CT 2.1: Al (Chainsaw) Dunlap, who as chief executive officer at Scott Paper, was responsible for turning the company around and making millions for stockholders, has argued that CEOs of firms should focus solely on maximizing stock prices, and that the actions that they take in the process enrich society as well. Under what conditions would his argument hold? Under what conditions might it break down?
Answer: For this argument to hold, markets would have to be efficient and the potential for social costs (from firms maximizing stock prices) limited. In addition, bondholders would need to be protected.
CT 2.2: Many of the problems that we have noted with stock price maximization in this chapter arise from the different objectives of stockholders, lenders, managers and society. One mechanism that can help balance the competing interests is the legal mechanism - firms can be sued for creating social costs, investors can sue firms that reveal misleading information, lenders can sue if they feel that they have been unfairly victimized and stockholders can sue managers for breach of fiduciary responsibility. How effective will this legal mechanism be at reducing problems? What are its costs?
Answer: the legal mechanism can be partially effective, but not completely for two reasons. One is that the legal process is both lengthy and occurs after the fact. Lawsuits can make tobacco companies pay, but they cannot make lung cancer go away. The second is that there are tremendous side costs to the legal process. Firms that create no social costs can be targeted by lawyers, and even if they win, may incur large expenses.
CT 2.3: Assume that you a have been hired to run a not-for-profit organization. Do you still need an objective? How would you come up with an objective, and put it into practice in decision-making in the organization?
Answer: Every organization needs a dominant objective. For a non-profit, the objective may be stated in terms of the service it plans to provide, and the costs can be a constraint. Thus, the objective for a hospital might be to deliver quality health care to a specified population at the lowest cost - quality would have to be defined for this objective to have teeth. Once the objective is specified, the organization would use it to decide how to allocate resources and to choose between alternatives.
CT 2.4: Assume that you have been appointed economic czar of an emerging market economy. You would like to create the conditions needed for managers of firms in the economy to focus on maximizing stock prices. What are some of the actions you would take to facilitate this transition?
Answer: There are several actions that I would take. The first is to create a fair financial market, where insiders do not have a clear advantage over other investors. To allow for this fairness, I would require firms to reveal information about themselves to financial markets on a regular basis. The perception of fairness is critical for markets to be well functioning and liquid. Second, I would eliminate any laws or taxes that are designed to discourage trading. Third, I would work on increasing the power stockholders have over publicly traded firms.
CT 2.5: In recent years, there are some who have argued that firms should maximize stakeholder wealth, rather than stockholder wealth, where stakeholders include stockholders, bondholders, employees and society. What are the advantages and disadvantages of this alternative objective function? How would you put this objective function into practice?
Answer: The advantage of the stakeholder approach is that it can lead to more balance in decisions and potentially leave them better off, at least collectively. The disadvantage is that the approach leads to a division of responsibility and to buck-passing by managers. To put this objective into practice, you would need to specify the objectives for each group (employees, society, stockholders, bondholders, customers) in clear and quantitative terms, and specify a mechanism for weighting the different (and sometimes competing) objectives.
CT 3.1: Economists and government officials have been wringing their hands over the desire for current consumption that has led American families to save less and consume more of their income. What are the implications for discount rates?
Answer: Consuming more and saving less, as a society, leads to higher real interest rates, which increases nominal interest rates. Other things remaining equal, such societies will under invest for the future.
CT 3.2: Assume that you are comparing interest rates on several loans, with different approaches to computing interest. The first loan has a stated interest rate of 8%, with compounding occurring every month. The second loan has a stated interest rate of 7.8%, with compounding occurring every week. The third loan has a stated interest rate of 7.5%, with continuous compounding. Which is the cheapest loan?
Answer: You would need to make the three rates comparable.
Interest rate on first loan = (1 + .08/12)12 - 1= 8.30%
Interest rate on second loan = (1 + .078/52)52 - 1 = 8.11%
Interest rate on third loan = exp.075-1 = 7.79%
The third loan is the cheapest.
CT 3.3: Assume that you have a cash flow that is expected to grow at different rates each year over time, but the average growth rate forever is 5%. Can you use the growing perpetutity formula? Why or why not?
Answer: Yes. It will be an approximation, but it will be pretty close to the true value, since the cash flows occur forever.
CT 4.1: Financial statements are prepared once every three months at most firms in the United States. Which of the three statements - the income statement, the balance sheet or the statement of cash flows - is likely to show the least change from period to period?
Answer: The balance sheet is likely to show the least change from period to period because it reflects the cumulated effects of all actions taken by a firm over its lifetime. The income statement and the statement of cash flows are likely to be much more volatile since they reflect a firm's operations only during the period.
CT 4.2: The distinction between assets in place and growth assets is a key component of financial analysis. Why is this distinction important?
Answer: For several reasons. The first is that assets in place generate cash flows currently and reflect investments already made. Growth assets reflect investments yet to be made, and thus do not generate cash flows today. The second is that the two might have very different risk profiles, and thus need to be judged differently. The third is that the type of financing used can be very different for the two groups of assets- equity is the choice for growth assets, while debt and equity may finance assets-in-place.
