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Chapter 1


An Overview of Corporate Finance and


The Financial Environment



ANSWERS TO END-OF-CHAPTER QUESTIONS



1-1 a. A proprietorship, or sole proprietorship, is a business owned by one


individual. A partnership exists when two or more persons associate to


conduct a business. In contrast, a corporation is a legal entity created by


a state. The corporation is separate and distinct from its owners and


managers.


b. In a limited partnership, limited partners' liabilities, investment returns and control


are limited, while general partners have unlimited liability and control. A limited


liability partnership (LLP), sometimes called a limited liability company (LLC),


combines the limited liability advantage of a corporation with the tax advantages of a


partnership. A professional corporation (PC), known in some states as a


professional association (PA), has most of the benefits of incorporation but the


participants are not relieved of professional (malpractice) liability.


c. Stockholder wealth maximization is the appropriate goal for management decisions.


The risk and timing associated with expected earnings per share and cash flows are


considered in order to maximize the price of the firm's common stock.


d. A money market is a financial market for debt securities with maturities of less than


one year (short-term). The New York money market is the world's largest. Capital


markets are the financial markets for long-term debt and corporate stocks. The New


York Stock Exchange is an example of a capital market. Primary markets are the


markets in which newly issued securities are sold for the first time. Secondary


markets are where securities are resold after initial issue in the primary market. The


New York Stock Exchange is a secondary market.




Answers and Solutions: 1- 1 e. In private markets, transactions are worked out directly between two parties and


structured in any manner that appeals to them. Bank loans and private placements


of debt with insurance companies are examples of private market transactions. In


public markets, standardized contracts are traded on organized exchanges.


Securities that are issued in public markets, such as common stock and corporate


bonds, are ultimately held by a large number of individuals. Private market


securities are more tailor-made but less liquid, whereas public market securities are


more liquid but subject to greater standardization. Derivatives are claims whose


value depends on what happens to the value of some other asset. Futures and


options are two important types of derivatives, and their values depend on what


happens to the prices of other assets, say IBM stock, Japanese yen, or pork bellies.


Therefore, the value of a derivative security is derived from the value of an


underlying real asset.


f. An investment banker is a middleman between businesses and savers.


Investment banking houses assist in the design of corporate securities and


then sell them to savers (investors) in the primary markets. Financial


service corporations offer a wide range of financial services such as


brokerage operations, insurance, and commercial banking. A financial


intermediary buys securities with funds that it obtains by issuing its own


securities. An example is a common stock mutual fund that buys


common stocks with funds obtained by issuing shares in the mutual fund.


g. A mutual fund is a corporation that sells shares in the fund and uses the


proceeds to buy stocks, long-term bonds, or short-term debt instruments.


The resulting dividends, interest, and capital gains are distributed to the


fund's shareholders after the deduction of operating expenses. Different


funds are designed to meet different objectives. Money market funds are


mutual funds which invest in short-term debt instruments and offer their


shareholders check writing privileges; thus, they are essentially


interest-bearing checking accounts.


h. Physical location exchanges, such as the New York Stock Exchange, facilitate


communication between buyers and sellers of securities. Each physical location


exchange is a physical entity at a particular location and is governed by an elected


board of governors. A computer/telephone network, such as Nasdaq, consists of all


the facilities that provide for security transactions not conducted at a physical


location exchange. These facilities are, basically, the communications network that


links the buyers and sellers.


i. An open outcry auction is a method of matching buyers and sellers. In an auction,


the buyers and sellers are face-to-face, with each stating the prices and which they


will buy or sell. In a dealer market, a dealer holds an inventory of the security and


makes a market by offering to buy or sell. Others who wish to buy or sell can see



Answers and Solutions: 1- 2 the offers made by the dealers, and can contact the dealer of their choice to arrange a


transaction. In an ECN, orders from potential buyers and sellers are automatically


matched, and the transaction is automatically completed.


j. Production opportunities are the returns available within an economy from


investment in productive assets. The higher the production opportunities, the more


producers would be willing to pay for required capital. Consumption time


preferences refer to the preferred pattern of consumption. Consumer's time


preferences for consumption establish how much consumption they are willing to


defer, and hence save, at different levels of interest.


k. The real risk-free rate is that interest rate which equalizes the aggregate supply of,


and demand for, riskless securities in an economy with zero inflation. The real


risk-free rate could also be called the pure rate of interest since it is the rate of interest


that would exist on very short-term, default-free U.S. Treasury securities if the


expected rate of inflation were zero. It has been estimated that this rate of interest,


denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4


percent. The nominal risk-free rate of interest, denoted by rRF, is the real risk-free


rate plus a premium for expected inflation. The short-term nominal risk-free rate is


usually approximated by the U.S. Treasury bill rate, while the long-term nominal


risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while


T-bonds are free of default and liquidity risks, they are subject to risks due to changes


in the general level of interest rates.


l. The inflation premium is the premium added to the real risk-free rate of interest to


compensate for the expected loss of purchasing power. The inflation premium is the


average rate of inflation expected over the life of the security. Default risk is the


risk that a borrower will not pay the interest and/or principal on a loan as they


become due. Thus, a default risk premium (DRP) is added to the real risk-free rate


to compensate investors for bearing default risk. Liquidity refers to a firm's cash


and marketable securities position, and to its ability to meet maturing obligations. A


liquid asset is any asset that can be quickly sold and converted to cash at its "fair"


value. Active markets provide liquidity. A liquidity premium is added to the real


risk-free rate of interest, in addition to other premiums, if a security is not liquid.


m. Interest rate risk arises from the fact that bond prices decline when interest rates rise.


Under these circumstances, selling a bond prior to maturity will result in a capital loss,


and the longer the term to maturity, the larger the loss. Thus, a maturity risk


premium must be added to the real risk-free rate of interest to compensate for interest


rate risk. Reinvestment rate risk occurs when a short-term debt security must be


"rolled over." If interest rates have fallen, the reinvestment of principal will be at a


lower rate, with correspondingly lower interest payments and ending value. Note


that long-term debt securities also have some reinvestment rate risk because their


interest payments have to be reinvested at prevailing rates.



Answers and Solutions: 1- 3 n. The term structure of interest rates is the relationship between yield to maturity and


term to maturity for bonds of a single risk class. The yield curve is the curve that


results when yield to maturity is plotted on the Y-axis with term to maturity on the


X-axis.


o. When the yield curve slopes upward, it is said to be "normal," because it is like this


most of the time. Conversely, a downward-sloping yield curve is termed


"abnormal" or "inverted."


p. The expectations theory states that the slope of the yield curve depends on


expectations about future inflation rates and interest rates. Thus, if the annual rate


of inflation and future interest rates are expected to increase, the yield curve will be


upward sloping, whereas the curve will be downward sloping if the annual rates are


expected to decrease.


r. A foreign trade deficit occurs when businesses and individuals in the U. S. import


more goods from foreign countries than are exported. Trade deficits must be


financed, and the main source of financing is debt. Therefore, as the trade deficit


increases, the debt financing increases, driving up interest rates. U. S. interest rates


must be competitive with foreign interest rates; if the Federal Reserve attempts to set


interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing


bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative


to the size of the overall economy, it may hinder the Fed's ability to combat a


recession by lowering interest rates.


1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business


organization. The advantages of the first two include the ease and low cost of formation.


The advantages of the corporation include limited liability, indefinite life, ease of


ownership transfer, and access to capital markets.


The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums


of capital; (2) unlimited personal liability for business debts; and (3) limited life. The


disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of


transferring ownership, and (4) difficulty of raising large amounts of capital. The


disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to


file state and federal reports for registration, which are expensive, complex and


time-consuming.


1-3 The three primary determinants of a firm's cash flows are: (1) sales revenues; (2)


operating expenses, such as raw materials costs and labor costs; and (3) the necessary


investments in operating capital, such as buildings, equipment, and inventory.


1-4 Financial intermediaries are business organizations that receive funds in one form and


repackage them for the use of those who need funds. Through financial intermediation,



Answers and Solutions: 1- 4 resources are allocated more effectively, and the real output of the economy is thereby


increased.


1-5 Short-term rates are more volatile because (1) the Fed operates mainly in the short-term


sector, hence Federal Reserve intervention has its major effect here, and (2) long-term


rates reflect the average expected inflation rate over the next 20 to 30 years, and this


average does not change as radically as year-to-year expectations.


1-6 a. If transfers between the two markets were costly, interest rates would be


different in the two areas. Area Y, with the relatively young population,


would have less in savings accumulation and stronger loan demand. Area


O, with the relatively old population, would have more savings accumula-


tion and weaker loan demand as the members of the older population have


already purchased their houses, and are less consumption oriented. Thus,


supply/demand equilibrium would be at a higher rate of interest in Area Y.


b. Yes. Nationwide branching, and so forth, would reduce the cost of financial


transfers between the areas. Thus, funds would flow from Area O with excess


relative supply to Area Y with excess relative demand. This flow would increase the


interest rate in Area O and decrease the interest rate in Y until the rates were roughly


equal, the difference being the transfer cost.


1-7 a. The immediate effect on the yield curve would be to lower interest rates in


the short-term end of the market, since the Fed deals primarily in that


market segment. However, people would expect higher future inflation,


which would raise long-term rates. The result would be a much steeper


yield curve.


b. If the policy is maintained, the expanded money supply will result in increased rates


of inflation and increased inflationary expectations. This will cause investors to


increase the inflation premium on all debt securities, and the entire yield curve would


rise; that is, all rates would be higher.




Answers and Solutions: 1- 5 SOLUTIONS TO END-OF-CHAPTER PROBLEMS



1-1 r* = 3%; I1 = 2%; I2 = 4%; I3 = 4%; MRP = 0; rT-2 = ?; rT-3 = ?


r = r* + IP + DRP + LP + MRP.


Since these are Treasury securities, DRP = LP = 0.


rT-2 = r* + IP2


IP2 = (2% + 4%)/2 = 3%


rT-2 = 3% + 3% = 6%.


rT-3 = r* + IP3


IP3 = (2% + 4% + 4%)/3 = 3.33%


rT-3 = 3% + 3.33% = 6.33%.



1-2 rT-10 = 6%; rC-10 = 8%; LP = 0.5%; DRP = ?


r = r* + IP + DRP + LP + MRP.


rT-10 = 6% = r* + IP + MRP; DRP = LP = 0.


rC-10 = 8% = r* + IP + DRP + 0.5% + MRP.


Because both bonds are 10-year bonds the inflation premium and maturity risk premium


on both bonds are equal. The only difference between them is the liquidity and default


risk premiums.


rC-10 = 8% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP +


MRP = 6%; therefore,


rC-10 = 8% = 6% + 0.5% + DRP


1.5% = DRP.



1-3 r* = 3%; IP = 3%; rT-2 = 6.2%; MRP2 = ?


rT-2 = k* + IP + MRP = 6.2%


rT-2 = 3% + 3% + MRP = 6.2%


MRP = 0.2%.


Answers and Solutions: 1- 6 1-4 r = r* + IP + MRP + DRP + LP.


r* = 0.03.


IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.


MRP = 0.0005(6) = 0.003.


DRP = 0.


LP = 0.


r = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.



1-5 First, note that we will use the equation rt = 3% + IPt + MRPt. We have the data needed


to find the IPs:



8% + 5% + 4% + 4% + 4% 25%


IP5 = = = 5%.


5 5



8% + 5%


IP2 = = 6.5%.


2



Now we can substitute into the equation:


r2 = 3% + 6.5% + MRP2 = 10%. r5 = 3% + 5% + MRP5 = 10%.


Now we can solve for the MRPs, and find the difference:


MRP5 = 10% - 8% = 2%. MRP2 = 10% - 9.5% = 0.5%.


Difference = (2% - 0.5%) = 1.5%.




Answers and Solutions: 1- 7 1-6 Basic relevant equations:


rt = r* + IPt + DRPt + MRPt + LPt.


But here IP is the only premium, so rt = r* + IPt.


IPt = Avg. inflation = (I1 + I2 + ...)/N.


We know that I1 = IP1 = 3% and r* = 2%. Therefore,


r1 = 2% + 3% = 5%. r3 = r1 + 2% = 5% + 2% = 7%. But,


r3 = r* + IP3 = 2% + IP3 = 7%, so


IP3 = 7% - 2% = 5%.


We also know that It = Constant after t = 1.


We can set up this table:


r* I Avg. I = IPt r = r* + IPt


1 2 3 3%/1 = 3% 5%


2 2 I (3% + I)/2 = IP2


3 2 I (3% + I + I)/3 = IP3 r3 = 7%, so IP3 = 7% - 2% = 5%.


Avg. I = IP3 = (3% + 2I)/3 = 5%


2I = 12%


I = 6%.




Answers and Solutions: 1- 8 1-7 a. Real


Years to Risk-Free


Maturity Rate (r*) IP** MRP rT = r* + IP + MRP


1 2% 7.00% 0.2% 9.20%


2 2 6.00 0.4


8.40


3 2 5.00 0.6


7.60


4 2 4.50 0.8


7.30


5 2 4.20 1.0


7.20


10 2 3.60 1.0


6.60


20 2 3.30 1.0 6.30



**The computation of the inflation premium is as follows:


Expected Average


Year Inflation Expected Inflation


1 7% 7.00%


2 5 6.00


3 3 5.00


4 3 4.50


5 3 4.20


10 3 3.60


20 3 3.30


For example, the calculation for 3 years is as follows:



7% + 5% + 3%


= 5.00%.


3


Thus, the yield curve would be as follows:




Answers and Solutions: 1- 9 Interest Rate


(%)


11.0


10.5


10.0


9.5


9.0


8.5


LILCO


8.0


7.5


Exxon


7.0


6.5


T-bonds



0 2 4 6 8 10 12 14 16 18 20


Years to Maturity



b. The interest rate on the Exxon bonds has the same components as the Treasury


securities, except that the Exxon bonds have default risk, so a default risk premium


must be included. Therefore,


rExxon = r* + IP + MRP + DRP.



For a strong company such as Exxon, the default risk premium is virtually zero for


short-term bonds. However, as time to maturity increases, the probability of default,


although still small, is sufficient to warrant a default premium. Thus, the yield risk


curve for the Exxon bonds will rise above the yield curve for the Treasury securities.


In the graph, the default risk premium was assumed to be 1.0 percentage point on the


20-year Exxon bonds. The return should equal 6.3% + 1% = 7.3%.


c. LILCO bonds would have significantly more default risk than either Treasury


securities or Exxon bonds, and the risk of default would increase over time due to


possible financial deterioration. In this example, the default risk premium was


assumed to be 1.0 percentage point on the 1-year LILCO bonds and 2.0 percentage


points on the 20-year bonds. The 20-year return should equal 6.3% + 2% = 8.3%.




Answers and Solutions: 1- 10 SOLUTION TO SPREADSHEET PROBLEM



1-8 The detailed solution for the spreadsheet problem is available both on the instructor's


resource CD-ROM (in the file Solution for FM11 Ch 01 P08 Build a Model.xls) and on


the instructor's side of the textbook's web site, http://brigham.swcollege.com.




Answers and Solutions: 1- 11 MINI CASE



Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm's clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money. Your boss has developed the following set of questions which you must ask and answer to explain the U.S. financial system to Dellatorre.


a. Why is corporate finance important to all managers?


Answer: Corporate finance provides the skills managers need to: (1) identify and select the corporate


strategies and individual projects that add value to their firm; and (2) forecast the funding


requirements of their company, and devise strategies for acquiring those funds.


b. Describe the organizational forms a company might have as it evolves from a start-up to a major


corporation. List the advantages and disadvantages of each form.


Answer: The three main forms of business organization are (1) sole proprietorships, (2) partnerships, and


(3) corporations. In addition, several hybrid forms are gaining popularity. These hybrid forms


are the limited partnership, the limited liability partnership, the professional corporation, and the s


corporation.


The proprietorship has three important advantages: (1) it is easily and inexpensively


formed, (2) it is subject to few government regulations, and (3) the business pays no


corporate income taxes. The proprietorship also has three important limitations: (1)


it is difficult for a proprietorship to obtain large sums of capital; (2) the proprietor has


unlimited personal liability for the business's debts, and (3) the life of a business


organized as a proprietorship is limited to the life of the individual who created it.


The major advantage of a partnership is its low cost and ease of formation. The


disadvantages are similar to those associated with proprietorships: (1) unlimited liability, (2)


limited life of the organization, (3) difficulty of transferring ownership, and (4) difficulty of


raising large amounts of capital. The tax treatment of a partnership is similar to that for


proprietorships, which is often an advantage.


The corporate form of business has three major advantages: (1) unlimited life, (2) easy


transferability of ownership interest, and (3) limited liability. While the corporate form offers


significant advantages over proprietorships and partnerships, it does have two primary


disadvantages: (1) corporate earnings may be subject to double taxation and (2) setting up a


corporation and filing the many required state and federal reports is more complex and


time-consuming than for a proprietorship or a partnership.


Answers and Solutions: 2 - 12 In a limited partnership, the limited partners are liable only for the amount of their investment


in the partnership; however, the limited partners typically have no control. The limited liability


partnership form of organization combines the limited liability advantage of a corporation with


the tax advantages of a partnership. Professional corporations provide most of the benefits of


incorporation but do not relieve the participants of professional liability. S corporations are


similar in many ways to limited liability partnerships, but LLPS frequently offer more flexibility


and benefits to their owners.


c. How do corporations "go public" and continue to grow? What are agency problems?


Answer: A company goes public when it sells stock to the public in an initial public as the firm grows, it


might issue additional stock or debt. An agency problem occurs when the managers of the firm act


in their own self interests and not in the interests of the shareholders.



d. What should be the primary objective of managers?


Answer: The corporation's primary goal is stockholder wealth maximization, which translates to


maximizing the price of the firm's common stock.


d. 1. Do firms have any responsibilities to society at large?


Answer: Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the


air or water, and to produce safe products. However, the most significant cost-increasing actions


will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls


uniformly on all businesses.



d. 2. Is stock price maximization good or bad for society?


Answer: The same actions that maximize stock prices also benefit society. Stock price maximization


requires efficient, low-cost operations that produce high-quality goods and services at the lowest


possible cost. Stock price maximization requires the development of products and services that


consumers want and need, so the profit motive leads to new technology, to new products, and to


new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate


stocks of merchandise, and well-located business establishments--factors that are all necessary to


make sales, which are necessary for profits.


d. 3. Should firms behave ethically?


Answer: Yes. Results of a recent study indicate that the executives of most major firms in the United


States believe that firms do try to maintain high ethical standards in all of their business dealings.


Furthermore, most executives believe that there is a positive correlation between ethics and


long-run profitability. Conflicts often arise between profits and ethics. Companies must deal


with these conflicts on a regular basis, and a failure to handle the situation properly can lead to


Answers and Solutions: 2 - 13 huge product liability suits and even to bankruptcy. There is no room for unethical behavior in


the business world.


e. What three aspects of cash flows affect the value of any investment?


Answer: (1) amount of expected cash flows; (2) timing of the cash flow stream; and (3) riskiness of the


cash flows.


f. What are free cash flows? What are the three determinants of free cash flows?


Answer: free cash flows are the cash flows available for distribution to all investors (stockholders and


creditors) after paying expenses (including taxes) and making the necessary investments to


support growth. Three factors determine cash flows: (1) current level and growth rates of sales; (2)


operating expenses; and (3) capital expenses.


g. What is the weighted average cost of capital? What affects it?


Answer: The weighted average cost of capital (WACC) is the average rate of return required by all of the


company's investors (stockholders and creditors). It is affected by the firm's capital structure,


interest rates, the firm's risk, and the market's overall attitude toward risk. h. How do free cash flows and the weighted average cost of capital interact to determine a


firm's value?


Answer: A firm's value is the sum of all future expected free cash flows, converted into today's dollars.


FCF1 FCF2 FCF


Value = + + ... .


(1 + WACC)1 (1 + WACC) 2 (1 + WACC)


i. What are financial assets? Describe some financial instruments.


Answer: Financial assets are pieces of paper with contractual obligations. Some short-term (i.e., they


mature in less than a year) are instruments with low default risk are u.s. treasury bills, banker's


acceptances, commercial paper, negotiable CDs, and eurodollar deposits. Commercial loans


(which have maturities up to seven years) have rates that are usually tied to the prime rate (i.e., the


rate that U.S. banks charge to their best customers) or LIBOR (the London Interbank Offered Rate,


which is the rate that banks in the U.K. charge one another. U.S. treasury notes and bonds have


maturities from two to thirty years; they are free of default risk. Mortgages have maturities up to


thirty years. Municipal bonds have maturities of up to thirty years; their interest is exempt from


most taxes. Corporate bonds have maturities up to forty years. Municipal and corporate


bonds are subject to default risk. Some preferred stocks have no maturity date, some do have a


specific maturity date. Common stock has no maturity date, and is riskier than preferred stock.



j. Who are the providers (savers) and users (borrowers) of capital? How is capital


transferred between savers and borrowers?



Answers and Solutions: 2 - 14 Answer: Households are net savers. Non-financial corporations are net borrowers. Governments are net


borrowers, although the U.S. government is a net saver when it runs a surplus. Non-financial


corporations (i.e., financial intermediaries) are slightly net borrowers, but they are almost


breakeven. Capital is transferred through: (1) direct transfer (e.g., corporation issues commercial


paper to insurance company); (2) an investment banking house (e.g., IPO, seasoned equity


offering, or debt placement); (3) a financial intermediary (e.g., individual deposits money in bank,


bank makes commercial loan to a company).



k. List some financial intermediaries.


Answer: Commercial banks, savings & loans, mutual savings banks, and credit unions, life insurance


companies, mutual funds, and pension funds are financial intermediaries.


l. What are some different types of markets?


Answer: A market is a method of exchanging one asset (usually cash) for another asset. Some types of


markets are: physical assets vs. financial assets; spot versus future markets; money versus capital


markets; primary versus secondary markets.


m. How are secondary markets organized?


Answer: They are categorized by "location" (physical location exchanges or computer/telephone networks)


and by the way that orders from buyers and sellers are matched (open outcry auctions, dealers (i.e.,


market makers), and electronic communications networks (ECNS).


m. 1. List some physical location markets and some computer/telephone networks.


Answer: Physical location exchanges include the NYSE, AMEX, CBOT, and Tokyo stock exchange.


Computer/telephone networks include Nasdaq, government bond markets, and foreign exchange


markets.


m. 2. Explain the differences between open outcry auctions, dealer markets, and electronic


communications networks (ECNS).


Answer: The NYSE and AMEX are the two largest auction markets for stocks (NYSE is a modified


auction, with a "specialist"). Participants have a seat on the exchange, meet face-to-face, and


place orders for themselves or for their clients; e.g., CBOT. Some orders are market orders,


which are executed at the current market price, some are limit orders, which specify that the trade


should occur only at a certain price within a certain time period (or the trade does not occur at all).


In dealer markets, "dealers" keep an inventory of the stock (or other financial asset) and place bid


and ask "advertisements," which are prices at which they are willing to buy and sell. A


computerized quotation system keeps track of bid and ask prices, but does not automatically


match buyers and sellers. Some examples of dealer markets are the Nasdaq national market,


Answers and Solutions: 2 - 15 the Nasdaq small cap market, the London SEAQ, and the German Neuer market. ECNS are


computerized systems that match orders from buyers and sellers and automatically execute the


trades. Some examples are Instinet (US, stocks), Eurex (Swiss-German, futures contracts), sets


(London, stocks). In the old days, securities were kept in a safe behind the counter, and passed


"over the counter" when they were sold. Now the OTC market is the equivalent of a computer


bulletin board, which allows potential buyers and sellers to post an offer. However, the OTC has


no dealers and very poor liquidity.


n. What do we call the price that a borrower must pay for debt capital? What is the price of


equity capital? What are the four most fundamental factors that affect the cost of money,


or the general level of interest rates, in the economy?


Answer: The interest rate is the price paid for borrowed capital, while the return on equity capital comes


in the form of dividends plus capital gains. The return that investors require on capital depends


on (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.


Production opportunities refer to the returns that are available from investment in productive


assets: the more productive a producer firm believes its assets will be, the more it will be willing


to pay for the capital necessary to acquire those assets.


Time preference for consumption refers to consumers' preferences for current consumption


versus savings for future consumption: consumers with low preferences for current consumption


will be willing to lend at a lower rate than consumers with a high preference for current


consumption.


Inflation refers to the tendency of prices to rise, and the higher the expected rate of inflation,


the larger the required rate of return.


Risk, in a money and capital market context, refers to the chance that a loan will not be repaid


as promised--the higher the perceived default risk, the higher the required rate of return.


Risk is also linked to the maturity and liquidity of a security. The longer the


maturity and the less liquid (marketable) the security, the higher the required rate of


return, other things constant.


The preceding discussion related to the general level of money costs, but the level of interest


rates will also be influenced by such things as fed policy, fiscal and foreign trade deficits, and the


level of economic activity. Also, individual securities will have higher yields than the risk-free


rate because of the addition of various premiums as discussed below.




Answers and Solutions: 2 - 16 o. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How


are these two rates measured?


Answer: Keep these equations in mind as we discuss interest rates. We will define the terms as we go


along:


r = r* + IP + DRP + LP + MRP.


rRF = r* + IP.


The real risk-free rate, r*, is the rate that would exist on default-free securities in the absence of


inflation.


The nominal risk-free rate, rrf, is equal to the real risk-free rate plus an inflation premium


which is equal to the average rate of inflation expected over the life of the security.


There is no truly riskless security, but the closest thing is a short-term U. S. Treasury bill


(t-bill), which is free of most risks. The real risk-free rate, r*, is estimated by subtracting the


expected rate of inflation from the rate on short-term treasury securities. It is generally assumed


that r* is in the range of 1 to 4 percentage points. The t-bond rate is used as a proxy for the


long-term risk-free rate. However, we know that all long-term bonds contain interest rate risk,


so the t-bond rate is not really riskless. It is, however, free of default risk.


p. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium


(LP), and maturity risk premium (MRP). Which of these premiums is included when


determining the interest rate on (1) short-term U.S. treasury securities, (2) long-term U.S.


treasury securities, (3) short-term corporate securities, and (4) long-term corporate


securities? Explain how the premiums would vary over time and among the different


securities listed above.


Answer: The inflation premium (IP) is a premium added to the real risk-free rate of interest to compensate


for expected inflation.


The default risk premium (DRP) is a premium based on the probability that the issuer will


default on the loan, and it is measured by the difference between the interest rate on a U.S.


treasury bond and a corporate bond of equal maturity and marketability.


A liquid asset is one that can be sold at a predictable price on short notice; a liquidity


premium is added to the rate of interest on securities that are not liquid.


The maturity risk premium (MRP) is a premium which reflects interest rate risk; longer-term


securities have more interest rate risk (the risk of capital loss due to rising interest rates) than do


shorter-term securities, and the MRP is added to reflect this risk.


1. Short-term treasury securities include only an inflation premium.


2. Long-term treasury securities contain an inflation premium plus a maturity risk premium.


Note that the inflation premium added to long-term securities will differ from that for


short-term securities unless the rate of inflation is expected to remain constant.


3. The rate on short-term corporate securities is equal to the real risk-free rate plus premiums for


inflation, default risk, and liquidity. The size of the default and liquidity premiums will


vary depending on the financial strength of the issuing corporation and its degree of liquidity,


with larger corporations generally having greater liquidity because of more active trading.



Answers and Solutions: 2 - 17 4. The rate for long-term corporate securities also includes a premium for maturity risk. Thus,


long-term corporate securities generally carry the highest yields of these four types of


securities.


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


Answer: The term structure of interest rates is the relationship between interest rates, or


yields, and maturities of securities. When this relationship is graphed, the resulting


curve is called a yield curve.


r. Suppose most investors expect the inflation rate to be 5 percent next year, 6


percent the following year, and 8 percent thereafter. The real risk-free rate is 3


percent. The maturity risk premium is zero for securities that mature in 1 year


or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1


percent per year thereafter for 20 years, after which it is stable. What is the


interest rate on 1-year, 10-year, and 20-year treasury securities? Draw a yield


curve with these data. What factors can explain why this constructed yield


curve is upward sloping?


Answer: Step 1: find the average expected inflation rate over years 1 to 20:


Yr 1: IP = 5.0%.


Yr 10: IP = (5 + 6 + 8 + 8 + 8 + ... + 8)/10 = 7.5%.


Yr 20: IP = (5 + 6 + 8 + 8 + ... + 8)/20 = 7.75%.


Step 2: find the maturity premium in each year:


Yr 1: MRP = 0.0%.


Yr 10: MRP = 0.1 9 = 0.9%.


Yr 20: MRP = 0.1 19 = 1.9%.


Step 3: sum the IPS and MRPS, and add r* = 3%:


Yr 1: rRF = 3% + 5.0% + 0.0% = 8.0%.


Yr 10: rRF = 3% + 7.5% + 0.9% = 11.4%.


Yr 20: rRF = 3% + 7.75% + 1.9% = 12.65%.


The shape of the yield curve depends primarily on two factors:


(1) expectations about future inflation and (2) the relative riskiness of securities with different


maturities.



Answers and Solutions: 2 - 18 Interest


rate (%)


13


12


11


10


9


8



0 1 5 10 15 20


Years to maturity



The constructed yield curve is upward sloping. This is due to increasing expected inflation


and an increasing maturity risk premium.


s. At any given time, how would the yield curve facing an AAA-rated company compare with


the yield curve for U. S. Treasury securities? At any given time, how would the yield curve


facing a BB-rated company compare with the yield curve for U. S. Treasury securities?


Draw a graph to illustrate your answer.


Answer: The yield curve normally slopes upward, indicating that short-term interest rates are lower than


long-term interest rates. Yield curves can be drawn for government securities or for the


securities of any corporation, but corporate yield curves will always lie above government yield


curves, and the riskier the corporation, the higher its yield curve. The spread between a


corporate yield curve and the treasury curve widens as the corporate bond rating decreases.




Answers and Solutions: 2 - 19 4 - 20


Hypothetical Treasury and


Corporate Yield Curves


Interest


Rate (%)


15



BB-Rated


10


AAA-Rated


Treasury


6.0%


5 5.9% yield curve


5.2%


Years to


0


maturity


0 1 5 10 15 20


Copyright ? 2002 by Harcourt, Inc. All rights reserved.



t. What is the pure expectations theory? What does the pure expectations theory


imply about the term structure of interest rates?


Answer: The pure expectations theory assumes that investors establish bond prices and interest rates


strictly on the basis of expectations for interest rates. This means that they are indifferent with


respect to maturity in the sense that they do not view long-term bonds as being riskier than


short-term bonds. If this were true, then the maturity risk premium would be zero, and long-term


interest rates would simply be a weighted average of current and expected future short-term


interest rates. If the pure expectations theory is correct, you can use the yield curve to "back


out" expected future interest rates.




Answers and Solutions: 2 - 20 u. Finally, Dellatorre is also interested in investing in countries other than the


United States. Describe the various types of risks that arise when investing


overseas.


Answer: First, Dellatorre should consider country risk, which refers to the risk that arises from investing or


doing business in a particular country. This risk depends on the country's economic, political,


and social environment. Country risk also includes the risk that property will be expropriated


without adequate compensation, as well as new host country stipulations about local production,


sourcing or hiring practices, and damage or destruction of facilities due to internal strife.


Second, Dellatorre should consider exchange rate risk. Dellatorre needs to keep in mind


when investing overseas that more often than not the security will be denominated in a currency


other than the dollar, which means that the value of the investment will depend on what happens


to exchange rates. Two factors can lead to exchange rate fluctuations. Changes in relative inflation


will lead to changes in exchange rates. Also, an increase in country risk will also cause the


country's currency to fall. Consequently, inflation risk, country risk, and exchange rate risk are


all interrelated.




Answers and Solutions: 2 - 21 Chapter 2


Time Value of Money ANSWERS TO END-OF-CHAPTER QUESTIONS


2-1 a. PV (present value) is the value today of a future payment, or stream of payments, discounted at


the appropriate rate of interest. PV is also the beginning amount that will grow to some future


value. The parameter i is the periodic interest rate that an account pays. The parameter INT is


the dollars of interest earned each period. FVn (future value) is the ending amount in an account,


where n is the number of periods the money is left in the account. PVAn is the value today of a


future stream of equal payments (an annuity) and FVAn is the ending value of a stream of equal


payments, where n is the number of payments of the annuity. PMT is equal to the dollar amount


of an equal, or constant cash flow (an annuity). In the EAR equation, m is used to denote the


number of compounding periods per year, while iNom is the nominal, or quoted, interest rate.


b. FVIFi,n is the future value interest factor for a lump sum left in an account for n periods paying i


percent interest per period. PVIFi,n is the present value interest factor for a lump sum received n


periods in the future discounted at i percent per period. FVIFAi,n is the future value interest


factor for an ordinary annuity of n periodic payments paying i percent interest per period.


PVIFAi,n is the present value interest factor for an ordinary annuity of n periodic payments


discounted at i percent interest per period. All the above factors represent the appropriate PV or


FVn when the lump sum or ordinary annuity payment is $1. Note that the above factors can also


be defined using formulas.


c. The opportunity cost rate (i) of an investment is the rate of return available on the best alternative


investment of similar risk.


d. An annuity is a series of payments of a fixed amount for a specified number of periods. A single


sum, or lump sum payment, as opposed to an annuity, consists of one payment occurring now or


at some future time. A cash flow can be an inflow (a receipt) or an outflow (a deposit, a cost, or an


amount paid). We distinguish between the terms cash flow and PMT. We use the term cash


flow for uneven streams, while we use the term PMT for annuities, or constant payment amounts.


An uneven cash flow stream is a series of cash flows in which the amount varies from one period


to the next. The PV (or FVn) of an uneven payment stream is merely the sum of the present


values (or future values) of each individual payment.


e. An ordinary annuity has payments occurring at the end of each period. A deferred annuity is just


another name for an ordinary annuity. An annuity due has payments occurring at the beginning


of each period. Most financial calculators will accommodate either type of annuity. The


payment period must be equal to the compounding period.


f. A perpetuity is a series of payments of a fixed amount that last indefinitely. In other words, a


perpetuity is an annuity where n equals infinity. Consol is another term for perpetuity. Consols


were originally bonds issued by England in 1815 to consolidate past debt.


g. An outflow is a deposit, a cost, or an amount paid, while an inflow is a receipt. A time line is an


important tool used in time value of money analysis; it is a graphical representation which is used


to show the timing of cash flows. The terminal value is the future value of an uneven cash flow


stream.


Answers and Solutions: 2 - 22 h. Compounding is the process of finding the future value of a single payment or series of payments.


Discounting is the process of finding the present value of a single payment or series of payments;


it is the reverse of compounding.


i. Annual compounding means that interest is paid once a year. In semiannual, quarterly, monthly,


and daily compounding, interest is paid 2, 4, 12, and 365 times per year respectively. When


compounding occurs more frequently than once a year, you earn interest on interest more often,


thus increasing the future value. The more frequent the compounding, the higher the future


value.


j. The effective annual rate is the rate that, under annual compounding, would have produced the


same future value at the end of 1 year as was produced by more frequent compounding, say


quarterly. The nominal (quoted) interest rate, iNom, is the rate of interest stated in a contract. If


the compounding occurs annually, the effective annual rate and the nominal rate are the same. If


compounding occurs more frequently, the effective annual rate is greater than the nominal rate.


The nominal annual interest rate is also called the annual percentage rate, or APR. The periodic


rate, iPER, is the rate charged by a lender or paid by a borrower each period. It can be a rate per


year, per 6-month period, per quarter, per month, per day, or per any other time interval (usually


one year or less).


k. An amortization schedule is a table that breaks down the periodic fixed payment of an installment


loan into its principal and interest components. The principal component of each payment


reduces the remaining principal balance. The interest component is the interest payment on the


beginning-of-period principal balance. An amortized loan is one that is repaid in equal periodic


amounts (or "killed off" over time).


2-2 The opportunity cost rate is the rate of interest one could earn on an alternative investment with a risk


equal to the risk of the investment in question. This is the value of i in the TVM equations, and it is


shown on the top of a time line, between the first and second tick marks. It is not a single rate--the


opportunity cost rate varies depending on the riskiness and maturity of an investment, and it also


varies from year to year depending on inflationary expectations.


2-3 True. The second series is an uneven payment stream, but it contains an annuity of $400 for 8 years.


The series could also be thought of as a $100 annuity for 10 years plus an additional payment of $100


in Year 2, plus additional payments of $300 in Years 3 through 10.


2-4 True, because of compounding effects--growth on growth. The following example demonstrates the


point. The annual growth rate is i in the following equation:


$1(1 + i)10 = $2.


The term (1 + i)10 is the FVIF for i percent, 10 years. We can find i in one of two ways:


1. Using a financial calculator input N = 10, PV = -1, PMT = 0, FV = 2, and I = ?. Solving for I


you obtain 7.18%.


2. Using a financial calculator, input N = 10, I = 10, PV = -1, PMT = 0, and FV = ?.


Solving for FV you obtain $2.59. This formulation recognizes the "interest on


interest" phenomenon.


2-5 For the same stated rate, daily compounding is best. You would earn more "interest on interest."


Answers and Solutions: 2 - 23 Answers and Solutions: 2 - 24 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


2-1 a. 0 6% 1


| | $500(1.06) = $530.00.


-500 FV = ?


b. 0 6% 1 2


| | | $500(1.06)2 = $561.80.


-500 FV = ?


c. 0 6% 1


| | $500(1/1.06) = $471.70.


PV = ? 500


d. 0 6% 1 2


| | | $500(1/1.06)2 = $445.00.


PV = ? 500


6% 2-2 a. 0 1 2 3 4 5 6 7 500 (FVIF6%,10 ) =


$ 8 9 10


| | | | | | | | | | |


$500 (1.7908) = $895.40.


-500 FV =?


b. 012% 1 2 3 4 5 6 7 8


$500 (FVIF12%,10 ) =9 10


| | | | | | | | | | |


$500 (3.1058) = $1,552.90.


-500 FV =?


c. 6%


0 1 2 3 4 5 6 $500 (FVIF6%,10 ) = 9


7 8 10


| | | | | | | | | | |


$500 (0.5584) = $279.20.


PV = ? 500


d. 12%


0 1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


PV = ? 1,552.90


$1,552.90(PVIF12%,10) = $1,552.90(PVIF6%,10) =


$1,552.90(0.3220) = $500.03; i = 6%: $1,552.90(0.5584) = $867.14.


The present value is the value today of a sum of money to be received in the future. For


example, the value today of $1,552.90 to be received 10 years in the future is


about $500 at an interest rate of 12 percent, but it is approximately $867 if the


interest rate is 6 percent. Therefore, if you had $500 today and invested it at 12


percent, you would end up with $1,552.90 in 10 years. The present value


depends on the interest rate because the interest rate determines the amount of


interest you forgo by not having the money today.



7%


Answers and Solutions: 2 - 25 2-3 a. ?


| | $400 = $200(FVIF7%,n)


-200 400 2 = FVIF7%,n


n 10 years.


With a financial calculator, enter I = 7, PV = -200, PMT = 0, and FV = 400. Then press the N


key to find N = 10.24. Override I with the other values to find N = 7.27, 4.19, and 1.00.


b. 10% ?


| | 2 = FVIF10%,n


-200 400 n 7 years.


c. 18% ?


| | 2 = FVIF18%,n


-200 400 n 4 years.


d. 100% ?


| | 2 = FVIF100%,n


-200 400 n = 1 year.


2-4 The general formula is FVAn = PMT(FVIFAi,n).


a. 10%


0 1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


400 400 400 400 400 400 400 400 400 400


FV = ?


FVA10 = ($400)15.9374 = $6,374.96.


With a financial calculator, enter N = 10, I = 10, PV = 0, and PMT = -400. Then press the FV


key to find FV = $6,374.97.


b. 0 5% 1 2 3 4 5


| | | | | | ($200)5.5256 = $1,105.12.


200 200 200 200 200


FV = ?


With a financial calculator, enter N = 5, I = 5, PV = 0, and PMT =


-200. Then press the FV key to find FV = $1,105.13.




0%


c. 0 1 2 3 4 5


| | | | | | ($400)5 = $2,000.00.


400 400 400 400 400


FV = ?


With a financial calculator, enter N = 5, I = 0, PV = 0, and PMT =


-400. Then press the FV key to find FV = $2,000.


Answers and Solutions: 2 - 26 d. To solve Part d using a financial calculator, repeat the procedures discussed in Parts a, b, and c,


but first switch the calculator to "BEG" mode. Make sure you switch the calculator back to


"END" mode after working the problem.


(1) 0 10% 1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


400 400 400 400 400 400 400 400 400 400 FV =?


FVAn(Annuity due) = PMT(FVIFAi,n)(1 + i). Therefore,


FVA10 = $400(15.9374)(1.10) = $7,012.46.


(2) 0 5% 1 2 3 4 5


| | | | | |


200 200 200 200 200 FV = ?


FVA5 = $200(5.5256)(1.05) = $1,160.38.


(3) 0 0% 1 2 3 4 5


| | | | | |


400 400 400 400 400 FV = ?


FVA5 = $400(5)(1.00) = $2,000.00.



2-5 The general formula is PVAn = PMT(PVIFAi,n).


a. 0


10% 1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


PV = ? 400 400 400 400 400 400 400 400 400 400


PV = $400 (6.1446) = $2,457.83.



Answers and Solutions: 2 - 27 With a financial calculator, simply enter the known values and then press the key for the


unknowns. Except for rounding errors, the answers are as given below.


b. 0


5% 1 2 3 4 5


| | | | | | $200(4.3295) = $865.90.


PV = ? 200 200 200 200 200


c. 0%


0 1 2 3 4 5


| | | | | | $400(5) = $2,000.00.


PV = ? 400 400 400 400 400


10%


d. (1) 0 1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


400 400 400 400 400 400 400 400 400 400 PV =?


PVAn (Annuity due) = PMT(PVIFAi,n)(1 + i). Therefore,


$400(6.1446)(1.10) = $2,703.62.


(2) 0 5% 1 2 3 4 5


| | | | | |


200 200 200 200 200 200


PVAn (Annuity due) = $200(4.3295)(1.05) = $909.20.


(3) 0 0% 1 2 3 4 5


| | | | | |


400 400 400 400 400


PV = ?


PVAn (Annuity due)= $400(5)(1.00) = $2,000.00.



2-6 a. Cash Stream A Cash Stream B 8%


0 1 2 3 4 5 0 1 2 3 8%


4 5


| | | | | | | | | | | |


PV = ? 100 400 400 400 300 PV = ? 300 400 400 400 100


With a financial calculator, simply enter the cash flows (be sure to enter CF0 = 0), enter I = 8, and


press the NPV key to find NPV = PV = $1,251.25 for the first problem. Override I = 8 with I = 0 to


find the next PV for Cash Stream A. Repeat for Cash Stream B to get NPV = PV = $1,300.32.


b. PVA = $100 + $400 + $400 + $400 + $300 = $1,600.


PVB = $300 + $400 + $400 + $400 + $100 = $1,600



Answers and Solutions: 2 - 28 2-7 These problems can all be solved using a financial calculator by entering the known values shown on


the time lines and then pressing the I button.


a. 0 1


|


i=? |


+700 -749


7 percent: $700 = $749(PVIFi,1); PVIFi,1 = 0.9346.


b. 0 1


i=?


| | 7 percent.


-700 +749


c. 0 10


i=?


| |


+85,000 -201,229


$201,229/$85,000 = 2.3674 = FVIFi,10; i = 9%.


i=?


d. 0 1 2 3 4 5


| | | | | |


+9,000 -2,684.80 -2,684.80 -2,684.80 -2,684.80 -2,684.80


$9,000/$2,684.80 = 3.3522 = PVIFAi,5; i = 15%.




Answers and Solutions: 2 - 29 2-8 a. 0 12% 1 2 3 4 5


| | | | | |


-500 FV = ?


With a financial calculator, enter N = 5, I = 12, PV = -500, and PMT = 0, and then press FV to


obtain FV = $881.17. With a regular calculator, proceed as follows:


Fvn = PV(1 + i)n = $500(1.12)5 = $500(1.7623) = $881.15.


b. 0


6%


1 2 3 4 5 6 7 8 9 10


| | | | | | | | | | |


-500 FV =?


Enter the time line values into a financial calculator to obtain FV = $895.42, or


mn


i


PVn= PV 1 +


m


2 5)


(


0.12


= $500 1 + = $500(1.06)10


2


= $500(FVIF6%, 10) = $500(1.7908) = $895.40.


c. 0 4 8 12 16 20


| 3% | | | | |


-500 FV = ?


Enter the time line values into a financial calculator to obtain FV = $903.06, or


4 (5)


0.12


FVn = $500 1 + = $500(1.03)20 = $500(1.8061) = $903.05.


4


d. 0 1% 12 24 36 48 60


| | | | | |


-500 ?


Enter the time line values into a financial calculator to obtain FV = $908.35, or


12(5)


0.12


FVn = $500 1 + = $500(1.01)60 = $500(1.8167) = $908.35.


12




Answers and Solutions: 2 - 30 2-9 a. 0 2 4 6 8 10


| 6% | | | | |


PV = ? 500


Enter the time line values into a financial calculator to obtain PV = $279.20, or


mn 2 (5)




1


PV = FVn 1 = $500


i 0.12


1 + 1+


m 2


10


1


= $500 = $500(PVIF6%, 10) = $500(0.5584) = $279.20.


1.06


b. 0 4 8 12 16 20


| 3% | | | | |


PV = ? 500


Enter the time line values into a financial calculator to obtain PV = $276.84, or


4 (5)



20


1 1


PV = $500 = $500 = $500(0.5537) = $276.85.


0.12 1.03


1 +


4


c. 0 1 2 12


| 1% | | |


PV = ? 500


Enter the time line values into a financial calculator to obtain PV = $443.72, or


12(1)




1


PV = $500


0.12


1+


12


12


1


= $500 = $500(1.01)-12 = $500(0.8874) = $443.70.


1.01




Answers and Solutions: 2 - 31 2-10 a. 0 1 2 3 9 10 6%


| | | | | |


400 400 400 400 400


FV = ?


Enter N = 5 2 = 10, I = 12/2 = 6, PV = 0, PMT = -400, and then press FV to get FV = $5,272.32.



b. Now the number of periods is calculated as N = 5 x 4 = 20, I = 12/4 = 3, PV = 0, and PMT =


-200. The calculator solution is $5,374.07.


Note that the solution assumes that the nominal interest rate is compounded at the annuity period.


c. The annuity in Part b earns more because some of the money is on deposit for a longer period of


time and thus earns more interest. Also, because compounding is more frequent, more interest is


earned on interest.


2-11 a. Universal Bank: Effective rate = 7%.


Regional Bank:


4


0.06


Effective rate = 1 + - 1.0 = (1.015)4 1.0


4


= 1.0614 1.0 = 0.0614 = 6.14%.


With a financial calculator, you can use the interest rate conversion feature to obtain the same


answer. You would choose the Universal Bank.


b. If funds must be left on deposit until the end of the compounding period (1 year for Universal and


1 quarter for Regional), and you think there is a high probability that you will make a withdrawal


during the year, the Regional account might be preferable. For example, if the withdrawal is


made after 10 months, you would earn nothing on the Universal account but (1.015)3 - 1.0 =


4.57% on the Regional account.


Ten or more years ago, most banks and S&Ls were set up as described above, but now


virtually all are computerized and pay interest from the day of deposit to the day of withdrawal,


provided at least $1 is in the account at the end of the period.




Answers and Solutions: 2 - 32 2-12 a. With a financial calculator, enter N = 5, I = 10, PV = -25000, and FV = 0, and then press the PMT


key to get PMT = $6,594.94. Then go through the amortization procedure as described in your


calculator manual to get the entries for the amortization table.


Repayment Remaining


Year Payment Interest of Principal Balance


1 $ 6,594.94 $2,500.00 $ 4,094.94 $20,905.06


2 6,594.94 2,090.51 4,504.43 16,400.63


3 6,594.94 1,640.06 4,954.88 11,445.75


4 6,594.94 1,144.58 5,450.36 5,995.39


5 6,594.93* 599.54 5,995.39 0


$32,974.69 $7,974.69 $25,000.00


*The last payment must be smaller to force the ending balance to zero.


b. Here the loan size is doubled, so the payments also double in size to $13,189.87.


c. The annual payment on a $50,000, 10-year loan at 10 percent interest would be $8,137.27.


