Problems and Questions

1. Most utilities in the United States are regulated monopolies. Why are they regulated? What are the implications of removing the regulations for excess returns?

2. Assume that you are the leading manufacturer of industrial chemicals, and that there is a long lead time for a new entrant to become an established competitor. You have a decided advantage over your existing competitors in terms of access to funds. What is your differential advantage and how will it manifest itself in project analysis? What are some of the ways in which you might lose this differential advantage?

3. You are a private firm in the environmental waste disposal industry in which the rest of your competitors are publicly traded. What, if any, differential advantages would you have over your competitors? What, if any, are they differential advantages they would have over you?

4. In the early 1980s, Lotus Corporation introduced Lotus 1-2-3 and dominated the spreadsheet market. In the late 1980s, as Lotus failed to introduce newer versions of its program, Microsoft stepped in and offered its version, Excel, and took away a significant portion of Lotusís market share.

a. What was the differential advantage that Lotus offered in the early 1980s that allowed them to dominate and profit from this market?

b. What was the differential advantage that Microsoft offered that allowed them to overtake Lotus?

c. Assume that you are advising a small software firm that plans to offer its own spreadsheet program. What differential advantages can a product from such a firm offer?

5. The pharmaceutical firms in the United States have historically been able to maintain high returns on equity and earn surplus returns. It has been argued by many that this is due to the protection that the patent system offers them against competition.

a. Why would patents lead to higher returns on equity and capital?

b. Assume that a law is passed weakening patent protection against competition. What implications would this law have for the profitabity of pharmaceutical firms?

c. In the absence of patent protection, what differential advantages would a pharmaceutical firm have over its competitors? What types of firms are likely to succeed under this scenario?

6. In the consumer product sector, brand names have traditionally allowed a firm to charge higher prices and have much larger profit margins.

a. In a project analysis, how does the effect of a brand name show up in the estimates?

b. What are the implications of declining brand name loyalty for the capacity of a consumer product firm, like Procter and Gamble or Unilever, to maintain high returns on their projects?

7. Assume that a friend of yours, who has substantial technical experience in computers, is considering starting a firm to manufacture personal computers and has lined up investors who are willing to back her up. She has come to you for advice on how to make this venture succeed.

a. Outline the potential differential advantages in the personal computer market.

b. Specify what you would need to do to achieve these differential advantages,

c. What path would you suggest offers the greatest chance for success for a small firm, with significant technical expertise?

8. In 1995, Iomega, a small firm manufacturing disk storage systems for personal computers, introduced a new product called the Zip Drive. The Zip drive, which was priced at around $ 200, allowed computer users to store up to 100 MB of data on small disks, and access the data easily. The demand for the Zip drive surged ahead of the supply, and the company reported a surge in profits and an increase in the stock price.

a. Given that the Zip drive had no patent protection, what would you expect to happen in the market over the months following its introduction?

b. If you were an analyst looking at Iomega as a firm, would you expect the surge in profitability to continue into the future? Why or why not?

9. In one of great business success stories of the twentieth century, Ray Kroc bought the rights to a hamburger chain in the late 1950s and converted it into a chain of hundreds of franchises in the United States and abroad. As one of the first fast-food chains with standardized menus and food, McDonaldís clearly succeeded in meeting a need and profiting from it.

a. To what factors would you attribute the early success of McDonaldís? What differential advantage did it offer that allowed it to be profitable?

b. Given that there is far more competition from other fast-food chains now, what differential advantages does McDonaldís have looking forward? How can it exploit these advantages?

9. Firms spend large amounts of money on advertising to increase brand name awareness and value. How would you measure the payoff to advertising in terms of project characteristics?

10. Assume that you are analyzing a 5-year project for a manfacturing firm after its completion. The following table summarizes the original forecasts and the actual cash flows over each of the 5 years ñ
Forecasted CF
Actual CF

a. Estimate the internal rate of return on the project, based on the initial forecasts of cash flows.

b. Estimate the actual rate of return on the project.

c. Assuming that the cost of capital is 12%, did the project add value to the firm during the period of the analysis.