CT 4.3: Given current accounting standards, what types of firms will see the values of their assets understated and why?
Answer: Firms with substantial research and development (technology firms and pharmaceuticals) and firms with substantial operating leases (specialty retailers) will have understated assets. R&D expenses and operating lease expenses are treated as operating expenses and not capitalized.
CT 4.4: Sports teams often enter into multi-year contracts with their star players. These contracts usually involve the commitment to make large payments over several years to the players, with no escape clauses. How would you treat these commitments in computing how much these sports teams owe?
Answer: I would take the present value of these commitments and treat them as debt, if the sports team has little or no flexibility on the payments contractually agreed to.
CT 4.5: A high-technology firm announces a large increase in profits, largely as a consequence of cutting back on R&D expenses. Is the firm more profitable? Why or why not?
Answer: This firm may report higher net income and earnings per share, but it is not more profitable, from a financial standpoint. It has cut back on capital expenses (which are designed to generate growth in the future) and has not really generated additional income from its existing investments.
CT 4.6: What accounting ratios would you use, and how would you use them, to measure a firm’s exposure to equity risk (as opposed to default risk)?
Answer: One ratio would be the price to book value ratio. The higher this ratio, the more of its value a firm gets from its growth assets, and thus the more equity risk it should have. The most useful accounting ratios are likely to be comparisons over time. For instance, the variance in net income or earnings per share over several years or quarters is likely to be correlated with equity risk.
CT 4.7: As an investor in stocks, why might you want uniform accounting standards in different markets? What are some of the features you would like to have these uniform accounting standards to have?
Answer: You might want to choose between investments traded in different markets, and compare them on their profitability or leverage. You would want these uniform standards to measure profits fairly, enforce the distinction between operating and capital expenses, and reveal the existing assets of the firm. You would also want these standards to show all of the outstanding liabilities of the firm.
CT 5.1: The duration of a bond generally increases as the maturity of the bond increases. Estimate the duration of a perpetual bond.
Answer: The duration of a perpetual bond is approximately the inverse of its coupon yield. Thus, the duration of a 10% console bond is approximately 10 years. With a 5% console, it becomes 20 years.
CT 5.2: A significant portion of the value of the store comes from the estimated value of the land at the end of the store’s life. If the Home Depot had leased the store rather than buying it, the land would have reverted back to the lessor at the end of the store’s life. Does this imply that the net present value of the store will decline if the store is leased?
Answer: No. It depends upon what the lease payments are and how they reflect the value of the real estate component.
CT 5.3: Assume that you value equity by discounting free cash flows to equity at the cost of equity. If you revalue the firm, using free cash flows to the firm and the cost of capital, and then subtract out the outstanding debt, would you get the same value for the equity? Should you?
Answer: Yes, if the debt to capital ratios that you use are the same in both analysis, and both debt and equity are fairly priced. If not, you can get different answers.
CT 5.4: With a conventional asset, the value of the asset decreases as the riskiness of the asset increases. With a contingent claim asset or option, the value of the option increases as the riskiness of the asset increases. Explain the reason for the difference.
Answer: With options, you are protected from losses on the downside. Hence, you gain from the upside generated by volatility, without being affected by the downside.
CT 5.5: The efficiency of a market can be measured by the speed and accuracy of the price response to new information or by whether some investors can consistently earn higher returns than the rest of the market. Is there a link between the two measures? Which is the stronger test?
Answer: Yes. If markets did not respond quickly and accurately to new information, investors can trade after new information releases and generate excess returns for themselves. The first (market response to information) is the stronger test, since it is possible for markets to be inefficient in responding to information but to be efficient in terms of not letting investors earn excess returns (because of transactions costs or other trading impediments). It is much more difficult to visualize a scenario where investors make excess returns in a market that is efficiently reacting to new information.
CT 6.1: When we argue that higher risk should be compensated for with a higher expected return, are we assuming that all investors are risk averse? Would this argument still hold if all investors were risk neutral?
Answer: We are assuming that investors are risk averse, on average, and not that all investors are risk averse. If all investors were risk neutral, there would be no need for a higher expected return on risky investments.
CT 6.2: Bill Gates is the largest stockholder in Microsoft. Given our definition of the marginal investor (the investor most likely to be involved in the next trade as a buyer or seller), would Bill Gates also be the marginal investor in Microsoft? Why or why not?
Answer: While Mr. Gates is the largest investor in Microsoft, he does not trade in his stock frequently. Consequently, it is unlikely that he is the marginal investor in the stock. (A large institutional investor is more likely to be the marginal investor in the stock)
CT 6.3: All risk and return models in finance consider only that portion of risk that cannot be diversified away as risk that will be rewarded with a higher expected return. Why do the capital asset pricing model, the arbitrage pricing model and the multi-factor model measure this risk differently?
Answer: Because they make different assumptions about the nature of market risk. The CAPM assumes that marginal investors will hold the market portfolio, and that all market risk can therefore be measured by the relationship of individual investments to the market portfolio (one beta). The arbitrage pricing and multi-factor models allow for multiple sources of market risk, and measure an investment's risk relative to each source.
CT 6.4: Assuming that you have the right model for risk and return, would you expect the actual returns on individual investments in any period to be equal to the expected returns? Why or why not?