Because the payments are spread out over a longer time period, more interest must be paid on the


loan, which raises the amount of each payment. The total interest paid on the 10-year loan is


$31,372.70 versus interest of $15,949.37 on the 5-year loan.



2-13 a. 1997 ? 1998 1999 2000 2001 2002


| | | | | |


-6 12 (in millions)



With a calculator, enter N = 5, PV = -6, PMT = 0, FV = 12, and then solve for I = 14.87%.


b. The calculation described in the quotation fails to take account of the compounding effect. It can


be demonstrated to be incorrect as follows:


$6,000,000(1.20)5 = $6,000,000(2.4883) = $14,929,800,


which is greater than $12 million. Thus, the annual growth rate is less than 20 percent; in


fact, it is about 15 percent, as shown in Part a.




Answers and Solutions: 2 - 33 2-14 0 1 2 3 4 5 6 7 8 9 10= ?


i


| | | | | | | | | | |


-4 8 (in millions)


$4,000,000/$8,000,000 = 0.50, which is slightly less than the PVIFi,n for 7 percent in 10 years. Thus,


the expected rate of return is just over 7 percent. With a calculator, enter N = 10, PV = -4, PMT =


0, FV = 8, and then solve for I = 7.18%.


2-15 0 1 2 3


i=?


4 30


| | | | | |


85,000 -8,273.59 -8,273.59 -8,273.59 -8,273.59 -8,273.59


$85,000/$8,273.59 = 10.2737 = PVIFAi,n for a 30-year annuity.


With a calculator, enter N = 30, PV = 85000, PMT = -8273.59, FV = 0, and then solve for I = 9%.


2-16 a. 0 1 2 3


7% 4


| | | | |


PV = ? -10,000 -10,000 -10,000 -10,000


With a calculator, enter N = 4, I = 7, PMT = -10000, and FV = 0. Then press PV to get PV =


$33,872.11.


b. (1) At this point, we have a 3-year, 7% annuity whose value is $26,243.16. You can also


think of the problem as follows:


$33,872(1.07) $10,000 = $26,243.04.


(2) Zero after the last withdrawal.


2-17 0 1 2 ?


| 9% | | |


12,000 -1,500 -1,500 -1,500


PVA n = PMT(PVIFA i,n ).


$12,000 = $1,500(PVIFA 9%,n )


PVIFA 9%,n = 8.000.


With a calculator, enter I = 9, PV = 12000, PMT = -1500, and FV = 0. Press N to get N = 14.77 15


years. Therefore, it will take approximately 15 years to pay back the loan.




Answers and Solutions: 2 - 34 2-18 0 1 2 3 4 5 6 12%


| | | | | | |


1,250 1,250 1,250 1,250 1,250 ?


FV = 10,000


With a financial calculator, get a "ballpark" estimate of the years by entering I = 12, PV = 0, PMT =


-1250, and FV = 10000, and then pressing the N key to find N = 5.94 years. This answer assumes


that a payment of $1,250 will be made 94/100th of the way through Year 5.


Now find the FV of $1,250 for 5 years at 12%; it is $7,941.06. Compound this value for 1 year at


12% to obtain the value in the account after 6 years and before the last payment is made; it is


$7,941.06(1.12) = $8,893.99. Thus, you will have to make a payment of $10,000 - $8,893.99 =


$1,106.01 at Year 6, so the answer is: it will take 6 years, and $1,106.01 is the amount of the last


payment.



2-19 PV = $100/0.07 = $1,428.57. PV = $100/0.14 = $714.29.


When the interest rate is doubled, the PV of the perpetuity is halved.


2-20 0


8.24%


1 2 3 4


| | | | |


PV = ? 50 50 50 1,050


Discount rate: Effective rate on bank deposit:


EAR = (1 + 0.08/4)4 - 1 = 8.24%.


Find PV of above stream at 8.24%:


PV = $893.26 using the cash flow register.


Also get PV = $893.26 using the TVM register, inputting N = 4, I = 8.24, PMT = 50, and FV = 1000.




Answers and Solutions: 2 - 35 2-21 This can be done with a calculator by specifying an interest rate of 5% per period for 20 periods with


1 payment per period, or 10% interest, 20 periods, 2 payments per year. Either way, we get the


payment each 6 months:


N = 10 2 = 20.


I = 10%/2 = 5.


PV = -10000.


FV = 0.


Solve for PMT = $802.43. Set up amortization table:



Pmt of


Period Beg Bal Payment Interest Principal End Bal


1 $10,000.00 $802.43 $500.00 $302.43 $9,697.57


2 9,697.57 802.43 484.88


$984.88


You can also work the problem with a calculator having an amortization function. Find the interest


in each 6-month period, sum them, and you have the answer. Even simpler, with some calculators


such as the HP-17B, just input 2 for periods and press INT to get the interest during the first year,


$984.88. The HP-10B does the same thing.


2-22 First, find PMT by using a financial calculator: N = 5, I/YR = 15, PV = -1000000, and FV = 0.


Solve for PMT = $298,315.55. Then set up the amortization table:


Beginning Ending


Year Balance Payment Interest Principal Balance


1 $1,000,000.00 $298,315.55 $150,000.00 $148,315.55 $851,684.45


2 851,684.45 298,315.55 127,752.67 170,562.88 681,121.57


Fraction that is principal = $170,562.88/$298,315.55 = 0.5718 = 57.18%.




Answers and Solutions: 2 - 36 2-23 a. Begin with a time line:


6-mos. 0 1 2 3 4 5 6 8 10 12 14 16 18 20


Years 0 1 2 3 4 5


6% 6 7 8 9 10


| | | | | | | | | | | | | | | | | | | | |


100 100 100 100 100 FVA


Since the first payment is made today, we have a 5-period annuity due. The applicable interest rate


is I = 12/2 = 6 per period, N = 5, PV = 0, and PMT = -100. Setting the calculator on "BEG," we


find FVA (Annuity due) = $597.53. That will be the value at the 5th 6-month period, which is t =


2.5. Now we must compound out to t = 10, or for 7.5 years at an EAR of 12.36%, or 15


semiannual periods at 6%.


$597.53 20 - 5 = 15 periods @ 6% $1,432.02,


or $597.53 10 - 2.5 = 7.5 years @ 12.36% $1,432.02.



b. 1 10 years


0 3% 1 2 3 4 5 40 quarters


| | | | | | |


PMT PMT PMT PMT PMT FV = 1,432.02


The time line depicting the problem is shown above. Because the payments only occur for 5


periods throughout the 40 quarters, this problem cannot be immediately solved as an annuity


problem. The problem can be solved in two steps:


(1) Discount the $1,432.02 back to the end of Quarter 5 to obtain the PV of that future amount


at Quarter 5.


(2) Then solve for PMT using the value solved in Step 1 as the FV of the five-period annuity


due.


Step 1: Input the following into your calculator: N = 35, I = 3, PMT = 0, FV = 1432.02,


and solve for PV at Quarter 5. PV = $508.92.


Step 2: The PV found in Step 1 is now the FV for the calculations in this step. Change your


calculator to the BEGIN mode. Input the following into your calculator: N = 5, I


= 3, PV = 0, FV = 508.92, and solve for PMT = $93.07.




Answers and Solutions: 2 - 37 2-24 Here we want to have the same effective annual rate on the credit extended as on the bank loan that


will be used to finance the credit extension.


First, we must find the EAR = EFF% on the bank loan. Enter NOM% = 15, N = P/YR = 12, and


press EFF% to get EAR = 16.08%.


Now recognize that giving 3 months of credit is equivalent to quarterly compounding--interest is


earned at the end of the quarter, so it is available to earn interest during the next quarter. Therefore,


enter P/YR = 4, EFF% = EAR = 16.08%, and press NOM% to find the nominal rate of 15.19 percent.


Therefore, if a 15.19 percent nominal rate is charged and credit is given for 3 months, the cost of


the bank loan will be covered.


Alternative solution: We need to find the effective annual rate (EAR) the bank is charging first.


Then, we can use this EAR to calculate the nominal rate that should be quoted to the customers.


Bank EAR: EAR = (1 + iNom/m)m - 1 = (1 + 0.15/12)12 - 1 = 16.08%.


Nominal rate that should be quoted to customers:


16.08% = (1 + iNom/4)4 - 1


1.1608 = (1 + iNom/4)4


1.0380 = 1 + iNom/4


iNom = 0.0380(4) = 15.19%.




Answers and Solutions: 2 - 38 2-25 Information given:


1. Will save for 10 years, then receive payments for 25 years.


2. Wants payments of $40,000 per year in today's dollars for first payment only. Real income will


decline. Inflation will be 5 percent. Therefore, to find the inflated fixed payments, we have this


time line:


0 5 10


| 5% | | | | | | | | | |


40,000 FV = ?


Enter N = 10, I = 5, PV = -40000, PMT = 0, and press FV to get FV = $65,155.79.


3. He now has $100,000 in an account which pays 8 percent, annual compounding. We need to


find the FV of the $100,000 after 10 years. Enter N = 10, I = 8, PV = -100000, PMT = 0, and


press FV to get FV = $215,892.50.


4. He wants to withdraw, or have payments of, $65,155.79 per year for 25 years, with the first


payment made at the beginning of the first retirement year. So, we have a 25-year annuity due


with PMT = 65,155.79, at an interest rate of 8 percent. (The interest rate is 8 percent annually,


so no adjustment is required.) Set the calculator to "BEG" mode, then enter N = 25, I = 8, PMT


= 65155.79, FV = 0, and press PV to get PV = $751,165.35. This amount must be on hand to


make the 25 payments.


5. Since the original $100,000, which grows to $215,892.50, will be available, we must save enough


to accumulate $751,165.35 - $215,892.50 = $535,272.85.


6. The $535,272.85 is the FV of a 10-year ordinary annuity. The payments will be deposited in the


bank and earn 8 percent interest. Therefore, set the calculator to "END" mode and enter N = 10,


I = 8, PV = 0, FV = 535272.85, and press PMT to find PMT = $36,949.61.




Answers and Solutions: 2 - 39 SOLUTION TO SPREADSHEET PROBLEM



2-26 The detailed solution for the spreadsheet problem is available both on the instructor's resource


CD-ROM (in the file Solution for Ch 02 P26 Build a Model.xls) and on the instructor's side of the


textbook's web site, brigham.swcollege.com.




Answers and Solutions: 2 - 40 MINI CASE



Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you have been asked to take an examination which covers several financial analysis techniques. The first section of the test addresses discounted cash flow analysis. See how you would do by answering the following questions.


a. Draw time lines for (a) a $100 lump sum cash flow at the end of year 2, (b) an ordinary


annuity of $100 per year for 3 years, and (c) an uneven cash flow stream of -$50, $100, $75,


and $50 at the end of years 0 through 3.


Answer: (Begin by discussing basic discounted cash flow concepts, terminology, and solution methods.)


A time line is a graphical representation which is used to show the timing of cash flows. The


tick marks represent end of periods (often years), so time 0 is today; time 1 is the end of the first


year, or 1 year from today; and so on.


0 1 2 year


| i% | |


lump sum


100 cash flow


0 1 2 3


| i% | | | annuity


100 100 100


0 1 2 3


| i% | | |


uneven cash flow stream


-50 100 75 50


A lump sum is a single flow; for example, a $100 inflow in year 2, as shown in the top time line.


An annuity is a series of equal cash flows occurring over equal intervals, as illustrated in the


middle time line. An uneven cash flow stream is an irregular series of cash flows which do not


constitute an annuity, as in the lower time line. -50 represents a cash outflow rather than a


receipt or inflow.




Answers and Solutions: 3- 41 b. 1. What is the future value of an initial $100 after 3 years if it is invested in an account paying


10 percent annual interest?


Answer: Show dollars corresponding to question mark, calculated as follows:


0 1 2


3 10%


| | | |


100 FV


=?


After 1 year:


FV1 = PV + i1 = PV + PV(i) = PV(1 + i) = $100(1.10) = $110.00.


Similarly:


FV2 = FV1 + i2 = FV1 + FV1(i) = FV1(1 + i)


= $110(1.10) = $121.00 = PV(1 + i)(1 + i) = PV(1 + i)2.


FV3 = FV2 + i3 = FV2 + FV2(i) = FV2(1 + i)


= $121(1.10)=$133.10=PV(1 + i)2(1 + i)=PV(1 + i)3.


In general, we see that:


FVn = PV(1 + i)n,


SO FV3 = $100(1.10)3 = $100(1.3310) = $133.10.


Note that this equation has 4 variables: FVn, PV, i, and n. Here we know all except FVn, so we


solve for FVn. We will, however, often solve for one of the other three variables. By far, the


easiest way to work all time value problems is with a financial calculator. Just plug in any 3 of


the four values and find the 4th.


Finding future values (moving to the right along the time line) is called compounding. Note that


there are 3 ways of finding FV3: using a regular calculator, financial calculator, or spreadsheets.


For simple problems, we show only the regular calculator and financial calculator methods.


(1) regular calculator:


1. $100(1.10)(1.10)(1.10) = $133.10.


2. $100(1.10)3 = $133.10.




(2) financial calculator:


This is especially efficient for more complex problems, including exam problems. Input


the following values: N = 3, I = 10, PV = -100, pmt = 0, and solve for FV = $133.10.


Answers and Solutions: 3- 42 b. 2. What is the present value of $100 to be received in 3 years if the appropriate interest rate is


10 percent?


Answer: Finding present values, or discounting (moving to the left along the time line), is the reverse of


compounding, and the basic present value equation is the reciprocal of the compounding equation:


0 1 2


10%


3


| | | |


PV = ? 100


FVn = PV(1 + i)n transforms to:


n


FVn 1


PV = = FVn = FVn(1 + i)-n


(1 + i) n 1+ i


thus:


3


1


PV = $100 = $100(PVIFi,n) = (0.7513) = $75.13.


1.10


The same methods used for finding future values are also used to find present values.


Using a financial calculator input N = 3, I = 10, pmt = 0, FV = 100, and then solve for PV =


$75.13.


c. We sometimes need to find how long it will take a sum of money (or anything else) to grow


to some specified amount. For example, if a company's sales are growing at a rate of 20


percent per year, how long will it take sales to double?


Answer: We have this situation in time line format:


0 1 2 3 3.8 4


20%


| | | | | |


-12 2


Say we want to find out how long it will take us to double our money at an interest rate of


20%. We can use any numbers, say $1 and $2, with this equation:


FVn = $2 = $1(1 + i)n = $1(1.20)n.


(1.2)n = $2/$1 = 2


n LN(1.2) = LN(2)


n = LN(2)/LN(1.2)


n = 0.693/0.182 = 3.8.



Answers and Solutions: 3- 43 Alternatively, we could use a financial calculator. We would plug I = 20, PV = -1, PMT = 0, and FV = 2 into our calculator, and then press the N button to find the number of years it would take 1


(or any other beginning amount) to


FV double when growth occurs at a 20% rate. The answer is 3.8 years, but some calculators will round this value 2


up to the next highest whole number. The graph also shows what is happening.


1


3.8




0 1 2 3 4


Year




Answers and Solutions: 3- 44 d. If you want an investment to double in three years, what interest rate must it earn?


Answer: 0 1 2 3


| | | |


-1 2


1(1 + i) 1(1 + i)2 1(1 + i)3


FV = $1(1 + i)3 = $2.


$1(1 + i)3 = $2.


(1 + i)3 = $2/$1 = 2.


1+i = (2)1/3


1+i = 1.2599


i = 25.99%.


Use a financial calculator to solve: enter N = 3, PV = -1, PMT = 0, FV = 2, then press the I


button to find I = 25.99%.


Calculators can find interest rates quite easily, even when periods and/or interest rates are not


even numbers, and when uneven cash flow streams are involved. (With uneven cash flows, we


must use the "CFLO" function, and the interest rate is called the IRR, or "internal rate of return;"


we will use this feature in capital budgeting.)



e. What is the difference between an ordinary annuity and an annuity due? What type of


annuity is shown below? How would you change it to the other type of annuity?


0 1 2 3


| | | |


100 100 100


Answer: This is an ordinary annuity--it has its payments at the end of each period; that is, the first payment


is made 1 period from today. Conversely, an annuity due has its first payment today. In other


words, an ordinary annuity has end-of-period payments, while an annuity due has


beginning-of-period payments.


The annuity shown above is an ordinary annuity. To convert it to an annuity due, shift each


payment to the left, so you end up with a payment under the 0 but none under the 3.




Answers and Solutions: 3- 45 f. 1. What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate


is 10 percent?


Answer: 0 1 2 3


| 10% | | |


100 100 100


110


121


$331


Go through the following discussion. One approach would be to treat each annuity flow


as a lump sum. Here we have


FVAn = $100(1) + $100(1.10) + $100(1.10)2


= $100[1 + (1.10) + (1.10)2] = $100(3.3100) = $331.00.


Using a financial calculator, N = 3, I = 10, PV = 0, PMT = -100. This gives FV = $331.00.


f. 2. What is the present value of the annuity?


Answer: 0 10% 1 2 3


| | | |


100 100 100


90.91


82.64


75.13


$248.68


The present value of the annuity is $248.68. Using a financial calculator, input N = 3, I =


10, PMT = 100, FV = 0, and press the PV button.


Spreadsheets are useful for time lines with multiple cash flows.


The following spreadsheet shows this problem:


A B C D


1 0 1 2 3


2 100 100 100


3 248.69


The excel formula in cell A3 is = NPV(10%,B2:D2). This gives a result of 248.69. Note


that the interest rate can be either 10% or 0.10, not just 10. Also, note that the


range does not include any cash flow at time zero.


Excel also has special functions for annuities. For ordinary annuities, the excel formula is =


PV(interest rate, number of periods, payment). In this problem, = PV(10%,3,-100), gives a


result of 248.96. For the future value, it would be = FV(10%,3,-100), with a result of 331.




Answers and Solutions: 3- 46 f. 3. What would the future and present values be if the annuity were an annuity due?


Answer: If the annuity were an annuity due, each payment would be shifted to the left, so each payment is


compounded over an additional period or discounted back over one less period.


To find the future value of an annuity due use the following formula:


FVAn(Annuity Due) = FVAn(1 + i).


In our situation, the future value of the annuity due is $364.10:


FVA3(Annuity Due) = $331.00(1.10)1 = $364.10.


This same result could be obtained by using the time line: $133.10 + $121.00 + $110.00 =


$364.10.


The best way to work annuity due problems is to switch your calculator to "beg" or beginning


or "due" mode, and go through the normal process. Note that it's critical to remember to change


back to "end" mode after working an annuity due problem with your calculator.


This formula could be used to find the present value of an annuity due:


PVAn(Annuity Due) = PVAn(1 + i) = PMT(PVIFAi,n)(1 + i).


In our situation, the present value of the annuity due is $273.56:


PVA3(Annuity Due) = $248.69(1.10)1 = $273.56.


The Excel function is = PV(10%,3,-100,0,1). The fourth term, 0, tells Excel there are no


additional cash flows. The fifth term, 1, tells Excel it is an annuity due. The result is $273.56.


A similar modification gives the future value: = FV(10%,3,-100,0,1), with a result of


364.10.




Answers and Solutions: 3- 47 g. What is the present value of the following uneven cash flow stream? The appropriate


interest rate is 10 percent, compounded annually.


0 1 2 3 4 years


| | | | |


0 100 300 300 -50


Answer: Here we have an uneven cash flow stream. The most straightforward approach is to find the PVs


of each cash flow and then sum them as shown below:


0 10% 1 2 3 4 years


| | | | |


100 300 300 -50


90.91


247.93


225.39


(34.15)


530.08


Note (1) that the $50 year 4 outflow remains an outflow even when discounted. There are


numerous ways of finding the present value of an uneven cash flow stream. But by far the


easiest way to deal with uneven cash flow streams is with a financial calculator or a spreadsheet.


Calculators have a function which on the HP 17B is called "CFLO," for "cash flow." other


calculators could use other designations such as cf0 and CFi, but they explain how to use them in


the manual. You would input the cash flows, so they are in the calculator's memory, then input


the interest rate, I, and then press the NPV or PV button to find the present value.


Spreadsheets are especially useful for uneven cash flows. The following spreadsheet shows


this problem:


A B C D E


1 0 1 2 3 4


2 100 300 300 -50


3 530.09


The Excel formula in cell A3 is = NPV(10%,B2:E2), with a result of 530.09.


h. 1. Define (a) the stated, or quoted, or nominal rate, (iNom), and (b) the periodic rate (iPer).


ANSWER: The quoted, or nominal, rate is merely the quoted percentage rate of return. The periodic rate is


the rate charged by a lender or paid by a borrower each period (periodic rate = inom/m).




Answers and Solutions: 3- 48 h. 2. Will the future value be larger or smaller if we compound an initial amount more often


than annually, for example, every 6 months, or semiannually, holding the stated interest rate


constant? Why?


Answer: Accounts that pay interest more frequently than once a year, for example, semiannually, quarterly,


or daily, have future values that are higher because interest is earned on interest more often.


Virtually all banks now pay interest daily on passbook and money fund accounts, so they use daily


compounding.


h. 3. What is the future value of $100 after 5 years under 12 percent annual compounding?


Semiannual compounding? Quarterly compounding? Monthly compounding? Daily


compounding


Answer: Under annual compounding, the $100 is compounded over 5 annual periods at a 12.0 percent


periodic rate:


iNom = 12%.


mn 1*5


i 0.12


FVn = PV1 + Nom


= $100 1 + = $100(1.12)5 = $176.23.


m 1


Under semiannual compounding, the $100 is compounded over 10 semiannual periods at a 6.0


percent periodic rate:


iNom = 12%.


mn 2*5


i 0.12


FVn = PV1 + Nom


= $100 1 + = $100(1.06)10 = $179.08.


m 2


quarterly: FVn = $100(1.03)20 = $180.61.


monthly: FVn = $100(1.01)60 = $181.67.


daily: FVn = $100(1+ 0.12/365)365*5 = $182.19.




Answers and Solutions: 3- 49 h. 4. What is the effective annual rate (EAR)? What is the ear for a nominal rate of 12 percent,


compounded semiannually? Compounded quarterly? Compounded monthly?


Compounded daily?


Answer: The effective annual rate is the annual rate that causes the PV to grow to the same FV as under


multi-period compounding. For 12 percent semiannual compounding, the ear is 12.36 percent:


m


1 + i Nom


EAR = Effective Annual Rate = - 1.0.


m


IF iNom = 12% and interest is compounded semiannually, then:


2


0.12 2


EAR = 1 + - 1.0 = (1.06) 1.0 = 1.1236 1.0 = 0.1236 = 12,36%.


2


For quarterly compounding, the effective annual rate is:


(1.03)4 - 1.0 = 12.55%.


For monthly compounding, the effective annual rate is:


(1.01)12 - 1.0 = 12.55%.


For daily compounding, the effective annual rate is:


(1 + 0.12/365)365 - 1.0 = 12.75%.


i. Will the effective annual rate ever be equal to the nominal (quoted) rate?


Answer: If annual compounding is used, then the nominal rate will be equal to the effective annual rate.


If more frequent compounding is used, the effective annual rate will be above the nominal rate.




Answers and Solutions: 3- 50 j. 1. Construct an amortization schedule for a $1,000, 10 percent annual rate loan with 3 equal


installments.


2. What is the annual interest expense for the borrower, and the annual interest income for the


lender, during year 2?


Answer: To begin, note that the face amount of the loan, $1,000, is the present value of a 3-year annuity at


a 10 percent rate:


0 10% 1 2


3


| | | |


-1,000 PMT PMT PMT


1 2 3


1 1 1


PVA3 = PMT + PMT + PMT


1 + i 1 + i 1 + i


$1,000 = PMT(1 + i)-1 + PMT(1 + i)-2 + PMT(1 + i)-3


= PMT(1.10)-1 + PMT(1.10)-2 + PMT(1.10)-3.


We have an equation with only one unknown, so we can solve it to find PMT. The easy way is


with a financial calculator. Input n = 3, i = 10, PV = -1,000, FV = 0, and then press the PMT


button to get PMT = 402.1148036, rounded to $402.11.


Now make the following points regarding the amortization schedule:


The $402.11 annual payment includes both interest and principal. Interest in the


first year is calculated as follows:


1st year interest = i beginning balance = 0.1 $1,000 = $100.


The repayment of principal is the difference between the $402.11 annual payment


and the interest payment:


1st year principal repayment = $402.11 - $100 = $302.11.


The loan balance at the end of the first year is:


1st year ending balance = beginning balance principal repayment


= $1,000 - $302.11 = $697.89.


We would continue these steps in the following years.


Notice that the interest each year declines because the beginning loan balance is


declining. Since the payment is constant, but the interest component is declining,


the principal repayment portion is increasing each year.




Answers and Solutions: 3- 51 The interest component is an expense which is deductible to a business or a


homeowner, and it is taxable income to the lender. If you buy a house, you will


get a schedule constructed like ours, but longer, with 30 12 = 360 monthly


payments if you get a 30-year, fixed rate mortgage.


The payment may have to be increased by a few cents in the final year to take


care of rounding errors and make the final payment produce a zero ending


balance.


The lender received a 10% rate of interest on the average amount of money that


was invested each year, and the $1,000 loan was paid off. This is what


amortization schedules are designed to do.


Most financial calculators have amortization functions built in.


k. Suppose on January 1 you deposit $100 in an account that pays a nominal, or quoted,


interest rate of 11.33463 percent, with interest added (compounded) daily. How much will


you have in your account on October 1, or after 9 months?


Answer: The daily periodic interest rate is rPer = 11.3346%/365 = 0.031054%. There are 273 days between


January 1 and October 1. Calculate FV as follows:


FV273 = $100(1.00031054)273


= $108.85.


Using a financial calculator, input n = 273, i = 0.031054, PV = -100, and PMT = 0.


Pressing FV gives $108.85.


An alternative approach would be to first determine the effective annual rate of interest, with


daily compounding, using the formula:


365


0.1133463


EAR = 1 + - 1 = 0.12 = 12.0%.


365


(Some calculators, e.g., the hp 10b and 17b, have this equation built in under the ICNV [interest


conversion] function.)


Thus, if you left your money on deposit for an entire year, you would earn $12 of


interest, and you would end up with $112. The question, though, is this: how


much will be in your account on October 1, 2002?


Here you will be leaving the money on deposit for 9/12 = 3/4 = 0.75 of a year.


0 12% 0.75 1


| | |


-100 FV = ? 112


You would use the regular set-up, but with a fractional exponent:



Answers and Solutions: 3- 52 FV0.75 = $100(1.12)0.75 = $100(1.088713) = $108.87.


This is slightly different from our earlier answer, because n is actually 273/365 = 0.7479 rather than 0.75.


Fractional time periods


Thus far all of our examples have dealt with full years. Now we are going to look at the situation when we are dealing with fractional years, such as 9 months, or 10 years. In these situations, proceed as follows:


As always, start by drawing a time line so you can visualize the situation.


Then think about the interest rate--the nominal rate, the compounding periods per


year, and the effective annual rate. If you have been given a nominal rate, you


may have to convert to the ear, using this formula:


m


i


EAR = 1 + Nom - 1 .


m


If you have the effective annual rate--either because it was given to you or after


you calculated it with the formula--then you can find the PV of a lump sum by


applying this equation:


t


1


PV = FVt .


1 + EAR


Here t can be a fraction of a year, such as 0.75, if you need to find the PV of


$1,000 due in 9 months, or 450/365 = 1.2328767 if the payment is due in 450


days.


If you have an annuity with payments different from once a year, say every month,


you can always work it out as a series of lump sums. That procedure always


works. We can also use annuity formulas and calculator functions, but you have


to be careful.




Answers and Solutions: 3- 53 l. 1. What is the value at the end of year 3 of the following cash flow stream if the quoted interest


rate is 10 percent, compounded semiannually?


0 1 2 3 YEARS


| | | | | | |


100 100 100


Answer: 0 1 2


5% 3


| | | | | | |


100 100 100


110.25 = 100(1.05)2


121.55 = 100(1.05)4


331.80


Here we have a different situation. The payments occur annually, but compounding occurs each


6 months. Thus, we cannot use normal annuity valuation techniques. There are two


approaches that can be applied: (1) treat the cash flows as lump sums, as was done above, or (2)


treat the cash flows as an ordinary annuity, but use the effective annual rate:


m 2


0.10


EAR = 1 + i Nom - 1 = 1 + - 1 = 10.25%.


m 2


Now we have this 3-period annuity:


FVA3 = $100(1.1025)2 + $100(1.1025)1 + $100 = $331.80.


You can plug in n = 3, I = 10.25, PV = 0, and PMT = -100, and then press the FV button to find


FV = $331.80.


l. 2. What is the PV of the same stream?


Answer: 0 1 2 3 5%


| | | | | | |


100 100 100


90.70


82.27 PV = 100(1.05)-4


74.62


247.59


PV = $100(2.4759) = $247.59 AT 10.25%.


To use a financial calculator, input N = 3, I = 10.25, PMT = 100, FV = 0, and then press the PV


key to find PV = $247.59.




Answers and Solutions: 3- 54 l. 3. Is the stream an annuity?


Answer: The payment stream is an annuity in the sense of constant amounts at regular intervals, but the


intervals do not correspond with the compounding periods. This kind of situation occurs often.


In this situation the interest is compounded semiannually, so with a quoted rate of 10%, the ear


will be 10.25%. Here we could find the effective rate and then treat it as an annuity. Enter N =


3, I = 10.25, PMT = 100, and FV = 0. Now press PV to get $247.59.


l. 4. An important rule is that you should never show a nominal rate on a time line or use it in


calculations unless what condition holds? (Hint: think of annual compounding, when iNom


= EAR = iPer.) What would be wrong with your answer to questions l(1) and l(2) if you used


the nominal rate (10%) rather than the periodic rate (iNom /2 = 10%/2 = 5%)?


Answer: iNom can only be used in the calculations when annual compounding occurs. If the nominal rate of


10% was used to discount the payment stream the present value would be overstated by $272.32 -


$247.59 = $24.73.




Answers and Solutions: 3- 55 m. Suppose someone offered to sell you a note calling for the payment of $1,000 15 months from


today. They offer to sell it to you for $850. You have $850 in a bank time deposit which


pays a 6.76649 percent nominal rate with daily compounding, which is a 7 percent effective


annual interest rate, and you plan to leave the money in the bank unless you buy the note.


The note is not risky--you are sure it will be paid on schedule. Should you buy the note?


Check the decision in three ways: (1) by comparing your future value if you buy the note


versus leaving your money in the bank, (2) by comparing the PV of the note with your


current bank account, and (3) by comparing the ear on the note versus that of the bank


account.


Answer: You can solve this problem in three ways--(1) by compounding the $850 now in the bank for 15


months and comparing that FV with the $1,000 the note will pay, (2) by finding the PV of the note


and then comparing it with the $850 cost, and (3) finding the effective annual rate of return on the


note and comparing that rate with the 7% you are now earning, which is your opportunity cost of


capital. All three procedures lead to the same conclusion. Here is the time line:



0 1 1.25


7%


| | |


-850 1,000


(1) FV = $850(1.07)1.25 = $925.01 = amount in bank after 15 months versus $1,000 if you buy


the note. (Again, you can find this value with a financial calculator. Note that certain


calculators like the hp 12c perform a straight-line interpolation for values in a fractional


time period analysis rather than an effective interest rate interpolation. The value that the


hp 12c calculates is $925.42.) This procedure indicates that you should buy the note.


Alternatively, 15 months = (1.25 years)(365 days per year) = 456.25 456 days.


FV456 = $850(1.00018538)456


= $924.97.


The slight difference is due to using n = 456 rather than n = 456.25.


(2) PV = $1,000/(1.07)-1.25 = $918.90. Since the present value of the note is greater than the


$850 cost, it is a good deal. You should buy it.


Alternatively, PV = $1000/(1.00018538)456 = $918.95.



(3) FVn = PV(1 + i)n, SO $1,000 = $850(1 + i)1.25 = $1,000. Since we have an equation with


one unknown, we can solve it for i. You will get a value of i = 13.88%. The easy way is


to plug values into your calculator. Since this return is greater than your 7% opportunity


cost, you should buy the note. This action will raise the rate of return on your asset


portfolio.


Alternatively, we could solve the following equation:


$1,000 = $850(1 + i)456 for a daily i = 0.00035646,


With a result of EAR = EFF% = (1.00035646)365 - 1 = 13.89%.




Answers and Solutions: 3- 56 Chapter 3


Financial Statements, Cash Flow, and Taxes


ANSWERS TO END-OF-CHAPTER QUESTIONS


3-1 a. The annual report is a report issued annually by a corporation to its stockholders. It contains


basic financial statements, as well as management's opinion of the past year's operations and the


firm's future prospects. A firm's balance sheet is a statement of the firm's financial position at a


specific point in time. It specifically lists the firm's assets on the left-hand side of the balance


sheet, while the right-hand side shows its liabilities and equity, or the claims against these assets.


An income statement is a statement summarizing the firm's revenues and expenses over an


accounting period. Net sales are shown at the top of each statement, after which various costs,


including income taxes, are subtracted to obtain the net income available to common stockholders.


The bottom of the statement reports earnings and dividends per share.


b. Common Stockholders' Equity (Net Worth) is the capital supplied by common


stockholders--capital stock, paid-in capital, retained earnings, and, occasionally, certain reserves.


Paid-in capital is the difference between the stock's par value and what stockholders paid when


they bought newly issued shares. Retained earnings is the portion of the firm's earnings that


have been saved rather than paid out as dividends.


c. The statement of retained earnings shows how much of the firm's earnings were retained in the


business rather than paid out in dividends. Note that retained earnings represents a claim against


assets, not assets per se. Firms retain earnings primarily to expand the business, not to


accumulate cash in a bank account. The statement of cash flows reports the impact of a firm's


operating, investing, and financing activities on cash flows over an accounting period.


d. Depreciation is a non-cash charge against tangible assets, such as buildings or machines. It is


taken for the purpose of showing an asset's estimated dollar cost of the capital equipment used up


in the production process. Amortization is a non-cash charge against intangible assets, such as


goodwill. EBITDA is earnings before interest, taxes, depreciation, and amortization.


e. Operating current assets are the current assets used to support operations, such as cash, accounts


receivable, and inventory. It does not include short-term investments. Operating current


liabilities are the current liabilities that are a natural consequence of the firm's operations, such as


accounts payable and accruals. It does not include notes payable or any other short-term debt


that charges interest. Net operating working capital is operating current assets minus operating


current liabilities. Total net operating capital is sum of net operating working capital and


operating long-term assets, such as net plant and equipment. Operating capital also is equal to


the net amount of capital raised from investors. This is the amount of interest-bearing debt plus


preferred stock plus common equity minus short-term investments.


f. Accounting profit is a firm's net income as reported on its income statement. Net cash flow, as


opposed to accounting net income, is the sum of net income plus non-cash adjustments. NOPAT,


net operating profit after taxes, is the amount of profit a company would generate if it had no debt


Answers and Solutions: 3- 57 and no financial assets. Free cash flow is the cash flow actually available for distribution to


investors after the company has made all investments in fixed assets and working capital


necessary to sustain ongoing operations.


g. Market value added is the difference between the market value of the firm (i.e., the sum of the


market value of common equity, the market value of debt, and the market value of preferred stock)


and the book value of the firm's common equity, debt, and preferred stock. If the book values of


debt and preferred stock are equal to their market values, then MVA is also equal to the difference


between the market value of equity and the amount of equity capital that investors supplied.


Economic value added represents the residual income that remains after the cost of all capital,


including equity capital, has been deducted.


h. A progressive tax means the higher one's income, the larger the percentage paid in taxes.


Taxable income is defined as gross income less a set of exemptions and deductions which are


spelled out in the instructions to the tax forms individuals must file. Marginal tax rate is defined


as the tax rate on the last unit of income. Average tax rate is calculated by taking the total


amount of tax paid divided by taxable income.


i. Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less) than its


purchase price. Ordinary corporate operating losses can be carried backward for 2 years or


forward for 20 years to offset taxable income in a given year.


j. Improper accumulation is the retention of earnings by a business for the purpose of enabling


stockholders to avoid personal income taxes on dividends. An S corporation is a small


corporation which, under Subchapter S of the Internal Revenue Code, elects to be taxed as a


proprietorship or a partnership yet retains limited liability and other benefits of the corporate form


of organization.


3-2 The four financial statements contained in most annual reports are the balance sheet, income statement,


statement of retained earnings, and statement of cash flows.


3-3 No, because the $20 million of retained earnings would probably not be held as cash. The retained


earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million


would be an investment in all of the firm's assets.


3-5 Operating capital is the amount of interest bearing debt, preferred stock, and common equity used to


acquire the company's net operating assets. Without this capital a firm cannot exist, as there is no


source of funds with which to finance operations.


3-6 NOPAT is the amount of net income a company would generate if it had no debt


and held no financial assets. NOPAT is a better measure of the performance of


a company's operations because debt lowers income. In order to get a true


reflection of a company's operating performance, one would want to take out


debt to get a clearer picture of the situation.


3-7 Free cash flow is the cash flow actually available for distribution to investors after


the company has made all the investments in fixed assets and working capital


necessary to sustain ongoing operations. It is the most important measure of


cash flows because it shows the exact amount available to all investors.



Answers and Solutions: 3- 58 3-8 If the business were organized as a partnership or a proprietorship, its income could be taken out by


the owners without being subject to double taxation. Also, if you expected to have losses for a few


years while the company was getting started, if you were not incorporated, and if you had outside


income, the business losses could be used to offset your other income and reduce your total tax bill.


These factors would lead you to not incorporate the business. An alternative would be to organize as


an S Corporation, if requirements are met.




Answers and Solutions: 3- 59 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


3-1 Corporate yield = 9%; T = 35.5%


AT yield = 9%(1 - T)


= 9%(0.645) = 5.76%.


3-2 Corporate bond yields 8%. Municipal bond yields 6%.


Equivalent pretax yield Yield on muni


=


on taxable bond (1 - T )


6%


8% =


(1 - T )


0.08 - 0.08T = 0.06


- 0.08T = -0.02


T = 25%.


3-2 Income $365,000


Less Interest deduction (50,000)


Plus: Dividends receiveda 4,500


Taxable income $319,500


a


For a corporation, 70% of dividends received are excluded from taxes; therefore, taxable dividends


are calculated as $15,000(1 - 0.70) = $4,500.


Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 = $107,855.


After-tax income:


Taxable income $319,500


Taxes (107,855)


Plus Non-taxable dividends receivedb 10,500


Net income $222,145


b


Non-taxable dividends are calculated as $15,000 x 0.7 = $10,500.


The company's marginal tax rate is 39 percent. The company's average tax rate is


$107,855/$319,500 = 33.76%.


3-4 a. Tax = $3,400,000 + ($10,500,000 - $10,000,000)(0.35) = $3,575,000.


b. Tax = $1,000,000(0.35) = $350,000.



Answers and Solutions: 3- 60 c. Tax = ($1,000,000)0.30(0.35) = $105,000.


3-5 A-T yield on FLA bond = 5%.


A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%.


Check: Invest $10,000 @ 7.5% = $750 interest.


Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50.


A-T rate of return = $487.50/$10,000 = 4.875%.


A-T yield on AT&T preferred stock:


A-T yield = 6% - Taxes = 6% - 0.3(6%)(0.35) = 6% - 0.63% = 5.37%.


Therefore, invest in AT&T preferred stock. We could make this a harder problem by asking for the


tax rate that would cause the company to prefer the Florida bond or the AT&T bond.


3-6 EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%


NI = ?; NCF = ?; OCF = ?


First, determine net income by setting up an income statement:


EBIT $750,000


Interest 0


EBT $750,000


Taxes (40%) 300,000


NI $450,000


NCF = NI + DEP = $450,000 + $200,000 = $650,000.




Answers and Solutions: 3- 61 3-7 a. Income Statement


Sales revenues $12,000,000


Costs except


depreciation 9,000,000


Depreciation 1,500,000


EBT $ 1,500,000


Taxes (40%) 600,000


Net income $ 900,000


Add back depreciation 1,500,000


Net cash flow $ 2,400,000


b. If depreciation doubled, taxable income would fall to zero and taxes would be zero. Thus, net


income would decrease to zero, but net cash flow would rise to $3,000,000. Menendez would


save $600,000 in taxes, thus increasing its cash flow:


CF = T(Depreciation) = 0.4($1,500,000) = $600,000.


c. If depreciation were halved, taxable income would rise to $2,250,000 and taxes to $900,000.


Therefore, net income would rise to $1,350,000, but net cash flow would fall to $2,100,000.


d. You should prefer to have higher depreciation charges and higher cash flows. Net cash flows are


the funds that are available to the owners to withdraw from the firm and, therefore, cash flows


should be more important to them than net income.




Answers and Solutions: 3- 62 3-8 a. NOPAT = EBIT(1 - Tax rate)


= $150,000,000(0.6)


= $90,000,000.


b. NOWC03 = Operating CA operating CL


= $360,000,000 - ($90,000,000 + $60,000,000)


= $210,000,000.


NOWC04 = $372,000,000 - $180,000,000 = $192,000,000.


Net plant Net operating


c. Operating capital03 = +


and equipment working capital


= $250,000,000 + $210,000,000


= $460,000,000.


Operating capital04 = $300,000,000 + $192,000,000


= $492,000,000.


d. FCF = NOPAT - Net investment in operating capital


= $90,000,000 - ($492,000,000 - $460,000,000)


= $58,000,000.


e. The large increase in dividends for 2004 can most likely be attributed to a large increase in free


cash flow from 2003 to 2004, since FCF represents the amount of cash available to be paid out to


stockholders after the company has made all investments in fixed assets and working capital


necessary to sustain the business.



3-9 Prior Years 2002 2003


Profit earned $150,000 $150,000


Carry-back credit 150,000 150,000


Adjusted profit $ 0 $ 0


Tax previously


paid (40%) 60,000 60,000


Tax refund: Taxes


Answers and Solutions: 3- 63 previously paid $ 60,000 $ 60,000


Total check from U.S. Treasury = $60,000 + $60,000 = $120,000.


Future Years 2005 2006 2007 2008 2009


Estimated


profit $150,000 $150,000 $150,000 $150,000 $150,000


Carry-forward


credit 150,000 150,000 50,000 0 0


Adjusted


profit $ 0 $ 0 $100,000 $150,000 $150,000


Tax (at 40%) 0 $ 0 $ 40,000 $ 60,000 $ 60,000




Answers and Solutions: 3- 64 SOLUTION TO SPREADSHEET PROBLEM 3-13 The detailed solution for the spreadsheet problem is available both on the


instructor's resource CD-ROM (in the file Solution for FM11 Ch 03 P13 Build a


Model.xls) and on the instructor's side of the book's web site,


http://brigham.swcollege.com.




Answers and Solutions: 3- 65 MINI CASE



Donna Jamison, a recent graduate of the University of Tennessee with four years of banking experience, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of electronic calculators.


The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Computron's results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice-president plus its major stockholders (who were all local business people), was most upset when directors learned how the expansion was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Al Watkins, Computron's president, was informed that changes would have to be made, and quickly, or he would be fired. Also, at the board's insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was Computron's chairman and largest stockholder. Campo agreed to give up a few of his golfing days and to help nurse the company back to health, with Jamison's help.


Jamison began by gathering financial statements and other data. Assume that you are Jamison's assistant, and you must help her answer the following questions for Campo.


Balance Sheets


Assets 2003 2004


Cash $ 9,000 $ 7,282


Short-term investments. 48,600 20,000


Accounts receivable 351,200 632,160


Inventories 715,200 1,287,360


total current assets $ 1,124,000 $ 1,946,802


Gross fixed assets 491,000 1,202,950


Less: accumulated depreciation 146,200 263,160


net fixed assets $ 344,800 $ 939,790


Total assets $ 1,468,800 $ 2,886,592


Liabilities and equity 2003 2004


Accounts payable $ 145,600 $ 324,000


Notes payable 200,000 720,000


Accruals 136,000 284,960


total current liabilities $ 481,600 $ 1,328,960


Long-term debt 323,432 1,000,000


Common stock (100,000 shares) 460,000 460,000


Retained earnings 203,768 97,632


total equity $ 663,768 $ 557,632


Total liabilities and equity $ 1,468,800 $ 2,886,592



Answers and Solutions: 4 - 66 Income Statements


2003 2004 Sales $ 3,432,000 $ 5,834,400 Cost of goods sold 2,864,000 4,980,000 Other expenses 340,000 720,000 Depreciation 18,900 116,960


total operating costs $ 3,222,900 $ 5,816,960


EBIT $ 209,100 $ 17,440 Interest expense 62,500 176,000


EBT $ 146,600 $ (158,560) Taxes (40%) 58,640 (63,424) Net income $ 87,960 $ (95,136)


Other data 2002 2003 Stock price $ 8.50 $ 6.00 Shares outstanding 100,000 100,000 EPS $ 0.880 $ (0.951) DPS $ 0.220 $ 0.110



Statement of retained earnings, 2004


Balance of retained earnings, 12/31/2003 $ 203,768


add: net income, 2004 $ (95,136)


less: dividend paid, 2004 $ (11,000)


Balance of retained earnings, 12/31/2004 $ 97,632




Answers and Solutions: 4 - 67 Statement of Cash Flows


Operating activities


Net income $ (95,136)


Adjustments:


noncash adjustments:


depreciation 116,960


changes in working capital:


change in accounts receivable (280,960)


change in inventories (572,160)


change in accounts payable 178,400


change in accruals 148,960


Net cash provided by operating activities $ (503,936)


Long-term investing activities


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


Financing activities


change in short term investments $ 28,600


change in notes payable $ 520,000


change in long-term debt $ 676,568


change in common stock $ -


payment of cash dividends $ (11,000)


Net cash provided by financing activities $ 1,214,168


Summary


Net change in cash $ (1,718)


Cash at beginning of year 9,000


Cash at end of year $ 7,282


a. What effect did the expansion have on sales and net income? What effect did the


expansion have on the asset side of the balance sheet? What effect did it have on liabilities


and equity?


Answer: Sales increased by over by over $2.4 million, but net income fell by over $190,000. Assets


almost doubled. Debt and funds provided by suppliers increased, but retained earnings fell due


to the year's loss.



b. What do you conclude from the statement of cash flows?


Answer: Net CF from operations = -$503,936, because of negative net income and increases in working


capital. The firm spent $711,950 on FA. The firm borrowed heavily and sold some short-term


investments to meet its cash requirements. Even after borrowing, the cash account fell by


$1,718.



Answers and Solutions: 4 - 68 c. What is free cash flow? Why is it important? What are the five uses of FCF?


Answer: FCF is the amount of cash available from operations for distribution to all investors (including


stockholders and debtholders) after making the necessary investments to support operations. A


company's value depends upon the amount of FCF it can generate.


1. Pay interest on debt.


2. Pay back principal on debt.


3. Pay dividends.


4. Buy back stock.


5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)


d. What are operating current assets? What are operating current liabilities? How much


net operating working capital and total net operating capital does Computron have?


Answer: Operating current assets are the CA needed to support operations. OP CA include: cash,


inventory, receivables. OP CA exclude: short-term investments, because these are not a part of


operations. Operating current liabilities are the CL resulting as a normal part of operations. OP


CL include: accounts payable and accruals. OP CA exclude: notes payable, because this is a


source of financing, not a part of operations.


NOWC = operating CA operating CL


NOWC04 = ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960)


= $1,317,842.


NOWC03 = $793,800.


Total operating working capital = NOWC + net fixed assets.


Operating capital in 2004 = $1,317,842 + $939,790


= $2,257,632.


Operating capital in 2003 = $1,138,600. e. What are Computron's net operating profit after taxes (NOPAT) and free cash flow (FCF)?


ANSWER: NOPAT = EBIT(1 - TAX RATE)


NOPAT04 = $17,440(1 - 0.4)


= $10,464.


NOPAT03 = $125,460.


FCF = NOPAT - NET INVESTMENT IN CAPITAL


= $10,464 - ($2,257,632 - $1,138,600)


= $10,464 - $1,119,032


= -$1,108,568.




