CC 2.1: Managers involved in making acquisitions often argue that the immediate response of stockholders to acquisition announcements is flawed because stockholders do not have the information to make this judgment. Do you agree?
Answer: While it is true that managers have substantially more information than stockholders, they tend to be more biased and less objective than stockholders. This bias affects the judgment of managers and can lead them to make poor acquisition decisions.
CC 2.2: If you are convinced that financial markets are not efficient, do you have to abandon the objective of value maximization? Why or why not?
Answer: If financial markets are not efficient, then we may not be able to justify the objective function of maximizing stock prices. However, we can still focus on maximization of stockholder wealth or firm value.
CC 2.3: Corporate governance is best left to managers, since they are much more likely to think about the long term than stockholders. Comment.
Answer: While there are stockholders who have short time horizons, the same can be said about some managers. In fact, it is unfair to argue that stockholders are always more short term in their demands than managers. The evidence (some of which is cited in the text) is that stockholders are often willing to accept lower earnings and cash flows in the near term for higher growth in the long term.
CC 2.4: The interests of institutional investors and individual investors may sometimes diverge. Can you think of a scenario where the two groups might have conflicting interests?
Answer: Institutional investors may have more information than individual investors, and their tax status can be very different. These differences may cause conflicts of interests between these two groups of investors. Consider the scenario, where pension funds and individual investors both hold stock in a firm, which is considering returning the cash in the form of dividends. Pension funds, which are tax exempt, may want the dividends paid, and individual investors might not
CC 2.5: Many emerging financial markets are characterized by the absence of good information about firms, thin trading and extreme volatility. What are the consequences for value maximization in these markets? What about stock price maximization?
Answer: In emerging markets that are not very efficient, stock price maximization may not be the right objective for firms. Value maximization, however, does not require assumptions about market efficiency and still is the correct objective.
CC 3.1: In computing the future value of $ 50,000 in the example above, we assumed that interest earned was allowed to remain in the account and earn more interest. What would the future value be if you intended to withdraw all the interest income from the account each year?
Answer: The account will have $ 50,000 at the end of the period. If we count the interest income, we would make $ 3,000 in interest income each year from the account, resulting in a total of $ 80,000. (The difference of $9,542 is the compounding effect)
CC 3.2: How much would you need to save each year for the next 40 years to arrive at a future value of $ 400,000 if you saved at the beginning of each year instead of the end?
Answer: You would need to save less. In fact, it will be $1,544 discounted back one year at 8%, which would be equal to $1,430.
CC 3.3: Assume that you run the lottery and you want to ensure that 50% of ticket revenues go towards education, while preserving the nominal prizes at $40 million. How much can you afford to pay out each year, assuming a discount rate of 10%?
Answer: The present value of the payments over the next 30 years has to be equal $20 million (50% of $ 40 million). There are a number of possible combinations that will provide this present value. For instance, paying $ 1 million a year for the next 14 years, and $ 1.625 million a year for the following 16 years, will yield a nominal value of $ 40 million and a present value of $ 20 million.
CC 3.4: If both the growth rate and the discount rate increase by 1%, will the present value of the gold to be extracted from this mine increase or decrease? Why?
Answer: The present value of the gold to be extracted from the mine would increase to $16,229,046. The present value effect (of a higher discount rate) is dominated by the growth effect ( of a higher growth rate), but only because r<g. If r were greater than g, the present value effect would have dominated. (Try it out and think of the implications of higher inflation for the stock prices of high growth versus low growth companies.)
CC 4.1: What factors might cause the market value of an asset to deviate dramatically from its book value?
Answer: The market value of an asset in the secondary market is determined by the interaction of supply and demand, while the book value of an asset is determined by its purchase price and depreciation method used. To the extent that the market price reflects the earning power of assets, assets that are earning positive excess returns will have higher market values than book value. Assets that have seen a deterioration of earning power will have book values that exceed market value.
CC 4.2: Assume that all of the debt on your books was borrowed three years ago, when the treasury bond rate was 7% and you were borrowing at 7.5%. If the treasury bond rate today is 6%, and you are a riskier firm than you used to be, will the market value of your debt be greater than or less than your book value? Explain.
Answer: It depends upon whether the increase in default risk (and the resulting increase in the default spread) offsets the lower level of interest rates. If the market interest rate on the bond today is less than 7.5%, the market value will exceed book value. This will be the case if the default spread is less than 1.5%.
CC 4.3: A number of different definitions of return on assets exist. One measure divides the net income by the total assets. What are the problems with this measure, and what types of firms are likely to have low returns on assets, using this measure?
Answer: The net income is a measure of equity income and is thus after interest expenses. The book value of assets includes both debt and equity. Consequently, firms with high leverage will have low returns on assets, but the low return is not a measure of project quality. It would be far more consistent to use operating income to compute return on assets, or to divide net income by the book value of equity.
CC 4.4: Two firms in the same business can arrive at similar returns on equity, one by taking great projects (high ROC) and the other by taking high leverage on average projects. Is there a qualitative difference between the two firms? Which ROE is of higher quality? Why?
Answer: Yes. The firm that earns a high return on equity by using debt will be riskier than the firm that earns a high return on equity by investing in great projects. The second firm will be worth more than the first firm, and can be viewed as having a higher quality return on equity.