Answer: No. The essence of risk is that the actual returns can deviate from the expected returns. If the actual returns on an investment were always equal to the expected returns, it would be a riskless investment.
CT 6.5: Why, with bonds, do we not measure risk using betas? Can you think of any types of bonds, whose risk you would measure using betas?
Answer: Bonds have limited upside potential and large downside potential. The use of variance (and betas) is built on the presumption of symmetric distributions - potential upside as well as downside - and this does not hold for bonds. Instead, we look at just the downside risk (default risk) when we look at bonds.
CT 7.1: As long as firms are growing rapidly, they do not need to know their costs of equity or capital. Is this statement true? Why or why not?
Answer: This statement is not true. Even as firms grow rapidly, they are making new investments. Firms need to know their costs of financing in order to determine whether these investments are good investments.
CT 7.2: If private businesses have higher costs of equity than otherwise similar publicly traded businesses, what are the implications for competition between the two? How can a private business survive this competition?
Answer: Private businesses start off with a disadvantage. They cannot accept investments that otherwise similar publicly traded firms can. To survive, a private business has to generate higher cash flows (perhaps private owners work harder than managers of publicly traded firms) from the same investments.
CT 7.3: Can the cost of debt be higher than the cost of equity? If yes, when might this happen? If not, does it follow that the cost of capital will always decrease as a firm borrows more?
Answer: While we can think of a really convoluted example where this is possible (negative beta equity, high default risk debt), it will almost never occur. Debt investors have prior claims on cash flows, both in operations and in bankruptcy, and should thus demand lower returns, on an expected basis, than equity investors in a firm. It does not follow that the cost of capital will decrease as we take on more debt, because increasing leverage increases the costs of both debt and equity.
CT 8.1: Defined broadly, everything that a firm does can be categorized as a project. Would you expect the same decision rules to apply to all projects? Why or why not?
Answer: While projects can vary a great deal in scale and characteristics, the objective of the firm is the same - to maximize firm value. Consequently, I would expect the same decision rules to work on all types of projects.
CT 8.2: Assume that you apply the firm's hurdle rates to all investments considered by a firm. What will happen to the risk profile of the firm over time? Why?
Answer: Over time, the firm will over invest in risky projects and under invest in safe ones. Consequently, it will become riskier.
CT 8.3: When a firm has businesses with very different risk profiles, different investments can have very different costs of equity and capital. What is the relationship between the firm's cost of equity and capital and its projects' costs of equity and capital?
Answer: The firm's costs of equity and capital should reflect the weighted average of the costs of equity and capital of all of the different businesses that the firm operates in, with the weights depending upon the contribution they make to firm value.
CT 8.4: Under what conditions might the cost of debt for a project be lower than the cost of debt for the firm considering the project?
Answer: If the project is a stand-alone project with high and stable cash flows, it can have a cost of debt that is lower than that of the parent firm. (To obtain this cost of debt, though, the project's cash flows and assets will have to be used to back up the project's debt rather than the firm's debt.)
CT 8.5: Assume that you are estimating the cost of capital for a project, and that you use the financing mix used for the project to estimate the cost of capital. When is this appropriate and when is it not?
Answer: If the project carries its own debt and has risk characteristics that are very different from that of the rest of the firm, you would use the project's financing mix to compute the cost of capital. It is not appropriate to do so, if the project does not carry its own debt or has risk characteristics similar to that of the rest of the firm.
CT 8.6: Assume that you are looking at an investment analysis of a project. The project analyst has used a high discount rate, to reflect the riskiness of the project. She has also used conservative (low) estimates of the cash flows, because of the riskiness of the project. Is there a problem with the project analysis? Explain.
Answer: There is a problem with this analysis. The risk has been counted twice - once by using a high discount rate, and once when the cash flows were made conservative (below expected values)
CT 8.7: Assume that managers routinely consider diversifiable risk in making their investment decisions. Will the firm invest too much, or too little, or could either occur?
Answer: The firm will invest too little, since all risk will be considered in project analysis, rather than just non-diversifiable risk. If projects are being compared for selection, this process will be biased against investments with substantial diversifiable risk and towards investments with substantial market risk.
CT 9.1: What are some of the factors you would consider in deciding whether to use historical data, market testing or scenario analysis in making revenue and expense forecasts for a project?
Answer: I would look at whether I had done similar projects before. If I have, I would use historical data. If the project is directed towards a market that I do not know much about, I would use market testing. If I know the market, but the success of the project is contingent on three of four major factors (the economy, competitive reactions…) I would use scenario analysis.
CT 9.2: The depreciation that we used for the project above is assumed to be the same for both tax and reporting purposes. Assume now that the Home Depot uses more accelerated depreciation methods for tax purposes and straight line depreciation for reporting purposes. In estimating project earnings, which depreciation should we use?
Answer: For project earnings, a case can be made for either. While tax depreciation is more meaningful, the accounting earnings I will report to stockholders is based upon my reporting books. For project cash flows, the choice is much cleared. I would use the depreciation in my tax books, since my tax benefit will be based upon it.