Answers and Solutions: 4 - 69 f. Calculate Computron's return on invested capital. Computron has a 10% cost of capital


(WACC). Do you think Computron's growth added value?


ANSWER: ROIC = NOPAT / TOTAL NET OPERATING CAPITAL.


ROIC04 = $10,464 / $2,257,632


= 0.5%.


ROIC03 = 11.0%.


The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require.


Note: high growth usually causes negative FCF (due to investment in capital), but that's ok if


ROIC > WACC. For example, home depot has high growth, negative FCF, but a high ROIC.


g. Jamison also has asked you to estimate Computron's EVA. She estimates that the after-tax cost of


capital was 10 percent in both years.


ANSWER: EVA = NOPAT- (WACC)(CAPITAL).


EVA04 = $10,464 - (0.1)($2,257,632)


= $10,464 - $225,763


= -$215,299.


EVA03 = $125,460 - (0.10)($1,138,600)


= $125,460 - $113,860


= $11,600.



h. What happened to Computron's market value added (MVA)?


Answer: MVA = market value of the firm - book value of the firm.


Market value = (# shares of stock)(price per share) + value of debt.


Book value = total common equity + value of debt.


If the market value of debt is close to the book value of debt, then MVA is market value of equity


minus book value of equity. Assume market value of debt equals book value of debt.


Market value of equity 2003 = (100,000)($6.00) = $600,000.


Book value of equity 2003 = $557,632.


MVA03 = $600,000 - $557,632 = $42,368.


MVA02 = $850,000 - $663,768 = $186,232.



i. Assume that a corporation has $100,000 of taxable income from operations plus


$5,000 of interest income and $10,000 of dividend income. What is the company's


tax liability?


Answers and Solutions: 4 - 70 Answer: Calculation of the company's tax liability:


Taxable operating income $100,000


Taxable interest income 5,000


Taxable dividend income (0.3 $10,000) 3,000


Total taxable income $108,000


Tax = $22,250 + ($108,000 - $100,000)0.39 = $25,370.


taxable dividend income = dividends - exclusion


= $10,000 - 0.7($10,000)


= $3,000.



j. Assume that you are in the 27 percent marginal tax bracket and that you have


$5,000 to invest. You have narrowed your investment choices down to California


bonds with a yield of 7 percent or equally risky Exxon bonds with a yield of 10


percent. Which one should you choose and why? At what marginal tax rate would


you be indifferent to the choice between California and Exxon bonds?


Answer: After-tax return income at t = 27%:


Exxon = 0.10($5,000) - (0.10)($5,000)(0.27) = $365.


California = 0.07($5,000) - $0 = $350.


Alternatively, calculate after-tax yields:


A-T yieldExxon = 10.0%(1 - t) = 10%(1 - 0.27) = 7.3%.


A-T yieldCalif. = 7.0%.


At what marginal tax rate would you be indifferent?


7.0% = 10.0%(1 - t). Solve for t.


7.0% = 10.0% - 10.0%(t)


10.0%(t) = 3%


t = 30%.




Answers and Solutions: 4 - 71 Chapter 4


Risk and Return: The Basics


ANSWERS TO END-OF-CHAPTER QUESTIONS



4-1 a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by holding


only one asset. Risk is the chance that some unfavorable event will occur. For instance, the


risk of an asset is essentially the chance that the asset's cash flows will be unfavorable or less than


expected. A probability distribution is a listing, chart or graph of all possible outcomes, such as


expected rates of return, with a probability assigned to each outcome. When in graph form, the


tighter the probability distribution, the less uncertain the outcome.



b. The expected rate of return ( r ) is the expected value of a probability distribution of expected


returns.


c. A continuous probability distribution contains an infinite number of outcomes and is graphed


from - and +.


d. The standard deviation () is a statistical measure of the variability of a set of observations. The


variance (2) of the probability distribution is the sum of the squared deviations about the


expected value adjusted for deviation. The coefficient of variation (CV) is equal to the standard


deviation divided by the expected return; it is a standardized risk measure which allows


comparisons between investments having different expected returns and standard deviations.


e. A risk averse investor dislikes risk and requires a higher rate of return as an inducement to buy


riskier securities. A realized return is the actual return an investor receives on their investment.


It can be quite different than their expected return.


f. A risk premium is the difference between the rate of return on a risk-free asset and the expected


return on Stock i which has higher risk. The market risk premium is the difference between the


expected return on the market and the risk-free rate.


g. CAPM is a model based upon the proposition that any stock's required rate of return is equal to


the risk free rate of return plus a risk premium reflecting only the risk re-maining after


diversification.



h. The expected return on a portfolio. r p, is simply the weighted-average expected return of the


individual stocks in the portfolio, with the weights being the fraction of total portfolio value


invested in each stock. The market portfolio is a portfolio consisting of all stocks.


i. Correlation is the tendency of two variables to move together. A correlation coefficient () of


+1.0 means that the two variables move up and down in perfect synchronization, while a


coefficient of -1.0 means the variables always move in opposite directions. A correlation


coefficient of zero suggests that the two variables are not related to one another; that is, they are


independent.



Answers and Solutions: 4 - 72 j. Market risk is that part of a security's total risk that cannot be eliminated by diversification. It is


measured by the beta coefficient. Diversifiable risk is also known as company specific risk, that


part of a security's total risk associated with random events not affecting the market as a whole.


This risk can be eliminated by proper diversification. The relevant risk of a stock is its


contribution to the riskiness of a well-diversified portfolio.


k. The beta coefficient is a measure of a stock's market risk, or the extent to which the returns on a


given stock move with the stock market. The average stock's beta would move on average with


the market so it would have a beta of 1.0.


l. The security market line (SML) represents in a graphical form, the relationship between the risk


of an asset as measured by its beta and the required rates of return for individual securities. The


SML equation is essentially the CAPM, ri = rRF + bi(rM - rRF).


m. The slope of the SML equation is (rM - rRF), the market risk premium. The slope of the SML


reflects the degree of risk aversion in the economy. The greater the average investors aversion to


risk, then the steeper the slope, the higher the risk premium for all stocks, and the higher the


required return.


4-2 a. The probability distribution for complete certainty is a vertical line.


b. The probability distribution for total uncertainty is the X axis from - to +.


4-3 Security A is less risky if held in a diversified portfolio because of its lower beta and negative


correlation with other stocks. In a single-asset portfolio, Security A would be more risky because A


> B and CVA > CVB.


4-4 a. No, it is not riskless. The portfolio would be free of default risk and liquidity risk, but inflation


could erode the portfolio's purchasing power. If the actual inflation rate is greater than that


expected, interest rates in general will rise to incorporate a larger inflation premium (IP) and the


value of the portfolio would decline.


b. No, you would be subject to reinvestment rate risk. You might expect to "roll over" the Treasury


bills at a constant (or even increasing) rate of interest, but if interest rates fall, your investment


income will decrease.


c. A U.S. government-backed bond that provided interest with constant purchasing power (that is, an


indexed bond) would be close to riskless.


4-5 The risk premium on a high beta stock would increase more.


RPj = Risk Premium for Stock j = (rM - rRF)bj.


If risk aversion increases, the slope of the SML will increase, and so will the market risk premium (rM


rRF). The product (rM rRF)bj is the risk premium of the jth stock. If bj is low (say, 0.5), then the


product will be small; RPj will increase by only half the increase in RPM. However, if bj is large (say,


2.0), then its risk premium will rise by twice the increase in RPM.


4-6 According to the Security Market Line (SML) equation, an increase in beta will increase a company's


expected return by an amount equal to the market risk premium times the change in beta. For


example, assume that the risk-free rate is 6 percent, and the market risk premium is 5 percent. If the



Answers and Solutions: 4 - 73 company's beta doubles from 0.8 to 1.6 its expected return increases from 10 percent to 14 percent.


Therefore, in general, a company's expected return will not double when its beta doubles.


4-7 Yes, if the portfolio's beta is equal to zero. In practice, however, it may be impossible to find


individual stocks that have a nonpositive beta. In this case it would also be impossible to have a stock


portfolio with a zero beta. Even if such a portfolio could be constructed, investors would probably


be better off just purchasing Treasury bills, or other zero beta investments.




Answers and Solutions: 4 - 74 SOLUTIONS TO END-OF-CHAPTER PROBLEMS



4-1 r = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)


= 11.40%.


2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4)


+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)


2


= 712.44; = 26.69%.


26.69%


CV = = 2.34.


11.40%


4-2 Investment Beta


$35,000 0.8


40,000 1.4


Total $75,000


($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.


4-3 rRF = 5%; RPM = 6%; rM = ?


rM = 5% + (6%)1 = 11%.


rs when b = 1.2 = ?


rs = 5% + 6%(1.2) = 12.2%.


4-4 rRF = 6%; rM = 13%; b = 0.7; rs = ?


rs = rRF + (rM - rRF)b


= 6% + (13% - 6%)0.7


= 10.9%.




Answers and Solutions: 4 - 75 4-5 a. r m= (0.3)(15%) + (0.4)(9%) + (0.3)(18%) = 13.5%.



r j= (0.3)(20%) + (0.4)(5%) + (0.3)(12%) = 11.6%.


b. M = [(0.3)(15% - 13.5%)2 + (0.4)(9% - 13.5%)2 + (0.3)(18% -13.5%)2]1/2


= 14.85% = 3.85%.


J = [(0.3)(20% - 11.6%)2 + (0.4)(5% - 11.6%)2 + (0.3)(12% - 11.6%)2]1/2


= 38.64% = 6.22%.


3.85%


c. CVM = = 0.29.


13.5%


6.22%


CVJ = = 0.54.


11.6%


4-6 a. rA = rRF + (rM - rRF)bA


12% = 5% + (10% - 5%)bA


12% = 5% + 5%(bA)


7% = 5%(bA)


1.4 = bA.


b. rA = 5% + 5%(bA)


rA = 5% + 5%(2)


rA = 15%.


4-7 a. ri = rRF + (rM - rRF)bi = 9% + (14% - 9%)1.3 = 15.5%.


b. 1. rRF increases to 10%:


rM increases by 1 percentage point, from 14% to 15%.


ri = rRF + (rM - rRF)bi = 10% + (15% - 10%)1.3 = 16.5%.


2. rRF decreases to 8%:


rM decreases by 1%, from 14% to 13%.


ri = rRF + (rM - rRF)bi = 8% + (13% - 8%)1.3 = 14.5%.


c. 1. rM increases to 16%:


ri = rRF + (rM - rRF)bi = 9% + (16% - 9%)1.3 = 18.1%.


2. rM decreases to 13%:


ri = rRF + (rM - rRF)bi = 9% + (13% - 9%)1.3 = 14.2%.



Answers and Solutions: 4 - 76 $142,500 $7,500 4-8 Old portfolio beta = (b) + (1.00)


$150,000 $150,000


1.12 = 0.95b + 0.05


1.07 = 0.95b


1.13 = b.


New portfolio beta = 0.95(1.13) + 0.05(1.75) = 1.16.


Alternative Solutions:


1. Old portfolio beta = 1.12 = (0.05)b1 + (0.05)b2 +...+ (0.05)b20


1.12 = (bi)(0.05)


bi = 1.12/0.05 = 22.4.


New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575 = 1.16.


2. bi excluding the stock with the beta equal to 1.0 is 22.4 - 1.0 = 21.4, so the beta of the portfolio


excluding this stock is b = 21.4/19 = 1.1263. The beta of the new portfolio is:


1.1263(0.95) + 1.75(0.05) = 1.1575 = 1.16.




$400,000 $600,000 4-9 Portfolio beta = (1.50) + (-0.50)


$4,000,000 $4,000,000


$1,000,000 $2,000,000


+ (1.25) + (0.75)


$4,000,000 $4,000,000


= 0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)


= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625.


rp = rRF + (rM - rRF)(bp) = 6% + (14% - 6%)(0.7625) = 12.1%.



Answers and Solutions: 4 - 77 Alternative solution: First compute the return for each stock using the CAPM equation [rRF + (rM -


rRF)b], and then compute the weighted average of these returns.


rRF = 6% and rM - rRF = 8%.



Stock Investment Beta r = rRF + (rM - rRF)b Weight


A $ 400,000 1.50 18% 0.10


B 600,000 (0.50) 2 0.15


C 1,000,000 1.25 16 0.25


D 2,000,000 0.75 12 0.50


Total $4,000,000 1.00


rp = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1%.


4-10 First, calculate the beta of what remains after selling the stock:


bp = 1.1 = ($100,000/$2,000,000)0.9 + ($1,900,000/$2,000,000)bR


1.1 = 0.045 + (0.95)bR


bR = 1.1105.


bN = (0.95)1.1105 + (0.05)1.4 = 1.125.


4-11 We know that bR = 1.50, bS = 0.75, rM = 13%, rRF = 7%.


ri = rRF + (rM - rRF)bi = 7% + (13% - 7%)bi.


rR = 7% + 6%(1.50) = 16.0%


rS = 7% + 6%(0.75) = 11.5


4.5%



4-12 The answers to a, b, c, and d are given below:


rA rB Portfolio


2000 (18.00%) (14.50%) (16.25%)


2001 33.00 21.80


27.40


2002 15.00 30.50


22.75


2003 (0.50) (7.60)


(4.05)



Answers and Solutions: 4 - 78 2004 27.00 26.30


26.65


Mean 11.30 11.30


11.30


Std Dev 20.79 20.78


20.13


CV 1.84 1.84


1.78


e. A risk-averse investor would choose the portfolio over either Stock A or Stock B alone, since the


portfolio offers the same expected return but with less risk. This result occurs because returns on


A and B are not perfectly positively correlated (AB = 0.88).


4-13 a. bX = 1.3471; bY = 0.6508.


b. rX = 6% + (5%)1.3471 = 12.7355%.


rY = 6% + (5%)0.6508 = 9.2540%.


c. bp = 0.8(1.3471) + 0.2(0.6508) = 1.2078.


rp = 6% + (5%)1.2078 = 12.04%.


Alternatively,


rp = 0.8(12.7355%) + 0.2(9.254%) = 12.04%.


d. Stock X is undervalued, because its expected return exceeds its required rate of return.




Answers and Solutions: 4 - 79 SOLUTION TO SPREADSHEET PROBLEM



4-14 The detailed solution for the spreadsheet problem is available both on the instructor's resource


CD-ROM (in the file Solution for FM11 Ch 04 P14 Build a Model.xls) and on the instructor's side of


the textbook's web site, brigham.swcollege.com.




Answers and Solutions: 4 - 80 MINI CASE



Assume that you recently graduated with a major in finance, and you just landed a job as a financial planner with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of one year, you have been instructed to plan for a one-year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will fill in the blanks later.)


Returns On Alternative Investments


Estimated Rate Of Return


State of the T- Alta Repo Am.


Market 2-stock


economy prob. Bills Inds Men Foam portfolio portfolio


Recession 0.1 8.0% -22.0% 28.0% 10.0%* -13.0% 3.0%


Below avg 0.2 8.0 -2.0 14.7 -10.0 1.0


Average 0.4 8.0 20.0 0.0 7.0 15.0 10.0


Above avg 0.2 8.0 35.0 -10.0 45.0 29.0


Boom 0.1 8.0 50.0 -20.0 30.0 43.0 15.0



r-hat ( r ) 1.7% 13.8% 15.0%


Std dev () 0.0 13.4 18.8 15.3


Coef of var (cv) 7.9 1.4 1.0


beta (b) -0.86 0.68


*Note that the estimated returns of American Foam do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner spring mattress may purchase, instead, a cheaper foam mattress. Under these circumstances, we would expect American Foam's stock price to be higher if there is a recession than if the economy was just below average.


Barney Smith's economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program which was used to estimate the rate of return on each alternative under each state of the economy. Alta Industries is an electronics firm; Repo Men collects past-due debts; and American Foam manufactures mattresses and other foam products. Barney Smith also maintains an "index fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions.




Answers and Solutions: 5 - 81 a. What are investment returns? What is the return on an investment that costs


$1,000 and is sold after one year for $1,100?


Answer: Investment return measures the financial results of an investment. They may be expressed in


either dollar terms or percentage terms. The dollar return is $1,100 - $1,000 = $100. The percentage return is $100/$1,000 = 0.10 =


10%.


b. 1. Why is the t-bill's return independent of the state of the economy? Do t-bills promise a


completely risk-free return?


Answer: The 8 percent t-bill return does not depend on the state of the economy because the treasury must


(and will) redeem the bills at par regardless of the state of the economy.


The t-bills are risk-free in the default risk sense because the 8 percent return will be realized


in all possible economic states. However, remember that this return is composed of the real


risk-free rate, say 3 percent, plus an inflation premium, say 5 percent. Since there is uncertainty


about inflation, it is unlikely that the realized real rate of return would equal the expected 3


percent. For example, if inflation averaged 6 percent over the year, then the realized real return


would only be 8% - 6% = 2%, not the expected 3%. Thus, in terms of purchasing power, t-bills


are not riskless.


Also, if you invested in a portfolio of T-bills, and rates then declined, your nominal income


would fall; that is, t-bills are exposed to reinvestment rate risk. So, we conclude that there are no


truly risk-free securities in the United States. If the treasury sold inflation-indexed, tax-exempt


bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.


b. 2. Why are Alta Ind.'s returns expected to move with the economy whereas Repo


Men's are expected to move counter to the economy?


Answer: Alta Industries' returns move with, hence are positively correlated with, the economy, because the


firm's sales, and hence profits, will generally experience the same type of ups and downs as the


economy. If the economy is booming, so will Alta. On the other hand, Repo Men is considered


by many investors to be a hedge against both bad times and high inflation, so if the stock market


crashes, investors in this stock should do relatively well. Stocks such as Repo Men are thus


negatively correlated with (move counter to) the economy. (note: in actuality, it is almost


impossible to find stocks that are expected to move counter to the economy. Even Repo Men


shares have positive (but low) correlation with the market.)




Answers and Solutions: 5 - 82 c. Calculate the expected rate of return on each alternative and fill in the blanks on the row for



r in the table above.


Answer: The expected rate of return, r , is expressed as follows:


n


r= P r .


i =1


i i




Here Pi is the probability of occurrence of the ith state, r i is the estimated rate of return for


that state, and n is the number of states. Here is the calculation for Alta Inds.:



r Alta Inds = 0.1(-22.0%) + 0.2(-2.0%) + 0.4(20.0%) + 0.2(35.0%) + 0.1(50.0%)


= 17.4%.


We use the same formula to calculate r's for the other alternatives:



r T-bills = 8.0%.



r Repo Men = 1.7%.



r Am Foam = 13.8%.



r M = 15.0%.



d. You should recognize that basing a decision solely on expected returns is only appropriate


for risk-neutral individuals. Since your client, like virtually everyone, is risk averse, the



Answers and Solutions: 5 - 83 riskiness of each alternative is an important aspect of the decision. One possible measure


of risk is the standard deviation of returns.


1. Calculate this value for each alternative, and fill in the blank on the row for in the table


above.


Answer: The standard deviation is calculated as follows:


n


= (r - r )


i =1


i


2


i


Pi .



Alta = [(-22.0 - 17.4)2(0.1) + (-2.0 - 17.4)2(0.2) + (20.0 - 17.4)2(0.4)


+ (35.0 - 17.4)2(0.2) + (50.0 - 17.4)2(0.1)]0.5


= 401.4 = 20.0%.


Here are the standard deviations for the other alternatives:


T-bills = 0.0%.


Repo = 13.4%.


Am Foam = 18.8%.


M = 15.3%.


d. 2. What type of risk is measured by the standard deviation?


Answer: The standard deviation is a measure of a security's (or a portfolio's) stand-alone risk. The larger


the standard deviation, the higher the probability that actual realized returns will fall far below the


expected return, and that losses rather than profits will be incurred.



d. 3. Draw a graph which shows roughly the shape of the probability distributions for Alta Inds,


Am Foam, and T-bills.


Answer:




Answers and Solutions: 5 - 84 Probability of


Occurrence



T-Bills




ALTA INDS




AM FOAM



-60 -45 -30 -15 0 15 30 45 60


Rate of Return (%)


Based on these data, Alta Inds is the most risky investment, t-bills the least risky.


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


regarded as being a better measure of stand-alone risk than the standard deviation when the


alternatives being considered have widely differing expected returns. Calculate the missing


CVs, and fill in the blanks on the row for CV in the table above. Does the CV produce the


same risk rankings as the standard deviation?



Answer: The coefficient of variation (CV) is a standardized measure of dispersion about the expected value;


it shows the amount of risk per unit of return.



CV =


.


r


CVT-bills = 0.0%/8.0% = 0.0.


CVAlta Inds = 20.0%/17.4% = 1.1.


Answers and Solutions: 5 - 85 CVRepo Men = 13.4%/1.7% = 7.9.


CVAm Foam = 18.8%/13.8% = 1.4.


CVM = 15.3%/15.0% = 1.0.


When we measure risk per unit of return, Repo Men, with its low expected return, becomes


the most risky stock. The CV is a better measure of an asset's stand-alone risk than because


CV considers both the expected value and the dispersion of a distribution--a security with a low


expected return and a low standard deviation could have a higher chance of a loss than one with a



high but a high r .


f. Suppose you created a 2-stock portfolio by investing $50,000 in Alta Inds and


$50,000 in Repo Men.



1. Calculate the expected return ( r p), the standard deviation (p), and the coefficient of


variation (cvp) for this portfolio and fill in the appropriate blanks in the table above.



Answer: To find the expected rate of return on the two-stock portfolio, we first calculate the rate of return


on the portfolio in each state of the economy. Since we have half of our money in each stock,


the portfolio's return will be a weighted average in each type of economy. For a recession, we


have: rp = 0.5(-22%) + 0.5(28%) = 3%. We would do similar calculations for the other states


of the economy, and get these results:


State Portfolio


Recession 3.0%


Below Average 6.4


Average 10.0


Above Average 12.5


Boom 15.0


Now we can multiply probabilities times outcomes in each state to get the expected return on


this two-stock portfolio, 9.6%.


Alternatively, we could apply this formula,


R = wi x ri = 0.5(17.4%) + 0.5(1.7%) = 9.6%,



Answers and Solutions: 5 - 86 Which finds r as the weighted average of the expected returns of the individual securities in the


portfolio.


It is tempting to find the standard deviation of the portfolio as the weighted average of the


standard deviations of the individual securities, as follows:


p wi(i) + wj(j) = 0.5(20%) + 0.5(13.4%) = 16.7%.


However, this is not correct--it is necessary to use a different formula, the one for that we used


earlier, applied to the two-stock portfolio's returns.


The portfolio's depends jointly on (1) each security's and (2) the correlation between the


securities' returns. The best way to approach the problem is to estimate the portfolio's risk and


return in each state of the economy, and then to estimate p with the formula. Given the


distribution of returns for the portfolio, we can calculate the portfolio's and CV as shown below:


p = [(3.0 - 9.6)2(0.1) + (6.4 - 9.6)2(0.2) + (10.0 - 9.6)2(0.4)


+ (12.5 - 9.6)2(0.2) + (15.0 - 9.6)2(0.1)]0.5


= 3.3%.


CVp = 3.3%/9.6% = 0.3.



f. 2. How does the riskiness of this 2-stock portfolio compare with the riskiness of the individual


stocks if they were held in isolation?


Answer: Using either or CV as our stand-alone risk measure, the stand-alone risk of the portfolio is


significantly less than the stand-alone risk of the individual stocks. This is because the two


stocks are negatively correlated--when Alta Inds is doing poorly, Repo Men is doing well, and


vice versa. Combining the two stocks diversifies away some of the risk inherent in each stock if


it were held in isolation, i.e., in a 1-stock portfolio.


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


stock. What would happen (1) to the riskiness and (2) to the expected return of


the portfolio as more and more randomly selected stocks were added to the


portfolio? What is the implication for investors? Draw a graph of the two


portfolios to illustrate your answer.


Answer:




Answers and Solutions: 5 - 87 Density



Portfolio of stocks


with rp = 16%




One


Stock


%


0 16 Return



The standard deviation gets smaller as more stocks are combined in the portfolio, while rp (the


portfolio's return) remains constant. Thus, by adding stocks to your portfolio, which initially started


as a 1-stock portfolio, risk has been reduced.


In the real world, stocks are positively correlated with one another--if the economy does well,


so do stocks in general, and vice versa. Correlation coefficients between stocks generally range


from +0.5 to +0.7. A single stock selected at random would on average have a standard


deviation of about 35 percent. As additional stocks are added to the portfolio, the portfolio's


standard deviation decreases because the added stocks are not perfectly positively correlated.


However, as more and more stocks are added, each new stock has less of a risk-reducing impact,


and eventually adding additional stocks has virtually no effect on the portfolio's risk as measured


by . In fact, stabilizes at about 20.4 percent when 40 or more randomly selected stocks are


added. Thus, by combining stocks into well-diversified portfolios, investors can eliminate


almost one-half the riskiness of holding individual stocks. (Note: it is not completely costless


to diversify, so even the largest institutional investors hold less than all stocks. Even index funds


generally hold a smaller portfolio which is highly correlated with an index such as the S&P 500


rather than hold all the stocks in the index.)


The implication is clear: investors should hold well-diversified portfolios of stocks rather


than individual stocks. (In fact, individuals can hold diversified portfolios through mutual fund


investments.) By doing so, they can eliminate about half of the riskiness inherent in individual


stocks.



h. 1. Should portfolio effects impact the way investors think about the riskiness of individual


stocks?


Answer: Portfolio diversification does affect investors' views of risk. A stock's stand-alone risk as


measured by its or CV, may be important to an undiversified investor, but it is not relevant to a


well-diversified investor. A rational, risk-averse investor is more interested in the impact that the


stock has on the riskiness of his or her portfolio than on the stock's stand-alone risk. Stand-alone



Answers and Solutions: 5 - 88 risk is composed of diversifiable risk, which can be eliminated by holding the stock in a


well-diversified portfolio, and the risk that remains is called market risk because it is present even


when the entire market portfolio is held.


h. 2. If you decided to hold a 1-stock portfolio, and consequently were exposed to more risk than


diversified investors, could you expect to be compensated for all of your risk; that is, could


you earn a risk premium on that part of your risk that you could have eliminated by


diversifying?


Answer: If you hold a one-stock portfolio, you will be exposed to a high degree of risk, but you won't be


compensated for it. If the return were high enough to compensate you for your high risk, it


would be a bargain for more rational, diversified investors. They would start buying it, and these


buy orders would drive the price up and the return down. Thus, you simply could not find stocks


in the market with returns high enough to compensate you for the stock's diversifiable risk.


i. How is market risk measured for individual securities? How are beta coefficients


calculated?


Answer: Market risk, which is relevant for stocks held in well-diversified portfolios, is defined


as the contribution of a security to the overall riskiness of the portfolio. It is


measured by a stock's beta coefficient, which measures the stock's volatility relative


to the market. Run a regression with returns on the stock in question plotted on the y axis and returns on the


market portfolio plotted on the x axis. The slope of the regression line, which measures relative volatility, is defined as the stock's


beta coefficient, or b.



j. Suppose you have the following historical returns for the stock market and for


another company, P.Q. Unlimited. Explain how to calculate beta, and use the


historical stock returns to calculate the beta for PQU. Interpret your results.




Answers and Solutions: 5 - 89 YEAR MARKET PQU


1 25.7% 40.0%


2 8.0% -15.0%


3 -11.0% -15.0%


4 15.0% 35.0%


5 32.5% 10.0%


6 13.7% 30.0%


7 40.0% 42.0%


8 10.0% -10.0%


9 -10.8% -25.0%


10 -13.1% 25.0%


Answer: Betas are calculated as the slope of the "characteristic" line, which is the regression


line showing the relationship between a given stock and the general stock market.



PQU


40%



20%



0% rM


-40% -20% 0% 20% 40%


-20%


r PQU = 0.83r M + 0.03


-40% 2


R = 0.36



Show the graph with the regression results. Point out that the beta is the slope


coeeficient, which is 0.83. State that an average stock, by definition, moves with the


market. Beta coefficients measure the relative volatility of a given stock relative to


the stock market. The average stock's beta is 1.0. Most stocks have betas in the


range of 0.5 to 1.5. Theoretically, betas can be negative, but in the real world they


are generally positive.


In practice, 4 or 5 years of monthly data, with 60 observations, would generally be used.


Some analysts use 52 weeks of weekly data. Point out that the r2 of 0.36 is slightly higher than


the typical value of about 0.29. A portfolio would have an r2 greater than 0.9.




Answers and Solutions: 5 - 90 k. The expected rates of return and the beta coefficients of the alternatives as


supplied by barney smith's computer program are as follows:



Security Return ( r ) Risk (Beta)


Alta Inds 17.4% 1.29


Market 15.0 1.00


Am. Foam 13.8 0.68


T-Bills 8.0 0.00


Repo Men 1.7 (0.86)



(1) Do the expected returns appear to be related to each alternative's market risk?


(2) Is it possible to choose among the alternatives on the basis of the


information developed thus far?


Answer: The expected returns are related to each alternative's market risk--that is, the higher the alternative's


rate of return the higher its beta. Also, note that t-bills have 0 risk. We do not yet have enough information to choose among the various alternatives. We need to


know the required rates of return on these alternatives and compare them with their


expected returns.


l. 1. Write out the security market line (SML) equation, use it to calculate the required rate of


return on each alternative, and then graph the relationship between the expected and


required rates of return.


Answer: Here is the SML equation:


ri = rrf + (rm - rrf)bi.


If we use the t-bill yield as a proxy for the risk-free rate, then rRF = 8%. Further, our



estimate of rm = rm is 15%. Thus, the required rates of return for the alternatives are as follows:


Alta Inds: 8% + (15% - 8%)1.29 = 17.03% 17.0%.


Market: 8% + (15% - 8%)1.00 = 15.0%.


Am Foam : 8% +(15% - 8%)0.68 = 12.76% 12.8%.


T-Bills: 8% + (15% - 8%)1.29 = 17.03% 17.0%.


Repo Men: 8% + (15% - 8%)-0.86 = 1.98% 2%.


l. 2. How do the expected rates of return compare with the required rates of return?


Answer: We have the following relationships:



Answers and Solutions: 5 - 91 Expected Required


Return Return



SECURITY (r ) (r) CONDITION



Alta Inds 17.4% 17.0% Undervalued: r > R


Market 15.0 15.0 Fairly Valued (Market Equilibrium)



Am Foam 13.8 12.8 Undervalued: r> R


T-Bills 8.0 8.0 Fairly Valued



Repo Men 1.7 2.0 Overvalued: R > r



SML: r i = r + RP M b i


RF


Required and Expected Rates of


= 8% + 7%(b i )


25%


20% Alta Inds.


15% Am. Foam Market


Return


10%


5% T-Bills



0% Repo Men


-5%


-10%


-3 -2 -1 0 1 2 3


Beta



(Note: the plot looks somewhat unusual in that the x axis extends to the left of zero. We have a


negative beta stock, hence a required return that is less than the risk-free rate.) The t-bills and


market portfolio plot on the SML, Alta Inds. And Am. Foam plot above it, and Repo Men plots


below it. Thus, the t-bills and the market portfolio promise a fair return, Alta Inds and Am.


Foam are good deals because they have expected returns above their required returns, and Repo


Men has an expected return below its required return.


l. 3. Does the fact that Repo Men has an expected return which is less than the t-bill


rate make any sense?


Answer: Repo Men is an interesting stock. Its negative beta indicates negative market risk--including it


in a portfolio of "normal" stocks will lower the portfolio's risk. Therefore, its required rate of


return is below the risk-free rate. Basically, this means that Repo Men is a valuable security to


rational, well-diversified investors. To see why, consider this question: would any rational


investor ever make an investment which has a negative expected return? The answer is


"yes"--just think of the purchase of a life or fire insurance policy. The fire insurance policy has a


negative expected return because of commissions and insurance company profits, but businesses


buy fire insurance because they pay off at a time when normal operations are in bad shape. Life


insurance is similar--it has a high return when work income ceases. A negative beta stock is


conceptually similar to an insurance policy.



Answers and Solutions: 5 - 92 l. 4. What would be the market risk and the required return of a 50-50 portfolio of


Alta Inds and Repo Men? Of Alta Inds and Am. Foam?


Answer: Note that the beta of a portfolio is simply the weighted average of the betas of the stocks in the


portfolio. Thus, the beta of a portfolio with 50 percent Alta Inds and 50 percent Repo Men is:


n


bp = w b .


i =1


i i



bp = 0.5(bAlta) + 0.5(bRepo) = 0.5(1.29) + 0.5(-0.86)


= 0.215,


rp = rRF + (rM - rRF)bp = 8.0% + (15.0% - 8.0%)(0.215)


= 8.0% + 7%(0.215) = 9.51% 9.5%.


For a portfolio consisting of 50% Alta Inds plus 50% Am. Foam, the required return


would be 14.9%:


bp = 0.5(1.29) + 0.5(0.68) = 0.985.


rp = 8.0% + 7%(0.985) = 14.9%.




Answers and Solutions: 5 - 93 m. 1. Suppose investors raised their inflation expectations by 3 percentage points over current


estimates as reflected in the 8 percent t-bill rate. What effect would higher inflation have


on the SML and on the returns required on high- and low-risk securities?


Answer:



Required and Expected


Rates of Return (%)


40


35


Increased Risk Aversion


30


Increased Inflation


25


20


15 Original Situation



10


5


Beta


0.00 0.50 1.00 1.50 2.00



Here we have plotted the SML for betas ranging from 0 to 2.0. The base case SML is based on


r RF = 8% and r M = 15%. If inflation expectations increase by 3 percentage points, with no


change in risk aversion, then the entire SML is shifted upward (parallel to the base case SML) by


3 percentage points. Now, r RF = 11%, r M = 18%, and all securities' required returns rise by


3 percentage points. Note that the market risk premium, rm - r RF , remains at 7 percentage


points.


m. 2. Suppose instead that investors' risk aversion increased enough to cause the


market risk premium to increase by 3 percentage points. (inflation remains


constant.) What effect would this have on the SML and on returns of high- and


low-risk securities?


Answer: When investors' risk aversion increases, the SML is rotated upward about the y-intercept ( r RF ).


r RF remains at 8 percent, but now r M increases to 18 percent, so the market risk premium


increases to 10 percent. The required rate of return will rise sharply on high-risk (high-beta)


stocks, but not much on low-beta securities.




Answers and Solutions: 5 - 94 Optional question (cover if time is available)


Financial managers are more concerned with investment decisions relating to real assets such as plant and equipment than with investments in financial assets such as securities. How does the analysis that we have gone through relate to real asset investment decisions, especially corporate capital budgeting decisions?


Answer: There is a great deal of similarity between your financial asset decisions and a firm's capital


budgeting decisions. Here is the linkage:


1. A company may be thought of as a portfolio of assets. If the company diversifies its assets,


and especially if it invests in some projects that tend to do well when others are doing badly,


it can lower the variability of its returns.


2. Companies obtain their investment funds from investors, who buy the firm's


stocks and bonds. When investors buy these securities, they require a risk


premium which is based on the company's risk as they (investors) see it. Further,


since investors in general hold well-diversified portfolios of stocks and bonds, the


risk that is relevant to them is the security's market risk, not its stand-alone risk.


Thus, investors view the risk of the firm from a market risk perspective.


3. Therefore, when a manager makes a decision to build a new plant, the riskiness of


the investment in the plant that is relevant to the firm's investors (its owners) is its


market risk, not its stand-alone risk. Accordingly, managers need to know how


physical asset investment decisions affect their firm's beta coefficient. A


particular asset may look quite risky when viewed in isolation, but if its returns


are negatively correlated with returns on most other stocks, the asset may really


have low risk. We will discuss all this in more detail in our capital budgeting


discussions.




Answers and Solutions: 5 - 95 Chapter 5


Risk and Return: Portfolio Theory and Asset Pricing


Models ANSWERS TO END-OF-CHAPTER QUESTIONS


5-1 a. A portfolio is made up of a group of individual assets held in combination. An asset that would


be relatively risky if held in isolation may have little, or even no risk if held in a well-diversified


portfolio.


The feasible, or attainable, set represents all portfolios that can be constructed from a given set of


stocks. This set is only efficient for part of its combinations.


An efficient portfolio is that portfolio which provides the highest expected return for any degree


of risk. Alternatively, the efficient portfolio is that which provides the lowest degree of risk for


any expected return.


The efficient frontier is the set of efficient portfolios out of the full set of potential portfolios. On


a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios.


b. An indifference curve is the risk/return trade-off function for a particular investor and reflects that


investor's attitude toward risk. The indifference curve specifies an investor's required rate of return


for a given level of risk. The greater the slope of the indifference curve, the greater is the


investor's risk aversion.


The optimal portfolio for an investor is the point at which the efficient set of portfolios--the


efficient frontier--is just tangent to the investor's indifference curve. This point marks the


highest level of satisfaction an investor can attain given the set of potential portfolios.


c. The Capital Asset Pricing Model (CAPM) is a general equilibrium market model developed to


analyze the relationship between risk and required rates of return on assets when they are held in


well-diversified portfolios. The SML is part of the CAPM.


The Capital Market Line (CML) specifies the efficient set of portfolios an investor can attain by


combining a risk-free asset and the risky market portfolio M. The CML states that the expected


return on any efficient portfolio is equal to the riskless rate plus a risk premium, and thus


describes a linear relationship between expected return and risk.


d. The characteristic line for a particular stock is obtained by regressing the historical returns on that


stock against the historical returns on the general stock market. The slope of the characteristic


line is the stock's beta, which measures the amount by which the stock's expected return increases


for a given increase in the expected return on the market.


The beta coefficient (b) is a measure of a stock's market risk. It measures the stock's volatility


relative to an average stock, which has a beta of 1.0.


e. Arbitrage Pricing Theory (APT) is an approach to measuring the equilibrium risk/return


relationship for a given stock as a function of multiple factors, rather than the single factor (the


market return) used by the CAPM. The APT is based on complex mathematical and statistical



Answers and Solutions: 5 - 96 theory, but can account for several factors (such as GNP and the level of inflation) in determining


the required return for a particular stock.


The Fama-French 3-factor model has one factor for the excess market return (the market return


minus the risk free rate), a second factor for size (defined as the return on a portfolio of small


firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect


(defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on


a portfolio of firms with a low book-to-market ratio).


Most people don't behave rationally in all aspects of their personal lives, and behavioral finance


assume that investors have the same types of psychological behaviors in their financial lives as in


their personal lives.


5-2 Security A is less risky if held in a diversified portfolio because of its lower beta and negative


correlation with other stocks. In a single-asset portfolio, Security A would be more risky because A


> B and CVA > CVB.




Answers and Solutions: 5 - 97 SOLUTIONS TO END-OF-CHAPTER PROBLEMS



5-1 a. A plot of the approximate regression line is shown in the following figure:


rX (%)


30


25


20


15


10


5


rY


0


-30 -20 -10 0 10 20 30 40 50


-5


-10


-15


-20



Using Excel, the regression equation estimates are: Beta = 0.56; Intercept = 0.037; R2 = 0.96.


b. The arithmetic average return for Stock X is calculated as follows:


(-14.0 + 23.0 + ... + 18.2)


r Avg = = 10.6%.


7


The arithmetic average rate of return on the market portfolio, determined similarly, is 12.1%.


For Stock X, the estimated standard deviation is 13.1 percent:


(-14.0 - 10.6) 2 + (23.0 - 10.6) 2 + ... + (18.2 - 10.6) 2


X = = 13.1%.


7 -1



The standard deviation of returns for the market portfolio is similarly determined to be 22.6


percent. The results are summarized below:



Answers and Solutions: 5 - 98 Stock X Market Portfolio


Average return, r Avg 10.6% 12.1%


Standard deviation, 13.1 22.6


Several points should be noted: (1) M over this particular period is higher than the historic


average M of about 15 percent, indicating that the stock market was relatively volatile during this


period; (2) Stock X, with X = 13.1%, has much less total risk than an average stock, with Avg =


22.6%; and (3) this example demonstrates that it is possible for a very low-risk single stock to


have less risk than a portfolio of average stocks, since X < M.


c. Since Stock X is in equilibrium and plots on the Security Market Line (SML), and given the



further assumption that r X = r X and r M = r M --and this assumption often does not hold--then


this equation must hold:


r X = rRF + (r - rRF )b X .


This equation can be solved for the risk-free rate, rRF, which is the only unknown:


10.6 = rRF + (12.1 - rRF ) 0.56


10.6 = rRF + 6.8 - 0.56 rRF


0.44 rRF = 10.6 - 6.8


rRF = 3.8 / 0.44 = 8.6%.




Answers and Solutions: 5 - 99 d. The SML is plotted below. Data on the risk-free security (bRF = 0,


rRF = 8.6%) and Security X (bX = 0.56, r X = 10.6%) provide the two points through which the


SML can be drawn. rM provides a third point.



r(%)


k(%)



20




rX X = 10.6%


k = 10.6%


kM = 12.1%



rRF = 8.6%10


kRF = 8.6




1.0 2.0 Beta



e. In theory, you would be indifferent between the two stocks. Since they have the same beta, their


relevant risks are identical, and in equilibrium they should provide the same returns. The two


stocks would be represented by a single point on the SML. Stock Y, with the higher standard


deviation, has more diversifiable risk, but this risk will be eliminated in a well-diversified


portfolio, so the market will compensate the investor only for bearing market or relevant risk. In


practice, it is possible that Stock Y would have a slightly higher required return, but this premium


for diversifiable risk would be small.



5-2



Answers and Solutions: 5 - 100 a. The regression graph is shown above. Using a speadsheet, we find b = 0.62.



rk y(%)


S (%)


45




30




15




-30 -15 15 30 45 k M (%)


rM(%)


-15




b. Because b = 0.62, Stock Y is about 62 percent as volatile as the market; thus, its relative risk is


about 62 percent of that of an average firm.


c. 1. Total risk ( 2 ) would be greater because the second term of the firm's risk equation,


Y


2 = b 2 2 + eY , would be greater.


Y Y M


2



2. CAPM assumes that company-specific risk will be eliminated in a portfolio, so the


risk premium under the CAPM would not be affected.


d. 1. The stock's variance would not change, but the risk of the stock to an investor holding a


diversified portfolio would be greatly reduced.


2. It would now have a negative correlation with rM.


3. Because of a relative scarcity of such stocks and the beneficial net effect on portfolios that


include it, its "risk premium" is likely to be very low or even negative. Theoretically, it


should be negative.




iM i 5-3 a. ri = rRF + (rM - rRF )b i = rRF + (rM - rRF ) .


M




Answers and Solutions: 5 - 101


r M - rRF r -r


b. CML: r p = rRF + p . SML: ri = rRF + M RF


riM i .



M M



With some arranging, the similarities between the CML and SML are obvious. When in this


form, both have the same market price of risk, or slope,(rM - rRF)/M.


The measure of risk in the CML is p. Since the CML applies only to efficient portfolios, p


not only represents the portfolio's total risk, but also its market risk. However, the SML


applies to all portfolios and individual securities. Thus, the appropriate risk measure is not i,


the total risk, but the market risk, which in this form of the SML is riMi, and is less than for all


assets except those which are perfectly positively correlated with the market, and hence have riM =


+1.0.


5-4 a. Using the CAPM:


ri = rRF + (rM - rRF)bi = 7% + (1.1)(6.5%) = 14.15%


b. Using the 3-factor model:


ri = rRF + (rM rrf)bi + (rSMB)ci + (rHML)di


= 7% + (1.1)(6.5%) + (5%)(0.7) + (4%)(-0.3) = 16.45%




Answers and Solutions: 5 - 102 MINI CASE



To begin, briefly review the Chapter 4 Mini Case. Then, extend your knowledge of risk and return by answering the following questions.


a. Suppose asset A has an expected return of 10 percent and a standard deviation of 20 percent.


Asset B has an expected return of 16 percent and a standard deviation of 40 percent. If the


correlation between A and B is 0.4, what are the expected return and standard deviation for


a portfolio comprised of 30 percent asset A and 70 percent asset B?


Answer:


rP = w A rA + (1 - w A ) rB


^ ^ ^


= 0.3(0.1) + 0.7(0.16)


= 0.142 = 14.2%.



p = WA 2 + (1 - WA ) 2 2 + 2 WA (1 - WA ) AB A B


2


A B


= 0.3 2 (0.2 2 ) + 0.7 2 (0.4 2 ) + 2(0.3)(0.7)(0.4)(0.2)(0.4)


= 0.309


b. Plot the attainable portfolios for a correlation of 0.4. Now plot the attainable portfolios for


correlations of +1.0 and -1.0.


Answer:



AB = +0.4: Attainable Set of


Risk/Return Combinations


20%


Expected return




15%


10%


5%


0%


0% 10% 20% 30% 40%


Risk, p




Answers and Solutions: 6 - 103 AB = +1.0: Attainable Set of


Risk/Return Combinations


20%



Expected return


15%


10%


5%


0%


0% 10% 20% 30% 40%


Risk, p




AB = -1.0: Attainable Set of Risk/Return


Combinations


20% Expected return




15%


10%


5%


0%


0% 10% 20% 30% 40%


Risk, p




Answers and Solutions: 6 - 104 c. Suppose a risk-free asset has an expected return of 5 percent. By definition, its standard


deviation is zero, and its correlation with any other asset is also zero. Using only asset A and the


risk-free asset, plot the attainable portfolios.


Answer:



Attainable Set of Risk/Return


Combinations with Risk-Free Asset


15%


Expected return


10%



5%



0%


0% 5% 10% 15% 20%


Risk, p




Answers and Solutions: 6 - 105 d. Construct a reasonable, but hypothetical, graph which shows risk, as measured by


portfolio standard deviation, on the x axis and expected rate of return on the y axis.


Now add an illustrative feasible (or attainable) set of portfolios, and show what


portion of the feasible set is efficient. What makes a particular portfolio efficient?


Don't worry about specific values when constructing the graph--merely illustrate


how things look with "reasonable" data.


Answer:


Expected Portfolio


Return


Expected Portfolio


^


Return, kp


^


rP


B


Efficient Set (A,B)


C




A


D


Feasible, or


Attainable, Set


E



risk, Pp


Risk,


The figure above shows the feasible set of portfolios. The points B, C, D, and E represent single


securities (or portfolios containing only one security). All the other points in the shaded area,


including its boundaries, represent portfolios of two or more securities. The shaded area is


called the feasible, or attainable, set.


The boundary AB defines the efficient set of portfolios, which is also called the efficient


frontier. Portfolios to the left of the efficient set are not possible because they lie outside the


attainable set. Portfolios to the right of the boundary line (interior portfolios) are inefficient


because some other portfolio would provide either a higher return with the same degree of risk or


a lower level of risk for the same rate of return.




e. Now add a set of indifference curves to the graph created for part B. What do these


curves represent? What is the optimal portfolio for this investor? Finally, add a


second set of indifference curves which leads to the selection of a different optimal


portfolio. Why do the two investors choose different portfolios?



Answers and Solutions: 6 - 106 Expected Portfolio


Return,


Expected Portfolio


^^


Return, kp


r p


B


I B2


C


I B1


Optimal


Portfolio


I A3 Investor B


I A2


A


D


I A1


Optimal


Portfolio


Investor A


E


risk, P


Risk, p



Answer:


The figure above shows the indifference curves for two hypothetical investors, A and B. To


determine the optimal portfolio for a particular investor, we must know the investor's attitude


towards risk as reflected in his or her risk/return tradeoff function, or indifference curve. Curves


Ia1, Ia2, and Ia3 represent the indifference curves for individual A, with the higher curve (Ia3)


denoting a greater level of satisfaction (or utility). Thus, Ia3 is better than Ia2 for any level of risk.


The optimal portfolio is found at the tangency point between the efficient set of portfolios and


one of the investor's indifference curves. This tangency point marks the highest level of


satisfaction the investor can attain. The arrows point toward the optimal portfolios for both


investors A and B.


The investors choose different optimal portfolios because their risk aversion is different.


Investor A chooses the portfolio with the lower expected return, but the riskiness of that portfolio


is also lower than investor's B optimal portfolio, because investor a is more risk averse.



f. What is the capital asset pricing model (CAPM)? What are the assumptions that underlie


the model?


