLUEPRINTS: CHAPTER 6

 Constructing an amortization table:

» Interest paid declines with each payment as

the balance declines. What are the tax
implications of this?

Illustrating an amortized payment:

Where does the money go?

Laaaaaaas, [<K EAA)

0) 1 2
= Constant payments.
# Declining interest payments.
» Declining balance.

Partial amortization
« Bank agrees to lend a home buyer $220,000
to buy a $250,000 home, requiring a
$30,000 down payment.
= The home buyer only has $7,500 in cash, so
the seller agrees to take a note with the
following terms:
= Face value = $22,500
» 7.5% nominal interest rate
» Payments made at the end of the year, based
upon a 20-year amortization schedule.
» Loan matures at the end of the 10" year. oe

BLUEPRINTS: CHAPTER 6
 Calculating annual loan payments
» Based upon the loan information, the
home buyer must make annual
payments of $2,207.07 on the loan.

Determining the balloon payment

» Using an amortization table
(spreadsheet or calculator), it can be
found that at the end of the 10" year,
the remaining balance on the loan will
be $15,149.54.
« Therefore,
» Balloon payment = $15,149.54
» Final payment = $17,356.61

Page 6 - 18
BLUEPRINTS: CHAPTER 6
 EXAM-TYPE PROBLEMS

6-1. Which of the following statements is most correct?

a. The first payment under a 3-year, annual payment, amortized loan for $1,000
will include a smaller percentage (or fraction) of the payment as interest if the
interest rate is 5 percent than if it is 10 percent.
b. If you are lending money, then, based on effective interest rates, you should
prefer to lend at a 10 percent nominal, or quoted, rate but with semiannual
payments, rather than at a 10.1 percent nominal rate with annual payments.
However, as a borrower you should prefer the annual payment loan.
c. The value of a perpetuity (say for $100 per year) will approach infinity as the
interest rate used to evaluate the perpetuity approaches zero.
d. Statements a, b, and c are true.
e. Only statements b and c are true.

You want to buy a new BMW sports car on your 27th birthday. You have priced
these cars and found that they currently sell for $25,000. You believe that the price
will increase by 10 percent per year until you are ready to buy one. You can
presently invest to earn 14 percent. If you just turned 20 years old, how much must
you invest at the end of each of the next 7 years to be able to purchase the BMW in
7 years? ($4,540.15)

On January 1, 2003, a graduate student developed a 5-year financial plan that

would provide enough money at the end of her graduate work (January 1, 2008) to
open a business of her own. Her plan was to deposit $8,000 per year for 5 years,
starting immediately, into an account paying 10 percent compounded annually. Her
activities proceeded according to plan except that at the end of her third year
(1/1/06) she withdrew $5,000 to take a Caribbean cruise, at the end of the fourth
year (1/1/07) she withdrew $5,000 to buy a used Prelude, and at the end of the fifth
year (1/1/08) she had to withdraw $5,000 for her dissertation to be typed. Her
account, at the end of the fifth year, was less than the amount she had originally
planned on by how much? ($16,550)

6-4. You have just taken out a 30-year, $120,000 mortgage on your new home. This
mortgage is to be repaid in 360 equal end-of-month installments. If each of the
monthly installments is $1,500, what is the effective annual interest rate on this
mortgage? (15.87%)

6-5. Assume that your father is now 50 years old, that he plans to retire in 10 years, and
that he expects to live for 25 years after he retires, that is, until he is 85. He wants a
fixed retirement income that has the same purchasing power at the time he retires
ee

BLUEPRINTS: CHAPTER 6 Page 6 - 19

 as $40,000 has today. (He realizes that the real value of his retirement income will
decline year by year after he retires.) His retirement income will begin the day he
retires, 10 years from today, and he will then get 24 additional annual payments.
Inflation is expected to be 5 percent per year from today forward; he currently has
$100,000 saved up; and he expects to earn a return on his savings of 8 percent per
year, annual compounding. To the nearest dollar, how much must he save during
each of the next 10 years (with deposits being made at the end of each year) to
meet his retirement goal? ($36,950)

6-6. An investment pays you 10 percent interest, compounded quarterly.

a. What is the periodic rate of interest? (2.5%)
b. What is the nominal rate of interest? (10%)
c. What is the effective annual rate of interest? (10.38%)

se ie ae ee ee ee
Page 6 - 20
BLUEPRINTS: CHAPTER 6
 BLUEPRINTS: CHAPTER 7
BONDS AND THEIR VALUATION

7-23 Robert Black and Carol Alvarez are vice-presidents of Western Money Management
and codirectors of the company’s pension fund management division. A major new
client, the California League of Cities, has requested that Western present an
investment seminarto the mayors of the represented cities, and Black and Alvarez,
who will make the actual presentation, have asked you to help them by answering
the following questions.

a. What are the key features of a bond?

b. What are call provisions and sinking fund provisions? Do these provisions make
bonds more or less risky?

How is the value of any asset whose value is based on expected future cash
flows determined?

How is the value of a bond determined? What is the value of a 10-year, $1,000
par value bond with a 10 percent annual coupon if its required rate of return is
10 percent?

. (1) What would be the value of the bond described in part d if, just after it had
been issued, the expected inflation rate rose by 3 percentage points, causing
investors to require a 13 percent return? Would we now have a discount or a
premium bond?
(2) What would happen to the bond’s value if inflation fell, and ky declined to
7 percent? Would we now have a premium or a discount bond?
(3) What would happen to the value of the 10-year bond over time if the required
rate of return remained at 13 percent, or if it remained at 7 percent? (Hint:
With a financial calculator, enter PMT, I, FV, and N, and then change
(override) N to see what happens to the PV as the bond approaches
maturity.)

(1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000
par value bond that sells for $887.00? That sells for $1,134.20? What does
the fact that a bond sells at a discount or at a premium tell you about the
relationship between kg and the bond’s coupon rate?

BLUEPRINTS: CHAPTER 7 Page 7-1

 (2) What are the total return, the current yield, and the capital gains yield for the
discount bond? (Assume the bond is held to maturity and the company does
not default on the bond.)

g. What is interest rate (or price) risk? Which bond has more interest rate risk, an
annual payment 1-year bond or a 10-year bond? Why?

h. Whatis reinvestment rate risk? Which has more reinvestment rate risk, a 1-year
bond or a 10-year bond?

i. How does the equation for valuing a bond change if semiannual payments are
made? Find the value of a 10-year, semiannual payment, 10 percent coupon
bond if nominal kg = 13%.

j. Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual
payment bond or a 10 percent, 10-year, semiannual payment bond. They are
equally risky. Which would you prefer? If $1,000 is the proper price for the
semiannual bond, what is the equilibrium price for the annual payment bond?

k. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of

$1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of
8 percent. However, the bond can be called after 4 years for a price of $1,050.
(1) What is the bond’s nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be more likely to earn the
YTM or the YTC? Why?

|. Does the yield to maturity represent the promised or expected return on the
bond?

m. These bonds were rated AA- by S&P. Would you consider these bonds
investment grade or junk bonds?

n. What factors determine a company’s bond rating?

o. If this firm were to default on the bonds, would the company be immediately
liquidated? Would the bondholders be assured of receiving all of their promised
payments?

ee ee ee ee A
Baden
BLUEPRINTS: CHAPTER 7
 CHAPTER 7
Bonds and Their Valuation

Key features of bonds

Bond valuation
Measuring yield
Assessing risk

What isa bond? ©2277

» A long-term debt instrument in which
a borrower agrees to make payments
of principal and interest, on specific
dates, to the holders of the bond.

Bond markets
a Primarily traded in the over-the-counter
(OTC) market.
= Most bonds are owned by and traded among
large financial institutions.
s Full information on bond trades in the OTC
market is not published, but a representative
group of bonds is listed and traded on the
bond division of the NYSE.

BLUEPRINTS: CHAPTER 7 Page 7-3

 Par valu
is paid at maturity (assume $1,000).
Coupon interest rate — stated interest rate
(generally fixed) paid by the issuer. Multiply
by par to get dollar payment of interest.
Maturity date— years until the bond must be
repaid. S7A7EL LL,
Issue date — when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).

Effect of a call provision _

» Allows issuer to refund the bond issue
if rates decline (helps the issuer, but
hurts the investor).
» Borrowers are willing to pay more,
and lenders require more, for callable
bonds.
= Most bonds have a deferred call and a
declining call premium.

What is a sinking fund?

» Provision to pay off a loan over its life
rather than all at maturity.
» Similar to amortization on a term
loan.
» Reduces risk to investor, shortens
average maturity.
« But not good for investors if rates
decline after issuance.

Page 7 -4 BLUEPRINTS: CHAPTER 7

 How are sinking funds executed?
= Call x% of the issue at par, for sinking
fund purposes.
» Likely to be used if k, is below the coupon
rate and the bond sells at a premium.
» Buy bonds in the open market.
« Likely to be used if k, is above the coupon
rate and the bond sells at a discount.

The value of financial assets

aaah
Value
ae
Malte CF,tee nee
CF, ees CE
CF,
ek! | +k?” +k

Convertible bond — may be exchanged for

common stock of the firm, at the holder’s
option.
Warrant — long-term option to buy a stated
number of shares of common stock at a
specified price. | ie ‘ ae
= Putable bond— allows holder to sell the bond —— WE i niet nerge
bac the company prior to maturity. 2 eee eee ee ee eee
Ce lr
Income bond > pays interest only when interest
—s-earned
by the firm. “SKier for Buyer
s Indexed bond— interest rate paid is based upon
the rate of inflation. 7-9

BLUEPRINTS: CHAPTER 7 Page7-5

 “= The discount rate (k;) is the
opportunity cost of capital, and is the
rate that could be earned on MK = merKeT NIK Dremiya
alternative investments of equal risk.
O ) we Fhoepend.
+" a
g
\) ?: TO Kit \eap Y iG ; te ih ¥ by N }

k, = k* + IP + MRP + DRP + LP B, - j (¢ y iN ;

What is the value of a 10-year, 10%

annual coupon bond, if ky = 10%?

y, - $100 , $100 | $1,000

Peto) CLO) e110)
Vz= $90.91 +..+ $38.55 + $385.54
V; = $1,000
PoeI

Using a financial calculator to

value a bond
= This bond has a $1,000 lump sum due at t = 10,
and annual $100 coupon payments beginning at
t = 1 and continuing through t = 10, the price of
the bond can be found by solving for the PV of
these cash flows.

Page 7-6 BLUEPRINTS: CHAPTER 7

 ort. we ish J K HW)
CV] ‘VT | be

An example: bee
Increasing inflation and(k,)\ mand
renner neni (YxyTte

a Suppose inflation rises by 3%, causing ky =

13%. When k, rises above the coupon rate,
the bond’s value falls below par, and sells at
a discount. 3 c(nor

A LC KILIE FUCA

An example:
Decreasing inflation and k,
» Suppose inflation falls by 3%, causing ky =
7%. When k, falls below the coupon rate,
the bond’s value rises above par, and sells
at a premium.

MGCount
i Ne —
a ———_Y” a“ v Fa \ \
fe ™ eae . \

4 a) c i Gowy ner = qy-

( Does hu 4 ie ‘ nine rate my

s What would on to the value of this bond if

its required rate of return remained at 10%, or
at 13%, or at 7% until maturity?

| Years
to Maturity
7-15

ELE LL EE TE AS EI eR
ora e a , , f Page7-7
BLUEPRINTS CHAPTER 7 Dlen ust yah ) INCL PAL S&S (2™0 | t Ay
(‘\ yi Uy

eer al
 » At maturity, the value of any bond must
equal its par value.
=» If ky remains constant:
» The value of a premium bond would
decrease over time, until it reached
$1,000.
» The value of a discount bond would
increase over time, until it reached
$1,000.
» A value of a par bond stays at $1,000.

annual coupon, $1,000 par value ond,

selling for $887? _sphyio7 VATE Nig itty
» Must find theksthat solves this model.

TD a eee) aan
ew (isk,) tC KY (EK)
OS 7c
90 90
ye
1,000
: (+k) +k)"* +k.)

Using a financial calculator to

find YTM
» Solving for I/YR, the YT of this bond is
10.91%. SThis'bondiselistata discount,
“because
YTM > coupon rate. »

Page 7-8 BLUEPRINTS: CHAPTER 7

 Find YTM, if the bond price was
$1,134.20.

» Solving for I/YR, the YT of this bond is

7.08%.

Current yield (CY) = ee

——ein price
Capital gains yield (CGY) = Chang :
Beginning price

eae zgEee
Expected total return = YTM= (
Cy, CGY
7-20

An example:
Current and capital gains yield
» Find the current yield and the capital
gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and
has a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%
7-21

nnn EEEyEEIEtItEtESS asda

CHAPTER 7 Page 7-9

BLUEPRINTS:
 Calculating capital gains yield
YTM = Current yield + Capital gains yield

CGY = YTM-CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year

from now and divide the change in price by the
beginning price, which gives the same answer.

What is interest rate (or price) risk?

% change lyr 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
7-23

What is reinvestment rate risk?

Reinvestment rate risk is the concern that
ky will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You
intend to invest the money and
live off the interest.

TOErr

Page
7 - 10 BLUEPRINTS: CHAPTER 7
 ment rate risk example
» You may invest in either a 10-year bond or a
series of ten 1-year bonds. Both 10-year and
1-year bonds currently yield 10%.
= If you choose the 1-year bond strategy: ~~

}-
» You can lock in a 10% interest rate, and
$50,000 annual income.

Conclusions about interest rate and

Interest Law
rate risk
Reinvestment ;

» CONCLUSION: Nothing is riskless!

Multiply years by 2 : number of periods = 2n.

2. Divide nominal rate by 2 : periodic rate (I/YR) =
ky / 2.
Divide annual coupon by 2 : PMT = ann cpn// 2.

BLUEPRINTS: CHAPTER 7
 What is the value of a 10-year, 10%
semiannual coupon bond, if ky = 13%?

1. Multiply years by 2: N = 2 * 10 = 20.

2. Divide nominal rate by 2 : I/YR = 13/2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

Would you prefer to buy a 10-year, 10%

annual coupon bond or a 10-year, 10%
semiannual coupon bond, all else equal?

The semiannual bond's effective rate is:

|-1=(1+°5°) -1-10.25%
: m V7 2

cwerrab=(1+tee
10% (the annual bond’s
effective rate), so you would prefer the
\semiannual bond.

# The semiannual coupon bond has an effective

rate of 10.25%, and the annual coupon bond
should earn the same EAR. At these prices,
the annual and semiannual coupon bonds are
in equilibrium, as they earn the same
effective return.

Page 7-12 BLUEPRINTS: CHAPTER 7

 A 10-year, 10% semiannual coupon bond
selling for $1,135.90 can be called in 4 years
for $1,050, what is its|yield tocall (YTC)?
we

The bond's yield to maturity can be determined

to be 8%. Solving
for the YTC is identical to
solving for YTM; except the time to call is used
for N and thé call premium is FV.
/

Yield to call
» 3.568% represents the periodic
semiannual yield to call.
= YTCyom = Kyom = 3-5968% x 2 = 7.137%
is the rate that a broker would quote.
= The effective yield to call can be
calculated
« YTCere = (1.03568)? - 1 = 7.26%

If you bought these callable bonds, would

you be more likely to earn the YTM or YTC?

= The coupon rate = 10% compared to YTC

= 7.137%. The firm could raise money by
selling new bonds which pay 7.137%.
2 Could replace bonds paying $100 per year

BLUEPRINTS: CHAPTER 7 Page 7 - 13

 meSopexpect'to earn:
eam\E@*on" premium bonds.
eee TM.onpar’& discount bonds.

« If an issuer defaults, investors receive

less than the promised return.
Therefore, the expected return on
corporate and municipal bonds is less
than the promised return.
« Influenced by the issuer’s financial
strength-and the terms of the bond
contract Bond
VAT Ie

« Mortgage bonds
» Debentures
» Subordinated debentures
» Investment-grade bonds
» Junk bonds

Page 7 - 14 BLUEPRINTS: CHAPTER 7

 Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds

Aaa Aa A Baa

BB B CCC D

» Bond ratings are designed to reflect the

probability of a bond issue going into
default.

a eeensessemieneenaneasnseae eee ecoererrnenial

» Financial performance
» Debt ratio
« TlEratio MME wtwear EREN
» Current ratio=?! Wyant /SSE7S 7 Currectlie
» Bond contract provisions
» Secured vs. Unsecured debt
= Senior v&,subordinated
debt
» Guarantee and sinking fund provisions
» Debt maturity = a)

CrAree YDVACI
F OME, ON

(O00 (Ue - &

« Earnings stability
= Regulatory environment
» Potential antitrust or product liabilities
» Pension liabilities
» Potential labor problems
» Accounting policies

BLUEPRINTS: CHAPTER 7
 a Bankruptcy
ape:

» Two main chapters of the Federal

Bankruptcy Act:
« Chapter 11, Reorganization
= Chapter 7, Liquidation (terms

|. Chapter 11 Bankruptcy
« If company can’t meet its obligations ...
» It files under Chapter 11 to stop creditors from
foreclosing, taking assets, and closing the
business.
» Has 120 days to file a reorganization plan.
« Court appoints a “trustee” to supervise
reorganization.
« Management usually stays in control.
=» Company must demonstrate in its
reorganization plan that it is “worth
more alive than dead”.
» If not, judge will order liquidation under Chapter 7.
7-41

|. Priority of claims in liquidation

. Secured creditors from sales of
secured assets.
. Trustee’s costs
. Wages, subject to limits
. Taxes
. Unfunded pension liabilities
. Unsecured creditors }Bonp hold es
. Preferred stock
. Common stock
:
ANI 9X IFS
lin
Ger Dd Mes Hh Gein

Page 7-16 BLUEPRINTS: CHAPTER 7

 Reorganization
= Ina liquidation, unsecured creditors
generally get zero. This makes them
more willing to participate in
reorganization even though their claims
are greatly scaled back.
Various groups of creditors vote on the
reorganization plan. If both the majority
of the creditors and the judge approve,
company “emerges” from bankruptcy
with lower debts, reduced interest
charges, and a chance for success.

a SS
a
Page
ag 7 - 17
BLUEPRINTS: CHAPTER 7
 EXAM-TYPE PROBLEMS

7-1. Gator Services Unlimited (GSU) needs to raise $25 million in new debt capital.
GSU's currently outstanding bonds have a $1,000 par value, an 8 percent coupon
rate, pay interest semiannually, and have 30 years remaining to maturity. The
bonds are callable after 5 years at a price of $1,080, and currently sell at a price of
$676.77. Right now, the yield curve is flat and is expected to remain flat for a while.
The risk on GSU’s new bonds is the same as for its old bonds. On the basis of
these data, what is the best estimate of GSU’s nominal interest rate on new bonds?
(12%)

7-2. Florida Financial Corporation (FFC) purchases packages of guaranteed student

loans from banks for its portfolio. FFC is considering a package with the following
characteristics. The securities, which are similartobonds, have a $1,000 par value,
pay 8 percent interest semiannually for 5 years, and then pay a stepped-up interest
rate of 10 percent semiannually for the next 7 years. The maturity value is $1,000,
paid at the end of 12 years. FFC’s alternatives to this investment are 9 percent
coupon bonds, selling at par of $1,000, which pay interest quarterly. Assuming that
the investments are of similar risk, how much should FFC be willing to pay for the
student loan package? ($985.97)

7-3. Trickle Corporation’s 12 percent coupon rate, semiannual payment, $1,000 par
value bonds that mature in 25 years, are callable at a price of $1,080 five years
from now. The bonds currently sell for $1,230.51 in the market, and the yield curve
is flat. Assuming that the yield curve is expected to remain flat, what is Trickle’s
most likely before-tax cost of debt if it issues new bonds today? (7.70%)

Recycler Battery Corporation (RBC) issued zero coupon bonds 5 years ago at a
price of $214.50 per bond. RBC’s zeros had a 20-year original maturity, and a
$1,000 par value. The bonds were callable 10 years after the issue date at a price
7 percent over their accrued value on the call date. If the bonds sell for $239.39 in
the market today, what annual rate of return should an investor who buys the bonds
today expect to earn on them? (Hint: Material covered in Web Appendix 7A.)
(10%)

7-5. Suppose a new company decides to raise its initial $200 million of capital as $100
million of common equity and $100 million of long-term debt. By an iron-clad
provision in its charter, the company can never borrow any more money. Which of
the following statements is most correct?
a. If the debt were raised by issuing $50 million of debentures and $50 million of
first mortgage bonds, we could be absolutely certain that the firm’s total interest
expense would be lower than if the debt were raised by issuing $100 million of
debentures.

Page 7 - 18 BLUEPRINTS: CHAPTER 7

 . If the debt were raised by issuing $50 million of debentures and $50 million of
first mortgage bonds, we could be absolutely certain that the firm’s total interest
expense would be lower than if the debt were raised by issuing $100 million of
first mortgage bonds.
. The higher the percentage of total debt represented by debentures, the greater
the risk of, and hence the interest rate on, the debentures.
. The higher the percentage of total debt represented by mortgage bonds, the
riskier both types of bonds will be, and, consequently, the higher the firms’ total
dollar interest charges will be.
. In this situation, we cannot tell for sure how, or whether, the firm’s total interest
expense on the $100 million of debt would be affected by the mix of debentures
versus first mortgage bonds. Interest rates on the two types of bonds would vary
as their percentages were changed, but the result might well be such that the
firm's total interest charges would not be affected materially by the mix between
the two.

7-6. Which of the following statements is most correct?

a. Because bonds can generally be called only at a premium, meaning that the
bondholder will enjoy a capital gain, including a call provision (other than a
sinking fund call) in the indenture increases the value of the bond and lowers the
bond’s required rate of return.
. You are considering two bonds. Both are rated AA, both mature in 20 years,
both have a 10 percent coupon, and both are offered to you at their $1,000 par
value. However, Bond X has a sinking fund while Bond Y does not. This is
probably not an equilibrium situation, as Bond X, which has the sinking fund,
would generally be expected to have a higher yield than Bond Y.
A sinking fund provides for the orderly retirement of a debt (or preferred stock)
issue. Sinking funds generally force the firm to call a percentage of the issue
each year. However, the call price for sinking fund purposes is generally higher
than the call price for refunding purposes.
. Zero coupon bonds are bought primarily by pension funds and other tax-exempt
investors because they avoid the tax that non-tax exempt investors must pay on
the accrued value each year.
e. All of the above statements are false.

7-7. Research Technologies’ noncallable bonds have 10 years remaining to maturity.

The bonds have a face value of $1,000, a yield to maturity of 12 percent, pay
interest semiannually, and have a 10 percent coupon rate. What is their current
yield? (11.30%)

nT EEE

BLUEPRINTS: CHAPTER 7 Page 7 - 19

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 BLUEPRINTS: CHAPTER 8
STOCKS AND THEIR VALUATION

8-27 Robert Balik and Carol Kiefer are senior vice-presidents of the Mutual of Chicago
Insurance Company. They are co-directors of the company’s pension fund
management division, with Balik having responsibility for fixed income securities
(primarily bonds) and Kiefer being responsible for equity investments. A major new
client, the California League of Cities, has requested that Mutual of Chicago present
an investment seminarto the mayors of the represented cities, and Balik and Kiefer,
who will make the actual presentation, have asked you to help them.
To illustrate the common stock valuation process, Balik and Kiefer have asked you
to analyze the Bon Temps Company, an employment agency that supplies word
processor operators and computer programmers to businesses with temporarily
heavy workloads. You are to answer the following questions.

a. Describe briefly the legal rights and privileges of common stockholders.

b. (1) Write out a formula that can be used to value any stock, regardless of its
dividend pattern.
(2) What is a constant growth stock? How are constant growth stocks valued?
(3) What happens if a company has a constant g that exceeds its ks? Will many
stocks have expected g > k, in the short run (that is, for the next few years)? In
the long run (that is, forever)?

C. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the
yield on T-bonds) is 7 percent, and that the required rate of return on the market is
12 percent. What is the required rate of return on the firm’s stock?

d. Assume that Bon Temps is a constant growth company whose last dividend (Do,
which was paid yesterday) was $2.00 and whose dividend is expected to grow
indefinitely at a 6 percent rate.
(1) What is the firm’s expected dividend stream over the next 3 years?
(2) What is the firm’s current stock price?
(3) What is the stock’s expected value 1 year from now?
(4) What are the expected dividend yield, the capital gains yield, and the total return
during the first year?

rn nnn Lat etEyEtEtEEEsS a

BLUEPRINTS: CHAPTER 8 Page 8 - 1

e. Now assume that the stock is currently selling at $30.29. What is the expected rate
of return on the stock?

f. What would the stock price be if its dividends were expected to have zero growth?

g. Now assume that Bon Temps is expected to experience supernormal growth of 30

percent for the next 3 years, then to return to its long-run constant growth rate of
6 percent. What is the stock’s value under these conditions? What is its expected
dividend yield and capital gains yield in Year 1? Year 4?

h. Suppose Bon Temps is expected to experience zero growth during the first 3 years
and then to resume its steady-state growth of 6 percent in the fourth year. What is
the stock’s value now? What is its expected dividend yield and its capital gains
yield in Year 1? Year 4?

i. Finally, assume that Bon Temps’ earnings and dividends are expected to decline by
a constant 6 percent per year, that is, g = -6%. Why would anyone be willing to buy
such a stock, and at what price should it sell? What would be the dividend yield and
capital gains yield in each year?

j. Bon Temps embarks on an aggressive expansion that requires additional capital.

Management decides to finance the expansion by borrowing $40 million and by
halting dividend payments to increase retained earnings. The projected free cash
flows for the next three years are -$5 million, $10 million, and $20 million. After the
third year, free cash flow is projected to grow at a constant 6 percent. The overall
cost of capital is 10 percent. What is Bon Temps’ total value? If it has 10 million
shares of stock and $40 million total debt, what is the price per share?

K. What does market equilibrium mean?

I. If equilibrium does not exist, how will it be established?

m. What is the Efficient Markets Hypothesis, what are its three forms, and what are its
implications?

n. Phyfe Company recently issued preferred stock. It pays an annual dividend of $5,
and the issue price was $50 per share. What is the expected return to an investor
on this preferred stock?

trcc cn
Page 8-2 BLUEPRINTS: CHAPTER 8
 CHAPTER 8
| Stocks and Their Valuation
Seaton

Features of common stock

Determining common stock values
Efficient markets
Preferred stock

Facts about common stock

» Represents ownership
» Ownership implies control
» Stockholders elect directors
« Directors elect management
«» Management's goal: Maximize the
stock price

» Should management be equally concerned

about employees, customers, suppliers,
and “the public,” or just the stockholders?
» In an enterprise economy, management
should work for stockhoHers subject to
constraints (envirormental, fair hiring,
etc.) and competition.

BLUEPRINTS: CHAPTER 8 Page 8-3

 Types of stock market
=| transactions

» Secondary market
= Primary market
« Initial public offering market
(“going public”)

Different approaches for

=). Valuing common stock
« Dividend growth model
= Corporate value model
» Using the multiples of comparable
firms

a. Dividend growth
model
ee Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

eh wees D,
PO ak) ke Cake Gk

Soccer BLUEPRINTS: CHAPTER 8

 Constant growth stock
* « A stock whos dividends are expected to
grow forever at a constant rate, g.

D, = Dy (1+g)!
D, = Dy (1+g)?
D, = Do (1+9)'

« If g is constant, the dividend growth formub

converges to:

Future dividends and their

resent values

Years (t)
8-8

What happens if g > k.2)

» If g > k,, the constant growth formula
leads to a negative stock price, which
does not make sense.
» The constant growth model can only be
used if:
. k, >g

= g is expected to be constant forever

ED

BLUEPRINTS: CHAPTER 8 Page 8-5

 If Kae = 7%, Ky = 12%, and B = 1.2,
mfp What is the required rate of return on
gee the firm’s stock?
» Use the SML to calculate the required
rate of return (k,):

— s J% + (12% - 7%)1.2
= 13%

If Dp = $2 and g is a constant 6%,

4. find the expected dividend stream for
Stage the next 3 years, and their PVs.

2.382

sg) What is the stock’s market value?

| » Using the constant growth model:

geo NU PSE
°k,-g /0.13- 0.06
~$2:12
20.07"
= $30.29

Page 8-6 BLUEPRINTS: CHAPTER 8

 What is the expected market price
of the stock, one year from now?
D, will have been paid out already. So,
P, is the present value (as of year 1) of
D2, D3, Da, etc. =
Oe $2047 \
‘ * k,-g 0.13-0.06 /
S92 10

Could also find expected P, as:

P, =P, (1:06) = $32.10

——~ What is the expected dividend yield,

capital gains yield, and total return
pduring the first year?
» Dividend yield
= D, / Pp = $2.12 / $30.29 = 7.0%
« Capital gains yield
= (P,—Po)/ Po
= ($32.10 - $30.29) / $30.29 = 6.0%
» Total return (k,)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

What would the expected price

today be, if g = 0? |
= The dividend stream would be a
perpetuity.

0 1 2 3
k, = 13% | |
2.00 ~ _—s2.00 2.00
“PMT
eee $2.00 OS 36
y ken 0.15 §

BLUEPRINTS: CHAPTER 8 Page 8-7

 Supernormal growth:
What if g = 30% for 3 years before
, achieving long-run growth of 6%?
: » Can no longer use just the constant growth
model to find stock value.
» However, the growth does become
constant after 3 years.

Valuing common stock with

nonconstant growth

g = 30% g =30% g =6%

, 2.600 3.380 4.394 4.658 |

4.658.
10.13] ~ 0.06
8-17

Find expected dividend and capital gains

= J. yields during the first and fourth years.
“= Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
» Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
» During nonconstant growth, dividend yield
and capital gains yield are not constant,
and capital gains yield + g.
» After t = 3, thestock has constant growth
and dividend yield = 7%, while capital
gains yield = 6%.

Page 8-8 BLUEPRINTS: CHAPTER 8

 Nonconstant growth:
What if g = 0% for 3 years before long-
fun growth of 6%?

D, = 2.00 | 2.00 2.00 2.00

Find expected dividend and capital gains

. yields during the first and fourth years.

" « Dividend yield (first year)

= $2.00 / $25.72 = 7.78%
» Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
« After t= 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

If the stock was expected to have

negative growth (g = -6%), would anyone
. buy the stock, and what is its value?
= The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

_ $2.00 (0.94) _ $1.88 _ 49 99

0.13-(-0.06) 0.19

a
a

BLUEPRINTS: CHAPTER 8 Page 8-9

 Find expected annual dividend and

» Capital gains yield

=g = -6.00%
» Dividend yield
= 13.00% - (-6.00%) = 19.00%

a Since the stock is experiencing constant

growth, dividend yield and capital gains
yield are constant. Dividend yield is
sufficiently large (19%) to offset a negative
capital gains.
8-22

Corporate value model

» Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s
free cash flows.
«» Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
» FCF = NOPAT — Net capital investment
8-23

_Applying the corporate value model

« Find the market value (MV) of the firm.
» Find PV of firm’s future FCFs
» Subtract MV of firm’s debt and preferred stock to
get. MV of common stock.
" MV of = MV of — MV of debt and
“common stock _ firm preferred
« Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value}-——___
= Py, = MV of common stock/ # of shares

Page 8 - 10 BLUEPRINTS: CHAPTER 8

 Issues regarding the
corporate value model
= Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
» Similar to dividend growth model, assumes at
some point free cash flow will grow at a
constant rate.
» Terminal value (TV,) represents value of firm
at the point that growth becomes constant.
8-25

Given the long-run Gece = 6%, and

. WACC of 10%, use the corporate value
E model to find the firm's intrinsic value.

LRG aeegammcrers= am 530 =

416.942) si
/
PRS 4

If the firm has $40 million in debt and

_ has 10 million shares of stock, what is
he firm’s intrinsic value per share?

» MV of equity = MV of firm — MV of debt

= $416.94m - $40m
= $376.94 million
= Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69

BLUEPRINTS: CHAPTER 8
 Firm multiples method
» Analysts often use the following multiples
to value stocks.
» P/E
» P/ CF
» P/ Sales
EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.

What is market equilibrium?

» In equilibrium, stock prices are stable and
there is no general tendency for people to
buy versus to sell.
» In equilibrium, expected returns must equal
required returns.

k= 5'+9 = kK, = Kee + (Ky — Kye)B

0

Market equilibrium
» Expected returns are obtained by
estimating dividends and expected
capital gains.
» Required returns are obtained by
estimating risk and applying the CAPM.

Page 8-12 BLUEPRINTS: CHAPTER 8

 How is market equilibrium

aati expected return exceeds required

return ...
« The current price (P,) is “too low” and
offers a bargain.
« Buy orders will be greater than sell
orders.
» Py will be bid up until expected return
equals required return

=. Factors that affect stock price

» Required return (k,) could change
« Changing inflation could cause ke, to
change
« Market risk premium or exposure to
market risk (8B) could change
» Growth rate (g) could change
» Due to econanic (market) conditions
« Due to firm conditions

What is the Efficient Market

_ Hypothesis (EMH)?
“a Securities are normally in equilibrium
and are “fairly priced.”
» Investors cannot “beat the market”
except through good luck or better
information.
= Levels of market efficiency
» Weak-form efficiency
» Semistrong-form efficiency
» Strong-form efficiency

CHAPTER 8 Page 8 - 13
BLUEPRINTS:
 s) Weak-form efficiency
» Can't profit by looking at past trends.
A recent decline is no reason to think
stocks will go up (or down) in the
future.
« Evidence supports weak-form EMH,
but “technical analysis” is still used.

_Semistrong-form efficiency
« All publicly available information is
reflected in stock prices, so it doesn’t
pay to over analyze annual reports
looking for undervalued stocks.
« Largely true, but superior analysts
can still profit by finding and using
new information

Strong-form efficiency
» All information, even inside
information, is embedded in stock
prices.
» Not true--insiders can gain by
trading on the basis of insider
information, but that’s illegal.

Page 8 - 14 BLUEPRINTS: CHAPTER 8

 Is the stock market efficient?

test the three forms of efficiency. Most of

which suggest the stock market was:
« Highly efficient in the weak form.
« Reasonably efficient in the semistrong form.
« Not efficient in the strong form. Insiders could
and did make abnormal (and sometimes
illegal) profits.
» Behavioral finance — incorporates elements
of cognitive psychology to better
understand how individuals and markets
respond to different situations. et

Preferred stock
» Hybrid security
a Like bonds, preferred stockholders
receive a fixed dividend that must be
paid before dividends are paid to
common stockholders.
» However, companies can omit
preferred dividend payments without
fear of pushing the firm into
bankruptcy.