11. Assume that you are analyzing a 10-year project, for a consumer product company, 5 years into the project and that you have the following information on the project.
$ 2.00
$ 2.40
$ 2.10
$ 2.40
Cash Flow
Cash Flow
$ (10.50)
$ (10.00)
$ 1.50
$ 3.00
$ 1.60
$ 3.10
$ 1.60
$ 2.80
$ 1.65
$ 2.85
$ 1.70
$ 2.60
$ 1.75
$ 2.65
$ 1.80
$ 2.40
$ 1.85
$ 2.45
$ 1.90
$ 2.40
$ 2.00
$ 2.50

a. Assuming that the cost of capital was 11% at the time of the initial analysis, would you have taken this project?

b. Estimate the forecast error, by year, for the 5 years the project has been in existence.

c. Estimate the accounting and cash flow returns earned by this project during the 5 years of its existence.

d. Based on these forecast errors, reestimate the cash flows you will have on the remaining 5 years of the project.

e. Estimate the net present value of continuing this project, assuming that the cost of capital is now 12%.

12. Assume that you are analyzing the performance of two companies, one a computer software firm and the other a automobile manufacturer, in picking projects. You have collected the following information on the two companies:

Company Actual ROE Beta ROE of Peer Group Forecasted ROE

Software Firm 20.5% 1.2 16% 22.0%

Auto Firm 12.5% 1.4 10% 10.5%

The treasury bond rate is 7%. Evaluate the performance of each of these companies relative to

a. the required rate of return

b. the return on equity of the peer group

c. the forecasted return on equity

What conclusions would you draw about the investment choices made by these firms.

13. The following table summarizes net income and average book value of equity each year for The Gap between 1991 and 1995:

Year Net Income Average BV of Equity

1991 $ 230 million $ 576 million

1992 $ 211 million $ 773 million

1993 $ 258 million $ 1,001 million

1994 $ 320 million $ 1260 million

1995 $ 343 million $ 1480 million

a. If the firm had a beta of 1.45 during the period, how would you evaluate the quality of The Gapís investments during the period?

b. Is the trend in return on equity a relevant factor to consider in the analysis?

c. If the market had been anticipating that The Gap would earn a return on equity of 28%, would your conclusions change?

d. Would your conclusions be affected by the fact that all specialty retailers reported declines of 5% or greater in return on equity during the period?

14. The following table summarizes returns on equity and betas at major automobile firms in 1995.

Firm Return on Equity - 1995 Beta

Chrsyler 14.0% 1.20

Ford Motor 16.0% 1.10

General Motors 11.5% 1.15

a. Estimate the differential between return on equity and cost of equity in 1995.

b. What conclusions would you draw about project choice at these companies in 1995?

c. What concerns would you have about using this approach to measure project quality?

15. Cooper Tire, the ninth largest tire manufacturer in the world in 1995 reported earnings before interest and taxes of $ 175 million. It had a book value of equity of $ 750 million (market value of equity was $ 2.4 billion) and debt outstanding of $ 38 million in 1995. The beta for the stock was 1.25, while the pre-tax cost of debt was 8%. Evaluate whether the returns that Cooper made on its projects earned surplus returns during 1995.

16. Kollmorgen Corporation, a diversified technology company in motion technologies and electro optical instruments, is evaluating what might have gone wrong in an investment that they made ten years ago in photo research. The original forecasts of cash flows, made when the project was taken, and the actual cash flows on the project are summarized below.

Year Forecasted CF Actual CF

1986 - 1,500 -2,200

1987 +100 -150

1988 + 150 + 50

1989 + 200 + 100

1990 + 250 + 150

1991 + 275 + 100

1992 + 300 + 175

1993 + 325 + 200

1994 + 350 + 200

1995 + 350 + 175

a. Estimate the net present value of the project, using the original forecasted cash flows and a discount rate of 12%.

b. Estimate the net present value of the project, using the actual cash flows and a discount rate of 11.5%.

c. You have a choice of continuing the project now or abandoning it. If cash flows are expected to remain at 1995 levels in perpetuity and the assets invested in the project have a salvage value of $ 1,000, would you continue the project? Why or why not?

17. Folly Industries, a consumer product firm in cosmetics and appliances, is in serious fiscal trouble and is unable to meet its debt obligations. It is considering whether to divest itself of its cosmetic division, and the division is projected to have the following expected cash flows for the next five years.

Year Expected Cash Flow

1 $ 10 million

2 $ 12.5 million

3 $ 15 million

4 $ 17.5 million

5 $ 120 million

The cost of capital for the division is 12.5%.

a. How much is the division worth to Folly Industries?

b. If there is an offer of $ 150 million for this division, should they accept it?