Answer: The Capital Asset Pricing Model (CAPM) is an equilibrium model which specifies the


relationship between risk and required rates of return on assets when they are held in


well-diversified portfolios. The CAPM requires an extensive set of assumptions:


All investors are single-period expected utility of terminal wealth maximizers, who


choose among alternative portfolios on the basis of each portfolio's expected


return and standard deviation.


Answers and Solutions: 6 - 107 All investors can borrow or lend an unlimited amount at a given risk-free rate of


interest.


Investors have homogeneous expectations (that is, investors have identical


estimates of the expected values, variances, and covariances of returns among all


assets).


All assets are perfectly divisible and perfectly marketable at the going price, and


there are no transactions costs.


There are no taxes.


All investors are price takers (that is, all investors assume that their own buying and


selling activity will not affect stock prices).


The quantities of all assets are given and fixed.


g. Now add the risk-free asset. What impact does this have on the efficient frontier?


Answer: The risk-free asset by definition has zero risk, and hence = 0%, so it is plotted on the vertical


axis. Now, given the possibility of investing in the risk-free asset, investors can create new


portfolios that combine the risk-free asset with a portfolio of risky assets. This enables them to


achieve any combination of risk and return that lies along any straight line connecting rRF with


any portfolio in the feasible set of risky portfolios. However, the straight line connecting rRF


with m, the point of tangency between the line and the portfolio's efficient set curve, is the one


that all investors would choose. Since all portfolios on the line rRFmz are preferred to the other


risky portfolio opportunities on the efficient frontier AB, the points on the line rRFmz now


represent the best attainable combinations of risk and return. Any combination under the rRFmz


line offers less return for the same amount of risk, or offers more risk for the same amount of


return. Thus, everybody wants to hold portfolios which are located on the rRFmz line.



h. Write out the equation for the capital market line (CML) and draw it on the graph.


Interpret the CML. Now add a set of indifference curves, and illustrate how an investor's


optimal portfolio is some combination of the risky portfolio and the risk-free asset. What is


the composition of the risky portfolio?




Answers and Solutions: 6 - 108 Expected Portfolio


Return, Portfolio


Expected


^


Return, k p^ Z


rp


B



M




A


krRF


RF




risk, Pp


Risk,



Answer: The line rRFmz in the figure above is called the capital market line (CML). It has an intercept of



rRF and a slope of ( r M - rRF ) / M . Therefore the equation for the capital market line may be


expressed as follows:


^


r M - rRF


CML: r p = rRF + p .


M



The CML tells us that the expected rate of return on any efficient portfolio (that is, any portfolio


on the CML) is equal to the risk-free rate plus a risk premium, and the risk premium is equal to



( r M - rRF ) / M multiplied by the portfolio's standard deviation, p . Thus, the CML specifies a


linear relationship between expected return and risk, with the slope of the CML being equal to the



expected return on the market portfolio of risky stocks, r M , minus the risk-free rate, rRF, which is


called the market risk premium, all divided by the standard deviation of returns on the market


portfolio, m.




Answers and Solutions: 6 - 109 Expected Rate


of Return,


Expected Rate


^


^


r


of Return,pk p


I I CML


3 2 I1




rRFRF


k


Optimal


Portfolio



Risk, p




The figure above shows a set of indifference curves (i1, i2, and i3), with i1 touching the CML.


This point of tangency defines the optimal portfolio for this investor, and he or she will buy a


combination of the market portfolio and the risk-free asset.


The risky portfolio, m, must contain every asset in exact proportion to that asset's fraction of


the total market value of all assets; that is, if security g is x percent of the total market value of all


securities, x percent of the market portfolio must consist of security g.



i. What is a characteristic line? How is this line used to estimate a stock's beta coefficient?


Write out and explain the formula that relates total risk, market risk, and diversifiable risk.


Answer: Betas are calculated as the slope of the characteristic line, which is the regression line formed by


plotting returns on a given stock on the y axis against returns on the general stock market on the x



Answers and Solutions: 6 - 110 axis. In practice, 5 years of monthly data, with 60 observations, would be used, and a computer


would be used to obtain a least squares regression line.


The relationship between stock J's total risk, market risk, and diversifiable risk can be


expressed as follows:


TOTAL RISK = VARIANCE = MARKET RISK + DIVERSIFIABLE RISK


2 =


J b 22


J M + 2


eJ


Here J is the variance or total risk of stock j, 2 is the variance of the market, bj is stock J's


2


M


beta coefficient, and 2 is the variance of stock J's regression error term. If stock J is held in


eJ


isolation, then the investor must bear its total risk. However, when stock J is held as part of a


well-diversified portfolio, the regression error term, 2 is driven to zero; hence, only the market


eJ


risk remains.


j. What are two potential tests that can be conducted to verify the CAPM? What are the


results of such tests? What is roll's critique of CAPM tests?


Answer: Since the CAPM was developed on the basis of a set of unrealistic assumptions, empirical tests


should be used to verify the CAPM. The first test looks for stability in historical betas. If betas


have been stable in the past for a particular stock, then its historical beta would probably be a


good proxy for its ex-ante, or expected beta. Empirical work concludes that the betas of individual


securities are not good estimators of their future risk, but that betas of portfolios of ten or more


randomly selected stocks are reasonably stable, hence that past portfolio betas are good estimators


of future portfolio volatility.


The second type of test is based on the slope of the SML. As we have seen, the CAPM states


that a linear relationship exists between a security's required rate of return and its beta. Further,


when the SML is graphed, the vertical axis intercept should be rRF, and the required rate of return


for a stock (or portfolio) with beta = 1.0 should be rm, the required rate of return on the market.


Various researchers have attempted to test the validity of the CAPM model by calculating betas


and realized rates of return, plotting these values in graphs, and then observing whether or not (1)


the intercept is equal to rRF, (2) the regression line is linear, and (3) the SML passes through the


point b = 1.0, rm. Evidence shows a more-or-less linear relationship between realized returns and


market risk, but the slope is less than predicted. Tests that attempt to assess the relative


importance of market and company-specific risk do not yield definitive results, so the irrelevance


of diversifiable risk specified in the CAPM model can be questioned.


Roll questioned whether it is even conceptually possible to test the CAPM. Roll showed


that the linear relationship which prior researchers had observed in graphs resulted from the


mathematical properties of the models being tested, hence that a finding of linearity proved


nothing about the validity of the CAPM. Roll's work did not disprove the CAPM theory, but he


did show that it is virtually impossible to prove that investors behave in accordance with the


theory.


In general, evidence seems to support the CAPM model when it is applied to portfolios, but


the evidence is less convincing when the CAPM is applied to individual stocks.


Nevertheless, the CAPM provides a rational way to think about risk and return as long as one


recognizes the limitations of the CAPM when using it in practice.



k. Briefly explain the difference between the CAPM and the arbitrage pricing theory



Answers and Solutions: 6 - 111 (APT).


Answer: The CAPM is a single-factor model, while the Arbitrage Pricing Theory (APT) can include any


number of risk factors. It is likely that the required return is dependent on many fundamental


factors such as the GNP growth, expected inflation, and changes in tax laws, and that different


groups of stocks are affected differently by these factors. Thus, the apt seems to have a stronger


theoretical footing than does the CAPM. However, the apt faces several major hurdles in


implementation, the most severe being that the apt does not identify the relevant factors--a


complex mathematical procedure called factor analysis must be used to identify the factors. To


date, it appears that only three or four factors are required in the apt, but much more research is


required before the apt is fully understood and presents a true challenge to the CAPM.



l. Suppose you are given the following information. The beta of company, bi, is 0.9, the risk


free rate, rRF, is 6.8%, and the expected market premium, rM-rRF, is 6.3%. Because your


company is larger than average and more successful than average (i.e., it has a lower


book-to-market ratio), you think the Fama-French 3-factor model might be more


appropriate than the CAPM. You estimate the additional coefficients from the


Fama-French 3-factor model: the coefficient for the size effect, Ci, is -0.5, and the coefficient


for the book-to-market effect, di, is 0.3. If the expected value of the size factor is 4% and


the expected value of the book-to-market factor is 5%, what is the required return using the


Fama-French 3-factor model? (assume that Ai = 0.0.) What is the required return using


CAPM?


Answer: The Fama-French model:


ri = rRF + (rm - rRF)bi + (rsmb)ci + (rhmb)dj


ri = 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3)


= 8.97%


The CAPM:


ri = rrf + (rm - rrf)bi


ri = 6.8% + (6.3%)(0.9)


= 12.47%




Answers and Solutions: 6 - 112 Chapter 6


Bonds and Their Valuation


ANSWERS TO END-OF-CHAPTER QUESTIONS


6-1 a. A bond is a promissory note issued by a business or a governmental unit. Treasury bonds,


sometimes referred to as government bonds, are issued by the Federal government and are not


exposed to default risk. Corporate bonds are issued by corporations and are exposed to default


risk. Different corporate bonds have different levels of default risk, depending on the issuing


company's characteristics and on the terms of the specific bond. Municipal bonds are issued by


state and local governments. The interest earned on most municipal bonds is exempt from


federal taxes, and also from state taxes if the holder is a resident of the issuing state. Foreign


bonds are issued by foreign governments or foreign corporations. These bonds are not only


exposed to default risk, but are also exposed to an additional risk if the bonds are denominated in


a currency other than that of the investor's home currency.


b. The par value is the nominal or face value of a stock or bond. The par value of a bond generally


represents the amount of money that the firm borrows and promises to repay at some future date.


The par value of a bond is often $1,000, but can be $5,000 or more. The maturity date is the date


when the bond's par value is repaid to the bondholder. Maturity dates generally range from 10 to


40 years from the time of issue. A call provision may be written into a bond contract, giving the


issuer the right to redeem the bonds under specific conditions prior to the normal maturity date.


A bond's coupon, or coupon payment, is the dollar amount of interest paid to each bondholder on


the interest payment dates. The coupon is so named because bonds used to have dated coupons


attached to them which investors could tear off and redeem on the interest payment dates. The


coupon interest rate is the stated rate of interest on a bond.


c. In some cases, a bond's coupon payment may vary over time. These bonds are called floating


rate bonds. Floating rate debt is popular with investors because the market value of the debt is


stabilized. It is advantageous to corporations because firms can issue long-term debt without


committing themselves to paying a historically high interest rate for the entire life of the loan.


Zero coupon bonds pay no coupons at all, but are offered at a substantial discount below their par


values and hence provide capital appreciation rather than interest income. In general, any bond


originally offered at a price significantly below its par value is called an original issue discount


bond (OID).


d. Most bonds contain a call provision, which gives the issuing corporation the right to call the


bonds for redemption. The call provision generally states that if the bonds are called, the


company must pay the bondholders an amount greater than the par value, a call premium.


Redeemable bonds give investors the right to sell the bonds back to the corporation at a price that


is usually close to the par value. If interest rates rise, investors can redeem the bonds and


reinvest at the higher rates. A sinking fund provision facilitates the orderly retirement of a bond


issue. This can be achieved in one of two ways: The company can call in for redemption (at par


value) a certain percentage of bonds each year. The company may buy the required amount of


bonds on the open market.


e. Convertible bonds are securities that are convertible into shares of common stock, at a fixed price,


at the option of the bondholder. Bonds issued with warrants are similar to convertibles.


Warrants are options which permit the holder to buy stock for a stated price, thereby providing a


Answers and Solutions: 6 - 113 capital gain if the stock price rises. Income bonds pay interest only if the interest is earned.


These securities cannot bankrupt a company, but from an investor's standpoint they are riskier


than "regular" bonds. The interest rate of an indexed, or purchasing power, bond is based on an


inflation index such as the consumer price index (CPI), so the interest paid rises automatically


when the inflation rate rises, thus protecting the bondholders against inflation.


f. Bond prices and interest rates are inversely related; that is, they tend to move in the opposite


direction from one another. A fixed-rate bond will sell at par when its coupon interest rate is


equal to the going rate of interest, rd. When the going rate of interest is above the coupon rate, a


fixed-rate bond will sell at a "discount" below its par value. If current interest rates are below the


coupon rate, a fixed-rate bond will sell at a "premium" above its par value.


g. The current yield on a bond is the annual coupon payment divided by the current market price.


YTM, or yield to maturity, is the rate of interest earned on a bond if it is held to maturity. Yield


to call (YTC) is the rate of interest earned on a bond if it is called. If current interest rates are


well below an outstanding callable bond's coupon rate, the YTC may be a more relevant estimate


of expected return than the YTM, since the bond is likely to be called.


h. The shorter the maturity of the bond, the greater the risk of a decrease in interest rates. The risk


of a decline in income due to a drop in interest rates is called reinvestment rate risk. Interest


rates fluctuate over time, and people or firms who invest in bonds are exposed to risk from


changing interest rates, or interest rate risk. The longer the maturity of the bond, the greater the


exposure to interest rate risk. Interest rate risk relates to the value of the bonds in a portfolio,


while reinvestment rate risk relates to the income the portfolio produces. No fixed-rate bond can


be considered totally riskless. Bond portfolio managers try to balance these two risks, but some


risk always exists in any bond. Another important risk associated with bonds is default risk. If


the issuer defaults, investors receive less than the promised return on the bond. Default risk is


influenced by both the financial strength of the issuer and the terms of the bond contract,


especially whether collateral has been pledged to secure the bond. The greater the default risk,


the higher the bond's yield to maturity.


i. Corporations can influence the default risk of their bonds by changing the type of bonds they


issue. Under a mortgage bond, the corporation pledges certain assets as security for the bond.


All such bonds are written subject to an indenture, which is a legal document that spells out in


detail the rights of both the bondholders and the corporation. A debenture is an unsecured


bond, and as such, it provides no lien against specific property as security for the obligation.


Debenture holders are, therefore, general creditors whose claims are protected by property not


otherwise pledged. Subordinated debentures have claims on assets, in the event of bankruptcy,


only after senior debt as named in the subordinated debt's indenture has been paid off.


Subordinated debentures may be subordinated to designated notes payable or to all other debt.


j. A development bond is a tax-exempt bond sold by state and local governments whose proceeds


are made available to corporations for specific uses deemed (by Congress) to be in the public


interest. Municipalities can insure their bonds, in which an insurance company guarantees to pay


the coupon and principal payments should the issuer default. This reduces the risk to investors


who are willing to accept a lower coupon rate for an insured bond issue vis-a-vis an uninsured


issue. Bond issues are normally assigned quality ratings by major rating agencies, such as


Moody's Investors Service and Standard & Poor's Corporation. These ratings reflect the


probability that a bond will go into default. Aaa (Moody's) and AAA (S&P) are the highest


ratings. Rating assignments are based on qualitative and quantitative factors including the firm's


debt/assets ratio, current ratio, and coverage ratios. Because a bond's rating is an indicator of its



Answers and Solutions: 6 - 114 default risk, the rating has a direct, measurable influence on the bond's interest rate and the firm's


cost of debt capital. Junk bonds are high-risk, high-yield bonds issued to finance leveraged


buyouts, mergers, or troubled companies. Most bonds are purchased by institutional investors


rather than individuals, and many institutions are restricted to investment grade bonds, securities


with ratings of Baa/BBB or above.


6-2 False. Short-term bond prices are less sensitive than long-term bond prices to interest rate changes


because funds invested in short-term bonds can be reinvested at the new interest rate sooner than


funds tied up in long-term bonds.



6-3 The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still has a long


term to maturity, its YTM will reflect long-term rates. Of course, the bond's price will be less


affected by a change in interest rates if it has been outstanding a long time and matures shortly.


While this is true, it should be noted that the YTM will increase only for buyers who purchase the


bond after the change in interest rates and not for buyers who purchased previous to the change. If


the bond is purchased and held to maturity, the bondholder's YTM will not change, regardless of what


happens to interest rates.


6-4 If interest rates decline significantly, the values of callable bonds will not rise by as much as those of


bonds without the call provision. It is likely that the bonds would be called by the issuer before


maturity, so that the issuer can take advantage of the new, lower rates.


6-5 From the corporation's viewpoint, one important factor in establishing a sinking fund is that its own


bonds generally have a higher yield than do government bonds; hence, the company saves more


interest by retiring its own bonds than it could earn by buying government bonds. This factor causes


firms to favor the second procedure. Investors also would prefer the annual retirement procedure if


they thought that interest rates were more likely to rise than to fall, but they would prefer the


government bond purchases program if they thought rates were likely to fall. In addition,


bondholders recognize that, under the government bond purchase scheme, each bondholder would be


entitled to a given amount of cash from the liquidation of the sinking fund if the firm should go into


default, whereas under the annual retirement plan, some of the holders would receive a cash benefit


while others would benefit only indirectly from the fact that there would be fewer bonds outstanding.


On balance, investors seem to have little reason for choosing one method over the other, while


the annual retirement method is clearly more beneficial to the firm. The consequence has been a


pronounced trend toward annual retirement and away from the accumulation scheme.




Answers and Solutions: 6 - 115 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


6-1 With your financial calculator, enter the following:


N = 10; I = YTM = 9%; PMT = 0.08 1,000 = 80; FV = 1000; PV = VB = ?


PV = $935.82.


Alternatively,


VB = $80(PVIFA9%,10) + $1,000(PVIF9%,10)


= $80((1- 1/1.0910)/0.09) + $1,000(1/1.0910)


= $80(6.4177) + $1,000(0.4224)


= $513.42 + $422.40 = $935.82.


6-2 With your financial calculator, enter the following:


N = 12; PV = -850; PMT = 0.10 1,000 = 100; FV = 1000; I = YTM = ?


YTM = 12.48%.


6-3 With your financial calculator, enter the following to find YTM:


N = 10 2 = 20; PV = -1100; PMT = 0.08/2 1,000 = 40; FV = 1000; I = YTM = ?


YTM = 3.31% 2 = 6.62%.


With your financial calculator, enter the following to find YTC:


N = 5 2 = 10; PV = -1100; PMT = 0.08/2 1,000 = 40; FV = 1050; I = YTC = ?


YTC = 3.24% 2 = 6.49%.


6-4 With your financial calculator, enter the following to find the current value of the bonds, so you can


then calculate their current yield:


N = 7; I = YTM = 8; PMT = 0.09 1,000 = 90; FV = 1000; PV = VB = ?


PV = $1,052.06. Current yield = $90/$1,052.06 = 8.55%.


Alternatively,


VB = $90(PVIFA8%,7) + $1,000(PVIF8%,7)


= $90((1- 1/1.087)/0.08) + $1,000(1/1.087)


= $90(5.2064) + $1,000(0.5835)


= $468.58 + $583.50 = $1,052.08.


Current yield = $90/$1,052.08 = 8.55%.




Answers and Solutions: 6 - 116 6-5 The problem asks you to find the price of a bond, given the following facts:


N = 16; I = 8.5/2 = 4.25; PMT = 45; FV = 1000.


With a financial calculator, solve for PV = $1,028.60


6-6 a. VB = PMT(PVIFAi,n) + FV(PVIFi,n)


= PMT((1- 1/(1+in))/i) + FV(1/(1+i)n)


1. 5%: Bond L: VB = $100(10.3797) + $1,000(0.4810) = $1,518.97.


Bond S: VB = ($100 + $1,000)(0.9524) = $1,047.64.


2. 8%: Bond L: VB = $100(8.5595) + $1,000(0.3152) = $1,171.15.


Bond S: VB = ($100 + $1,000)(0.9259) = $1,018.49.


3. 12%: Bond L: VB = $100(6.8109) + $1,000(0.1827) = $863.79.


Bond S: VB = ($100 + $1,000)(0.8929) = $982.19.


Calculator solutions:


1. 5%: Bond L: Input N = 15, I = 5, PMT = 100, FV = 1000, PV = ?, PV = $1,518.98.


Bond S: Change N = 1, PV = ? PV = $1,047.62.


2. 8%: Bond L: From Bond S inputs, change N = 15 and I = 8, PV = ?, PV = $1,171.19.


Bond S: Change N = 1, PV = ? PV = $1,018.52.


3. 12%: Bond L: From Bond S inputs, change N = 15 and I = 12, PV = ? PV = $863.78.


Bond S: Change N = 1, PV = ? PV = $982.14.


b. Think about a bond that matures in one month. Its present value is influenced primarily by the


maturity value, which will be received in only one month. Even if interest rates double, the price


of the bond will still be close to $1,000. A one-year bond's value would fluctuate more than the


one-month bond's value because of the difference in the timing of receipts. However, its value


would still be fairly close to $1,000 even if interest rates doubled. A long-term bond paying


semiannual coupons, on the other hand, will be dominated by distant receipts, receipts which are


multiplied by 1/(1 + rd/2)t, and if rd increases, these multipliers will decrease significantly.


Another way to view this problem is from an opportunity point of view. A one-month bond can


be reinvested at the new rate very quickly, and hence the opportunity to invest at this new rate is


not lost; however, the long-term bond locks in subnormal returns for a long period of time.




Answers and Solutions: 6 - 117 N


INT M 6-7 a. VB = (1 + r


t =1 d)


t


+


(1 + r d ) N


= PMT((1- 1/(1+rdn))/rd) + FV(1/(1+rd)n).


M = $1,000. INT = 0.09($1,000) = $90.


1. $829= $90((1- 1/(1+rd4))/rd) + $1,000(1/(1+rd)4).


The YTM can be found by trial-and-error. If the YTM was 9 percent, the bond value


would be its maturity value. Since the bond sells at a discount, the YTM must


be greater than 9 percent. Let's try 10 percent.


At 10%, VB = $285.29 + $683.00


= $968.29.


$968.29 > $829.00; therefore, the bond's YTM is greater than 10 percent.


Try 15 percent.


At 15%, VB = $256.95 + $571.80


= $828.75.


Therefore, the bond's YTM is approximately 15 percent.


2. $1,104 = $90((1- 1/(1+rd4))/rd) + $1,000(1/(1+rd)4).


The bond is selling at a premium; therefore, the YTM must be below 9 percent. Try 6


percent.


At 6%, VB = $311.86 + $792.10


= $1,103.96.


Therefore, when the bond is selling for $1,104, its YTM is approximately 6 percent.


Calculator solution:


1. Input N = 4, PV = -829, PMT = 90, FV = 1000, I = ? I = 14.99%.


2. Change PV = -1104, I = ? I = 6.00%.


b. Yes. At a price of $829, the yield to maturity, 15 percent, is greater than your required rate of


return of 12 percent. If your required rate of return were 12 percent, you should be willing to


buy the bond at any price below $908.88.




Answers and Solutions: 6 - 118 6-8 $1,000 = $140((1- 1/(1+rd6))/rd) + $1,090(1/(1+rd)6).


Try 18 percent:


PV18% = $140(3.4976) + $1,090(0.3704) = $489.66 + $403.74 = $893.40.


18 percent is too high.


Try 15 percent:


PV15% = $140(3.7845) + $1,090(0.4323) = $529.83 + $471.21 = $1,001.04.


15 percent is slightly low.


The rate of return is approximately 15.03 percent, found with a calculator using the following inputs.


N = 6; PV = -1000; PMT = 140; FV = 1090; I = ? Solve for I = 15.03%.


6-9 a. Using a financial calculator, input the following:


N = 20, PV = -1100, PMT = 60, FV = 1000, and solve for I = 5.1849%.


However, this is a periodic rate. The nominal annual rate = 5.1849%(2) = 10.3699% 10.37%.


b. The current yield = $120/$1,100 = 10.91%.


c. YTM = Current Yield + Capital Gains (Loss) Yield


10.37% = 10.91% + Capital Loss Yield


-0.54% = Capital Loss Yield.


d. Using a financial calculator, input the following:


N = 8, PV = -1100, PMT = 60, FV = 1060, and solve for I = 5.0748%.


However, this is a periodic rate. The nominal annual rate = 5.0748%(2) = 10.1495% 10.15%.




Answers and Solutions: 6 - 119 6-10 The problem asks you to solve for the YTM, given the following facts:


N = 5, PMT = 80, and FV = 1000. In order to solve for I we need PV.


However, you are also given that the current yield is equal to 8.21%. Given this information, we can


find PV.


Current yield = Annual interest/Current price


0.0821 = $80/PV


PV = $80/0.0821 = $974.42.


Now, solve for the YTM with a financial calculator:


N = 5, PV = -974.42, PMT = 80, and FV = 1000. Solve for I = YTM = 8.65%.


6-11 The problem asks you to solve for the current yield, given the following facts: N = 14, I = 10.5883/2


= 5.2942, PV = -1020, and FV = 1000. In order to solve for the current yield we need to find PMT.


With a financial calculator, we find PMT = $55.00. However, because the bond is a semiannual


coupon bond this amount needs to be multiplied by 2 to obtain the annual interest payment:


$55.00(2) = $110.00. Finally, find the current yield as follows:


Current yield = Annual interest/Current Price = $110/$1,020 = 10.78%.


6-12 The bond is selling at a large premium, which means that its coupon rate is much higher than the


going rate of interest. Therefore, the bond is likely to be called--it is more likely to be called than to


remain outstanding until it matures. Thus, it will probably provide a return equal to the YTC rather


than the YTM. So, there is no point in calculating the YTM--just calculate the YTC. Enter these


values:


N = 10, PV = -1353.54, PMT = 70, FV = 1050, and then solve for I.


The periodic rate is 3.24 percent, so the nominal YTC is 2 x 3.24% = 6.47%. This would be close to


the going rate, and it is about what the firm would have to pay on new bonds.




Answers and Solutions: 6 - 120 6-13 a. The bonds now have an 8-year, or a 16-semiannual period, maturity, and their value is calculated


as follows:


16


$50 $1,000


VB = (1.03 )


t =1


t


+


(1.03 )16


= $50(12.5611) + $1,000(0.6232)


= $628.06 + $623.20 = $1,251.26.


Calculator solution: Input N = 16, I = 3, PMT = 50, FV = 1000,


PV = ? PV = $1,251.22.


b. VB = $50(10.1059) + $1,000(0.3936) = $505.30 + $393.60 = $898.90.


Calculator solution: Change inputs from Part a to I = 6, PV = ?


PV = $898.94.


c. The price of the bond will decline toward $1,000, hitting $1,000 (plus accrued interest) at the


maturity date 8 years (16 six-month periods) hence.


6-14


Price at 8% Price at 7% Pctge. change


10-year, 10% annual coupon $1,134.20 $1,210.71 6.75%


10-year zero 463.19 508.35 9.75


5-year zero 680.58 712.99 4.76


30-year zero 99.38 131.37 32.19


$100 perpetuity 1,250.00 1,428.57 14.29




Answers and Solutions: 6 - 121 6-15 a.


t Price of Bond C Price of Bond Z


0 $1,012.79 $ 693.04


1 1,010.02 759.57


2 1,006.98 832.49


3 1,003.65 912.41


4 1,000.00 1,000.00



b.



Bond Value Time Path


($)


1,100


Bond C


1,000


900


Bond Z



800



700


Years


0 1 2 3 4




Answers and Solutions: 6 - 122 SOLUTION TO SPREADSHEET PROBLEM


6-16 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 06 P16 Build a Model.xls) and on the instructor's side of the book's web


site, brigham.swcollege.com.




Answers and Solutions: 6 - 123 Answers and Solutions: 7 - 124 MINI CASE



Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund management division. A major new client, the Northwestern Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one of the league's cities, you are to work Boeing into the presentation.


a. What are the key features of a bond?


Answer:


1. Par or face value. We generally assume a $1,000 par value, but par can be anything, and


often $5,000 or more is used. With registered bonds, which is what are issued today, if you


bought $50,000 worth, that amount would appear on the certificate.


2. Coupon rate. The dollar coupon is the "rent" on the money borrowed, which is generally the


par value of the bond. The coupon rate is the annual interest payment divided by the par


value, and it is generally set at the value of r on the day the bond is issued.


3. Maturity. This is the number of years until the bond matures and the issuer must repay the


loan (return the par value).


4. Issue date. This is the date the bonds were issued.


5. Default risk is inherent in all bonds except treasury bonds--will the issuer have the cash to


make the promised payments? Bonds are rated from AAA to D, and the lower the rating the


riskier the bond, the higher its default risk premium, and, consequently, the higher its required


rate of return, r.




Answers and Solutions: 7 - 125 b. What are call provisions and sinking fund provisions? Do these provisions make bonds


more or less risky?


Answer: A call provision is a provision in a bond contract that gives the issuing corporation the right to


redeem the bonds under specified terms prior to the normal maturity date. The call provision


generally states that the company must pay the bondholders an amount greater than the par value


if they are called. The additional sum, which is called a call premium, is typically set equal to


one year's interest if the bonds are called during the first year, and the premium declines at a


constant rate of INT/n each year thereafter.


A sinking fund provision is a provision in a bond contract that requires the issuer to retire a


portion of the bond issue each year. A sinking fund provision facilitates the orderly retirement of


the bond issue.


The call privilege is valuable to the firm but potentially detrimental to the investor, especially


if the bonds were issued in a period when interest rates were cyclically high. Therefore, bonds


with a call provision are riskier than those without a call provision. Accordingly, the interest rate


on a new issue of callable bonds will exceed that on a new issue of noncallable bonds.


Although sinking funds are designed to protect bondholders by ensuring that an issue is


retired in an orderly fashion, it must be recognized that sinking funds will at times work to the


detriment of bondholders. On balance, however, bonds that provide for a sinking fund are


regarded as being safer than those without such a provision, so at the time they are issued sinking


fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.




Answers and Solutions: 7 - 126 c. How is the value of any asset whose value is based on expected future cash flows


determined?


Answer: 0 1 2 3 n


| | | | |


CF1 CF2 CF3 CFn


PV CF1


PV CF2


The value of an asset is merely the present value of its expected future cash flows:


n


VALUE = PV =


CF1


1


+


CF2


(1 + r ) (1 + r ) 2


+


CF3


(1 + r ) 3


+ ... +


CFn


(1 + r ) n


= CFt


t = 1 (1 + r )


t


.



If the cash flows have widely varying risk, or if the yield curve is not horizontal, which signifies


that interest rates are expected to change over the life of the cash flows, it would be logical for


each period's cash flow to have a different discount rate. However, it is very difficult to make


such adjustments; hence it is common practice to use a single discount rate for all cash flows.


The discount rate is the opportunity cost of capital; that is, it is the rate of return that could be


obtained on alternative investments of similar risk. Thus, the discount rate depends primarily on


factors discussed back in chapter 1:


ri = r* + IP + LP + MRP + DRP.




Answers and Solutions: 7 - 127 d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par


value bond with a 10 percent annual coupon if its required rate of return is 10


percent?


Answer: A bond has a specific cash flow pattern consisting of a stream of constant interest payments plus


the return of par at maturity. The annual coupon payment is the cash flow: pmt = (coupon rate)


(par value) = 0.1($1,000) = $100.


For a 10-year, 10 percent annual coupon bond, the bond's value is found as follows:


0 1 2 3 9


10%


10


| | | | | |


100 100 100 100 100


90.91 + 1,000


82.64


.


.


.


38.55


385.54


1,000.00


Expressed as an equation, we have:


$100 $100 $1,000


VB = 1


+ ... + 10


+


(1 + r ) (1 + r ) (1 + r )10


= $90.91 + . . . + $38.55 + $385.54 = $1,000.


or:


VB = $100(PVIFA10%,10) + $1,000(PVIF10%,10)


= $100 ((1-1/(1+.1)10)/0.10)+ $1,000 (1/(1+0.10)10).


The bond consists of a 10-year, 10% annuity of $100 per year plus a $1,000 lump sum payment at


t = 10:


PV Annuity = $ 614.46


PV Maturity Value = 385.54


Value Of Bond = $1,000.00


The mathematics of bond valuation is programmed into financial calculators which do the


operation in one step, so the easy way to solve bond valuation problems is with a financial


calculator. Input n = 10, rd = i = 10, PMT = 100, and FV = 1000, and then press PV to find the


bond's value, $1,000. Then change n from 10 to 1 and press PV to get the value of the 1-year


bond, which is also $1,000.




Answers and Solutions: 7 - 128 e. 1. What would be the value of the bond described in part d if, just after it had been issued, the


expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent


return? Would we now have a discount or a premium bond?


Answer: with a financial calculator, just change the value of r = i from 10% to 13%, and press the PV


button to determine the value of the bond:


10-year = $837.21.


Using the formulas, we would have, at r = 13 percent,


VB(10-YR) = $100(PVIFA13%,10) + $1,000(PVIF13%,10)


= $100 ((1- 1/(1+0.13)10)/0.13) + $1,000 (1/(1+0.13)10)


= $542.62 + $294.59 = $837.21.


In a situation like this, where the required rate of return, r, rises above the coupon rate, the bonds'


values fall below par, so they sell at a discount.


e. 2. What would happen to the bonds' value if inflation fell, and rd declined to 7 percent?


Would we now have a premium or a discount bond?


Answer: In the second situation, where r falls to 7 percent, the price of the bond rises above par. Just


change r from 13% to 7%. We see that the 10-year bond's value rises to $1,210.71.


With tables, we have:


VB(10-YR) = $100(PVIFA7%,10) + $1,000(PVIF7%,10)


= $100 ((1- 1/(1+0.07)10)/0.07) + $1,000 (1/(1+0.07)10)


= $702.36 + $508.35 = $1,210.71.


Thus, when the required rate of return falls below the coupon rate, the bonds' value rises above


par, or to a premium. Further, the longer the maturity, the greater the price effect of any given


interest rate change.




Answers and Solutions: 7 - 129 e. 3. What would happen to the value of the 10-year bond over time if the required rate of


return remained at 13 percent, or if it remained at


7 percent? (Hint: with a financial calculator, enter PMT, I, FV, and N, and then


change (override) n to see what happens to the PV as the bond approaches maturity.)


Answer: Assuming that interest rates remain at the new levels (either 7% or 13%), we could find the bond's


value as time passes, and as the maturity date approaches. If we then plotted the data, we would


find the situation shown below:


Bond Value ($)


rd = 7%.



rd = 10%. M



837


rd = 13%.


775


30 25 20 15 10 5 0


Years remaining to Maturity


At maturity, the value of any bond must equal its par value (plus accrued interest).


Therefore, if interest rates, hence the required rate of return, remain constant over time, then a


bond's value must move toward its par value as the maturity date approaches, so the value of a


premium bond decreases to $1,000, and the value of a discount bond increases to $1,000 (barring


default).




Answers and Solutions: 7 - 130 f. 1. What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond


that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a


discount or at a premium tell you about the relationship between rd and the bond's coupon


rate?


Answer: The yield to maturity (YTM) is that discount rate which equates the present value of a bond's cash


flows to its price. In other words, it is the promised rate of return on the bond. (Note that the


expected rate of return is less than the YTM if some probability of default exists.) On a time line,


we have the following situation when the bond sells for $887:


0 1 9


10


| | | |


90 90 90


PV1 1,000


.


. r=?


PV1


PVM


SUM = PV = 887


We want to find r in this equation:


INT INT M


V B = PV = 1


+ ... + N


+ .


(1 + r ) (1 + r ) (1 + r ) N


We know n = 10, PV = -887, pmt = 90, and FV = 1000, so we have an equation with one unknown,


r. We can solve for r by entering the known data into a financial calculator and then pressing the


I = r button. The YTM is found to be 10.91%.


Alternatively, we could use present value interest factors:


$887 = $90(PVIFAr,10) + $1,000(PVIFr,10)


= $90 ((1- 1/(1+r)10)/r) + $1,000 (1/(1+r)10)


.


We would substitute for various interest rates, in a trial-and-error manner, until we found the rate


that produces the equality. This is tiresome, and the procedure will not give an exact answer


unless the YTM is a whole number. Consequently, in the real world everyone uses financial


calculators.


We can tell from the bond's price, even before we begin the calculations, that the YTM must be


above the 9% coupon rate. We know this because the bond is selling at a discount, and discount


bonds always have r > coupon rate.


If the bond were priced at $1,134.20, then it would be selling at a premium. In that case, it


must have a YTM that is below the 9 percent coupon rate, because all premium bonds must have


coupons which exceed the going interest rate. Going through the same procedures as


before--plugging the appropriate values into a financial calculator and then pressing the r = I


button, we find that at a price of $1,134.20, r = YTM = 7.08%.


f. 2. What are the total return, the current yield, and the capital gains yield for the discount


bond? (Assume the bond is held to maturity and the company does not default on


Answers and Solutions: 7 - 131 the bond.)


Answer: The current yield is defined as follows:


Annual coupon interest payment


Current Yield = .


Current price of the bond


The capital gains yield is defined as follows:


Expected Change in bond' s price


Capital gains yield = .


Beginning - of - year price


The total expected return is the sum of the current yield and the expected capital gains yield:


Expected Expected


Expected capital


= + .


Total Return current yield gains yield


The term yield to maturity, or YTM, is often used in discussing bonds. It is simply the expected



total return (assuming no default risk), so r = expected total return = expected YTM.


Recall also that securities have required returns, r, which depend on a number of factors:


Required return = r = r* + IP + LP + MRP + DRP.


We know that (1) security markets are normally in equilibrium, and (2) that for equilibrium to



exist, the expected return, r = YTM, as seen by the marginal investor, must be equal to the


required return, r. If that equality does not hold, then buying and selling will occur until it does


hold, and equilibrium is established. Therefore, for the marginal investor:



r = YTM = r.


For our 9% coupon, 10-year bond selling at a price of $887 with a YTM of 10.91%, the current


yield is:


$90


Current yield = = 0.1015 = 10.15%.


$887


Knowing the current yield and the total return, we can find the capital gains yield:


YTM = current yield + capital gains yield


And


Capital gains yield = YTM - current yield = 10.91% - 10.15% = 0.76%.


The capital gains yield calculation can be checked by asking this question: "What is the


expected value of the bond 1 year from now, assuming that interest rates remain at current


levels?" This is the same as asking, "What is the value of a 9-year, 9 percent annual coupon



Answers and Solutions: 7 - 132 bond if its YTM (its required rate of return) is 10.91 percent?" The answer, using the bond


valuation function of a calculator, is $893.87. With this data, we can now calculate the bond's


capital gains yield as follows:


Capital Gains Yield = ( V B - V B )/ V B


1 0 0


= ($893.87 - $887)/$887 = 0.0077 = 0.77%,


This agrees with our earlier calculation (except for rounding). When the bond is selling for


$1,134.20 and providing a total return of r = YTM = 7.08%, we have this situation:


Current Yield = $90/$1,134.20 = 7.94%


and


Capital Gains Yield = 7.08% - 7.94% = -0.86%.


The bond provides a current yield that exceeds the total return, but a purchaser would incur a


small capital loss each year, and this loss would exactly offset the excess current yield and force


the total return to equal the required rate.



g. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual


payment 1-year bond or a 10-year bond? Why?


Answer: Interest rate risk, which is often just called price risk, is the risk that a bond will lose value as the


result of an increase in interest rates. Earlier, we developed the following values for a 10 percent,


annual coupon bond:


Maturity


r 1-Year Change


10-Year Change 38.6%


5% $1,048 $1,386


4.8% 1,000 25.1%


10 1,000


15 956 4.4% 749


A 5 percentage point increase in r causes the value of the 1-year bond to decline by only 4.8


percent, but the 10-year bond declines in value by more than 38 percent. Thus, the 10-year bond


has more interest rate price risk.




Answers and Solutions: 7 - 133 Bond Value Interest Rate Price Risk for 10 Percent Coupon


($) Bonds with Different Maturities


1,800




1,400




1,000


1-Year


5-Year


10-Year


20-Year


30-Year


600




5 6 7 8 9 10 11 12 13 14 15


Interest Rate (%)


The graph above shows the relationship between bond values and interest rates for a 10


percent, annual coupon bond with different maturities. The longer the maturity, the greater the


change in value for a given change in interest rates, rd.


h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year


bond or a 10-year bond?


Answer: Investment rate risk is defined as the risk that cash flows (interest plus principal repayments) will


have to be reinvested in the future at rates lower than today's rate. To illustrate, suppose you just


won the lottery and now have $500,000. You plan to invest the money and then live on the


income from your investments. Suppose you buy a 1-year bond with a YTM of 10 percent.


Your income will be $50,000 during the first year. Then, after 1 year, you will receive your


$500,000 when the bond matures, and you will then have to reinvest this amount. If rates have


fallen to 3 percent, then your income will fall from $50,000 to $15,000. On the other hand, had


you bought 30-year bonds that yielded 10%, your income would have remained constant at


$50,000 per year. Clearly, buying bonds that have short maturities carries reinvestment rate risk.


Note that long maturity bonds also have reinvestment rate risk, but the risk applies only to the


coupon payments, and not to the principal amount. Since the coupon payments are significantly


less than the principal amount, the reinvestment rate risk on a long-term bond is significantly less


than on a short-term bond.




Answers and Solutions: 7 - 134 i. How does the equation for valuing a bond change if semiannual payments are made? Find


the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%.


Answer: In reality, virtually all bonds issued in the U.S. have semiannual coupons and are valued using the


setup shown below:


1 2 N YEARS


0 1 2 3 4 2N-1 2N SA PERIODS


| | | | | | |


INT/2 INT/2 INT/2 INT/2 INT/2 INT/2


M


PV1


.


.


.


PVN


PVM


VBOND = sum of PVs


We would use this equation to find the bond's value:


2N


INT/ 2 M


VB = (1 + r


t =1 d / 2) t


+


(1 + r d / 2 )2 N


.



The payment stream consists of an annuity of 2n payments plus a lump sum equal to the maturity


value.


To find the value of the 10-year, semiannual payment bond, semiannual interest = annual


coupon/2 = $100/2 = $50 and n = 2 (years to maturity) = 2(10) = 20. To find the value of the


bond with a financial calculator, enter n = 20, rd/2 = I = 5, pmt = 50, FV = 1000, and then press


PV to determine the value of the bond. Its value is $1,000.


You could then change r = I to see what happens to the bond's value as r changes, and plot the


values--the graph would look like the one we developed earlier.


For example, if r rose to 13%, we would input I= 6.5 rather than 5%, and find the 10-year


bond's value to be $834.72. If r fell to 7%, then input I = 3.5 and press PV to find the bond's new


value, $1,213.19.


We would find the values with a financial calculator, but they could also be found with


formulas. Thus:


V10-YEAR= $50(PVIFA5%,20) + $1,000(PVIF5%,20)


= $50 ((1- 1/(1+0.05)20)/0.065) + $1,000 (1/(1+0.05)20)


= $50(12.4622) + $1,000(0.37689) = $623.11 + $376.89 = $1,000.00.



At a 13 percent required return:


V10-YEAR = $50(PVIFA6.5%,20) + $1,000(PVIF6.5%,20)


= $50 ((1- 1/(1+0.065)20)/0.065) + $1,000 (1/(1+0.065)20)


= $834.72.



Answers and Solutions: 7 - 135 At a 7 percent required return:


V10-YEAR = $50(PVIFA3.5%,20) + $1,000(PVIF3.5%,20)


= $50 ((1- 1/(1+0.035)20)/0.035) + $1,000 (1/(1+0.035)20)


= $1,213.19.


j. Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment


bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky.


Which would you prefer? If $1,000 is the proper price for the semiannual bond,


what is the equilibrium price for the annual payment bond?


Answer: The semiannual payment bond would be better. Its EAR would be:


m 2


r 0.10


EAR = 1 + Nom -1= 1+ - 1 = 10.25%.


m 2


An EAR of 10.25% is clearly better than one of 10.0%, which is what the annual payment bond


offers. You, and everyone else, would prefer it.


If the going rate of interest on semiannual bonds is rNom = 10%, with an EAR of 10.25%, then


it would not be appropriate to find the value of the annual payment bond using a 10% EAR. If


the annual payment bond were traded in the market, its value would be found using 10.25%,


because investors would insist on getting the same EAR on the two bonds, because their risk is


the same. Therefore, you could find the value of the annual payment bond, using 10.25%, with


your calculator. It would be $984.80 versus $1,000 for the semiannual payment bond.


Note that, if the annual payment bond were selling for $984.80 in the market, its EAR would


be 10.25%. This value can be found by entering n = 10, PV = -984.80, pmt = 100, and FV =


1000 into a financial calculator and then pressing the r = I button to find the answer, 10.25%.


With this rate, and the $984.80 price, the annual and semiannual payment bonds would be in


equilibrium--investors would get the same rate of return on either bond, so there would not be a


tendency to sell one and buy the other (as there would be if they were both priced at $1,000.)




Answers and Solutions: 7 - 136 k. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is


currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent.


However, the bond can be called after 5 years for a price of $1,050.


k. 1. What is the bond's nominal yield to call (YTC)?


Answer: If the bond were called, bondholders would receive $1,050 at the end of year 5. Thus, the time


line would look like this:


0 1 2 3 4 5


| | | | | |


50 50 50 50 50 50 50 50 50 50


1,050


PV1


.


.


PV4


PV5C


PV5CP


1,135.90 = sum of PVs


The easiest way to find the YTC on this bond is to input values into your calculator: n = 10; PV


= -1135.90; pmt = 50; and FV = 1050, which is the par value plus a call premium of $50; and then


press the r = I button to find I = 3.765%. However, this is the 6-month rate, so we would find the


nominal rate on the bond as follows:


rNom = 2(3.765%) = 7.5301% 7.5%.


This 7.5% is the rate brokers would quote if you asked about buying the bond.


You could also calculate the EAR on the bond:


EAR = (1.03765)2 - 1 = 7.672%.


Usually, people in the bond business just talk about nominal rates, which is OK so long as all the


bonds being compared are on a semiannual payment basis. When you start making comparisons


among investments with different payment patterns, though, it is important to convert to EARs.




Answers and Solutions: 7 - 137 k. 2. If you bought this bond, do you think you would be more likely to earn the YTM or


the YTC? Why?


Answer: Since the coupon rate is 10% versus YTC = rd = 7.53%, it would pay the company to call the bond,


get rid of the obligation to pay $100 per year in interest, and sell replacement bonds whose


interest would be only $75.30 per year. Therefore, if interest rates remain at the current level


until the call date, the bond will surely be called, so investors should expect to earn 7.53%. In


general, investors should expect to earn the YTC on premium bonds, but to earn the YTM on par


and discount bonds. (Bond brokers publish lists of the bonds they have for sale; they quote


YTM or YTC depending on whether the bond sells at a premium or a discount.)


l. Boeing's bonds were issued with a yield to maturity of 7.5 percent. Does the yield


to maturity represent the promised or expected return on the bond?


Answer: The yield to maturity is the rate of return earned on a bond if it is held to maturity. It can be


viewed as the bond's promised rate of return, which is the return that investors will receive if all


the promised payments are made. The yield to maturity equals the expected rate of return only if


(1) the probability of default is zero and (2) the bond cannot be called. For bonds where there is


some default risk, or where the bond may be called, there is some probability that the promised


payments to maturity will not be received, in which case, the promised yield to maturity will


differ from the expected return.


m. Boeing's bonds were rated AA- by S&P. Would you consider these bonds


investment grade or junk bonds?


Answer: The Boeing bonds would be investment grade bonds. Triple-A double-A, single-A, and triple-B


bonds are considered investment grade. Double-B and lower-rated bonds are considered


speculative, or junk bonds, because they have a significant probability of going into default. Many


financial institutions are prohibited from buying junk bonds.




Answers and Solutions: 7 - 138 n. What factors determine a company's bond rating?


Answer: Bond ratings are based on both qualitative and quantitative factors, some of which are listed


below.


1. Financial performance--determined by ratios such as the debt, TIE, FCC, and current ratios.


2. Provisions in the bond contract:


A. Secured vs. Unsecured debt


B. Senior vs. Subordinated debt


C. Guarantee provisions


D. Sinking fund provisions


E. Debt maturity


3. Other factors:


A. Earnings stability


B. Regulatory environment


C. Potential product liability


D. Accounting policy




Answers and Solutions: 7 - 139 o. If this firm were to default on the bonds, would the company be immediately liquidated?


Would the bondholders be assured of receiving all of their promised payments?


Answer: When a business becomes insolvent, it does not have enough cash to meet scheduled interest and


principal payments. A decision must then be made whether to dissolve the firm through


liquidation or to permit it to reorganize and thus stay alive.