If preferred stock with an annual

dividend of $5 sells for $50, what is the
preferred stock’s expected return?

VED
$50
= $5/k,
k, = $5 / $50
= 0.10 = 10%

NN $$

Page 8-15
BLUEPRINTS: CHAPTER 8
 EXAM-TYPE PROBLEMS

8-1. Carlson Products, a constant growth company, has a current market (and
equilibrium) stock price of $20.00. Carlson’s next dividend, D,, is forecasted to be
$2.00, and Carlson is growing at an annual rate of 6 percent. Carlson has a beta
coefficient of 1.2, and the required rate of return on the market is 15 percent. As
Carlson’s financial manager, you have access to insider information concerning a
switch in product lines that would not change the growth rate, but would cut
Carlson's beta coefficient in half. If you buy the stock at the current market price,
what is your expected percentage capital gain? (43%)

8-2. The Hart Mountain Company has recently discovered a new type of kitty litter that is
extremely absorbent. It is expected that the firm will experience (beginning now) an
unusually high growth rate of 20 percent during the 3-year period it has exclusive
rights to the property where the raw material used to make this kitty litter is found.
However, beginning with the fourth year the firm’s competition will have access to
the material, and from that time on, the firm will achieve a normal growth rate of
8 percent annually. During the rapid growth period, the firm’s dividend payout ratio
will be a relatively low 20 percent to conserve funds for reinvestment. However, the
decrease in growth in the fourth year will be accompanied by an increase in the
dividend payout to 50 percent. Last year’s earnings were Ep = $2.00 per share, and
the firm’s required return is 10 percent. What should be the current price of the
common stock? ($71.54)

8-3. Which of the following statements is most correct?

a. One of the advantages of common stock financing is that there is no dilution of
owner's equity, as there is with debt.
b. If the market price of a stock falls below its book value, the firm can be
liquidated, with the book value proceeds then distributed to the shareholders.
Thus, a stock’s book value per share sets a floor below which the stock’s market
price is unlikely to fall.
c. The preemptive right gives a firm’s preferred stockholders preference to assets
over common stockholders in the event the firm is liquidated.
d. All of the above statements are true.
e. All of the above statements are false.

8-4. Bosio Enterprises has preferred stock outstanding that pays a dividend of $8.75 at
the end of each year. If the preferred stock’s required return is 12.5 percent, for
how much does each share of preferred stock sell? ($70)

eeee ae ee en eee
Page 8 - 16 BLUEPRINTS: CHAPTER 8
8-5. Today is December 31, 2002. The following information applies to Harberford
Enterprises:
e After-tax, operating income [EBIT(1 — T)] for the Year 2003 is expected to be
$800 million.
e The company’s depreciation expense for the Year 2003 is expected to be $160
million.
e The company’s capital expenditures for the Year 2003 are expected to be $320
million.
No change is expected in the company’s net operating working capital.
The company’s free cash flow is expected to grow at a constant rate of 4 percent
per year.
The company’s cost of equity is 12 percent.
The company’s WACC is 9 percent.
The market value of the company’s debt is $4.8 billion.
The company has 320 million shares of stock outstanding.
Using the free cash flow approach, what should the company’s stock price be
today? ($25)

es

Page 8 - 17
BLUEPRINTS: CHAPTER 8
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 BLUEPRINTS: CHAPTER 9
THE COST OF CAPITAL

9-22 Coleman Technologies is considering a major expansion program that has been
proposed by the company’s information technology group. Before proceeding
with the expansion, the company needs to develop an estimate of its cost of
capital. Assume that you are an assistant to Jerry Lehman, the financial vice-
president. Your first task is to estimate Coleman’s cost of capital. Lehman has
provided you with the following data, which he believes may be relevant to your
task:
i The firm's tax rate is 40 percent.
a The current price of Coleman’s 12 percent coupon, semiannual payment,
noncallable bonds with 15 years remaining to maturity is $1,153.72. Coleman
does not use short-term interest-bearing debt on a permanent basis. New
bonds would be privately placed with no flotation cost.
. The current price of the firm’s 10 percent, $100 par value, quarterly dividend,
perpetual preferred stock is $111.10.
. Coleman’s common stock is currently selling at $50 per share. Its last
dividend (Do) was $4.19, and dividends are expected to grow at a constant
rate of 5 percent in the foreseeable future. Coleman’s beta is 1.2, the yield on
T-bonds is 7 percent, and the market risk premium is estimated to be 6
percent. For the bond-yield-plus-risk-premium approach, the firm uses a 4
percentage point risk premium.
. Coleman’s target capital structure is 30 percent long-term debt, 10 percent
preferred stock, and 60 percent common equity.
To structure the task somewhat, Lehman has asked you to answer the following
questions.

a. (1) What sources of capital should be included when you estimate Coleman's
weighted average cost of capital (WACC)?
(2) Should the component costs be figured on a before-tax or an after-tax
basis?
(3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Coleman’s.debt and its component cost of
debt?

C. (1) What is the firm’s cost of preferred stock?

nnn Ua EEEEEEEE SEE

BLUEPRINTS: CHAPTER 9 Page 9-1

 (2) Coleman's preferred stock is riskier to investors than its debt, yet the
preferred’s yield to investors is lower than the yield to maturity on the debt.
Does this suggest that you have made a mistake? (Hint: Think about
taxes.)

d. (1) Why is there a cost associated with retained earnings?

(2) What is Coleman’s estimated cost of common equity using the CAPM
approach?

e. What is the estimated cost of common equity using the discounted cash flow
(DCF) approach?

f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of

common equity?

g. What is your final estimate for ks?

h. Explain in words why new common stock has a higher percentage cost than
retained earnings.

i. (1) What are two approaches that can be used to account for flotation costs?
(2) Coleman estimates that if it issues new common stock, the flotation cost
will be 15 percent. Coleman incorporates the flotation costs into the DCF
approach. What is the estimated cost of newly issued common stock,
taking into account the flotation cost?

j. What is Coleman's overall, or weighted average, cost of capital (WACC)?

Ignore flotation costs.

k. What factors influence Coleman’s composite WACC?

|. Should the company use the composite WACC as the hurdle rate for each of
its projects?

m. What are three types of project risk? How is each type of risk used?

n. Coleman is interested in establishing a new division, which will focus primarily

on developing new Internet-based projects. In trying to determine the cost of
capital for this new division, you discover that stand-alone firms involved in
similar projects have on average the following characteristics:
e Their capital structure is 40 percent debt and 60 percent common equity.
e Their cost of debt is typically 12 percent.

Page 9-2 BLUEPRINTS: CHAPTER 9

 e The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of
capital? Note that Coleman uses the CAPM to calculate the division's cost of
capital.

ee —————————e—e ———eeeeeEeee
eS
Page 9-3
BLUEPRINTS: CHAPTER 9
 CHAPTER 9
ee The Cost of Capital

Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk

What sources of long-term

.|_ Capital do firms use?

Long-Term Capital

Preferred Stock} | Common Stock

Retained Earnings } | New Common Stock

Calculating the weighted

average cost of capital

WACC = Wgk,(1-T) + wk, + wk,

» The w’s refer to the firm’s capital

structure weights.
» The k’s refer to the cost of each
component.

Page 9 - 4 BLUEPRINTS: CHAPTER 9

 Should our analysis focus on
before-tax or after-tax capital costs?

» Stockholders focus on A-T CFs.

Therefore, we should focus on A-T
capital costs, i.e. use A-T costs of
capital in WACC. Only k, needs
adjustment, because interest is tax
deductible.

Should our analysis focus on

historical (embedded) costs or new
(marginal) costs?

= The cost of capital is used primarily to

make decisions that involve raising new
capital. So, focus on today’s marginal
costs (for WACC).

How are the weights determined?

WACC = wgk4(1-T) + wok, + Wk,

» Use accounting numbers or market

value (book vs. market weights)?
» Use actual numbers or target capital
structure?

neeeaeEEE EESEEEEE ESSERE

BLUEPRINTS: CHAPTER 9 Page 9-5

 Component cost of debt
WACC = wgk,(1-T) + Wyk, + Wek,

« k, is the marginal cost of debt capital.

» The yield to maturity on outstanding
L-T debt is often used as a measure
of ky.
a Why tax-adjust, i.e. why k,(1-T)?

A 15-year, 12% semiannual coupon

bond sells for $1,153.72. What is
the cost of debt (ky)?
« Remember, the bond pays a semiannual
coupon, so ky = 5.0% x 2 = 10%.

Component cost of debt

= Interest is tax deductible, so
A-T ky = B-T ky (1-T)
= 10% (1 - 0.40) = 6%
« Use nominal rate.
» Flotation costs are small, so ignore
them.

Page 9-6 BLUEPRINTS: CHAPTER 9

 Component cost of preferred
stock
— WACC = wk,(1 -T) + Whky Wk,

s the inal cost of preferred

stock.
= The rate of return investors require on
the firm’s preferred stock.

» The cost of preferred stock can be

solved by using this formula:

- ae
oe

p
= $10 / $111.10
= 9%

Component cost of preferred

stock
Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use k,.
« Nominal k, is used.
» Our calculation ignores possible
flotation costs.

BLUEPRINTS: CHAPTER 9 Page 9-7

 | » More risky; company not required to
pay preferred dividend.
» However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.

Why is the yield on preferred

stock lower than debt?
» Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations. \\4_ “sl
» Therefore, preferred stock often has a lower
B-T yield than the B-T yield on debt.
s The A-T yield to an investor, and the A-T cost
to the issuer, are higher on preferred stock
than on debt. Consistent with higher risk of
preferred stock.

“Tilustrating the differences between

_A-T costs of debt and preferred stock
Recall, that the firm’s tax rate is 40%, and its
before-tax costs of debt and preferred stock
are ky = 10% and k, = 9%, respectively.

A-T k, = ky — kp (1 -0.7(T)
= 9% -9% (0.30.4) =7.92%
A-T ky = 10% - 10% (0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%

9-15

Page 9-8 BLUEPRINTS: CHAPTER 9

 WACC = wgkq(1-T) + Wok, + Wek, )

« k, is the marginal cost of common

equity using retained earnings.
» The rate of return investors require on
the firm’s common equity using new
equity is k,.

» Why is there a cost for

|. retained earnings?
( Earnings can be reinvested
or paid out as
dividends.
» Investors could buy other securities, earn a
return.
« If earnings are retained, there is an
opportunity cost (the return that
stockholders could earn on alternative
investments of equal risk).
» Investors could buy similar stocks and earn k,.
» Firm could repurchase its own stock and earn k,.
» Therefore, k, is the cost of retained earnings.
9-17

= CAPM: k, = Kee + (Ky — Kee) B

\ |\/

= DCF: k,=D,/P)
+9 /
|

= Own-Bond-Yield-Plus-Risk Premium:
k, = kg + RP)

BLUEPRINTS: CHAPTER 9 Page 9-9

 If the kpe = 7%, RP = 6%, and the
firm’s beta is 1.2, what’s the cost of
iil

kK, = Kee + (Ky — Ker) B

= 7.0% + (6.0%)1.2 = 14.2%

If D. = $4.19, Pp = $50, and g = 5%,

what’s the cost of common equity based
upon the DCF approach? ‘

D, = Dy (1+g)
D, = $4.19 (1 + .05) |
D, = $4.3995

k, =D,/P)+9
= $4.3995 / $50 + 0.05
=13-896

= The firm has been earning 15% on equity

(ROE = 15%) and retaining 35% of its
earnings (dividend payout = 65%). This
situation Is expected to continue.

g =(1-Payout ) (ROE)
(0.35) (15%)
5.25%

» Very close to the g that was given before.

Lhe!

Page 9 - 10 BLUEPRINTS: CHAPTER 9

 Can DCF methodology be applied if
growth is not constant?

Yes, nonconstant growth stocks are

expected to attain constant growth at
some point, generally in 5 to 10 years.
» May be complicated to compute.

If ky = 10% and RP = 4%, what is k,

. using the own-bond-yield-plus-risk-
. premium method? et

“a This RP is not the same as the CAPM

RP).
» This method produces a ballpark
estimate of k,, and can serve as a
useful check.

k, = ky + RP
k, = 10.0% + 4.0% = 14.0%

me
What is a reasonable final
stimate of k,? 7
a
Method Estimate
CAPM 14.2%
DCF 13.8%
Ka Re
Average

ee eae

BLUEPRINTS: CHAPTER 9 Page 9-11

 Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
» When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
» Issuing new common stock may send a
negative signal to the capital markets,
which may depress the stock price.

If issuing new common stock incurs a

flotation cost of 15% of the proceeds,
what is k,?

D,(1+9)
g

_ $4.19(1.05)
+5.0%
~ $50(1-0.15)
_ $4.3995

Flotation costs
» Flotation costs depend on the risk of the firm
and the type of capital being raised.
= The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
» We will frequently ignore flotation costs when
calculating the WACC.

Page 9 - 12 BLUEPRINTS: CHAPTER 9

 WACC = wgkg(1-T) + Wyk, + Wek,
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1% ‘
7 Wnts | voll ,

a Market conditions.
« The firm’s capital structure and
dividend policy. (YG) 1 Lyi’
« The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
i

=» NO! The composite WACC reflects the risk

of an average project undertaken by the
firm. Therefore, the WACC only represents
the “hurdle rate” for a typical project with
average risk.
= Different projects have different risks. The
project’s WACC should be adjusted to
reflect the project's risk.

BLUEPRINTS: CHAPTER 9 Page 9 - 13

 Risk and the Cost of Capital
Rate of Return

» What are the three types of

isk?
a Stand-alone risk “~
» Corporate risk
» Market risk

» Market risk is theoretically best in most

situations.
« However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
» Therefore, corporate risk is also
relevant.

Page 9 - 14 BLUEPRINTS: CHAPTER 9

 » Depreciation-generated funds
= Privately owned firms
» Measurement problems
» Adjusting costs of capital for
different risk
» Capital structure weights

= Subjective adjustments to the firm’s

composite WACC.
= Attempt to estmate what the cost of
capital would be if the project/division
were a stand-alone firm. This requires
estimating the project’s beta.

Finding a divisional cost of capital:

Using similar stand-alone firms to
estimate a project's cost of capital
= Comparison firms have the following
characteristics:
» Target capital structure consists of 40%
debt and 60% equity.
» ky = 12%
a kee = 7%
2 RPw = 6%

= Bow = 1.7
« Tax rate = 40%

NN ss

BLUEPRINTS: CHAPTER 9 Page 9-15

 Calculating a divisional cost of capital

« Division’s required return on equity

=k = Ker + (Ky — Kee)B
= 7% + (6%)1.7 = 17.2%
= Division’s weighted average cost of capital
» WACC = wgky(1-T) + w,k,
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
» Typical projects in this division are
acceptable if their returns exceed 13.2%.
9-37

Page 9-16 BLUEPRINTS: CHAPTER 9

 EXAM-TYPE PROBLEMS

9-1. Barak Company’s 8 percent coupon rate, quarterly payment, $1,000 par value
bond, which matures in 20 years, currently sells at a price of $686.86. The
company’s tax rate is 40 percent. Based on the nominal interest rate, not the
EAR, what is the firm’s component cost of debt for purposes of calculating the
WACC? (7.32%)

Allison Engines Corporation has established a target capital structure of 40

percent debt and 60 percent common equity. The current market price of the
firm’s stock is Po = $28; its last dividend was Do = $2.20, and its expected
dividend growth rate is 6 percent. Allison can issue new common stock at a
flotation cost of 15 percent. What is Allison’s marginal cost of outside equity
capital, ke? (15.8%)

9-3. Gator Services Unlimited’s (GSU) financial analyst must determine the firm’s
WACC for use in capital budgeting. She has gathered the following relevant
data:
(1) Target capital structure: Debt 55 percent, Common equity 45 percent.
(2) Interest rate on new debt = 10%.
(3) GSU’s current stock price = $42.50; its last dividend was $3.00.
(4) The firm’s constant growth rate is 10 percent; its tax rate is 35 percent.
What is GSU’s WACC? (11.57%)

The Hiers Company has a target capital structure of 42 percent debt and 58
percent equity. The yield to maturity on the company’s bonds is 11 percent, and
the company’s tax rate is 40 percent. Hiers’ treasurer has calculated the
company’s WACC as 10.53 percent. What is the company’s cost of equity
capital, according to the treasurer's calculation? (13.38%)

NN

Page 9-17
BLUEPRINTS: CHAPTER 9
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 BLUEPRINTS: CHAPTER 10
THE BASICS OF CAPITAL BUDGETING

10-25 Assume that you recently went to work for Allied Components Company, a supplier
of auto repair parts used in the after-market with products from DaimlerChrysler,
Ford, and other auto makers. Your boss, the chief financial officer (CFO), has just
handed you the estimated cash flows for two proposed projects. Project L involves
adding a new item to the firm’s ignition system line; it would take some time to build
up the market for this product, so the cash inflows would increase over time.
Project S involves an add-on to an existing line, and its cash flows would decrease
over time. Both projects have 3-year lives, because Allied is planning to introduce
entirely new models after 3 years.
Here are the projects’ net cash flows (in thousands of dollars):
Expected Net Cash Flow
Year Project L Project S
0 ($100) ($100)
1
“4
3 80 20
Depreciation, salvage values, net operating working capital requirements, and tax
effects are all included in these cash flows.
The CFO also made subjective risk assessments of each project, and he concluded
that both projects have risk characteristics that are similar to the firm’s average
project. Allied’s weighted average cost of capital is 10 percent. You must now
determine whether one or both of the projects should be accepted.

a. What is capital budgeting? Are there any similarities between a firm’s capital
budgeting decisions and an individual’s investment decisions?

b. What is the difference between independent and mutually exclusive projects?

Between projects with normal and nonnormal cash flows?

c. (1) What is the payback period? Find the paybacks for Projects L and S.
(2) What is the rationale for the payback method? According to the payback
criterion, which project or projects should be accepted if the firm’s maximum
acceptable payback is 2 years, and if Projects L and S are independent? If
they are mutually exclusive?
(3) What is the difference between the regular and discounted payback periods?

nn EET

BLUEPRINTS: CHAPTER 10 Page 10-1

 (4) What is the main disadvantage of discounted payback? Is the payback
method of any real usefulness in capital budgeting decisions?

d. (1) Define the term net present value (NPV). What is each project’s NPV?
(2) What is the rationale behind the NPV method? According to NPV, which
project or projects should be accepted if they are independent? Mutually
exclusive?
(3) Would the NPVs change if the cost of capital changed?

e. (1) Define the term internal rate of return (IRR). What is each project’s IRR?
(2) How is the IRR on a project related to the YTM on a bond?
(3) What is the logic behind the IRR method? According to IRR, which projects
should be accepted if they are independent? Mutually exclusive?
(4) Would the projects’ IRRs change if the cost of capital changed?

f. (1) Draw NPV profiles for Projects L and S. At what discount rate do the profiles
cross?
(2) Look at your NPV profile graph without referring to the actual NPVs and
IRRs. Which project or projects should be accepted if they are independent?
Mutually exclusive? Explain. Are your answers correct at any cost of capital
less than 23.6 percent?

g. (1) What is the underlying cause of ranking conflicts between NPV and IRR?
(2) What is the “reinvestment rate assumption,” and how does it affect the NPV
versus IRR conflict?
(3) Which method is the best? Why?

h. (1) Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.
(2) What are the MIRR’s advantages and disadvantages vis-a-vis the regular
IRR? What are the MIRR’s advantages and disadvantages vis-a-vis the
NPV?

i. Asaseparate project (Project P), the firm is considering sponsoring a pavilion at

the upcoming World's Fair. The pavilion would cost $800,000, and it is expected
to result in $5 million of incremental cash inflows during its 1 year of operation.
However, it would then take another year, and $5 million of costs, to demolish
the site and return it to its original condition. Thus, Project P’s expected net
cash flows look like this (in millions of dollars):

Page 10-2 BLUEPRINTS: CHAPTER 10

 Year Net Cash Flows
0
1
4 (5.0)
The project is estimated to be of average risk, so its cost of capital is 10 percent.
(1) What is Project P’s NPV? What is its IRR? Its MIRR?
(2) Draw Project P’s NPV profile. Does Project P have normal or nonnormal
cash flows? Should this project be accepted?

a
Page 10 -3
BLUEPRINTS: CHAPTER 10
 \
CHAPTER 10
| The Basics of Capital Budgeting
: ———
® <4 Should we
| ( __ build this
e plant?

What is capital budgeting?

c Analysis of potential additions to
fixed assets.
« Long-term decisions; involve large
expenditures.
= Very important to firm’s future.

_ Steps to capital budgeting

Estimate CFs (inflows & outflows).
Assess riskiness of CFs. _~
Determine the ap yiate cost of capital.
Find NPV and/or IRR
AcceptifNPV > 0 and/or IRR > WACC.

Pe an Ce. aa
Page 10-4
eee
wAC,
= [\VACL
dS am
= IRE
BLUEPRINTS: CHAPTER10
VEY=O
tr & Ce |
ph (\. a { ; ' i, ¥ ¥ {

WA = is @
i ae ay
 _
difference
What is the betwee n
~
independentiand mutually exclusive
_ projects?
_=
Independent projects — if the cash flows of
one are unaffected by the acceptance of
mn ihe _
ually exclusive projects — if the cash
flows of one can be adversely impacted by
the acceptance of the other.
f

* /L. She Dg

ash flow streams?

» Normal cash flow stream— Cost rpacaive

CF) followed by a series of positive cash
inflows. One change of signs.
= Nonnormal cash flow stream — Two or
more changes of signs. Most common:
Cost (negative CF), then string of positive
CFs, then cost to close project. Nuclear
power plant, strip mine, etc.

eo

‘«
number
The of years required to
recover a project’s cost, or “How long
does it take to get our money back?”
« Calculated by adding project's cash
inflows to its cost until the cumulative
cash flow for the project turns positive.

BLUEPRINTS: CHAPTER10 Mnweveald€VU) eur

2C7Page 10-5
Ae 7
| ,
y

f } wag. ae ; (AQ - is J. Ih ry 4

(2 hy) as aC LAN ue +yla} Ment

 Calculating payback
——— 2.4 3
|Project L | ae ease sin ie
CF, -100 10 60 100 (80
Cumulative -100 -90 -30 200 50
Payback, = 2 + 30 1{80 | = 2.375 years

ES eS
: 1.6 3

CF, -100 70. 100 | 50

Cumulative -100 -30 0 20

Payback, 30 //50| = 1.6 years

10-7

« Strengths
» Provides an indication of a project's risk
and liquidity.
« Easy to calculate and understand.
» Weaknesses
» Ignores the time value of money.
» Ignores CFs occurring after the payback
period.

Discounted payback period

a Uses discounted cash flows rather than
raw CFs,

CF, -100
PV of CF, -100 9.09 49.59 160.11
Cumulative -100 -90.91 -41.32 18.79

Disc Payback,= 2 + 41.32 //60.11 = 2.7 years

a a a a aa a a EE

Page 10-6 BLUEPRINTS: CHAPTER 10

 = Sum of the PVs of all cash inflows and
outflows of a project:

NPV = 2: }°——"t
CF
Sa+ky

What is Project L’s NPV?

PV of CF,
-$100
9.09
49.59 oes re 0 Sat) ieee ee
60.11 ‘7
NPV, = $18.79

NPV, = $19.98

Solving for NPV:

Financial calculator solution
« Enter CFs into the calculator’s CFLO
register.
= CF, = -100
» CF, = 10
. CF, = 60

« CF; = 80

» Enter I/YR = 10, press NPV button to

get NPV, = $18.78.
10-12

BLUEPRINTS: CHAPTER 10 Page 10-7

 ~ NPV = PV of inflows — Cost
= Net gain in wealth
» If projects are independent, accept if the
project NPV > 0.
« If projects are mutually exclusive, accept
projects with the highest positive NPV,
those that add the most value.
» In this example, would accept S if
mutually exclusive (NPV, > NPV,), and
would accept both if independent. 50-29

» IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

oe react
F

fo (1+IRR)

» Solving for IRR with a financial calculator:

« Enter CFs in CFLO register.
» Press IRR; IRR, = 18.13% and IRR, = 23.56%.

10-14

e They are the same thing.

» Think of a bond as a project. The
YTM on the bond would be the IRR
of the “bond” project.
» EXAMPLE: Suppose a 10-year bond
with a 9% annual coupon sells for
$1,134.20.
» Solve for IRR = YTM = 7.08%, the
annual return for this project/bond.

Page 10-8 BLUEPRINTS: CHAPTER 10

 « If IRR > WACC, the project’s rate of
return is greater than its costs. y=

There
issome return left over to
boost stockholders’ returns. -

IRR Acceptance Criteria

« If IRR <k, reject project.

« If projects are independent, accept

both projects, as both IRR > k =
10%. Aoeipt 4A Prseus
= If projects are mutually exclusive,
accept S, because IRR, > IRR,.
Aecupt Get Pree

“« A graphical representation of project NPVs at

various different costs of capital.

NPV.
$40
29
20

BLUEPRINTS: CHAPTER 10 Page 10-9

 Drawing NPV profiles

Crassover Point = 8.7%

IRR, = 18.1%

IRRg = 23.6%

Discount Rate (%)

10-19

methods always lead to the same

accept/reject decisions.
« If projects are mutually exclusive ...
» If k > crossover point, the two methods
lead to the same decision and there is no
conflict.
« If k < crossover point, the two methods
lead to different accept/reject decisions.
10-20

ding the crossover point

Findscash flow differences between the
projects for each year.
Enter these differences in CFLO register,
then press IRR. Crossover rate = 8.68%,
rounded to 8:7%.
Can subtract S from L or vice versa, but
better to have first CF negative.
If profiles don’t cross, one project
dominates the other.

Page 10 - 10 BLUEPRINTS: CHAPTER 10

 Reasons why NPV profiles cross
= Size (scale) differences — the smaller
project frees up funds at t = 0 for
investment. The higher the opportunity
cost, the more valuable these funds, so
high k favors small projects.
Timing differences — the project with faster
payback provides more CF in early years
for reinvestment. If k is high, early CF
especially good, NPV, > NPV,.

se | oa ae JOY LAD Uy Y/) LH1CUY (fJtoTttivin {

NPV method assumes CFs are reinvested \ fF
at k, the opportunity cost of capital.
i See assumes CFs are reinvested
a :
Assuming CFs are reinvested at the
opportunity cost of capital is more
realistic, so NPV method is the best. NPV
method should be used to choose 2
between mutually exclusive projects. Ve 3 ;
Perhapsa hybrid of the IRR that assumes — IVDO - Vif | Ke
cost of capital reinvestment is needed. SS nee ‘
10-23

« Yes, MIRR is the discount rate that

causes the PV of a project’s terminal
value (TV) to equal the PV of costs. TV
is found by compounding inflows at
WACC.
» MIRR assumes cash flows are aT

reinvested at the WACC.

BLUEPRINTS: CHAPTER 10 o “i 2 Page 10 - 11

 80.0
SO 10% 66.0
10% 12.1
MIRR = 16.5% 458.1

100 |= —2 $158.1.
ee
$100 + MIRR,)?
MIRR, = 16.5%

» MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
« Managers like rate of return
comparisons, and MIRR is better for
this than IRR.

- =$800,
CF,= $5,000, and CF, = -$5,000.
sFind Project P's NPV and IRR.

0 k = 10% 1 2

-800 5,000 -5,000

» Enter CFs into calculator CFLO register.

» Enter I/YR = 10. : we ah
» NPV = -$386.78. “ DDN a
» IRR = ERROR Why? Ke AT

Page 10-12 {| BLUEPRINTS: CHAPTER 10

 At very low discount rates, the PV of CF, is
large & negative, so NPV < 0.
At very high discount rates, the PV of both
CF, and CF, are low, so CF, dominates and
again NPV < 0.
In between, the discount rate hits CF,
harder than CF,, so NPV > 0.
Result: 2 IRRs.

Solving the multiple IRR problem

« Using a calculator
» Enter CFs as before.
« Store a “guess” for the IRR (try 10%)
10 = STO
@ IRR = 25% (the lower IRR)
» Now guess a larger IRR (try 200%)
200 = STO
= IRR = 400% (the higher IRR)
« When there are nonnormal CFs and more than
one IRR, use the MIRR.
10-30

iD

BLUEPRINTS: CHAPTER 10 Page 10-13

 Whento use the MIRR instead of
P?

» When there are nonnormal CFs and

more than one IRR, use MIRR.
« PV of outflows @ 10% = -$4,932.2314.
« TV of inflows @ 10% = $5,500.
» MIRR = 5.6%.
» Do not accept Project P.
« NPV = -$386.78 < 0.
« MIRR = 5.6% < k = 10%.

ee ae ae Rees MOE ere ee Se

Page 10 - 14
BLUEPRINTS: CHAPTER 10
 EXAM-TYPE PROBLEMS

10-1. A company is analyzing two mutually exclusive projects, S and L, whose cash flows
are shown below:
Years 0 12% 1 2 3 ;

S -1,100 900 350 50 10

e100 0 300 500 850
The company’s cost of capital is 12 percent, and it can get an unlimited amount of
capital at that cost. What is the regular /RR (not MIRR) of the better project? (Hint:
Note that the better project may or may not be the one with the higher IRR.)
(13.09%)

10-2. As the director of capital budgeting for Lasser Company, you are evaluating two
mutually exclusive projects with the following net cash flows:
Year ProjectX ProjectZ
0 -$100 -$100
1 50 10
2 40 30
3 30 40
4 10 60
Do the two NPV profiles cross in the relevant part of the NPV profile graph (the
upper right quadrant) and, if they do cross, at what rate do the profiles cross?
(7.17%)

10-3. Below are the returns of Nulook Cosmetics and the “market” over a 3-year period:
Year Nulook Market
1 9% 6%
2 15 10
3 36 24
Nulook finances internally using only retained earnings, and it uses the Capital
Asset Pricing Model with a historical beta to determine its cost of equity. Currently,
the risk-free rate is 7 percent, and the estimated market risk premium is 6 percent.
Nulook is evaluating a project that has a cost today of $2,028 and will provide
estimated after-tax cash inflows of $1,000 at the end of each of the next 3 years.
What is this project's MIRR? (20.01%)

nn EEEEEEEEEEeeeE

BLUEPRINTS: CHAPTER 10 Page 10 - 15

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 BLUEPRINTS: CHAPTER 11
CASH FLOW ESTIMATION AND RISK ANALYSIS

11-12 After seeing Snapple’s success with noncola soft drinks and learning of Coke’s and
Pepsi's interest, Allied Food Products has decided to consider an expansion of its
own in the fruit juice business. The product being considered is fresh lemon juice.
Assume that you were recently hired as assistant to the director of capital
budgeting, and you must evaluate the new project.
The lemon juice would be produced in an unused building adjacent to Allied’s Fort
Myers plant; Allied owns the building, which is fully depreciated. The required
equipment would cost $200,000, plus an additional $40,000 for shipping and
installation. In addition, inventories would rise by $25,000, while accounts payable
would go up by $5,000. All of these costs would be incurred at t= 0. By a special
ruling, the machinery could be depreciated under the MACRS system as 3-year
property. The applicable depreciation rates are 33%, 45%, 15%, and 7%.
The project is expected to operate for 4 years, at which time it will be terminated.
The cash inflows are assumed to begin 1 year after the project is undertaken, or at
t = 1, and to continue out to t = 4. At the end of the project’s life (t = 4), the
equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 cans per year, and the expected sales price
is $2.00 per can. Cash operating costs for the project (total operating costs less
depreciation) are expected to total 60 percent of dollar sales. Allied’s tax rate is 40
percent, and its weighted average cost of capital is 10 percent. Tentatively, the
lemon juice project is assumed to be of equal risk to Allied’s other assets.
You have been asked to evaluate the projects and to make a recommendation as to
whether it should be accepted or rejected. To guide you in your analysis, your boss
gave you the following set of questions.

a. Draw atime line that shows when the net cash inflows and outflows will occur,
and explain how the time line can be used to help structure the analysis.

b. Allied has a standard form that is used in the capital budgeting process; see
Table 1C11-1. Part of the table has been completed, but you must replace the
blanks with the missing numbers.

ce eaaUtdtttdtIdEISSISEEIEESSSSSSSE

BLUEPRINTS: CHAPTER 11 Page 11-1

 Table IC11-1. Allied’s Lemon Juice Project
(Total Cost in Thousands)

End of Year: 0 1 2 i] 4
1. Investment Outlay
Equipment cost
Installation

|
Increase in inventory
Increase in accounts payable
Total net investment
ll. Operating Cash Flows
Unit sales (thousands) 100
Price/unit $ 2.00 $ 2.00
Total revenues $200.0
Operating costs, excluding depreciation $120.0
Depreciation 36.0 16.8
Total costs $199.2 $228.0
Operating income before taxes
Taxes on operating income 0.3
Operating income after taxes
Depreciation 79.2
Operating cash flow SOO S2707
lil. Terminal Year Cash Flows
Return of net operating working capital
Salvage value
Tax on salvage value
Total termination cash flows
IV. Net Cash Flows
Net cash flow ($260.0) $ 89,7
V. Results

Payback =

See

Page 11-2 BLUEPRINTS: CHAPTER 11

 Complete the table in the following steps:
(1) Fill in the blanks under Year 0 for the initial investment outlay.
(2) Complete the table for unit sales, sales price, total revenues, and operating
costs excluding depreciation.
(3) Complete the depreciation data.
(4) Now complete the table down to operating income after taxes, and then
down to net cash flows.
(5) Now fill in the blanks under Year4 for the terminal cash flows, and complete
the net cash flow line. Discuss net operating working capital. What would
have happened if the machinery were sold for less than its book value?

c. (1) Allied uses debt in its capital structure, so some of the money used to
finance the project will be debt. Given this fact, should the projected cash
flows be revised to show projected interest charges? Explain.
(2) Suppose you learned that Allied had spent $50,000 to renovate the building
last year, expensing these costs. Should this cost be reflected in the
analysis? Explain.
(3) Now suppose you learned that Allied could lease its building to another party
and earn $25,000 per year. Should that fact be reflected in the analysis? If
so, how?
(4) Now assume that the lemon juice project would take away profitable sales
from Allied’s fresh orange juice business. Should that fact be reflected in
your analysis? If so, how?

d. Disregard all the assumptions made in part c, and assume there was no
alternative use for the building over the next 4 years. Now calculate the project's
NPV, IRR, MIRR, and regular payback. Do these indicators suggest that the
project should be accepted?

e. If this project had been a replacement rather than an expansion project, how
would the analysis have changed? Think about the changes that would have to
occur in the cash flow table.

f. Assume that inflation is expected to average 5 percent over the next 4 years;
that this expectation is reflected in the WACC; and that inflation will increase
variable costs and revenues by the same percentage, 5 percent. Does it appear
that inflation has been dealt with properly in the analysis? If not, what should be
done, and how would the required adjustment affect the decision? You can
modify the numbers in the table to quantify your results.