CC 4.5: A standard approach to analyzing the debt ratio of a firm is to compare it to the debt ratios of firms in its peer group, using book value debt ratios. Which firms are likely to underutilize their debt capacities, using this approach, and why? Which are likely to overutilize debt and why?
Answer: Those firms that have high-quality assets, earning high returns and generating high cash flows, will look like they are overutlilizing debt. This is because they will borrow based upon their cash flow generating potential, and the book value will not reflect this potential. Firms with poor quality or low cashflow generating assets will look like they are underutilizing their debt capacities.
CC 5.1: This bond trades at above its face value of $1,000 and has a yield to maturity below the coupon rate. What would the yield to maturity on this bond have to be for the bond to trade at par?
Answer: The yield to maturity would have to be equal to the bond’s coupon rate.
CC 5.2: Assume now that Boeing is viewed as a riskier firm, and that its’ rating drops. If the market interest rate increases to 8.75%, estimate how much you would lose as the holder of this bond.
Answer: If the interest rate climbs to 8.75%, the bond will be trading at par, which will be a loss of $ 404 per bond.
CC 5.3: If the stock is actually trading at $ 45, estimate the growth rate the market expects in Con Ed’s dividends.
Answer: $ 45 = $2.12 (1+g) / (.094 - g)
Solving for g,
Growth rate = 4.48%
CC 5.4: Would Coca Cola’s value per share be halved if the period of high growth is 5 years instead of 10 (the growth rate remains 25%)?
Answer: No. The change will not be linear. Part of the reason for this is present value - the value of growth in future years is not the same as the value of growth in earlier years. The other is the terminal value, which will also change as the growth period is shortened. In the case of Coca Cola, the value per share will drop to $ 31.49.
CC 5.5: Draw the payoff diagram on a put option on Boeing with an exercise price of $ 35.
Answer:
CC 5.6: In an efficient market, would you expect stock prices to go up when firms announce good news. Why or why not?
Answer: No. It depends upon whether the announcement was anticipated or not. If it was anticipated, the good news will have no effect on stock prices. If it was not, it will have a positive effect. In fact, if it is good news, but not as good as expected, the stock price can drop.
CC 6.1: Assume that you had to pick between two investments. They have the same expected return of 15% and the same standard deviation of 25%; however, investment A offers a small possibility that you could quadruple your money, while investment B’s highest possible payoff is a 60% return. Would you prefer one investment over the other? If so, which one would you pick?
Answer: There is no right answer to this question, since it will depend upon the nature of your preferences. Given what we know about people, though, many would prefer investment A over investment B because of the potential for a high payoff. This preference for skewness can be a problem in a mean-variance framework. In a mean-variance world, we should all be indifferent between the two investments.
CC 6.2: Is the minimum variance portfolio the best portfolio to hold for all investors? Why or why not?
Answer: Not necessarily. The minimum variance portfolio would be the best portfolio for a very risk-averse investor to hold in a world with only risky assets. For investors who want to bear higher risk (and earn higher expected returns), it is not the right choice.
CC 6.3: The marginal benefits of diversification calculated in the example above are based upon random additions to the portfolio. If you followed a more deliberate strategy, such as picking stocks with low price/earnings ratios, would you need more or fewer stocks to get an equivalent amount of diversification?
Answer: More deliberate strategies generally result in less diversified portfolios. Picking stocks with low price earnings ratios may yield a portfolio with too many utilities and mature, manufacturing firms, relative to diversified portfolio. Consequently, you would need more stocks to get an equivalent amount of diversification.
CC 6.4: The CAPM implies that the most efficient way to take risk is to borrow money and invest it in the market portfolio. Why is this more efficient than just investing in a portfolio of the "riskiest stocks" in the market?
Answer: Investing in the riskiest stocks in the market results in a portfolio that is not fully diversified. Consequently, the portfolio's variance include some that could have been diversified away. In contrast, borrowing money and buying the market portfolio results in a portfolio with no diversifiable risk.
CC 6.5: Can an investment have a negative beta? What does this mean in terms of market risk? What kind of return would you expect to make on this investment, in the long term (relative to the riskless rate)?
Answer: Yes. Investments can have negative betas. These investments, when added to a market portfolio, actually reduce the risk of the overall portfolio. They act as insurance against certain kinds of risk. (An example would be gold and real assets, which hedge against inflation risk.) An investment with a negative beta will have an expected return that is less than the riskless rate.
CC 7.1: Assume that stocks are the only risky assets and that you are offered two investment options. One is a riskless investment on which you can make 6.7%, and the other is a stock mutual fund. How much more than 6.7% would you need to be offered, on an expected basis, to pick the latter? Would you ever settle for less than 6.7%?
Answer: The answer will depend upon your risk aversion. More risk averse individuals will want a much higher premium. Less risk averse individuals will settle for a smaller premium. No rational individual should settle for an expected return that is less than the riskless rate. (The actual returns may be lower but not the expected return)
CC 7.2: Assume that the implied premium in the market is 3%, and that you are using a historical premium of 7.5%. If you valued stocks using this historical premium, are you likely to find more under or over valued stocks? Why?