CT 9.3: In the analysis above, we assumed that InfoSoft would have to maintain additional inventory for its on-line software store. If, instead, we had assumed that Infosoft could use its existing inventory, would the cash flows on this project have increased, decreased or remained unchanged?
Answer: The cash flows would have increased during the operating life of the project since there would have no need for the investment in inventory each period.
CT 9.4: In the analysis above, we assumed that the Home Depot borrowed $5 million to finance the new store. If instead, we had assumed that they had used no debt, would the cash flows to equity have been higher, lower or unchanged?
Answer: The initial investment (in equity terms) would have been more negative, but the cash flows each period to equity investors would have been more positive (since there would have been no interest and principal payments). The net present value effect could have cut either way….
CT 9.5: When cash flows on investments are time-weighted (discounted), we are biasing ourselves against investing in long term projects. Is this statement true? If yes, why? If not, why not?
Answer: This is not true. We might be taking fewer long term investments than we otherwise would have, but the ones we reject are rejected for the right reason. They do not generate a sufficient return for us, given the time value of money.
CT 10.1: Firms with good managers do not need investment decision rules. Is this statement true? Why or why not?
Answer: This statement is false. Even good managers need a consistent rule that they can use to determine where and when to invest. Without an investment decision rule, each manager may follow a different rule, resulting in a final portfolio of projects that does not maximize firm value.
CT 10.2: Do discounted cash flow rules require more information than accounting income based rules? If yes, what additional information do they require?
Answer: We do need some additional information. To get from earnings to cash flows, we do need to know how much is being spent on working capital and capital investments. To discount these cash flows, we need a cost of equity and capital. It can be argued, however, that to use the accounting return on capital, for instance, we would still need a cost of capital.
CT 10.3: What types of firms are good candidates for the IRR rule? What types of firms are suited for the NPV rule?
Answer: Firms with severe capital rationing constraints and lots of high return projects are good candidates for the IRR rule. Firms without capital rationing constraints and projects with returns closer to the cost of capital are good candidates for the NPV rule.
CT 10.4: In the 1980s and 1990s, the attractiveness of net present value as an investment decision rule increased, relative to other decision rules. What might account for this shift?
Answer: There are at least two reasons we would offer for this shift. The first is the greater focus on stock prices and value maximization at many firms. The second is easier access to capital markets for even smaller firms (reducing the capital rationing constraint).
CT 11.1: Under what conditions will a project's net present value be unaffected by unanticipated inflation?
Answer: For the net present value to be unaffected by unanticipated inflation, the cash flows would have to increase proportionately with the discount rate. For cash flows to increase proportionately, inflation will have to affect cash inflows (revenues) the same way it affects outflows (expenses & taxes).
CT 11.2: A company in a high-inflation economy has asked for your advice regarding which currency to use for investment analysis. The company believes that using the local currency to estimate the NPV will yield too low a value, because domestic interest rates are very high - this, in turn, would push up the discount rate. Is this true?
Answer: No. If domestic interest rates are high, the expected inflation is also high. The cash flows in the local currency will reflect this higher inflation, and thus offset the effect of the higher discount rates.
CT 11.3: Assume that you are worried about risk in the above transaction, but that you believe that there is still a much greater chance that the Singapore dollar will strengthen rather than weaken. Would you use the forward contract or the put option? Why?
Answer: I would use a put option in this case. This would allow me to protect myself against the downside risk, while I could benefit from the upside rewards if my belief is right.
CT 12.1: Implicitly, by computing the net present value of making the replacement, we are assuming that the new machine will have the same life as the old machine. How would you modify this analysis if the old machine has a much shorter remaining life than the new machine?
Answer: If the machines have different lives, I would either allow for replication of the investments to have the same overall life, or compute an equivalent annual cost for both machines.
CT 12.2: Firms that believe they are under valued by financial markets are much more likely to view themselves as facing a capital rationing constraint than firms that view themselves as fairly or over valued. Why?
Answer: Firms that believe that their stock is undervalued are less likely to issue stock to raise equity for new projects. This leaves them dependent upon internal equity (retained earnings) and thus makes them more capital constrained than firms that issue stock to raise equity.
CT 12.3: An analyst at the Home Depot argues that it is better to be conservative in investment analysis and always consider the cannibalized sales at other stores when doing investment analysis. Do you agree?
Answer: No. This would result in more stores being rejected. If what follows is competition moving in and opening stores close by, the firm will be worse off, since the cannibalization will occur anyway.
CT 12.4: In the analysis above, the cost of capital for both the restaurant and the store were assumed to be 9.51%. Assume that the cost of capital for the restaurant had been 15%, while the cost of capital for the store had stayed at 9.51%. Which discount rate would you use for estimating the present value of synergy benefits?
Answer: The synergy accrues to the store, in this case, since more books are sold (not more cappucinos). I would therefore use the cost of capital of 9.51%. If the synergy accrues to both the store and the restaurant, I would have value each synergy stream separately.
CT 12.5: If we perceive research and development expenses as the price of acquiring options (product patents), will research and development expenditure have more value if directed to areas where the technology is stable or areas where the technology is volatile. Explain.