BLUEPRINTS: CHAPTER 11 Page 11-3

 Although inflation was considered in the initial analysis, the riskiness of the project
was not considered. The expected cash flows, considering inflation (in thousands of
dollars), are given in Table 1C11-2. Allied’s overall cost of capital (WACC) is 10
percent.

Table 1C11-2. Allied’s Lemon Juice Project Considering Inflation

(in Thousands)

Year
0 1 2 3 4
Investment in:
Fixed assets ($240)
Net operating working capital (20)
Unit sales (thousands) 100 100 100 100
Sale price (dollars 2.100 2209 2310 2.431
Total revenues $210.0 $220.5 $231.5 $243.1
Cash operating costs (60%) 126.0 V32-3 138.9 145.9
Depreciation 79.2 108.0 36.0 16.8
Operating income before taxes $ 4.8 ($ 19.8) $ 56.6 $ 80.4
Taxes on operating income (40%) 1.9 (7.9) 22.6 321
Operating income after taxes $ 2.9 ($ 11.9) $ 34.0 $ 48.3
Plus depreciation 79.2 108.0 36.0 16.8
Operating cash flow $ 82.1 $ 96.1 o 70.0 43° 65.1
Salvage value 25.0
Tax on SV (40%) (10.0)
Recovery of NOWC ine LS 20.0
Net cash flow ($260) $ 82,1 $ 96.14 $70.0 $100.1
Cumulative cash flows for payback: (260.0) (177.9) (81.8) (11.8) 88.3
Compounded inflows for MIRR: 109.2 116-3 77.0 100.1
Terminal value of inflows: 402.6
NPV at 10% cost of capital = $15.0
IRR = 12.6%
MIRR = 11.6%

You have been asked to answer the following questions.

g. (1) What are the three levels, or types, of project risk that are normally
considered?
(2) Which type is most relevant?
(3) Which type is easiest to measure?
(4) Are the three types of risk generally highly correlated?

h. (1) What is sensitivity analysis?

(2) Discuss how one would perform a sensitivity analysis on the unit sales,
salvage value, and cost of capital for the project. Assume that each of these
EES

Page 11-4 BLUEPRINTS: CHAPTER 11

 variables deviates from its base-case, or expected, value by plus and minus
10, 20, and 30 percent. Explain how you would calculate the NPV, IRR,
MIRR, and payback for each case.
(3) What is the primary weakness of sensitivity analysis? What are its primary
advantages?

i. Assume that you are confident about the estimates of all the variables that affect
the cash flows except unit sales. If product acceptance is poor, sales would be
only 75,000 units a year, while a strong consumer response would produce
sales of 125,000 units. In either case, cash costs would still amount to 60
percent of revenues. You believe that there is a 25 percent chance of poor
acceptance, a 25 percent chance of excellent acceptance, and a 50 percent
chance of average acceptance (the base case).
(1) What is the worst-case NPV? The best-case NPV?
(2) Use the worst-, most likely (or base), and best-case NPVs, with their
probabilities of occurrence, to find the project’s expected NPV, standard
deviation, and coefficient of variation.

j. (1) Assume that Allied’s average project has a coefficient of variation (CV) in the
range of 1.25 to 1.75. Would the lemon juice project be classified as high
risk, average risk, or low risk? What type of risk is being measured here?
(2) Based on common sense, how highly correlated do you think the project
would be with the firm’s other assets? (Give a correlation coefficient or
range of coefficients, based on your judgment.)
(3) How would this correlation coefficient and the previously calculated o
combine to affect the project’s contribution to corporate, or within-firm, risk?
Explain.

k. (1) Based on your judgment, what do you think the project's correlation
coefficient would be with respect to the general economy and thus with
returns on “the market’?
(2) How would correlation with the economy affect the project's market risk?

|. (1) Allied typically adds or subtracts 3 percentage points to the overall cost of
capital to adjust for risk. Should the lemon juice project be accepted?
(2) What subjective risk factors should be considered before the final decision is
made?

nn—Ss ———— ————

BLUEPRINTS: CHAPTER 11 Page 11-5

 CHAPTER i1
Cash Flow Estimation and Risk
E Analysis

« Relevant cash flows

» Incorporating inflation
» Types of risk
Risk Analysis

, Proposed Project
: one re
~« Total depreciable cost” aS “he
» Equipment: $200,000 ou
« Shipping: $10,000
= Installation: $30,000
» Changes in working capital-
» Inventories will rise by $25,000
» Accounts payable will rise by $5,000
» Effect on operations
» New sales: 100,000 units/year @ $2/uni
. gy 60% of. sales

Proposed Project
« Life of the project
» Economic life: 4 years
» Depreciable life: MACRS 3-year class
« Salvage value: $25,000
a Tax rate: 40%
» WACC: 10%

Page 11-6 BLUEPRINTS: CHAPTER 11

 “a Estimate relevant cash flows
« Calculating annual operating cash flows.
« Identifying changes in working capital.
» Calculating terminal cash flows.
1 2 3 4
—a a
Initial OCF, OCF, OCF, OCF,
Costs *
Terminal

NCF, NCF,

« Find A NOWC.
« f in inventories of $25,000
« Funded partly by an ft in A/P of $5,000

= Combine A NOWC with initial costs.

Equipment -$200,000 A
Installation -40,000 (0 WU
A NOWC -20,000-——— /|0f |
Net CF -$260,000
11-5

Due to the MACRS 2-year convention, a

3-year asset is depreciated over 4 years.

BLUEPRINTS: CHAPTER 11 Page 11-7

 = Annual operating cash flows
1 2 3 4
Revenues 200 200 200 200
- Op. Costs (60%) -120 -120 -120-120
- Deprn Expense -79 -108 -36 -17
Oper. Income (BT) 1 -28 44 63
- Tax (40%) ee ee gee 25
Oper. Income (AT) 1 -17 26 38
+ Deprn Expense 79 10 3617
Operating CF 80 91 62 55

Ci Ha (uuu = :Cth yprive =

Bop Valu
Recovery of NOWC $20,000
Salvage value 25,000
Tax on SV (40%) -10,000
Terminal CF $35,000

Q. How is NOWC recovered?

Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash

mShould financing effects be

included in cash flows?
» No, dividends and interest expense should
not be included in the analysis.
» Financing effects have already been taken
into account by discounting cash flows at the
WACC of 10%.
» Deducting interest expense and dividends
would be “double counting” financing costs.

—_—
eee

Page 11-8 BLUEPRINTS: CHAPTER 14

 0,000 improvement cost
from the previous year be included in
the analysis?

» No, the building improvement cost is

a sunk cost and should not be
considered, “<7 > fliea
a This analysis should only include
incremental investment.

If the facility could be leased out for

$25,000 per year, would this affect
the analysis?
| » Yes, by accepting the project, the firm
foregoes a possible annual cash flow of
$25;000-whichis-an-opportunity
cost'to"be

= The relevant cash flow is the annual after-

tax opportunity cost.

= $25,000(0.6)
= $15,000

decrease the sales of the firm’s other

LC. 12ttly he from One
lines, would this affect the analysis?
Yate 70 AIP, (or
rojyects sis an
GB 70ST LX HOT tr
= Net CFNoss per year on other lines would be
a cost to this project.
« Externdlities can be positive (in the case of
= a or negative (substitutes).

(will becomereq OF /

BLUEPRINTS: CHAPTER 11 Page 11-9

 » Enter CFs into calculator CFLO register,
and enter I/YR = 10%.
» NPV = -$4.03 million
» IRR = 9.3%

89.7
| L_—. 686
410.4
106.14
374.8 .
+2

=|. Payback period

1

79.7

Cumulative:
-260 -180.3

Page 11-10 BLUEPRINTS: CHAPTER 11

 If this were a replacement rather than a
new project, would the analysis change?

» Yes, the old equipment would be sold, and new

equipment purchased.
The incremental CFs would be the changes from
the old to the new situation.
The relevant depreciation expense would be the
change with the new equipment.
If the old machine was sold, the firm would not
receive the SV at the end of the machine's life.
This is the opportunity cost for the replacement
project.

What if there is expected annual

inflation of 5%, is NPV biased?
« Yes, inflation causes the discount rate
to be upwardly revised.
« Therefore, inflation creates a
downward bias on PV.
« Inflation should be built into CF
forecasts.

Annual operating cash flows, if

expected annual inflation = 5%
1 2 3 4
Revenues 210 220 232 243
Op. Costs (60%) -126 -132 -139 -146
- Deprn Expense -79 -108 -36 -17
- Oper. Income (BT) 5 -20 57 80
- Tax (40%) pee pk yay
Oper. Income (AT) 3 -12 34 48
+ Deprn Expense _79 108 36 17
Operating CF 82. 96 70 65

nw

BLUEPRINTS: CHAPTER 11 Page 11-11

 Considering inflation:
= _Project net CFs, NPV, and IRR
0 1 2 3 4

A 96.1 70.0 65.1

Terminal CF — 35.0
100.1

» Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
» NPV = $15.0 million.
« IRR = 12.6%.

What are the 3 types of

project risk?

= Stand-alone risk
» Corporate risk
« Market risk

« The project’s total risk, if it were

operated independently.
» Usually measured by standard
deviation (or coefficient of variation).
« However, it ignores the firm’s
diversification among projects and
investor’s diversification among firms.

Page 11-12 BLUEPRINTS: CHAPTER 11

 » The project’s risk when considering
the firm’s other projects, i.e.,
diversification within the firm.
» Corporate risk is a function of the
project’s NPV and standard
deviation
) andr its correlation
é with the
imcthneo

What is market risk?

« The project’s risk to a well-diversified
investor.
» Theoretically, it is measured by the
project’s beta and it considers both
corporate and stockholder
diversification.

Which type of risk is most

relevant?
« Market risk is the most relevant risk
for capital projects, because
management's primary goal is
shareholder wealth maximization.
» However, since total risk affects
creditors, customers, suppliers, and
employees, it should not be
completely ignored.

a ce UEEUytyEIEIEEIESSII SEES!

BLUEPRINTS: CHAPTER 11 Page 11-13

 Which risk is the easiest to
e) measure?
» Stand-alone risk is the easiest to*
measure. Firms often focus on stand-
alone risk when making capital
budgeting decisions.
» Focusing on stand-alone risk is not
theoretically correct, but it does not
necessarily lead to poor decisions.

types of risk
aL. \generallyshighly correlated?
» Yes, since most projects the firm
undertakes are in its core business,
stand-alone risk is likely to be highly
correlated with its corporate risk.
» In addition, corporate risk is likely to
be highly correlated with its market
risk.

» Sensitivity analysis measures the

effect of changes in a variable on the
project’s NPV.
» TO perform a sensitivity analysis, all
variables are fixed at their expected
values, except for the variable in
question which is allowed to fluctuate.
» Resulting changes in NPV are noted.

11-27

Page 11 - 14 BLUEPRINTS: CHAPTER 11

 What are the advantages and
disadvantages of sensitivi
: Advantage
» Identifies variables that may have the
greatest potential impact on profitability
and allows management to focus on these
variables.

S not incorporate any information about

e possible magnitudes of the forecast
errors.

t of all the variable

sales. The actual unit

Probability Unit Sales

0.25 75,000
0.50 100,000
0.25 125,000

Probability NPV.
0.25 ($27.8)
0.50 $15.0
0.25 $57.8

nn a tEt EE aSSaa

BLUEPRINTS: CHAPTER 11 Page 11-15

 Determining expected NPV, Oypy, and
. CVypy from the scenario analysis

, E(NPV) = 0.25(-$27.8)+0.5($15.0}-0.25($57.8)
= $15.0

Gypy = [0.25(-$27.8-$15.0)2 + 0.5($15.0-

$15.02 + 0.25($57.8-$15.0]/2
=e SOOLSe

CVnpy = $30.3 /$15.0 = 2.0.

If the firm’s average projects have CVypy

ranging from 1.25 to 1.75, would this
- project be of high, average, or low risk?

» With a CVypy of 2.0, this project

would be classified as a high-risk
project.
» Perhaps, some sort of risk correction
is required for proper analysis.

Is this project likely to be correlated with

the firm’s business? How would it
=contribute to the firm’s overall risk?

=» We would expect a positive correlation with

the firm’s aggregate cash flows.
» As long as correlation is not perfectly positive
(i.e., Pp# 1), we would expect it to contribute
to the lowering of the firm’s total risk.

Sse

Page 11 - 16 BLUEPRINTS: CHAPTER 11

 If the project had a high correlation
with the economy, how would
, corporate and market risk be affected?

= The project’s corporate risk would not be

directly affected. However, when combined
with the project’s high stand-alone risk,
correlation with the economy would suggest
that market risk (beta) is high.

If the firm uses a +/- 3% risk

adjustment for the cost of capital,
»should the project beaccepted?
» Reevaluating this project at a 13% cost
of capital (due to high stand-alone
risk), the NPV of the project is -$2.2 .
« If, however, it were a low-risk project,
we would use a 7% cost of capital and
the project NPV is $34.1.

What subjective risk factors should be

: considered before a decision is made?

» Numerical analysis sometimes fails to

capture all sources of risk for a project.
= If the project has the potential for a
lawsuit, it is more risky than previously
thought.
« If assets can be redeployed or sold easily,
the project may be less risky.

BLUEPRINTS: CHAPTER 11 Page 11-17

 ; What is Monte Carlo simulation?

» A risk analysis technique in which

probable future events are simulated
on a computer, generating estimated
rates of return and risk indexes.
«Simulation software packages are
often add-ons to spreadsheet
programs.

eee

Page 11 - 18 BLUEPRINTS: CHAPTER 11

 EXAM-TYPE PROBLEMS

tla. General Communications encounters significant uncertainty in its sales volume and
price with its primary product. The firm uses scenario analysis to determine an
expected NPV, which it then uses in its capital budget. The base-case, best-case,
and worst-case scenarios and probabilities are provided in the following table. What
are this product's expected NPV, standard deviation, and coefficient of variation?
($23,411,250; $19,682,424.70; 0.8407)
Probability Unit Sales Sales NPV
Scenario of Outcome Volume Price (in 000’s)
Worst case 0.20 9,000 $5,750 -$9 000
Base case 0:45 15,600 $7,000 +$20,500
Best case 0.35 21,500 $8,150 +$45,675

. The Merry Milling Company is evaluating the proposed acquisition of a new milling
machine. The machine’s base price is $540,000, and it would cost another $62,500
to modify it for special use by your firm. The machine falls into the MACRS 3-year
class, and it would be sold after 3 years for $325,000. The applicable MACRS
depreciation rates are 0.33, 0.45, 0.15, and 0.07. The machine would require an
increase in net operating working capital (inventory) of $27,500. The milling
machine would have no effect on revenues, but it is expected to save the firm
$220,000 per year in before-tax operating costs, mainly labor. The firm’s marginal
tax rate is 35 percent. If the project’s cost of capital is 12 percent, should the
machine be purchased? (Yes, NPV = $54,202)

——
nn.

BLUEPRINTS: CHAPTER 11 Page 11 - 19

 BLUEPRINTS: CHAPTER 12
OTHER TOPICS IN CAPITAL BUDGETING

12-13 21st Century Educational Products (21st Century) is a rapidly growing software
company, and consistent with its growth, it has a relatively large capital budget.
While most of the company’s projects are fairly easy to evaluate, a handful of
projects involve more complex evaluations.
John Keller, a senior member of the company’s finance staff, coordinates the
evaluation of these more complex projects. His group brings their recom-
mendations directly to the company’s CFO and CEO, Kristin Riley and Bob Stevens,
respectively.

a. Right now, Keller's group is looking at a variety of interesting projects. For

example, the group has been asked to choose between the following two
mutually exclusive projects:
Expected Net Cash Flows
Year Project S Project L
0 ($100,000) ($100,000)
1 59,000 33,500
2 59,000 33,000
3 ---- 33,500
4 ---- 33,500
Both projects may be repeated and both are of average risk, so they should be
evaluated at the firm's cost of capital, 10 percent. Which one should be
chosen?

b. In recent months, Keller's group has begun to focus on real option analysis.
(1) What is real option analysis?
(2) What are some examples of projects with embedded real options?

c. Taking real options into account, one of Keller's colleagues, Barbara Hudson,
has suggested that instead of investing in Project L today, it might make sense
to wait a year because 21st Century would learn a lot more about market
conditions and would be better able to forecast the project's cash flows. Right
now, 21st Century forecasts that Project L will generate expected yearly net
cash flows of $33,500. However, if the company waits a year, it will learn more
about market conditions. There is a 50 percent chance that the market will be
strong and a 50 percent chance it will be weak. If the market is strong, the
yearly cash-flows will be $43,500. If the market is weak, the yearly cash flows

BLUEPRINTS: CHAPTER 12 Page 12 - 1

 will be only $23,500. If 21st Century chooses to wait a year, the initial
investment will remain $100,000. Assume that all cash flows are discounted at
10 percent. Should 21st Century invest in Project L today, or should it wait a
year before deciding whether to invest in the project?

d. Now let's assume that there is more uncertainty about the future cash flows.
More specifically, assume that the yearly cash flows are now $53,500 if the
market is strong and $13,500 if the market is weak. Assume that the up-front
cost is still $100,000 and that the cost of capital is still 10 percent. Will this
increased uncertainty make the firm more or less willing to invest in the project
today?

e. 21st Century is considering another project, Project Y. Project Y has an up-front

cost of $200,000 and an economic life of three years. If the company develops
the project, its after-tax operating costs will be $100,000 a year; however, the
project is expected to produce after-tax cash inflows of $180,000 a year. Thus,
the project’s estimated cash flows are as follows:
Year Cash Outflows Cash Inflows Net Cash Flows
0 -$200,000 $ 0 -$200,000
1 -100,000 180,000 80,000
2 -100,000 180,000 80,000
5) -100,000 180,000 80,000
(1) The project has an estimated cost of capital of 10 percent. What is the
project's NPV?
(2) While the project's operating costs are fairly certain at $100,000 per year, the
estimated cash inflows depend critically on whether 21st Century's largest
customer uses the product. Keller estimates that there is a 60 percent
chance the customer will use the product, in which case the project will
produce after-tax cash inflows of $250,000. Thus, its net cash flows would
be $150,000 per year. However, there is a 40 percent chance the customer
will not use the product, in which case the project will produce after-tax cash
inflows of only $75,000. Thus, its net cash flows would be -$25,000. Write
out the estimated cash flows, and calculate the project's NPV under each of
the two scenarios.
(3) While 21st Century does not have the option to delay the project, it will know
1 year from now if the key customer has selected the product. If the
customer chooses not to adopt the product, 21st Century has the option to
abandon the project. If it abandons the project, it will not receive any cash
flows after Year 1, and it will not incur any operating costs after Year 1.
Thus, if the company chooses to abandon the project, its estimated cash
flows are as follows:

Page 12-2 BLUEPRINTS: CHAPTER 12

 0 1 2 3
0.60 -$200,000 $150,000 $150,000 $150,000

0.40
-$200,000 -$25,000
Again, assuming a cost of capital of 10 percent, what is the project's
expected NPV if it abandons the project? Should 21st Century invest in
Project Y today, realizing it has the option to abandon the project at t = 1?
(4) Up until now we have assumed that the abandonment option has not
affected the project’s cost of capital. Is this assumption reasonable? How
might the abandonment option affect the cost of capital?

f. Finally, 21st Century is also considering Project Z. Project Z has an up-front

cost of $500,000, and it is expected to produce after-tax cash inflows of
$100,000 at the end of each of the next five years (t = 1, 2, 3, 4, and 5).
Because Project Z has a cost of capital of 12 percent, it clearly has a negative
NPV. However, Keller and his group recognize that if 21st Century goes ahead
with Project Z today, there is a 10 percent chance that this will lead to
subsequent opportunities that have a net present value at t = 5 equal to
$3,000,000. At the same time, there is a 90 percent chance that the subsequent
opportunities will have a negative net present value (-$1,000,000) att =5. On
the basis of their knowledge of real options, Keller and his group understand that
the company will choose to develop these subsequent opportunities only if they
appear to be profitable at t= 5. Given this information, should 21st Century
invest in Project Z today?

cn nn EEUU tEIEEEEEEEEIE ESSE

BLUEPRINTS: CHAPTER 12 Page 12-3

 CHAPTER 12
wi Other Topics in Capital Budgeting

« Evaluating projects with unequal lives

« Identifying embedded options
« Valuing real options in projects

unequal lives
Projects S and L are mutually exclusive, and will
be repeated. If k = 10%, which is better?

Expected Net CFs

Year Project S Project L
0 ($100,000) ($100,000)
59,000 33,500
59,000 33,500
2 33,500
= 33,500

Solvingfor NPV,
with no repetition
« Enter CFs into calculator CFLO register for
both projects, and enter I/YR = 10%.
» NPV, = $2,397
« NPV, = $6,190
= Is Project L better?
« Need replacement chain analysis.

eeee eee

Page 12-4 BLUEPRINTS: CHAPTER 12

 = Use the replacement chain to calculate an
extended NPV, to a common life.
» Since Project S has a 2-year life and L has a
4-year life, the common life is 4 years.

72 3 4
10% :

-100,000 59,000 59,000 59,000 59,000

-100,000
-41,000
NPV, = $4,377 (on extended basis)

y} ihn Vffh MCG

€ 2) fp ; ; —e ‘ , .

option analysis?
« Real options exist when managers can
influence the size and riskiness of a
project’s cash flows by taking different
actions during the project’s life.
« Real option analysis incorporates
typical NPV budgeting analysis with an
analysis for opportunities resulting
from managers’ decisions.

What are some examples of

_real options?
“« Investment timing options Whin |
«» Abandonment/shutdown options
« Growth/expansion options
« Flexibility options

BLUEPRINTS: CHAPTER 12 Page 12-5

 Illustrating an investment
timing option
» If we proceed with Project L, its annual cash
flows are $33,500, and its NPV is $6,190.
However, if we wait one year, we will find
out some additional information regarding
output prices and the cash flows from
Project L.
If we wait, the up-front cost will remain at
$100,000 and there is a 50% chance the
subsequent CFs will be $43,500 a year, and
a 50% chance the subsequent CFs will be
$23,500 a year.

On tree
-$100,000 43,500 43,500 43,500 43,500
50% prob, us et T 4

-$100,000 23,500 23,500 23,500 23,500

50% op prob. 0
1 2 3 4 5
Years

«» Atk = 10%, the NPV at t = 1 is:

« $37,889, if CF’s are $43,500 per year, or
» -$25,508, if CF’s are $23,500 per year, in
which case the firm would not proceed with
the project.

Should we wait or proceed?

If we proceed today, NPV = $6,190.
If we wait one year, Expected NPV at
t = 1 is 0.5($37,889) + 0.5(0) =
$18,944.57, which is worth
$18,944.57 / (1.10) = $17,222.34 in
today’s dollars (assuming a 10%
discount rate).
Therefore, it makes sense to wait.

Page 12-6 BLUEPRINTS: CHAPTER 12

 « What's the appropriate discount rate? -
» Note that increased volatility makes the option to
delay more attractive.
« If instead, there was a 50% chance the
subsequent CFs will be $53,500 a year, anda
50% chance the subsequent CFs will be
$13,500 a year, expected NPV next year (if we
delay) would be:
0.5($69,588) + 0.5(0) = $34,794 > $18,944.5

» Delaying the sencemeans that cash

flows come later rather than sooner.
« It might make sense to proceed
today if there are important
advantages to being the first
competitor to enter a market.
« Waiting may allow you to take
advantage of changing conditions.

» Project Y has an initial, up-front cost of

$200,000, at t = 0. The project is
expected to produce after-tax net cash
flows of $80,000 for the next three years.
« At a 10% discount rate, what is Project Y’s
NPV?
BS eo se Se ee ee
0__k= 10% 1 2 af3
-$200,000 80,000 80,000 80,000

NPV = -$1,051.84

BLUEPRINTS: CHAPTER 12
shi ees
ars NhsPage 12-7
 gL. Abandonment option
» Project Y's A-T net cash flows depend
critically upon customer acceptance of
the product.
« There is a 60% probability that the
product will be wildly successful and
produce A-T net CFs of $150,000, and
a 40% chance it will produce annual
A-T net CFs of -$25,000.

_ Abandonment decision tree

150,000 150,000 150,000
60% prob.
$200,000 :
40% prob. ab,000 25,000 25,000
0 1 2 3
Years
« If the customer uses the product,
NPV is $173,027.80.
« If the customer does not use the product,
NPV is -$262,171.30.
» E(NPV) = 0.6(173,027.8) + 0.4(-262,171.3)
= -1,051.84

» The company does not have the

option to delay the project.
» The company may abandon the
project after a year, if the customer
has not adopted the product.
« If the project is abandoned, there
will be no operating costs incurred
nor cash inflows received after the
first year.

Page 12-8 BLUEPRINTS: CHAPTER 12

 NPV with abandonment option
150,000 150,000 150,000
60% prob. See a 1
-$200,000
40% prob. desist
0 1 2 3
Years

= If the customer uses the product,

NPV is $173,027.80.
= If the customer does not use the product,
NPV is -$222,727.27.
» E(NPV) = 0.6(173,027.8) + 0.4(-222,727.27)
= 14,725.77

reasonab
to assu
le me

= No, it is not reasonable to assume

that the abandonment option has
no effect on the cost of capital.
« The abandonment’Option
reduces”
eatisk-andetherefor@
reduces the Cost
ofseapital”

Growth option
i? Project Z has an initial up-front cost of
$500,000.
The project is expected to produce A-T cash
inflows of $100,000 at the end of each of the
next five years. Since the project carries a 12%
cost of capital, it clearly has a negative NPV.
There is a 10% chance the project will lead to
subsequent opportunities that have an NPV of
$3,000,000 at t = 5, and a 90% chance of an
NPV of -$1,000,000 at t = 5.

BLUEPRINTS: CHAPTER 12 Page 12-9

 _NPV with the growth option
400,000 100,000 100,000 100,000
10% prob. : + i +

-$500,000
100,000 100,000 100,000 100,
90% prob: + —+— —_+— —t
0 1 2 3 4
Years

« Atk = 12%, © : ‘
» NPV of top branch (10% prob) = $1,562,758.19
» NPV of lower branch (90% prob) = -$139,522.38

12-19

» If it turns out that the project has future

opportunities with a negative NPV, the company
would choose not to pursue them.
= Therefore, the NPV of the bottom branch should
include only the -$500,000 initial outlay and the
$100,000 annual cash flows, which lead to an NPV
of -$139,522.38.
« Thus, the expected value of this project should be:
NPV = 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.

= Flexibility options exist when it’s

worth spending money today, which
enables you to maintain flexibility
down the road.

oo SSFSSSSSSSeeFeeeeeeeeeeeeeeeeeeeeSSSSSeeeeeee
Page 12 - 10 BLUEPRINTS: CHAPTER 12
 EXAM-TYPE PROBLEMS

12-1. McQueen Corporation is considering two mutually exclusive projects that are
expected to generate the following cash flows:
0 1 2 3 4 Years
ProjectM: §,_———_+———____#__
-700 265°. 265 265: > 4265

0 1 2 3 Years
Project S: pie85
-200
eel130
140
The two projects are not repeatable. McQueen evaluates investment projects with
close to equal lives, such as these, only with the NPV method. At what cost of
capital should McQueen be indifferent between the two projects? (14.19%)

12-2. Far West Airlines seeks to purchase one of two alternative jetliners. Jet A costs $2
million, has an expected life of 7 years, and will generate net cash flows of
$520,000 per year. An identical Jet A can be purchased for the same price when
the first jet’s life is over. Jet B costs $6.2 million, has an expected life of 14 years,
and is expected to produce net cash flows of $1,012,000 per year. Assume that
inflation in operating costs, airplane expenditures, and fares will be zero, that the
cash inflows occur at the end of the year, and that the firm’s cost of capital is 12
percent. If the firm chooses the jet project that will add the most value to the firm, by
how much will the company’s value increase? ($541,949.05)

12-3. The Metropolitan Oil Company is deciding whether to drill for oil on a tract of land
that the company owns. The company estimates that the project would cost $13.6
million today. Metropolitan estimates that once drilled, the oil will generate positive
net cash flows of $6.8 million a year at the end of each of the next 4 years. While
the company is fairly confident about its cash flow forecast, it recognizes that if it
waits 2 years, it would have more information about the local geology as well as the
price of oil. Metropolitan estimates that if it waits 2 years, the project would cost
$15.3 million. Moreover, if it waits 2 years, there is a 90 percent chance that the net
cash flows would be $7.14 million a year for 4 years, and there is a 10 percent
chance that the cash flows will be $3.74 million a year for 4 years. Assume that all
cash flows are discounted at 10 percent.
a. If the company chooses to drill today, what is the project’s net present value?
($7.9551 million) |
b. Would it make sense to wait 2 years before deciding whether
to drill? (No, NPV
= $5.4542 million)

BLUEPRINTS: CHAPTER 12 Page 12-11

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 BLUEPRINTS: CHAPTER 13
CAPITAL STRUCTURE AND LEVERAGE

13-16 Assume that you have just been hired as business manager of Campus Deli (CD),
which is located adjacent to the campus. Sales were $1,100,000 last year; variable
costs were 60 percent of sales; and fixed costs were $40,000. Therefore, EBIT
totaled $400,000. Because the university's enrollment is capped, EBIT is expected
to be constant over time. Since no expansion capital is required, CD pays out all
earnings as dividends. Assets are $2 million, and 80,000 shares are outstanding.
The management group owns about 50 percent of the stock, which is traded in the
over-the-counter market.
CD currently has no debt—+t is an all-equity firm—and its 80,000 shares outstanding
sell at a price of $25 per share, which is also the book value. The firm’s federal-
plus-state tax rate is 40 percent. On the basis of statements made in your finance
text, you believe that CD’s shareholders would be better off if some debt financing
were used. When you suggested this to your new boss, she encouraged you to
pursue the idea, but to provide support for the suggestion.
In today’s market, the risk-free rate, Krr, is 6 percent and the market risk premium,
Ku — Kerr, iS 6 percent. CD’s unlevered beta, by, is 1.0. Since CD currently has no
debt, its cost of equity (and WACC) is 12 percent.
If the firm were recapitalized, debt would be issued, and the borrowed funds would
be used to repurchase stock. Stockholders, in turn, would use funds provided by the
repurchase to buy equities in other fast-food companies similartoCD. You plan to
complete your report by asking and then answering the following questions.

a. (1) What is business risk? What factors influence a firm’s business risk?
(2) What is operating leverage, and how does it affect a firm’s business risk?

b. (1) What is meant by the terms “financial leverage” and “financial risk”?
(2) How does financial risk differ from business risk?

c. Now, to develop an example that can be presented to CD’s management as an

illustration, consider two hypothetical firms, Firm U, with zero debt financing, and
Firm L, with $10,000 of 12 percent debt. Both firms have $20,000 in total assets
and a 40 percent federal-plus-state tax rate, and they have the following EBIT
probability distribution for next year:

BLUEPRINTS: CHAPTER 13 Page 13 - 1

 Probability EBIT
0.25 $2,000
0.50 3,000
0.25 4,000
(1) Complete the partial income statements and the firms’ ratios in Table 1C13-1.

Table I1C13-1. Income Statements and Ratios

Firm U Firm L
Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000
Probability 0.25 0.50 0.25 0.25 0.50 0.25
Sales $ 6,000 $9,000 $12,000 $6,000 $9,000 $12,000
Oper. costs 4.000 _6,000 8,000 4.000 6,000 8,000
EBIT $ 2,000 $3,000 $4,000 $2,000 $3,000 $ 4,000
Interest (12%) 0 0 0 1,200 1,200
EBT $2,000 $3,000 $4000 $ 800 $ $ 2,800
Taxes (40%) 800 1,200 1,600 320 dateo)
Net income $ 1,200 1,800 2 AND Pie =480au$ $ 1,680 |
BEP
(BEP = EBIT/Assets) 10.0% 15.0% 20.0% 10.0% % 20.0%
ROE 6.0% 9.0% 12-09% 4.8% % 16.8%
TIE 00 £0 00 1.7x x 3.3x
E(BEP) 15.0% %
E(ROE) 9.0% 10.8%
E(TIE) 00 2.5x

o(BEP) 3.5% %
o(ROE) 2A% 4.2%
o(TIE) 0 0.6x
(2) Be prepared to discuss each entry in the table and to explain how this
example illustrates the impact of financial leverage on expected rate of return
and risk.

d. After speaking with a local investment banker, you obtain the following estimates
of the cost of debt at different debt levels (in thousands of dollars):

Sana

Page 13-2 BLUEPRINTS: CHAPTER 13

 Amount Debt/Assets Debt/Equity Bond
Borrowed Ratio Ratio Rating kg
> 0 0 0 -- --
250 0.125 0.1429 AA 8.0%
900 0.250 0.3333 A 9.0
750 0'375 0.6000 BBB A120
1,000 0.500 1.0000 BB 14.0
Now consider the optimal capital structure for CD.
(1) To begin, define the terms “optimal capital structure” and “target capital
structure.”
(2) Why does CD’s bond rating and cost of debt depend on the amount of
money borrowed?
(3) Assume that shares could be repurchased at the current market price of $25
per share. Calculate CD’s expected EPS and TIE at debt levels of $0,
$250,000, $500,000, $750,000, and $1,000,000. How many shares would
remain after recapitalization under each scenario?
(4) Using the Hamada equation, what is the cost of equity if CD recapitalizes
with $250,000 of debt? $500,000? $750,000? $1,000,000?
(5) Considering only the levels of debt discussed, what is the capital structure
that minimizes CD’s WACC?
(6) What would be the new stock price if CD recapitalizes with $250,000 of
debt? $500,000? $750,000? $1,000,000? Recall that the payout ratio is
100 percent, so g = 0.
(7) ls EPS maximized at the debt level that maximizes share price? Why or why
not?
(8) Considering only the levels of debt discussed, what is CD's optimal capital
structure?
(9) What is the WACC at the optimal capital structure?

e. Suppose you discovered that CD had more business risk than you originally
estimated. Describe how this would affect the analysis. What if the firm had
less business risk than originally estimated?

f. What are some factors a manager should consider when establishing his or her
firm’s target capital structure?

g. Put labels on Figure IC 13-1, and then discuss the graph as you might use it to
explain to your boss why CD might want to use some debt.