Answer: The higher premium would result in a higher discount rate which in turn would produce lower values for all stocks. Consequently, you will find more stocks to be overvalued using the historical premium.
CC 7.3: Assume that, after we have done the regression analysis, both Boeing and Biogen, a biotechnology company, have betas of 0.96. Boeing, however, has an R-squared of 30%, while Biogen has an R-squared of only 10%. If you were a well diversified investor, which of these two stocks would you prefer for your portfolio? If you were not well diversified, which of these two stocks would you prefer?
Answer: If you were a well diversified investor, you would not care since the diversifiable risk would be eliminated in your portfolio anyway. (Thus, the fact that Biogen has more diversfiable risk than Boeing becomes irrelevant.) If you were not well diversified, you would want to minimize your exposure to diversifiable risk, and you would therefore choose Boeing.
CC 7.4: Polo Ralph Lauren, the noted fashion design house, went public in 1997. Based upon what you know about the firm’s products, would you expect its beta to be higher or lower than one?
Answer: Ralph Lauren produces high-priced, discretionary products. I would expect it to have a beta higher than one.
CC 7.5: Assume that Boeing had borrowed the funds ($12,555 million) needed for this acquisition. Estimate Boeing's beta after the transaction.
Answer: Boeing's beta would be much higher. While the unlevered beta of the combined firm will remain unchanged, the debt to equity ratio after the transaction will be higher:
Beta = 0.86 (1 + (1-.35) [(2143+3980+12555)/32438]) = 1.18
CC 7.6: It is often argued that debt becomes a more attractive mode of financing than equity as interest rates go down, and a less attractive mode when interest rates go up. Is this true? Why or why not?
Answer: This is not true. As interest rates increase and decrease, both the cost of debt and cost of equity increase and decrease. Since it is the relative cost that matters, there is no reason why debt should become the more or less attractive option.
CC 8.1: Based upon our discussion of market risk, what characteristics would you look for in a comparable firm? Should we require firms to be in the same business, have the same cost structure or both? Why?
Answer: A comparable firm will have products that are of similar discretionary nature to its' customers, a similar operating leverage and a similar debt to equity ratio. Comparable firms do not have to be in the same business. They do not even need to have the same cost structure or financial leverage, if you can unlever betas and control for differences. If you do not want to control for differences, it is safest to pick firms with similar operating and financial leverage, operating in the same business.
CC 8.2: In estimating the beta for a division, when might we choose not to use the debt to equity ratio for the firm and why?
Answer: If the firm borrows money for the project, and the project is similar in characteristics to other projects that the firm has on its books, you would use the debt to equity ratio for the firm. If the project is very different from the rest of the firm in terms of its risk and cash flow characteristics, and borrows its own funds, you would use the project's debt to equity ratio.
CC 8.3: What measure of earnings would you use to estimate an accounting beta for equity? Why?
Answer: You would use net income to estimate the equity beta, and operating income to estimate the unlevered or asset beta. Net income is income to equity investors, while operating income is income to all claimholders in the firm.
CC 9.1: On what type of projects is historical experience likely to be most useful in making predictions of expected revenues and income? On what types is it least likely to be useful?
Answer: Historical experience is most useful when a firm has done similar projects before. It is least useful for first-time or unique projects or entry into new markets.
CC 9.2: The marginal tax rate, for most firms, is higher than the effective tax rate. Why do we use the marginal tax rate to assess the after-tax income on projects?
Answer: Because interest expenses are deducted from your last dollar of income, rather than the average dollar, the taxes you save are on the last dollar of income (which is the marginal tax rate).
CC 9.3: If the earnings for a firm are positive, the cash flows will also be positive. Is this statement true? If not, why not?
Answer: No. Cash flows are after reinvestment needs. Thus, if a firm has large capital expenditures or working capital investments, its cash flows can be negative, even though its earnings might be positive.
CC 9.4: Firms in the United States often maintain two sets of books, one for tax purposes and one for reporting purposes. Since firms like to report higher income to their stockholders and pay lower taxes, what depreciation methods would you expect to see in each set of books?
Answer: You would expect to see accelerated depreciation in the tax books, and straight line depreciation in the reporting books.
CC 10.1: The Boeing Super Jumbo jet project was analyzed using accelerated depreciation. Assume that you switched to straight line depreciation. What effect would that switch have on the return on capital? On the cash return on capital?
Answer: Switching to straight line depreciation would increase the reported income in the earlier years and reduce the reported income in later years. It would also cause the book value of capital (equity) to drop much more quickly in the earlier years. The net effect would be an increase in the return on capital. The cash return on capital will also be affected by the change in the denominator, but there would be no effect on the cash income. Thus, while the cash return on capital will also increase, it will not increase by as much.
CC 10.2: Assume that you have analyzed a $100 million investment in a new online venture, using a cost of capital of 15%, and come up with a net present value of $ 1 million. The manager who has to decide on the project argues that this is too small a NPV for a project of this size, and that it indicates a "poor" project. Is this true?
Answer: This is not true. The net present value is surplus value, i.e., it is over an above the cost of capital. This project is making 15% plus a net present value of $ 1 million.
CC 10.3: In illustration 10.9, assume that you had been asked to use one discount rate for all of the cash flows. Is there a discount rate that would yield the same NPV as the one above? If yes, how would you interpret this discount rate?