The decision to force a firm to liquidate or to permit it to reorganize depends on whether the


value of the reorganized firm is likely to be greater than the value of the firm's assets if they were


sold off piecemeal. In a reorganization, a committee of unsecured creditors is appointed by the


court to negotiate with management on the terms of a potential reorganization. The


reorganization plan may call for a restructuring of the firm's debt, in which case the interest rate


may be reduced, the term to maturity lengthened, or some of the debt may be exchanged for


equity. The point of the restructuring is to reduce the financial charges to a level that the firm's


cash flows can support.


If the firm is deemed to be too far gone to be saved, it will be liquidated and the priority of


claims would be as follows:


1. Secured creditors.


2. Trustee's costs.


3. Expenses incurred after bankruptcy was filed.


4. Wages due workers, up to a limit of $2,000 per worker.


5. Claims for unpaid contributions to employee benefit plans.


6. Unsecured claims for customer deposits up to $900 per customer.


7. Federal, state, and local taxes.


8. Unfunded pension plan liabilities.


9. General unsecured creditors.


10. Preferred stockholders, up to the par value of their stock.


11. Common stockholders, if anything is left.


If the firm's assets are worth more "alive" than "dead," the company would be reorganized.


Its bondholders, however, would expect to take a "hit." Thus, they would not expect to receive


all their promised payments. If the firm is deemed to be too far gone to be saved, it would be


liquidated.




Answers and Solutions: 7 - 140 Chapter 7


Stocks and Their Valuation


ANSWERS TO END-OF-CHAPTER QUESTIONS



7-1 a. A proxy is a document giving one person the authority to act for another, typically the power to


vote shares of common stock. If earnings are poor and stockholders are dissatisfied, an outside


group may solicit the proxies in an effort to overthrow management and take control of the


business, known as a proxy fight. A takeover is an action whereby a person or group succeeds in


ousting a firm's management and taking control of the company. The preemptive right gives the


current shareholders the right to purchase any new shares issued in proportion to their current


holdings. The preemptive right may or may not be required by state law. When granted, the


preemptive right enables current owners to maintain their proportionate share of ownership and


control of the business. It also prevents the sale of shares at low prices to new stockholders


which would dilute the value of the previously issued shares. Classified stock is sometimes


created by a firm to meet special needs and circumstances. Generally, when special


classifications of stock are used, one type is designated "Class A", another as "Class B", and so on.


Class A might be entitled to receive dividends before dividends can be paid on Class B stock.


Class B might have the exclusive right to vote. Founders' shares are stock owned by the firm's


founders that have sole voting rights but restricted dividends for a specified number of years.


b. Some companies are so small that their common stocks are not actively traded; they are owned by


only a few people, usually the companies' managers. Such firms are said to be closely held


corporations. In contrast, the stocks of most larger companies are owned by a large number of


investors, most of whom are not active in management. Such companies are said to be publicly


owned corporations.


c. The secondary market deals with trading in previously issued, or outstanding, shares of


established, publicly owned companies. The company receives no new money when sales are


made in the secondary market. The primary market handles additional shares sold by established,


publicly owned companies. Companies can raise additional capital by selling in this market.


Going public is the act of selling stock to the public at large by a closely held corporation or its


principal stockholders, and this market is often termed the initial public offering (IPO) market.


^


d. Intrinsic value ( P0 ) is the present value of the expected future cash flows. The market price (P0)


is the price at which an asset can be sold.



e. The required rate of return on common stock, denoted by rs, is the minimum acceptable rate of


return considering both its riskiness and the returns available on other investments. The



expected rate of return, denoted by rs , is the rate of return expected on a stock given its current


price and expected future cash flows. If the stock is in equilibrium, the required rate of return


will equal the expected rate of return. The realized (actual) rate of return, denoted by r s , is the


rate of return that was actually realized at the end of some holding period. Although expected


Answers and Solutions: 7 - 141 and required rates of return must always be positive, realized rates of return over some periods


may be negative.


f. The capital gains yield results from changing prices and is calculated as (P1 - P0)/P0, where P0 is


the beginning-of-period price and P1 is the end-of-period price. For a constant growth stock, the


capital gains yield is g, the constant growth rate. The dividend yield on a stock can be defined as


either the end-of-period dividend divided by the beginning-of-period price, or the ratio of the


current dividend to the current price. Valuation formulas use the former definition. The


expected total return, or expected rate of return, is the expected capital gains yield plus the


expected dividend yield on a stock. The expected total return on a bond is the yield to maturity.


g. Normal, or constant, growth occurs when a firm's earnings and dividends grow at some constant


rate forever. One category of nonconstant growth stock is a "supernormal" growth stock which


has one or more years of growth above that of the economy as a whole, but at some point the


growth rate will fall to the "normal" rate. This occurs, generally, as part of a firm's normal life


cycle. A zero growth stock has constant earnings and dividends; thus, the expected dividend


payment is fixed, just as a bond's coupon payment. Since the company is presumed to continue


operations indefinitely, the dividend stream is a perpetuity. A perpetuity is a security on which


the principal never has to be repaid.


h. Equilibrium is the condition under which the expected return on a security is just equal to its



required return, r = r, and the price is stable. The Efficient Markets Hypothesis (EMH) states (1)


that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently


"beat the market." In essence, the theory holds that the price of a stock will adjust almost


immediately in response to any new developments. In other words, the EMH assumes that all


important information regarding a stock is reflected in the price of that stock. Financial theorists


generally define three forms of market efficiency: weak-form, semistrong-form, and strong-form.


Weak-form efficiency assumes that all information contained in past price movements is fully


reflected in current market prices. Thus, information about recent trends in a stock's price is of


no use in selecting a stock. Semistrong-form efficiency states that current market prices reflect


all publicly available information. Therefore, the only way to gain abnormal returns on a stock


is to possess inside information about the company's stock. Strong-form efficiency assumes that


all information pertaining to a stock, whether public or inside information, is reflected in current


market prices. Thus, no investors would be able to earn abnormal returns in the stock market.


i. Preferred stock is a hybrid--it is similar to bonds in some respects and to common stock in other


respects. Preferred dividends are similar to interest payments on bonds in that they are fixed in


amount and generally must be paid before common stock dividends can be paid. If the preferred


dividend is not earned, the directors can omit it without throwing the company into bankruptcy.


So, although preferred stock has a fixed payment like bonds, a failure to make this payment will


not lead to bankruptcy. Most preferred stocks entitle their owners to regular fixed dividend


payments.


7-2 True. The value of a share of stock is the PV of its expected future dividends. If the two investors


expect the same future dividend stream, and they agree on the stock's riskiness, then they should reach


similar conclusions as to the stock's value.


7-3 A perpetual bond is similar to a no-growth stock and to a share of preferred stock in the following


ways:



Answers and Solutions: 7 - 142 1. All three derive their values from a series of cash inflows--coupon payments from the perpetual


bond, and dividends from both types of stock.


2. All three are assumed to have indefinite lives with no maturity value (M) for the perpetual bond


and no capital gains yield for the stocks.




SOLUTIONS TO END-OF-CHAPTER PROBLEMS


7-1 D0 = $1.50; g1-3 = 5%; gn = 10%; D1 through D5 = ?


D1 = D0(1 + g1) = $1.50(1.05) = $1.5750.


D2 = D0(1 + g1)(1 + g2) = $1.50(1.05)2 = $1.6538.


D3 = D0(1 + g1)(1 + g2)(1 + g3) = $1.50(1.05)3 = $1.7364.


D4 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn) = $1.50(1.05)3(1.10) = $1.9101.


D5 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn)2 = $1.50(1.05)3(1.10)2 = $2.1011.


7-2 D1 = $0.50; g = 7%; rs = 15%; P0 = ?


^



^ D1 $0.50


P0 = = = $6.25.


rs - g 0.15 - 0.07



7-3 P0 = $20; D0 = $1.00; g = 10%; P1 = ?;


^ r s= ?


^


P1 = P0(1 + g) = $20(1.10) = $22.


D1 $1.00(1.10)


rs = +g= + 0.10


P0 $20



$1.10


= + 0.10 = 15.50%. r s = 15.50%.


$20


7-4 Dps = $5.00; Vps = $60; rps = ?


D ps $5.00


rps = = = 8.33%.


v ps $60.00




Answers and Solutions: 7 - 143 7-5 0 1 2 3


| | | |


D0 = 2.00 D1 D2 D3


^


P2


Step 1: Calculate the required rate of return on the stock:


rs = rRF + (rM - rRF)b = 7.5% + (4%)1.2 = 12.3%.


Step 2: Calculate the expected dividends:


D0 = $2.00


D1 = $2.00(1.20) = $2.40


D2 = $2.00(1.20)2 = $2.88


D3 = $2.88(1.07) = $3.08


Step 3: Calculate the PV of the expected dividends:


PVDiv = $2.40/(1.123) + $2.88/(1.123)2 = $2.14 + $2.28 = $4.42.


^


Step 4: Calculate P2 :


^


P2 = D3/(rs - g) = $3.08/(0.123 - 0.07) = $58.11.


^


Step 5: Calculate the PV of P2 :


PV = $58.11/(1.123)2 = $46.08.


Step 6: Sum the PVs to obtain the stock's price:


^


P0 = $4.42 + $46.08 = $50.50.


Alternatively, using a financial calculator, input the following:


CF0 = 0, CF1 = 2.40, and CF2 = 60.99 (2.88 + 58.11) and then enter I = 12.3 to solve for NPV =


$50.50.



7-6 The problem asks you to determine the constant growth rate, given the following facts: P0 = $80, D1


= $4, and rs = 14%. Use the constant growth rate formula to calculate g:



Answers and Solutions: 7 - 144 D1


rs= +g


P0


$4


0.14 = +g


$80


g = 0.09 = 9%.


7-7 ^


The problem asks you to determine the value of P3 , given the following facts: D1 = $2, b = 0.9, rRF


= 5.6%, RPM = 6%, and P0 = $25. Proceed as follows:


Step 1: Calculate the required rate of return:


rs = rRF + (rM - rRF)b = 5.6% + (6%)0.9 = 11%.


Step 2: Use the constant growth rate formula to calculate g:


D1


rs = +g


P0


$2


0.11 = +g


$25


g = 0.03 = 3%.


^


Step 3: Calculate P3 :


^


P3 = P0(1 + g)3 = $25(1.03)3 = $27.3182 $27.32.


^


Alternatively, you could calculate D4 and then use the constant growth rate formula to solve for P3 :


D4 = D1(1 + g)3 = $2.00(1.03)3 = $2.1855.


^


P3 = $2.1855/(0.11 - 0.03) = $27.3188 $27.32.



7-8 Vps = Dps/rps; therefore, rps = Dps/Vps.


a. rps = $8/$60 = 13.3%.


b. rps = $8/$80 = 10%.


c. rps = $8/$100 = 8%.


Answers and Solutions: 7 - 145 d. rps = $8/$140 = 5.7%.



^ D1 D 0 (1 + g ) $5[1 + ( -0.05)] $5(0.95) $4.75 7-9 P0 = = = = = = $23.75.


rs - g rs - g 0.15 - ( -0.05)] 0.15 + 0.05 0.20


7-10 a. ri = rRF + (rM - rRF)bi.


rC = 9% + (13% - 9%)0.4 = 10.6%. rD = 9% + (13% - 9%)-0.5 = 7%.


Note that rD is below the risk-free rate. But since this stock is like an insurance policy because it


"pays off" when something bad happens (the market falls), the low return is not unreasonable.


b. In this situation, the expected rate of return is as follows:



r c= D1/P0 + g = $1.50/$25 + 4% = 10%.


However, the required rate of return is 10.6 percent. Investors will seek to sell the stock,


dropping its price to the following:


^ $1.50


PC = = $22.73.


0.106 - 0.04


$1.50


At this point, r c= + 4% = 10.6%, and the stock will be in equilibrium.


$22.73


7-11 D0 = $1, rS = 7% + 6% = 13%, g1 = 50%, g2 = 25%, gn = 6%.


0 rs = 13% 1 2 3 4


| | | | |


g1 = 50% g2 = 25% g1 = 6%


1.50 1.875 1.9875


1.327 + 28.393 = 1.9875/(0.13 - 0.06)


= 30.268


23.704


$25.03




Answers and Solutions: 7 - 146 7-12 Calculate the dividend stream and place them on a time line. Also, calculate the price of the stock at


the end of the supernormal growth period, and include it, along with the dividend to be paid at t = 5, as


CF5. Then, enter the cash flows as shown on the time line into the cash flow register, enter the


required rate of return as I = 15, and then find the value of the stock using the NPV calculation. Be


sure to enter CF0 = 0, or else your answer will be incorrect.


D0 = 0; D1 = 0, D2 = 0, D3 = 1.00


D4 = 1.00(1.5) = 1.5; D5 = 1.00(1.5)2 = 2.25; D6 = 1.00(1.5)2(1.08)


= $2.43.


^


P0 = ?


0 rs = 15% 1 2


g = 50% 3 g = 8% 4 5 6


| | | | | | |


1.00 1.50 2.25 2.43


0.66 34.71


0.86 36.96 0.15 - 0.08


18.38


^


$19.89 = P0


^


P5 = D6/(rs - g) = 2.43/(0.15 - 0.08) = 34.71. This is the price of the stock at the end of Year 5.


CF0 = 0; CF1-2 = 0; CF3 = 1.0; CF4 = 1.5; CF5 = 36.96; I = 15%.


With these cash flows in the CFLO register, press NPV to get the value of the stock today: NPV =


$19.89.



D ps $10 7-13 a. Vps = = = $125.


rps 0.08


$10


b. Vps = = $83.33.


0.12




Answers and Solutions: 7 - 147 7-14 0 1 2 3 4 g = 5%


| | | | |


D0 = 2.00 D1 D2 D3 D4


^


P3


a. D1 = $2(1.05) = $2.10. D2 = $2(1.05)2 = $2.21. D3 = $2(1.05)3 = $2.32.


b. PV = $2.10(0.8929) + $2.21(0.7972) + $2.32(0.7118) = $5.29.


Calculator solution: Input 0, 2.10, 2.21, and 2.32 into the cash flow register, input I = 12, PV = ?


PV = $5.29.


c. $34.73(0.7118) = $24.72.


Calculator solution: Input 0, 0, 0, and 34.73 into the cash flow register, I = 12, PV = ? PV =


$24.72.


d. $24.72 + $5.29 = $30.01 = Maximum price you should pay for the stock.


D (1 + g ) D1 $2.10


e. P0 = 0


^ = = = $30.00.


rs - g rs - g 0.12 - 0.05


f. The value of the stock is not dependent upon the holding period. The value calculated in Parts a


through d is the value for a 3-year holding period. It is equal to the value calculated in Part e


except for a small rounding error. Any other holding period would produce the same value of


^ ^


P0 ; that is, P0 = $30.00.


7-15 a. g = $1.1449/$1.07 - 1.0 = 7%.


Calculator solution: Input N = 1, PV = -1.07, PMT = 0, FV = 1.1449,


I = ? I = 7.00%.


b. $1.07/$21.40 = 5%.



c. r s= D1/P0 + g = $1.07/$21.40 + 7% = 5% + 7% = 12%.




Answers and Solutions: 7 - 148 ^ $2(1 - 0.05) $1.90 7-16 a. 1. P0 = = $9.50.


0.15 + 0.05 0.20


2. ^


P0 = $2/0.15 = $13.33.


^ $2(1.05) $2.10


3. P0 = = = $21.00.


0.15 - 0.05 0.10


^ $2(1.10) $2.20


4. P0 = = = $44.00.


0.15 - 0.10 0.05


b. 1. ^


P0 = $2.30/0 = Undefined.


2. ^


P0 = $2.40/(-0.05) = -$48, which is nonsense.


These results show that the formula does not make sense if the required rate of return is equal to


or less than the expected growth rate.


c. No.




Answers and Solutions: 7 - 149 7-17 a. End of Year: 0 1 2 3


r = 12% 4 5 6


| | | | | | |


g = 15% g = 5%


D0 = 1.75 D1 D2 D3 D4 D5 D6


Dt = D0(1 + g)t


D1 = $1.75(1.15)1 = $2.01.


D2 = $1.75(1.15)2 = $1.75(1.3225) = $2.31.


D3 = $1.75(1.15)3 = $1.75(1.5209) = $2.66.


D4 = $1.75(1.15)4 = $1.75(1.7490) = $3.06.


D5 = $1.75(1.15)5 = $1.75(2.0114) = $3.52.


b. Step 1


5


D


PV of dividends = (1 + rt ) t .


t =1 s


PV D1 = $2.01(PVIF12%,1) = $2.01(0.8929) = $1.79


PV D2 = $2.31(PVIF12%,2) = $2.31(0.7972) = $1.84


PV D3 = $2.66(PVIF12%,3) = $2.66(0.7118) = $1.89


PV D4 = $3.06(PVIF12%,4) = $3.06(0.6355) = $1.94


PV D5 = $3.52(PVIF12%,5) = $3.52(0.5674) = $2.00


PV of dividends = $9.46


Step 2


D6 D5 (1 + g n ) $3.52(1.05) $3.70


^


P5 = = = = = $52.80.


rs - g n rs - g n 0.12 - 0.05 0.07


This is the price of the stock 5 years from now. The PV of this price, discounted back 5 years, is


as follows:


^


PV of P5 = $52.80(PVIF12%,5) = $52.80(0.5674) = $29.96.


Step 3


The price of the stock today is as follows:


^


P0 ^


= PV dividends Years 1 through 5 + PV of P5


= $9.46 + $29.96 = $39.42.


This problem could also be solved by substituting the proper values into the following equation:


5


5


D 0 (1 + g s ) t D6 1


^


P0 = (1 + rs ) t


+r -g 1+ r .



t =1 s n s



Answers and Solutions: 7 - 150 Calculator solution: Input 0, 2.01, 2.31, 2.66, 3.06, 56.32 (3.52 + 52.80) into the cash flow


register, input I = 12, PV = ? PV = $39.43.


c. First Year


D1/P0 = $2.01/$39.42 = 5.10%


Capital gains yield = 6.90%


Expected total return = 12.00%


Sixth Year


D6/P5 = $3.70/$52.80 = 7.00%


Capital gains yield = 5.00


Expected total return = 12.00%


*We know that r is 12 percent, and the dividend yield is 5.10 percent; therefore, the capital gains


yield must be 6.90 percent.


The main points to note here are as follows:


1. The total yield is always 12 percent (except for rounding errors).


2. The capital gains yield starts relatively high, then declines as the supernormal growth period


approaches its end. The dividend yield rises.


3. After t=5, the stock will grow at a 5 percent rate. The dividend yield will equal 7 percent,


the capital gains yield will equal 5 percent, and the total return will be 12 percent.




Answers and Solutions: 7 - 151 7-18 a. Part 1. Graphical representation of the problem:


Supernormal Normal


growth growth


0 1 2 3


| | | | |


D0 D1 ^


(D2 + P2 ) D3 D


PVD1


PVD2


PV P2


^


P0


D1 = D0(1 + gs) = $1.6(1.20) = $1.92.


D2 = D0(1 + gs)2 = $1.60(1.20)2 = $2.304.


^ D3 D 2 (1 + g n ) $2.304 (1.06)


P2 = = = = $61.06.


rs - g n rs - g n 0.10 - 0.06


P0 = PV(D1) + PV(D2) + PV( P2 )


^ ^


D1 D2 ^


P2


= + +


(1 + rs ) (1 + rs ) 2 (1 + rs ) 2


= $1.92(0.9091) + $2.304(0.8264) + $61.06(0.8264) = $54.11.


Calculator solution: Input 0, 1.92, 63.364(2.304 + 61.06) into the cash flow register, input I = 10,


PV = ? PV = $54.11.


Part 2.


Expected dividend yield: D1/P0 = $1.92/$54.11 = 3.55%.


^ ^


Capital gains yield: First, find P1 which equals the sum of the present values of D2 and P2 ,


discounted for one year.


^ ^ $2.304 + $61.06


P1 = D2(PVIF10%, 1) + P2 (PVIF10%, 1) = = $57.60.


(1.10)1


Calculator solution: Input 0, 63.364(2.304 + 61.06) into the cash flow register, input I = 10, PV


= ? PV = $57.60.


Second, find the capital gains yield:


^


P1 - P0 $57.60 - $54.11


= = 6.45%.


P0 $54.11


Answers and Solutions: 7 - 152 Dividend yield = 3.55%


Capital gains yield = 6.45


10.00% = rs.


b. Due to the longer period of supernormal growth, the value of the stock will be higher for each


year. Although the total return will remain the same, rs = 10%, the distribution between dividend


yield and capital gains yield will differ: The dividend yield will start off lower and the capital


gains yield will start off higher for the 5-year supernormal growth condition, relative to the 2-year


supernormal growth state. The dividend yield will increase and the capital gains yield will


decline over the 5-year period until dividend yield = 4% and capital gains yield = 6%.


c. Throughout the supernormal growth period, the total yield will be 10 percent, but the dividend


yield is relatively low during the early years of the supernormal growth period and the capital


gains yield is relatively high. As we near the end of the supernormal growth period, the capital


gains yield declines and the dividend yield rises. After the supernormal growth period has


ended, the capital gains yield will equal gn = 6%. The total yield must equal rs = 10%, so the


dividend yield must equal 10% - 6% = 4%.


d. Some investors need cash dividends (retired people) while others would prefer growth. Also,


investors must pay taxes each year on the dividends received during the year, while taxes on


capital gains can be delayed until the gain is actually realized.


7-19 a. rs = rRF + (rM - rRF)b = 11% + (14% - 11%)1.5 = 15.5%.


^


P0 = D1/(rs - g) = $2.25/(0.155 - 0.05) = $21.43.


b. rs = 9% + (12% - 9%)1.5 = 13.5%. ^


P0 = $2.25/(0.135 - 0.05) = $26.47.


c. rs = 9% + (11% - 9%)1.5 = 12.0%. ^


P0 = $2.25/(0.12 - 0.05) = $32.14.


d. New data given: rRF = 9%; rM = 11%; g = 6%, b = 1.3.


rs = rRF + (rM - rRF)b = 9% + (11% - 9%)1.3 = 11.6%.


^


P0 = D1/(rs - g) = $2.27/(0.116 - 0.06) = $40.54.




Answers and Solutions: 7 - 153 SOLUTION TO SPREADSHEET PROBLEM



7-20 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 07 P20 Build a Model.xls) and on the instructor's side of the web site,


brigham.swcollege.com.




Answers and Solutions: 7 - 154 MINI CASE



Sam Strother and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company's pension fund management division, with Strother having responsibility for fixed income securities (primarily bonds) and Tibbs being responsible for equity investments. A major new client, the Northwestern Municipal League, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them.


To illustrate the common stock valuation process, Strother and Tibbs have asked you to analyze the Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions.


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


Answer: The common stockholders are the owners of a corporation, and as such, they have certain rights


and privileges as described below.


1. Ownership implies control. Thus, a firm's common stockholders have the right to


elect its firm's directors, who in turn elect the officers who manage the business.


2. Common stockholders often have the right, called the preemptive right, to purchase


any additional shares sold by the firm. In some states, the preemptive right is


automatically included in every corporate charter; in others, it is necessary to insert it


specifically into the charter.


b. 1. Write out a formula that can be used to value any stock, regardless of its dividend


pattern.


Answer: The value of any stock is the present value of its expected dividend stream:


^ D1 D2 D3 D


P0 = + + + + .


(1 + rs ) t


(1 + rs ) (1 + rs ) 3


(1 + rs )


However, some stocks have dividend growth patterns which allow them to be valued using


short-cut formulas.




Answers and Solutions: 8 - 155 b. 2. What is a constant growth stock? How are constant growth stocks valued?


Answer: A constant growth stock is one whose dividends are expected to grow at a constant rate forever.


"Constant growth" means that the best estimate of the future growth rate is some constant number,


not that we really expect growth to be the same each and every year. Many companies have


dividends which are expected to grow steadily into the foreseeable future, and such companies are


valued as constant growth stocks.


For a constant growth stock:


D1 = D0(1 + g), D2 = D1(1 + g) = D0(1 + g)2, and so on.


With this regular dividend pattern, the general stock valuation model can be simplified to


the following very important equation:


^ D1 D 0 (1 + g )


P0 = = .


rs - g rs - g


This is the well-known "Gordon," or "constant-growth" model for valuing stocks. Here D1, is


the next expected dividend, which is assumed to be paid 1 year from now, rs is the required rate of


return on the stock, and g is the constant growth rate.


b. 3. What happens if a company has a constant g which exceeds its rs? Will many stocks have


expected g > rs in the short run (i.e., for the next few years)? In the long run (i.e., forever)?


Answer: The model is derived mathematically, and the derivation requires that rs > g. If g is greater than rs,


the model gives a negative stock price, which is nonsensical. The model simply cannot be used


unless (1) rs > g, (2) g is expected to be constant, and (3) g can reasonably be expected to continue


indefinitely.


Stocks may have periods of supernormal growth, where gs > rs; however, this growth rate


cannot be sustained indefinitely. In the long-run, g < rs.


c. Assume that temp force has a beta coefficient of 1.2, that the risk-free rate (the yield


on T-bonds) is 7 percent, and that the market risk premium is 5 percent. What is the


required rate of return on the firm's stock?


Answer: Here we use the SML to calculate temp force's required rate of return:


rs = rRF + (rM rRF)bTemp Force = 7% + (12% - 7%)(1.2)


= 7% + (5%)(1.2) = 7% + 6% = 13%.




Answers and Solutions: 8 - 156 d. Assume that Temp Force is a constant growth company whose last dividend (D0, which was


paid yesterday) was $2.00, and whose dividend is expected to grow indefinitely at a 6 percent


rate.


d. 1. What is the firm's expected dividend stream over the next 3 years?


Answer: Temp Force is a constant growth stock, and its dividend is expected to grow at a constant rate of 6


percent per year. Expressed as a time line, we have the following setup. Just enter 2 in your


calculator; then keep multiplying by 1 + g = 1.06 to get D1, D2, and D3:


0 rs = 13% 1 2


3 4


| | | | |


g = 6%


D0 = 2.00 2.12 2.247 2.382


1.88


1.76


1.65


.


.


.


d. 2. What is the firm's current stock price?


Answer: We could extend the time line on out forever, find the value of Temp Force's dividends for every


year on out into the future, and then the PV of each dividend, discounted at r = 13%. For


example, the PV of D1 is $1.76106; the PV of D2 is $1.75973; and so forth. Note that the


dividend payments increase with time, but as long as rs > g, the present values decrease with time.


If we extended the graph on out forever and then summed the PVs of the dividends, we would


have the value of the stock. However, since the stock is growing at a constant rate, its value can


be estimated using the constant growth model:


^ D1 $2.12 $2.12


P0 = = = = $30.29.


rs - g 0.13 - 0.06 0.07



d. 3. What is the stock's expected value one


year from now?


Answer: After one year, D1 will have been paid, so the expected dividend stream will then be D2, D3, D4,


and so on. Thus, the expected value one year from now is $32.10:


^ D2 $2.247 $2.247


P1 = = = = $32.10.


( rs - g) (0.13 - 0.06) 0.07




Answers and Solutions: 8 - 157 d. 4. What are the expected dividend yield, the capital gains yield, and the total return


during the first year?


Answer: The expected dividend yield in any year n is


Dn


Dividend Yield = ,


^


P n -1


While the expected capital gains yield is


^ ^


( Pn - Pn -1 ) Dn


Capital Gains Yield = =r- .


^


Pn -1 Pn -1


Thus, the dividend yield in the first year is 10 percent, while the capital gains yield is 6


percent:


Total return = 13.0%


Dividend yield = $2.12/$30.29 = 7.0%


Capital gains yield = 6.0%


e. Now assume that the stock is currently selling at $30.29. What is the expected


rate of return on the stock?


Answer: The constant growth model can be rearranged to this form:


D1


r s= +g.


P0


Here the current price of the stock is known, and we solve for the expected return. For


Temp Force:



r s= $2.12/$30.29 + 0.060 = 0.070 + 0.060 = 13%.




Answers and Solutions: 8 - 158 f. What would the stock price be if its dividends were expected to have zero growth?


Answer: If Temp Force's dividends were not expected to grow at all, then its dividend


stream would be a perpetuity. Perpetuities are valued as shown below:


0 rs = 13% 1 2 3


| | | |


g = 0%


2.00 2.00 2.00


1.77


1.57


1.39


.


.


.


P0 = 15.38


P0 = PMT/r = $2.00/0.13 = $15.38.


Note that if a preferred stock is a perpetuity, it may be valued with this formula.




Answers and Solutions: 8 - 159 g. Now assume that Temp Force is expected to experience supernormal growth of 30


percent for the next 3 years, then to return to its long-run constant growth rate of 6


percent. What is the stock's value under these conditions? What is its expected


dividend yield and capital gains yield be in year 1? In year 4?


Answer: Temp Force is no longer a constant growth stock, so the constant growth model is not applicable.


Note, however, that the stock is expected to become a constant growth stock in 3 years. Thus, it


has a nonconstant growth period followed by constant growth. The easiest way to value such


nonconstant growth stocks is to set the situation up on a time line as shown below:


0r = 13% 1 2


s


3 4


| | | | |


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


2.600 3.380 4.394


4.658


2.301


2.647


3.045


^ 4.658


46.116 P3 = $66.54 =


54.109 0.13 - 0.06


Simply enter $2 and multiply by (1.30) to get D1 = $2.60; multiply that result by 1.3 to get D2 =


$3.38, and so forth. Then recognize that after year 3, Temp Force becomes a constant growth


^ ^


stock, and at that point P3 can be found using the constant growth model. P3 is the present


value as of t = 3 of the dividends in year 4 and beyond.


^


With the cash flows for D1, D2, D3, and P3 shown on the time line, we discount each value


back to year 0, and the sum of these four PVs is the value of the stock today, P0 = $54.109.


The dividend yield in year 1 is 4.80 percent, and the capital gains yield is 8.2


percent:


$2.600


Dividend yield = = 0.0480 = 4.8%.


$54.109


Capital gains yield = 13.00% - 4.8% = 8.2%.


During the nonconstant growth period, the dividend yields and capital gains yields are not


constant, and the capital gains yield does not equal g. However, after year 3, the stock becomes


a constant growth stock, with g = capital gains yield = 6.0% and dividend yield = 13.0% - 6.0% =


7.0%.




Answers and Solutions: 8 - 160 h. Is the stock price based more on long-term or short-term expectations? Answer this


by finding the percentage of Temp Force current stock price based on dividends


expected more than three years in the future.


$46.116 Answer: = 85.2%.


$54.109


Stock price is based more on long-term expectations, as is evident by the fact that over 85


percent of temp force stock price is determined by dividends expected more than


three years from now.


i. Suppose Temp Force is expected to experience zero growth during the first 3 years


and then to resume its steady-state growth of 6 percent in the fourth year. What is


the stock's value now? What is its expected dividend yield and its capital gains


yield in year 1? In year 4?


Answer: Now we have this situation:


0


rs = 13% 1 2


3 4


| | | | |


g = 0% g = 0% g = 0% g = 6%


2.00 2.00 2.00 2.00


2.12


1.77


1.57


1.39


20.99 ^ 2.12


P3 = 30.29 =


^


25.72 = P0 0.07


During year 1:


$2.00


Dividend Yield = = 0.0778 = 7.78%.


$25.72


Capital Gains Yield = 13.00% - 7.78% = 5.22%.


Again, in year 4 temp force becomes a constant growth stock; hence g = capital gains yield =


6.0% and dividend yield = 7.0%.




Answers and Solutions: 8 - 161 j. Finally, assume that Temp Force's earnings and dividends are expected to decline by


a constant 6 percent per year, that is, g = -6%. Why would anyone be willing to buy


such a stock, and at what price should it sell? What would be the dividend yield and


capital gains yield in each year?


Answer: The company is earning something and paying some dividends, so it clearly has a value greater


than zero. That value can be found with the constant growth formula, but where g is negative:


D1 D 0 (1 + g ) $2.00(0.94) $1.88


P0 = = = = = $9.89.


rS - g rS - g 0.13 - ( -0.06) 0.19


Since it is a constant growth stock:


g = Capital Gains Yield = -6.0%,


hence:


Dividend Yield = 13.0% - (-6.0%) = 19.0%.


As a check:


$1.88


Dividend Yield = = 0.190 = 19.0%.


$9.89


The dividend and capital gains yields are constant over time, but a high (19.0 percent)


dividend yield is needed to offset the negative capital gains yield.


k. What is market mutliple analysis?


Answer: Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the


P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus


the dividends per share) to value stocks. For example, estimate the average P/E ratio of


comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected


earnings of the company to estimate its stock price. The entity value (V) is the market value of


equity (# shares of stock multiplied by the price per share) plus the value of debt. Pick a measure,


such as EBITDA, sales, customers, eyeballs, etc. Calculate the average entity ratio for a sample of


comparable firms. For example, V/EBITDA, V/customers. Then find the entity value of the


firm in question. For example, multiply the firm's sales by the V/sales multiple, or multiply the


firm's # of customers by the V/customers ratio. The result is the total value of the firm. Subtract


the firm's debt to get the total value of equity. Divide by the number of shares to get the price per


share. There are problems with market multiple analysis. (1) It is often hard to find comparable


firms. (2) The average ratio for the sample of comparable firms often has a wide range. For


example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you


know whether your firm should be compared to the low, average, or high performers?


l. Why do stock prices change? Suppose the expected D1 is $2, the growth rate is 5


Answers and Solutions: 8 - 162 percent, and rs is 10 percent. Using the constant growth model, what is the impact


on stock price if g is 4 percent or 6 percent? If rs is 9 percent or 11 percent?


Answer: Using the constant growth model, the price of a stock is P0 = D1 / (rs g). If estimates of g


change, then the price will change. If estimates of the required return on stock change, then the


stock price will change. Notice that rs = rRF + (rpm)bi, so rs will change if there are changes in


inflation expectations, risk aversion, or company risk. The following table shows the stock price


for various levels of g and rs.


g g g


rs 4% 5% 6%


9% 40.00 50.00 66.67


10% 33.33 40.00 50.00


11% 28.57 33.33 40.00



m. What does market equilibrium mean?


Answer: Equilibrium means stable, no tendency to change. Market equilibrium means that prices are


stable--at its current price, there is no general tendency for people to want to buy or to sell a


security that is in equilibrium. Also, when equilibrium exists, the expected rate of return will be


equal to the required rate of return:



r = D1/P0 + g = r = rRF + (rM - rRF)b.



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


Answer: Securities will be bought and sold until the equilibrium price is established.


o. What is the efficient markets hypothesis, what are its three forms, and what are its


implications?


Answer: The EMH in general is the hypothesis that securities are normally in equilibrium, and are "priced


fairly," making it impossible to "beat the market."


Weak-form efficiency says that investors cannot profit from looking at past movements in


stock prices--the fact that stocks went down for the last few days is no reason to think that they


will go up (or down) in the future. This form has been proven pretty well by empirical tests,


even though people still employ "technical analysis."


Semistrong-form efficiency says that all publicly available information is reflected in stock


prices, hence that it won't do much good to pore over annual reports trying to find undervalued


stocks. This one is (I think) largely true, but superior analysts can still obtain and process new


information fast enough to gain a small advantage.


Strong-form efficiency says that all information, even inside information, is embedded in


stock prices. This form does not hold--insiders know more, and could take advantage of that


information to make abnormal profits in the markets. Trading on the basis of insider information


is illegal.


Answers and Solutions: 8 - 163 p. Temp Force recently issued preferred stock. It pays an annual dividend of $5,


and the issue price was $50 per share. What is the expected return to an


investor on this preferred stock?


D ps Answer: r ps =


Vps


$5


=


$50


= 10%.




Answers and Solutions: 8 - 164 Chapter 8


Financial Options and Their Valuation


ANSWERS TO END-OF-CHAPTER QUESTIONS


8-1 a. An option is a contract which gives its holder the right to buy or sell an asset at some


predetermined price within a specified period of time. A call option allows the holder to buy the


asset, while a put option allows the holder to sell the asset.


b. A simple measure of an option's value is its exercise value. The exercise value is


equal to the current price of the stock (underlying the option) less the striking


price of the option. The strike price is the price stated in the option contract at


which the security can be bought (or sold). For example, if the underlying


stock sells for $50 and the striking price is $20, the exercise value of the option


would be $30.


c. The Black-Scholes Option Pricing Model is widely used by option traders to value options. It is


derived from the concept of a riskless hedge. By buying shares of a stock and simultaneously


selling call options on that stock, the investor will create a risk-free investment position. This


riskless return must equal the risk-free rate or an arbitrage opportunity would exist. People


would take advantage of this opportunity until the equilibrium level estimated by the


Black-Scholes model was reached.



8-2 The market value of an option is typically higher than its exercise value due to the speculative nature


of the investment. Options allow investors to gain a high degree of personal leverage when buying


securities. The option allows the investor to limit his or her loss but amplify his or her return. The


exact amount this protection is worth is the premium over the exercise value.


8-3 (1) An increase in stock price causes an increase in the value of a call option. (2) An increase in


exercise price causes a decrease in the value of a call option. (3) An increase in the time to expiration


causes an increase in the value of a call option. (4) An increase in the risk-free rate causes an increase


in the value of a call option. (1) An increase in the variance of stock return causes an increase in the


value of a call option.




Answers and Solutions: 8 - 165 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


8-1 P = $15; X = $15; t = 0.5; rRF = 0.06; 2 = 0.12; d1 = 0.24495;


d2 = 0.0000; N(d1) = 0.59675; N(d2) = 0.500000; V = ?


Using the Black-Scholes Option Pricing Model, you calculate the option's value as:


-r t


V = P[N(d1)] - Xe RF [N(d2)]


= $15(0.59675) - $15e(-0.10)(0.5)(0.50000)


= $8.95128 - $15(0.9512)(0.50000)


= $1.6729 $1.67.


8-2 Option's exercise price = $15; Exercise value = $22; Premium value = $5;


V = ? P0 = ?


Premium = Market price of option - Exercise value


$5 = V - $22


V = $27.


Exercise value = P0 - Exercise price


$22 = P0 - $15


P0 = $37.



ln (P/X) + [rRF + ( 2 / 2)]t ln ($30 /$35) + [0.05 + (0.25/ 2)](0 .333333) 8-3 d1 = = = - 0.3319.


t 0.5 0.33333)


d2 = d1 s (t)0.5 = -0.3319 0.5(0.33333)0.5 = -0.6206.


N(d1) = 0.3700 (from Excel NORMSDIST function).


N(d2) = 0.2674 (from Excel NORMSDIST function).


-r t


V = P[N(d1)] - Xe RF [N(d2)]


= $30(0.3700) - $35e(-0.05)(0.33333)(0.2674)


= $11.1000 - $9.2043


= $1.8957 $1.90.




Answers and Solutions: 8 - 166 8-4 The stock's range of payoffs in one year is $26 - $16 = $10. At expiration, the option will be worth


$26 - $21 = $5 if the stock price is $26, and zero if the stock price $16. The range of payoffs for the


stock option is $5 0 = $5.


Equalize the range to find the number of shares of stock: Option range / Stock range = $5/$10 = 0.5.


With 0.5 shares, the stock's payoff will be either $13 or $8. The portfolio's payoff will be $13 - $5 =


$8, or $8 0 = $8.


The present value of $8 at the daily compounded risk-free rate is: PV = $8 / (1+ (0.05/365))365 =


$7.610.


The option price is the current value of the stock in the portfolio minus the PV of the payoff:


V = 0.5($20) - $7.610 = $2.39.


8-5 The stock's range of payoffs in six months is $18 - $13 = $5. At expiration, the option will be worth


$18 - $14 = $4 if the stock price is $18, and zero if the stock price $13. The range of payoffs for the


stock option is $4 0 = $5.


Equalize the range to find the number of shares of stock: Option range / Stock range = $4/$5 = 0.8.


With 0.8 shares, the stock's payoff will be either 0.8($18) = $14.40 or 0.8($13) = $10.40. The


portfolio's payoff will be $14.4 - $4 = $10.40, or $10.40 0 = $10.40.


The present value of $10.40 at the daily compounded risk-free rate is: PV = $10.40 / (1+


(0.06/365))365/2 = $10.093.


The option price is the current value of the stock in the portfolio minus the PV of the payoff:


V = 0.8($15) - $10.093 = $1.907 .$1.91.


8-6 Put = V P + X exp(-rRF t)


= $6.56 - $33 + $32 e-0.06(1)


= $6.56 - $33 + $30.136 = $3.696 $3.70.




Answers and Solutions: 8 - 167 SOLUTION TO SPREADSHEET PROBLEMS


8-7 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM 11 Ch 08 P07 Build a Model.xls) and on the instructor's side of the textbook's


web site, http://brigham.swcollege.com.




Answers and Solutions: 8 - 168 MINI CASE


Assume that you have just been hired as a financial analyst by Triple Trice Inc., a mid-sized California company that specializes in creating exotic clothing. Since no one at Triple Trice is familiar with the basics of financial options, you have been asked to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topic.


To begin, you gathered some outside materials the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.


a. What is a financial option? What is the single most important characteristic of an


option?


Answer: A financial option is a contract which gives its holder the right to buy (or sell) an asset at a


predetermined price within a specified period of time. An option's most important characteristic


is that it does not obligate its owner to take any action; it merely gives the owner the right to buy


or sell an asset.


b. Options have a unique set of terminology. Define the following terms: (1) call


option; (2) put option; (3) exercise price; (4) striking, or strike, price; (5) option price;


(6) expiration date; (7) exercise value; (8) covered option; (9) naked option; (10)


in-the-money call; (11) out-of-the-money call; and (12) LEAPS.


Answer: 1. A call option is an option to buy a specified number of shares of a security within some


future period.


2. A put option is an option to sell a specified number of shares of a security within some


future period.


3. Exercise price is another name for strike price, the price stated in the option contract at


which the security can be bought (or sold).


4. The strike price is the price stated in the option contract at which the security can be bought


(or sold).


5. The option price is the market price of the option contract.


6. The expiration date is the date the option matures.


7. The exercise value is the value of a call option if it were exercised today, and it is equal to


the current stock price minus the strike price. Note: the exercise value is zero if the


stock price is less than the strike price.


8. A covered option is a call option written against stock held in an investor's portfolio.


9. A naked option is an option sold without the stock to back it up.



Answers and Solutions: 9- 169 10. An in-the-money call is a call option whose exercise price is less than the current price of


the underlying stock.


11. An out-of-the-money call is a call option whose exercise price exceeds the current stock


price.


12. LEAPS stands for long-term equity anticipation securities. They are similar to


conventional options except they are long-term options with maturities of up to 2 years.


c. Consider Triple Trice's call option with a $25 strike price. The following table


contains historical values for this option at different stock prices:


Stock Price Call Option Price


$25 $ 3.00


30 7.50


35 12.00


40 16.50


45 21.00


50 25.50


1. Create a table which shows (a) stock price, (b) strike price, (c) exercise value, (d)


option price, and (e) the premium of option price over exercise value.


Answer: Price Of Strike Exercise Value Market Price Premium


Stock Price Of Option Of Option


(D) - (C) =


(A) (B) (A) - (B) = (C) (D) (E)


$25.00 $25.00 $ 0.00 $ 3.00 $3.00


30.00 25.00 5.00 7.50 2.50


35.00 25.00 10.00 12.00 2.00


40.00 25.00 15.00 16.50 1.50


45.00 25.00 20.00 21.00 1.00


50.00 25.00 25.00 25.50 0.50


c. 2. What happens to the premium of option price over exercise value as the stock price


rises? Why?


Answer: As the table shows, the premium of the option price over the exercise value declines as the stock


price increases. This is due to the declining degree of leverage provided by options as the


underlying stock prices increase, and to the greater loss potential of options at higher option


prices.


Answers and Solutions: 9- 170 d. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option


Pricing Model (OPM).


1. What assumptions underlie the OPM?


Answer: The assumptions which underlie the OPM are as follows:


The stock underlying the call option provides no dividends during the life of the


option.


No transactions costs are involved with the sale or purchase of either the stock or


the option.


The short-term, risk-free interest rate is known and is constant during the life of


the option.


Security buyers may borrow any fraction of the purchase price at the short-term,


risk-free rate.


Short-term selling is permitted without penalty, and sellers receive immediately


the full cash proceeds at today's price for securities sold short.


The call option can be exercised only on its expiration date.


Security trading takes place in continuous time, and stock prices move randomly


in continuous time.




Answers and Solutions: 9- 171 d. 2. Write out the three equations that constitute the model.


Answer: The OPM consists of the following three equations:


V = P[N(d1) - Xe - rRF t [N(d2)].


ln( P/X ) + [ rRF + ( 2 /2)]t


d1 = .


t


d2 = d1 - t .


Here,


V = current value of a call option with time t until expiration.


P = current price of the underlying stock.


N(di) = probability that a deviation less than di will occur in a standard normal distribution.


Thus, N(d1) and N(d2) represent areas under a standard normal distribution function.


X = exercise, or strike, price of the option.


e 2.7183.


rRF = risk-free interest rate.


t = time until the option expires (the option period).


ln(P/X) = natural logarithm of P/X.


2 = variance of the rate of return on the stock.




Answers and Solutions: 9- 172 d. 3. What is the value of the following call option according to the OPM?


Stock Price = $27.00.


Exercise Price = $25.00


Time To Expiration = 6 Months.


Risk-Free Rate = 6.0%.


Stock Return Variance = 0.11.


Answer: the input variables are:


P = $27.00; X = $25.00; rRF = 6.0%; t = 6 months = 0.5 years; and 2 = 0.11.


Now, we proceed to use the OPM:


V = $27[N(d1)] - $25e-(0.06)(0.5)[N(d2)].


ln($27/$25) + [(0.06 + 0.11/2)](0.5)


d1 =


(0.3317)(0.7071)


0.0770 + 0.0575


= = 0.5736.


0.2345


d2 = d1 - (0.3317)(0.7071) = d1 - 0.2345


= 0.5736 - 0.2345 = 0.3391.


N(d1) = N(0.5736) = 0.5000 + 0.2168 = 0.7168.


N(d2) = N(0.3391) = 0.5000 + 0.1327 = 0.6327.


Therefore,


V = $27(0.7168) - $25e-0.03(0.6327) = $19.3536 - $25(0.97045)(0.6327)


= $19.3536 - $15.3500 = $4.0036 $4.00.


Thus, under the OPM, the value of the call option is about $4.00.




Answers and Solutions: 9- 173 e. What impact does each of the following call option parameters have on the value of a


call option?


1. Current Stock Price


2. Exercise Price


3. Option's Term To Maturity


4. Risk-Free Rate


5. Variability Of The Stock Price


Answer: 1. The value of a call option increases (decreases) as the current stock price increases


(decreases).


2. As the exercise price of the option increases (decreases), the value of the option


decreases (increases).


3. As the expiration date of the option is lengthened, the value of the option increases.


This is because the value of the option depends on the chance of a stock price


increase, and the longer the option period, the higher the stock price can climb.


4. As the risk-free rate increases, the value of the option tends to increase as well.


Since increases in the risk-free rate tend to decrease the present value of the option's


exercise price, they also tend to increase the current value of the option.


5. The greater the variance in the underlying stock price, the greater the possibility that


the stock's price will exceed the exercise price of the option; thus, the more valuable


the option will be.


f. What is put-call parity?


Answer: Put-call parity specifies the relationship between puts, calls, and the underlying stock price that


must hold to prevent arbitrage:


Put + Stock = Call + PV Of Exercise Price




Answers and Solutions: 9- 174 Chapter 9


The Cost of Capital


ANSWERS TO END-OF-CHAPTER QUESTIONS


9-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component


costs of capital---debt, preferred stock, and common equity. Each weighting factor is the


proportion of that type of capital in the optimal, or target, capital structure. The after-tax cost of


debt, rd(1 - T), is the relevant cost to the firm of new debt financing. Since interest is deductible


from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus,


rd(1 - T) is the appropriate component cost of debt (in the weighted average cost of capital).


b. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock. For


perpetual preferred, it is the preferred dividend, Dps, divided by the net issuing price, Pn. Note


that no tax adjustments are made when calculating the component cost of preferred stock because,


unlike interest payments on debt, dividend payments on preferred stock are not tax deductible.