BLUEPRINTS: CHAPTER 13 Page 13 - 3

 Figure IC13-1
Relationship between Capital Structure and Stock Price

Value of
Firm’s Stock

0 D, D, Leverage, D/A

h. How does the existence of asymmetric information and signaling affect capital :
structure?

a ee a ee re ee ee
eeoataas BLUEPRINTS: CHAPTER 13
 CHAPTER 13
| Capital Structure and Leverage
rs

Business vs. financial risk

Optimal capital structure
Operating leverage
Capital structure theory

What is business risk?

« Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Probability Low risk

High risk

0 E(EBIT) EBIT
Note that business risk does not include financing
effects.
13-2

|. What determines business risk?

» Uncertainty about demand (sales).
« Uncertainty about output prices.
« Uncertainty about costs.
» Product, other types of liability.
» Operating leverage.

BLUEPRINTS: CHAPTER 13 Page 13-5

 _,_ What is operating leverage, and how
=. does it affect a firm’s business risk?
» Operating leverage is the use of
fixed costs rather than variable
costs.
« If most costs are fixed, hence do not
decline when demand falls, then the
firm has high operating leverage.

_Effect of operating leverage

» More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.

Qse Sales Qse

« What happens if variable costs change?

Using operating leverage

Low operating leverage |

Probability I : : =
High operating leverage

EBIT, EBIT,,

« Typical situation: Can use operating leverage

to get higher E(EBIT), but risk also increases.
13-6

Page 13-6 BLUEPRINTS: CHAPTER 13

 What is financial leverage?
Financial risk?
» Financial leverage is the use of debt
and preferred stock.
« Financial risk is the additional risk
concentrated on common
stockholders as a result of financial
leverage.

Business risk vs. Financial risk

» Business risk depends on business
factors such as competition, product
liability, and operating leverage.
« Financial risk depends only on the
types of securities issued.
» More debt, more financial risk.
» Concentrates bugness risk on
stockholders.

_ An example:
Illustrating effects of financial leverage
"= Two firms with the same operating leverage,
business risk, and probability distribution of
EBIT.
« Only differ with respect to their use of debt
(capital structure).

Firm U FirmL
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

nn nnn cee UeEEttddE ty ESSESSENSE Sanne

BLUEPRINTS: CHAPTER 13 Page 13 -7

 _ Firm U: Unleveraged
Economy

Prob. : 0.50
EBIT $3,000
Interest 0
EBT $3,000
Taxes (40%) _1,200
NI $1,800

Leveraged
Economy

Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI

*Same as for Firm U.

Ratio comparison between

_ leveraged and unleveraged firms
FIRM U Bad Avg Good
BEP 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%
He co co co

FIRM L Bad Avg Good

BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
gle 1.67x 2.50x 3.30x
13-12

pygedeee BLUEPRINTS: CHAPTER 13

 Risk and return for leveraged
and unleveraged firms
Expected Values:
Firm L
E(BEP) ‘ 15.0%
E(ROE) y 10.8%
E(TIE) 2.5x

Risk Measures:

ORoE

The effect of leverage on

profitability and debt coverage
« For leverage to raise expected ROE, must
have BEP > ky.
« Why? If k, > BEP, then the interest expense
will be higher than the operating income
produced by debt-financed assets, so
leverage will depress income.
« As debt increases, TIE decreases because
EBIT is unaffected by debt, and interest
expense increases (Int Exp = k,D).

» Basic earning power (BEP) is

unaffected by financial leverage.
» L has higher expected ROE because
BEP = ky.
» L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk.

NN— See

BLUEPRINTS: CHAPTER 13 Page 13-9

 wl Optimal Capital Structure

» That capital structure (mix of debt,

preferred, and common equity) at which Py
is maximized. Trades off higher E(ROE)
and EPS against higher risk. The tax-
related benefits of leverage are exactly
offset by the debt’s risk-related costs.
The target capital structure is the mix of
debt, preferred stock, and common equity
with which the firm intends to raise capital.
13-16

Describe the sequence of

events in a recapitalization.
» Campus Deli announces the
recapitalization.
= New debt is issued.
« Proceeds are used to repurchase
stock.
» The number of shares repurchased is
equal to the amount of debt issued
divided by price per share.

Cost of debt at different levels of debt,

after the proposed recapitalization

Amount D/A D/E Bond

borrowed ratio ratio rating
$ 0 0 0
250 0.125 0.1429
500 0.250 0.3333
750 0.375 0.6000
1,000 0.500 1.0000

Page 13 - 10 BLUEPRINTS: CHAPTER 13

 Why do the bond rating and cost of debt

« As the firm borrows more money,

the firm increases its financial risk
causing the firm’s bond rating to
decrease, and its cost of debt to
increase.

Analyze the proposed recapitalization

at various levels of debt. Determine
he EPS and TIE at each level of debt.

(EBIT -k,D)(1-T)
Shares outstanding
_ ($400,000)(0.6)
~ 80,000
= $3.00

Determining EPS and TIE at different

levels of debt.
D = $250,000
and ky =8%)
$250,000
Shares repurchased = = 10,000

(EBIT
-k,D )(1-T)
EPS =
Shares outstanding
($400,000 - 0.08($250,000))(0.6)
2 80,000 - 10,000
= $3.26

EBIT — $400,000
= - 20x
Int Exp $20,000

BLUEPRINTS: CHAPTER 13 Page 13-11

 Determining EPS and TIE at different
levels of debt.
Sf (D= $500,000 and ky = 9%)

Shares repurchased = SULLY = 20,000

$25
a (EBIT -k,D )(1-T)
EES
~ Shares outstanding
_ ($400,000 - 0.09($500,000))(0.6)
r 80,000 - 20,000
=O.)

EBIT _ $400,000_
ME=
IntExp $45,000

Determining EPS and TIE at different

levels of debt.
g (D = $750,000 and ky = 11.5%)
$750,000
Shares repurchased = = 30,000

(EBIT
-k,D )(1-T)
EPS=
Shares outstanding
($400,000 - 0.115($750,000))(0.6)
7 80,000 - 30,000
SCM)

EBIT — $400,000 _
4.6x
~IntExp $86,250

Determining EPS and TIE at different

levels of debt.
(D = $1,000,000 and k, = 14%)
$1,000,000
Shares repurchased = = 40,000

EPS
_ (EBIT
-k,D )(1-T)
~ Shares outstanding
($400,000 - 0.14($1,000,000))(0.6)
7 80,000 - 40,000
= $3.90

EBIT — $400,000_
2.9x
IntExp $140,000

ee A LL AS

Page 13-12 BLUEPRINTS: CHAPTER 13

 Stock Price, with zero growth

« If all earnings are paid out as dividends,

E(g) = 0.
» EPS = DPS
» To find the expected stock price (Py), we
must find the appropriate k, at each of
the debt levels discussed.

What effect does increasing debt have

on the cost of equity for the firm?

« If the level of debt increases, the

riskiness of the firm increases.
» We have already observed the increase
in the cost of debt.
«» However, the riskiness of the firm’s
equity also increases, resulting in a
higher k,

The Hamada Equation

Because the increased use of debt causes
both the costs of debt and equity to increase,
we need to estimate the new cost of equity.
« The Hamada equation attempts to quantify
the increased cost of equity due to financial
leverage.
Uses the unlevered beta of a firm, which
represents the business risk of a firm as if it
had no debt.
13-27

on EEUU EEE

BLUEPRINTS: CHAPTER 13 Page 13 - 13

 = _The Hamada Equation

B. = Bul 1 + (1 - T) (D/E)]
« Suppose, the risk-free rate is 6%, as
is the market risk premium. The
unlevered beta of the firm is 1.0.
We were previously told that total
assets were $2,000,000.

Calculating levered betas and

_costs of equity /
- ee Qh)
If D = $250, )
B, = 1.0[ 1 + (0.6)($250/$1,750) ]
eree0e57-—* ioe

K, = kee + (Ky — Kee) By

k, = 6.0% + (6.0%) 1.0857
k, = 12.51%

Table for calculating levered _ 1S (or won \S |

. betas and costs of aA
Amount D/A D/E Levered
borrowed _ ratio ratio Beta

0.00% 0.00%
12.50 14.29
25.00 33.33
37.50 60.00
50.00 100.00

Page 13 - 14 BLUEPRINTS: CHAPTER 13

 Finding Optimal Capital Structure
« The firm’s optimal capital structure
can be determined two ways:
« Minimizes WACC,.
« Maximizes stock price.
» Both methods yield the same results.

Table for calculating WACC and

Amount D/A E/JA

borrowed ratio ratio k, ky(1-T) WACC
$ 0 0.00% 100.00% 12.00% 0.00% 12.00%
= = 50

70 S750" 6250" 4aNG 6.00

4,000 50.00 50.00 15.60 8.40 12.00
* Amount borrowed expressed in terms of thousands of dollars
13-32

Table for determining the stock

price maximizing capital structure
Amount f
Borrowed DPS k, Po
$ 0 $3.00 12.00% $25.00
250; pee 3.26 12.51

750,000 Sel
1,000,000 3.90

BLUEPRINTS: CHAPTER 13
 yun De yvion 15 50

S| What debt ratio maximizes EPS?”

7 SeK eG WAL dor (NCUA
" « Maximum EPS = $3.90 at D = $1,000,000,
and D/A = 50%. (Remember DPS = EPS
because payout = 100%.)
» Risk is too high at D/A = 50%.

What is Campus Deli’s optimal

_capital structure?
» Py is maximized ($26.89) at D/A =
$500,000/$2,000,000= 25%, so optimal D/A
= 25%.
« EPS is maximized at 50%, but primary
interest is stock prie, not E(EPS).
= The example shows that we can push up
E(EPS) by using more debt, but the risk
resulting fram increased leverage more than
offsets the benefit of higher E(EPS).

What if there were more/less business nN he VaryibleC87, Whe

risk than originally estimated, how would
. the analysis be affected? DEE FAKED wasp Laws (eB

» If there were higher business risk, then

the probability of financial distress would
be greater at any debt level, and the
optimal capital structure wauld be one
that had less debt. On the other hand,
lower business risk would lead to an
optimal capital structure with more debt.

Page 13-16 BLUEPRINTS: CHAPTER 13

 Other factors to consider when
establishing the firm’s target capital
structure

Industry average debt ratio

. TIE ratios under different scenarios
Lender/rating agency attitudes
Reserve borrowing capacity
Effects of financing on control
. Asset structure
Expected tax rate

How would these factors affect

the target capital structure?
Sales stability?
High operating leverage?
Increase in the corporate tax rate?
Increase in the personal tax rate?
Increase in bankruptcy costs?
Management spending lots of money
on lavish perks?

Modigliani-Miller Irrelevance Theory

Value of Stock MM result

No leverage

BLUEPRINTS: CHAPTER 13 Page 13-17

 _Modigliani-Miller Irrelevance Theory
= The graph shows MMs tax benefit vs.
bankruptcy cost theory.
= Logical, but doesn’t tell whole capital
structure story. Main problem--
assumes investors have same
information as managers.

ignaling effects)
» Signaling theory suggests firms
should use less debt than MM
suggest.
« This unused debt capacity helps
avoid stock sales, which depress
stock price because of signaling
effects.

» Assume:
» Managers have better information about a
firm’s long-run value than outside
investors.
» Managers act in the best interests of
current stockholders.

Page 13-18 BLUEPRINTS: CHAPTER 13

 overvalued.
« Issue debt if they think stock is
undervalued.
« As a result, investors view a common
stock offering as a negative signal--
managers think stock is overvalued.

Conclusions on Capital Structure

Need to make calculations as we did, but
should also recognize inputs are
“guesstimates.”
As a result of imprecise numbers, capital
structure decisions have a large judgmental
content.
We end up with capital structures varying
widely among firms, even similar ones in
same industry.

Ws— ———_—

BLUEPRINTS: CHAPTER 13 Page 13 - 19

 EXAM-TYPE PROBLEMS

13-1. If you know that your firm is facing relatively poor prospects but needs new capital,
and you know that investors do not have this information, signaling theory would
predict that you would
a. Issue debt to maintain the returns of equity holders.
b. Issue equity to share the burden of decreased equity returns between old and
new shareholders.
c. Be indifferent between issuing debt and equity.
d. Postpone going into the capital markets until your firm’s prospects improve.
e. Convey your inside information to investors using the media to eliminate the
information asymmetry.

13-2. Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm
has 10,000 shares outstanding; it pays 12 percent interest on its debt; and it faces a
40 percent marginal tax rate. Its estimated fixed costs are $80,000, while its
variable costs are estimated at 40 percent of revenues. The firm’s target capital
structure is 40 percent equity and 60 percent debt, and it has total assets of
$400,000. On what level of sales is Howell basing its EPS forecast? ($292,445)

13-3. A company estimates that its fixed operating costs are $900,000, and its variable
costs are $3.25 per unit sold. Each unit produced sells for $4.75. What is the
company’s breakeven point? In other words, how many units must it sell before its
operating income becomes positive? (600,000)

13-4. Harris Enterprises is trying to estimate its optimal capital structure. The firm’s
current capital structure consists of 30 percent debt and 70 percent equity; however,
management believes the firm should use more debt. The risk-free rate, Ker, is
6 percent, the market risk premium, ky — Ker, is 5 percent, and the firm’s tax rate is
40 percent. Currently, Harris’ cost of equity is 12 percent, which is determined on
the basis of the CAPM. What would be Harris’ estimated cost of equity if it were to
change from its present capital structure to a capital structure consisting of 45
percent debt and 55 percent equity? (13.12%)

—_
——EeeeSSSSSS
— SSSSSSSMMMMMMMMMhFFeFeFesesesee

Page 13 - 20 BLUEPRINTS: CHAPTER 13

 BLUEPRINTS: CHAPTER 14
DISTRIBUTIONS TO SHAREHOLDERS:
DIVIDENDS AND SHARE REPURCHASES

14-12 Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new
continuous-casting process. SSC’s founders, Donald Brown and Margo Valencia,
had been employed in the research department of a major integrated-steel
company, but when that company decided against using the new process (which
Brown and Valencia had developed), they decided to strike out on their own. One
advantage of the new process was that it required relatively little capital in
comparison with the typical steel company, so Brown and Valencia have been able
to avoid issuing new stock, and thus they own all of the shares. However, SSC has
now reached the stage in which outside equity capital is necessary if the firm is to
achieve its growth targets yet still maintain its target capital structure of 60 percent
equity and 40 percent debt. Therefore, Brown and Valencia have decided to take
the company public. Until now, Brown and Valencia have paid themselves
reasonable salaries but routinely reinvested all after-tax earnings in the firm, so
dividend policy has not been an issue. However, before talking with potential
outside investors, they must decide on a dividend policy.
Assume that you were recently hired by Arthur Adamson & Company (AA), a
national consulting firm, which has been asked to help SSC prepare for its public
offering. Martha Millon, the senior AA consultant in your group, has asked you to
make a presentation to Brown and Valencia in which you review the theory of
dividend policy and discuss the following questions.

a. (1) What is meant by the term “dividend policy’?

(2) The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been
used to describe three major theories regarding the way dividend policy
affects a firm’s value. Explain what these terms mean, and briefly describe
each theory.
(3) What do the three theories indicate regarding the actions management
should take with respect to dividend policy?
(4) What results have empirical studies of the dividend theories produced? How
does all this affect what we can tell managers about dividend policy?

b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele
effect, and (3) their effects on dividend policy.

BLUEPRINTS: CHAPTER 14 Page 14 - 1

 (1) Assume that SSC has an $800,000 capital budget planned for the coming
year. You have determined that its present capital structure (60 percent
equity and 40 percent debt) is optimal, and its net income is forecasted at
$600,000. Use the residual dividend model approach to determine SSC’s
total dollar dividend and payout ratio. In the process, explain what the
residual dividend model is. Then, explain what would happen if net income
were forecasted at $400,000, or at $800,000.
(2) In general terms, how would a change in investment opportunities affect the
payout ratio under the residual payment policy?
(3) What are the advantages and disadvantages of the residual policy? (Hint:
Don’t neglect signaling and clientele effects.)

What is a dividend reinvestment plan (DRIP), and how does it work?

Describe the series of steps that most firms take in setting dividend policy in
practice.

What are stock repurchases? Discuss the advantages and disadvantages of a

firm’s repurchasing its own shares.

What are stock dividends and stock splits? What are the advantages and
disadvantages of stock dividends and stock splits?

eee

Page 14-2
BLUEPRINTS: CHAPTER 14
 CHAPTER 14
Distributions to shareholders:
Dividends and share repurchases

Theories of investor preferences

Signaling effects
Residual model
Dividend reinvestment plans
Stock dividends and stock splits
Stock repurchases

What is dividend policy?

« The decision to pay out earnings versus
retaining and reinvesting them.
= Dividend policy includes
» High or low dividend payout?
« Stable or irregular dividends?
« How frequent to pay dividends?
» Announce the policy?

Do investors prefer high or

ow dividend payouts?
= Three theories of dividend policy:
» Dividend irrelevance: Investors don’t
care about payout.
» Bird-in-the-hand: Investors prefer a
high payout.
« Tax preference: Investors prefer a low
payout.

BLUEPRINTS: CHAPTER 14 Page 14-3

 and m '
_ Dividend irrelevance theory
”. Investors are indifferent between
dividends and retention-generated capital At
gains. Investors can create their own 2G
dividend policy:
» If they want cash, they can sell stock.’
« If they don’t want cash, they can use
dividends to buy stock.
» Proposed by Modigliani and Miller and
based on unrealistic assumptions (no
taxes or brokerage costs), hence may not
be true. Need an empirical test.
« Implication: any payout is OK.

(Hrmoflund oy Vrwe rsh flonis

\nghy Geers Stes pw
Bird-in-the-hand theory
gf Investors think dividends are less risky
than potential future capital gains, hence
they like dividends.
» If so, investors would value high-payout
firms more highly, i.e., a high payout
would result in a high Po.
« Implication: set a high payout.

Tax Preference Theory

» Retained earnings lead to long-term capital
gains, which are taxed at lower rates than
dividends: 20% vs. up to 38.6%. Capital
gains taxes are also deferred.
» This could cause investors to prefer firms
with low payouts, i.e., a high payout results
in a low Pp.
« Implication: Set a low payout.

Page 14-4 BLUEPRINTS: CHAPTER 14

 Possible stock price effects
Stock Price ($)
Bird-in-the-Hand

Irrelevance

Tax preference

100%0 Payout a9

Tax preference

Irrelevance

Bird-in-the-Hand

100%9, Payout Fe

Which theory is most correct?

Ma Empirical testing has not been able to
determine which theory, if any, is
correct.
« Thus, managers use judgment when
setting policy.
« Analysis is used, but it must be
applied with judgment.

BLUEPRINTS: CHAPTER 14 Page 14-5

 What's the “information content,”
=). OF “Signaling,” hypothesis?
« Managers hate to cut dividends, so they
won't raise dividends unless they think
raise is sustainable. So, investors view
dividend increases as signals of
management's view of the future.
= Therefore, a stock price increase at time
of a dividend increase could reflect
higher expectations for future EPS, not a
desire for dividends.

_What's the “clientele effect”?

“a Different groups of investors, or
clienteles, prefer different dividend
policies.
» Firm’s past dividend policy determines
its current clientele of investors.
» Clientele effects impede changing
dividend policy. Taxes & brokerage
costs hurt investors who have to
switch companies.

What is the “residual dividend

model”?
“a Find the retained earnings needed for
the capital budget.
» Pay out any leftover earnings (the
residual) as dividends.
» This policy minimizes flotation and
equity signaling costs, hence minimizes
the WACC.

———— — —— ee SSSSSSSSSSSSSSSFFFFeseee

Page 14-6 , BLUEPRINTS: CHAPTER 14

 Residual dividend model
Target Total
Dividends
= Net Income -|| equity |x| capital
ratio budget

Capital budget — $800,000

Target capital structure — 40% debt, 60%
equity
Forecasted net income — $600,000
How much of the forecasted net income
should be paid out as dividends?
14-13

Residual dividend model:

Calculating dividends paid
“s Calculate portion of capital budget to be
funded by equity.
» Of the $800,000 capital budget, 0.6($800,000)
= $480,000 will be funded with equity.
Calculate excess or need for equity capital.
» With net income of $600,000, there is more
than enough equity to fund the capital budget.
There will be $600,000 - $480,000 =
$120,000 left over to pay as dividends.
= Calculate dividend payout ratio
« $120,000 / $600,000 = 0.20 = 20%

Residual dividend model:

What if net income drops to $400,000?
Rises to $800,000?
= If NI = $400,000 ...
« Dividends = $400,000 — (0.6)($800,000) = -$80,000.
« Since the dividend results in a negative number, the
firm must use all of its net income to fund its budget,
and probably should issue equity to maintain its
target capital structure.
» Payout = $0 / $400,000 = 0%
= If NI = $800,000 ...
« Dividends = $800,000 — (0.6)($800,000) = $320,000.
» Payout = $320,000 /$800,000 = 40% aaae

a a EEE EE EEE SS SS

BLUEPRINTS: CHAPTER 14 Page 14-7

 How would a change in investment
opportunities affect dividend under the
residual policy?

» Fewer good investments would lead

to smaller capital budget, hence to a
higher dividend payout.
» More good investments would lead to
a lower dividend payout.

Comments on Residual
a... Dividend Policy
* Advantage — Minimizes new stock
issues and flotation costs.
» Disadvantages — Results in variable
dividends, sends conflicting signals,
increases risk, and doesn’t appeal to
any specific clientele.
» Conclusion — Consider residual policy
when setting target payout, but don’t
follow it rigidly.

What's a “dividend
=. reinvestment plan (DRIP)?
| » Shareholders can automatically reinvest
their dividends in shares of the
company’s common stock. Get more
stock than cash.
» There are two types of plans:
» Open market
» New stock

ee

Page 14-8 BLUEPRINTS: CHAPTER 14

 _Open Market Purchase Plan
a Dollars to be reinvested are turned over
to trustee, who buys shares on the
open market.
« Brokerage costs are reduced by volume
purchases.
» Convenient, easy way to invest, thus
useful for investors.

» Firm issues new stock to DRIP enrollees

(usually at a discount from the market
price), keeps money and uses it to buy
assets.
Firms that need new equity capital use new
stock plans.
Firms with no need for new equity capital
use open market purchase plans.
Most NYSE listed companies have a DRIP.
Useful for investors.
14-20

setting Dividend Policy

Forecast capital needs over a planning
horizon, often 5 years.
» Set a target capital structure.
= Estimate annual equity needs.
« Set target payout based on the residual
model.
Generally, some dividend growth rate
emerges. Maintain target growth rate if
possible, varying capital structure somewhat
if necessary.

pe
eS ee SSS SS SS

BLUEPRINTS: CHAPTER 14 Page 14-9

 el Stock Repurchases
S

» Buying own stock back from

stockholders
» Reasons for repurchases:
« As an alternative to distributing cash as
dividends.
« TO dispose of one-time cash from an
asset sale.
» TO make a large capital structure change.

A\dvantages of Repurchases
Stockholders can tender or not.
Helps avoid setting a high dividend that cannot
be maintained.
Repurchased stock can be used in takeovers or
resold to raise cash as needed.
Income received is capital gains rather than
higher-taxed dividends.
Stockholders may take as a positive signal--
management thinks stock is undervalued.

=| Disadvantages of Repurchases
» May be viewed as a negative signal (firm has
poor investment opportunities).
= IRS could impose penalties if repurchases
were primarily to avoid taxes on dividends.
» Selling stockholders may not be well
informed, hence be treated unfairly.
» Firm may have to bid up price to complete
purchase, thus paying too much for its own
stock.

Page 14 - 10 BLUEPRINTS: CHAPTER 14

 Stock dividends vs. Stock splits
» Stock dividend: Firm issues new shares
in lieu of paying a cash dividend. If
10%, get 10 shares for each 100 shares
owned.
» Stock split: Firm increases the number
of shares outstanding, say 2:1. Sends
shareholders more shares.

_ Stock dividends vs. Stock splits

» Both stock dividends and stock splits
increase the number of shares outstanding,
so “the pie is divided into smaller pieces.”
« Unless the stock dividend or split conveys
information, or is accompanied by another
event like higher dividends, the stock price
falls so as to keep each investor’s wealth
unchanged.
s But splits/stock dividends may get us to an
“optimal price range.”

When and why should a firm

consider splitting its stock?
« There’s a widespread belief that the optimal
price range for stocks is $20 to $80. Stock
splits can be used to keep the price in this
optimal range.
Stock splits generally occur when
management is confident, so are interpreted

C024
as positive signals.
; On average, stocks tend to outperform the-
market in the year following a split.

BLUEPRINTS: CHAPTER 14 Page 14- 11

 EXAM-TYPE PROBLEMS

14-1. If you were to argue that the firm’s cost of equity, ks, increases as the dividend
payout decreases, you would be making an argument with MM's
dividend irrelevance theory, and with Gordon and Lintner’s “bird-in-
the-hand” theory.
a. consistent; consistent
b. inconsistent; consistent
c. consistent; inconsistent
d. inconsistent; inconsistent
e . The argument above does not make sense, neither theory involves the cost of
equity capital.

14-2. Which of the following statements is most correct?

a. The tax preference and bird-in-the-hand theories lead to identical conclusions as
to the optimal dividend policy.
b. If a company raises its dividend by an unexpectedly large amount, the
announcement of this new and higher dividend is generally accompanied by an
increase in the stock price. This is consistent with the bird-in-the-hand theory,
and Modigliani and Miller used these findings to support their position on
dividend theory.
c. If it could be demonstrated that a clientele effect exists, this would suggest that
firms could alter their dividend payment policies from year to year to take
advantage of investment opportunities without having to worry about the effects
of changing dividends on capital costs.
d. Each of the above statements is false.

14-3. Driver Corporation is considering a number of positive NPV projects for a total
capital budget of $60 million. Its optimal capital structure is 60 percent equity and
40 percent debt. Its earnings before interest and taxes (EBIT) were $98 million for
the year. The firm has $200 million in assets, pays an average of 10 percent on all
its debt, and faces a marginal tax rate of 34 percent. If the firm maintains a residual
dividend policy and will finance its capital budget so as to keep its optimal capital
structure intact, what will be the amount of the dividends it pays out? ($23.4 million)

SSS

Page 14 - 12 BLUEPRINTS: CHAPTER 14

 BLUEPRINTS: CHAPTER 15
MANAGING CURRENT ASSETS

15-15 Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited, but
apprehensive. The company’s founder recently sold his 51 percent controlling block
of stock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is
found by taking the after-tax operating profit and then subtracting the dollar cost of
all the capital the firm uses:
EVA = EBIT(1 — T) — Capital costs
= EBIT(1 — T) - WACC (Capital employed).
If EVA is positive, then the firm is creating value. On the other hand, if EVA is
negative, the firm is not covering its cost of capital, and stockholders’ value is being
eroded. Koren rewards managers handsomely if they create value, but those
whose operations produce negative EVAs are soon looking for work. Koren
frequently points out that if a company can generate its current level of sales with
less assets, it would need less capital. That would, other things held constant,
lower capital costs and increase its EVA.
Shortly after he took control of SKI, Kent Koren met with SKI’s senior executives to
tell them of his plans for the company. First, he presented some EVA data that
convinced everyone that SKI had not been creating value in recent years. He then
stated, in no uncertain terms, that this situation must change. He noted that SKI’s
designs of skis, boots, and clothing are acclaimed throughout the industry, but
something is seriously amiss elsewhere in the company. Costs are too high, prices
are too low, or the company employs too much capital, and he wants SKl’s
managers to correct the problem or else.
Barnes has long felt that SKI’s working capital situation should be studied—the
company may have the optimal amounts of cash, securities, receivables, and
inventories, but it may also have too much or too little of these items. In the past,
the production manager resisted Barnes’ efforts to question his holdings of raw
materials inventories, the marketing manager resisted questions about finished
goods, the sales staff resisted questions about credit policy (which affects accounts
receivable), and the treasurer did not want to talk about her cash and securities
balances. Koren’s speech made it clear that such resistance would no longer be
tolerated.
Barnes also knows that decisions about working capital cannot be made in a
vacuum. For example, if inventories could be lowered without adversely affecting
operations, then less capital would be required, the dollar cost of capital would
decline, and EVA would increase. However, lower raw materials inventories might
lead to production slowdowns and higher costs, while lower finished goods

BLUEPRINTS: CHAPTER 15 Page 15 - 1

 inventories might lead to the loss of profitable sales. So, before inventories are
changed, it will be necessary to study operating as well as financial effects. The
situation is the same with regard to cash and receivables.

a. Barnes plans to use the ratios in Table IC15-1 as the starting point for
discussions with SKI’s operating executives. He wants everyone to think about
the pros and cons of changing each type of current asset and how changes
would interact to affect profits and EVA. Based on the Table |C15-1 data, does
SKI seem to be following a relaxed, moderate, or restricted working capital
policy?

Table 1C15-1. Selected Ratios: SKI and Industry Average

ons Industry
Current Ares 2:20
Debt/assets 58.76% 50.00%
Turnover of cash and securities 16.67 PELE:
Days sales outstanding (365-day basis) 45.63 32.00
Inventory turnover 4.82 7.00
Fixed assets turnover Giese 12.00
Total assets turnover 2.08 3.00
Profit margin on sales 2.07% 3.50%
Return on equity (ROE) 10.45% 21.00%

b. How can one distinguish between a relaxed but rational working capital policy
and a situation where a firm simply has a lot of current assets because it is
inefficient? Does SKI’s working capital policy seem appropriate?

c. Assume that SKI’s payables deferral period is 30 days. Now, calculate the firm’s
cash conversion cycle.

d. What might SKI do to reduce its cash and securities without harming
operations?

e. What is “float,” and how is it affected by the firm’s cash manager (treasurer)?

In an attempt to better understand SKI’s cash position, Barnes developed a cash

budget. Data for the first two months of the year are shown in Table |C15-2. (Note
that Barnes’ preliminary cash budget does not account for interest income or
interest expense.) He has the figures for the other months, but they are not shown
in Table 1C15-2.

ee SSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSesee
Page 15-2 BLUEPRINTS: CHAPTER 15
 Table 1C15-2. SKI’s Cash Budget for January and February

Nov DEC JAN FEB MAR APR

|. COLLECTIONS AND PURCHASES WORKSHEET
(1) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524
Collections:
(2) During month of sale
(0.2)(0.98)(month’s sales) 12,781.75 10,285.10
(3) During first month after sale
0.7(previous month’s sales) 47,748.40 45,649.10
(4) During second month after sale
0.1(sales 2 months ago) 7,121.80 6,821.20
(5) Total collections (Lines 2 + 3 + 4) $62,755.40
Purchases:
(6) 0.85(forecasted sales 2 months from now) $44,603.75 $36,472.65 $25,945.40
(7) Payments (1-month lag) 44,603.75 36,472.65
Il. CASH GAIN OR LOSS FOR MONTH
(8) Collections (from Section |) $67,651.95 $62,755.40
(9) Payments for purchases (from Section |) 44,603.75 36,472.65
(10) Wages and salaries 6,690.56 5,470.90
(11) Rent 2,500.00 2,500.00
(12) Taxes
(13) Total payments $53,794.31 $44,443.55
(14) Net cash gain (loss) during month
(Line 8 - Line 13) $13,857.64 $18,311.85
Ill. CASH SURPLUS OR LOAN REQUIREMENT
(15) Cash at beginning of month if no borrowing is done 3,000.00
$ $16,857.64
(16) Cumulative cash (cash at start, + gain or - loss =
Line 14 + Line 15) 16,857.64 35,169.49
(17) Target cash balance __1,500.00 _1,500.00
(18) Cumulative surplus cash or loans outstanding to
maintain $1,500 target cash balance
(Line 16 - Line 17) $15,357.64 $33,669.49

ie Should depreciation expense be explicitly included in the cash budget? Why or

why not?

In his preliminary cash budget, Barnes has assumed that all sales are collected
and, thus, that SKI has no bad debts. Is this realistic? If not, how would bad
debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect
collections but not purchases.)

Barnes’ cash budget for the entire year, although not given here, is based
heavily on his forecast for monthly sales. Sales are expected to be extremely
low between May and September but then increase dramatically in the fall and
winter. November is typically the firm’s best month, when SKI ships equipment
to retailers for the holiday season. Interestingly, Barnes’ forecasted cash budget
indicates that the company’s cash holdings will exceed the targeted cash
balance every month except for October and November, when shipments will be
high but collections will not be coming in until later. Based on the ratios in

BLUEPRINTS: CHAPTER 15 Page 15-3

 Table 1C15-1, does it appear that SKI’s target cash balance is appropriate? In
addition to possibly lowering the target cash balance, what actions might SKI
take to better improve its cash management policies, and how might that affect
its EVA?

i. What reasons might SKI have for maintaining a relatively high amount of cash?

j. What are the three categories of inventory costs? If the company takes steps to
reduce its inventory, what effect would this have on the various costs of holding
inventory?

k. Is there any reason to think that SKI may be holding too much inventory? If so,
how would that affect EVA and ROE?

|. If the company reduces its inventory without adversely affecting sales, what
effect should this have on the company’s cash position (1) in the short run and
(2) in the long run? Explain in terms of the cash budget and the balance sheet.

m. Barnes knows that SKI sells on the same credit terms as other firms in its
industry. Use the ratios presented in Table IC15-1 to explain whether SKI’s
customers pay more or less promptly than those of its competitors. If there are,
differences, does that suggest that SKI should tighten or loosen its credit policy? '
What four variables make up a firm’s credit policy, and in what direction should
each be changed by SKI?

n. Does SKI face any risks if it tightens its credit policy?

o. If the company reduces its DSO without seriously affecting sales, what effect
would this have on its cash position (1) in the short run and (2) in the long run?
Answer in terms of the cash budget and the balance sheet. What effect should
this have on EVA in the long run?

ee ESSSFSFSSSSSSSSSSMMMMSsFFFhssFFFesese
Page 15-4 BLUEPRINTS: CHAPTER 15
 CHAPTER 15
Managing Current Assets
eo

Alternative working capital policies

Cash management
Inventory management
Accounts receivable management

Gross working capital — total current assets.