Answer: Yes. This discount rate will be geometric average of the discount rates over time. This geometric average discount rate can be compared to the geometric average return over the project's life.
CC 10.4: Why is it more reasonable to assume, as the NPV rule does, that the intermediate cash flows are reinvested at the cost of equity or capital rather than the internal rate of return?
Answer: The cost of capital is the rate of return that you can make, in the market, on investments of equivalent risk. Since such investments exist in abundance, it is amore reasonable assumption to make.
CC 11.1: Currencies such as the Mexican Peso, the Brazilian Real and the Russian Ruble have depreciated dramatically over the last few years against the U.S. dollar. To what would you attribute this depreciation?
Answer: While one can point the finger at political risk or economic turmoil, the single biggest culprit in large devaluations is inflation. Mexico, Brazil and Russia have all had bouts of high inflation that have caused their currencies to lose value, relative to currencies from countries with lower and more stable inflation.
CC 11.2: Suppose you have a choice between investing in a democracy, in which political power can shift quickly from one political party to another, with unpredictable effects on policy, and a dictatorship, in which the existing regime promises you stable policy. Which one has more political risk? Which one would you choose? Why?
Answer: I think that the discontinuous shifts that occur in dictatorships are much more difficult to hedge against and plan for than the more continuous shifts that occur in democracies. At any point in time, though, dictatorships can look more stable and less risky than democracies.
CC 11.3: Would your conclusions have been different if you felt that the Chilean peso were undervalued today? Why or why not?
Answer: Yes. It would make the investment more attractive. As the peso strengthens to its normal level, I would expect to benefit from my Chilean investment. (This is based on the assumption that my feeling has a basis in reality)
CC 11.4: Assume that you have invested in a project in Brazil, and that you expect the Brazilian real to depreciate 8% a year for the next 10 years. Why is this expected depreciation not a source of risk for the project? If it is not the source of risk, what is the exchange rate risk?
Answer: It is not because the expected cash flows will already reflect the depreciation in the currency. The real risk arises from the fact that the actual depreciation can be much greater (which would be a negative) or much smaller (which would be a positive) than anticipated.
CC 12.1: When comparing mutually exclusive projects with different risk levels and discount rates, what discount rate should we use to discount the differential cash flows? Explain your answer.
Answer: This is a trick question. You cannot discount differential cash flows between two projects, if the projects have different risk levels. You would have to discount each cash flow stream separately, at its own discount rate, and compare the present values.
CC 12.2: Assume that the cost of the third-party storage option will increase 3% a year forever. Compute the equivalent annual cost of that option.
Answer: NPV = 2 (1.03)/(.10 - .03) = $ 29.43 mil; EAC = $ 29.43 (.1) = $ 2.94 mil.
CC 12.3: Assume, in illustration 12.8, that the initial investment required for project B were $40 million. How would that change your analysis? If it would, how and what is the best combination of projects?
Answer: Accepting the projects in the order of profitability index would lead to an investment of $ 80 million, and excess cash of $ 20 million. We would have to find the combination of projects that yields the highest cumulative net present value, by trial and error. (A, B and G creates the highest combined net present value)
CC 12.4: A colleague argues that resources a firm owns already should not be considered in investment analysis, because the cost is a sunk cost. Do you agree? How would you reconcile the competing arguments of sunk and opportunity costs?
Answer: He is right about the original investment in the asset. That is why we do not consider the book value of resources owned by a firm to be an opportunity cost. We do, however, consider the present value of expected cash flows in the future. These cash flows are incremental and should be attributed to the project.
CC 12.5: Of the two options —— cutting back on sales and building new capacity —— which one would become relatively more attractive if the project life for Cinnamon Bran were increased?
Answer: As the project life extends, building new capacity will become the more attractive alternative. In the cost comparison, the cost of new capacity is unaffected by extending project life, but the cost of sales foregone will increase as project life increases.
CC 13.1: What are the sources of economies of scale in working capital management?
Answer: There are several potential economies of scale. There are fixed costs associated with managing inventory or collecting on accounts receivable. As these items increase, the costs will decrease as a percent of revenues. Firms may also be able to diversify their risks more when they grant more credit to more customers, and to keep lower inventories as their revenues increase.
CC 13.2: In the above example, how would your answer change if changing working capital did not affect discount rates?
Answer: If the cost of capital did not decrease as working capital increased, the optimal working capital ratio will be lower (The benefits of lowering working capital would be unaffected, but the costs would be lower).
CC 13.3: Estimate the average inventory as a function of the carrying cost and the ordering cost. As interest rates increase, what will be the effect be on optimal average inventory?
Answer: When interest rates increase, the carrying cost (for inventory) will increase. This will make the optimal order quantity and the optimal inventory lower.
CC 13.4: As long as the firm charges a higher interest rate on credit sales than its cost of capital, the firm value will increase with credit sales. Do you agree? Why or why not?
Answer: No necessarily. The sales might come with a very high risk of default by customers. The cost of bad debts can result in lower firm value.
CC 14.1: As the variance in cash balances increases, what would you anticipate happening to the upper and lower bounds in this model?
Answer: As the variance in cash balances increases, the upper bound will become higher and the lower bound lower still. The spread will widen.