The cost of new common equity, re, is the cost to the firm of equity obtained by selling new


common stock. It is, essentially, the cost of retained earnings adjusted for flotation costs.


Flotation costs are the costs that the firm incurs when it issues new securities. The amount


actually available to the firm for capital investment from the sale of new securities is the sales


price of the securities less flotation costs. Note that flotation costs consist of (1) direct expenses


such as printing costs and brokerage commissions, (2) any price reduction due to increasing the


supply of stock, and (3) any drop in price due to informational asymmetries.


c. The target capital structure is the relative amount of debt, preferred stock, and common equity that


the firm desires. The WACC should be based on these target weights.


d. There are considerable costs when a company issues a new security, including fees to an


investment banker and legal fees. These costs are called flotation costs. The cost of new


common equity is higher than that of common equity raised internally by reinvesting earnings.


Project's financed with external equity must earn a higher rate of return, since they project must


cover the flotation costs.


9-2 The WACC is an average cost because it is a weighted average of the firm's component costs of


capital. However, each component cost is a marginal cost; that is, the cost of new capital. Thus, the


WACC is the weighted average marginal cost of capital.



9-3 Probable Effect on


rd(1 - T) rs WACC


a. The corporate tax rate is lowered. + 0 +


b. The Federal Reserve tightens credit. + + +


c. The firm uses more debt; that is, it


increases its debt/assets ratio. + + 0



Answers and Solutions: 9- 175 d. The firm doubles the amount of capital


it raises during the year. 0 or + 0 or + 0 or +


e. The firm expands into a risky


new area. + + +


f. Investors become more risk averse. + + +


9-4 Stand-alone risk views a project's risk in isolation, hence without regard to portfolio effects;


within-firm risk, also called corporate risk, views project risk within the context of the firm's portfolio


of assets; and market risk (beta) recognizes that the firm's stockholders hold diversified portfolios of


stocks. In theory, market risk should be most relevant because of its direct effect on stock prices.


9-5 If a company's composite WACC estimate were 10 percent, its managers might use 10 percent to


evaluate average-risk projects, 12 percent for those with high-risk, and 8 percent for low-risk projects.


Unfortunately, given the data, there is no completely satisfactory way to specify exactly how much


higher or lower we should go in setting risk-adjusted costs of capital.




Answers and Solutions: 9- 176 SOLUTIONS TO END-OF-CHAPTER PROBLEMS



9-1 40% Debt; 60% Equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?


WACC = (wd)(rd)(1 - T) + (wce)(rs)


9.96% = (0.4)(9%)(1 - 0.4) + (0.6)rs


9.96% = 2.16% + 0.6rs


7.8% = 0.6rs


rs = 13%.


9-2 Vps = $50; Dps = $3.80; F = 5%; rps = ?


D ps


rps =


Vps (1 - F)


$3.80


=


$50(1 - 0.05)


$3.80


= = 8%.


$47.50


9-3 P0 = $30; D1 = $3.00; g = 5%; rs = ?


D1


rs = + g = + 0.05 = 15%.


P0


9-4 a. rd(1 - T) = 13%(1 - 0) = 13.00%.


b. rd(1 - T) = 13%(0.80) = 10.40%.


c. rd(1 - T) = 13%(0.65) = 8.45%.


9-5 rd(1 - T) = 0.12(0.65) = 7.80%.



$100(0.11) $11 $11 9-6 rps = = = = 11.94%.


$97.00(1 - 0.05) $97.00(0.95) $92.15


9-7 Enter these values: N = 60, PV = -515.16, PMT = 30, and FV = 1000, to get I = 6% = periodic rate.


The nominal rate is 6%(2) = 12%, and the after-tax component cost of debt is 12%(0.6) = 7.2%.



Answers and Solutions: 9- 177 D1 $2.14 9-8 a. rs = +g= + 7% = 9.3% + 7% = 16.3%.


P0 $23


b. rs = rRF + (rM - rRF)b


= 9% + (13% - 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.


c. rs = Bond rate + Risk premium = 12% + 4% = 16%.


d. The bond-yield-plus-risk-premium approach and the CAPM method both resulted in lower cost of


equity values than the DCF method. The firm's cost of equity should be estimated to be about


15.9 percent, which is the average of the three methods.


9-9 a. $6.50 = $4.42(1+g)5


(1+g)5 = 6.50/4.42 = 1.471


(1+g) = 1.471(1/5) = 1.080


g = 8%.


Alternatively, with a financial calculator, input N = 5, PV = -4.42, PMT = 0, FV = 6.50, and then


solve for I = 8.02% 8%.


b. D1 = D0(1 + g) = $2.60(1.08) = $2.81.


c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.


D1 9-10 a. rs = +g


P0


$3.60


0.09 = +g


$60.00


0.09 = 0.06 + g


g = 3%.


b. Current EPS $5.400


Less: Dividends per share 3.600


Retained earnings per share $1.800


Rate of return 0.090


Increase in EPS $0.162


Current EPS 5.400


Next year's EPS $5.562


Alternatively, EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.




Answers and Solutions: 9- 178 9-11 a. Common equity needed:


0.5($30,000,000) = $15,000,000.


b. Cost using rs:


After-Tax


Percent Cost = Product


Debt 0.50 4.8%* 2.4%


Common equity 0.50 12.0 6.0


WACC =


8.4%


*8%(1 - T) = 8%(0.6) = 4.8%.


c. rs and the WACC will increase due to the flotation costs of new equity.


9-12 The book and market value of the current liabilities are both $10,000,000.


The bonds have a value of


V = $60(PVIFA10%,20) + $1,000(PVIF10%,20)


= $60([1/0.10]-[1/(0.1*(1+0.10)20)]) + $1,000((1+0.10)-20)


= $60(8.5136) + $1,000(0.1486)


= $510.82 + $148.60 = $659.42.


Alternatively, using a financial calculator, input N = 20, I = 10, PMT = 60, and FV = 1000 to arrive at


a PV = $659.46.


The total market value of the long-term debt is 30,000($659.46) = $19,783,800.


There are 1 million shares of stock outstanding, and the stock sells for $60 per share. Therefore,


the market value of the equity is $60,000,000.


The market value capital structure is thus:


Short-term debt $10,000,000 11.14%


Long-term debt 19,783,800 22.03


Common equity 60,000,000 66.83


$89,783,800 100.00%




Answers and Solutions: 9- 179 9-13 Several steps are involved in the solution of this problem. Our solution follows:


Step 1.


Establish a set of market value capital structure weights. In this case, A/P and accruals, and also


short-term debt, may be disregarded because the firm does not use these as a source of permanent


financing.


Debt:


The long-term debt has a market value found as follows:


40


$40 $1,000


V0 = t


+ = $699,


t =1 (1.06) (1.06) 40


or 0.699($30,000,000) = $20,970,000 in total.


Preferred Stock:


The preferred has a value of


$2


Pps = = $72.73.


0.11 / 4


There are $5,000,000/$100 = 50,000 shares of preferred outstanding, so the total market value of the


preferred is


50,000($72.73) = $3,636,500.


Common Stock:


The market value of the common stock is


4,000,000($20) = $80,000,000.


Therefore, here is the firm's market value capital structure, which we assume to be optimal:


Long-term debt $ 20,970,000 20.05%


Preferred stock 3,636,500 3.48


Common equity 80,000,000 76.47


$104,606,500 100.00%


We would round these weights to 20 percent debt, 4 percent preferred, and 76 percent common equity.


Step 2.


Establish cost rates for the various capital structure components.


Debt cost:


rd(1 - T) = 12%(0.6) = 7.2%.



Answers and Solutions: 9- 180 Preferred cost:


Annual dividend on new preferred = 11%($100) = $11. Therefore,


rps = $11/$100(1 - 0.05) = $11/$95 = 11.6%.


Common equity cost:


There are three basic ways of estimating rs: CAPM, DCF, and risk premium over own bonds. None of the methods is very exact.


CAPM:


We would use rRF = T-bond rate = 10%. For RPM, we would use 4.5% to 5.5%. For beta, we would use a beta in the 1.3 to 1.7 range. Combining these values, we obtain this range of values for rs:


Highest: rs = 10% + (5.5)(1.7) = 19.35%.


Lowest: rs = 10% + (4.5)(1.3) = 15.85%.


Midpoint: rs = 10% + (5.0)(1.5) = 17.50%.


DCE:


The company seems to be in a rapid, nonconstant growth situation, but we do not have the inputs necessary to develop a nonconstant rs. Therefore, we will use the constant growth model but temper our growth rate; that is, think of it as a long-term average g that may well be higher in the immediate than in the more distant future.


Data exist that would permit us to calculate historic growth rates, but problems would clearly arise, because the growth rate has been variable and also because gEPS gDPS. For the problem at hand, we would simply disregard historic growth rates, except for a discussion about calculating them as an exercise.


We could use as a growth estimator this method:


g = b(r) = 0.5(24%) = 12%.


It would not be appropriate to base g on the 30% ROE, because investors do not expect that rate.


Finally, we could use the analysts' forecasted g range, 10 to 15 percent. The dividend yield is D1/P0. Assuming g = 12%,


D1 $1(1.12)


= = 5.6%.


P0 $20


One could look at a range of yields, based on P in the range of $17 to $23, but because we believe in efficient markets, we would use P0 = $20. Thus, the DCF model suggests a rs in the range of 15.6 to 20.6 percent:


Highest: rs = 5.6% + 15% = 20.6%.


Lowest: rs = 5.6% + 10% = 15.6%.


Midpoint: rs = 5.6% + 12.5% = 18.1%.



Answers and Solutions: 9- 181 Generalized risk premium.


Highest: rs = 12% + 6% = 18%.


Lowest: rs = 12% + 4% = 16%.


Midpoint: rs = 12% + 5% = 17%.


Based on the three midpoint estimates, we have rs in this range:


CAPM 17.5%


DCF 18.1%


Risk Premium 17.0%


Step 3.


Calculate the WACC:


WACC = (D/V)(rdAT) + (P/V)(rps) + (S/V)(rs or re)


= 0.20(rdAT) + 0.04(rps) + 0.76(rs or re).


It would be appropriate to calculate a range of WACCs based on the ranges of component costs, but to


save time, we shall assume rdAT = 7.2%, rps = 11.6%, and rs = 17.5%. With these cost rates, here is


the WACC calculation:


WACC = 0.2(7.2%) + 0.04(11.6%) + 0.76(17.5%) = 15.2%.



9-14 P0 = $30; D1 = $3.00; g = 5%; F = 10%; rs = ?


rs = [D1/(1-F) P0] + g = [3/(1-0.10)(30)] + 0.05 = 16.1%.


9-15 Enter these values: N = 20, PV =1000(1-0.02)=980, PMT = -90(1-.4)=-54, and


FV = -1000, to get I = 5.57%, which is the after-tax component cost of debt.




Answers and Solutions: 9- 182 SPREADSHEET PROBLEM



9-16 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 09 P16 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.




Answers and Solutions: 9- 183 MINI CASE



During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis' cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:


1. The firm's tax rate is 40 percent.


2. The current price of Harry Davis' 12 percent coupon, semiannual payment,


noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry


Davis does not use short-term interest-bearing debt on a permanent basis. New


bonds would be privately placed with no flotation cost.


3. The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred


stock is $113.10. Harry Davis would incur flotation costs of $2.00 per share on a new issue.


4. Harry Davis' common stock is currently selling at $50 per share. Its last dividend (d0) was $4.19,


and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Harry


Davis' beta is 1.2; the yield on t-bonds is 7 percent; and the market risk premium is estimated to be


6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk


premium.


5. Harry Davis' target capital structure is 30 percent long-term debt, 10 percent preferred stock, and


60 percent common equity.


To structure the task somewhat, Jones has asked you to answer the following questions.




Answers and Solutions: 10 - 184 a. 1. What sources of capital should be included when you estimate Harry Davis' weighted


average cost of capital (WACC)?


Answer: The WACC is used primarily for making long-term capital investment decisions,


i.e., for capital budgeting. Thus, the WACC should include the types of capital


used to pay for long-term assets, and this is typically long-term debt, preferred


stock (if used), and common stock. Short-term sources of capital consist of (1)


spontaneous, noninterest-bearing liabilities such as accounts payable and


accruals and (2) short-term interest-bearing debt, such as notes payable. If the


firm uses short-term interest-bearing debt to acquire fixed assets rather than


just to finance working capital needs, then the WACC should include a


short-term debt component. Noninterest-bearing debt is generally not included


in the cost of capital estimate because these funds are netted out when


determining investment needs, that is, net rather than gross working capital is


included in capital expenditures.


a. 2. Should the component costs be figured on a before-tax or an after-tax basis?


Answer: Stockholders are concerned primarily with those corporate cash flows that are available for their


use, namely, those cash flows available to pay dividends or for reinvestment. Since dividends


are paid from and reinvestment is made with after-tax dollars, all cash flow and rate of return


calculations should be done on an after-tax basis.


a. 3. Should the costs be historical (embedded) costs or new (marginal) costs?


Answer: In financial management, the cost of capital is used primarily to make decisions which involve


raising new capital. Thus, the relevant component costs are today's marginal costs rather than


historical costs.




Answers and Solutions: 10 - 185 b. What is the market interest rate on Harry Davis' debt and its component cost of debt?


Answer: Harry Davis' 12 percent bond with 15 years to maturity is currently selling for $1,153.72. Thus,


its yield to maturity is 10 percent:


0 1 2 3


29 30


| | | | | |


-1,153.72 60 60 60 60


60


1,000


Enter n = 30, PV = -1153.72, pmt = 60, and FV = 1000, and then press the i button to find rd/2 = i


= 5.0%. Since this is a semiannual rate, multiply by 2 to find the annual rate, rd = 10%, the


pre-tax cost of debt.


Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Harry Davis'


relevant component cost of debt is the after-tax cost:


rd(1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%.



Optional Question


Should flotation costs be included in the estimate?


Answer: The actual component cost of new debt will be somewhat higher than 6 percent because the firm


will incur flotation costs in selling the new issue. However, flotation costs are typically small on


public debt issues, and, more important, most debt is placed directly with banks, insurance


companies, and the like, and in this case flotation costs are almost nonexistent.



Optional Question


Should you use the nominal cost of debt or the effective annual cost?


Answer: Our 10 percent pre-tax estimate is the nominal cost of debt. Since the firm's debt has semiannual


coupons, its effective annual rate is 10.25 percent:


(1.05)2 - 1.0 = 1.1025 - 1.0 = 0.1025 = 10.25%.


However, nominal rates are generally used. The reason is that the cost of capital is used in


capital budgeting, and capital budgeting cash flows are generally assumed to occur at year-end.


Therefore, using nominal rates makes the treatment of the capital budgeting discount rate and cash


flows consistent.




Answers and Solutions: 10 - 186 c. 1. What is the firm's cost of preferred stock?


Answer: Since the preferred issue is perpetual, its cost is estimated as follows:


D ps 0.1($100) $10


rps = = = = 0.090 = 9.0%.


Pn $133.10 - $2.00 $111.10


Note (1) that flotation costs for preferred are significant, so they are included here, (2) that since


preferred dividends are not deductible to the issuer, there is no need for a tax adjustment, and (3)


that we could have estimated the effective annual cost of the preferred, but as in the case of debt,


the nominal cost is generally used.


c. 2. Harry Davis' preferred stock is riskier to investors than its debt, yet the preferred's


yield to investors is lower than the yield to maturity on the debt. Does this suggest


that you have made a mistake? (Hint: think about taxes.)


Answer: Corporate investors own most preferred stock, because 70 percent of preferred dividends received


by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield than the


before-tax yield on debt issued by the same company. Note, though, that the after-tax yield to a


corporate investor, and the after-tax cost to the issuer, are higher on preferred stock than on debt.


d. 1. What are the two primary ways companies raise common equity?


Answer: A firm can raise common equity in two ways: (1) by retaining earnings and (2) by issuing new


common stock.


d. 2. Why is there a cost associated with reinvested earnings?


Answer: Management may either pay out earnings in the form of dividends or else retain earnings for


reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred:


stockholders could have received those earnings as dividends and then invested that money in


stocks, bonds, real estate, and so on.


d. 3. Harry Davis doesn't plan to issue new shares of common stock. Using the CAPM


approach, what is Harry Davis' estimated cost of equity?


Answer: rs = 0.07 + (0.06)1.2 = 14.2%.


e. 1. What is the estimated cost of equity using the discounted cash flow (DCF) approach?


D1 D 0 (1 + g ) $4.19 (1.05) Answer: rs = = +g = + 0.05 = 13.8%.


P0 P0 $50


Answers and Solutions: 10 - 187 e. 2. Suppose the firm has historically earned 15 percent on equity (ROE) and retained 35


percent of earnings, and investors expect this situation to continue in the future.


How could you use this information to estimate the future dividend growth rate, and


what growth rate would you get? Is this consistent with the 5 percent growth rate


given earlier?


Answer: Another method for estimating the growth rate is to use the retention growth model:


g = (1 - Payout Ratio)ROE


In this case g = (0.35)0.15 = 5.25%. This is consistent with the 5% rate given earlier.


e. 3. Could the DCF method be applied if the growth rate was not constant? How?


Answer: yes, you could use the DCF using nonconstant growth. You would find the PV of the dividends


during the nonconstant growth period and add this value to the PV of the series of inflows when


growth is assumed to become constant.


f. What is the cost of equity based on the bond-yield-plus-risk-premium method?


Answer: rs = company's own bond yield + risk premium.


First find the YTM of the bond:


Enter n = 30, PV = -1153.72, pmt = 60, and FV = 1000, and then press the i button to find r/2 = i =


5%. Since this is a semiannual rate, multiply by 2 to find the annual rate, r = 10%.


The assumed risk premium is 4%, thus


rs = 0.10 + 0.04 = 14%.


g. What is your final estimate for the cost of equity, rs?


Answer: The final estimate for the cost of equity would simply be the average of the values found using the


above three methods.


CAPM 14.2%


DCF 13.8


BOND YIELD + R.P. 14.0


AVERAGE 14.0%


h. What is Harry Davis' weighted average cost of capital (WACC)?


Answer: WACC= wdrd(1 - T) + wpsrps + wce(rs)



Answers and Solutions: 10 - 188 = 0.3(0.10)(0.6) + 0.1(0.09) + 0.6(0.14)


= 0.111 = 11.1%.


i. What factors influence Harry Davis' composite WACC?


Answer: There are factors that the firm cannot control and those that they can control that influence


WACC.


Factors The Firm Cannot Control:



}


Level Of Interest Rates


Tax Rates Market Conditions


Factors The Firm Can Control:


Capital Structure Policy


Dividend Policy


Investment Policy


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


Answer: No. The composite WACC reflects the risk of an average project undertaken by the firm.


Therefore, the WACC only represents the "hurdle rate" for a typical project with average risk.


Different projects have different risks. The project's WACC should be adjusted to reflect the


project's risk.


k. What procedures are used to determine the risk-adjusted cost of capital for a particular


division? What approaches are used to measure a division's beta?


Answer: The following procedures can be used to determine a division's risk-adjusted cost of capital:


(1) Subjective adjustments to the firm's composite WACC.


(2) Attempt to estimate what the cost of capital would be if the division were a stand-alone


firm. This requires estimating the division's beta.


The following approaches can be used to measure a division's beta:


(1) Pure play approach. Find several publicly traded companies exclusively in the project's


business. Then, use the average of their betas as a proxy for the project's beta. (It's hard


to find such companies.)


(2) Accounting beta approach. Run a regression between the project's ROA and the S&P


index ROA. Accounting betas are correlated (0.5 - 0.6) with market betas. However,


you normally can't get data on new project ROAs before the capital budgeting decision has


been made.




Answers and Solutions: 10 - 189 l. Harry Davis is interested in establishing a new division, which will focus primarily on


developing new internet-based projects. In trying to determine the cost of capital for


this new division, you discover that stand-alone firms involved in similar projects


have on average the following characteristics:


Their capital structure is 10 percent debt and 90 percent common equity.


Their cost of debt is typically 12 percent.


The beta is 1.7.


given this information, what would your estimate be for the division's cost of


capital?


Answer:


rs DIV. = rRF + (rM - rRF)bDIV.


= 7% + (6%)1.7 = 17.2%.


WACCDIV. = Wdrd(1 - T) + Wcrs


= 0.1(12%)(0.6) + 0.9(17.2%)


= 16.2%.


The division's WACC = 16.2% vs. The corporate WACC = 11.1%. The division's


market risk is greater than the firm's average projects. Typical projects within this


division would be accepted if their returns are above 16.2 percent.


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


Answer: The three types of project risk are:


Stand-Alone Risk


Corporate Risk


Market Risk


Market risk is theoretically best in most situations. However, creditors, customers,


suppliers, and employees are more affected by corporate risk. Therefore, corporate


risk is also relevant. Stand-alone risk is the easiest type of risk to measure.


Taking on a project with a high degree of either stand-alone or corporate risk will not


necessarily affect the firm's market risk. However, if the project has highly uncertain returns, and


if those returns are highly correlated with returns on the firm's other assets and with most other


assets in the economy, the project will have a high degree of all types of risk.


n. Explain in words why new common stock that is raised externally has a higher


percentage cost than equity that is raised internally by reivesting earnings.


Answer: The company is raising money in order to make an investment. The money has a cost, and this


cost is based primarily on the investors' required rate of return, considering risk and alternative


investment opportunities. So, the new investment must provide a return at least equal to the


investors' opportunity cost.


If the company raises capital by selling stock, the company doesn't get all of the money that


investors put up. For example, if investors put up $100,000, and if they expect a 15 percent return


Answers and Solutions: 10 - 190 on that $100,000, then $15,000 of profits must be generated. But if flotation costs are 20 percent


($20,000), then the company will receive only $80,000 of the $100,000 investors put up. That


$80,000 must then produce a $15,000 profit, or a 15/80 = 18.75% rate of return versus a 15


percent return on equity raised as retained earnings.


o. 1. Harry Davis estimates that if it issues new common stock, the flotation cost will be 15


percent. Harry Davis incorporates the flotation costs into the DCF approach. What is the


estimated cost of newly issued common stock, taking into account the flotation cost?


Answer:


D0 (1 + g) + g


re =


P0 (1 - F)


$4.19(1.05)


= + 5.0%


$50(1 - 0.15)


$4.40


= + 5.0% = 15.4%.


$42.50


o. 2. Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of


10%, paid annually. If flotation costs are 2 percent, what is the after-tax cost of debt for


the new bond?


Answer: Using a financial calculator, n = 30, PV = (1-0.02)(1000) = 980, pmt = -(1-0.40)(100) = -60, FV =


-1000. The resulting i is 6.15%, which is the after-tax cost of debt.



p. What four common mistakes in estimating the WACC should Harry Davis avoid?


Answer: 1. Don't use the coupon rate on a firm's existing debt as the pre-tax cost of debt. Use the


current cost of debt.


2. When estimating the risk premium for the CAPM approach, don't subtract the current


long-term t-bond rate from the historical average return on stocks.


For example, the historical average return on stocks has been about 12.7%. If inflation


has driven the current risk-free rate up to 10%, it would be wrong to conclude that the current


market risk premium is 12.7% - 10% = 2.7%. In all likelihood, inflation would also have


driven up the expected return on the market. Therefore, the historical return on the market


would not be a good estimate of the current expected return on the market.


3. Don't use book weights to estimte the weights for the capital structure. Use the target


capital structure to determine the weights for the WACC. If you don't have the target


weights, then use market value rather than book value to obtain the weights. Use the book


value of debt only as a last resort.


4. Always remember that capital components are sources of funding that come from investors.


If it's not a source of funding from an investor, then it's not a capital component.



Answers and Solutions: 10 - 191 Chapter 10


The Basics of Capital Budgeting


Evaluating Cash Flows


ANSWERS TO END-OF-CHAPTER QUESTIONS



10-1 a. Capital budgeting is the whole process of analyzing projects and deciding whether they should be


included in the capital budget. This process is of fundamental importance to the success or


failure of the firm as the fixed asset investment decisions chart the course of a company for many


years into the future. The payback, or payback period, is the number of years it takes a firm to


recover its project investment. Payback may be calculated with either raw cash flows (regular


payback) or discounted cash flows (discounted payback). In either case, payback does not


capture a project's entire cash flow stream and is thus not the preferred evaluation method. Note,


however, that the payback does measure a project's liquidity, and hence many firms use it as a risk


measure.


b. Mutually exclusive projects cannot be performed at the same time. We can choose either Project


1 or Project 2, or we can reject both, but we cannot accept both projects. Independent projects


can be accepted or rejected individually.


c. The net present value (NPV) and internal rate of return (IRR) techniques are discounted cash flow


(DCF) evaluation techniques. These are called DCF methods because they explicitly recognize


the time value of money. NPV is the present value of the project's expected future cash flows


(both inflows and outflows), discounted at the appropriate cost of capital. NPV is a direct


measure of the value of the project to shareholders. The internal rate of return (IRR) is the


discount rate that equates the present value of the expected future cash inflows and outflows.


IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at


the IRR rate.


d. The modified internal rate of return (MIRR) assumes that cash flows from all projects are


reinvested at the cost of capital as opposed to the project's own IRR. This makes the modified


internal rate of return a better indicator of a project's true profitability. The profitability index is


found by dividing the project's PV of future cash flows by its initial cost. A profitability index


greater than 1 is equivalent to a positive NPV project.


e. An NPV profile is the plot of a project's NPV versus its cost of capital. The crossover rate is the


cost of capital at which the NPV profiles for two projects intersect.


f. Capital projects with nonnormal cash flows have a large cash outflow either sometime during or


at the end of their lives. A common problem encountered when evaluating projects with


nonnormal cash flows is multiple IRRs. A project has normal cash flows if one or more cash


outflows (costs) are followed by a series of cash inflows.


g. The hurdle rate is the project cost of capital, or discount rate. It is the rate used in


discounting future cash flows in the NPV method, and it is the rate that is


compared to the IRR. The mathematics of the NPV method imply that project


cash flows are reinvested at the cost of capital while the IRR method assumes


Answers and Solutions: 10 - 192 reinvestment at the IRR. Since project cash flows can be replaced by new


external capital which costs r, the proper reinvestment rate assumption is the


cost of capital, and thus the best capital budget decision rule is NPV. The


post-audit is the final aspect of the capital budgeting process. The post-audit is a


feedback process in which the actual results are compared with those predicted


in the original capital budgeting analysis. The post-audit has several purposes,


the most important being to improve forecasts and improve operations.


h. A replacement chain is a method of comparing mutually exclusive projects that have unequal lives.


Each project is replicated such that they will both terminate in a common year. If projects with


lives of 3 years and 5 years are being evaluated, the 3-year project would be replicated 5 times


and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years. Not all


projects maximize their NPV if operated over their engineering lives and therefore it may be best


to terminate a project prior to its potential life. The economic life is the number of years a


project should be operated to maximize its NPV, and is often less than the maximum potential life.


Capital rationing occurs when management places a constraint on the size of the firm's capital


budget during a particular period.


10-2 Project classification schemes can be used to indicate how much analysis is required to evaluate a


given project, the level of the executive who must approve the project, and the cost of capital that


should be used to calculate the project's NPV. Thus, classification schemes can increase the


efficiency of the capital budgeting process.


10-3 The NPV is obtained by discounting future cash flows, and the discounting process actually


compounds the interest rate over time. Thus, an increase in the discount rate has a much greater


impact on a cash flow in Year 5 than on a cash flow in Year 1.


10-4 This question is related to Question 10-3 and the same rationale applies. With regard to the second


part of the question, the answer is no; the IRR rankings are constant and independent of the firm's cost


of capital.


10-5 The NPV and IRR methods both involve compound interest, and the mathematics of discounting


requires an assumption about reinvestment rates. The NPV method assumes reinvestment at the cost


of capital, while the IRR method assumes reinvestment at the IRR. MIRR is a modified version of


IRR which assumes reinvestment at the cost of capital.


10-6 Generally, the failure to employ common life analysis in such situations will bias the NPV against the


shorter project because it "gets no credit" for profits beyond its initial life, even though it could


possibly be "renewed" and thus provide additional NPV.




Answers and Solutions: 10 - 193 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


10-1 a. $52,125/$12,000 = 4.3438, so the payback is about 4 years.


b. Project K's discounted payback period is calculated as follows:


Annual Discounted @12%


Period Cash Flows Cash Flows Cumulative


0 ($52,125) ($52,125.00) ($52,125.00)


1 12,000 10,714.80 (41,410.20)


2 12,000 9,566.40 (31,843.80)


3 12,000 8,541.60 (23,302.20)


4 12,000 7,626.00 (15,676.20)


5 12,000 6,808.80 (8,867.40)


6 12,000 6,079.20 (2,788.20)


7 12,000 5,427.60 2,639.40


8 12,000 4,846.80 7,486.20


$2,788.20


The discounted payback period is 6 + years, or 6.51 years.


$5,427.60


Alternatively, since the annual cash flows are the same, one can divide $12,000 by 1.12 (the discount


rate = 12%) to arrive at CF1 and then continue to divide by 1.12 seven more times to obtain the


discounted cash flows (Column 3 values). The remainder of the analysis would be the same.


c. NPV = -$52,125 + $12,000[(1/i)-(1/(i*(1+i)n)]


= -$52,125 + $12,000[(1/0.12)-(1/(0.12*(1+0.12)8)]


= -$52,125 + $12,000(4.9676) = $7,486.20.


Financial calculator: Input the appropriate cash flows into the cash flow register, input I = 12, and


then solve for NPV = $7,486.68.


d. Financial calculator: Input the appropriate cash flows into the cash flow


register and then solve for IRR = 16%.




Answers and Solutions: 10 - 194 e. MIRR: PV Costs = $52,125.


FV Inflows:


PV FV


0 1 2 3 4 5 6


12% 7 8


| | | | | | | | |


12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000


13,440


15,053


16,859


18,882


21,148


23,686


26,528 52,125 MIRR = 13.89% 147,596


Financial calculator: Obtain the FVA by inputting N = 8, I = 12, PV = 0, PMT = 12000, and then solve for FV = $147,596. The MIRR can be obtained by inputting N = 8, PV = -52125, PMT = 0, FV = 147596, and then solving for I = 13.89%.




Answers and Solutions: 10 - 195 10-2 Project A:


Using a financial calculator, enter the following:


CF0 = -15000000


CF1 = 5000000


CF2 = 10000000


CF3 = 20000000


I = 10; NPV = $12,836,213.


Change I = 10 to I = 5; NPV = $16,108,952.


Change I = 5 to I = 15; NPV = $10,059,587.


Project B:


Using a financial calculator, enter the following:


CF0 = -15000000


CF1 = 20000000


CF2 = 10000000


CF3 = 6000000


I = 10; NPV = $15,954,170.


Change I = 10 to I = 5; NPV = $18,300,939.


Change I = 5 to I = 15; NPV = $13,897,838.



10-3 Truck:


NPV = -$17,100 + $5,100(PVIFA14%,5)


= -$17,100 + $5,100(3.4331) = -$17,100 + $17,509


= $409. (Accept)



Answers and Solutions: 10 - 196 Financial calculator: Input the appropriate cash flows into the cash flow register, input I = 14, and


then solve for NPV = $409.


Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for


IRR = 14.99% 15%.


MIRR: PV Costs = $17,100.


FV Inflows:


PV FV


14%


0 1 2 3 4 5


| | | | | |


5,100 5,100 5,100 5,100 5,100


5,814


6,628


7,556


8,614


17,100 MIRR = 14.54% (Accept) 33,712


Financial calculator: Obtain the FVA by inputting N = 5, I = 14, PV = 0, PMT = 5100, and then


solve for FV = $33,712. The MIRR can be obtained by inputting N = 5, PV = -17100, PMT = 0, FV


= 33712, and then solving for I = 14.54%.


Pulley:


NPV = -$22,430 + $7,500(3.4331) = -$22,430 + $25,748


= $3,318. (Accept)


Financial calculator: Input the appropriate cash flows into the cash flow register, input I = 14, and


then solve for NPV = $3,318.


Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for


IRR = 20%.


MIRR: PV Costs = $22,430.




Answers and Solutions: 10 - 197 FV Inflows:


PV FV


0 1 2 3


14% 4 5


| | | | | |


7,500 7,500 7,500 7,500 7,500


8,550


9,747


11,112


12,667


22,430 MIRR = 17.19% (Accept) 49,576


Financial calculator: Obtain the FVA by inputting N = 5, I = 14, PV = 0, PMT = 7500, and then


solve for FV = $49,576. The MIRR can be obtained by inputting N = 5, PV = -22430, PMT = 0, FV


= 49576, and then solving for I = 17.19%.


10-4 Electric-powered:


NPVE = -$22,000 + $6,290 [(1/i)-(1/(i*(1+i)n)]


= -$22,000 + $6,290 [(1/0.12)-(1/(0.12*(1+0.12)6)]


= -$22,000 + $6,290(4.1114) = -$22,000 + $25,861 = $3,861.


Financial calculator: Input the appropriate cash flows into the cash flow register, input I = 12, and


then solve for NPV = $3,861.


Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for


IRR = 18%.


Gas-powered:


NPVG = -$17,500 + $5,000 [(1/i)-(1/(i*(1+i)n)]


= -$17,500 + $5,000 [(1/0.12)-(1/(0.12*(1+0.12)6)]


= -$17,500 + $5,000(4.1114) = -$17,500 + $20,557 = $3,057.


Financial calculator: Input the appropriate cash flows into the cash flow register, input I = 12, and


then solve for NPV = $3,057.


Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for


IRR = 17.97% 18%.


The firm should purchase the electric-powered forklift because it has a higher NPV than the


gas-powered forklift. The company gets a high rate of return (18% > r = 12%) on a larger


investment.




Answers and Solutions: 10 - 198 10-5 Financial calculator solution, NPV:


Project S


Inputs 5 12 3000 0


N I PV PMT FV


Output = -10,814.33


NPVS = $10,814.33 - $10,000 = $814.33.


Project L


Inputs 5 12 7400 0


N I PV PMT FV


Output = -26,675.34


NPVL = $26,675.34 - $25,000 = $1,675.34.


Financial calculator solution, IRR:


Input CF0 = -10000, CF1 = 3000, Nj = 5, IRRS = ? IRRS = 15.24%.


Input CF0 = -25000, CF1 = 7400, Nj = 5, IRRL = ? IRRL = 14.67%.


Financial calculator solution, MIRR:


Project S


Inputs 5 12 0 3000


N I PV PMT FV


Output = -19,058.54


PV costsS = $10,000.


FV inflowsS = $19,058.54.


Inputs 5 -10000 0 19058.54


N I PV PMT FV


Output = 13.77


MIRRS = 13.77%.



Project L


Inputs 5 12 0 7400


N I PV PMT FV


Answers and Solutions: 10 - 199 Output = -47,011.07


PV costsL = $25,000.


FV inflowsL = $47,011.07.


Inputs 5 -25000 0 47011.07


N I PV PMT FV


Output = 13.46


MIRRL = 13.46%.


$10,814.33 $26,675.34 PIS = = 1.081. PIL = = 1.067.


$10,000 $25,000


Thus, NPVL > NPVS, IRRS > IRRL, MIRRS > MIRRL, and PIS > PIL. The scale difference between Projects S and L result in the IRR, MIRR, and PI favoring S over L. However, NPV favors Project L, and hence L should be chosen.




Answers and Solutions: 10 - 200 10-6 Project X: 0 1 2 3


12% 4


| | | | |


-1,000 100 300 400


700.00


448.00


376.32


140.49


1,664.81


1,000 13.59% = MIRRX`


$1,000 = $1,664.81/(1 + MIRRX)4.


Project Y: 0 1 2 3


12%


4


| | | | |


-1,000 1,000 100 50


50.00


56.00


125.44


1,404.93


1,636.37


1,000 13.10% = MIRRY


$1,000 = $1,636.37/(1 + MIRRY)4.


Thus, since MIRRX > MIRRY, Project X should be chosen.


Alternative step: You could calculate NPVs, see that Project X has the higher NPV, and just


calculate MIRRX.


NPVX = $58.02 and NPVY = $39.94.


10-7 a. Purchase price $ 900,000


Installation 165,000


Initial outlay $1,065,000


CF0 = -1065000; CF1-5 = 350000; I = 14; NPV = ?


NPV = $136,578; IRR = 19.22%.


b. Ignoring environmental concerns, the project should be undertaken because its


NPV is positive and its IRR is greater than the firm's cost of capital.


c. Environmental effects could be added by estimating penalties or any other cash outflows that


might be imposed on the firm to help return the land to its previous state (if possible). These


outflows could be so large as to cause the project to have a negative NPV--in which case the


project should not be undertaken.




Answers and Solutions: 10 - 201 10-8 a.


NPV


($)


1,000


900


800


700


600


500


Project A


400


300


200 Project B


100 Cost of


Capital (%)


5 10 15 20 25 30


-100


-200


-300




r NPVA NPVB


0.0% $890 $399


10.0 283 179


12.0 200 146


18.1 0 62


20.0 (49) 41


24.0 (138) 0


30.0 (238) (51)



b. IRRA = 18.1%; IRRB = 24.0%.


c. At r = 10%, Project A has the greater NPV, specifically $283.34 as compared to


Project B's NPV of $178.60. Thus, Project A would be selected. At r = 17%,


Project B has an NPV of $75.95 which is higher than Project A's NPV of $31.05.


Thus, choose Project B if r = 17%.




Answers and Solutions: 10 - 202 d. Here is the MIRR for Project A when r = 10%:


PV costs = $300 + $387/(1.10)1 + $193/(1.10)2


+ $100/(1.10)3 + $180/(1.10)7 = $978.82.


TV inflows = $600(1.10)3 + $600(1.10)2 + $850(1.10)1 = $2,459.60.


Now, MIRR is that discount rate which forces the TV of $2,459.60 in 7 years to equal $978.82:


$952.00 = $2,547.60(1+MIRR)7.


MIRRA = 14.07%.


Similarly, MIRRB = 15.89%.


At r = 17%,


MIRRA = 17.57%.


MIRRB = 19.91%.


e. To find the crossover rate, construct a Project which is the difference in the two projects' cash


flows:


Project =


Year CFA - CFB


0 $105


1 (521)


2 (327)


3 (234)


4 466


5 466


6 716


7 (180)


IRR = Crossover rate = 14.53%.


Projects A and B are mutually exclusive, thus, only one of the projects can be chosen. As long


as the cost of capital is greater than the crossover rate, both the NPV and IRR


methods will lead to the same project selection. However, if the cost of capital is


less than the crossover rate the two methods lead to different project selections--a


conflict exists. When a conflict exists the NPV method must be used.


Because of the sign changes and the size of the cash flows, Project has multiple IRRs.


Thus, a calculator's IRR function will not work. One could use the trial and error method of


entering different discount rates until NPV = $0. However, an HP can be "tricked" into giving


the roots. After you have keyed Project Delta's cash flows into the g register of an HP-10B, you


will see an "Error-Soln" message. Now enter 10 STO IRR/YR and the 14.53% IRR is


found. Then enter 100 STO IRR/YR to obtain IRR = 456.22%. Similarly, Excel or Lotus


1-2-3 can also be used.


10-9 a. Incremental Cash


Year Plan B Plan A Flow (B - A)


0 ($10,000,000) ($10,000,000) $ 0


1 1,750,000 12,000,000 (10,250,000)



Answers and Solutions: 10 - 203 2-20 1,750,000 0 1,750,000


If the firm goes with Plan B, it will forgo $10,250,000 in Year 1, but will receive $1,750,000 per


year in Years 2-20.


b. If the firm could invest the incremental $10,250,000 at a return of 16.07%, it would receive cash


flows of $1,750,000. If we set up an amortization schedule, we would find that payments of


$1,750,000 per year for 19 years would amortize a loan of $10,250,000 at 16.0665%.


Financial calculator solution:


Inputs 19 -10250000 1750000 0


N I PV PMT FV


Output = 16.0665


c. Yes, assuming (1) equal risk among projects, and (2) that the cost of capital is a constant and does


not vary with the amount of capital raised.


d. See graph. If the cost of capital is less than 16.07%, then Plan B should be accepted; if r >


16.07%, then Plan A is preferred.


NPV ( Mi l l i ons of Dol l ar s)


25




B


20




15




10 Cr ossover Rat e = 16. 07%



A


I RRB = 16. 7%


5


I RRA = 20%



Cost of


Capi t al ( %)


5 10 15 20 25




Answers and Solutions: 10 - 204 10-10 a. Financial calculator solution:


Plan A


Inputs 20 10 8000000 0


N I PV PMT FV


Output = -68,108,510


NPVA = $68,108,510 - $50,000,000 = $18,108,510.


Plan B


Inputs 20 10 3400000 0


N I PV PMT FV


Output = -28,946,117


NPVB = $28,946,117 - $15,000,000 = $13,946,117.


Plan A


Inputs 20 -50000000 8000000 0


N I PV PMT FV


Output = 15.03


IRRA = 15.03%.


Plan B


Inputs 20 -15000000 3400000 0


N I PV PMT FV


Output = 22.26


IRRB = 22.26%.




Answers and Solutions: 10 - 205 b. If the company takes Plan A rather than B, its cash flows will be (in millions of dollars):


Cash Flows Cash Flows Project


Year from A from B Cash


Flows


0 ($50) ($15.0)


($35.0)


1 8 3.4


4.6


2 8 3.4


4.6


. . .


.


. . .


.


. . . .


20 8 3.4 4.6


So, Project has a "cost" of $35,000,000 and "inflows" of $4,600,000 per year for 20 years.


Inputs 20 10 4600000 0


N I PV PMT FV


Output = -39,162,393


NPV = $39,162,393 - $35,000,000 = $4,162,393.


Inputs 2 -35000000 4600000 0


N I PV PMT FV


Output = 11.71


IRR = 11.71%.


Since IRR > r, and since we should accept . This means accept the larger project (Project A).


In addition, when dealing with mutually exclusive projects, we use the NPV method for choosing


the best project.




Answers and Solutions: 10 - 206 c.


N P V ( Mi l l i o n s o f D o l l a r s )


125



A


100 Cr oss over Rat e = 11. 7%



75 B



50 I RRA = 1 5. 03%


I RRB = 2 2 . 2 6 %


25




5 10 15 20 25 30


C o s t o f C a p i t a l ( %)


-25



I RR = 11 . 7%


-50



d. The NPV method implicitly assumes that the opportunity exists to reinvest the cash flows


generated by a project at the cost of capital, while use of the IRR method implies the opportunity


to reinvest at the IRR. If the firm's cost of capital is constant at 10 percent, all projects with an


NPV > 0 will be accepted by the firm. As cash flows come in from these projects, the firm will


either pay them out to investors, or use them as a substitute for outside capital which costs 10


percent. Thus, since these cash flows are expected to save the firm 10 percent, this is their


opportunity cost reinvestment rate.


The IRR method assumes reinvestment at the internal rate of return itself, which is an


incorrect assumption, given a constant expected future cost of capital, and ready access to capital


markets.



10-11 a. The project's expected cash flows are as follows (in millions of dollars):


Time Net Cash Flow


0 ($ 4.4)


1 27.7


2 (25.0)




Answers and Solutions: 10 - 207 We can construct the following NPV profile:


NP V ( Mi l l i o n s o f Do l l a r s )


Ma x i mu m


3 NP V a t 8 0 . 5 %



2



1


Di s c o u n t


Ra t e ( %)


10 20 80.5 420



-1


I RR 1 = 9 . 2 % I RR2 = 4 20%


-2



-3


NPV appr oac hes - $4. 0 as


t he cost of capi t al


-4 appr oaches


-4. 4




Discount Rate NPV


0% ($1,700,000)


9 (29,156)


10 120,661


50 2,955,556


100 3,200,000


200 2,055,556


300 962,500


400 140,000


410 70,204


420 2,367


430 (63,581)


The table above was constructed using a financial calculator with the following inputs: CF0 =


-4400000, CF1 = 27700000, CF2 = -25000000, and I = discount rate to solve for the NPV.


b. If r = 8%, reject the project since NPV < 0. But if r = 14%, accept the project because NPV > 0.


c. Other possible projects with multiple rates of return could be nuclear power plants where disposal


of radioactive wastes is required at the end of the project's life, or leveraged leases where the


borrowed funds are repaid at the end of the lease life. (See Chapter 20 for more information on


leases.)


d. Here is the MIRR for the project when r = 8%:


PV costs = $4,400,000 + $25,000,000/(1.08)2 = $25,833,470.51.


Answers and Solutions: 10 - 208 TV inflows = $27,700,000(1.08)1 = $29,916,000.00.


Now, MIRR is that discount rate which forces the PV of the TV of $29,916,000 over 2 years to


equal $25,833,470.51:


$25,833,470.51 = $29,916,000(PVIFr,2).


Inputs 2 -25833470.51 0 29916000


N I PV PMT FV


Output = 7.61


MIRR = 7.61%.


At r = 14%,


Inputs 2 -23636688.21 0 31578000


N I PV PMT FV


Output = 15.58


MIRR = 15.58%.


PV costs = $4,400,000 + $25,000,000/(1.14)2 = $23,636,688.21.


TV inflows = $27,700,000(1.14)1 = $31,578,000.


Now, MIRR is that discount rate which forces the PV of the TV of $31,578,000 over 2 years to


equal $23,636,688.21:


$23,636,688.21 = $31,578,000(PVIFr,2).


Yes. The MIRR method leads to the same conclusion as the NPV method. Reject the project if


r = 8%, which is greater than the corresponding MIRR of 7.61%, and accept the


project if r = 14%, which is less than the corresponding MIRR of 15.58%.


10-12 a. The IRRs of the two alternatives are undefined. To calculate an IRR, the cash flow stream must


include both cash inflows and outflows.


b. The PV of costs for the conveyor system is ($911,067), while the PV of costs for the forklift


system is ($838,834). Thus, the forklift system is expected to be ($838,834) - ($911,067) =


$72,233 less costly than the conveyor system, and hence the forklift trucks should be used.


Financial calculator solution:


Input: CF0 = -500000, CF1 = -120000, Nj = 4, CF2 = -20000, I = 8, NPVC = ? NPVC =


-911,067.


Answers and Solutions: 10 - 209 Input: CF0 = -200000, CF1 = -160000, N1 = 5, I = 8, NPVF = ? NPVF = -838,834.


10-13 a. Payback A (cash flows in thousands):


Annual


Period Cash Flows Cumulative


0 ($25,000) ($25,000)


1 5,000 (20,000)


2 10,000 (10,000)


3 15,000 5,000


4 20,000 25,000


PaybackA = 2 + $10,000/$15,000 = 2.67 years.




Payback B (cash flows in thousands):


Annual


Period Cash Flows Cumulative


0 ($25,000) $25,000)


1 20,000 (5,000)


2 10,000 5,000


3 8,000 13,000


4 6,000 19,000


PaybackB = 1 + $5,000/$10,000 = 1.50 years.




Answers and Solutions: 10 - 210 b. Discounted payback A (cash flows in thousands):


Annual Discounted @10%


Period Cash Flows Cash Flows Cumulative


0 ($25,000) ($25,000.00) ($25,000.00)


1 5,000 4,545.45 ( 20,454.55)


2 10,000 8,264.46 ( 12,190.09)


3 15,000 11,269.72 ( 920.37)


4 20,000 13,660.27 12,739.90


Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.


Discounted payback B (cash flows in thousands):


Annual Discounted @10%


Period Cash Flows Cash Flows Cumulative


0 ($25,000) ($25,000.00) ($25,000.00)


1 20,000 18,181.82 ( 6,818.18)


2 10,000 8,264.46 1,446.28


3 8,000 6,010.52 7,456.80


4 6,000 4,098.08 11,554.88


Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.


c. NPVA = $12,739,908; IRRA = 27.27%.


NPVB = $11,554,880; IRRB = 36.15%.


Both projects have positive NPVs, so both projects should be undertaken.


d. At a discount rate of 5%, NPVA = $18,243,813.


At a discount rate of 5%, NPVB = $14,964,829.


At a discount rate of 5%, Project A has the higher NPV; consequently, it should be accepted.


e. At a discount rate of 15%, NPVA = $8,207,071.


At a discount rate of 15%, NPVB = $8,643,390.