Net working capital — current assets minus
non-interest bearing current liabilities.
Working capital policy — deciding the level
of each type of current asset to hold, and
how to finance current assets.
Working capital management — controlling
cash, inventories, and A/R, plus short-term
liability management.
15-2

Selected ratios for SKI Inc.

SKI Ind. Avg.
Current 1575 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 45.63 32.00
Inv. turnover 4.82x 7.00x
F. A. turnover 11.35x 12.00x
T. A. turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
ROE 10.45% 21.00%

15-3

EE

BLUEPRINTS: CHAPTER 15 Page 15-5

 How does SKI’s working capital
|. policy compare with its industry?
= SKI appears to have large amounts of
working capital given its level of sales.
« Working capital policy is reflected in
current ratio, turnover of cash and
securities, inventory turnover, and DSO.
« These ratios indicate SKI has large
amounts of working capital relative to its
level of sales. SKI is either very
conservative or inefficient.

Is SKI inefficient or just

conservative?
» A conservative (relaxed) policy may be
appropriate if it leads to greater
profitability.
=» However, SKI is not as profitable as the
average firm in the industry. This
suggests the company has excessive
working capital.

Cash conversion cycle

= The cash conversion model focuses on the
length of time between when a company
makes payments to its creditors and when a
company receives payments from its
customers.

Inventory Receivables Payables

CCC = conversion + collection — deferral .
period period period

Page 15-6 BLUEPRINTS: CHAPTER 15

 Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection -— deferral
period period period
Payables
. Days per year _ Days sales
CCC = Inv. turnover * outstanding ~ deferral
period
_ 365
ooo aes + 46 — 30

CCC = 76 + 46 - 30
CCC = 92 days.

Cash doesn’t earn a profit, so

why hold it?
Transactions — must have some cash to
operate.
Precaution — “safety stock”. Reduced by
line of credit and marketable securities.
Compensating balances — for jioans and/or
services provided.
Speculation — to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.

15-8

What is the goal of cash

management?
= TO meet above objectives, especially
to have cash for transactions, yet not
have any excess cash.
» TO minimize transactions balances in
particular, and also needs for cash to
meet other objectives.

ne

BLUEPRINTS: CHAPTER 15 Page 15-7

 _Ways to minimize cash holdings
Use a lockbox.
Insist on wire transfers from customers.
Synchronize inflows and outflows.
Use a remote disbursement account.
Increase forecast accuracy to reduce
need for “safety stock” of cash.
Hold marketable securities (also reduces
need for “safety stock”).
Negotiate a line of credit (also reduces
need for “safety stock”).

What is “float”, and how is it affected

by the firm’s cash manager?
Float is the difference between cash as
shown on the firm’s books and on its
bank’s books.
If SKI collects checks in 2 days but those
to whom SKI writes checks don’t process
them for 6 days, then SKI will have 4 days
of net float.
If a firm with 4 days of net float writes and
receives $1 million of checks per day, it
would be able to operate with $4 million
less capital than if it had zero net float.

Cash budget:
The primary cash management tool
Purpose: Forecasts cash inflows,
outflows, and ending cash balances.
Used to plan loans needed or funds
available to invest.
Timing: Daily, weekly, or monthly,
depending upon purpose of forecast.
Monthly for annual planning, daily for
actual cash management.

eee

Page 15-8
BLUEPRINTS: CHAPTER 15
 SKI’s cash budget:
For January and February
Net Cash Inflows
Jan Feb
Collections $67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net CF $13,857.44 $18,311.85
15-13

SKI’s cash budget

Net Cash Inflows
Jan Feb
Cash at start if
no borrowing $3,000.00 $16,857.64
Net CF 13,857.64 18,311.85
Cumulative cash 16,857.64 35,169.49
Less: target cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49

15-14

Should depreciation be explicitly

included in the cash budget?
« No. Depreciation is a noncash
charge. Only cash payments and
receipts appear on cash budget.
« However, depreciation does affect
taxes, which appear in the cash
budget.

nn ttt tIdEIIISINSISISIESEIESSSSSRSE ER

BLUEPRINTS: CHAPTER 15 Page 15-9

 What are some other potential
cash inflows besides collections?

» Proceeds from the sale of fixed

assets.
« Proceeds from stock and bond
sales.
= Interest earned.
= Court settlements.

How could bad debts be worked

into the cash budget?
» Collections would be reduced by the
amount of the bad debt losses.
« For example, if the firm had 3% bad
debt losses, collections would total
only 97% of sales.
= Lower collections would lead to
higher borrowing requirements.

L_.Analyze SKI’s forecasted cash budget

tg Cash holdings will exceed the target
balance for each month, except for
October and November.
s Cash budget indicates the company is
holding too much cash.
» SKI could improve its EVA by either
investing cash in more productive assets,
or by returning cash to its shareholders.

Ss
EEE

Page 15 - 10 BLUEPRINTS: CHAPTER 15

 Why might SKI want to maintain a
relatively high amount of cash?
= If sales turn out to be considerably less than
expected, SKI could face a cash shortfall.
» A company may choose to hold large
amounts of cash if it does not have much
faith in its sales forecast, or if it is very
conservative.
» The cash may be used, in part, to fund future
investments.

Types of inventory costs

= Carrying costs — storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
Ordering costs — cost of placing orders,
shipping, and handling costs.
Costs of running short — loss of sales or
customer goodwill, and the disruption of
production schedules.
Reducing the average amount of inventory
generally reduces carrying costs, increases
ordering costs, and may increase the costs of
running short. E20

Is SKI holding too much

inventory?
SKI’s inventory turnover (4.82) is
considerably lower than the industry
average (7.00). The firm is carrying a lot of
inventory per dollar of sales.
By holding excessive inventory, the firm is
increasing its costs, which reduces its ROE.
Moreover, this additional working capital
must be financed, so EVA is also lowered.

ee SUUEEEEIEIEEE EIEN ESSERE

CHAPTER 15 Page 15-11

BLUEPRINTS:
 If SKI reduces its inventory, without
adversely affecting sales, what effect
will this have on the cash position?

« Short run: Cash will increase as

inventory purchases decline.
» Long run: Company is likely to take
steps to reduce its cash holdings and
increase its EVA.

Do SKI’s customers pay more or less

promptly than those of its competitors?

« SKI’s DSO (45.6 days) is well above the

industry average (32 days).
a SKI’s customers are paying less
promptly.
» SKI should consider tightening its credit
policy in order to reduce its DSO.

Elements of credit policy

“1, Credit Period — How long to pay? Shorter
period reduces DSO and average A/R, but it
may discourage sales.
. Cash Discounts — Lowers price. Attracts new
customers and reduces DSO.
. Credit Standards — Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
. Collection Policy —How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
15-24

eee

Page 15-12 BLUEPRINTS: CHAPTER 15

 Does SKI face any risk if it
tightens its credit policy?
» Yes, a tighter credit policy may
discourage sales. Some customers
may choose to go elsewhere if they
are pressured to pay their bills sooner.

If SKI succeeds in reducing DSO without

adversely affecting sales, what effect
would this have on its cash position?

« Short run: If customers pay sooner,

this increases cash holdings.
a Long run: Over time, the company
would hopefully invest the cash in
more productive assets, or pay it out
to shareholders. Both of these actions
would increase EVA.

nnn a

Page 15-13
BLUEPRINTS: CHAPTER 15
 EXAM-TYPE PROBLEMS

15-1. Ziltest Company's treasurer had $1 million of excess funds that were invested in
marketable securities. At the time the investment was made, it was known that the
funds would be needed in 6 months to fund an ongoing construction project. Six-
month T-bills with a face value of $10,000 sold for $9,708.74 to yield a 6 percent
nominal annual rate. As an alternative, the treasurer could purchase 7 percent
coupon, semiannual payment, 10-year Treasury bonds at par. Seeking to earn a
higher yield, he purchased the T-bonds. At the end of 6 months, when the funds
were needed for construction, interest rates had risen to 9.5 percent on the
T-bonds. The treasurer was forced to liquidate the T-bond holdings at a lower price.
What was the absolute value of the dollar difference between the T-bond’s
purchase price and selling price? ($154,192.20)

15-2. Which of the following statement completions is most correct? If the yield curve is
upward sloping, then a firm’s marketable securities portfolio, assumed to be held for
liquidity purposes, should be
a. Weighted toward long-term securities because they pay higher rates.
Weighted toward short-term securities because they pay higher rates.
Weighted toward U.S. Treasury securities to avoid interest rate risk.
Weighted toward short-term securities to avoid interest rate risk.
is:
£5.
PicBalanced between long- and short-term securities to minimize the effects of
either an upward or a downward shift in interest rates.

15-3. Which of the following statements is most correct?

a. lf afirm’s volume of credit sales declines then its DSO will also decline.
b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10, net 60 days,
the impact on sales can’t be determined because the increase in the discount is
offset by the longer net terms, which tends to reduce sales.
c. The DSO ofa firm with seasonal sales can vary because while the sales per day
figure is usually based on the total annual sales, the accounts receivable
balance will be high or low depending on the season.
d. An aging schedule is used to determine what portion of customers pay cash and
what portion buy on credit.
e. Aging schedules can be constructed from the summary data provided in the
firm’s financial statements.

15-4. Jarrett Enterprises is considering whether to pursue a restricted or a relaxed current

asset investment policy. The firm’s annual sales are $400,000; its fixed assets are

Page 15 - 14 BLUEPRINTS: CHAPTER 15

 $100,000; debt and equity are each 50 percent of total assets. EBIT is $36,000, the
interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent.
With a restricted policy, current assets will be 15 percent of sales. Under a relaxed
policy, current assets will be 25 percent of sales. What is the difference in the
projected ROEs between the restricted and relaxed policies? (5.4%)

15-5. Porta Stadium Inc. has annual sales of $40,000,000 and keeps average inventory of
$10,000,000. On average, the firm has accounts receivable of $8,000,000. The
firm buys all raw materials on credit and its trade credit terms are net 30 days. It
pays on time. The firm’s managers are searching for ways to shorten the cash
conversion cycle. If sales can be maintained at existing levels but inventory can be
lowered by $2,000,000 and accounts receivable lowered by $1,000,000, what will be
the net change in the cash conversion cycle? (27.375 days shorter)

nes

Page 15 - 15
BLUEPRINTS: CHAPTER 15
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 BLUEPRINTS: CHAPTER 16
FINANCING CURRENT ASSETS

16-18 Bats and Balls (B&B) Inc., a baseball equipment manufacturer, is a small company
with seasonal sales. Each year before the baseball season, B&B purchases
inventory that is financed through a combination oftrade credit and short-term bank
loans. At the end of the season, B&B uses sales revenues to repay its short-term
obligations. The company is always looking for ways to become more profitable,
and senior management has asked one of its employees, Ann Taylor, to review the
company’s current asset financing policies. Putting together her report, Ann is trying
to answer each of the following questions:

a. B&B tries to match the maturity of its assets and liabilities. Describe how B&B
could adopt either a more aggressive or more conservative financing policy.

What are the advantages and disadvantages of using short-term credit as a

source of financing?

Is it likely that B&B could make significantly greater use of accrued liabilities?

Assume that B&B buys on terms of 1/10, net 30, but that it can get away with
paying on the 40th day if it chooses not to take discounts. Also, assume that it
purchases $3 million of components per year, net of discounts. How much free
trade credit can the company get, how much costly trade credit can it get, and
what is the percentage cost of the costly credit? Should B&B take discounts?

. Would it be feasible for B&B to finance with commercial paper?

Suppose B&B decided to raise an additional $100,000 as a 1-year loan from its
bank, for which it was quoted a rate of 8 percent. What is the effective annual
cost rate assuming (1) simple interest, (2) discount interest, (3) discount interest
with a 10 percent compensating balance, and (4) add-on interest on a 12-month
installment loan? For the first three of these assumptions, would it matter if the
loan were for 90 days, but renewable, rather than for a year?

. How large would the loan actually be in each of the cases in Part f?

. What are the pros and cons of borrowing on a secured versus an unsecured
basis? If inventories or receivables are to be used as collateral, how would the
loan be handled?

BLUEPRINTS: CHAPTER 16 Page 16-1

 CHAPTER 16
| Financing Current Assets
» Working capital financing
policies
» A/P (trade credit)
» Commercial paper
a S-T bank loans

Working capital financing policies

a Moderate — Match the maturity of the
assets with the maturity of the
financing.
» Aggressive — Use short-term financing
to finance permanent assets.
» Conservative — Use permanent capital
for permanent assets and temporary
assets.

Moderate financing policy

S-T
Loans

L-T Fin:
Stock,
Bonds,
Spon. C.L.

Years
Lower dashed line would be more aggressive.
16-3

Page 16-2 BLUEPRINTS: CHAPTER 16

 _Conservative financing policy
Marketable
securities

Short-term credit
‘a Any debt scheduled for repayment within one
year.
= Major sources of short-term credit
« Accounts payable (trade credit)
« Bank loans
» Commercial loans
» Accruals
= From the firm's perspective, S-T credit is
more risky than L-T debt.
« Always a required payment around the corner.
« May have trouble rolling over loans.
16-5

Advantages and disadvantages of

using short-term financing
« Advantages
« Speed
« Flexibility
» Lower cost than long-term debt
« Disadvantages
» Fluctuating interest expense
« Firm may be at risk of default as a result of
temporary economic conditions

BLUEPRINTS: CHAPTER 16 Page 16-3

 € |Accrued liabilities
» Continually recurring short-term
liabilities, such as accrued wages or
taxes.
s Is there a cost to accrued liabilities?
» They are free in the sense that no
explicit interest is charged.
« However, firms have little control over
the level of accrued liabilities.

What is trade credit?

» Trade credit is credit furnished by a firm’s
suppliers.
» Trade credit is often the largest source of
short-term credit, especially for small
firms.
= Spontaneous, easy to get, but cost can
be high.

The cost of trade credit

« A firm buys $3,000,000 net ($3,030,303
gross) on terms of 1/10, net 30.
= The firm can forego discounts and pay on
Day 40, without penalty.

Net daily purchases = $3,000,000 / 365

= $8,219.18

5]99 ee

Page 16-4 BLUEPRINTS: CHAPTER 16

 Breaking down net and gross
expenditures
= Firm buys goods worth $3,000,000. That's
the cash price.
» They must pay $30,303 more if they don’t
take discounts.
# Think of the extra $30,303 as a financing
cost similar to the interest on a loan.
» Want to compare that cost with the cost of
a bank loan.

Breaking down trade credit

= Payables level, if the firm takes discounts
» Payables = $8,219.18 (10) = $82,192
« Payables level, if the firm takes no discounts
« Payables = $8,219.18 (40) = $328,767
« Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575

Nominal cost of costly trade credit

"a The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain
$246,575 in extra trade credit:

kyom = $30,303 / $246,575

= 0.1229 = 12.29%
s The $30,303 is paid throughout the
year, so the effective cost of costly
trade credit is higher.

BLUEPRINTS: CHAPTER 16 Page 16-5

 | -Nominal trade credit cost formula

Discount % § 365 days

Kom 7
1- Discount % Days taken - Disc. period
ecily 365
99 40-10
= 0.1229
= 12.29%

Effective cost of trade credit

« Periodic rate = 0.01 / 0.99 = 1.01%
» Periods/year = 365/ (40-10) = 12.1667
a Effective cost of trade credit
» EAR =(1 + periodic rate)"-1
= (1.0101)12-1667 - 1 = 13.01%

. Commercial paper (CP)

Short-term notes issued by large, strong
companies. B&B couldn't issue CP--it’s
too small.
CP trades in the market at rates just
above T-bill rate.
CP is bought with surplus cash by banks
and other companies, then held as a
marketable security for liquidity purposes.

Sees

Page 16-6 BLUEPRINTS: CHAPTER 16

 Bank loans
» The firm can borrow $100,000 for 1
year at an 8% nominal rate.
» Interest may be set under one of the
following scenarios:
« Simple annual interest
» Discount interest
« Discount interest with 10% compensating
balance
« Installment loan, add-on, 12 months

Must use the appropriate EARs to

evaluate the alternative loan terms

« Nominal (quoted) rate = 8% in all cases.

=» We want to compare loan cost rates and
choose lowest cost loan.
» We must make comparison on EAR =
Equivalent (or Effective) Annual Rate basis.

Simple annual interest

» “Simple interest” means no discount or
add-on.

Interest = 0.08($100,000) = $8,000

Kyom = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, Kyoy = EAR

16-18

th ge

BLUEPRINTS: CHAPTER 16 Page 16-7

 Discount interest
» Deductible interest = 0.08 ($100,000)
= $8,000
» Usable funds = $100,000 - $8,000

Raising necessary funds with a

discount interest loan
» Under the current scenario, $100,000 is
borrowed but $8,000 is forfeited
because it is a discount interest loan.
» Only $92,000 is available to the firm.
» If $100,000 of funds are required, then
the amount of the loan should be:
Amt borrowed = Amt needed / (1 — discount)
= $100,000 / 0.92 = $108,696
16-20

Discount interest loan with a

. LO% compensating balance
Amount needed
Amount borrowed =
1 - discount - comp. balance
— $100,000 _
SENS

» Interest = 0.08 ($121,951) = $9,756

a Effective cost = $9,756 / $100,000 = 9.756%

Page 16-8 BLUEPRINTS: CHAPTER 16

 Add-on interest on a 12-month
installment loan

Interest = 0.08 ($100,000) = $8,000

Face amount = $100,000 + $8,000 = $108,000
Monthly payment = $108,000/12 = $9,000
Avg loan outstanding = $100,000/2 = $50,000
Approximate cost = $8,000/$50,000 = 16.0%
To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000. This constitutes an
annuity.

Installment loan
From the calculator out put below, we have:

kyom = 12 (0.012043)
= 0.1445 = 14.45%
(1.012043) !2— 1 = 15.45%

What is a secured loan?

In a secured loan, the borrower pledges
assets as collateral for the loan.
For short-term loans, the most commonly
pledged assets are receivables and
inventories.
Securities are great collateral, but
generally not available.

EEE EI SEES

BLUEPRINTS: CHAPTER 16 Page 16-9

 EXAM-TYPE PROBLEMS

16-1. The Lasser Company needs to finance an increase in its working capital for the
coming year. Lasser is reviewing the following three options: (1) The firm can
borrow from its bank on a simple interest basis for one year at 13 percent. (2) It can
borrow on a 3-month, but renewable, loan at a 12 percent nominal rate. The loan is
a simple interest loan, completely paid off at the end of each quarter, then renewed
for another quarter. (3) The firm can increase its accounts payable by not taking
discounts. Lasser buys on credit terms of 1/30, net 60 days. What is the effective
annual cost (not the approximate cost) of the least expensive type of credit,
assuming 365 days per year? (12.55%)

16-2. Which of the following statements is most correct?

a. Under normal conditions the shape of the yield curve implies that the interest
cost of short-term debt is greater than that of long-term debt, although short-term
debt has other advantages that make it desirable as a financing source.
b. Flexibility is an advantage of short-term credit but this is somewhat offset by the
higher flotation costs associated with the need to repeatedly renew short-term
credit.
c. A short-term loan can usually be obtained more quickly than a long-term loan
but the penalty for early repayment of a short-term loan is significantly higher
than for a long-term loan.
d. Statements about the flexibility, cost, and riskiness of short-term versus long-
term credit are dependent on the type of credit that is actually used.
e. Short-term debt is often less costly than long-term debt and the major reason for
this is that short-term debt exposes the borrowing firm to much less risk than
long-term debt.

16-3. A chain of lighting fixture stores, LCG Corporation, purchases inventory with a net
price of $750,000 each day. The company purchases the inventory under the credit
terms of 2/20, net 50. LCG always takes the discount, but takes the full 20 days to
pay its bills. What is the average accounts payable for LCG? ($15,000,000)

ee ee See ee ee ee Pe ee SE
Page16 240 BLUEPRINTS: CHAPTER 16
 BLUEPRINTS: CHAPTER 17
FINANCIAL PLANNING AND FORECASTING

17-19 Sue Wilson, the new financial manager of New World Chemicals (NWC), a
California producer of specialized chemicals for use in fruit orchards, must prepare
a financial forecast for 2003. NWC’s 2002 sales were $2 billion, and the marketing
department is forecasting a 25 percent increase for 2003. Wilson thinks the
company was operating at full capacity in 2002, but she is not sure about this. The
2002 financial statements, plus some other data, are given in Table 1C17-1.

Table I1C17-1. Financial Statements and Other Data on NWC

(Millions of Dollars)
A. 2002 Balance Sheet
Cash and securities o 20 Accounts payable and accrued liabilities$100
Accounts receivable 240 Notes payable 100
Inventories 240 Total current liabilities $200
Total current assets $ 500 Long-term debt 100
Net fixed assets 500 Common stock 500
Retained earnings 200
Total assets $1,000 Total liabilities and equity $1,000

B. 2002 Income Statement

Sales $2,000.00
Less: Variable costs 1,200.00
Fixed costs 700.00
Earnings before interest and taxes (EBIT) $ 100.00
Interest 16.00
Earnings before taxes (EBT) $ 84.00
Taxes (40%) 33,00
Net income $ 50.40

Dividends (30%) Sa et5x12

Addition to retained earnings > 30.20

C. Key ratios NWC Industry Comment

Basic earning power 10.00% 20.00%
Profit margin 2.52 4.00
Return on equity 7:20 15.60
Days sales outstanding (365 days) 43.80 days 32.00 days
Inventory turnover 8.33%x 11.00x
Fixed assets turnover 4.00 5.00
Total assets turnover 2.00 2.50
Debt/assets 30.00% 36.00%
Times interest earned 6.25x 9.40x
Current ratio 2.50 3.00
Payout ratio 30.00% 30.00%
oo ee

BLUEPRINTS: CHAPTER 17 Page 17-1

 Assume that you were recently hired as Wilson’s assistant, and your first major task
is to help her develop the forecast. She asked you to begin by answering the
following set of questions.

a. Assume (1) that NWC was operating at full capacity in 2002 with respect to all
assets, (2) that all assets must grow proportionally with sales, (3) that accounts
payable and accrued liabilities will also grow in proportion to sales, and (4) that
the 2002 profit margin and dividend payout will be maintained. Under these
conditions, what will the company’s financial requirements be for the coming
year? Use the AFN equation to answer this question.

b. Now estimate the 2003 financial requirements using the projected financial
statement approach. Disregard the assumptions in part a, and now assume
(1) that each type of asset, as well as payables, accrued liabilities, and fixed and
variable costs, grow in proportion to sales; (2) that NWC was operating at full
capacity; (3) that the payout ratio is held constant at 30 percent; and (4) that
external funds needed are financed 50 percent by notes payable and 50 percent
by long-term debt. (No new common stock will be issued.)

c. Why do the two methods produce somewhat different AFN forecasts? Which
method provides the more accurate forecast?

d. Calculate NWC’s forecasted ratios, and compare them with the company’s 2002
ratios and with the industry averages. How does NWC compare with the
average firm in its industry, and is the company expected to improve during the
coming year?

e. Calculate NWC’s free cash flow for 2003.

f. Suppose you now learn that NWC’s 2002 receivables and inventories were in
line with required levels, given the firm’s credit and inventory policies, but that
excess Capacity existed with regard to fixed assets. apeciicaly, fixed assets
were operated at only 75 percent of capacity.
(1) What level of sales could have existed in 2002 with the available fixed
assets? What would the fixed assets-to-sales ratio have been if NWC had
been operating at full capacity?
(2) How would the existence of excess capacity in fixed assets affect the
additional funds needed during 2003?

g. Without actually working out the numbers, how would you expect the ratios to
change in the situation where excess capacity in fixed assets exists? Explain
your reasoning.

_—_—
SFSSSsw
SSSSSSSSSSSSMSSSSSSSseheeee

Page 17-2 BLUEPRINTS: CHAPTER 17

 h. On the basis of comparisons between NWC’s days sales outstanding (DSO) and
inventory turnover ratios with the industry average figures, does it appear that
NWC is operating efficiently with respect to its inventories and accounts
receivable? If the company were able to bring these ratios into line with the
industry averages, what effect would this have on its AFN and its financial ratios?

i. How would changes in these items affect the AFN? (1) The dividend payout
ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) if NWC begins
buying from its suppliers on terms that permit it to pay after 60 days rather than
after 30 days. (Consider each item separately and hold all other things
constant.)

OOOO
Page 17 -3
BLUEPRINTS: CHAPTER 17
 CHAPTER 17
Financial Planning and Forecasting

Forecasting sales
Projecting the assets and internally
generated funds
Projecting outside funds needed
Deciding how to raise funds

Balance sheet (2002),

~|_ in millions of dollars

Cash & sec. Accts. pay. &

accruals
Accounts rec. Notes payable
Inventories Total CL
Total CA L-T debt
Common stock
Net fixed Retained
assets earnings
Total assets ; Total claims

Income statement (2002),

| in millions of dollars
Sales $2,000.00
Less: Var. costs (60%) 1,200.00
Fixed costs 700.00
EBIT $ 100.00
Interest 16.00
EBT $ 84.00
Taxes (40%) 33.60
Net income $ 50.40
Dividends (30%) $15.12
Add’n to RE $35.28

eee

Page 17-4 BLUEPRINTS: CHAPTER 17

 Key ratios
Industry Condition
BEP 10.00% 20.00% Poor
Profit margin 2.52% 4.00% ‘
ROE 7.20% 15.60%
DSO 43.80 days 32.00 days
Inv. turnover .33x 11.00x
F. A. turnover 5.00x
T. A. turnover 2.50x w
Debt/assets 36.00% Good
TIE 9.40x Poor
Current ratio 3.00x ’
Payout ratio 30.00% O. K.

17-4

Key assumptions
Operating at full capacity in 2002.
Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2002 profit margin (2.52%) and payout
(30%) will be maintained.
= Sales are expected to increase by $500
million. (%AS = 25%)

Determining additional funds

needed, using the AFN equation

(A*/Sp)AS — (L*/So) AS — M(S,)(RR)

($1,000/$2,000)($500)
~ ($100/$2,000)($500)
~ 0.0252($2,500)(0.7)
$180.9 million.

nn nn LEU EEIEEEEESS

BLUEPRINTS: CHAPTER 17 Page 17-5

 we -How shall AFN be raised?
= The payout ratio will remain at 30 percent
(d = 30%; RR = 70%).
» No new common stock will be issued.
» Any external funds needed will be raised as
debt, 50% notes payable and 50% L-T
debt.

Forecasted Income Statement (2003)

“~~ Forecast 2003
Basis Forecast
1.25
0.60
0.35

Interest a ar
EBT
Taxes (40%)
Net income
Div. (30%)
Add’n to RE

Forecasted Balance Sheet (2003)

Assets
Forecast 2003
Basis 1st Pass

Cash 0.01 $725

Accts. rec. 0.12 300
Inventories 0.12 300
Total CA $625
Net FA 0.25 625
Total assets $1,250

Page 17-6 BLUEPRINTS: CHAPTER 17

 Forecasted Balance Sheet (2003)
Liabilities and Equity
Forecast 2003
Basis 1st Pass
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims

* From income statement.

What is the additional

financing needed (AFN)?
Required increase inassets = $ 250
Spontaneous increase in liab. = $ 25
Increase in retained earnings =$ 46
Total AFN =$ 179

NWC must have the assets to generate

forecasted sales. The balance sheet must
balance, so we must raise $179 million
externally.

_How will the AFN be financed?

« Additional N/P
=» 0.5 ($179) = $89.50
« Additional L-T debt
» 0.5 ($179) = $89.50

« But this financing will add to interest

expense, which will lower NI and retained
earnings. We will generally ignore financing
feedbacks.

ee

BLUEPRINTS: CHAPTER 17 Page 17-7

 Forecasted Balance Sheet (2003)
€: Assets — 24 pass

Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets

Forecasted Balance Sheet (2003)

Liabilities and Equity — 2"4 pass
2003
1st Pass

AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims

* From income statement.

Why do the AFN equation and financial

statement method have different results?

a Equation method assumes a constant

profit margin, a constant dividend payout,
and a constant capital structure.
a Financial statement method is more
flexible. More important, it allows
different items to grow at different rates.

Page 17-8 BLUEPRINTS: CHAPTER 17

 Forecasted ratios (2003)
2002 2003(E) Industry
BEP 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% #
ROE 7.20% 8.77% 15.60%
DSO (days) 43.80 43.80 32.00
Inv. turnover 8.33x 8:33x%) 1'1/00x
F. A. turnover 4.00x 4.00x 5.00x
T. A. turnover 2.00x 2.00x 2.50x
D/A ratio 30.00% 40.34% 36.00%
TIE 6.25x WeOwx 9.40x
Current ratio 2.50x 1.99x 3.00x
Payout ratio 30.00% 30.00% 30.00%

What was the net investment in

_ operating capital?
= OCro93 = NOWC + Net FA
= $625 - $125 + $625
= $1,125

= OCs9. = $900
=» Net investment in OC = $1,125 - $900
=1$225

How much free cash flow is expected

to be generated in 2003?
FCF = NOPAT — Net inv. in OC
= EBIT-(t— 71) — Netinv.in OC
= $125 (0.6) — $225
= $75 — $225
= -$150.

BLUEPRINTS: CHAPTER 17 Page 17-9

 Suppose fixed assets had only been
operating at 75% of capacity in 2002

« Additional sales could be supported with the

existing level of assets.
» The maximum amount of sales that can be
supported by the current level of assets is:
» Capacity sales = Actual sales / % of capacity
= $2,000 / 0.75 = $2,667
» Since this is less than 2003 forecasted sales,
no additional assets are needed.

How would the excess capacity

situation affect the 2003 AFN?
i The projected increase in fixed assets
was $125, the AFN would decrease by
$125.
a Since no new fixed assets will be
needed, AFN will fall by $125, to
» AFN = $179 — $125 = $54.

If sales increased to $3,000 instead, what

. would be the fixed asset requirement?

7 Target ratio = FA/ Capacity sales

= $500 / $2,667 = 18.75%
» Have enough FA for sales up to $2,667,
but need FA for another $333 of sales
» AFA = 0.1875 ($333) = $62.4

ss
EE

Page 1740 BLUEPRINTS: CHAPTER 17

 How would excess capacity
affect the forecasted ratios?
« Sales wouldn't change but assets
would be lower, so turnovers would
be better.
» Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks were considered).
» Debt ratio, TIE would improve.

Forecasted ratios (2003)

with projected 2003 sales of $2,500

% of 2002 Capacity
100% 75% Industry
BEP 10.00% 11.11% 20.00%
Profit margin 2.62% 2.62% 4.00%
ROE 8.77% 8.77% 15.60%
DSO (days) 43.80 43.80 32.00
Inv. turnover 8.33x 8.33x 11.00x
F. A. turnover 4.00x 5.00x 5.00x
T. A. turnover 2.00x 2.22x 2.50x
D/A ratio 40.34% 33.71% 36.00%
We 7.81x 7.81x 9.40x
Current ratio 1.99x 2.48x 3.00x

17-23

How is NWC managing its receivables

_and inventories?
« DSO is higher than the industry
average, and inventory turnover is
lower than the industry average.
« Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.

nn ne ETEEEIEEEEEEEEEEEEEEEEEEREEEEEEEEEEE

BLUEPRINTS: CHAPTER 17 Page 17-11

 How would the following items
_affect the AFN?
» Higher dividend payout ratio?
« Increase AFN: Less retained earnings.
« Higher profit margin?
« Decrease AFN: Higher profits, more retained
eamings.
« Higher capital intensity ratio?
« Increase AFN: Need more assets for given sales.
a Pay suppliers in 60 days, rather than 30 days?
» Decrease AFN: Trade creditors supply more
capital (i.e., L*/S) increases).