CC 14.2: The returns on investments shown in figure 14.2 are at a point in time. Would you expect the differences in returns between these investments to change as the level of interest rates rise? Why or why not?
Answer: Probably. The most likely scenario is that the spreads will widen as interest rates increase. While the empirical evidence for this is weak in the United States, interest rates have generally moved within a fairly narrow range in the U.S. In countries where interest rates have risen much more dramatically, we see the spreads on riskier investments increasing with rates.
CC 14.3: Assume that you are analyzing a firm with very large investments in the equity of other firms, relative to the rest of the firms in the industry. How would you determine whether these investments were creating or destroying value for the firm?
Answer: You could compute the excess returns earned by the firm relative to the overall market. You could then compute the excess returns earned by the sector (the rest of the firms in the industry) relative to the overall market. The difference between the two excess returns can then be attributed to the investments made by this firm in other firms. (This test does assume that everything else about these firms is the same)
CC 15.1: You are analyzing a firm that has made extraordinary returns on its projects over the last 10 years, largely as a consequence of a few products that are patent protected. You know that the patent protection will end in 2 years. How will that affect future returns for the firm?
Answer: I would expect excess returns to start declining as the patent protection ends but not disappear immediately. The firm will still retain some brand name advantages that allow it to charge higher prices than generic substitutes.
CC 15.2: Given a choice between acquiring a publicly traded or a private firm, where would you suppose the odds of success (in terms of eventual returns to the acquiring company) would be greater? Why?
Answer: I would expect my odds of success to be higher with a private firm, since I do not have to pay a premium on top of a market price, which may already reflect many of the advantages of the acquisition.
CC 15.3: You are comparing two companies. The first is a manufacturing company that makes only two or three large investments each year. The second is a service company that makes dozens of smaller investments each year. Which of these two companies should worry more about estimation error and why?
Answer: The first company should worry more about estimation error, especially if it is closely held or a private business. The fact that it makes only two or three investments a year implies that estimation errors will not average out easily.
CC 15.4: An optimistic bias is dangerous because it encourages firms to take bad projects. By contrast, a pessimistic bias, where cash flows are underestimated, is beneficial because it provides a way to be more conservative in investment analyses. Do you agree or disagree with this statement? Why?
Answer: I disagree. When a firm rejects good investments, it also rejects the value that would have been created by these investments. Unless the firm has a capital rationing constraint, this is not conducive to value maximization.
CC 16.1: Venture capitalists often make investments in several private companies in one business. How would this lack of diversification affect the way in which venture capitalists evaluate their investments?
Answer: The lack of diversification will imply that venture capitalists will want to be rewarded for taking on diversifiable risk. This will lead to higher required returns on investments than would have been demanded by diversified investors.
CC 16.2: A firm has a choice of taking on bank debt or issuing bonds. Under what conditions will it take on bank debt?
Answer: If a firm has proprietary information that it does not want to reveal to the market or wants to borrow a small amount of money, bank debt may be the better option. It is easier to reveal proprietary information to a bank and there are fewer economies of scale in bank borrowing.
CC 16.3: Can preferred stock ever have a lower pre-tax cost to a company than straight debt? Explain your answer.
Answer: Generally not. Preferred stockholders have lower priority than bondholders when it comes to cash flows - preferred dividends get paid after interest payments. Consequently, preferred stockholders should demand a higher return.
CC 17.1: Some argue that internal equity financing is cheaper than external equity financing because there is a cost associated with issuing new stock. How would you quantify the difference?
Answer: It is true that there is a flotation cost associated with issuing new equity, especially if the equity is raised by issuing new stock at current market prices to the public. There are, however, two counter factors. One is that equity is a source of long-term financing, and the cost will be amortized over time. The second is the availability of cheaper ways of raising external equity, such as through rights issues.
CC 17.2: Assume that you are comparing the financing mix used by firms in the United States and Brazil. What are some of the qualitative factors that might cause differences between the countries?
Answer: While the biggest difference may be in what stage of the life cycle each firm is in, differences in corporate governance and access to debt may also make a difference. In particular, the greater focus on stockholder wealth maximization and access to bond markets (in addition to banks) will increase the pressure to borrow at U.S. firms.
CC 17.3: If you were a venture capitalist, what are some of the factors you would consider in deciding whether to invest in a private business?
Answer: The first factor would be the quality of the personnel in the business, and in particular, the management capabilities of the entrepreneur. The second factor would be the quality of the idea being promoted - Is it well thought out? Is there a large potential market? What is possibility for making high returns?
CC 17.4: Assume that the market is correct in its assessment of UPS value and that the investment bankers underpriced the issue. How much did the underpricing cost the owners of UPS? How much would it have cost if all the stock, rather than only 10%, had been offered to the public at $ 50?
Answer: The underpricing per share was approximately $ 17.25 per share. There were 109 million shares offered, leading to a total loss to the owners of the firm of $1.88 billion ($17.25*109). If all of the shares had been offered, rather than only 10%, the total loss would have been ten times higher.
CC 17.5: Some financial managers believe rights offerings dilute stockholders’ holdings. Describe how an existing stockholder is unaffected by the price decrease wrought by a rights offering.