Answer: If viewed as options, R&D expenditures will have more value in areas where technology is volatile, assuming other things remaining equal. Higher variance makes options more valuable.
CT 13.1: Under what conditions would you use the broader measure of working capital (current assets — current liabilities) in estimating cash flows?
Answer: If cash were necessary for the day-to-day operations of the firm, and short-term debt is not counted as part of debt in the cost of capital computation, I would use the broader definition of working capital.
CT 13.2: As inflation and interest rates rise, will the effect of working capital changes on net present value increase or decrease? Explain.
Answer: It will increase. The cash outflows from working capital occur early (as the project is initiated and grows) while the cash inflows occur late (when the working capital is salvaged). As interest rates increase, the present value effect will increase and become more negative.
CT 13.3: Manufacturing firms tend to have high working capital due to inventory needs at every stage in the process. If you were the manufacturer of high-priced goods, would you expect working capital needs to be higher or lower than for a manufacturer of low-priced goods?
Answer: I would expect it to be higher for two reasons. First, the inventory that I have will have a higher cost, because I sell more high-priced goods. Second, the turnover ratios are likely to be lower, since I will sell than a low-priced good manufacturer.
CT 13.4: Assume that you are a retailer who carries hundreds of items in your store. What are some of the factors you would consider in trying to decide which items you should reduce your inventory of?
Answer: I would reduce the inventory on those items where the cost of lost sales is likely to be lowest. Thus, if there are items that are seldom asked for or where I am the sole distributor, I would be more inclined to reduce inventory on these items.
CT 14.1: Do you think technological advances in banking will increase or decrease net float for firms? Are some firms more likely to benefit than others? Explain.
Answer: I think they will decrease net float at large firms. These firms will take advantage of technology to process payments to them faster, while using the same technology to slow down payments to their customers. Smaller firms may also be able to use technology to their advantage while working with customers, but may find themselves on the wrong end when dealing with larger firms. Overall, float in the economy should decrease.
CT 14.2: Assume that you are comparing two firms in the same sector with very large cash balances. MicroTemp Inc, the first firm, has maintained a return on equity of 35% over the last 5 years of its existence. GenWaste Inc, the second firm has had an average return on equity of 22%, but the returns have been dropping significantly each year. In which of these two firms is cash likely to be viewed as value destroying and why?
Answer: Cash is likely to be viewed as potentially value decreasing at GenWaste because of its declining return on equity. Investors will assume that the marginal investments are becoming less attractive, and will worry about the cash going into these investments.
CT 14.3: Assume that a firm invests its cash in private businesses. How would you evaluate whether these investments will increase or decrease the value of the firm?
Answer: The same way that I would judge its investments in publicly traded firms. I would look at the cash invested in the businesses, and the cash returned by these businesses over time. If the present value of the cash inflows from these businesses exceeds the cash invested in these businesses, they will increase value.
CT 14.4: The Home Depot holds less cash than its peer group. Under what conditions is this low cash balance likely to become a liability and why?
Answer: The low cash balance can become a liability if cash is needed for day-to-day operations or for taking advantage of sudden investment opportunities (a takeover opportunity, for instance).
CT 15.1: Is the fact that the EVA is negative necessarily an indication of poor project choices? Why or why not?
Answer: The EVA just measures whether an investment earned more than its cost of capital in the current period. This is not necessarily indicative of the quality of the project. A good project may earn less than its hurdle rate early in its life and make up for it with much higher returns later. A good project can also have a bad year. Finally, the return on capital, which is based upon accounting measures of operating income and capital invested, may not accurately reflect the true return on an investment.
CT 15.2: In the personal computer business, Dell Computer had emerged as the leader by the end of the 1990s. What is the strategy it adopted and what was its competitive advantage?
Answer: Dell established a clear cost advantage over its rivals by revamping its manufacturing operations, cutting out middlemen and selling directly to customers. It used this cost advantage to aggressively under-price its competition and earn market share.
CT 15.3: A manager of a firm with a significant number of divisions earning less than their required returns argues that firms should always divest or terminate underperforming divisions (i.e., divisions that earn less than the cost of capital). Do you agree? Why or why not?
Answer: I do not agree. The question of whether a division that earns less than its cost of capital should be divested or terminated cannot be answered without looking at the cash flows the firm would get from these actions (divestiture or salvage value) and comparing them to the present value of cash flows from continuing in business. Divestiture or termination makes sense only if the divestiture or salvage value is higher than the continuing value.
CT 16.1: Can a firm be financed entirely with debt? Why or why not?
Answer: No. Someone has to bear the residual risk. When a firm's debt ratio climbs towards 100%, the debt will begin to take on the characteristics of equity. (This is why junk bonds behave more like stocks than bonds)
CT 16.2: Both warrants and contingent value rights are equity options. Why might some firms use warrants and others contingent value rights?
Answer: Warrants are call options and are more likely to be used by growth firms to take advantage of both the perception that they are volatile and that their stock prices will rise over time. Contingent value rights are put options and are more likely to be used by mature firms to provide investors with an instrument to protect themselves against downside risk.
CT 16.3: In a lease, both the lessor and the lessee can gain from the transaction. How is this possible? If they both gain, who is the loser?