SEE nnn

Page 17 - 12 BLUEPRINTS: CHAPTER 17

 EXAM-TYPE PROBLEMS

17-1. Snowball & Company has the following balance sheet:

Current assets $ 7,000 A/P & accrued liabilities $. 16500
Fixed assets 3,000 S-T (3-month) loans 2,000
Common stock 1,500
Retained earnings 5,000
Total assets 10,000 Total claims $10,000
Snowball’s after-tax profit margin is 11 percent, and the company pays out 60
percent of its earnings as dividends. Its sales last year were $10,000; its assets
were used to full capacity; no economies of scale exist in the use of assets; and the
profit margin and payout ratio are expected to remain constant. The company uses
the AFN equation to estimate funds requirements, and it plans to raise any required
external capital as short-term bank loans. If sales grow by 50 percent, what will
Snowball’s current ratio be after it has raised the necessary funds? (1.34)

17-2. Hogan Inc. generated EBIT of $240,000 this past year on $750,000 of sales and
using assets of $1,100,000. The interest rate on its existing long-term debt of
$640,000 is 12.5 percent and the firm’s tax rate is 40 percent. The firm paid a
dividend of $1.27 on each of its 37,800 shares outstanding from net income of
$96,000. The total book value of equity is $446,364 of which the common stock
account equals $335,000. The firm’s shares sell for $28.00 per share. The firm
forecasts a 10 percent increase in sales, assets, and EBIT next year, and a dividend
of $1.40 per share. If the firm needs additional capital funds, it will raise 60 percent
with debt and 40 percent with equity. The spontaneous liabilities balance is
$13,636. Except for spontaneous liabilities, the firm uses no other sources of
current liabilities and will continue this policy in the future. What will be the AFN
Hogan will need to balance its projected balance sheet using the projected financial
statement method? Do not include any financing feedbacks. ($51,156)

_——
a a aa RIES

BLUEPRINTS: CHAPTER 17 Page 17 - 13

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x
 BLUEPRINTS: CHAPTER 18
DERIVATIVES AND RISK MANAGEMENT

18-9 Assume that you have just been hired as a financial analyst by Tropical Sweets Inc.,
a mid-sized California company that specializes in creating exotic candies from
tropical fruits such as mangoes, papayas, and dates. The firm’s CEO, George
Yamaguchi, recently returned from an industry corporate executive conference in
San Francisco, and one of the sessions he attended was on the pressing need for
smaller companies to institute corporate risk management programs. Since no one
at Tropical Sweets is familiar with the basics of derivatives and corporate risk
management, Yamaguchi has asked you to prepare a brief report that the firm’s
executives could use to gain at least a cursory understanding of the topics.
To begin, you gathered some outside materials on derivatives and corporate risk
management and used these materials to draft a list of pertinent questions that
need to be answered. In fact, one possible approach to the paper is to use a
question-and-answer format. Now that the questions have been drafted, you have
to develop the answers.

a. Why might stockholders be indifferent to whether or not a firm reduces the

volatility of its cash flows?

b. What are seven reasons risk management might increase the value of a
corporation?

c. What is an option? What is the single most important characteristic of an

option?

d. Options have a unique set of terminology. Define the following terms: (1) call
option; (2) put option; (3) exercise price; (4) striking, or strike, price; (5) option
price; (6) expiration date; (7) exercise value; (8) covered option; (9) naked
option; (10) in-the-money call; (11) out-of-the-money call; and (12) LEAPS.

e. Consider Tropical Sweets’ call option with a $25 strike price. The following table
contains historical values for this option at different stock prices:

a SEU Ua SIESISSIES SESS

BLUEPRINTS: CHAPTER 18 Page 18 - 1

 Stock Price Call Option Price
$25 $ 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
(1) Create a table that shows (a) stock price, (b) strike price, (c) exercise value,
(d) option price, and (e) the premium of option price over exercise value.
(2) What happens to the premium of option price over exercise value as the
stock price rises? Why?

f. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option
Pricing Model (OPM).
(1) What assumptions underlie the OPM?
(2) Write out the three equations that constitute the model.
(3) What is the value of the following call option according to the OPM?
Stock price = $27.00
Exercise price = $25.00
Time to expiration = 6 months
Risk-free rate = 6.0%
Stock return variance = 0.11

g. What effect does each of the following call option parameters have on the value
of a call option?
(1) Current stock price.
(2) Exercise price.
(3) Option’s term to maturity.
(4) Risk-free rate.
(5) Variability of the stock price.

h. What is corporate risk management? Why is it important to all firms?

i. Risks that firms face can be categorized in many ways. Define the following
types of risk: (1) speculative risks; (2) pure risks; (3) demand risks; (4) input
risks; (5) financial risks; (6) property risks; (7) personnel risks; (8) environmental
risks; (9) liability risks; and (10) insurable risks.

j. What are the three steps of corporate risk management?

Sh SSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSsSsSse
Page 18-2 BLUEPRINTS: CHAPTER 18
 k. What are some actions that companies can take to minimize or reduce risk
exposure?

|. What is financial risk exposure? Describe the following concepts and

techniques that can be used to reduce financial risks: (1) derivatives; (2) futures
markets; (3) hedging; and (4) swaps.

m. Describe how commodity futures markets can be used to reduce input price risk.

NN

BLUEPRINTS: CHAPTER 18 Page 18 - 3

 CHAPTER 18
} Derivatives and Risk Management
anasscte

» Derivative securities
» Fundamentals of risk management
« Using derivatives

Are stockholders concerned about

whether or not a firm reduces the
volatility of its cash flows?

» Not necessarily.
» If cash flow volatility is due to
systematic risk, it can be eliminated
by diversifying investors’ portfolios.

Reasons that corporations

engage in risk management
Increase their use of debt.
Maintain their optimal capital budget.
Avoid financial distress costs.
Utilize their comparative advantages in
hedging, compared to investors.
Reduce the risks and costs of borrowing.
Reduce the higher taxes that result from
fluctuating earnings.
Initiate compensation programs to reward
managers for achieving stable earnings.
18-3

Se ee enenreesion

Page 18-4 BLUEPRINTS: CHAPTER 18

 What is an option?
« A contract that gives its holder the
right, but not the obligation, to buy (or
sell) an asset at some predetermined
price within a specified period of time.
» Most important characteristic of an
option:
« It does not obligate its owner to take
action.
« It merely gives the owner the right to buy
or sell an asset.
18-4

Option terminology
Call option — an option to buy a specified
number of shares of a security within some
future period.
Put option — an option to sell a specified number
of shares of a security within some future
period.
Exercise (or strike) price — the price stated in
the option contract at which the security can be
bought or sold.
Option price — the market price of the option
contract.

ption terminology
Expiration date — the date the option matures.
Exercise value — the value of an option if it were
exercised today (Current stock price - Strike
price).
Covered option — an option written against stock
held in an investor's portfolio.
Naked (uncovered) option — an option written
without the stock to back it up.

a EE Een

BLUEPRINTS: CHAPTER 18 Page 18-5

 ee|Option terminology
» In-the-money call — a call option whose
exercise price is less than the current price of
the underlying stock.
Out-of-the-money call — a call option whose
exercise price exceeds the current stock price.
LEAPS: Long-term Equity AnticiPation
Securities are similar to conventional options
except that they are long-term options with
matunities of up to 2 1/2 years.

| a A Call option with an exercise price of $25,

has the following values at these prices:

Stock price Call option price

$25 $3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50

Determining option exercise

value and option premium
Stock
price
$25.00
30.00
35.00
40.00
45.00
50.00

Page 18-6 BLUEPRINTS: CHAPTER 18

 How does the option premium
: change as the stock price increases?

= The premium of the option price over

the exercise value declines as the stock
price increases.
= This is due to the declining degree of
leverage provided by options as the
underlying stock price increases, and the
greater loss potential of options at
higher option prices.

Market price

Stock
Exercise value Price

What are the assumptions of the

_Black-Scholes Option Pricing Model?
“= The stock underlying the call option
provides no dividends during the call
option’s life.
= There are no transactions costs for the
sale/purchase of either the stock or the
option.
» kg- is known and constant during the
option’s life.
» Security buyers may borrow any fraction
of the purchase price at the short-term,
risk-free rate.
18-12

BLUEPRINTS: CHAPTER 18 Page 18-7

 What are the assumptions of the
|. Black-Scholes Option Pricing Model?
« No penalty for short selling and
sellers receive immediately full cash
proceeds at today’s price.
» Call option can be exercised only on
its expiration date.
2 Security trading takes place in
continuous time, and stock prices
move randomly in continuous time.

Which equations must be solved to

find the Black-Scholes option price?
: x
In(P/X) + [k,, + 5)t]
as 2
4 ovt
d, = d, = ovt

V = P[N(d,)] - Xe**"[N(d,)]

Use the B-S OPM to find the option value

of a call option with P = $27, X = $25,
» Kap = 6%, t = 0.5 years, and ove 0.11.

_ In($27/$25) + [(0.06 + oy) (0.5)

(0.3317)(0.7071) ae
d, = 0.5736 - (0.3317)(0.7071) = 0.3391
From Table A - 5 in the textbook
N(d,) = N(0.5736) = 0.5000 + 0.2168 = 0.7168
N(d,) = N(0.3391) = 0.5000 + 0.1327 = 0.6327

eS

Page 18-8 BLUEPRINTS: CHAPTER 18

 Solving for option value

V = P[N(d,)]- Xe**"[N(d,)]
V = $27[0.7168] - $25e°9)[0,6327]
V = $4.0036

How do the factors of the B-S

_OPM affect a call option’s value?
As the factor increases... Option value ...
Current stock price Increases
Exercise price Decreases
Time to expiration Increases
Risk-free rate Increases
Stock return variance Increases

What is corporate risk management,

_and why is it important to all firms?
» Corporate risk management relates to the
management of unpredictable events that
would have adverse consequences for the
firm.
« All firms face risks, but the lower those
risks can be made, the more valuable the
firm, other things held constant. Of
course, risk reduction has a cost.

BLUEPRINTS: CHAPTER 18 Page 18-9

 Definitions of different types
gi. Of risk
Speculative risks — offer the chance of a gain
as well as a loss.
Pure risks — offer only the prospect of a loss.
Demand risks — risks associated with the
demand for a firm’s products or services.
Input risks — risks associated with a firm’s
input costs.
Financial risks — result from financial
transactions.

Definitions of different types

of risk
‘» Property risks — risks associated with loss
of a firm’s productive assets.
Personnel risk — result from human
actions.
Environmental risk — risk associated with
polluting the environment.
Liability risks — connected with product,
service, or employee liability.
Insurable risks — risks that typically can be
covered by insurance.
18-20

What are the three steps of

corporate risk management?
Identify the risks faced by the firm.
Measure the potential impact of the
identified risks.
Decide how each relevant risk
should be handled.

a a a a TT eee

Page 18 - 10 BLUEPRINTS: CHAPTER 18

 What can companies do to
minimize or reduce risk exposure?
Transfer risk to an insurance company by
paying periodic premiums.
Transfer functions that produce risk to third
parties.
Purchase derivative contracts to reduce input
and financial risks.
Take actions to reduce the probability of
occurrence of adverse events and the
magnitude associated with such adverse events.
Avoid the activities that give rise to risk.

What is financial risk exposure?

= Financial risk exposure refers to the
risk inherent in the financial markets
due to price fluctuations.
» Example: A firm holds a portfolio of
bonds, interest rates rise, and the
value of the bond portfolio falls.

Financial Risk Management

Concepts
‘a Derivative — a security whose value is
derived from the values of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.
Futures — contracts that call for the purchase
or sale of a financial (or real) asset at some
future date, but at a price determined today.
Futures (and other derivatives) can be used
either as highly leveraged speculations or to
hedge and thus reduce risk.
18-24

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cE a
Page 18-11
BLUEPRINTS: CHAPTER 18
 Financial Risk Management
Concepts
» Hedging — usually used when a price change
could negatively affect a firm’s profits.
» Long hedge — involves the purchase of a futures
contract to guard against a price increase.
» Short hedge — involves the sale of a futures
contract to protect against a price decline.
« Swaps — the exchange of cash payment
obligations between two parties, usually
because each party prefers the terms of the
other’s debt contract. Swaps can reduce
each party’s financial risk.
18-25

How can commodity futures markets

_be used to reduce input price risk?

« The purchase of a commodity futures

contract will allow a firm to make a
future purchase of the input at
today’s price, even if the market
price on the item has risen
substantially in the interim.

ees

Page 18 - 12 BLUEPRINTS: CHAPTER 18

 EXAM-TYPE PROBLEMS

18-1. A call option on the stock of Gemrock Jewelers has a market price of $13. The
stock sells for $40 a share, and the option has an exercise price of $32 a share.
a. What is the exercise value of the call option? ($8)
b. What is the premium on the option? ($5)

18-2. Assume you have been given the following information on Kazmirski Corporation:
Current stock price = $24 Exercise price of option = $24
Time to maturity of option =6 months _ Risk-free rate = 7%
Variance of stock price = 0.10 d, = 0.26833
d2 = 0.04472 N(d,) = 0.60572
N(d2) = 0.51783
Using the Black-Scholes Option Pricing Model, what would be the value of the
option? ($2.54)

18-3. What is the implied interest rate on a Treasury bond ($100,000) futures contract
that settled at 88-5? If interest rates decreased by % percent, what would be the
contract’s new value? (7.12%; $93,180.33)

SS

BLUEPRINTS: CHAPTER 18 Page 18 - 13

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 BLUEPRINTS: CHAPTER 19
MULTINATIONAL FINANCIAL MANAGEMENT

19-19 Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in
Indian River County, Florida. Until now, the company has confined its operations
and sales to the United States, but its CEO, George Gaynor, wants to expand into
the Pacific Rim. The first step would be to set up sales subsidiaries in Japan and
Australia, then to set up a production plant in Japan, and, finally, to distribute the
product throughout the Pacific Rim. The firm’s financial manager, Ruth Schmidt, is
enthusiastic about the plan, but she is worried about the implications of the foreign
expansion on the firm’s financial management process. She has asked you, the
firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that
explains the basics of multinational financial management. The tutorial will be
presented at the next board of directors meeting. To get you started, Schmidt has
supplied you with the following list of questions.

a. Whatis a multinational corporation? Why do firms expand into other countries?

b. What are the six major factors that distinguish multinational financial
management from financial management as practiced by a purely domestic
firm?

c. Consider the following illustrative exchange rates.

U.S. Dollars Required to Buy
One Unit of Foreign Currency
Japanese yen 0.009
Australian dollar 0.650
(1) Are these currency prices direct quotations or indirect quotations?
(2) Calculate the indirect quotations for yen and Australian dollars.
(3) What is a cross rate? Calculate the two cross rates between yen and
Australian dollars.
(4) Assume Citrus Products can produce a liter of orange juice and ship it to
Japan for $1.75. If the firm wants a 50 percent markup on the product, what
should the orange juice sell for in Japan?
(5) Now, assume Citrus Products begins producing the same liter of orange juice in
Japan. The product costs 250 yen to produce and ship to Australia, where it can
be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale?
(6) What is exchange rate risk?

BLUEPRINTS: CHAPTER 19 Page 19 - 1

 . Briefly describe the current international monetary system.

What is a convertible currency? What problems arise when a multinational

company operates in a country whose currency is not convertible?

What is the difference between spot rates and forward rates? When is the
forward rate at a premium to the spot rate? At a discount?

What is interest rate parity? Currently, you can exchange 1 yen for 0.0095
U.S. dollar in the 30-day forward market, and the risk-free rate on 30-day
securities is 4 percent in both Japan and the United States. Does interest rate
parity hold? If not, which securities offer the highest expected return?

What is purchasing power parity (PPP)? If grapefruit juice costs $2.00 a liter in
the United States and purchasing power parity holds, what should be the price of
grapefruit juice in Australia?

What impact does relative inflation have on interest rates and exchange rates?

Briefly discuss the international capital markets.

To what extent do average capital structures vary across different countries?

What is the impact of multinational operations on each ofthe following financial

management topics?
(1) Cash management.
(2) Capital budgeting decisions.
(3) Credit management.
(4) Inventory management.

eee

Page 19-2
BLUEPRINTS: CHAPTER 19
 CHAPTER 19
Multinational Financial
Management
NARS

Multinational vs. domestic financial

management
Exchange rates and trading in foreign
exchange
International money and capital markets
19-1

What is a multinational corporation?

« A corporation that
operates in two or more
countries.
Decision making within
the corporation may be
centralized in the home
country, or may be
decentralized across the
countries the corporation
does business in.

Why do firms expand into

other countries?
. To seek new markets.
. To seek raw materials.
. To seek new technology.
. To seek production efficiency.
To avoid political and regulatory
hurdles.
. To diversify.

nS

BLUEPRINTS: CHAPTER 19 Page 19-3

 What factors distinguish multinational
financial management from domestic
se financial management?

Different currency denominations.

Economic and legal ramifications.
Language differences.
Cultural differences.
Role of governments.
Political risk.

Consider the following

a. exchange rates
US $ to buy 1 unit
Japanese yen 0.009
Australian dollar 0.650

» Are these currency prices direct or indirect

quotations?
a Since they are prices of foreign
currencies expressed in dollars, they are
direct quotations.
19-5

What is an indirect quotation?

» The number of units of a foreign
currency needed to purchase one U.S.
dollar, or the reciprocal of a direct
quotation.
» Are you more likely to observe direct or
indirect quotations?
= Most exchange rates are stated in terms of
an indirect quotation.
« Except the British pound, which is usually in
terms of a direct quotation.
19-6

SE ee SS eee

Page 19-4 BLUEPRINTS: CHAPTER 19

 Calculate the indirect quotations
for yen and Australian dollar
# of units of foreign
currency per US $
Japanese yen de
Australian dollar 1.5385

» Simply find the inverse of the direct

quotations.

What is a cross rate?

» The exchange rate between any two
currencies. Cross rates are actually calculated
on the basis of various currencies relative to
the U.S. dollar.
» Cross rate between Australian dollar and the
Japanese yen.
« Cross rate = ("°"/ ys potiar) X (79 PO" / 9, potiar)
= 111.11 x 0.650
= 72.22 Yen/ A. Dollar
« The inverse of this cross rate yields:
0.0138 A. Dollars / Yen

Orange juice project:

Setting the appropriate price
» A firm can produce a liter of orange
juice and ship it to Japan for $1.75 per
unit. If the firm wants a 50% markup
on the project, what should the juice
sell for in Japan?

Price = (1.75)(1.50)(111.11)
= 291.66 yen

BLUEPRINTS: CHAPTER 19 Page 19-5

 Orange juice project:
~, Determining profitability
» The product will cost 250 yen to produce and
ship to Australia, where it can be sold for 6
Australian dollars. What is the U.S. dollar
profit on the sale?
» Cost in A. dollars = 250 yen (0.0138)
= 3.45 A. dollars
« A. dollar profit = 6 — 3.45 = 2.55 A. dollars
» U.S. dollar profit = 2.55 / 1.5385 = $1.66

What is exchange rate risk?

» The risk that the value of a cash flow in
one currency translated to another
currency will decline due to a change in
exchange rates.
» For example, in the last slide, a weakening
Australian dollar (strengthening dollar)
would lower the dollar profit.
» The current international monetary system
is a floating rate system.

European Monetary Union

# In 2002, the full implementation of
the “euro” was completed. The
national currencies of the 12
participating countries were phased
out in favor of the “euro.” The
newly formed European Central
Bank controls the monetary policy of
the EMU.

ee eeSsSSSsh

Page 19-6 BLUEPRINTS: CHAPTER 19

 Member nations of the EMU
» Austria =» Ireland
« Belgium « Italy
» Finland «#= Luxembourg
» France » Netherlands
Germany » Portugal
Greece = Spain
Notable European Union
countries not in the EMU:
= Britain, Sweden, and
Denmark

» A currency is convertible when the

issuing country promises to redeem
the currency at current market rates.
a Convertible currencies are traded in
world currency markets.

What problems may arise when a

firm operates in a country whose
. currency is not convertible?
« It becomes very difficult for multi-
national companies to conduct
business because there is no easy way
to take profits out of the country.
« Often, firms will barter for goods to
export to their home countries.

LUE EEE

BLUEPRINTS: CHAPTER 19 Page 19-7

 What is difference between
we spot rates and forward rates?
« Spot rates are the rates to buy
currency for immediate delivery.
» Forward rates are the rates to buy
currency at some agreed-upon date
in the future.

When is the forward rate at a

ai. Premium to the spot rate?
« If the U.S. dollar buys fewer units of a
foreign currency in the forward than in the
spot market, the foreign currency is selling
at a premium.
» In the opposite situation, the foreign
currency is selling at a discount.
a The primary determinant of the
spot/forward rate relationship is relative
interest rates.

What is interest rate parity?

# Interest rate parity holds that investors
should expect to earn the same return in all
countries after adjusting for risk.
f,1+k,
eek

f, = t - period forward exchange rate

e, = today's spot exchange rate
k, = periodic interest rate in home country
k, = periodic interest rate in foreign country
19-18

Snee ee ee

Page 19-8 BLUEPRINTS: CHAPTER 19

 Evaluating interest rate parity
« Suppose one yen buys $0.0095 in the 30-
day forward exchange market and Kyoy, for
a 30-day risk-free security in Japan and in
the U.S. is 4%.
» f, = 0.0095
« ky, = 4% / 12 = 0.333%
« ky = 4% / 12 = 0.333%

_Does interest rate parity hold?

0.0095 _ 1.0033
e, 1.0033
0.0095 _ 1
£5

« Therefore, for interest rate parity to hold,

€) must equal $0.0095, but we were given
earlier that e, = $0.0090.

Which security offers the

highest return?
= The Japanese security.
« Convert $1,000 to yen in the spot market.
$1,000 x 111.111 = 111,111 yen.
s Invest 111,111 yen in 30-day Japanese security.
In 30 days receive 111,111 yen x 1.00333 =
111,481 yen.
» Agree today to exchange 111,481 yen 30 days
from now at forward rate, 111,481/105.2632 =
$1,059.07.
« 30-day return = $59.07/$1,000 = 5.907%,
nominal annual return = 12 x 5.907% = 70.88%.
19-21

ae

BLUEPRINTS: CHAPTER 19 Page 19-9

 What is purchasing power parity
(PPP)?
» Purchasing power parity implies that the
level of exchange rates adjusts so that
identical goods cost the same amount
in different countries.
Pi, = Pr(€p)
=OR-

Ey = P,/Pr

If grapefruit juice costs $2.00 per liter

in the U.S. and PPP holds, what is the
» Price of grapefruit juice in Australia?

@y = P,/Pr
$0.6500 = $2.00/P,
P, = $2.00/$0.6500
= 3.0769 Australian dollars.

What impact does relative inflation have

.on interest rates and exchange rates?

= Lower inflation leads to lower interest

rates, so borrowing in low-interest
countries may appear attractive to
multinational firms.
However, currencies in low-inflation
countries tend to appreciate against those
in high-inflation rate countries, so the
effective interest cost increases over the
life of the loan.

Page 19 - 10 BLUEPRINTS: CHAPTER 19

 International money and
capital markets
» Eurodoilar markets
» a source of dollars outside the U.S.
« International bonds
» Foreign bonds — sold by foreign
borrower, but denominated in the
currency of the country of issue.
» Eurobonds — sold in country other
than the one in whose currency the
bonds are denominated.

To what extent do average capital

_structures vary across different countries?

« Previous studies suggested that

average capital structures vary among
the large industrial countries.
» However, a recent study, which
controlled for differences in accounting
practices, suggests that capital
structures are more similar across
different countries than previously
thought.

Impact of multinational operations

» Cash management
» Distances are greater.
» Access to more markets for loans and
for temporary investments.
= Cash is often denominated in different
currencies.

ee OO ee

CHAPTER 19 Page 19-11

BLUEPRINTS:
 es _Impact of multinational operations
« Capital budgeting decisions
« Foreign operations are taxed locally, and
then funds repatriated may be subject
to U.S. taxes.
» Foreign projects are subject to political
risk.
« Funds repatriated must be converted to
U.S. dollars, so exchange rate risk must
be taken into account.

_Impact of multinational operations

« Credit management
« Credit is more important, because commerce to
lesser-developed countries often relies on credit.
» Credit for future payment may be subject to
exchange rate risk.
» Inventory management
» Inventory decisions can be more complex,
especially when inventory can be stored in
locations in different countries.
« Some factors to consider are shipping times,
carrying costs, taxes, import duties, and
exchange rates. mes

SSeS

Page 19-12 BLUEPRINTS: CHAPTER 19

 EXAM-TYPE PROBLEMS

19-1. In 1985, a particular Japanese imported automobile sold for 1,476,000 yen or
$8,200. If the car still sells for the same amount of yen today but the current
exchange rate is 105 yen per dollar, what is the car selling for today in U.S. dollars?
($14,057.14)

19-2. Sunware Corporation, a U.S.-based importer, makes a purchase of crystal

glassware from a firm in Germany for 24,830 euros or $24,000, at the spot rate of
1.0346 euros per dollar. The terms of the purchase are net 90 days, and the U.S.
firm wants to cover this trade payable with a forward market hedge to eliminate its
exchange rate risk. Suppose the firm completes a forward hedge at the 90-day
forward rate of 1.0546 euros. If the spot rate in 90 days is actually 1.005 euros,
how much will the U.S. firm have saved in U.S. dollars by hedging its exchange rate
exposure? ($1,162.00)

19-3. Six months ago, a Swiss investor bought a 6-month U.S. Treasury bill at a price of
$9,708.74, with a maturity value of $10,000. The exchange rate at that time was
1.420 Swiss Francs per dollar. Today, at maturity, the exchange rate is 1.324 for
Swiss Francs. What is the nominal annual rate of return to the Swiss investor?
(-7.93%)

19-4. A refrigerator costs $899 in the United States. The same set costs 856 euros in
France. If purchasing power parity holds, what is the spot exchange rate between
the euro and the dollar? ($1.0502 per euro or 0.9522 euro per U.S. dollar)

19-5. 3-month T-bills have a nominal rate of 5 percent, while default-free Swiss bonds
that mature in 3 months have a nominal rate of 3.5 percent. In the spot exchange
market, one Swiss Franc equals $0.6935. If interest rate parity holds, what is the
3-month forward exchange rate? ($0.6961)

oO

BLUEPRINTS: CHAPTER 19 Page 19 - 13

 BLUEPRINTS: CHAPTER 20
HYBRID FINANCING:
PREFERRED STOCK, LEASING, WARRANTS, AND CONVERTIBLES

20-13 Martha Milion, financial manager for Fish & Chips Inc., has been asked to perform a
lease-versus-buy analysis on a new computer system. The computer costs
$1,200,000, and, if it is purchased, Fish & Chips could obtain a term loan for the full
amount at a 10 percent cost. The loan would be amortized over the 4-year life of
the computer, with payments made at the end of each year. The computer is
classified as special purpose, and hence it falls into the MACRS 3-year class. The
applicable MACRS rates are 0.33, 0.45, 0.15, and 0.07. If the computer is
purchased, a maintenance contract must be obtained at a cost of $25,000, payable
at the beginning of each year.
After4 years, the computer will be sold, and Millon’s best estimate of its residual
value at that time is $125,000. Because technology is changing rapidly, however,
the residual value is very uncertain.
As an alternative, National Leasing is willing to write a 4-year lease on the
computer, including maintenance, for payments of $340,000 at the beginning of
each year. Fish & Chips’ marginal federal-plus-state tax rate is 40 percent. Help
Millon conduct her analysis by answering the following questions.

a. (1) Why is leasing sometimes referred to as “off balance sheet” financing?

(2) What is the difference between a capital lease and an operating lease?
(3) What effect does leasing have on a firm’s capital structure?

b. (1) What is Fish & Chips’ present value cost of owning the computer? (Hint: Set
up a table whose bottom line is a “time line” which shows the net cash flows
over the period t = 0 to t = 4, and then find the PV of these net cash flows, or
the PV cost of owning.)
(2) Explain the rationale for the discount rate you used to find the PV.

c. (1) What is Fish & Chips’ present value cost of leasing the computer? (Hint:
Again, construct a time line.)
(2) What is the net advantage to leasing? Does your analysis indicate that the
firm should buy or lease the computer? Explain.

d. Now assume that Millon believes the computer's residual value could be as low
as $0 or as high as $250,000, but she stands by $125,000 as her expected
value. She concludes that the residual value is riskier than the other cash flows

BLUEPRINTS: CHAPTER 20 Page 20-1

 in the analysis, and she wants to incorporate this differential risk into her
analysis. Describe how this could be accomplished. What effect would it have
on the lease decision?

e. Millon knows that her firm has been considering moving its headquarters to a
new location for some time, and she is concerned that these plans may come to
fruition prior to the expiration of the lease. If the move occurs, the company
would obtain completely new computers, and hence Millon would like to include
a cancellation clause in the lease contract. What effect would a cancellation
clause have on the riskiness of the lease?

20-14 Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm
was founded 5 years ago to develop a new fast-food concept, and although Fish &
Chips has done well, the firm’s founder and chairman believes that an industry
shake-out is imminent. To survive, the firm must capture market share now, and
this requires a large infusion of new capital.
Because the stock price may rise rapidly, Millon does not want to issue new
common stock. On the other hand, interest rates are currently very high by
historical standards, and, with the firm’s B rating, the interest payments on a new
debt issue would be too much to handle if sales took a downturn. Thus, Millon has
narrowed her choice to bonds with warrants or convertible bonds. She has asked
you to help in the decision process by answering the following questions.

a. How does preferred stock differ from common equity and debt?

b. What is floating rate preferred?

c. How can a knowledge of call options help one understand warrants and
convertibles?

d. One of Millon’s alternatives is to issue a bond with warrants attached. Fish &
Chips’ current stock price is $10, and its cost of 20-year, annual coupon debt
without warrants is estimated by its investment bankers to be 12 percent. The
bankers suggest attaching 50 warrants to each bond, with each warrant having
an exercise price of $12.50. It is estimated that each warrant, when detached
and traded separately, will have a value of $1.50.
(1) What coupon rate should be set on the bond with warrants if the total
package is to sell for $1,000?
(2) Suppose the bonds are issued and the warrants immediately trade for $2.50
each. What does this imply about the terms of the issue? Did the company
“win” or “lose”?
(3) When would you expect the warrants to be exercised?
ee
eS ER eee
Page 20 - 2 BLUEPRINTS: CHAPTER 20
 (4) Will the warrants bring in additional capital when exercised? If so, how much
and what type of capital?
(5) Because warrants lower the cost of the accompanying debt, shouldn't all
debt be issued with warrants? What is the expected cost of the bond with
warrants if the warrants are expected to be exercised in 5 years, when Fish &
Chips’ stock price is expected to be $17.50? How would you expect the cost
of the bond with warrants to compare with the cost of straight debt? With the
cost of common stock?

e. As an alternative to the bond with warrants, Millon is considering convertible

bonds. The firm’s investment bankers estimate that Fish & Chips could sell a
20-year, 10 percent annual coupon, callable convertible bond for its $1,000 par
value, whereas a straight-debt issue would require a 12 percent coupon. Fish &
Chips’ current stock price is $10, its last dividend was $0.74, and the dividend is
expected to grow at a constant rate of 8 percent. The convertible could be
converted into 80 shares of Fish & Chips stock at the owner's option.
(1) What conversion price, Pe, is implied in the convertible’s terms?
(2) What is the straight-debt value of the convertible? What is the implied value
of the convertibility feature?
(3) What is the formula for the bond’s conversion value in any year? Its value at
Year 0? At Year 10?
(4) What is meant by the term “floor value” of a convertible? What is the
convertible’s expected floor value in Year 0? In Year 10?
(5) Assume that Fish & Chips intends to force conversion by calling the bond
when its conversion value is 20 percent above its par value, or at 1.2($1,000)
= $1,200. When is the issue expected to be called? Answer to the closest
year.
(6) What is the expected cost of the convertible to Fish & Chips? Does this cost
appear consistent with the riskiness of the issue? Assume conversion in
Year 5 at a conversion value of $1,200.

f. Millon believes that the costs of both the bond with warrants and the convertible
bond are essentially equal, so her decision must be based on other factors.
What are some of the factors that she should consider in making her decision?

a EE UE EEEEEE EEE

BLUEPRINTS: CHAPTER 20 Page 20 - 3

 CHAPTER 20
Hybrid Financing:
Preferred Stock, Leasing, Warrants, and
Convertibles
seoneansnnsasncessnensascovasctanusteii

» Preferred stock
» Leasing
« Warrants
a Convertibles

Leasing
« Often referred to as “off balance sheet”
financing if a lease is not “capitalized.”
Leasing is a substitute for debt financing and,
thus, uses up a firm’s debt capacity.
Capital leases are different from operating
leases:
« Capital leases do not provide for maintenance
service.
» Capital leases are not cancelable.
s Capital leases are fully amortized.

Analysis: Lease vs. Borrow-

New computer costs $1,200,000.

3-year MACRS class life; 4-year economic life.
Tax rate = 40%.
ky = 10%.
Maintenance of $25,000/year, payable at
beginning of each year.
Residual value in Year 4 of $125,000.
4-year lease includes maintenance.
Lease payment is $340,000/year, payable at
beginning of each year.
20-3

Page 20 - 4 BLUEPRINTS: CHAPTER 20

 Depreciation schedule
Depreciable basis = $1,200,000
MACRS Depreciation — End-of-Year
Year Rate Expense Book Value
iL 0.33 $ 396,000 $804,000
2 0.45 540,000 264,000
3 0.15 180,000 84,000
4 0.07 84,000 0
1.00 $1,200,000

In a lease analysis, at what discount

_rate should cash flows be discounted?

Since cash flows in a lease analysis are

evaluated on an after-tax basis, we should
use the after-tax cost of borrowing.
Previously, we were told the cost of debt, k,,
was 10%. Therefore, we should discount
cash flows at 6%.
A-T kd = 10%(1 — T) = 10%(1 — 0.4) = 6%.

Cost of Owning Analysis

Analysis in thousands: 0

Cost of asset (1,200.0)

Dep. tax savings’ 158.4 216.0 72.0
Maint. (AT) (15.0) (15.0) (15.0) (15.0)
Res. value (AT)?
Net cash flow

PV cost of owning (@ 6%) = -$766.948.

BLUEPRINTS: CHAPTER 20 Page 20-5

 =. Notes on Cost of Owning Analysis
Depreciation is a tax deductible
expense, so it produces a tax savings of
T(Depreciation). Year 1 = 0.4($396) =
$158.4.
Each maintenance payment of $25 is
deductible so the after-tax cost of the
lease is (1 — T)($25) = $15.
. The ending book value is $0 so the full
$125 salvage (residual) value is taxed,
(1 - T)($125) = $75.0.

Cost of Leasing Analysis

Analysis in thousands: 0 1 2

A-T Lease pmt 204-204 -204 = -204

» Each lease payment of $340 is deductible,

so the after-tax cost of the lease is
(1-T)($340) = -$204.

» PV cost of leasing (@6%) = -$749.294.

Net advantage of leasing

: NAL = PV cost of owning — PV cost of leasing

a NAL = $766.948 - $749,294

= $17.654 (Dollars in thousands)

» Since the cost of owning outweighs the cost

of leasing, the firm should lease.

Page 20-6 BLUEPRINTS: CHAPTER 20

 Suppose there is a great deal of
uncertainty regarding the computer’s

= Residual value could range from $0 to

$250,000 and has an expected value of
$125,000.
» To account for the risk introduced by an
uncertain residual value, a higher discount
rate should be used to discount the residual
value.
« Therefore, the cost of owning would be
higher and leasing becomes even more
attractive.

What if a cancellation clause were

included in the lease? How would this
affect the riskiness of the lease?

» A cancellation clause lowers the risk

of the lease to the lessee.
» However, it increases the risk to the
lessor.