Answer: While the new shares are priced lower than the current market price, and the price per share is lower after the rights issue, each stockholder owns proportionately more shares in the firm. It is the value of the total stockholding that matters, and that value should not be affected by a rights issue.
CC 18.1: Assume that you are examining the cost of capital of a firm that has large accumulated net losses. How would you calculate the after-tax cost of debt for such a firm? Would this calculation change over time?
Answer: The presence of large net losses can make the marginal tax rate zero for a few years (until the accumulated losses are used up). The after-tax cost of debt will be equal to the pre-tax cost of debt in those years.
CC 18.2: In the German and Japanese systems of corporate governance, loosely organized groups of firms invest in one other, creating complex cross holdings. If any of the companies in the group get in financial trouble, the stronger companies will step in and provide support and, if necessary, help extract the company from its financial predicament. What are the implications of this arrangement for capital structure?
Answer: I would expect the stronger companies in each group to be under levered and the weaker companies to be over levered. The stronger companies will subsidize the weaker companies.
CC 18.3: Some firms increase dividends because of higher earnings, while other firms increase dividends because they have large cash balances. As a bondholder in a firm, would you differentiate between the two in terms of the impact on your holdings?
Answer: Yes. I would be much more positive about the first group of companies, since I benefit from higher earnings. I would be much more negative about the second group of companies, because the presence of cash would have safeguarded my loans.
CC 18.4: The 1986 tax act eliminated the capital gains tax rate and made the tax rate on all income 28%, at the margin. What were the implications of this law for the Miller thesis?
Answer: If the tax rate to individual investors on both equity and debt income is equalized, and corporations still are allowed to deduct only interest income for tax purposes, debt will have a tax advantage relative to equity.
CC 19.1: What will happen to the optimal debt ratio if the operating cash flows are a function of the debt rating of a company? Will it be at the level where the cost of capital is minimized?
Answer: The optimal debt ratio will be lower than the optimal computed when operating income is kept constant. In general, it will be at a level lower than the level at which the cost of capital is minimized.
CC 19.2: How would we consider the implications of the higher agency costs and lost flexibility that result from the higher leverage in the analysis described above?
Answer: The higher agency costs can be built into the cost of debt (as a higher interest rate) and the lost flexibility can be shown as lower expected growth. The final value will then incorporate both effects.
CC 19.3: If InfoSoft were planning to make an initial public offering in six months, would you alter your analysis in any way?
Answer: Yes. I would then analyze it as if it were a publicly traded firm. Moving to the optimal will result in a much higher value at the initial public offering.
CC 19.4: The adjusted present value approach considers the expected bankruptcy cost to arrive at the optimal debt ratio, while the cost of capital approach does not; it is therefore a more reliable approach. Is this statement true or false?
Answer: No. The costs of debt and equity in the cost of capital incorporate expected bankruptcy cost. The cost of debt is based upon estimated ratings (and default risk) and will rise as the bankruptcy risk increases. The levered beta used to estimate the cost of equity also reflects the much higher variability in earnings that result from higher leverage.
CC 20.1: In chapter 18, we talked about indirect bankruptcy costs, where the perception of default risk affected sales and profits. Assume that a firm with substantial indirect bankruptcy costs has too much debt. Is the urgency to shift to an optimal debt ratio for this firm greater than or less than it is for a firm without such costs?
Answer: It is greater. This firm not only faces the risk of bankruptcy but also faces a drop in revenues and operating income as long as the perception remains that it might default.
CC 20.2: Assume that a firm, worth $ 1 billion, has no debt and needs to get to a 20% debt ratio. How much would the firm need to borrow if it wants to buy back stock? How much would it need to borrow if it were planning to borrow money and invest in new projects (with zero net present value)? What if the projects had a net present value of $ 50 million?
Answer: It would need to borrow $ 200 million approximately to get to a 20% debt ratio, if it buys back stock. It will need to borrow $ 250 million to get to a 20% debt ratio if takes new investments (If the new investments have a positive net present value, it will have to borrow an additional 20% of the net present value)
CC 20.3: In chapter 6, we argued that firms should focus on only market risk, since firm-specific risk can be diversified away. By the same token, it should not matter if firms use short term debt to finance long term assets, since investors in these firms can diversify away this risk anyway. Comment.
Answer: While this argument works from the perspective of equity investors, the argument for matching long term debt with long term assets is grounded in lower default risk. This lower default risk will allow the firm to borrow more (in terms of a debt ratio) and increase value.
CC 20.4: Assume the inflation rate both increases and becomes more volatile. Would you expect the use of floating rate debt to increase or decrease? Why?
Answer: I would expect the use of floating rate debt to increase, as firms become more uncertain about the level of interest rates in the future.
CC 21.1: A firm announces an increase in dividends, which is generally considered good news for stock prices. Would you expect stock prices to go up on the ex-dividend day? Why or why not?
Answer: Not necessarily. It depends upon whether the increase in dividends is greater than expected (in which case stock prices will go up) or less than expected (in which case stock prices will go down).
CC 21.2: Assume that you are studying a growth firm in which the growth rates have begun to decline. If the firm does not start paying dividends, what would you expect to happen to the firm’s cash reserves?
Answer: As growth opportunities decline, investment opportunities will as well. I would expect the firm’s cash reserves to increase.