Answer: The most common loser is the government. One of the largest benefits from leasing is that the lessor gets a larger tax benefit from the purchase of the asset than the lessee would have.
CT 16.4: Assume that a company has only convertible debt outstanding, and that the stock price increases over the following years. Assume, further, that the convertible debt is not converted. What will happen to the debt ratio over time, and why?
Answer: The proportion of the convertible bond's market value that is equity will risk as the stock price rises. Thus, the firm's debt ratio will decrease as the stock price increases.
CT 17.1: Firms prefer to finance investments with internal funds, because internal financing is cheaper than external financing. Is this statement true? Why or why not?
Answer: If by cheap, firms imply that internal financing has a low cost, they are wrong. Internal financing has the same cost as all equity, albeit without the issuance costs. It is more expensive than debt.
CT 17.2: Shelf registration is much more common with corporate bonds than with equities. Why might this be so?
Answer: Bonds are much more easily sold without investment banking support. Equity is much more dependent upon sales and marketing efforts by investment banks, especially when the issue is a public market issue. Furthermore, firms are much more willing to raise debt at short notice than equity.
CT 18.1: The returns on capital earned by European firms have traditionally been lower than the returns on capital earned by firms in the United States. European firms also have tended to use less debt and hold more cash than US firms. Is there a possible link between these two phenomena? What might explain them?
Answer: Firms with high and stable cash flows that do not borrow money tend to be undisciplined in their investment analysis. The low returns on capital (poor investments), high cash balances and low leverage could all be the result of this lack of discipline.
CT 18.2: The argument for preserving flexibility is in many ways the polar opposite of the free cash flow argument for increasing debt. Which of the two views do you agree with? Why?
Answer: It would depend upon the firm and its management. For firms in high return sectors with good management, I would lean towards the flexibility argument. For firms in mature businesses with poor management, I would lean towards the free cash flow argument.
CT 18.3: Why is the expected bankruptcy cost much larger to the owner of a private business than it is to the stockholders in a publicly traded firm?
Answer: When private firms go bankrupt, the owner’s personal assets might be put at risk (if there is no limited liability). In addition, the owner is likely to be undiversified and will be hit much worse by the loss of equity value. When publicly traded firms, their stockholders have limited liability and tend to be more diversified.
CT 18.4: Is it possible for firm value to be unaffected by capital structure decisions for some firms but not for others? Why or why not?
Answer: Yes. For some firms, the benefits and the costs from borrowing may be balanced (leading to no net benefits). For these firms, capital structure changes may not affect firm value. Another scenario where borrowing might not affect value is the case of a firm that is tax exempt and has large and stable cash flows — the tax benefits and bankruptcy costs at such a firm will both be close to zero.
CT 18.5: What other explanations could there be, besides firms being generally under levered, for stock prices tending to increase when firms increase leverage?
Answer: When firms increase leverage, they might send a signal to financial markets that they are confident about their capacity to generate cash flows to cover debt payments. This signal may lead to an increase in stock prices.
CT 18.6: Would you view the existence of a financing hierarchy as evidence that firms do not have optimal debt ratios? Why or why not?
Answer: No. Firms can have preferences about how they raise financing, but still have optimal debt ratios. Thus, a firm may prefer to use new debt rather than new equity, but it can still use internal equity to maintain a desired debt ratio.
CT 19.1: What are some of the factors that would determine the maximum acceptable probability of default for the management of a firm? Would you expect closely held companies, where managers hold a large percentage of the outstanding stock, to behave differently from widely held companies?
Answer: I would expect the managers’ risk aversion, past experience and holdings in the firm to all play a role. Managers who are more risk averse, who have had past experiences with default and who have more of their wealth invested in the firm will not be willing to accept a high probability of default. Consequently, managers in closely held companies will set lower probabilities of default than managers in widely held firms.
CT 19.2: Can you think of other industries where the operating income is sensitive to the bond rating? What are the implications for optimal capital structure analysis for firms in these industries?
Answer: I would expect the operating income to be sensitive to bond rating in any sector where the perception of default can affect revenues and operating income. Consequently, it should be high in firms that sell durable products that are expensive and require servicing (computers, copiers…). These firms should be more cautious about borrowing than other firms.
CT 19.3: We have stated the return differential in terms of equity: return on equity versus cost of equity. How would you reframe this analysis if you wanted to state the return differential in terms of capital?
Answer: I would look at the difference between the return on capital and the cost of capital. Since the return on capital is not a function of leverage, the optimal debt ratio will be the point at which the cost of capital is minimized.
CT 19.4: The most difficult input to obtain in the adjusted present value approach is the bankruptcy cost as a percentage of firm value. Why is it so difficult to estimate, and how would you go about estimating it?
Answer: You cannot draw on a firm’s history since a firm seldom go bankrupt and continue to exist. While one can use the experience of other bankrupt firms to estimate the direct cost of bankruptcy, this is much more difficult to do with indirect costs.
CT 19.5: Is it possible for a firm to be underlevered using the cost of capital approach, and overlevered, at the same time, when compared with its peer group? Why or why not?
Answer: Yes. In a market where all firms in a sector carry too little debt, firms can look overlevered relative to their peer group and under levered using the cost of capital approach.