How does preferred stock differ

from common equity and debt?
» Preferred dividends are fixed, but
they may be omitted without placing
the firm in default.
» Preferred dividends are cumulative up
to a limit.
» Most preferred stocks prohibit the
firm from paying common dividends
when the preferred is in arrears.

es

BLUEPRINTS: CHAPTER 20 Page 20-7

 |. What is floating rate preferred?
«Dividends are indexed to the rate on treasury
securities instead of being fixed.
» Excellent S-T corporate investment:
« Only 30% of dividends are taxable to
corporations.
« The floating rate generally keeps issue trading
near par.
» However, if the issuer is risky, the floating
rate pele stock may have too much price
instability for the liquid asset portfolios o
many corporate investors.
20-13

How can a knowledge of call options

help one understand warrants and
convertibles?

« A warrant is a long-term call option.

» A convertible bond consists of a
fixed rate bond plus a call option.

A firm wants to issue a bond with

warrants package at a face value of
$1,000. Here are thedetails of the issue.
» Current stock price (P,) = $10.
a k, of equivalent 20-year annual
payment bonds without warrants =
12%.
» 50 warrants attached to each bond with
an exercise price of $12.50.
» Each warrant’s value will be $1.50.

eee

Page 20 - 8 BLUEPRINTS: CHAPTER 20

 What coupon rate should be set for
this bond plus warrants package?

a Step 1 — Calculate the value of the

bonds in the package

Vpackage sa Veond o V warrants ‘<i $1,000.

Vwarrants = 50($1.50) = $75.
Veond + $75 = $1,000
Veond a $925.

Calculating required annual coupon

_rate for bond with warrants package
z Step 2 — Find coupon payment and rate.
x Solving for PMT, we have a solution of $110,
which corresponds to an annual coupon rate
of $110 / $1,000 = 11%.

If after the issue, the warrants sell for

$2.50 each, what would this imply about
the value of the package?

» The package would have been worth $925

+ 50(2.50) = $1,050. This is $50 more
than the actual selling price.
» The firm could have set lower interest
payments whose PV would be smaller by
$50 per bond, or it could have offered
fewer warrants with a higher exercise price.
« Current stockholders are giving up value to
the warrant holders. .

eed

BLUEPRINTS: CHAPTER 20 Page 20 - 9

 Assume the warrants expire 10 years
=| after issue. When would you expect
~Bie them to be exercised?
« Generally, a warrant will sell in the
open market at a premium above its
theoretical value (it can’t sell for less).
» Therefore, warrants tend not to be
exercised until just before they expire.

Optimal times to exercise

warrants
« In a stepped-up exercise price, the exercise
price increases in steps over the warrant’s
life. Because the value of the warrant falls
when the exercise price is increased, step-up
provisions encourage in-the-money warrant
holders to exercise just prior to the step-up.
Since no dividends are earned on the
warrant, holders will tend to exercise
voluntarily if a stock’s dividend rises enough.
20-20

Will the warrants bring in additional

wa Capital when exercised?
=» When exercised, each warrant will bring in
the exercise price, $12.50, per share
exercised.
» This is equity capital and holders will receive
one share of common stock per warrant.
= The exercise price is typically set at 10% to
30% above the current stock price on the
issue date.

Page 20 - 10 BLUEPRINTS: CHAPTER 20

 Because warrants lower the cost of
_ the accompanying debt issue, should
all debt be issued with warrants?
» No, the warrants have a cost that
must be added to the coupon
interest cost.

What is the expected rate of return to

holders of bonds with warrants, if
exercised in 5 years at P; = $17.50?
“a The company will exchange stock worth
$17.50 for one warrant plus $12.50.
The opportunity cost to the company is
$17.50 = $12.50 = $5.00, for each
warrant exercised.
» Each bond has 50 warrants, so on a par
bond basis, opportunity cost =
50($5.00) = $250.

Finding the opportunity cost of capital

_for the bond with warrants package

« Here is the cash flow time line:

7 le Seg 19 20
110 -110 -110 110 -110
-250 -1,000
-360 -1,110
« Input the cash flows into a financial
calculator (or spreadsheet) and find IRR
= 12.93%. This is the pre-tax cost.
20-24

BLUEPRINTS: CHAPTER 20 Page 20-11

 Interpreting the opportunity cost of
.., Capital for the bond with warrants
ee Package
« The cost of the bond with warrants
package is higher than the 12% cost of
straight debt because part of the expected
return is from capital gains, which are
riskier than interest income.
= The cost is lower than the cost of equity
because part of the return is fixed by
contract.

The firm is now considering a callable,

. a 20-year, 10% annual coupon, callable

convertible bond will sell at its $1,000
par value; straight debt issue would
require a 12% coupon.
a Call the bonds when conversion value
> $1,200.
» Py = $10; Dy = $0.74; g = 8%.
» Conversion ratio = CR = 80 shares.

What conversion price (P.) ;.

implied by this bond issue?
» The conversion price can be found by
dividing the par value of the bond by
the conversion ratio, $1,000 / 80 =
$12.50.
« The conversion price is usually set 10%
to 30% above the stock price on the
issue date.

ee

Page 20 - 12 BLUEPRINTS: CHAPTER 20

 What is the convertible’s
_ Straight debt value?
« Recall that the straight debt coupon
rate is 12% and the bond’s have 20
years until maturity.

Implied Convertibility Value

. » Because the convertibles will sell for $1,000,
the implied value of the convertibility feature
is
$1,000 — $850.61 = $149.39.
= $1.87 per share.

« The convertibility value corresponds to the

warrant value in the previous example.

What is the formula for the bond’s

expected conversion value in any year?

» Conversion value = C, = CR(P,)(1 + g)!.

« At t= 0, the conversion value is ...

C) = 80($10)(1.08)° = $800.
» Att = 10, the conversion value is ...
Cio = 80($10)(1.08)!° = $1,727.14.

20-30

BLUEPRINTS: CHAPTER 20 Page 20 - 13

 What is meant by the floor value
| of a convertible?

The floor value is the higher of the straight debt

value and the conversion value.
At t = 0, the floor value is $850.61.
» Straight debt value, = $850.61. C,) = $800.
At t = 10, the floor value is $1,727.14.
« Straight debt value;, = $887.00. Cy) = $1,727.14.
Convertibles usually sell above floor value
because convertibility has an additional value.

20-31

The firm intends to force conversion

when C = 1.2($1,000) = $1, 200. When
-is the issued expected to be called?

» We are solving for the period of time until

the conversion value equals the call price.
After this time, the conversion value is
expected to exceed the call price.

What is the convertible’s expected cost of

capital to the firm, if converted in Year 5?

ia 3 4 5
Ol
1,000 -100 -100 -100 -100 ~-100
-1,200
-1,300

= Input the cash flows from the

convertible bond and solve for IRR =
13.08%.

EE
es EE EE EE

Page 20 - 14 BLUEPRINTS: CHAPTER 20

 Is the cost of the convertible consistent
with the riskiness of the issue?

=» To be consistent, we require that ky < k. <

Ke
» The convertible bond's risk is a blend of the
risk of debt and equity, so k. should be
between the cost of debt and equity.
» From previous information, k, = $0.74(1.08)/
$10 + 0.08 = 16.0%.
» k. is between k, and k,, and is consistent.

Besides cost, what other factor should be

considered when using hybrid securities?

| « The firm’s future needs for capital:

» Exercise of warrants brings in new equity
capital without the need to retire low-
coupon debt.
» Conversion brings in no new funds, and
low-coupon debt is gone when bonds are
converted. However, debt ratio is lowered,
so new debt can be issued.

Other issues regarding the use of

hybrid securities
= Does the firm want to commit to 20
years of debt?
» Conversion removes debt, while the
exercise of warrants does not.
« If stock price does not rise over time,
then neither warrants nor convertibles
would be exercised. Debt would remain
outstanding.

nee EEEEIEnEnEIESEIEE DEES EEE

BLUEPRINTS: CHAPTER 20 Page 20-15

 EXAM-TYPE PROBLEMS

20-1. Redstone Corporation is considering a leasing arrangement to finance some special

manufacturing tools that it needs for production during the next three years. A
planned change in the firm’s production technology will make the tools obsolete
after three years. The firm will depreciate the cost of the tools on a straight-line
basis. The firm can borrow $4,800,000, the purchase price, at 10 percent to buy the
tools or make three equal end-of-year lease payments of $2,100,000. The firm's tax
rate is 40 percent and the firm’s before-tax cost of debt is 10 percent. Annual
maintenance costs associated with ownership are estimated at $240,000 and
payable at year end. What is the net advantage to leasing (NAL)? (+106.19—in
thousands)

20-2. Insight Incorporated just issued 20-year convertible bonds

at a price of $1,000 each.
The bonds pay 9 percent annual coupon interest, have apar value of $1,000, and
are convertible into 40 shares of the firm’s common stock.
Investors would require
a return of 12 percent on the firm’s bonds if they were not
convertible. The current
market price of the firm’s stock is $18.75 and the firm just
paid a dividend of $0.80.
Earnings and dividends are expected to grow at a rate of 7 percent into the
foreseeable future. What is the expected pure-bond value, Bi, and conversion
value, Cy, at the end of Year 5? ($795.67; $1,051.91)

20-3. Johnson Beverage’s common stock sells for $27.83, pays a dividend of $2.10, and
has an expected long-term growth rate of 6 percent. The firm’s straight-debt bonds
pay 10.8 percent. Johnson is planning a convertible bond issue. The bonds will
have a 20-year maturity, pay $100 interest annually, have a par value of $1,000,
and a conversion ratio of 25 shares per bond. The bonds will sell for $1,000 and will
be callable after 10 years. Assuming that the bonds will be converted at Year 10,
when they become callable, what will be the expected return on the convertible
when it is issued? (11.44%)

———
ee

Page 20 - 16 BLUEPRINTS: CHAPTER 20

 BLUEPRINTS: CHAPTER 21
MERGERS AND ACQUISITIONS

21-8 Smitty's Home Repair Company, a regional hardware chain that specializes in “do-
it-yourself’ materials and equipment rentals, is cash rich because of several
consecutive good years. One of the alternative uses for the excess funds is an
acquisition. Linda Wade, Smitty's treasurer and your boss, has been asked to place
a value on a potential target, Hill's Hardware, a small chain that operates in an
adjacent state, and she has enlisted your help.
The table below indicates Wade's estimates of Hill's earnings potential if it came
under Smitty's management (in millions of dollars). The interest expense listed here
includes the interest (1) on Hill’s existing debt, (2) on new debt that Smitty's would
issue to help finance the acquisition, and (3) on new debt expected to be issued
over time to help finance expansion within the new “H division,” the code name
given to the target firm. The retentions represent earnings that will be reinvested
within the H division to help finance its growth.
Hill’s Hardware currently uses 40 percent debt financing, and it pays federal-plus-
state taxes at a 30 percent rate. Security analysts estimate Hill’s beta to be 1.2. If
the acquisition were to take place, Smitty’s would increase Hill’s debt ratio to 50
percent, which would increase its beta to 1.3. Further, because Smitty’s is highly
profitable, taxes on the consolidated firm would be 40 percent. Wade realizes that
Hill’s Hardware also generates depreciation cash flows, but she believes that these
funds would have to be reinvested within the division to replace worn-out
equipment.
Wade estimates the risk-free rate to be 9 percent and the market risk premium to be
4 percent. She also estimates that net cash flows after 2006 will grow at a constant
rate of 6 percent.
2003 2004 2005 2006
Net sales $60.0 $90.0 $112.5 $1275
Cost of goods sold (60%) 36.0 54.0 62-5 76.5
Selling/administrative expense 4.5 6.0 (es 9.0
Interest expense 3.0 4.5 4.5 6.0
Necessary retained earnings 0.0 fae) 6.0 4.5
Smitty's management is new to the merger game, so Wade has been asked to
answer some basic questions about mergers as well as to perform the merger
analysis. To structure the task, Wade has developed the following questions, which
you must answer and then defend to Smitty's board.

BLUEPRINTS: CHAPTER 21 Page 21-1

 a. Several reasons have been proposed to justify mergers. Among the more
prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase
of assets at below-replacement cost, (5) synergy, and (6) globalization. In
general, which of the reasons are economically justifiable? Which are not?
Which fit the situation at hand? Explain.

b. Briefly describe the differences between a hostile merger and a friendly merger.

c. Use the data developed in the table to construct the H division’s cash flow
statements for 2003 through 2006. Why is interest expense deducted in merger
cash flow statements, whereas it is not normally deducted in a capital budgeting
cash flow analysis? Why are earnings retentions deducted in the cash flow
statement?

d. Conceptually, what is the appropriate discount rate to apply to the cash flows
developed in part c? What is your actual estimate of this discount rate?

e. What is the estimated terminal value of the acquisition; that is, what is the
estimated value ofthe H division’s cash flows beyond 2006? Whatis Hill’s value
to Smitty’s? Suppose another firm were evaluating Hill's as an acquisition
candidate. Would they obtain the same value? Explain.

f. Assume that Hill’s has 10 million shares outstanding. These shares are traded
relatively infrequently, but the last trade, made several weeks ago, was at a price
of $9 per share. Should Smitty's make an offer for Hill’s? If so, how much
should it offer per share?

g. What merger-related activities are undertaken by investment bankers?

aaaee ee
Page 21-2 BLUEPRINTS: CHAPTER 21
 CHAPTER 21
|Mergers and Divestitures

Types of mergers
Merger analysis
Role of investment bankers
Corporate alliances
LBOs, divestitures, and holding
companies

_Why do mergers occur?

» Synergy: Value of the whole exceeds sum
of the parts. Could arise from:
« Operating economies
« Financial economies
« Differential management efficiency
s Increased market power
« Taxes (use accumulated losses)
« Break-up value: Assets would be more
valuable if sold to some other company.
21-2

What are some questionable

_ reasons for mergers?
« Diversification
« Purchase of assets at below
replacement cost
» Get bigger using debt-financed
mergers to help fight off takeovers

eee
eee ee

BLUEPRINTS: CHAPTER 21 Page 21-3

 What is the difference between a
“friendly” and a “hostile” takeover?
~ a Friendly merger:
« The merger is supported by the
managements of both firms.
« Hostile merger:
« Target firm’s management resists the merger.
« Acquirer must go directly to the target firm’s
stockholders try to get 51% to tender their
shares.
« Often, mergers that start out hostile end up
as friendly when offer price is raised.
21-4

Reasons why alliances can make

_more sense than acquisitions
» Access to new markets and
technologies
« Multiple parties share risks and
expenses
» Rivals can often work together
harmoniously
» Antitrust laws can shelter cooperative
R&D activities

Merger analysis:
Post-merger cash flow statements
2003 2004 2005 2006
Net sales $60.0 $90.0 $112.5 $127.5
- Cost of goods sold 36.0 : 67:5) 376.5
- Selling/admin. exp. 4.5 75
- Interest expense _3.0 5
EBT 33.0
- Taxes 13.2
Net Income 19.8
Retentions 6.0
Cash flow 13.8

Page 21-4 BLUEPRINTS: CHAPTER 21

 What is the appropriate discount rate
_to apply to the target’s cash flows?
« Estimated cash flows are residuals which
belong to acquirer's shareholders.
» They are riskier than the typical capital
budgeting cash flows. Because fixed
interest charges are deducted, this
increases the volatility of the residual cash
flows.
s Because the cash flows are risky equity
flows, they should be discounted using the
cost of equity rather than the WACC.
21-7

Discounting the target's cash flows

» The cash flows reflect the target's

business risk, not the acquiring
company’s.
» However, the merger will affect the
target’s leverage and tax rate, hence
its financial risk.

Calculating terminal value

%, Find the appropriate discount rate
Ks(rarget) = Kpe ar (ki i Kar) Brarget
= 9% + (4%)(1.3) = 14.2%
» Determine terminal value
® TV2996 = CFao06(1 + 9) / (Ks - 9)
= $17.1 (1.06) / (0.142 — 0.06) ee ee
=$221.0 million

nee

BLUEPRINTS: CHAPTER 21 Page 21-5

me cash flow stream

Annual cash flow

Terminal value
Net cash flow

« Value of target firm

« Enter CK in calculator CFLO register, and
enter /YR = 14.2%. Solve for NPV = $163.9
million

Would another acquiring

company obtain the same value?
» No. The input estimates would be
different, and different synergies would
lead to different cash flow forecasts.
« Also, a different financing mix or tax rate
would change the discount rate.

The target firm has 10 million shares

outstanding at a price of $9.00 per share.
mie What should the offering price be?
The acquirer estimates the maximum price
they would be willing to pay by dividing the
target's value by its number of shares:

Max price = Target's value / # of shares

= $163.9 million / 10 million
= $16.39

Offering range is between $9 and $16.39 per

share.
21-12

BLUEPRINTS: CHAPTER 21
 Making the offer
“a The offer could range from $9 to
$16.39 per share.
» At $9 all the merger benefits would
go to the acquirer’s shareholders.
« At $16.39, all value added would go
to the target’s shareholders.
» Acquiring and target firms must
decide how much wealth they are
willing to forego.

Shareholder wealth in a merger

Shareholders’ : Bargaining :
Wealth ; Range

$16.39 : d
? Price Paid
for Target

21-14

Shareholder wealth
; « Nothing magic about crossover price from
the graph.
« Actual price would be determined by
bargaining. Higher if target is in better
bargaining position, lower if acquirer is.
» If target is good fit for many acquirers,
other firms will come in, price will be bid
up. If not, could be close to $9.

ee

BLUEPRINTS: CHAPTER 21 Page 21-7

 Shareholder wealth
Acquirer might want to make high
“preemptive” bid to ward off other
bidders, or low bid and then plan to go up.
It all depends upon their strategy.
Do target’s managers have 51% of stock
and want to remain in control?
What kind of personal deal will target’s
managers get?

_Do mergers really create value?

= The evidence strongly suggests:
» Acquisitions do create value as a result
of economies of scale, other synergies,
and/or better management.
» Shareholders of target firms reap most
of the benefits, because of competitive
bids.

= Functions of Investment Bankers

we. in Mergers
» Arranging mergers
» Assisting in defensive tactics
» Establishing a fair value
» Financing mergers
« Risk arbitrage

SUE

Page 21-8 BLUEPRINTS: CHAPTER 21

 EXAM-TYPE PROBLEMS

(The following information applies to the next four problems.)

Magiclean Corporation is considering an acquisition of Dustvac Company. Dustvac has a

capital structure of 50 percent debt, 50 percent equity, with a current book value of $10
million in assets. Dustvac’s pre-merger beta is 1.36 and is not likely to be altered as a
result of the proposed merger. Magiclean’s pre-merger beta is 1.02 and both it and
Dustvac face a 40 percent tax rate. Magiclean’s capital structure is 40 percent debt and 60
percent equity, and it has $24 million in total assets. The net cash flows from Dustvac
available to Magiclean’s stockholders are estimated at $4.0 million for each of the next
three years and a terminal value of $19.0 million in Year 4. Additionally, new debt issued
by the combined firm would yield 10 percent before tax, and the combined firm's cost of
equity is estimated at 12.59 percent. Currently, the risk-free rate is 6.0 percent and the
market risk premium is 5.88 percent.

21-1. What is the merged firm’s WACC? (9.76%)

21-2. What is the merged firm’s new beta? (1.12)

21-3. Whatis the appropriate discount rate Magiclean should use to value the equity cash
flows from Dustvac? (14%)

21-4. Ifthe acquisition price of Dustvac is 155 percent of Dustvac’s current book value of
assets, should Magiclean proceed with the acquisition? (NPV = +$5,036,053)

BLUEPRINTS: CHAPTER 21 Page 21-9

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 SOLUTIONS TO EXAM-TYPE PROBLEMS

CHAPTER 1

lat aed:

1-2. e

CHAPTER 2

2-1, Sar ERT $1,250,000

Interest 0
EBT $1,250,000
Taxes (40%) 900,000
Net income $ 750,000

b. Net cash flow = Net income + Depreciation

= $750,000 + $300,000
= $1,050,000.

c. Operating cash flow = EBIT(1 — T) + Depreciation

= $1,250,000(0.6) + $300,000
= $1,050,000.

d. NOPAT = EBIT(1 —T)

= $1,250,000(1 — 0.4)
= $750,000.
e. FCF = NOPAT — Net investment in operating capital
= $750,000 — $500,000
= $250,000.

CHAPTER 3

3-1. ROE = Profit margin x Total assets turnover x Equity multiplier

= NI/Sales x Sales/TA x TA/Equity.

Now we need to determine the inputs for the equation from the data that were given.
On the left we set up an income statement, and we put numbers in it on the right:

BLUEPRINTS: SOLUTIONS Page 1

 Sales (given) $20,000
Cost NA
EBIT (given) $ 2,000
Interest (given) 900
EBT $ 1,500
Taxes (30%) 450
Net income $_ 1,050

Now we can use some ratios to get some more data:

Total assets turnover = S/TA = 2.5 (given).

D/A = 70%, so E/A = 30%, and therefore A/E = 1/(E/A) = 1/0.3 = 3.3333.

Now we can complete the Du Pont equation to determine ROE:

ROE = $1,050/$20,000 x 2.5 x 3.3333 = 43.75%.

3-2. a. Current NI = 0.05 x $5,000,000 = $250,000.

Current ROE = Ni/Equity = $250,000/$4,000,000 = 6.25%.

Current DSO = Receivables/(Sales/365)

= $2,250,000/($5,000,000/365) = 164.25 days.

Reduce DSO to 60 days.

Freed up cash = 104.25 x $5,000,000/365 = $1,428,082.

Alternatively,

Accounts receivable/($5,000,000/365) = 60
Accounts receivable = $821,918.

A in A/R = $2,250,000 — $821,918 = $1,428,082.

Reduce Common Equity: $4,000,000 — $1,428,082 = $2,571,918.

New ROE = $250,000/$2,571,918 = 9.72%.

Change in ROE = 9.72% — 6.25% = +3.47%.

b. (1) Doubling the dollar amounts would not affect the answer; it would still be
+3.47%.

ss
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Page 2 BLUEPRINTS: SOLUTIONS

 (2) Target DSO = 70 days.
Freed up cash = 94.25 x $5,000,000/365 = $1,291,096.

Reduce Common Equity: $4,000,000 — $1,291,096 = $2,708,904.

New ROE = $250,000/$2,708,904 = 9.23%.

Change in ROE = 9.23% — 6.25% = +2.98%.

(3) Sales/Receivables = 6
$5,000,000/Receivables = 6
Receivables= $5,000,000/6 = $833,333.

A in AR = $2,250,000 — $833,333 = $1,416,667.

Reduce Common Equity: $4,000,000 — $1,416,667 = $2,583,333.

New ROE = $250,000/$2,583,333 = 9.68%.

Change in ROE = 9.68% — 6.25% = +3.43%.

(4) Original EPS = NI/Shares = $250,000/250,000 = $1.00.

New EPS calculation: Assume Book value = Market value. (M/B = 1.)

Price = $4,000,000/250,000 shares = $16. Stock is selling for $16 per share.

$1,428,082
Thus, must buy back = 89,255 shares.
$16

Number of shares outstanding = 250,000 — 89,255

= 160,745 shares.

$250,000
New EPS = ———— = $1.56.
160,745

A in EPS = $1.56 — $1.00 = +$0.56 per share.

(5) From Part 4, Book value = $16 per share. Market value = 2 x $16 = $32.

Thus, firm must buy back $1,428,082/$32 = 44,628 shares.

Number of shares outstanding = 250,000 — 44,628 = 205,372 shares.

BLUEPRINTS: SOLUTIONS Page 3

 New EPS = $250,000/205,372 = $1.22.

A in EPS = $1.22 — $1.00 = +$0.22 per share.

c. We could have started with lower receivables and higher fixed assets or
inventory, then had you calculate the fixed assets or inventory turnover ratios.
Then, we could have the company move to lower fixed assets or inventory
turnover reducing equity by like amounts, and then had you determine the
effects on ROE and EPS under different conditions. In any of these cases, we
could have used the funds generated to retire debt, which would have lowered
interest charges, and consequently, increased net income and EPS. (Note that
information would have had to be given on interest and EBIT too.)
If we had to increase assets, then we would have had to finance this
increase by adding either debt or equity, which would have lowered ROE and
EPS, other things held constant.

a:b

3-4. TIE =EBIT/I, so find EBIT and I.

Interest = $800,000 x 0.1 = $80,000.
Net income = $3,200,000 x 0.06 = $192,000.
Pre-tax income = $192,000/(1 — T) = $192,000/0.6 = $320,000.
EBIT = $320,000 + $80,000 = $400,000.
TIE = $400,000/$80,000 = 5.0x.

3-5. Before:
Equity multiplier = 1/(1 — D/A) = 1/(1 — 0.5) = 2.0.
ROE = (PM)(Assets turnover)(EM) = (10%)(0.25)(2.0) = 5%.

After:
ROE = 2(5%) = 10%
10% = (12%)(0.25)(EM)
EM =3.33.

Se
r>m|>
po

D/A = 2.33/3.33 = 0.70 = 70%.

a
SSeS

Page 4 BLUEPRINTS: SOLUTIONS

3-6. BT OROASE sa:
Seo
12.5%=3% x =
A

x
E
16% = 3% x 4.167 x EM
EM = 1.28.

c. From Part b, we know that A/E = 1.28; therefore, the firm’s ratio of equity to
assets is 1/1.28 = 0.78125 ~ 78%. Consequently, the firm’s debt ratio = D/A = 1
— E/A= 1-0.78 = 0.22 = 22%.

CHAPTER 4

4-1. b.

4-2. First, note that we will use the equation k; = 4% + IP; + MRP;. We have the data
needed to find the IPs:

IPs = (9% + 6% +4% + 4% + 4%)/5 = 27%/5 = 5.4%.

IPz = (9% + 6%)/2 = 7.5%.

Now we can substitute into the equation:

ks = 4% + 5.4% +MRPs = 12%.

ko = 4% + 7.5% +MRP2 = 12%.

Now we can solve for the MRPs, and find the difference between them:

MRPs = 12% — 9.4% = 2.6%.

MRP2 = 12% — 11.5% = 0.5%.

Difference = 2.6% — 0.5% = +2.1%.

BLUEPRINTS: SOLUTIONS Page 5

 kts = 6.6%; Keg = 9.3%; LPcg = 0.6%.

k= k* 41PMDRPS
Le > MRP:

ktg = 6.6% = k* + IP + MRP; DRP = LP = 0.

kog = 9.3% = k* + IP + MRP + 0.6% + DRP.

Because both bonds are 8-year bonds the inflation premium and maturity risk
premium on both bonds are equal. The only difference between them is the liquidity
and default risk premiums.

Kcg = 9.3% = k* + IP + MRP + 0.6% + DRP.

But we know from above that k* + IP + MRP = 6.6%; therefore,

Keg = 9.3% = 6.6% + 0.6% + DRP

DRP = 2.1%.

CHAPTER 5

5-1. a.

5-2. C.

9-3. Before: 1.15 =0.95(bpr) + 0.05(1.0)

0.95(br) = 1.10
bey = 1.15789.

After: bp = 0.95(br) + 0.05(2.0) = 1.10 + 0.10 = 1.20.

5-4. Electro b = 1.7; Flowers Galore b = 0.6; ky = 14%; kre = 7.8%.

Electro k = Ker + (ku _ Krr)b

= 7.8% + (14% —7.8%)1.7
= 18.34%.

Flowers Galore k = Ker + (Ky — Krr)b

= 7.8% + (14% — 7.8%)0.6
= 11.52%.

Ak = 18.34% — 11.52%
= +6.82%.

Page 6 BLUEPRINTS: SOLUTIONS

CHAPTER6

6-1. d.

6-2. Time line:

Vv see! 22 23 24

-25,000

20 21 22 23 24

Financial calculator solution:

Price of car on 27th birthday.

Inputs: N = 7; 1 = 10; PV = -25000; PMT = 0.

Output: FV = $48,717.93 ~ $48,718.

Annual investment required.

Inputs: N = 7; 1 = 14; PV =0; FV = 48718.

Output: PMT = -$4,540.15.

6-3. Time line:

1/1/03 1/1/08
0 10% 1 2 3 4 5 Years

PMT = 8,000 8,000 8,000 8,000 8,000 FVpian = ?

-5,000 -5,000 -5,000
FV withdrawals = ?

Financial calculator solution:

Calculate the FV of the withdrawals, which is how much her actual account fell short
of her plan.

END mode Inputs: N = 3; 1 = 10; PV = 0; PMT = -5000.

Output: FV = $16,550.

BLUEPRINTS: SOLUTIONS Page 7

 Alternative solution:

Calculate FV of original plan.

BEGIN mode Inputs: N = 5; 1 = 10; PV = 0; PMT = -8000.

Output: FV = $53,724.88.

Calculate FV of actual deposit less withdrawals, take the difference.

Step 1: Calculate PV of actual deposit less withdrawals.

Inputs: CFo = 8000; CF, = 8000; Nj = 2; CF2 = 3000; Nj = 2; CF3 = -5000;
|= 10.
Output: NPV = $23,082.68.

Step 2: Calculate FV of PV found in Step 1.

Inputs: N = 5; 1 = 10; PV = -23082.68; PMT = 0.
Output: FV = $37,174.88.

Difference: $53,724.88 — $37,174.88 = $16,550.

6-4. Time line:

EAR =? 30 Years
0;-% 1 2 3 4 5 6 if 8 9 10 11 12 360 Mos.
ft ee ae GR A RO a) a CE Fe eee nS
PMT =-1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500 -1,500
PV = 120,000 FV=0

Financial calculator solution:

Calculate periodic rate.

Inputs: N = 360; PV = 120000; PMT = -1500; FV = 0.

Output: | = 1.235% per period.

Use interest rate conversion feature to calculate the mortgage’s EAR.

Inputs: NOM% = 1.235 x 12 = 14.82; P/YR = 12.

Output: EFF% = 15.868% ~ 15.87%.

eee

Page 8 BLUEPRINTS: SOLUTIONS

6-5. Steps:

1 He will save for 10 years, then receive payments for 25 years.

2: He wants a payment of $40,000 per year in today’s dollars for the first payment
only. Real income will decline. Inflation will be 5%. Enter N = 10, 1=5,
PV = -40000, PMT = 0, and press FV to get FV = $65,155.79.

He now has $100,000 in an account that pays 8%, annual compounding. We

need to find the FV of the $100,000 after 10 years. Enter N = 10, | = 8, PV
= -100000, PMT = 0, and press FV to get FV = $215,892.50.

. He wants to withdraw, or have payments of, $65,155.79 per year for 25 years,
with the first payment made at the beginning of the first retirement year. So, we
have a 25-year annuity due with PMT = $65,155.79, at an interest rate of 8%.
(The interest rate is 8% annually, so no adjustment is required.) Set the
calculator to BEGIN MODE, then enter N = 25, | = 8, PMT = 65155.79, FV =0,
and press PV to get PV = $751,165.35. This amount must be on hand to make
the 25 payments.

. Since the original $100,000, which grows to $215,892.50, will be available, we

must save enough to accumulate $751,165.35 — $215,892.50 = $535,272.85.

. The $535,272.85 is the FV of a 10-year ordinary annuity. The payments will be

deposited in the bank and earn 8% interest. Therefore, set the calculator to
END MODE and enter N = 10, | = 8, PV =0, FV = 535272.85, and press PMT to
find PMT = $36,949.61 ~ $36,950.

6-6. a. i

pee a.025 =e Sea.

. iINom = Stated interest = 10%.

EAR= (14/2 =
m
4

= (14222) —1
4
= 0.1038 = 10.38%.

a en SEU UIEEEEEIEN

BLUEPRINTS: SOLUTIONS Page 9

CHAPTER 7

7-1. Time line:

0 30 Years
OF we 2 1 Z 10 60 6-month periods
|_1=— #4 _________ eee —_—_—_{__—— 0°

-676.77 40 40 40 40
(becomes FV = 1,000
callable)
BV esi = 1,080

Investors would expect to earn either the YTM or the YTC, and the expected return
on the old bonds is the cost GSU would have to pay in order to sell new bonds.

Financial calculator solution:

Calculate the YTM on the old bonds.

Inputs: N = 2(30) = 60; PV = -676.77; PMT = 80/2 = 40; FV = 1000.

Output: | = 6% = kg/2. 6% is the semiannual or periodic rate.

YTM = 2(6%) = 12%.

Calculate the YTC for comparison.

Inputs: N = 2(5) = 10; PV = -676.77; PMT = 80/2 = 40; FV = 1080.

Output: | = 9.70% = k,/2.

YTC = 2(9.70%) = 19.40%.

Would investors expect the company to call the bonds? No. The company
currently pays interest of only 8% on its debt. New debt would cost GSU at least
12%. It would be foolish for the company to call the bonds, because investors
would logically expect to earn the current YTM of 12% on new bonds. So kg = 12%
is the best estimate of the nominal annual interest rate GSU would have to pay on
the new bonds.

eee

Page 10 BLUEPRINTS: SOLUTIONS

7-2. Time line:

0 1 S) 12 Years
0 ee 1 2 10 11 23 24 6-mos.

Vea=? 40 40 40 50 50 50
FV = 1,000

Financial calculator solution:

We are comparing securities with different payment patterns, semiannual and

quarterly. To properly value the student loan securities, we must match the
opportunity cost rate on the bonds with the payment period on the student loan
securities, which is semiannual. Thus, convert the quarterly (periodic) rate on the
bonds to a semiannual effective rate.
Since the bonds are selling at par value, the 9% coupon rate is also the market
rate. The semiannual periodic rate is then 9%/2 = 4.5%. There are 2 compounding
periods (quarters) in a half year.

Calculate the opportunity cost semiannual EAR of the quarterly payment bonds
(using the interest rate conversion feature).

Inputs: P/YR = 2; NOM% = 9/2 = 4.5.

Output: EFF% = 4.55% = semiannual effective rate.

Calculate the present value of the student loan package, Vg, using the semiannual
effective rate (using cash flow register).

Inputs: CFo = 0; CF, = 40; Nj = 10; CF2 = 50; N; = 13; CF3 = 1050; | = 4.55.
Output: NPV = Vg = $985.97.

7-3. Time line:

0 | 2 5 25 Years
On x... . 1 2 3 4 10 50 6-mos.
l= ¢ sree a eee ~—-|

Ve =1,230.51 60 60 60 60 60 60
Call,=5 = 1,080 FV = 1,000

Calculate the nominal yield to call.