At a discount rate of 15%, Project B has the higher NPV; consequently, it should be accepted.


f. Project =


Year CFA - CFB


0 $ 0


1 (15)


2 0


3 7


4 14


IRR = Crossover rate = 13.5254% 13.53%.


g. Use 3 steps to calculate MIRRA @ r = 10%:



Answers and Solutions: 10 - 211 Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be calculated.


With a financial calculator, enter the cash flow stream into the cash flow registers,


then enter I = 10, and solve for NPV = $37,739,908.


Step 2: Calculate the FV of the cash flow stream as follows:


Enter N = 4, I = 10, PV = -37739908, and PMT = 0 to solve for FV = $55,255,000.


Step 3: Calculate MIRRA as follows:


Enter N = 4, PV = -25000000, PMT = 0, and FV = 55255000 to solve for I = 21.93%.


Use 3 steps to calculate MIRRB @ r = 10%:


Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be calculated.


With a financial calculator, enter the cash flow stream into the cash flow registers,


then enter I = 10, and solve for NPV = $36,554,880.


Step 2: Calculate the FV of the cash flow stream as follows:


Enter N = 4, I = 10, PV = -36554880, and PMT = 0 to solve for FV = $53,520,000.


Step 3: Calculate MIRRB as follows:


Enter N = 4, PV = -25000000, PMT = 0, and FV = 53520000 to solve for I = 20.96%.


According to the MIRR approach, if the 2 projects were mutually exclusive, Project A would be chosen because it has the higher MIRR. This is consistent with the NPV approach.




Answers and Solutions: 10 - 212 10-14 Plane A: Expected life = 5 years; Cost = $100 million; NCF = $30 million; COC = 12%.


Plane B: Expected life = 10 years; Cost = $132 million; NCF = $25 million; COC = 12%.


0 1 2 3 4 5 6 7 8 9 10


A: | | | | | | | | | | |


-100 30 30 30 30 30 30 30 30 30 30


-100


-70


Enter these values into the cash flow register: CF0 = -100; CF1-4 = 30; CF5 = -70; CF6-10 = 30.


Then enter I = 12, and press the NPV key to get NPVA = 12.764 $12.76 million.



0 1 2 3 4 5 6 7 8 9 10


B: | | | | | | | | | | |


-132 25 25 25 25 25 25 25 25 25 25


Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV


key to get NPVB = 9.256 $9.26 million.


Project A is the better project and will increase the company's value by $12.76 million.


10-15 0 1 2 3 4 5 6 7 8


A: | | | | | | | | |


-10 4 4 4 4 4 4 4 4


-10


-6


Machine A's simple NPV is calculated as follows: Enter CF0 = -10 and CF1-4 = 4. Then enter I


= 10, and press the NPV key to get NPVA = $2.679 million. However, this does not consider the


fact that the project can be repeated again. Enter these values into the cash flow register: CF0


= -10; CF1-3 = 4; CF4 = -6; CF5-8 = 4. Then enter I = 10, and press the NPV key to get Extended


NPVA = $4.5096 $4.51 million.


0 1 2 3 4 5 6 7 8


B: | | | | | | | | |


-15 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5


Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV


key to get NPVB = $3.672 $3.67 million.


Machine A is the better project and will increase the company's value by $4.51 million.



Answers and Solutions: 10 - 213 10-16 a. Using a financial calculator, input the following: CF0 = -190000, CF1 = 87000, Nj = 3, and I =


14 to solve for NPV190-3 = $11,981.99 $11,982 (for 3 years).


Adjusted NPV190-3 = $11,982 + $11,982/(1.14)3 = $20,070.


Using a financial calculator, input the following: CF0 = -360000, CF1 = 98300, Nj = 6, and I =


14 to solve for NPV360-6 = $22,256.02 $22,256 (for 6 years).


Both new machines have positive NPVs, hence the old machine should be replaced. Further,


since its adjusted NPV is greater, choose Model 360-6.


10-17 a. NPV of termination after Year t:


NPV0 = -$22,500 + $22,500 = 0.


Using a financial calculator, input the following: CF0 = -22500, CF1 = 23750, and I = 10 to


solve for NPV1 = -$909.09 -$909.


Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, CF2 = 20250, and I


= 10 to solve for NPV2 = -$82.64 -$83.


Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 2, CF3 =


17250, and I = 10 to solve for NPV3 = $1,307.29 $1,307.


Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 3, CF4 =


11250, and I = 10 to solve for NPV4 = $726.73 $727.


Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 5, and I = 10


to solve for NPV5 = $1,192.42 $1,192.


The firm should operate the truck for 3 years, NPV3 = $1,307.


b. No. Salvage possibilities could only raise NPV and IRR. The value of the firm is maximized


by terminating the project after Year 3.




Answers and Solutions: 10 - 214 SOLUTION TO SPREADSHEET PROBLEM



10-18 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 10 P18 Build a Model.xls) and on the instructor's side of the web site,


brigham.swcollege.com.




Answers and Solutions: 10 - 215 MINI CASE



You have just graduated from the MBA program of a large university, and one of your favorite courses was "Today's Entrepreneurs." In fact, you enjoyed it so much you have decided you want to "be your own boss." While you were in the master's program, your grandfather died and left you $300,000 to do with as you please. You are not an inventor and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else.


You have narrowed your selection down to two choices; (1) Franchise L: Lisa's Soups, Salads, & Stuff and (2) Franchise S: Sam's Wonderful Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in year 3 and the forecast of how each franchise will do over the three-year period. Franchise L's cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: you could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds with the franchises directly competing against one another.


Here are the projects' net cash flows (in thousands of dollars):


Expected Net Cash Flow


Year Franchise L Franchise S


0 ($100) ($100)


1 10 70


2 60 50


3 80 20


Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.


You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require a return of 10 percent. You must now determine whether one or both of the projects should be accepted.




Answers and Solutions: 11 - 216 a. What is capital budgeting?


Answer: Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is


important because, more than anything else, fixed asset investment decisions chart a company's


course for the future. Conceptually, the capital budgeting process is identical to the decision


process used by individuals making investment decisions. These steps are involved:


1. Estimate the cash flows--interest and maturity value or dividends in the case of bonds and


stocks, operating cash flows in the case of capital projects.


2. Assess the riskiness of the cash flows.


3. Determine the appropriate discount rate, based on the riskiness of the cash flows and the


general level of interest rates. This is called the project cost of capital in capital budgeting.


4. Evaluate the cash flows.


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


Answer: Projects are independent if the cash flows of one are not affected by the acceptance of the other.


Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash


flows of the other; that is, at most one of two or more such projects may be accepted. Put


another way, when projects are mutually exclusive it means that they do the same job. For


example, a forklift truck versus a conveyor system to move materials, or a bridge versus a ferry


boat.


Projects with normal cash flows have outflows, or costs, in the first year (or years) followed


by a series of inflows. Projects with nonnormal cash flows have one or more outflows after the


inflow stream has begun. Here are some examples:


Inflow (+) Or Outflow (-) In Year


0 1 2 3 4 5


Normal - + + + + +


- - + + + +


- - - + + +


Nonnormal - + + + + -


- + + - + -


+ + + - - -




Answers and Solutions: 11 - 217 c. 1. What is the payback period? Find the paybacks for franchises L and S.


Answer: The payback period is the expected number of years required to recover a project's cost. We


calculate the payback by developing the cumulative cash flows as shown below for project l (in


thousands of dollars):


Expected NCF


Year Annual Cumulative


0 ($100) ($100)


1 10 (90)


2 60 Payback is between t = 2


(30)


3 80 50 and t = 3


0 1 2 3


| | | |


-100 10 60 80


-90 -30 +50


Franchise L's $100 investment has not been recovered at the end of year 2, but it has been more


than recovered by the end of year 3. Thus, the recovery period is between 2 and 3 years. If we


assume that the cash flows occur evenly over the year, then the investment is recovered $30/$80 =


0.375 0.4 into year 3. Therefore, paybackL = 2.4 years. Similarly, paybackS = 1.6 years.


c. 2. What is the rationale for the payback method? According to the payback criterion, which


franchise or franchises should be accepted if the firm's maximum acceptable payback is 2


years, and if franchises L and S are independent? If they are mutually exclusive?


Answer: Payback represents a type of "breakeven" analysis: the payback period tells us when the project


will break even in a cash flow sense. With a required payback of 2 years, franchise S is


acceptable, but franchise L is not. Whether the two projects are independent or mutually


exclusive makes no difference in this case.




Answers and Solutions: 11 - 218 c. 3. What is the difference between the regular and discounted payback periods?


Answer: Discounted payback is similar to payback except that discounted rather than raw cash flows are


used.


Setup for franchise L's discounted payback, assuming a 10% cost of capital:


Expected Net Cash Flows


Year Raw Discounted Cumulative


0 ($100) ($100.00) ($100.00)


1 10 9.09 (90.91)


2 60 49.59 (41.32)


3 80 60.11 18.79


Discounted PaybackL = 2 + ($41.32/$60.11) = 2.69 = 2.7 years.


Versus 2.4 years for the regular payback.


c. 4. What is the main disadvantage of discounted payback? Is the payback method of any real


usefulness in capital budgeting decisions?


Answer: Regular payback has two critical deficiencies: (1) it ignores the time value of money, and (2) it


ignores the cash flows that occur after the payback period. Discounted payback does consider


the time value of money, but it still fails to consider cash flows after the payback period; hence it


has a basic flaw. In spite of its deficiency, many firms today still calculate the discounted


payback and give some weight to it when making capital budgeting decisions. However,


payback is not generally used as the primary decision tool. Rather, it is used as a rough measure


of a project's liquidity and riskiness.




Answers and Solutions: 11 - 219 d. 1. Define the term net present value (NPV). What is each franchise's NPV?


Answer: The net present value (NPV) is simply the sum of the present values of a project's cash flows:


n


CF


NPV = (1 + rt) t .


t =0


Franchise L'S NPV is $18.79:


0 1 2 3


| 10%| | |


(100.00) 10 60 80


9.09


49.59


60.11


18.79 = NPVL


NPVs are easy to determine using a calculator with an NPV function. Enter the cash flows


sequentially, with outflows entered as negatives; enter the cost of capital; and then press the NPV


button to obtain the project's NPV, $18.78 (note the penny rounding difference). The NPV of


franchise S is NPVS = $19.98.


d. 2. What is the rationale behind the NPV method? According to NPV, which franchise or


franchises should be accepted if they are independent? Mutually exclusive?


Answer: The rationale behind the NPV method is straightforward: if a project has NPV = $0, then the


project generates exactly enough cash flows (1) to recover the cost of the investment and (2) to


enable investors to earn their required rates of return (the opportunity cost of capital). If NPV = $0,


then in a financial (but not an accounting) sense, the project breaks even. If the NPV is positive,


then more than enough cash flow is generated, and conversely if NPV is negative.


Consider franchise L's cash inflows, which total $150. They are sufficient (1) to return the


$100 initial investment, (2) to provide investors with their 10 percent aggregate opportunity cost


of capital, and (3) to still have $18.79 left over on a present value basis. This $18.79 excess PV


belongs to the shareholders--the debtholders' claims are fixed, so the shareholders' wealth will be


increased by $18.79 if franchise L is accepted. Similarly, Axis's shareholders gain $19.98 in


value if franchise S is accepted.


If franchises L and S are independent, then both should be accepted, because they both add to


shareholders' wealth, hence to the stock price. If the franchises are mutually exclusive, then


franchise S should be chosen over L, because s adds more to the value of the firm.


d. 3. Would the NPVs change if the cost of capital changed?


Answer: The NPV of a project is dependent on the cost of capital used. Thus, if the cost of capital changed,


the NPV of each project would change. NPV declines as r increases, and NPV rises as r falls.




Answers and Solutions: 11 - 220 e. 1. Define the term Internal Rate Of Return (IRR). What is each franchise's IRR?


Answer: The internal rate of return (IRR) is that discount rate which forces the NPV of a project to equal


zero:


0 1 2 3


| IRR| | |


CF0 CF1 CF2 CF3


PVCF1


PVCF2


PVCF3


0 = SUM OF PVs = NPV.


Expressed as an equation, we have:


n


CF


IRR: (1 + IRR ) t


t = $0 = NPV.


t =0


Note that the IRR equation is the same as the NPV equation, except that to find the IRR the


equation is solved for the particular discount rate, IRR, which forces the project's


NPV to equal zero (the IRR) rather than using the cost of capital (r) in the


denominator and finding NPV. Thus, the two approaches differ in only one respect:


in the NPV method, a discount rate is specified (the project's cost of capital) and the


equation is solved for NPV, while in the IRR method, the NPV is specified to equal


zero and the discount rate (IRR) which forces this equality is found.


Franchise L's IRR is 18.1 percent:


0 1 2


18.1% 3


| | | |


-100.00 10 60 80


8.47


43.02


48.57


$ 0.06 $0 if IRRL = 18.1% is used as the discount rate.


therefore, IRRL 18.1%.




A financial calculator is extremely helpful when calculating IRRs. The cash flows are entered


sequentially, and then the IRR button is pressed. For franchise S, IRRS 23.6%. Note that


with many calculators, you can enter the cash flows into the cash flow register, also enter r = i,


and then calculate both NPV and IRR by pressing the appropriate buttons.



e. 2. How is the IRR on a project related to the YTM on a bond?



Answers and Solutions: 11 - 221 Answer: The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the


project, just as the YTM is the promised rate of return on a bond.


e. 3. What is the logic behind the IRR method? According to IRR, which franchises should be


accepted if they are independent? Mutually exclusive?


Answer: IRR measures a project's profitability in the rate of return sense: if a project's IRR equals its cost


of capital, then its cash flows are just sufficient to provide investors with their required rates of


return. An IRR greater than r implies an economic profit, which accrues to the firm's


shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn


enough to cover its cost of capital.


Projects' IRRs are compared to their costs of capital, or hurdle rates. Since franchises L and


S both have a hurdle rate of 10 percent, and since both have IRRs greater than that hurdle rate,


both should be accepted if they are independent. However, if they are mutually exclusive,


franchise S would be selected, because it has the higher IRR.



e. 4. Would the franchises' IRRs change if the cost of capital changed?


Answer: IRRs are independent of the cost of capital. Therefore, neither IRRS nor IRRL would change if r


changed. However, the acceptability of the franchises could change--L would be rejected if r


were above 18.1%, and S would also be rejected if r were above 23.6%.


f. 1. Draw NPV profiles for franchises L and S. At what discount rate do the profiles cross?


Answer: the NPV profiles are plotted in the figure below.


Note the following points:


1. The y-intercept is the project's NPV when r = 0%. This is $50 for L and $40 for S.


2. The x-intercept is the project's IRR. This is 18.1 percent for l and 23.6 percent for S.


3. NPV profiles are curves rather than straight lines. To see this, note that these profiles


approach cost = -$100 as r approaches infinity.


4. From the figure below, it appears that the crossover point is between 8 and 9 percent. The


precise value is approximately 8.7 percent. One can calculate the crossover rate by (1)


going back to the data on the problem, finding the cash flow differences for each year, (2)


entering those differences into the cash flow register, and (3) pressing the IRR button to get


the crossover rate, 8.68% 8.7%.




Answers and Solutions: 11 - 222 60



50



40


Crossover


Point = 8.7%


30



20


S


10


IRRS = 23.6%


L


0 Discount Rate (%)


0 5 10 15 20 23.6


-10


IRRL = 18.1%


r NPVL NPVS


0% $50 $40


5 33


29


10 19


20


15 7


12


20 (4)


5


f. 2. Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which


franchise or franchises should be accepted if they are independent? Mutually exclusive?


Explain. Are your answers correct at any cost of capital less than 23.6 percent?


Answer: The NPV profiles show that the IRR and NPV criteria lead to the same accept/reject decision for


any independent project. Consider franchise L. It intersects the x-axis at its IRR, 18.1 percent.


According to the IRR rule, L is acceptable if r is less than 18.1 percent. Also, at any r less than


18.1 percent, L's NPV profile will be above the x axis, so its NPV will be greater than $0. Thus,


for any independent project, NPV and IRR lead to the same accept/reject decision.


Now assume that L and S are mutually exclusive. In this case, a conflict might arise. First,


note that IRRS = 23.6% > 18.1% = therefore, regardless of the size of r, project S would be


ranked higher by the IRR criterion. However, the NPV profiles show that NPVL > NPVS if r is


less than 8.7 percent. Therefore, for any r below the 8.7% crossover rate, say r = 7 percent, the


NPV rule says choose L, but the IRR rule says choose S. Thus, if r is less than the crossover rate,


a ranking conflict occurs.




Answers and Solutions: 11 - 223 g. 1. What is the underlying cause of ranking conflicts between NPV and IRR?


Answer: For normal projects' NPV profiles to cross, one project must have both a higher vertical axis


intercept and a steeper slope than the other. A project's vertical axis intercept typically depends


on (1) the size of the project and (2) the size and timing pattern of the cash flows--large projects,


and ones with large distant cash flows, would generally be expected to have relatively high


vertical axis intercepts. The slope of the NPV profile depends entirely on the timing pattern of


the cash flows--long-term projects have steeper NPV profiles than short-term ones. Thus, we


conclude that NPV profiles can cross in two situations: (1) when mutually exclusive projects


differ in scale (or size) and (2) when the projects' cash flows differ in terms of the timing pattern


of their cash flows (as for franchises L and S).


g. 2. What is the "reinvestment rate assumption", and how does it affect the NPV versus IRR


conflict?


Answer: The underlying cause of ranking conflicts is the reinvestment rate assumption. All DCF methods


implicitly assume that cash flows can be reinvested at some rate, regardless of what is actually


done with the cash flows. Discounting is the reverse of compounding. Since compounding


assumes reinvestment, so does discounting. NPV and IRR are both found by discounting, so


they both implicitly assume some discount rate. Inherent in the NPV calculation is the


assumption that cash flows can be reinvested at the project's cost of capital, while the IRR


calculation assumes reinvestment at the IRR rate.




Answers and Solutions: 11 - 224 g. 3. Which method is the best? Why?


Answer: Whether NPV or IRR gives better rankings depends on which has the better reinvestment rate


assumption. Normally, the NPV's assumption is better. The reason is as follows: a project's


cash inflows are generally used as substitutes for outside capital, that is, projects' cash flows


replace outside capital and, hence, save the firm the cost of outside capital. Therefore, in an


opportunity cost sense, a project's cash flows are reinvested at the cost of capital. To see this


graphically, think of the following situation: assume the firm's cost of capital is a constant 10%


within the relevant range of financing considered, and it has projects available as shown in the


graph below:


Percent


I RRA = 25%


25




I RRB = 20%


20




IRRC = 15%


15



IRRD = 12%


MCC


10


IRRE = 8%



5 I RRF = 5%



Dollars Raised and Invested




What projects will be accepted, by either NPV or IRR? Projects A, B, C, and D.


If the same situation exists year after year, at what rate of return will cash flows from earlier


years' investments be reinvested? Capital budgeting decisions are made in this sequence: (1)


the company would say, "we can take on A, B, C, and D and finance them with 10% money, so


let's do it." (2) then, it would get cash flows from earlier years' projects. What would it do with


those cash flows? It would use them in lieu of raising money that costs 10%, so it would save


10%. Therefore, 10% is the opportunity cost of the cash flows. In effect, cash flows are


reinvested at the 10% cost of capital.


Note, however, that NPV and IRR always give the same accept/reject decisions for


independent projects, so IRR can be used just as well as NPV when independent projects are


being evaluated. The NPV versus IRR conflict arises only if mutually exclusive projects are


involved.




Answers and Solutions: 11 - 225 h. 1. Define the term Modified IRR (MIRR). Find the MIRRs for franchises L and S.


Answer: MIRR is that discount rate which equates the present value of the terminal value of the inflows,


compounded at the cost of capital, to the present value of the costs. Here is the setup for


calculating franchise L's modified IRR:


0 1 2 3 r = 10%


| | | |


PV Of Costs = (100.00) 10 60 80.00


66.00


12.10


TV OF INFLOWS


= 158.10


MIRR = ?


PV Of TV = 100.00


$158.10


= $100 = .


(1 + MIRR ) 3


n


n


COF


CIFt (1 + r ) n - t


TV


PV costs =


n


= (1 + r )t t = t =1 .


(1 + MIRR ) t =0 (1 + MIRR ) n


After you calculate the TV, enter n = 3, PV = -100, pmt = 0, fv = 158.1, and then press i to get the


answer, MIRRL = 16.5%. We could calculate MIRRS similarly: = 16.9%. Thus, franchise S is


ranked higher than L. This result is consistent with the NPV decision.


h. 2. What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are


the MIRR's advantages and disadvantages vis-a-vis the NPV?


Answer: MIRR is a better rate of return measure than IRR for two reasons: (1) it correctly assumes


reinvestment at the project's cost of capital rather than at its IRR. (2) MIRR avoids the problem


of multiple IRRs--there can be only one MIRR for a given project.


MIRR does not always lead to the same decision as NPV when mutually exclusive projects


are being considered. In particular, small projects often have a higher MIRR, but a lower NPV,


than larger projects. Thus, MIRR is not a perfect substitute for NPV, and NPV remains the


single best decision rule. However, MIRR is superior to the regular IRR, and if a rate of return


measure is needed, MIRR should be used.


Business executives agree. As noted in the text, business executives prefer to compare


projects' rates of return to comparing their NPVs. This is an empirical fact. As a result,


financial managers are substituting MIRR for IRR in their discussions with other corporate


executives. This fact was brought out in the October 1989 FMA meetings, where executives


from Du Pont, Hershey, and Ameritech, among others, all reported a switch from IRR to MIRR.




Answers and Solutions: 11 - 226 i. As a separate project (project P), you are considering sponsoring a pavilion at the upcoming


world's fair. The pavilion would cost $800,000, and it is expected to result in $5 million of


incremental cash inflows during its 1 year of operation. However, it would then take


another year, and $5 million of costs, to demolish the site and return it to its original


condition. Thus, project P's expected net cash flows look like this (in millions of dollars):


Year Net Cash Flows


0 ($0.8)


1 5.0


2 (5.0)


The project is estimated to be of average risk, so its cost of capital is 10 percent.


i. 1. What are normal and nonnormal cash flows?


Answer: Normal cash flows begin with a negative cash flow (or a series of negative cash flows), switch to


positive cash flows, and then remain positive. They have only one change in sign. (Note:


normal cash flows can also start with positive cash flows, switch to negative cash flows, and then


remain negative.) Nonnormal cash flows have more than one sign change. For example, they


may start with negative cash flows, switch to positive, and then switch back to negative.


i. 2. What is project P's NPV? What is its IRR? Its MIRR?


Answer: Here is the time line for the cash flows, and the NPV:


0 1 2 10%


| | |


-800,000 5,000,000 -5,000,000


NPVP = -$386,776.86.


We can find the NPV by entering the cash flows into the cash flow register, entering i = 10, and


then pressing the NPV button. However, calculating the IRR presents a problem. With the


cash flows in the register, press the IRR button. An hp-10b financial calculator will give the


message "error-soln." This means that project P has multiple IRRs. An HP-17B will ask for a


guess. If you guess 10%, the calculator will produce IRR = 25%. If you guess a high number,


such as 200%, it will produce the second IRR, 400%1. The MIRR of project P = 5.6%, and is


found by computing the discount rate that equates the terminal value ($5.5 million) to the present


value of cost ($4.93 million).



1


Looking at the figure below, if you guess an IRR to the left of the peak NPV rate, the lower IRR will appear. If you guess IRR > peak NPV rate, the higher IRR will appear.


Answers and Solutions: 11 - 227 i. 3. Draw project P's NPV profile. Does project P have normal or non-normal cash flows?


Should this project be accepted?


Answer: You could put the cash flows in your calculator and then enter a series of i values, get an NPV for


each, and then plot the points to construct the NPV profile. We used a spreadsheet program to


automate the process and then to draw the profile. Note that the profile crosses the x-axis twice,


at 25% and at 400%, signifying two IRRs. Which IRR is correct? In one sense, they both


are--both cause the project's NPV to equal zero. However, in another sense, both are


wrong--neither has any economic or financial significance.


Project P has nonnormal cash flows; that is, it has more than one change of signs in the cash


flows. Without this nonnormal cash flow pattern, we would not have the multiple IRRs.


Since project P's NPV is negative, the project should be rejected, even though both IRRs


(25% and 400%) are greater than the project's 10 percent cost of capital. The MIRR of 5.6%


also supports the decision that the project should be rejected.


NPV


500



375



250



125



Cost of Capital, r (%)


100 200 300 400 500 600


-125



-250



-375




Answers and Solutions: 11 - 228 j. In an unrelated analysis, you have the opportunity to choose between the following two


mutually exclusive projects:


Expected Net Cash Flows


Year Project S Project L


0 ($100,000) ($100,000)


1 60,000 33,500


2 60,000 33,500


3 -- 33,500


4 -- 33,500


The projects provide a necessary service, so whichever one is selected is expected to be


repeated into the foreseeable future. Both projects have a 10 percent cost of capital.


j. 1. What is each project's initial npv without replication?


Answer: The NPVs, found with a financial calculator, are calculated as follows:


Input the following: CF0 = -100000, CF1 = 60000, NJ = 2, AND I = 10 to solve for NPVS =


$4,132.23 $4,132.


Input the following: CF0 = -100000, CF1 = 33500, NJ = 4, AND I = 10 to solve for NPVL =


$6,190.49 $6,190.


However, if we make our decision based on the raw NPVs, we would be biasing the decision


against the shorter project. Since the projects are expected to be replicated, if we initially choose


project S, it would be repeated after 2 years. However, the raw NPVs do not reflect the


replication cash flows.




Answers and Solutions: 11 - 229 j. 2. Now apply the replacement chain approach to determine the projects' extended NPVs.


Which project should be chosen?


Answer: The simple replacement chain approach assumes that the projects will be replicated out to a


common life. Since project S has a 2-year life and L has a 4-year life, the shortest common life


is 4 years. Project L's common life NPV is its raw NPV:


Common Life NPVL = $6,190.


However, project S would be replicated in year 2, and if we assume that the replicated project's


cash flows are identical to the first set of cash flows, then the replicated NPV is also $4,132, but it


"comes in" in year 2. We can put project S's cash flow situation on a time line:


0 1 2


10%


3 4


| | | | |


4,132 4,312


3,415


7,547


Here we see that S's common life NPV is NPVS = $7,547.


Thus, when compared over a 4-year common life, project s has the higher NPV, hence it


should be chosen. Project s would have the higher NPV over any common life.


j. 3. Now assume that the cost to replicate project S in 2 years will increase to $105,000 because


of inflationary pressures. How should the analysis be handled now, and which project


should be chosen?


Answer: If the cost of project S is expected to increase, the replication project is not identical to the


original, and the EAA approach cannot be used. In this situation, we would put the cash flows


on a time line as follows:


0 1 2 3


4 r = 10%


| | | | |


-100,000 60,000 60,000 60,000


60,000


-105,000


- 45,000


Common Life NPVS = $3,415.


With this change, the common life NPV of project s is less than that for project


L, and hence project L should be chosen.


k. You are also considering another project which has a physical life of 3 years; that is, the


machinery will be totally worn out after 3 years. However, if the project were terminated


prior to the end of 3 years, the machinery would have a positive salvage value. Here are


the project's estimated cash flows:


Answers and Solutions: 11 - 230 Initial Investment End-Of-Year


And OperatingNet Salvage


Year Cash Flows Value_


0 ($5,000) $5,000


1 2,100 3,100


2 2,000 2,000


3 1,750 0


Using the 10 percent cost of capital, what is the project's NPV if it is operated


for the full 3 years? Would the NPV change if the company planned to


terminate the project at the end of year 2? At the end of year 1? What is the


project's optimal (economic) life? Answer: Here are the time lines for the 3 alternative lives:



No termination:


0 1 2


3 10%


| | | |


-5,000 2,100 2,000 1,750


0


1,750


NPV = -$123.


Terminate after 2 years:


0 1 2


| 10% | |


-5,000 2,100 2,000


2,000


4,000


NPV = $215.


Terminate after 1 year:


0 1


| 10% |


-5,000 2,100


3,100


5,200


NPV = -$273.


We see (1) that the project is acceptable only if operated for 2 years, and (2) that a project's


Answers and Solutions: 11 - 231 engineering life does not always equal its economic life.



l. After examining all the potential projects, you discover that there are many more projects


this year with positive NPVs than in a normal year. What two problems might this extra


large capital budget cause?


You only have a limited amount of capital to commit to projects. If you have to raise external


capital to fund some of these other positive NPV projects, then you may be faced with


an increasing cost of capital. This is called an increasing marginal cost of capital


schedule, and it also happens to companies when they exhaust their internal sources


of funds and have to go to external capital markets for their finding. This increased


cost of capital may cause you to reject projects that you might otherwise accept


because with your increased cost of capital, some projects may be negative NPV


when they would otherwise be positive NPV in a normal year.


Another effect of this large capital budget is that you may choose to ration capital--i.e. not fund


all of the projects. This is called capital rationing, and companies and investors do this when for


whatever reason they put a cap on the funds they are willing to invest in new projects.




Answers and Solutions: 11 - 232 Chapter 11


Cash Flow Estimation


and Risk Analysis


ANSWERS TO END-OF-CHAPTER QUESTIONS


11-1 a. Cash flow, which is the relevant financial variable, represents the actual flow of cash.


Accounting income, on the other hand, reports accounting data as defined by Generally Accepted


Accounting Principles (GAAP).


b. Incremental cash flows are those cash flows that arise solely from the asset that is being evaluated.


For example, assume an existing machine generates revenues of $1,000 per year and expenses of


$600 per year. A machine being considered as a replacement would generate revenues of $1,000


per year and expenses of $400 per year. On an incremental basis, the new machine would not


increase revenues at all, but would decrease expenses by $200 per year. Thus, the annual


incremental cash flow is a before-tax savings of $200. A sunk cost is one that has already


occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital


budgeting decisions. Within the context of this chapter, an opportunity cost is a cash flow that a


firm must forgo to accept a project. For example, if the project requires the use of a building that


could otherwise be sold, the market value of the building is an opportunity cost of the project.


c. Net operating working capital changes are the increases in current operating assets resulting from


accepting a project less the resulting increases in current operating liabilities, or accruals and


accounts payable. A net operating working capital change must be financed just as a firm must


finance its increases in fixed assets. Salvage value is the market value of an asset after its useful


life. Salvage values and their tax effects must be included in project cash flow estimation.


d. The real rate of return (rr), or, for that matter the real cost of capital, contains no adjustment for


expected inflation. If net cash flows from a project do not include inflation adjustments, then the


cash flows should be discounted at the real cost of capital. In a similar manner, the IRR resulting


from real net cash flows should be compared with the real cost of capital. Conversely, the


nominal rate of return (rn) does include an inflation adjustment (premium). Thus if nominal rates


of return are used in the capital budgeting process, the net cash flows must also be nominal.




e. Sensitivity analysis indicates exactly how much NPV will change in response to a given change in


an input variable, other things held constant. Sensitivity analysis is sometimes called "what if"


analysis because it answers this type of question. Scenario analysis is a shorter version of


simulation analysis that uses only a few outcomes. Often the outcomes considered are optimistic,


pessimistic and most likely. Monte Carlo simulation analysis is a risk analysis technique in


which a computer is used to simulate probable future events and thus to estimate the profitability


and risk of a project.


f. A risk-adjusted discount rate incorporates the riskiness of the project's cash flows. The cost of


capital to the firm reflects the average risk of the firm's existing projects. Thus, new projects


that are riskier than existing projects should have a higher risk-adjusted discount rate.


Answers and Solutions: 11 - 233 Conversely, projects with less risk should have a lower risk-adjusted discount rate. This


adjustment process also applies to a firm's divisions. Risk differences are difficult to quantify,


thus risk adjustments are often subjective in nature. A project's cost of capital is its risk-adjusted


discount rate for that project.


11-2 Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of


less fundamental importance than cash flows for investment analysis. Recall that in the stock


valuation chapters we focused on dividends and free cash flows, which represent cash flows, rather


than on earnings per share, which represent accounting profits.


11-3 Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means


that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV.


11-4 Capital budgeting analysis should only include those cash flows which will be affected by the decision.


Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting


decision. Opportunity costs represent the cash flows the firm gives up by investing in this project


rather than its next best alternative, and externalities are the cash flows (both positive and negative) to


other projects that result from the firm taking on this project. These cash flows occur only because


the firm took on the capital budgeting project; therefore, they must be included in the analysis.


11-5 When a firm takes on a new capital budgeting project, it typically must increase its investment in


receivables and inventories, over and above the increase in payables and accruals, thus increasing its


net operating working capital. Since this increase must be financed, it is included as an outflow in


Year 0 of the analysis. At the end of the project's life, inventories are depleted and receivables are


collected. Thus, there is a decrease in NOWC, which is treated as an inflow.


11-6 Simulation analysis involves working with continuous probability distributions, and the output of a


simulation analysis is a distribution of net present values or rates of return. Scenario analysis


involves picking several points on the various probability distributions and determining cash flows or


rates of return for these points. Sensitivity analysis involves determining the extent to which cash


flows change, given a change in one particular input variable. Simulation analysis is expensive.


Therefore, it would more than likely be employed in the decision for the $200 million investment in a


satellite system than in the decision for the $12,000 truck.




Answers and Solutions: 11 - 234 SOLUTIONS TO END-OF-CHAPTER PROBLEMS



11-1 Equipment $ 9,000,000


NWC Investment 3,000,000


Initial investment outlay $12,000,000


11-2 Operating Cash Flows: t = 1


Sales revenues $10,000,000


Operating costs 7,000,000


Depreciation 2,000,000


Operating income before taxes $ 1,000,000


Taxes (40%) 400,000


Operating income after taxes $ 600,000


Add back depreciation 2,000,000


Operating cash flow $ 2,600,000


11-3 Equipment's original cost $20,000,000


Depreciation (80%) 16,000,000


Book value $ 4,000,000


Gain on sale = $5,000,000 - $4,000,000 = $1,000,000.


Tax on gain = $1,000,000(0.4) = $400,000.



Answers and Solutions: 11 - 235 AT net salvage value = $5,000,000 - $400,000 = $4,600,000.




Answers and Solutions: 11 - 236 11-4 a. The net cost is $126,000:


Price ($108,000)


Modification (12,500)


Increase in NWC (5,500)


Cash outlay for new machine ($126,000)


b. The operating cash flows follow:


Year 1 Year 2 Year 3


1. After-tax savings $28,600 $28,600 $28,600


2. Depreciation tax savings 13,918 18,979 6,326


Net cash flow $42,518 $47,579 $34,926


Notes:


1. The after-tax cost savings is $44,000(1 - T) = $44,000(0.65)


= $28,600.


2. The depreciation expense in each year is the depreciable basis, $120,500, times the MACRS


allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively.


Depreciation expense in Years 1, 2, and 3 is $39,765, $54,225, and $18,075. The


depreciation tax savings is calculated as the tax rate (35%) times the depreciation expense in


each year.


c. The terminal year cash flow is $50,702:


Salvage value $65,000


Tax on SV* (19,798)


Return of NWC 5,500


$50,702


BV in Year 4 = $120,500(0.07) = $8,435.


*Tax on SV = ($65,000 - $8,435)(0.35) = $19,798.


d. The project has an NPV of $10,841; thus, it should be accepted.


Year Net Cash Flow PV @ 12%


0 ($126,000) ($126,000)


1 42,518 37,963


2 47,579 37,930


3 85,628 60,948


NPV = $ 10,841



Alternatively, place the cash flows on a time line:


0 1 2 3 12%


| | | |


-126,000 42,518 47,579 34,926



Answers and Solutions: 11 - 237 50,702


85,628


With a financial calculator, input the appropriate cash flows into the cash flow register, input I =


12, and then solve for NPV = $10,841.


11-5 a. The net cost is $89,000:


Price ($70,000)


Modification (15,000)


Change in NWC (4,000)


($89,000)


b. The operating cash flows follow:


Year 1 Year 2 Year 3


After-tax savings $15,000 $15,000 $15,000


Depreciation shield 11,220 15,300 5,100


Net cash flow $26,220 $30,300 $20,100


Notes:


1. The after-tax cost savings is $25,000(1 T) = $25,000(0.6)


= $15,000.


2. The depreciation expense in each year is the depreciable basis, $85,000, times the MACRS


allowance percentage of 0.33, 0.45, and 0.15 for Years 1, 2 and 3, respectively. Depreciation


expense in Years 1, 2, and 3 is $28,050, $38,250, and $12,750. The depreciation shield is


calculated as the tax rate (40%) times the depreciation expense in each year.


c. The additional end-of-project cash flow is $24,380:


Salvage value $30,000


Tax on SV* (9,620)


Return of NWC 4,000


$24,380


*Tax on SV = ($30,000 - $5,950)(0.4) = $9,620.


Note that the remaining BV in Year 4 = $85,000(0.07) = $5,950.


d. The project has an NPV of -$6,705. Thus, it should not be accepted.


Year Net Cash Flow PV @ 10%


0 ($89,000) ($89,000)


1 26,220 23,836


2 30,300 25,041


3 44,480 33,418


NPV = ($ 6,705)



Answers and Solutions: 11 - 238 Alternatively, with a financial calculator, input the following: CF0 = -89000, CF1 = 26220, CF2


= 30300, CF3 = 44480, and I = 10 to solve for NPV = -$6,703.83.


11-6 a. Sales = 1,000($138) $138,000


Cost = 1,000($105) 105,000


Net before tax $ 33,000


Taxes (34%) 11,220


Net after tax $ 21,780


Not considering inflation, NPV is -$4,800. This value is calculated as


$21,780


-$150,000 + = -$4,800.


0.15


Considering inflation, the real cost of capital is calculated as follows:


(1 + rr)(1 + i) = 1.15


(1 + rr)(1.06) = 1.15


rr = 0.0849.


Thus, the NPV considering inflation is calculated as


$21,780


-$150,000 + = $106,537.


0.0849


After adjusting for expected inflation, we see that the project has a positive NPV and should be


accepted. This demonstrates the bias that inflation can induce into the capital budgeting process:


Inflation is already reflected in the denominator (the cost of capital), so it must also be reflected in


the numerator.


b. If part of the costs were fixed, and hence did not rise with inflation, then sales revenues would rise


faster than total costs. However, when the plant wears out and must be replaced, inflation will


cause the replacement cost to jump, necessitating a sharp output price increase to cover the now


higher depreciation charges.


11-7 E(NPV) = 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)


= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5


= $3.0 million.


NPV = [0.05(-$70 - $3)2 + 0.20(-$25 - $3)2 + 0.50($12 - $3)2


+ 0.20($20 - $3)2 + 0.05($30 - $3)2]0.5


= $23.622 million.


$23.622


CV = = 7.874.


$3.0




Answers and Solutions: 11 - 239 11-8 a. Expected annual cash flows:


Project A: Probable


Probability Cash Flow = Cash Flow


0.2 $6,000 $1,200


0.6 6,750 4,050


0.2 7,500 1,500


Expected annual cash flow = $6,750


Project B: Probable


Probability Cash Flow = Cash Flow


0.2 $ 0 $ 0


0.6 6,750 4,050


0.2 18,000 3,600


Expected annual cash flow = $7,650


Coefficient of variation:


Standard deviation NPV


CV = =


Expected value Expected NPV


Project A:


A = (-$750 ) 2 (0.2) + ($0 ) 2 (0.6) + ($750 ) 2 (0.2) = $474.34.


Project B:


B = (-$7,650 ) 2 (0.2) + (-$900 ) 2 (0.6) + ($10,350 ) 2 (0.2)


= $5,797.84.


CVA = $474.34/$6,750 = 0.0703.


CVB = $5,797.84/$7,650 = 0.7579.


b. Project B is the riskier project because it has the greater variability in its probable cash flows,


whether measured by the standard deviation or the coefficient of variation. Hence, Project B is


evaluated at the 12 percent cost of capital, while Project A requires only a 10 percent cost of


capital.


Project A: With a financial calculator, input the appropriate cash flows into the cash flow register,


input I = 10, and then solve for NPV = $10,036.25.


Project B: With a financial calculator, input the appropriate cash flows into the cash flow register,


input I = 12, and then solve for NPV = $11,624.01.


Project B has the higher NPV; therefore, the firm should accept Project B.


c. The portfolio effects from Project B would tend to make it less risky than otherwise. This would


tend to reinforce the decision to accept Project B. Again, if Project B were negatively correlated


with the GDP (Project B is profitable when the economy is down), then it is less risky and Project


B's acceptance is reinforced.



Answers and Solutions: 11 - 240 11-9 a. First, note that with symmetric probability distributions, the middle value of each distribution is


the expected value. Therefore,


Expected Values


Sales (units) 200


Sales price $13,500


Sales in dollars $2,700,000


Costs (200 x $6,000) 1,200,000


Earnings before taxes $1,500,000


Taxes (40%) 600,000


Net income $ 900,000 =Cash flow under the assumption


used in the problem.


8


$900,000


0= t


- $4,000,000.


t =1 (1 + IRR )


Using a financial calculator, input the following: CF0 = -4000000, CF1 = 900000, and Nj = 8, to


solve for IRR = 15.29%.


Expected IRR = 15.29% 15.3%.


Assuming complete independence between the distributions, and normality, it would be possible


to derive IRR statistically. Alternatively, we could employ simulation to develop a distribution of


IRRs, hence IRR. There is no easy way to get IRR.


b. NPV = $900,000(PVIFA15%,8) - $4,000,000.


Using a financial calculator, input the following: CF0 = -4000000, CF1 = 900000, Nj = 8, and I =


15 to solve for NPV = $38,589.36. Again, there is no easy way to estimate NPV.


c. (1) a. Calculate developmental costs. The 44 random number value, coming between 30


and 70, indicates that the costs for this run should be taken to be $4 million.


b. Calculate the project life. The 17, being less than 20, indicates that a 3-year life


should be used.


(2) a. Estimate unit sales. The 16 indicates sales of 100 units.


b. Estimate the sales price. The 58 indicates a sales price of $13,500.


c. Estimate the cost per unit. The 1 indicates a cost of $5,000.


d. Now estimate the after-tax cash flow for Year 1. It is


[100($13,500) - 100($5,000)](1 - 0.4) = $510,000 = CF1.


(3) Repeat the process for Year 2. Sales will be 200 with a random number of 79; the price


will be $13,500 with a random number of 83; and the cost will be $7,000 with a random


Answers and Solutions: 11 - 241 number of 86:


[200($13,500) - 200($7,000)](0.6) = $780,000 = CF2.


(4) Repeat the process for Year 3. Sales will be 100 units with a random number of 19; the


price will be $13,500 with a random number of 62; and the cost will be $5,000 with a


random number of 6:


[100($13,500) - 100($5,000)](0.6) = $510,000 = CF3.


$510,000 $780,000 $510,000 (5) a. 0= + + - $4,000,000


(1 + IRR )1 (1 + IRR ) 2 (1 + IRR ) 3


IRR = -31.55%.


Alternatively, with a financial calculator, input the following: CF0 = -4000000, CF1 =


510000, CF2 = 780000, CF3 = 510000, and solve for IRR = -31.55%.


$510,000 $780,000 $510,000


b. NPV = + + - $4,000,000.


1 2


(1.15) (1.15) (1.15) 3


With a financial calculator, input the following: CF0 = -4000000, CF1 = 510000, CF2


= 780000, CF3 = 510000, and I = 15 to solve for NPV = -$2,631,396.40.


The results of this run are very bad because the project's life is so short. Had


the life turned out (by chance) to be 13 years, the longest possible life, the IRR would


have been about 25%, and the NPV would have been about $1 million.




Answers and Solutions: 11 - 242 (6) & (7) The computer would store NPVs and IRRs for the different trials, then display them


as frequency distributions:




Probability


of occurrence


X


XX


XXXX


XXXXXXXX


XXXXXXXXXXXXXXX


XXXXXXXXXXXXXXXXXXX


0 E(NPV)


NPV


Probability


of occurrence


X


XX


XXXX


XXXXXXXX


XXXXXXXXXXXXXXX


XXXXXXXXXXXXXXXXXXX


0 E(NPV)


NPV


The distribution would be reasonably symmetrical because all the input data were


from symmetrical distributions. One often finds, however, that the input and output


distributions are badly skewed. The frequency values would also be used to


calculate NPV and IRR; these values would be printed out and available for


analysis.




Answers and Solutions: 11 - 243 11-10 a. The resulting decision tree is:



NPV


t=0 t=1 t=2 t=3 P NPV Product


$3,000,000 0.24 $881,718 $211,612


($1,000,000) P = 0.5


P = 0.80 1,500,000 0.24 (185,952) (44,628)


($500,000) P = 0.5


P = 0.60


100,000 0.12 (376,709) (45,205)


($10,000) P = 0.20




0 0.40


(10,000) (4,000)


P = 0.40 1.00 Exp. NPV = $117,779


The NPV of the top path is:


$3,000,000 $1,000,000 $500,000


3


- 2


- - $10,000 = $881,718.


(1.12) (1.12) (1.12)1


Using a financial calculator, input the following: CF0 = -10000,


CF1 = -500000, CF2 = -1000000, CF3 = 3000000, and I = 12 to solve for NPV = $881,718.29


$881,718. The other NPVs were determined in the same manner. If the project is of average risk, it


should be accepted because the expected NPV of the total project is positive.


b. 2NPV = 0.24($881,718 - $117,779)2 + 0.24(-$185,952 - $117,779)2


+ 0.12(-$376,709 - $117,779)2 + 0.4(-$10,000 - $117,779)2


= 198,078,470,853.


NPV = $445,060.


$445,060


CVNPV = = 3.78.


$117,779


Since the CV is 3.78 for this project, while the firm's average project has a CV of 1.0 to


2.0, this project is of high risk.



Answers and Solutions: 11 - 244 SOLUTION TO SPREADSHEET PROBLEM


11-11 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 11 P11 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.




Answers and Solutions: 11 - 245 MINI CASE


Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Shrieves' main plant. The machinery's invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use.


THE NEW LINE WOULD GENERATE INCREMENTAL SALES OF 1,250 UNITS PER YEAR FOR FOUR YEARS AT AN INCREMENTAL COST OF $100 PER UNIT IN THE FIRST YEAR, EXCLUDING DEPRECIATION. EACH UNIT CAN BE SOLD FOR $200 IN THE FIRST YEAR. THE SALES PRICE AND COST ARE EXPECTED TO INCREASE BY 3% PER YEAR DUE TO INFLATION. FURTHER, TO HANDLE THE NEW LINE, THE FIRM'S NET OPERATING WORKING CAPITAL WOULD HAVE TO INCREASE BY AN AMOUNT EQUAL TO 12% OF SALES REVENUES. THE FIRM'S TAX RATE IS 40 PERCENT, AND ITS OVERALL WEIGHTED AVERAGE COST OF CAPITAL IS 10 PERCENT.


a. Define "incremental cash flow."


Answer: This is the firm's cash flow with the project minus the firm's cash flow without the project.


a. 1. Should you subtract interest expense or dividends when calculating project cash


flow?


Answer: The cash flow statement should not include interest expense or dividends. The return required


by the investors furnishing the capital is already accounted for when we apply the 10 percent cost


of capital discount rate, hence including financing flows would be "double counting." Put


another way, if we deducted capital costs in the table, and thus reduced the bottom line cash flows,


and then discounted those CFS by the cost of capital, we would, in effect, be subtracting capital


costs twice.


a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line site.


Should this cost be included in the analysis? Explain.


Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and presumably


also expensed for tax purposes. Since, it is a sunk cost, it should not be included in the analysis.


a. 3. Now assume that the plant space could be leased out to another firm at $25,000 a year.


Should this be included in the analysis? If so, how?


Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this project, it


would forgo the opportunity to receive $25,000 in annual cash flows. This represents an



Answers and Solutions: 12 - 246 opportunity cost to the project, and it should be included in the analysis. Note that the


opportunity cost cash flow must be net of taxes, so it would be a $25,000(1 - t) = $25,000(0.6) =


$15,000 annual outflow.


a. 4. Finally, assume that the new product line is expected to decrease sales of the firm's other


lines by $50,000 per year. Should this be considered in the analysis? If so, how?