CC 21.3: How would you defend these studies against the criticism that they do not factor in market movements on the ex-dividend days? For instance, the stock price may go up on an ex-dividend day because the market is up strongly, and this may overwhelm the dividend effect.
Answer: To the degree that ex-dividend days for different stocks are on different days (and markets go up on some and down on other), I would expect the market effect to cancel out across the sample.
CC 21.4: Over the last 30 years, the proportion of the market value of stocks held by pension funds has increased substantially. What implications does this trend have for dividend policy in the aggregate and why?
Answer: Pension funds do not pay taxes. Other things remaining equal, I would expect dividends in the aggregate to increase. (But other things are clearly not equal. Dividends have actually decreased over the period).
CC 22.1: What happens to that portion of free cash flow to equity that does not get returned to stockholders as a dividend or in the form of an equity repurchase?
Answer: It accumulates in cash and marketable securities. (It cannot be going into new investments, since free cash flow to equity is after net capital expenditures)
CC 22.2: What would Boeing need to do in order to acquire more flexibility to accumulate cash (like Microsoft)?
Answer: It needs to earn a higher return on its projects and better returns for its stockholders (with price appreciation).
CC 22.3: Assume that you are a stockholder in a firm with a poor track record of investments and high dividends. What questions would you have for the managers of this firm?
Answer: What are you doing to change the way you analyze investments? What plans do you have to divest or liquidate poor investments that you have already made? Can the cash from some divestitures be used to sustain your dividends?
CC 23.1: When firms make privately negotiated repurchases, would you expect them to pay a higher or lower price than if they made open market purchases?
Answer: It would depend upon how large the repurchase is, and how much the seller wants to get out of the position. In general, I would expect to pay a lower price. (If I expected to pay a higher price, I would gone ahead with an open market purchase in the first place)
CC 23.2: Some stocks, even in the studies noted above, report stock price decreases on the announcement of equity repurchases. How would you explain this?
Answer: There are two scenarios where a stock repurchase can be viewed as bad news: (1) If a firm with good investment opportunities, limited cash on hand and limited access to capital markets announces a stock buyback, I would view it as a value decreasing action. (2) If a firm that has never bought back stock and has always had ample investment opportunities available announces a stock buyback, I would view it as a signal of more limited project choice in the future.
CC 23.3: Why would the bid-ask spread increase as a percentage of the stock price when the stock price drops?
Answer: The spread moves in discrete increments (from 1/2 to 1/4 to 1/8) and generally does not drop below a minimum (1/16 or 1/32). Hence the spread will increase as a percent of the stock price, since it will drop in proportion to the stock price. (If the price is halved, the spread will generally not be halved.
CC 23.4: Assuming that the buyer of the division in the illustration above has the same expected growth rate and cost of capital as Boeing, how much more would it have to generate in cash flows next period from this division to break even with a value of $ 11 billion?
Answer: X(1.05)/(09-.05) = 11,000; Solving for X, we obtain $ 419 million. This is $ 26 million more than Boeing was able to generate last year. Next year, the firm will have to generate 5% more in savings, which would yield $ 27.3 million.
CC 24.1: Assume that you are valuing a firm with large net operating losses carried forward and that you decide, for simplicity, to use a marginal tax rate of 35% on income in all periods. Would you under or over value the firm? What if you used a marginal tax rate of 0% on income in all periods?
Answer: You would undervalue the firm, since you would be missing the tax savings that the firm will generate from the net operating losses. If you use a marginal tax rate of 0% on all income in the future, you would overstate the value, since you are assuming that the net operating losses will shelter income forever.
CC 24.2: In a discounted cash flow valuation, can the cost of capital change from period to period, and can future costs be different from current costs?. What are the possible reasons for these changes?
Answer: Yes. The cost of capital can change each period, since any or all of the ingredients in the computation can change. The beta can change (and usually will drop for high beta firms), and the default risk (the cost of debt) and debt ratio will change as the firm becomes larger and generates higher income. Even the tax rate can change, as the firm exhausts net operating losses and moves into a higher tax bracket.
CC 24.3: Assume that you are valuing a high-growth firm with high risk (beta) and large reinvestment needs (high reinvestment rate). You assume the firm will be in stable growth after 5 years, but you leave the risk and reinvestment rate at high growth levels. Will you under value or over value this firm?
Answer: You will significantly under value the firm. Leaving the beta at current high levels will push up the discount rate and leaving reinvestment needs at current high levels will push down the cash flow.
CC 24.4: Under what conditions would you expect voting and non-voting shares to sell at the same price? Assuming the same dividends on both types of shares, should non-voting shares ever sell for more than voting shares?
Answer: I would expect voting and non-voting shares to sell at the same price if the value of control is zero. This can happen either in an exceptionally well managed firm where the incumbent management owns a controlling interest in the voting shares. Assuming that the two shares pay the same dividends, the only scenario where the non-voting shares could sell for more than the voting shares is if there is a very large difference in liquidity (with the non-voting shares being much more liquid).
CC 24.5: Using the approach described above, what would be the determinants of the Value/FCFF multiple for a stable growth firm?