The bonds are selling at a premium because the coupon interest rate is above the
market rate. Under the expectation of a flat yield curve, the bonds will most likely be
called so that the firm can issue new, cheaper bonds. The FV is the call price and
the period is 5 years or 10 semiannual periods.
i

BLUEPRINTS: SOLUTIONS Page 11

 Financial calculator solution:

Calculate the semiannual interest rate and convert to a nominal annual rate.

Inputs: N = 10; PV = -1230.51; PMT = 60; FV = 1080.

Output: | = 3.85% periodic rate (semiannual).

The nominal annual rate equals 2 x 3.85% = 7.70%. Thus, the before-tax cost of
debt is 7.70%.

7-4. Time line:

‘age 9) 10 15 20 Years
| Lae

214.50 today 1st call FV = 1,000

Issue | date
price Market price
= 239.39

Financial calculator solution:

Calculate the original YTM when the bonds were issued.

Inputs: N = 20; PV = -214.50; PMT = 0; FV = 1000.

Output: | = 8.0%.

Calculate the current market rate using the current market price of $239.39.

Inputs: N = 15; PV = -239.39; PMT = 0; FV = 1000.

Output: | = 10.0%.

At a current market price of $239.39, market rates are 10%. Since market rates
have risen, the bond will not likely be called. So today, at Year 5, the YTM of 10%
is the most likely annual rate of return an investor who purchases the bonds today
will earn.

eee

Page 12 BLUEPRINTS: SOLUTIONS

7-7. Time line:

0 1 9 10 Years
19 20 6-mos.
1i= 6% j Sat 18

PV=? 50 50 50 50 50
FV = 1,000

Financial calculator solution:

Calculate the PV of the bond so the current yield can then be calculated.

Inputs: N = 2 x 10 = 20; | = 12/2 = 6; PMT = 100/2 = 50; FV = 1000.

Output: PV = $885.30.

Calculate the current yield.

Interest $100
Current yield = —_—————- = —__—_ =
ye Bond value $885.30

CHAPTER 8

8-1. Step 1: Calculate required rate of return.

ke = 2% 46% = 10% + 6% = 16%.

$20

Step 2: Calculate risk-free rate.

16% =kKpre + (15% = Krr)1 De

16% =kre + 18% — 1.2kepF
0.2kKrrF = 2%
KrF = 10%.

Step 3: Calculate capital gain.

New k, = 10% + (15% — 10%)0.6 = 13%.

PP
a =
$2 $28.57.
ee 0.43=0.06

BLUEPRINTS: SOLUTIONS Page 13

 Therefore, the percentage capital gain is approximately 43%, as calculated below:

8-2. Time line:

k = 10%
0 g.=20% 1 g.=20% 2 g,=20% ° g,=a% 4 Years
Fo=2.00 €,=240. .£, =288.,. E,= 3.456. E,.= 3.7325
P, =% BD. =048 D,=0.5/6 D,-=0.6912 DB, = 1.06025

oaoeemsal
0,476 a0 1.86625
eees icy he i
0.519 141.10
70.107 ~ 11(1.10)°
3 0.10-0.08

PB, = $71,538 ~ $71.54.

Financial calculator solution:

Inputs: CFo = 0; CF, = 0.48; CF2 = 0.576; CF3 = 94.001; | = 10.

Output: NPV = P, = $71.54.

8-3. e.

Bed)» Wmkessaee
Pp
pepe
p
P, = $70.
-5. = _ Si jati _
Capital
r
_ a(Net operating )
Boe ial =BELO Veer) Depreciation expenditures working capital
= $800,000,000 + $160,000,000 — $320,000,000 — $0
= $640,000,000.

—_—
eee eeSeSSSSSSSSSSSee
Page 14 BLUEPRINTS: SOLUTIONS
 Firm value
FCF,
WACC -g
_ $640,000,000
~0.09-0.04
_ $640,000,000
0.05
= $12,800,000,000.
This is the total firm value. Now find the market value of its equity.

MV total = MVequity + MVbeot

$12,800,000,000 = MVequity + $4,800,000,000
MVeauity = $8,000,000,000.
This is the market value of all the equity. Divide by the number of shares to find the
price per share. $8,000,000,000/320,000,000 = $25.00.

CHAPTER 9

9-1. Time line:

0 1 20 Years
a 1 2 3 4 80 3-mos.
a AG et
ia
PMT = 20 20 20 20 20 20
Vp = 686.86 FV = 1,000

Financial calculator solution:

Calculate the nominal YTM of the bond.

Inputs: N = 4 x 20 = 80; PV = -686.86; PMT = 80/4 = 20; FV = 1000.

Output: | = 3.05% periodic rate = quarterly rate.

Nominal annual rate = 3.05% x 4 = 12.20%.

Calculate kg after-tax.

kg at = 12.20%(1 — T) = 12.20%(1 — 0.4) = 7.32%.

9-2. Information given:

Debt = 0.4; Equity = 0.6; Po = $28; Do = $2.20; g = 6%; F = 15%.

BLUEPRINTS: SOLUTIONS Page 15

 Use the dividend growth model! to calculate ke.

_ Do(t+9) , - $2.20(1.06) | 9 og - $2.33 + 0.06

P,(1-F) $28(1-0.15) $23.80
= 0.0980 + 0.06 = 0.1580 = 15.8%.
9-3. Step 1: Calculate the cost of common stock, ks.

ge D, ‘gs $3.00(1.10) +0.10

PS $42.50

= eae + 0.10 = 0.0776 + 0.10 = 0.1776 = 17.76%.

$42.50

Step 2: Use the target capital structure weights to calculate WACC.

WACC = 0.55(0.10)(1 - 0.35) + 0.45(17.76%) = 11.57%.

9-4. Debt = 42%; Equity = 58%; YTM = 11%; T = 40%; WACC = 10.53%.
k, =?

kg (1 -—T) = 11%(1 -— 0.4) = 6.6%.

WACC = Wekg(1 — T) + Weks

10.53% = 0.42(6.6%) + (0.58)ks
7.758% = (0.58)ks
ks = 13.38%.

CHAPTER 10

10-1. Time line:

on 2 3 4 Years

Cash flows: S_ -1,100 900 350 50 10

NPV, =? IRR, =?

Cash flows: L_ -1,100 0 300 500 850

NPV_ =? IRR, =?

eee

Page 16 BLUEPRINTS: SOLUTIONS

 Financial calculator solution:

Calculate the NPV and IRR of each project, and then select the IRR of the higher
NPV project.

Project S: Inputs: CFo = -1100; CF, = 900; CF2 = 350; CF3 = 50; CF, = 10:1 = 12.
Outputs: NPVs = $24.53; IRRs = 13.88%.

Project L: Inputs: CFo = -1100; CF, = 0; CF2 = 300; CF3 = 500; CF, = 850; | = 12.
Outputs: NPV, = $35.24; IRR, = 13.09%.

Project L has the higher NPV and its IRR = 13.09%.

10-2. Time line:

IRRx =?
IRR, =2 1 2 3 i Years
op SeraSra aa saa Se ag
CFx -100 50 40 30 10
CFz -100 10 30 40 60
CFx_z 0 40 10 -10 -50

Financial calculator solution:

Net Present Value

40 Project
Z's NPV profile

Crossover rate = 7.17%

i}
| Project
X's NPV profile
|
|
|
| Cost of Capital (%)
0 ee
IRR, = 11.79% ape = 14.49%

Calculate the IRR of each project.

Project X:

Inputs: CFo = -100; CF, = 50; CF2 = 40; CF3 = 30; CF, = 10.
Output: IRR = 14.489% = 14.49%.

nL EUEEEEEEEE ET

BLUEPRINTS: SOLUTIONS Page 17

 Project Z:

Inputs: CFo = -100; CF, = 10; CF2 = 30; CF3 = 40; CF, = 60.
Output: IRR = 11.79%.

Calculate the NPVs of the projects at k = 0 discount rate.

NPVx =0% = -$100 + $50 + $40 + $30 + $10 = $30.

NPVzx=0% = -$100 + $10 + $30 + $40 + $60 = $40.

Calculate the IRR of the residual project cash flows, i.e., Projecty-z.

IRRx_z: Inputs: CFo = 0; CF, = 40; CF2 = 10; CF3 = -10; CF, = -50.
Output: IRR = 7.167% = 7.17%.

Using the calculator we can determine that the two NPV profiles cross in the
relevant part of the NPV profile graph. Project X has the higher IRR. Project Z has
the higher NPV at k= 0. The crossover rate is 7.17%.

10-3. Time line:

0 cae 1 2 3 Years

PVofcosts
Rika ie
-2,028 1,000 1,000
ae 1,000
| a 1,160.00
1,345.60
Terminal value (TV) =3,505.60
PV of TV = 2,028
NPV =0 MIRR
=?

Step 1: Calculate the historical beta.

Regression method; Financial calculator: Different calculators have

different list entry procedures and key stroke sequences.

Enter Nulook returns as the y-list:

Inputs: Item(1) = 9 INPUT; Item(2) = 15 INPUT; Item(3) = 36 INPUT.

Enter market returns as the x-list:

Inputs: Item(1) = 6 INPUT; Item(2) = 10 INPUT; Item(3) = 24 INPUT; use
linear model.
Output: m or slope = 1.50 = historical beta.

Ne
ee ee
Page 18
BLUEPRINTS: SOLUTIONS
 Graphical/numerical method: Note that this method works precisely in
this problem because the data points lie in a straight line. If the plotted
data points don't lie in a straight line, regression is a better method.

Slope = Rise/Run = (36 — 9)/(24 — 6) = 27/18 = 1.5. Beta = 1.5.

Step 2: Calculate the cost of equity using CAPM and beta, given inputs.

Ks = Krr + (RPm)b = 7.0% + (6.0%)1.5 = 16.0%.

Step 3: Calculate MIRR.

Financial calculator solution:

Terminal value using TVM:

Inputs: N = 3; 1 = 16; PV = 0; PMT = -1000.
Output: FV = $3,505.60.

Terminal value using cash flows:

Inputs: CFo = 0; CF, = 1000; N; = 3; | = 16.
Output: NFV = $3,505.60.

Note: Some calculators do not have the Net Future Value (NFV) function.
You can still calculate the NFV or terminal value using cash flows to
calculate NPV, then TVM to calculate NFV or TV from the NPV.

Calculate NPV of cash inflows.

Inputs: CFo = 0; CF, = 1000; Nj = 3; | = 16.

Output: NPV = -$2,245.89.

Now take the NPV of $2,245.89 and bring it forward at 16% for three
periods to get the FV or terminal value.

Inputs: N = 3; 1 = 16; PV =-2245.89; PMT = 0.

Output: FV = $3,505.60.

MIRR using TVM:

Inputs: N = 3; PV = -2028; PMT = 0; FV = 3505.60.
Output: | = 20.01% = MIRR ~ 20%.

BLUEPRINTS: SOLUTIONS Page 19

CHAPTER 11

11-1. E(NPV) = 0.20(-$9,000) + 0.45($20,500) + 0.35($45,675)

= -$1,800 + $9,225 + $15,986.25
= $23,411.25.
Since the NPV numbers are in thousands of dollars, E(NPV) = $23,411,250.

onpy = [0.20(-$9,000— $23,411 25) + 0.45($20,500— $23,411 25)

+ 0.35($45,675— $23,411. 25)*|”
= [$210,097,825.31 + $3,813,919.45 + $173,486,097.42]”
= $19,682.42.

Since the NPV numbers are in thousands of dollars, onpy = $19,682,424.70.

Bee ere =adur,

$23,411,250

11-2. The net cost is $630,000:

Price ($540,000)
Modification (62,500)
Increase in NOWC (27,500)
Cash outlay for new machine ($630,000)

The operating cash flows follow:

Year 1 Year 2 Year 3

After-tax savings’ $143,000 $143,000 $143,000
Depreciation tax savings” 69,589 94,894 21691
Net cash flow $212,589 $237,894 $174,631

Notes:

'The after-tax cost savings is $220,000(1 — T) = $220,000(0.65)

= $143,000.

*The depreciation expense in each year is the depreciable basis, $602,500, times
the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3,
respectively. Depreciation expense in Years 1, 2, and 3 is $198,825, $271,125, and
$90,375. The depreciation tax savings is calculated as the tax rate (35 percent)
times the depreciation expense in each year.

Page 20 BLUEPRINTS: SOLUTIONS

 The terminal cash flow is $253,511:

Salvage value $325,000

Tax on SV* (98,989)
Return of NOWC 27,500
$293,511

BV in Year 4 = $602,500(0.07) = $42,175.

*Tax on SV = ($325,000 — $42,175)(0.35) = $98,989.

The project has an NPV of $54,202; thus, it should be accepted.

OO ai e
-630,000 212,589 237,894 174,631
253,511
428,142

With a financial calculator, input the appropriate cash flows into the cash flow
register, input | = 12, and then solve for NPV = $54,202.

CHAPTER 12

12-1. Time line:

Determine the residual cash flows by subtracting the cash flows of Project S from
Project M:
0 ‘+ 1 2 3 4 Years
—— | ae par Sake Vor ae
Project M: -700 265 265 265 209
Project S: -200 85 140 130
Project M — S: -500 180 125 135 265

Financial calculator solution:

Calculate the IRR of the residual cash flows, Projecty- s.

Inputs: CFo = -500; CF, = 180; CF2 = 125; CF3 = 135; CF4 = 265.
Output: IRR = 14.19%.

ne ee UEUttdtEddEE USES ESESsESSS nS

BLUEPRINTS: SOLUTIONS Page 21

 When each ofthe projects is evaluated at a cost of capital of 14.19%, the NPVs are
approximately equal. This is the rate at which McQueen should be indifferent
between the two projects.

Check answer by evaluating each project at a rate of 14.19%.

Project M:
Inputs: CFo = -700; CF, = 265; Nj = 4; | = 14.19.
Output: NPV = $69.14.

Project S:
Inputs: CFo = -200; CF, = 85; CF2 = 140; CF3 = 130; | = 14.19.
Output: NPV = $69.11.

12-2. Time line:

(In thousands)
JetA: 0 ies 1 Z 3 7 Years
= eee Soe

CFy =-2,000 520 520 520 520

JetB: 0 ae 1 2 3 7 8 9 14 Years

CFo
= -6,200 1,012 1,012 1,012 Ole |O12) 1012 1,012

Financial calculator solution:

Calculate NPV of single, 7-year project for Jet A.

Inputs: CFo = -2000000; CF, = 520000; Nj = 7; | = 12.

Output: NPV = $373,153.40.

Calculate NPV of single, 14-year project for Jet B.

Inputs: CFo = -6200000; CF, = 1012000; N, = 14; 1 = 12.

Output: NPV = $507,706.25.

eee

Page 22 BLUEPRINTS: SOLUTIONS

 Calculate the NPV of the 7-year project (Jet A), using replacement chain analysis.

Time line:

JetA: 0O ee 1 zZ if 8 13 14 Years

-2,000 520 520

Se
920 520 520 520
-2,000
-1,480

Inputs: CFo = -2000000; CF, = 520000; N; = 6; CF2 = -1480000; CF3 = 520000;

Ny = 7:1 = 12.
Output: NPV = $541,949.05.

By the replacement chain method, the Jet A project replicated is the higher NPV
project, and will increase the firm’s value by $541,949.05.

12-3. a. 0 1
2 3 4
10%
-13.6 6.8 6.8 6.8 6.8

NPV = $7.9551 million.

b. Wait 2 years:

2 3 4 5 6 [email protected]
10% Prob,’ 0 -15.3 sear: 3.74 3.74 3.74 -$2.8469

90% Prob. 0 0 4-19.23 7.14 7.14 7.14 7.14 6.0602

If the cash flows are only $3.74 million, the NPV of the project is negative and,
thus, would not be undertaken. The value of the option of waiting two years is
evaluated as 0.10($0) + 0.90($6.0602) = $5.4542 million.
Since the NPV of waiting two years is less than going ahead and proceeding
with the project today, it makes sense to drill today.

CHAPTER 13

13-1. b.

Fixed interest (t-T)|/Shares outstanding.

13-2. EPS, .= (Sales Variable
ald Fixed

BLUEPRINTS: SOLUTIONS Page 23

 Step 1: Calculate the amount of debt and interest expense.

Debt = 0.60 x $400,000 = $240,000.

Interest = 0.12 x $240,000 = $28,800.

Step 2: Solve for sales using the forecasted EPS.

$4.00 = [(S — 0.40S — $80,000 — $28,800)(1 — 0.40)}/10,000

$4.00 = [(0.60S — $108,800)(0.6)}/10,000
$4.00 = (0.36S — $65,280)/10,000
$105,280 = 0.36S
Sales = $292,444.44 ~ $292,445.

Alternative method:

Note that Sales - VC — FC = EBIT. Calculate net income from EPS and shares
outstanding and work back up the income statement.

EPS, = [((EBIT — Interest)(1 — T)]/Shares outstanding.

Solve for net income, then EBT, interest (step 1 above), and EBIT.

Net Income = EPS x Shares outstanding = $4.00 x 10,000 = $40,000.

EBT =NI/(1 — T) = $40,000/0.6 = $66,667.

Interest (from above) = $28,800.

EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.

Solve for sales using VC percentage, EBIT, and FC.

S = 0.40S + $95,467 + $80,000

0.6S = $175,467
S = $175,467/0.6 = $292,445.
13-3. F = $900,000; VC = $3.25/unit; P = $4.75; Qge = ?
F

Qse =
P-v
$900,000

= 600,000 units.
Si eg
Page 24 BLUEPRINTS: SOLUTIONS
13-4. Facts as given: Current capital structure: 30% D; 70% E; kre = 6%: ky — kre = 5%:
T = 40%; ks = 12%. Spe SNE AN tte EDN RI
Step 1: Determine the firm’s current beta.

Ks = kre + (Km — Krr)b

12% = 6% + (5%)b
6% = 5%b
1.2=b.

Step 2: Determine the firm’s unlevered beta, by.

by = bi/[1 + (1 —T)(D/E)]
by = 1.2/[1 + (1 — 0.4)(0.30/0.70)}
by = 1.2/1.2571
by = 0.9545.
Step 3: Determine the firm’s beta under the new capital structure.

Bi, 45%p = bu[1 + (1 — T)(D/E)]

bi. 45% = 0.9545[1 + (1 — 0.4)(0.45/0.55)]
DL, 45%D = 0.9545(1 .4909)
bt, 45%D — 1.4231.

Step 4: Determine the firm’s new cost of equity under the changed capital structure.

Ks = kre + (Km — Krr)b

ke = 6% + (5%)1.4231
ks = 13.1157% = 13.12%.

CHAPTER 14

14-1. b.

14-2. d. The dividend irrelevance theory is MM's theory. The tax preference theory says
that capital gains are preferred to dividends, while the bird-in-the-hand (G-L)
theory says that dividends are preferred to capital gains. The clientele effect
assumes that investors are attracted to a firm's particular dividend payout policy.

14-3. Calculate the amount of debt and interest expense (in millions).
Total assets = $200; 40% debt x $200 = $80 debt.

Interest expense = $80 x 0.10 = $8.

BLUEPRINTS: SOLUTIONS Page 25

 Calculate net income (in millions).

EBIT $98.0
Less: Interest 8.0
EBT $90.0
Less: Taxes (34%) 30.6
Net income 59.4

Calculate portion of projects financed with retained earnings.

Capital budget consists of $60 million in positive NPV projects.

Retained earnings portion: $60M x 0.60 = $36 million.

Debt portion: $60M x 0.40 = $24 million.

Calculate residual of earnings available for dividends.

$59.4 — $36.0 = $23.4 million in dividends.

CHAPTER 15
15-1. Time line:

0 1 2 10 Years
0 1 2 3 4 20 6-mos. periods
4.75%

-1,000,000 35,000 35,000 35,000 35,000 35,000

(today) FV = 1,000,000
PV =?

Financial calculator solution:

Calculate the market value of the bonds, Vg;, today, at t = 1, on the time line above
using the new market interest rate.

Inputs: N = 19; | = 9.5/2 = 4.75; PMT = 35000; FV = 1000000.

Output: PV = -$845,807.80; Vs, = $845,807.80.

Calculate the capital loss on the bonds.

The bonds were purchased at par for $1,000,000, but are resold 6 months later for
considerably less.

Capital loss on bonds = $1,000,000 — $845,807.80 = $154,192.20.

15-2. d.

15-3. Cc.
I EE

Page 26 BLUEPRINTS: SOLUTIONS

15-4. Construct a simplified comparative balance sheet and income statement for the
restricted and relaxed policies (in thousands):

15% of Sales 25% of Sales

Restricted Relaxed
Balance sheet accounts:
Current assets $ 60 $ 100
Fixed assets 100 100
Total assets $ 160 § 200

Debt > «80 $ 100

Equity and retained earnings 80 100
Total liabilities and equity $ 160 $ 200

Income statement accounts:

ESU $ 36.0 $ 36.0
Less: Interest (10%) 8.0 10.0
EBT $198.0 $ 26.0
Less: Taxes (40%) TAZ 10.4
Net income 16.8 15.6

Calculate ROEs under each policy.

ROE = Ni/Equity.
ROE (Restricted policy) = $16.8/$80 = 21.0%.
ROE (Relaxed policy) = $15.6/$100 = 15.6%.
Difference in ROEs = 0.21 — 0.156 = 0.054 = 5.4%.

15-5. (Account balances stated in millions)

Old With Change

Inventory conversion period:

869). 365 3657. 365
ICP = 404
—— =—— = 91.25 days
91.25 days. ICP = 40
—— =——5 = 73 y days.

10 8
Receivables conversion period (or days sales outstanding):
8 tg
DSO = 40 73 days. DSO a 40 63.875
o/ days é

365 365
Payables deferral period:
PDP = 30 days. PDP = 30 days.

CCC = 91.25 + 73 — 30 = 134.25 days. CCC = 73 + 63.875 — 30 = 106.875 days.

Change in CCC = 134.25 — 106.875 = 27.375 days.
Net change is -27.375 days (CCC is 27.375 days shorter).

ae

BLUEPRINTS: SOLUTIONS Page 27

CHAPTER 16

16-1. Financial calculator solution:

(1) Simple interest: 13.0%. EAR = 13.0%.

(2) Renewable loan: The rate on this loan is essentially a 12% nominal annual rate
with quarterly compounding. Calculate the EAR.

Inputs: NOM% = 12; P/YR = 4.

Output: EFF% = 12.55%.

(3) Trade credit: Terms 1/30, net 60.

Note that the approximate rate is really the rate per period multiplied by the
number of periods, or a nominal annual rate.

1/99 x 365/(60 — 30) = 0.0101 x 12.1667 = 12.29% approximate rate.

Calculate the EAR.

EAR = (1 + 1/99)? — 1
4.0104 )12.1667 bea
=
= 13.01 %,

The least expensive type of credit is the quarterly renewable loan at a 12.55%
effective annual rate.

16-2. d.
16-3. 20 x $750,000 = $15,000,000.

CHAPTER 17

17-1. Formula solution:

Step 1: Use the AFN formula to calculate AFN.

AFN = A*/So(AS) — L*/So(AS) — M(S1)(RR)

_ $10,000 __ $1500 :
a sticae ($5,000) Sane ($5,000) -0.14($15,000)(0.4)
= 1($5,000) — 0.15($5,000) — 0.11($15,000)(0.4)
= $5,000 — $750 — $660 = $3,590.
Step 2: Calculate the new account levels for current assets and current liabilities.

Current assets will increase by ($7,000/$10,000)($15,000) = $10,500.

SS SSSFSFSSSSSSeFeSeEeee

Page 28 BLUEPRINTS: SOLUTIONS

 The AFN will be funded using short-term debt.

Current liabilities will increase to:

A/P + Accrued liabilities = ($1,500/$10,000)($15,000) = $2,250

S-T Debt = $2,000 + $3,590 = 5,590
Total G.k: = $7,840

Step 3: Calculate the new current ratio.

New current ratio = $10,500/$7 ,840 = 1.34.

17-2. Construct a partial projected income statement and balance sheet:

Forecast
Last Year Basis® First Pass AFN _ Second Pass
EBIT $ 240,000 x1.10 $ 264,000
Interest 80,000 80,000
EBT $ 160,000 $ 184,000
Taxes (40%) 64,000 73,600
NI $_ 110,400 $ 110,400

NI avail. to common $ 96,000 $ 110,400

Divs. to common
(37,800 x $1.27) 48,006 37,800 x $1.40 52,920
Addition to RE $__ 57,480 $57,480

Total assets $1,100,000 x1.10 $1,210,000 $1,210,000

Accrued liabilities $ 13,636 0.0182 $ 15,000 $4 715,000
Long-term debt 640,000 640,000 +30,694 670,694
Equity 335,000 335,000 +20,462 355,462
RE 111,364 +57,480° 168,844 168,844
Total liab & equity $1,158,844 $1,210,000
AFN® $__51,156
Notes:
“Operating income and assets are increased by 10%. Accrued liabilities are divided by last year's
sales to determine the appropriate ratio to apply to next year's sales to calculate next year's account
balances.
’See income statement.
°AFN financing:
The shortfall will be financed in accordance with the target capital structure.
Long-term debt 0.60 x $51,156 = $30,694
Common stock 0.40 x $51,156 =_20,462
$51,156

BLUEPRINTS: SOLUTIONS Page 29

CHAPTER 18

18-1. a. Exercise value = Current price of the stock — Strike price

= $40 — $32
= $8.

b. Premium = Market price of option — Exercise value

= $13 — $8
= $5.

18-2. V =P[N(d,)] — Xe“ [N(d2)}

= $24(0.60572) — $24e?")9_ 51783)
= $14.54 — $24(0.9656)(0.51783)
= $14.54 — $12.00
= $2.54.
18-3. Futures contract settled at 88 5/32% of $100,000 contract value, so PV =
0.8815625 x $1,000 = $881.5625 x 100 bonds = $88,156.25. Using a financial
calculator, we can solve for kg as follows:

N = 40; PV = -881.5625; PMT = 30; FV = 1000; and solve for | = kg/2 = 3.5597631%.
kg = 3.5597631% x 2 = 7.1195% = 7.12%.

If interest rates decrease by % percent to 6.62%, then we would solve for PV as

follows:

N = 40; | = 6.62/2 = 3.31; PMT = 30; FV = 1000; and solve for PV = $931.8033 x
100 = $93,180.33. Thus, the contract’s value has increased from $88,156.25 to
$93,180.33.

CHAPTER 19

19-1. Today's price = 1,476,000/105 = $14,057.14.

19-2. Time line:

0 30 60 90 Days
MES
a a ae
Spotrate 1.0346 Euros/US$ 24,830 Euros
Forward rate 1.0546 Euros/US$ 1.005 Euros/US$ spot rate
90-day forward contract: $23,544.47

SseESSSSSSSSSFSFSS
— SMSMMMMMMhheheFesesesFssssesese

Page 30 BLUEPRINTS: SOLUTIONS

 Calculate the cost of the forward contract at the forward rate.

24,830 Euros/(1.0546 Euros/US$) = $23,544.47.

Calculate the cost of purchasing exchange currency at the spot rate in 90 days to
Satisfy the payable.

24,830 Euros/1.005 Euros/US$ = $24,706.47.

Calculate the savings from the forward market hedge.

$24,706.47 — $23,544.47 = $1,162.00.

19-3. Time line:

6 months
i=?

US$: -9,708.74 FV = 10,000

Spot rate: 1.42 SWF/US$ Spot rate = 1.324 SWF/US$
SWF: -13,786.41 SWF FV = 13,240 SWF

PV of T-Bill in SWF is calculated as 9,708.74 x 1.42 = 13,786.41 SWF.

FV of T-Bill in SWF is calculated as 10,000 x 1.324 = 13,240 SWF.

Financial calculator solution:

Calculate the 6-month return to the Swiss investor after she has exchanged US$ for
Swiss Francs.

Inputs: N = 1; PV = -13786.41; PMT = 0; FV = 13240.

Output: | = -3.963%. This is a 6-month periodic rate.

Annualized nominal rate of return = -3.963%(2) = -7.93%.

. Spot rate = Pp
P
f

= pee = $1.0502 per euro or _ 0.9522 euro per U.S. dollar.

856 1.0502

19-5. Convert the annual yields to quarterly yields.

kn = U.S. T-Bill (90-day): 5%/4 = 1.25%.

ky = Swiss: 3.5%/4 = 0.875%.

a TTS

BLUEPRINTS: SOLUTIONS Page 31

 Calculate the 3-month forward exchange rate.

Forwardrate 1+k,,
Spotrate 1+k,
Forwardrate 1.0125
$0.6935 1.00875
Forward rate
=.003717
$0.6935
Forward rate = $0.6961.

CHAPTER 20

20-1. Annual depreciation = $4,800,000/3 = $1,600,000.

After-tax kg = 10%(1 — 0.4) = 6%.

(In thousands) Year

0 1 2 6)
|. Cost of owning

1. Net purchase price ($4,800)

2. Maintenance cost ($240) ($240) ($240)
3. Maintenance tax savings
(Line 2 x 0.4) 96 96 96
4. Depreciation 1,600 1,600 1,600
5. Depreciation tax savings
(Line 4 x 0.4) 640 640 640
6. Net cash flow (1+2+3+5) ($4,800) 496 $496 $496
7. PV cost of owning (@6%) ($3,474.19)

ll. Cost of leasing

8. Lease payment ($2,100) ($2,100) ($2,100)

9. Lease payment tax savings 840 840 840
10. Net cash flow (8 + 9) $ 0 ($1,260) ($1,260) ($1,260)
11. PV cost of leasing (@6%) ($3,368.00)

[Il. Cost comparison

12. Net advantage to leasing (In thousands):

NAL= PV cost of owning — PV cost of leasing

= $3,474.19 — $3,368.00 = $106.19.

Page 32 BLUEPRINTS: SOLUTIONS

 Time lines (In thousands):

0 be, 1 2 3 Years
Buying:
-4,800 496 496 496
PV =?

- 1 4 3 Years
Leasing: i
-1,260 -1,260 -1,260
PV=?

Financial calculator solution (In thousands):

The correct discount rate is the after-tax cost of debt kg, ar = 10%(1 — 0.40) = 6.0%.

Calculate the NPV of both buying and leasing and determine the net advantage to
leasing (NAL).

Buying:
Inputs: CFo = -4800; CF, = 496; N| = 3; 1=6.
Output: NPV = -$3,474.19.

Leasing:
Inputs: CFo = 0; CF, = -1260; Nj = 3;1=6.
Output: NPV = -$3,368.00.

NAL = $3,474.19 — $3,368.00 = $106.19. (Calculation is in thousands.)

20-2. Time line:

nee 1 2 a 4 5 20 Years
pee
—__4___}____}_____}___
4 ,,,
Bo=? 90 90 90 90 90 90
B5=? FV = 1,000
C5=?

Financial calculator solution:

Calculate the pure-bond value, B, at Year 5. Since no assumption is made

concerning future interest rates, the 12% required return on nonconvertible bonds is
the appropriate rate.

Inputs: N = 15; 1 = 12; PMT = 90; FV = 1000.

Output: PV = -$795.67; Vg = $795.67.

BLUEPRINTS: SOLUTIONS Page 33

 Calculate the conversion value, Ci, at Year 5.

Conversion value = Cs = Po(1 + g)\(CR) = $18.75(1.07)°(40) = $1,051.91.

Inputs: N = 5; 1 = 7; PV = 18.75(40) = -750; PMT = 0.
Output: FV = $1,051.91.

The expected pure bond value at Year 5, Bs = $795.67.

The expected conversion value at Year 5, Cs = $1,051.91.

20-3. Time line:

0 ae 1 Z 10 11 20 Years

Bo=? 100 100 100 100 100

PV = 1,000 becomes FV = 1,000
callable
Cio =?

Financial calculator solution:

Calculate the expected stock price at Year 10, P.,

Inputs: N = 10; | = 6; PV =-27.83; PMT = 0.

Output: FV = $49.84.

Calculate the conversion value, C;, at Year 10.

Information given: Po = 27.83; g = 6; t= 10; CR = 25.

Conversion value, C19 = $27.83(1.06)'°(CR)

= $49.84(25) = $1,245.98 ~ $1,246.
Calculate the expected return using the expected conversion value at Year 10, Cio.

Inputs: N = 10; PV = -1000; PMT = 100; FV = 1246.

Output: | = 11.44%.

SSeS

Page 34 BLUEPRINTS: SOLUTIONS

CHAPTER 21
21-1. Determine the capital structure of the merged firm (In millions).

Capital
ace ae ncaa Structure
iclean ustvac ombined Firm _Weights
Debt 0.4($24) = $ 9.6 0.5($10) = $ 5.0 $14.6 0.43
Equity 0.6(824) = Sth4 0.5($10)=$ 5.0 ra O:57
Total 24.0 10.0 34.0 1.00

Calculate the WACC.

WACC = 0.43(10%)(1 — 0.4) + 0.57(0.1259) = 0.0258 + 0.0718

= 0.0976 = 9.76%.

21-2. Calculate the weighted average beta using the relative capital weights of the two
firms (In millions).

Magiclean Dustvac Combined Firm

Total assets $24.0 $10.0 $34.0
Weight $24/$34 = 0.706 $10/$34 = 0.294 120
Beta 1.02 1.36 leat

Betanew Fim = 0.706(1.02) + 0.294(1.36) = 0.720 + 0.40 = 1.12.

21-3. The net cash flows from Dustvac are equity cash flows. Magiclean should discount
them with Dustvac's cost of equity, assuming that the merger will not significantly
alter Dustvac's risk, which is stated in the problem. We can estimate its cost of
equity using the Security Market Line (CAPM) and Dustvac's pre-merger beta.

Ks(Dustvac) = Ker ae (Ku = Krr)Betapremerger = 0.06 + (5.88%)1 .36 = 14.0%.

21-4. Time line (In millions):

0 44% 1 2 3 ; Years

-15.5 4.0 4.0 4.0 19.0

NPV =?

Acquisition price for Dustvac = 1.55($10,000,000) = $15,500,000.

Financial calculator solution:

Inputs: CFo = -15500000; CF, = 4000000; Nj = 3; CF2 = 19000000; | = 14.

Output: NPV = $5,036,053.

Since the NPV is positive, Magiclean should proceed with the acquisition.
a

BLUEPRINTS: SOLUTIONS Page 35

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ISBN O-324-25928-X

THOMSON Join us on the Internet 90000

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