CT 20.1: Assume a firm has excess debt capacity of $ 2 billion, and that firm value will increase by $ 800 million if this debt capacity is used. The firm is planning on acquiring another firm for $ 2 billion and financing the acquisition with new debt. Even though it is over paying by $ 300 million on the acquisition, the managers of the firm argue that the acquisition makes sense, because the value gained from using excess debt capacity ($ 800 million) is greater than the overpayment on the acquisition ($ 300 million). Do you agree?
Answer: I do not. The firm’s value would increase by $ 800 million if it just used the excess debt capacity to buy back stock. The acquisition itself creates a loss in value and is thus a bad investment.
CT 20.2: Adding special features to bonds, such as linking coupon payments to commodity prices or catastrophes, will reduce their attractiveness to investors and make the interest rates paid on them higher. Does it follow then that adding these special features will not create value to the issuing firm?
Answer: While it is true that adding features that shift the risk to bondholders will increase interest rates o bonds, it is not true that there will no added value. By shifting this risk to bondholders, a firm that otherwise would not have borrowed may be able to borrow some money. On an after-tax basis, the cost of this borrowing (even with the high interest rates) will be lower than the cost of equity.
CT 21.1: Some countries do not allow firms to buy back stock from their stockholders. Would you expect dividend payout ratios to be higher or lower in these countries?
Answer: I would expect the dividend payout to be higher, since this is the only way in which firms can return cash to stockholders.
CT 21.2: Given the assumptions needed for dividends to be irrelevant, what types of firms are most likely to find that their values are unaffected by their dividend policies?
Answer: Large firms with predictable investment opportunities, easy and cheap access to capital markets that are held by investors who are tax-exempt (pension funds) or in low tax brackets (poorer, older investors). [Regulated utilities would be a good example]
CT 21.3: Companies generally do not have to pay taxes on 85% of the dividends they receive from other companies, although they have to pay capital gains taxes on all their gains. What implications does this have for the relative tax advantages of dividends and capital gains?
Answer: The tax rate on dividends will be lower than the tax rate on capital gains when other corporations are the primary investors in a firm. This may lead to higher dividend payouts for these firms.
CT 21.4: Paying higher dividends can increase the value of the equity in some firms. What types of firms is this likely to occur in and why?
Answer: Firms with substantial cash build-up, poor investment opportunities and a management that is not trusted by stockholders…. (It would also help if the stockholders were tax exempt or low tax rate individuals)
CT 22.1: What reasons may foreign markets have for restricting stock buybacks by firms? What is the potential cost of such a restriction?
Answer: They might fear stock price manipulation or expropriation from lenders (banks and bondholders). The cost is that firms will accumulate much larger cash balances than they need, and this cash will not find its way to the best uses (young firms with attractive investments, for instance)
CT 22.2: Companies often start paying dividends because of their desire to attract new investors, who will hold only dividend-paying stock. Do you agree with this rationale for paying dividends for a firm that cannot afford these dividends? Why or why not?
Answer: No. Dividends will attract the wrong kind of stockholders to this firm. These dividend loving stockholders will demand more dividends and the firm will find itself having to choose between great investments and paying dividends.
CT 22.3: Assume you are running a firm that has a dividend policy very different from that of the rest of its industry. How would you defend this policy to investors?
Answer: Assuming that it is defensible, I would point to my firm’s better (worse) investment opportunities, higher (lower) variability in cash flows and tougher (easier) access to capital markets to justify a lower (higher) dividend payout than my peer group.
CT 22.4: Some firms that cut dividends announce stock splits or declare stock dividends simultaneously. Why might this make this a difference in the stock price reaction to the dividend cut?
Answer: The stock split and stock dividend may operate as a positive signal (or at least the firms the hope they do) and offset some of the negative impact of the dividend cut.
CT 23.1: An alternative strategy is to sell puts on the firm’s stock, giving holders the option to sell back stock to the firm at a fixed price in the future. How is this different from the forward contract described above?
Answer: A put provides a big downside risk, without much upside potential. The forward contract can yield both profits and losses for the firm, whereas the holders of the put contracts will exercise them only if the stock price goes down. Thus, the firm will have tied itself in to buying back stock at an inflated price, if the price drops below the exercise price.
CT 23.2: Some firms do reverse stock splits, in which investors receive one share for every three or four they own. What might be the rationale for a reverse stock split and what effect will it have on stock prices?
Answer: The same as for a stock split. By doing so, a firm might try to bring its stock price up to a reasonable trading range (say, from $ 3 per share to $ 10 per share). If the spreads do not increase proportionately, there should be a drop in transactions costs.
CT 23.3: Firms that introduce tracking stock on their highest growth divisions will see their values go up. Is this statement true? If not, why not?
Answer: This is not true. The tracking stock may be attractive, because it is on the highest growth divisions, but what is left of the firm will become less attractive. The sum of the two values is what matters, and there is no reason to believe that this will increase.
CT 23.4: Assume that management is viewed as incompetent creates tracking stock on the firm’s most valuable division. Would you expect the stock price reaction to be positive? Why or why not?