Answer: The determinants are the cost of capital and the expected growth rate. This can be obtained by setting up the value equation: Value = FCFF (1+g) / (Cost of Capital — g). Value/FCFF = (1+g)/(Cost of capital —g)
CC 25.1: Assume that the tax rate increases for all firms. Would you expect the value of firms with high debt or firms with relatively low debt to be most negatively affected by the tax increase? Why?
Answer: The firms with relatively low debt should be most negatively affected since they do not receive any offsetting benefits on debt. (The interest tax benefit from debt will increase as the tax rate increases).
CC 25.2: Assume that Gillette announces it will increases the prices of its products by 15%; this will increase margins by 25%. As a consequence, its revenues are expected to drop by 10%. Will the return on capital increase or decrease as a consequence?
Answer: I would expect the return on capital to increase, since it is the product of the turnover ratio and the operating margin. The increase in the margin is much greater than the decrease in the turnover ratio.
CC 25.3: You have become the CEO of a firm with long-term projects spread around the world. The firm has a substantial amount of short-term dollar U.S. dollar debt. Why might this affect value, and how would you correct the mismatch?
Answer: I would try to swap or replace the debt (when it comes due) with long term debt in a mix of foreign currencies. This will reduce default risk, allowing me to borrow more and get a greater tax benefit and higher value.
CC 25.4: You are looking at a ranking of firms based upon the economic value added. You notice that the EVA has been computed using the book value cost of capital and that the operating income and capital invested have not been corrected for either operating leases or R&D. What types of firms would be you expect to see at the top of the rankings?
Answer: I would expect successful high technology, specialty retailing and pharmaceutical firms to report the highest EVA. Their book capital will tend to be understated because neither R&D nor operating leases are being capitalized. While the operating income will also be understated, it will generally be less affected than the book capital.
CC 25.5: The economic value added is the difference between return and capital and the cost of capital, which is already risk adjusted. Thus, EVA fully corrects for risk. Comment.
Answer: This is not true. While the current EVA may be risk adjusted, the value of a firm is the present value of its EVA over time. If a firm increases its EVA by investing in riskier projects, the present value effect (which will be negative) may dominate the EVA effect.
CC 26.1: Synergy takes a long time to show up. Some argue that the reason most studies find no synergy benefits is that they look at short time periods (five years or less) after mergers. Do you agree with this statement?
Answer: If synergy, in fact, takes more than 5 years to show up, the present value of that synergy will be significantly lower than what many firms pay as an up-front premium fo rit.
CC 26.2: Does the fact that the value of control is $2.42 billion imply that this amount is available to be claimed by someone who acquires the firm? Why or why not?
Answer: Not necessarily. The current market price of the target will reflect the probability that the firm will be taken over and thus already incorporate a portion of the value of control. For instance, if the market assesses a probability of 50% that this firm will be taken over, the current market value will incorporate $1.21 billion of the value of control.
CC 26.3: In the example described above, what would happen to stockholder wealth, if the merger went through and the combined firm’s debt was kept at pre-merger levels? What would happen to bond prices?
Answer: Stockholder wealth would decrease while bondholder wealth would increase. The firm will be a safer firm after the merger, but it will still be paying pre-merger interest rates on its debt. (The ratings of the bonds will improve. With the same coupon rate, the bond price will increase)
CC 27.1:In a normal option, it almost never pays to exercise early. Why, in the case of a project option, might this not hold true?
Answer: With an option on a financial asset, you can exercise at the last moment and get the entire payoff on the option (the difference between the stock and strike price, for instance). With a real option, exercising on the last day of a patent period will mean that you have no protection from the patent for your product.
CC 27.2: Assume that oil prices increase by $ 5 per barrel today and drop back by $ 5 tomorrow. Will these changes affect the value of the oil reserve? Why or why not?
Answer: Probably. The variance in oil prices that is used to determine the value of undeveloped reserves is an expected variance. The surge and subsequent drop in prices will likely increase the expected variance and increase the value of the undeveloped reserves.
CC 27.3: This option-based approach pre-supposes that the research is applied and directed toward finding commercial products. Would the same arguments apply for basic research (such as the research done at universities) which are not directed towards commercial products? Why or why not?
Answer: The answer, at least in theory, is yes. It will be much more difficult to obtain the inputs to the model if we were looking at basic research. (We would have to guess what types of commercial products could eventually flow from the research, and the potential cash flows from these products).
CC 27.4: In illustration 27.6, the debt outstanding took the form of 10-year zero coupon bonds. Would the value of equity as an option increase or decrease if the bonds had been 10-year coupon bonds?
Answer: The value will decrease for two reasons. One is that the effective duration of the bond will be lower than 10 years, making the option less valuable (shorter life). The other is that this will shift some of the power that we have given stockholders to bondholders, since at each coupon date, the failure to make a coupon payment will result in a loss of control over the firm.
CC 27.5: Given this conflict between stockholder and bondholder interests, what type of covenants or restrictions would you put on the managers of firms in financial distress? What else would you try to do to reduce your exposure to a loss of wealth?
Answer: I would severely restrict investment policy and demand a veto (or a say) in where the firm invested its funds. I would also try to restrict financing policy (to keep the firm from borrowing more on existing assets) and dividend policy (to keep stockholders from liquidating assets and taking cash out of the firm). I would finally ask for an equity stake in the firm.