Answer: No. The tracked division will remain part of the parent firm, with no change of control. The incompetent management will continue to run it…
CT 24.1: Discounted cash flow models ignore qualitative factors such as the quality of management and brand name. Is this statement true? Why or why not?
Answer: This is not true. The inputs in a DCF model (growth rate, length of the high growth period, operating margins etc.) can reflect these qualitative factors.
CT 24.2: Analysts and equity portfolio managers are judged against how the market or sector they operate in has performed. Therefore, they are more likely to use relative valuation than discounted cash flow valuation. Why?
Answer: If you can find stocks that are under valued relative to the market or the sector that they perform in, you will come out ahead in the comparison even if all stocks in the market or sector are overvalued. If stock prices drop, your stocks should drop by less (assuming that you are right about the under valuation).
CT 24.3: A valuation based upon multiples is more reliable than one based on discounted cash flows because it requires fewer inputs and fewer assumptions. Is this statement true? Why or why not?
Answer: Implicit in every multiple are all of the same assumptions (about cash flows, growth and risk) that are explicit in a discounted cash flow valuation. Therefore, it is not true that there are fewer assumptions and inputs in a relative valuation. There is a much greater trust, though, that markets are, on average, right.
CT 25.1: What would happen to the value increases if these firms made the changes in debt ratios and returns on capital gradually, rather than instantaneously, as we have assumed?
Answer: The effect on value would be smaller, since it is the present value of the effects that matter.
CT 25.2: The economic value added is a dollar measure of excess returns, whereas CFROI is a percentage measure. For a small firm, with significant capital rationing constraints, what might be some of the advantages of using CFROI?
Answer: For firms with limited capital, investing in high CFROI projects may yield a much higher bang for the limited buck (capital) that they have. Investing in the highest EVA projects may eat up the capital very quickly, leading to less value enhancement….
CT 26.1: Merger waves seem to end with excesses — bidders overpaying for companies and paying a hefty price. The restructuring and buyout wave of the 1980s ended, for instance, after several leveraged buyouts towards the end of the decade failed. Why do merger waves crest?
Answer: Because firms overpay by larger and larger amounts as the wave continues — the deals become more and more difficult to find as the wave continues. At some point, a firm or firms overreach and pay so much that they go bankrupt or fact a crisis. When this happens, other firms notice and scale down their expectations….
CT 26.2: The managers of bidding firms whose stock prices go down on acquisitions, often argue that this occurs because stockholders do not have as much information as they do about the target firm’s finances and its fit with the bidding firm. How would you respond to the argument?
Answer: It is true that stockholders do not have has much information about the merger as managers do, but they have a much better perspective on the merger. Managers tend to get so close to the action of the deal that they lose their objectivity.
CT 26.3: Assume that you have been in put in charge of coming up with an acquisition strategy for your firm. What are some of the actions you would take to make the strategy a success for your stockholders?
Answer: I would focus on small firms that are closely held, where I can come in and make significant improvements to operations and relax severe capital constraints. I would also look for private businesses with valuable products or customers. I will rule out acquisitions where I have to bid against others to get a target firm. Finally, I will put together a team designed to come into acquired firms to put into practice the planned changes and synergies…
CT 26.4: Consider only anti-takeover amendments that require shareholder approval. What types of firms are most likely to be successful in getting such amendments approved? In particular, do you see such amendments having a greater chance of success in well managed or badly managed firms?
Answer: Firms that are well managed should have much greater chance of getting their stockholders to agree to such amendments, since they give incumbent managers more power,
CT 26.5: If the Congoleum acquisition creates value for the acquiring investors, what are the sources of the increase in value?
Answer: One could be the tax benefits that flow from the higher depreciation and a more efficient use of debt capacity. The second could be the more efficient operation that result from managers being owners as well. The third could be that Congoleum was under valued in the first place.
CT 27.1: Assume that you are valuing options on stock in a private firm. How would you go about estimating the value of the options? Why might you view the value you obtain from an option pricing model more cautiously than if the firm were public?
Answer: I would first estimate the value of equity in the private firm, and use the variance in stock prices of publicly traded firms in the same business. I would be cautious about using this value, since the underlying asset’s value is an estimate and arbitrage (which is what keeps the option pricing model together) is much more difficult.
CT 27.2: A firm that is considering a new project with a net present value of -$100 million decides to invest in it, because is provides it with expansion options. Under what conditions do you think this is reasonable? When is it not?
Answer: Only if the new project (with the negative net present value) is necessary for the subsequent expansion and there as substantial opportunities for sustained excess returns in the expansion (arising from strong competitive advantages).
CT 27.3: Assume that you are valuing the equity in two firms with high leverage and negative earnings. One has very long term debt, and the other has short term debt. Which one would you expect to have more valuable equity? Why?
Answer: I would expect the firm with the long term debt to have more valuable equiy, since the option to liquidate (which determines the value of equity) will have a longer maturity.
CT 27.4: What types of firms are likely to face significant constraints in raising external capital? What implications would you draw for the value of financing flexibility at these firms?
Answer: Small firms that are either private or closely held are likely to face significant constraints on external financing. I would expect them to value financial flexibility much more.