Answer: If a project affects the cash flows of another project, this is an "externality" which must be


considered in the analysis. If the firm's sales would be reduced by $50,000, then the net cash


flow loss would be a cost to the project. Note that this annual loss would not be the full $50,000,


because Shrieves would save on cash operating costs if its sales dropped. Note also that


externalities can be positive as well as negative.


b. Disregard the assumptions in part a. What is Shrieves' depreciable basis?


Answer: Get the depreciation rates from table 11-2 in the book. Note that because of the half-year


convention, a 3-year project is depreciated over 4 calendar years:


YEAR RATE BASIS = DEPRECIATION


1 0.33 $240 $ 79


2 0.45 240 108


3 0.15 240 36


4 0.07 240 17


$240


c. Calculate the annual sales revenues and costs (other than depreciation). Why is it


important to include inflation when estimating cash flows?


Answer: With an inflation rate of 3%, the annual revenues and costs are:


Year 1 Year 2 Year 3 Year 4


Units 1250 1250 1250 1250


Unit Price $200.00 $206.00 $212.18 $218.55


Unit Cost $100.00 $103.00 $106.09 $109.27


Sales $250,000 $257,500 $265,225 $273,188


Costs $125,000 $128,750 $132,613 $136,588


The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other words, it


is larger than the real cost of capital. Similarly, nominal cash flows (those that are inflated) are


larger than real cash flows. If you discount the low, real cash flows with the high, nominal rate,


then the resulting NPV is too low. Therefore, you should always discount nominal cash flows


with a nominal rate, and real cash flows with a real rate. In theory, you could do either way and


get the correct answer. However, there is no accurate way to convert a nominal cost of capital to


a real cost. Therefore, you should inflate cash flows and then discount at the nominal rate.



Answers and Solutions: 12 - 247 c. Calculate the annual sales revenues and costs (other than depreciation). Why is it


important to include inflation when estimating cash flows?


Answer: With an inflation rate of 3%, the annual revenues and costs are:



Here are the annual operating cash flows (in thousands of dollars):


1 2 3 4


Net Revenues $125 $125 $125 $125


Depreciation 79 108 36 17


Before-Tax Income $ 46 $ 17 $ 89 $108


Taxes (40%) 18 7 36 43


Net Income $ 28 $ 10 $ 53 $ 65


Plus Depreciation 79 108 36 17


Net Operating CF $107 $118 $ 89 $ 82


d. Construct annual incremental operating cash flow statements.


Answer:


Year 1 Year 2 Year 3 Year 4


Sales $250,000 $257,500 $265,225 $273,188


Costs $125,000 $128,750 $132,613 $136,588


Depreciation $79,200 $108,000 $36,000 $16,800


Op. EBIT $45,800 $20,750 $96,612 $119,800


Taxes (40%) $18,320 $8,300 $38,645 $47,920


NOPAT $27,480 $12,450 $57,967 $71,880


Depreciation $79,200 $108,000 $36,000 $16,800


Net Operating CF $106,680 $120,450 $93,967 $88,680


e. Estimate the required net operating working capital for each year, and the cash flow due to


investments in net operating working capital.


Answer: The project requires a level of net operating working capital in the amount equal to 12% of the


next year's sales. Any increase in NOWC is a negative cash flow, and any decrease is a positive


cash flow.


Year 0 Year 1 Year 2 Year 3 Year 4


Sales $250,000 $257,500 $265,225 $273,188


NOWC (% of sales) $30,000 $30,900 $31,827 $32,783 $0


CF due to NOWC) ($30,000) ($900) ($927) ($956) $32,783


f. Calculate the after-tax salvage cash flow.




Answers and Solutions: 12 - 248 Answer: When the project is terminated at the end of year 4, the equipment can be sold for $25,000. But,


since it has been depreciated to a $0 book value, taxes must be paid on the full salvage value.


For this project, the after-tax salvage cash flow is:



Salvage Value $25,000


Tax On Salvage Value (10,000)


Net After-Tax Salvage Cash Flow $15,000



g. Calculate the net cash flows for each year? Based on these cash flows, what are the


project's NPV, IRR, MIRR, and payback? Do these indicators suggest that the project


should be undertaken?


Answer: The net cash flows are:


Year 0 Year 1 Year 2 Year 3 Year 4


Initial Outlay ($240,000)


Operating Cash Flows $106,680 $120,450 $93,967 $88,680


CF Due To NOWC ($30,000) ($900) ($927) ($956) $32,783


Salvage Cash Flows $15,000


Net Cash Flows ($270,000) $105,780 $119,523 $93,011 $136,463



NPV = $88,030


IRR = 23.9%


MIRR = 18.0%


Payback = 2.5


h. What does the term "risk" mean in the context of capital budgeting, to what extent can risk


be quantified, and when risk is quantified, is the quantification based primarily on statistical


analysis of historical data or on subjective, judgmental estimates?


Answer: Risk throughout finance relates to uncertainty about future events, and in capital budgeting, this


means the future profitability of a project. For certain types of projects, it is possible to look back


at historical data and to statistically analyze the riskiness of the investment. This is often true


when the investment involves an expansion decision; for example, if Sears were opening a new


store, if Citibank were opening a new branch, or if GM were expanding its Chevrolet plant, then


past experience could be a useful guide to future risk. Similarly, a company that is considering


going into a new business might be able to look at historical data on existing firms in that industry


to get an idea about the riskiness of its proposed investment. However, there are times when it is


impossible to obtain historical data regarding proposed investments; for example, if GM were


considering the development of an electric auto, not much relevant historical data for assessing


the riskiness of the project would be available. Rather, GM would have to rely primarily on the


judgment of its executives, and they, in turn would have to rely on their experience in developing,


manufacturing, and marketing new products. We will try to quantify risk analysis, but you must



Answers and Solutions: 12 - 249 recognize at the outset that some of the data used in the analysis will necessarily be based on


subjective judgments rather than on hard statistical observations.


i. 1. What are the three types of risk that are relevant in capital


budgeting?


2. How is each of these risk types measured, and how do they relate to one another?


Answer: Here are the three types of project risk:


Stand-alone risk is the project's total risk if it were operated independently.


Stand-alone risk ignores both the firm's diversification among projects and investors'


diversification among firms. Stand-alone risk is measured either by the project's


standard deviation of NPV (NPV) or its coefficient of variation of NPV (CVNPV).


Note that other profitability measures, such as IRR and MIRR, can also be used to


obtain stand-alone risk estimates.


Within-firm risk is the total riskiness of the project giving consideration to the firm's


other projects, that is, to diversification within the firm. It is the contribution of the


project to the firm's total risk, and it is a function of (a) the project's standard


deviation of NPV and (b) the correlation of the projects' returns with those of the rest


of the firm. Within-firm risk is often called corporate risk, and it is measured by the


project's corporate beta, which is the slope of the regression line formed by plotting


returns on the project versus returns on the firm.


Market risk is the riskiness of the project to a well-diversified investor, hence it


considers the diversification inherent in stockholders' portfolios. It is measured by


the project's market beta, which is the slope of the regression line formed by plotting


returns on the project versus returns on the market.


i. 3. How is each type of risk used in the capital budgeting process?


Answer: Because management's primary goal is shareholder wealth maximization, the most relevant risk


for capital projects is market risk. However, creditors, customers, suppliers, and employees are


all affected by a firm's total risk. Since these parties influence the firm's profitability, a project's


within-firm risk should not be completely ignored.


Unfortunately, by far the easiest type of risk to measure is a project's stand-alone risk.


Thus, firms often focus on this type of risk when making capital budgeting


decisions. However, this focus does not necessarily lead to poor decisions,


because most projects that a firm undertakes are in its core business. In this


situation, a project's stand-alone risk is likely to be highly correlated with its


within-firm risk, which in turn is likely to be highly correlated with its market


risk.




Answers and Solutions: 12 - 250 j. 1. What is sensitivity analysis?


Answer: Sensitivity analysis measures the effect of changes in a particular variable, say revenues, on a


project's NPV. To perform a sensitivity analysis, all variables are fixed at their expected values


except one. This one variable is then changed, often by specified percentages, and the resulting


effect on NPV is noted. (One could allow more than one variable to change, but this then


merges sensitivity analysis into scenario analysis.)


j. 2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the


project. Assume that each of these variables can vary from its base case, or expected, value


by plus and minus 10, 20, and 30 percent. Include a sensitivity diagram, and discuss the


results.


Answer: The sensitivity data are given here in tabular form (in thousands of dollars):



NPV Deviation From Base Case


Deviation


From Units


Base Case WACC Sold Salvage


-30% $113,288 $16,668 $84,956


-15% $100,310 $52,348 $86,493


0% $88,030 $88,030 $88,030


15% $76,398 $123,711 $89,567


30% $65,371 $159,392 $91,103


Range 47,916 176,060 6,147



We generated these data with a spreadsheet model in the file ch 11 mini case.xls.




Answers and Solutions: 12 - 251 WACC


Sensitivity Analysis Units Sold


Salvage


$180,000


$160,000


$140,000


$120,000


$100,000 NPV




$80,000


$60,000


$40,000


$20,000


$0


-40% -20% 0% 20% 40%


Deviation from Base-Case Value




A. The sensitivity lines intersect at 0% change and the base case NPV, $81,573. Since all other


variables are set at their base case, or expected values, the zero change situation is the base


case.



B. The plots for unit sales and salvage value are upward sloping, indicating that higher variable


values lead to higher NPVs. Conversely, the plot for cost of capital is downward sloping,


because a higher cost of capital leads to a lower NPV.


C. The plot of unit sales is much steeper than that for salvage value. This indicates that NPV is


more sensitive to changes in unit sales than to changes in salvage value.


D. Steeper sensitivity lines indicate greater risk. Thus, in comparing two projects, the one with


the steeper lines is considered to be riskier.




Answers and Solutions: 12 - 252 j. 3. What is the primary weakness of sensitivity analysis? What is its primary usefulness?


Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the effects of


diversification and (2) that it does not incorporate any information about the possible magnitudes


of the forecast errors. Thus, a sensitivity analysis might indicate that a project's NPV is highly


sensitive to the sales forecast, hence that the project is quite risky, but if the project's sales, hence


its revenues, are fixed by a long-term contract, then sales variations may actually contribute little


to the project's risk. It also ignores any relationships between variables, such as unit sales and


sales price. Therefore, in many situations, sensitivity analysis is not a particularly good indicator of


risk. However, sensitivity analysis does identify those variables which


potentially have the greatest impact on profitability, and this helps management


focus its attention on those variables that are probably most important.


k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the


project's cash flows except unit sales and sales price: if product acceptance is poor, unit


sales would be only 900 units a year and the unit price would only be $160; a strong


consumer response would produce sales of 1,600 units and a unit price of $240. Sidney


believes that there is a 25 percent chance of poor acceptance, a 25 percent chance of


excellent acceptance, and a 50 percent chance of average acceptance (the base case).


k. 1. What is scenario analysis?


Answer: Scenario analysis examines several possible situations, usually worst case, most likely case, and


best case. It provides a range of possible outcomes.


k. 2. What is the worst-case NPV? The best-case NPV?


k. 3. Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the


project's expected NPV, standard deviation, and coefficient of variation.


Answer: We used a spreadsheet model to develop the scenarios (in thousands of dollars), which are


summarized below:


Scenario Probability Unit Sales Unit Price NPV


Best Case 25% 1600 $240 $278,965


Base Case 50% 1250 $200 $88,030


Worst Case 25% 900 $160 ($48,514)



Expected NPV = $101,628


Standard Deviation = $116,577


Coefficient Of Variation =


Std Dev / Expected NPV = 1.15



Answers and Solutions: 12 - 253 l. Are there problems with scenario analysis? Define simulation analysis, and discuss its


principal advantages and disadvantages.


Answer: Scenario analysis examines several possible scenarios, usually worst case, most likely case, and


best case. Thus, it usually considers only 3 possible outcomes. Obviously the world is much


more complex, and most projects have an almost infinite number of possible outcomes.


Simulation analysis is a type of scenario analysis which uses a relatively powerful financial


planning software such as interactive financial planning system (IFPs) or @risk (a spreadsheet


add-in). Simple simulations can also be conducted with other spreadsheet add-ins, such as


Simtools. Here the uncertain cash flow variables (such as unit sales) are entered as continuous


probability distribution parameters rather than as point values. Then, the computer uses a


random number generator to select values for the uncertain variables on the basis of their


designated distributions. Once all of the variable values have been selected, they are combined,


and an NPV is calculated. The process is repeated many times, say 1,000, with new values


selected from the distributions for each run. The end result is a probability distribution of NPV


based on a sample of 1,000 values. The software can graph the distribution as well as print out


summary statistics such as expected NPV and NPV. Simulation provides the decision maker


with a better idea of the profitability of a project than does scenario analysis because it


incorporates many more possible outcomes.


Although simulation analysis is technically refined, its usefulness is limited because


managers are often unable to accurately specify the variables' probability


distributions. Further, the correlations among the uncertain variables must be


specified, along with the correlations over time. If managers are unable to do


this with much confidence, then the results of simulation analyses are of limited


value.


Recognize also that neither sensitivity, scenario, nor simulation analysis provides a decision


rule--they may indicate that a project is relatively risky, but they do not indicate


whether the project's expected return is sufficient to compensate for its risk. Finally, remember that sensitivity, scenario, and simulation analyses all focus on


stand-alone risk, which is not the most relevant risk in capital budgeting


analysis.


m. 1. Assume that Shrieves' average project has a coefficient of variation in the range of 0.2 - 0.4.


Would the new line be classified as high risk, average risk, or low risk? What type of risk


is being measured here?


Answer: The project has a CV of 0.57, which is above the average range of 0.2-0.4, so it falls into the high


risk category. The CV measures a project's stand-alone risk-it is merely a measure of the


variability of returns (as measured by NPV) about the expected return.


m. 2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to


adjust for risk. Should the new furniture line be accepted?



Answers and Solutions: 12 - 254 Answer: Since the project is judged to have above-average risk, its differential risk-adjusted, or project,


cost of capital would be 13 percent. At this discount rate, its NPV would be $60,541, so it would


still be acceptable. If it were a low risk project, its cost of capital would be 7 percent, its NPV


would be $104,975, and it would be an even more profitable project on a risk-adjusted basis.


m. 3. Are there any subjective risk factors that should be considered before the final decision is


made?


Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in the project.


If the project has a potential for bringing on harmful lawsuits, then it might be riskier than first


assessed. Also, if the project's assets can be redeployed within the firm or can be easily sold,


then, as a result of "abandonment possibilities," the project may be less risky than the analysis


indicates.




Answers and Solutions: 12 - 255 Chapter 12


Real Options


ANSWERS TO END-OF-CHAPTER QUESTIONS


12-1 a. Real options occur when managers can influence the size and risk of a project's cash flows by


taking different actions during the project's life. They are referred to as real options because


they deal with real as opposed to financial assets. They are also called managerial options because


they give opportunities to managers to respond to changing market conditions. Sometimes they


are called strategic options because they often deal with strategic issues. Finally, they are also


called embedded options because they are a part of another project.


b. Investment timing options give companies the option to delay a project rather than implement it


immediately. This option to wait allows a company to reduce the uncertainty of market


conditions before it decides to implement the project. Capacity options allow a company to


change the capacity of their output in response to changing market conditions. This includes the


option to contract or expand production. Growth options allow a company to expand if market


demand is higher than expected. This includes the opportunity to expand into different


geographic markets and the opportunity to introduce complementary or second-generation


products. It also includes the option to abandon a project if market conditions deteriorate too


much.


c. Decision trees are a form of scenario analysis in which different actions are taken in different


scenarios.


12-2 Postponing the project means that cash flows come later rather than sooner; however, waiting may


allow you to take advantage of changing conditions. It might make sense, however, to proceed today if


there are important advantages to being the first competitor to enter a market.


12-3 Timing options make it less likely that a project will be accepted today. Often, if a firm can delay a


decision, it can increase the expected NPV of a project.


12-4 Having the option to abandon a project makes it more likely that the project will be accepted today.




SOLUTIONS TO END-OF-CHAPTER PROBLEMS



Answers and Solutions: 12 - 256 12-1 a. 0 1 2 20



-20 3 3 3


NPV = $1.074 million.


b. Wait 1 year:


PV @


0 1 2 3 21 Yr. 1


Tax imposed | r= 13% | | | |


50% Prob. 0 -20 2.2 2.2 2.2 15.45


Tax not imposed | | | | |


50% Prob. 0 -20 3.8 3.8 3.8 26.69


Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027


Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920


Expected NPV = .5(-4.027) + .5(5.920) = 0.947


Note though, that if the tax is imposed, the NPV of the project is negative and therefore would not


be undertaken. The value of this option of waiting one year is evaluated as 0.5($0) + (0.5)($ 5.920)


= $2.96 million.


Since the NPV of waiting one year is greater than going ahead and proceeding with the project today,


it makes sense to wait.




Answers and Solutions: 12 - 257 12-2 a. 0 1 2 3 4


10%



-8 4 4 4 4


NPV = $4.6795 million.


b. Wait 2 years:


PV @


0 1 2 3 4 5 6 Yr. 2


| r = 10% | | | | | |


10% Prob. 0 0 -9 2.2 2.2 2.2 2.2 $6.974


| | | | | | |


90% Prob. 0 0 -9 4.2 4.2 4.2 4.2 $13.313


Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674


High CF scenario: NPV = (-9 + 13.313)/(1.1)2 = $3.564


Expected NPV = .1(-1.674) + .9(3.564) = 3.040


If the cash flows are only $2.2 million, the NPV of the project is negative and, thus,


would not be undertaken. The value of the option of waiting two years is


evaluated as 0.10($0) + 0.90($3.564) = $3.208 million.


Since the NPV of waiting two years is less than going ahead and proceeding with


the project today, it makes sense to drill today.




Answers and Solutions: 12 - 258 12-3 a. 0 1 2 20


13%



-300 40 40 40


NPV = -$19.0099 million. Don't purchase.


b. Wait 1 year:


NPV @


0 1 2 3 4 21 Yr. 0


| r = 13% | | | | |


50% Prob. 0 -300 30 30 30 30 -$78.9889


| | | | | |


50% Prob. 0 -300 50 50 50 50 45.3430


If the cash flows are only $30 million per year, the NPV of the project is negative. However, we've


not considered the fact that the company could then be sold for $280 million. The decision tree


would then look like this:


NPV @


0 r = 13% 1 2 3 4 21 Yr. 0


| | | | | |


50% Prob. 0 -300 30 30 + 280 0 0 -$27.1468


| | | | | |


50% Prob. 0 -300 50 50 50 50 45.3430


The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) = $9.0981 million.


Given the option to sell, it makes sense to wait 1 year before deciding whether to make the


acquisition.




Answers and Solutions: 12 - 259 12-4 a. 0 1 14 12%


15


| | | |


-6,200,000 600,000 600,000 600,000


Using a financial calculator, input the following data: CF0 = -6,200,000;


CF1-15 = 600,000; I = 12; and then solve for NPV = -$2,113,481.31.


b. 0 1


12% 14 15


| | | |


-6,200,000 1,200,000 1,200,000 1,200,000


Using a financial calculator, input the following data: CF0 = -6,200,000;


CF1-15 = 1,200,000; I = 12; and then solve for NPV = $1,973,037.39.


c. If they proceed with the project today, the project's expected NPV = (0.5 -$2,113,481.31) + (0.5


$1,973,037.39) = -$70,221.96. So, Hart Enterprises would not do it.


d. Since the project's NPV with the tax is negative, if the tax were imposed the firm would abandon


the project. Thus, the decision tree looks like this:


NPV @


0 1 2 15 Yr. 0


50% Prob. | r= 12% | | |


Taxes -6,200,000 6,000,000 0 0 -$ 842,857.14


No Taxes | | | |


50% Prob. -6,200,000 1,200,000 1,200,000 1,200,000 1,973,037.39


Expected NPV $ 565,090.13


Yes, the existence of the abandonment option changes the expected NPV of the project from


negative to positive. Given this option the firm would take on the project because its expected


NPV is $565,090.13.


e. NPV @


0 1 Yr. 0


50% Prob. | r = 12% |


Taxes NPV = ? -1,500,000 $ 0.00


+300,000 = NPV @ t = 1 }wouldn't do


No Taxes | |


50% Prob. NPV = ? -1,500,000 2,232,142.86


+4,000,000 = NPV @ t = 1Expected NPV $1,116,071.43


If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the project is


exactly equal to zero. So the firm would not pay any more than this for the option.




Answers and Solutions: 12 - 260 12-5 P = PV of all expected future cash flows if project is delayed. From Problem 15-3 we know that PV


@ Year 1 of Tax Imposed scenario is $15.45 and PV @ Year 1 of Tax Not Imposed Scenario is $26.69.


So the PV is:


P = [0.5(15.45)+ 0.5(26.690] / 1.13 = $18.646.


X = $20.


t = 1.


rRF = 0.08.


2 = 0.0687.


d1 = ln[18.646/20] + [0.08 + .5(.0687)](1) = 0.1688


(.0687)0.5 (1)0.5


d2 = 0.1688 - (.0687)0.5 (1)0.5 = -0.0933


From Excel function NORMSDIST, or approximated from Table 13E-1 in Extension to Chapter 13:


N(d1) = 0.5670


N(d2) = 0.4628


Using the Black-Scholes Option Pricing Model, you calculate the option's value as:


-r t


V = P[N(d1)] - Xe RF [N(d2)]


= $18.646(0.5670) - $20e(-0.08)(1)(0.4628)


= $10.572 - $8.544


= $2.028 million.




Answers and Solutions: 12 - 261 12-6 P = PV of all expected future cash flows if project is delayed. From Problem 13-4 we know that PV


@ Year 2 of Low CF Scenario is $6.974 and PV @ Year 2 of High CF Scenario is $13.313. So the


PV is:


P = [0.1(6.974)+ 0.9(13.313] / 1.102 = $10.479.


X = $9.


t = 2.


rRF = 0.06.


2 = 0.0111.


d1 = ln[10.479/9] + [0.06 + .5(.0111)](2) = 1.9010


(.0111)0.5 (2)0.5


d2 = 1.9010 - (.0111)0.5 (2)0.5 = 1.7520


From Excel function NORMSDIST, or approximated from Table 12E-1 in Extension to Chapter 12:


N(d1) = 0.9713


N(d2) = 0.9601


Using the Black-Scholes Option Pricing Model, you calculate the option's value as:


-r t


V = P[N(d1)] - Xe RF [N(d2)]


= $10.479(0.9713) - $9e(-0.06)(2)(0.9601)


= $10.178 - $7.664


= $2.514 million.




Answers and Solutions: 12 - 262 SOLUTION TO SPREADSHEET PROBLEMS


12-7 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 12 P7 Build a Model.xls) and on the instructor's side of the textbook's web


site, http://brigham.swcollege.com.




Answers and Solutions: 12 - 263 MINI CASE


Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options. Since no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics.


To begin, you gathered some outside materials the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.


a. What are some types of real options?


Answer: 1. Investment timing options


2. Growth options


a. Expansion of existing product line


b. New products


c. New geographic markets


3. Abandonment options


a. Contraction


b. Temporary suspension


c. Complete abandonment


4. Flexibility options.



b. What are five possible procedures for analyzing a real option?


Answer: 1. DCF analysis of expected cash flows, ignoring option.


2. Qualitatively assess the value of the real option.


3. Decision tree analysis.


4. Use a model for a corresponding financial option, if possible.


5. Use financial engineering techniques if a corresponding financial option is not available.




Answers and Solutions: 13 - 264 c. Tropical Sweets is considering a project that will cost $70 million and will generate


expected cash flows of $30 per year for three years. The cost of capital for this type


of project is 10 percent and the risk-free rate is 6 percent. After discussions with the


marketing department, you learn that there is a 30 percent chance of high demand,


with future cash flows of $45 million per year. There is a 40 percent chance of


average demand, with cash flows of $30 million per year. If demand is low (a 30


percent chance), cash flows will be only $15 million per year. What is the expected


NPV?


Answer: Initial Cost = $70 Million


Expected Cash Flows = $30 Million Per Year For Three Years


Cost Of Capital = 10%


PV Of Expected CFs = $74.61 Million


Expected NPV = $74.61 - $70


= $4.61 Million


Alternatively, one could calculate the NPV of each scenario:


Demand Probability Annual Cash Flow


High 30% $45


Average 40% $30


Low 30% $15


Find NPV of each scenario:


PV High: N=3 I=10 PV=? PMT=-45 FV=0


PV= 111.91


NPV High = $111.91 - $70 = $41.91 Million.


PV Average: N=3 I=10 PV=? PMT=-30 FV=0


PV= 74.61


NPV Average = $74.61 - $70 = $4.71 Million.


PV Low: N=3 I=10 PV=? PMT=-15 FV=0


PV= 37.30


NPV Low = $37.30 - $70 = -$32.70 Million.


Find Expected NPV:


E(NPV)=.3($41.91)+.4($4.61)+.3(-$32.70)


E(PV)= $4.61.



d. Now suppose this project has an investment timing option, since it can be delayed for


a year. The cost will still be $70 million at the end of the year, and the cash flows


for the scenarios will still last three years. However, Tropical Sweets will know the


level of demand, and will implement the project only if it adds value to the company.



Answers and Solutions: 13 - 265 Perform a qualitative assessment of the investment timing option's value.


Answer: If we immediately proceed with the project, its expected NPV is $4.61 million. However,


the project is very risky. If demand is high, NPV will be $41.91 million. If demand is


average, NPV will be $4.61 million. If demand is low, NPV will be -$32.70 million. However,


if we wait one year, we will find out additional information regarding demand. If demand is


low, we won't implement project. If we wait, the up-front cost and cash flows will stay the


same, except they will be shifted ahead by a year.


The value of any real option increases if the underlying project is very risky or if there is a


long time before you must exercise the option.


This project is risky and has one year before we must decide, so the option to wait is probably


valuable.


e. Use decision tree analysis to calculate the NPV of the project with the investment


timing option.


Answer: The project will be implemented only if demand is average or high.


Here is the time line:


0 1 2 3 4


High $0 -$70 $45 $45 $45


Average $0 -$70 $30 $30 $30


Low $0 $0 $0 $0 $0


To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is


known for certain, and discount the other risky cash flows at the 10 percent cost


of capital.


High: NPV = -$70/1.06 + $45/1.102 + $45/1.103 +$45/1.104 = $35.70


Average: NPV = -$70/1.06 + $30/1.102 + $30/1.103 +$30/1.104 = $1.79


Low: NPV = $0.


Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42.


Since this is much greater than the NPV of immediate implementation (which is $4.61 million) we


should wait. In other words, implementing immediately gives an expected NPV of $4.61 million,


but implementing immediately means we give up the option to wait, which is worth $11.42


million.




Answers and Solutions: 13 - 266 f. Use a financial option pricing model to estimate the value of the investment timing


option.


Answer: The option to wait resembles a financial call option-- we get to "buy" the project for $70 million


in one year if value of project in one year is greater than $70 million. This is like a call option


with an exercise price of $70 million and an expiration date of one year.


X = Exercise Price = Cost Of Implement Project = $70 Million.


RRF = Risk-Free Rate = 6%.


T = Time To Maturity = 1 year.


P = Current Price Of Stock = Current Value Of The Project's Future Cash Flows.


2 = Variance Of Stock Return = Variance Of Project's Rate Of Return.


We explain how to calculate P and 2 below.


Just as the price of a stock is the present value of all the stock's future cash flows, the "price" of


the real option is the present value of all the project's cash flows that occur beyond the exercise


date. Notice that the exercise cost of an option does not affect the stock price. Similarly, the


cost to implement the real option does not affect the current value of the underlying asset (which


is the PV of the project's cash flows). It will be helpful in later steps if we break the calculation


into two parts. First, we find the value of all cash flows beyond the exercise date discounted


back to the exercise date. Then we find the expected present value of those values.


Step 1: Find the value of all cash flows beyond the exercise date discounted back to the exercise


date. Here is the time line. The exercise date is year 1, so we discount all future cash flows


back to year 1.


0 1 2 3 4


High $45 $45 $45


Average $30 $30 $30


Low $15 $15 $15


High: PV1 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91


Average: PV1 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61


Low: PV1 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30


The current expected present value, P, is:


P = 0.3[$111.91/1.1] + 0.4[$74.61/1.1] + 0.3[$37.30/1.1] = $67.82.


For a stock option, 2 is the variance of the stock return, not the variance of the stock price.


Therefore, for a real option we need the variance of the project's rate of return. There are three


ways to estimate this variance. First, we can use subjective judgment. Second, we can


calculate the project's return in each scenario and then calculate the return's variance. This is the


direct approach. Third, we know the projects value at each scenario at the expiration date, and


we know the current value of the project. Thus, we can find a variance of project return that


gives the range of project values that can occur at expiration. This is the indirect approach.


Following is an explanation of each approach.


Subjective estimate:


The typical stock has 2 of about 12%. Most projects will be somewhat riskier than the firm,


since the risk of the firm reflects the diversification that comes from having many projects.


Subjectively scale the variance of the company's stock return up or down to reflect the risk of the


Answers and Solutions: 13 - 267 project. The company in our example has a stock with a variance of 10%, so we might expect the project to have a variance in the range of 12% to 19%.


Direct approach: From our previous analysis, we know the current value of the project and the value for each scenario at the time the option expires (year 1). Here is the time line:


Current Value Value At Expiration


Year 0 Year 1 High $67.82 $111.91 Average $67.82 $74.61 Low $67.82 $37.30 The annual rate of return is: High: Return = ($111.91/$67.82) 1 = 65%. High: Average = ($74.61/$67.82) 1 = 10%. High: Return = ($37.30/$67.82) 1 = -45%.


Expected Return = 0.3(0.65) + 0.4(0.10) + 0.3(-0.45)


= 10%.


2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2 + 0.3(-0.45-0.10)2


= 0.182 = 18.2%.


The direct approach gives an estimate of 18.2% for the variance of the project's return.




Answers and Solutions: 13 - 268 The indirect approach: Given a current stock price and an anticipated range of possible stock prices at some point in the future, we can use our knowledge of the distribution of stock returns (which is lognormal) to relate the variance of the stock's rate of return to the range of possible outcomes for stock price. To use this formula, we need the coefficient of variation of stock price at the time the option expires. To calculate the coefficient of variation, we need the expected stock price and the standard deviation of the stock price (both of these are measured at the time the option expires). For the real option, we need the expected value of the project's cash flows at the date the real option expires, and the standard deviation of the project's value at the date the real option expires. We previously calculated the value of the project at the time the option expires, and we can use this to calculate the expected value and the standard deviation.


Value At Expiration


Year 1 High $111.91 Average $74.61 Low $37.30


Expected Value =.3($111.91)+.4($74.61)+.3($37.3)


= $74.61. value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2


+ .3($37.30-$74.61)2]1/2


= $28.90.


Coefficient Of Variation = CV = Expected Value / value CV = $74.61 / $28.90 = 0.39.


Here is a formula for the variance of a stock's return, if you know the coefficient of variation of the expected stock price at some point in the future. The CV should be for the entire project, including all scenarios: 2 = LN[CV2 + 1]/T = LN[0.392 + 1]/1 = 14.2%.



Now, we proceed to use the OPM:


V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].




Answers and Solutions: 13 - 269 ln($67.83/$70) + [( 0.06 + 0.142/2 )](15)


d1 =


0.5 0.5


(.142 ) (1)


= 0.2641.


d2 = d1 - (0.142)0.5(1)0.5 = 0.2641 - 0.3768


= -0.1127.


N(d1) = N(0.2641) = 0.6041.


N(d2) = N(-0.1127) = 0.4551.



therefore,


V = $67.83(0.6041) - $70e-0.06(0.4551)


= $10.98.


g. Now suppose the cost of the project is $75 million and the project cannot be


delayed. But if Tropical Sweets implements the project, then Tropical Sweets will


have a growth option. It will have the opportunity to replicate the original project at


the end of its life. What is the total expected NPV of the two projects if both are


implemented?


Answer: Suppose the cost of the project is $75 million instead of $70 million, and there is no option to


wait.


NPV = PV of future cash flows - cost


= $74.61 - $75 = -$0.39 million.


The project now looks like a loser. Using NPV analysis:


NPV = NPV Of Original Project + NPV Of Replication Project


= -$0.39 + -$0.39/(1+0.10)3


= -$0.39 + -$0.30 = -$0.69.


Still looks like a loser, but you will only implement project 2 if demand is high. We might have


chosen to discount the cost of the replication project at the risk-free rate, and this would have


made the NPV even lower.




Answers and Solutions: 13 - 270 h. Tropical Sweets will replicate the original project only if demand is high. Using


decision tree analysis, estimate the value of the project with the growth option.


Answer: The future cash flows of the optimal decisions are shown below. The cash flow in year 3 for the


high demand scenario is the cash flow from the original project and the cost of the replication


project.


0 1 2 3 4 5 6


High -$75 $45 $45 $45 -$70 $45 $45 $45


Average -$75 $30 $30 $30 $0 $0 $0


Low -$75 $15 $15 $15 $0 $0 $0


To find the NPV, we discount the risky cash flows at the 10 percent cost of capital, and the


non-risky cost to replicate (i.e., the $75 million) at the risk-free rate.


NPV high = -$75 + $45/1.10 + $45/1.102 + $45/1.103 + $45/1.104


+ $45/1.105 + $45/1.106 - $75/1.063


= $58.02


NPV average = -$75 + $30/1.10 + $30/1.102 + $30/1.103 = -$0.39


NPV average = -$75 + $15/1.10 + $15/1.102 + $15/1.103 = -$37.70


Expected NPV = 0.3($58.02) + 0.4(-$0.39) + 0.3(-$37.70) = $5.94.


Thus, the option to replicate adds enough value that the project now has a positive NPV.


i. Use a financial option model to estimate the value of the growth option.


Answer: X = Exercise Price = Cost Of Implement Project = $75 million.


RRF = Risk-Free Rate = 6%.


T = Time To Maturity = 3 years.


P = Current Price Of Stock = Current Value Of The Project's Future Cash Flows.


2 = Variance Of Stock Return = Variance Of Project's Rate Of Return.


We explain how to calculate P and 2 below.


Step 1: Find the value of all cash flows beyond the exercise date discounted back to the exercise


date. Here is the time line. The exercise date is year 1, so we discount all future cash flows


back to year 3.


0 1 2 3 4 5 6


High $45 $45 $45


Average $30 $30 $30


Low $15 $15 $15


High: PV3 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91


Average: PV3 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61


Low: PV3 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30



Answers and Solutions: 13 - 271 The current expected present value, P, is: P = 0.3[$111.91/1.13] + 0.4[$74.61/1.13] + 0.3[$37.30/1.13] = $56.05.


Direct approach for estimating 2:


From our previous analysis, we know the current value of the project and the value for each scenario at the time the option expires (year 3). Here is the time line:


Current Value Value At Expiration


Year 0 Year 3 High $56.02 $111.91 Average $56.02 $74.61 Low $56.02 $37.30


The annual rate of return is: High: Return = ($111.91/$56.02)(1/3) 1 = 25.9%. High: Average = ($74.61/$56.02)(1/3) 1 = 10%. High: Return = ($37.30/$56.02)(1/3) 1 = -12.7%.


Expected Return = 0.3(0.259) + 0.4(0.10) + 0.3(-0.127)


= 8.0%.


2 = 0.3(0..259-0.08)2 + 0.4(0.10-0.08)2 + 0.3(-0.127-0.08)2


= 0.182 = 2.3%.


This is lower than the variance found for the previous option because the dispersion of cash flows for the replication project is the same as for the original, even though the replication occurs much later. Therefore, the rate of return for the replication is less volatile. We do sensitivity analysis later.


The indirect approach: First, find the coefficient of variation for the value of the project at the time the option expires (year 3).



We previously calculated the value of the project at the time the option expires, and we can use this to calculate the expected value and the standard deviation.


Value At Expiration


Year 3 High $111.91 Average $74.61 Low $37.30



Answers and Solutions: 13 - 272 Expected Value =.3($111.91)+.4($74.61)+.3($37.3)


= $74.61.


value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2


+ .3($37.30-$74.61)2]1/2


= $28.90.


Coefficient Of Variation = CV = Expected Value / value


CV = $74.61 / $28.90 = 0.39.


To find the variance of the project's rate or return, we use the formula below:


2 = LN[CV2 + 1]/T = LN[0.392 + 1]/3 = 4.7%.


Now, we proceed to use the OPM:


V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].


ln($56.06/$75) + [( 0.06 + 0.047/2)]( 3)


d1 =


0.5 0.5


( 0.047 ) ( 3)


= -0.1085.


d2 = d1 - (0.047)0.5(3)0.5 = -.1085 - 0.3755


= -0.4840.


N(d1) = N(-0.1080) = 0.4568.


N(d2) = N(-0.4835) = 0.3142.


Therefore,


V = $56.06(0.4568) - $75e-(0.06)(3)(0.3142)


= $5.92.


Total Value = NPV Of Project 1 + Value Of Growth Option


=-$0.39 + $5.92


= $5.5 million


j. What happens to the value of the growth option if the variance of the project's return


is 14.2 percent? What if it is 50 percent? How might this explain the high


valuations of many dot.com companies?


Answer: If risk, defined by 2, goes up, then value of growth option goes up (see the file ch 12 mini


case.xls for calculations):


2 = 4.7%, option value = $5.92


2 = 14.2%, option value = $12.10


2 = 50%, option value = $24.09


If the future profitability of dot.com companies is very volatile (i.e., there is the potential for very


high profits), then a company with a real option on those profits might have a very high value for


its growth option.



Answers and Solutions: 13 - 273 Chapter 13


Analysis of Financial Statements


ANSWERS TO END-OF-CHAPTER QUESTIONS


13-1 a. A liquidity ratio is a ratio that shows the relationship of a firm's cash and other current assets to its


current liabilities. The current ratio is found by dividing current assets by current liabilities. It


indicates the extent to which current liabilities are covered by those assets expected to be


converted to cash in the near future. The quick, or acid test, ratio is found by taking current


assets less inventories and then dividing by current liabilities.


b. Asset management ratios are a set of ratios that measure how effectively a firm is managing its


assets. The inventory turnover ratio is sales divided by inventories. Days sales outstanding is


used to appraise accounts receivable and indicates the length of time the firm must wait after


making a sale before receiving cash. It is found by dividing receivables by average sales per


day. The fixed assets turnover ratio measures how effectively the firm uses its plant and


equipment. It is the ratio of sales to net fixed assets. Total assets turnover ratio measures the


turnover of all the firm's assets; it is calculated by dividing sales by total assets.


c. Financial leverage ratios measure the use of debt financing. The debt ratio is the ratio of total


debt to total assets, it measures the percentage of funds provided by creditors. The


times-interest-earned ratio is determined by dividing earnings before interest and taxes by the


interest charges. This ratio measures the extent to which operating income can decline before


the firm is unable to meet its annual interest costs. The EBITDA coverage ratio is similar to the


times-interest-earned ratio, but it recognizes that many firms lease assets and also must make


sinking fund payments. It is found by adding EBITDA and lease payments then dividing this


total by interest charges, lease payments, and sinking fund payments over one minus the tax rate.


d. Profitability ratios are a group of ratios, which show the combined effects of liquidity, asset


management, and debt on operations. The profit margin on sales, calculated by dividing net


income by sales, gives the profit per dollar of sales. Basic earning power is calculated by


dividing EBIT by total assets. This ratio shows the raw earning power of the firm's assets,


before the influence of taxes and leverage. Return on total assets is the ratio of net income to


total assets. Return on common equity is found by dividing net income into common equity.




e. Market value ratios relate the firm's stock price to its earnings and book value per share. The


price/earnings ratio is calculated by dividing price per share by earnings per share--this shows


how much investors are willing to pay per dollar of reported profits. The price/cash flow is


calculated by dividing price per share by cash flow per share. This shows how much investors


are willing to pay per dollar of cash flow. Market-to-book ratio is simply the market price per


share divided by the book value per share. Book value per share is common equity divided by


the number of shares outstanding.


f. Trend analysis is an analysis of a firm's financial ratios over time. It is used to estimate the


likelihood of improvement or deterioration in its financial situation. Comparative ratio analysis


Answers and Solutions: 13 - 274 is when a firm compares its ratios to other leading companies in the same industry. This technique


is also known as benchmarking.


g. The Du Pont chart is a chart designed to show the relationships among return on investment, asset


turnover, the profit margin, and leverage. The Du Pont equation is a formula, which shows that the


rate of return on assets can be found as the product of the profit margin times the total assets


turnover.


h. Window dressing is a technique employed by firms to make their financial statements look better


than they really are. Seasonal factors can distort ratio analysis. At certain times of the year a


firm may have excessive inventories in preparation of a "season" of high demand. Therefore an


inventory turnover ratio taken at this time as opposed to after the season will be radically


distorted.


13-2 The emphasis of the various types of analysts is by no means uniform nor should it be. Management


is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should


be strengthened; second, management recognizes that the other parties are interested in all the ratios


and that financial appearances must be kept up if the firm is to be regarded highly by creditors and


equity investors. Equity investors are interested primarily in profitability, but they examine the other


ratios to get information on the riskiness of equity commitments. Long-term creditors are more


interested in the debt ratio, TIE, and fixed-charge coverage ratios, as well as the profitability ratios.


Short-term creditors emphasize liquidity and look most carefully at the liquidity ratios.


13-3 Given that sales have not changed, a decrease in the total assets turnover means that the company's


assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies


that the company increased its current assets. Since the company's current ratio increased, and yet,


its quick ratio is unchanged means that the company has increased its inventories.


13-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios


to vary among industries. For example, a steel company needs a greater number of dollars in assets


to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios


may vary due to differences in the amount of expenses incurred to produce sales. For example, one


would expect a grocery store chain to spend more per dollar of sales than does a steel company.


Often, a large turnover will be associated with a low profit margin, and vice versa.


13-5 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with


seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary


unless averages (monthly ones are best) are used.


b. Common equity is determined at a point in time, say December 31, 2004. Profits are earned over


time, say during 2004. If a firm is growing rapidly, year-end equity will be much larger than


beginning-of-year equity, so the calculated rate of return on equity will be different depending on


whether end-of-year, beginning-of-year, or average common equity is used as the denominator.


Average common equity is conceptually the best figure to use. In public utility rate cases, people


are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on


equity appear excessive or inadequate. Similar problems can arise when a firm is being


evaluated.


13-6 Firms within the same industry may employ different accounting techniques, which make it difficult


to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the



Answers and Solutions: 13 - 275 same industry differ in their other investments. For example, comparing Pepsico and Coca-Cola may be misleading because apart from their soft drink business, Pepsi also owns other businesses such as Frito-Lay, Pizza Hut, Taco Bell, and KFC.




Answers and Solutions: 13 - 276 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


CA CA - I 13-1 CA = $3,000,000; = 1.5; = 1.0;


CL CL


CL = ?; I = ?


CA


= 1.5


CL


$3,000,000


= 1.5


CL


1.5 CL = $3,000,000


CL = $2,000,000.


CA - I


= 1.0


CL


$3,000,000 - I


= 1.0


$2,000,000


$3,000,000 - I = $2,000,000


I = $1,000,000.


13-2 DSO = 40 days; ADS = $20,000; AR = ?


AR


DSO =


S


365


AR


40 =


$20,000


AR = $800,000.



13-3 A/E = 2.4; D/A = ?




Answers and Solutions: 13 - 277


D 1


= 1 -


A A



E


D 1


= 1 -


A 2.4


D


= 0.5833 = 58.33%.


A 13-4 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; A/E = ?


ROA = NI/A; PM = NI/S; ROE = NI/E


ROA = PM S/TA


NI/A = NI/S S/TA


10% = 2% S/TA


S/TA = 5.


ROE = PM S/TA TA/E


NI/E = NI/S S/TA TA/E


15% = 2% 5 TA/E


15% = 10% TA/E


TA/E = 1.5.



13-5 We are given ROA = 3% and Sales/Total assets = 1.5.


From Du Pont equation: ROA = Profit margin Total assets turnover


3% = Profit margin (1.5)


Answers and Solutions: 13 - 278 Profit margin = 3%/1.5 = 2%.


We can also calculate the company's debt ratio in a similar manner, given the facts of the problem.


We are given ROA(NI/A) and ROE(NI/E); if we use the reciprocal of ROE we have the following


equation:


E NI E D E


= _ and =1- , so


A A NI A A


E 1


= 3% _


A 0.05


E


= 60% .


A


D


= 1 - 0.60 = 0.40 = 40% .


A


Alternatively,


ROE = ROA EM


5% = 3% EM


EM = 5%/3% = 5/3 = TA/E.


Take reciprocal:


E/TA = 3/5 = 60%;


therefore,


D/A = 1 - 0.60 = 0.40 = 40%.


Thus, the firm's profit margin = 2% and its debt ratio = 40%.




$1,312,500 13-6 Present current ratio = = 2.5.


$525,000


$1,312,500 + NP


Minimum current ratio = = 2.0.


$525,000 + NP


$1,312,500 + NP = $1,050,000 + 2NP


NP = $262,500.


Answers and Solutions: 13 - 279 Short-term debt can increase by a maximum of $262,500 without violating a 2 to 1 current ratio,


assuming that the entire increase in notes payable is used to increase current assets. Since we


assumed that the additional funds would be used to increase inventory, the inventory account will


increase to $637,500, and current assets will total $1,575,000.


Quick ratio = ($1,575,000 - $637,500)/$787,500 = $937,500/$787,500 = 1.19.



Current assets $810,000 13-7 1. = 3.0 = 3.0


Current liabilities Current liabilities


Current liabilities = $270,000.


Current assets - Inventories $810,000 - Inventories


2. = 1.4 = 1.4


Current liabilities $270,000


Inventories = $432,000.


Current Marketable Accounts


3. = Cash + + + Inventories


assets Securities receivable


$810,000 = $120,000 + Accounts receivable + $432,000


Accounts receivable = $258,000.


Sales Sales


4. = 6.0 = 6.0


Inventory $432,000


Sales = $2,592,000.


Accounts receivable $258,000


5. DSO = = = 36.33 days.


Sales/365 $2,592,000/ 365


13-8 TIE = EBIT/INT, so find EBIT and INT.


Interest = $500,000 0.1 = $50,000.


Net income = $2,000,000 0.05 = $100,000.


Pre-tax income = $100,000/(1 - T) = $100,000/0.7 = $142,857.


EBIT = $142,857 + $50,000 = $192,857.


TIE = $192,857/$50,000 = 3.86.


13-9 a. (Dollar amounts in thousands.)


Industry



Answers and Solutions: 13 - 280 Firm Average


Current assets $655,000


= = 1.98


Current liabilities $330,000 2.0


Accounts receivable $336,000


DSO = = = 76 days 35


Sales/ 365 $4,404.11 days


Sales $1,607,500


= = 6.66


Inventory $241,500 6.7


Sales $1,607,500


= = 5.50


Fixed assets $292,500 12.1


Sales $1,607,500


= =


Total assets $947,500 1.70 3.0



Net income $27,300


= =


Sales $1,607,500 1.7% 1.2%



Net income $27,300


= = 2.9%


Total assets $947,500 3.6%



Industry


Firm Average


Net income $27,300


= = 7.6%


Common equity $361,000 9.0%


Total debt $586,500


= = 61.9% 60.0%


Total assets $947,500



Answers and Solutions: 13 - 281 b. For the firm,


$947,500


ROE = PM T.A. turnover EM = 1.7% 1.7 = 7.6%.


$361,000


For the industry, ROE = 1.2% 3 2.5 = 9%.


Note: To find the industry ratio of assets to common equity, recognize that 1 - (total debt/total


assets) = common equity/total assets. So, common equity/total assets = 40%, and 1/0.40 = 2.5 =


total assets/common equity.


c. The firm's days sales outstanding is more than twice as long as the industry average, indicating


that the firm should tighten credit or enforce a more stringent collection policy. The total assets


turnover ratio is well below the industry average so sales should be increased, assets decreased, or


both. While the company's profit margin is higher than the industry average, its other


profitability ratios are low compared to the industry--net income should be higher given the


amount of equity and assets. However, the company seems to be in an average liquidity position


and financial leverage is similar to others in the industry.


d. If 2004 represents a period of supernormal growth for the firm, ratios based on this year will be


distorted and a comparison between them and industry averages will have little meaning.


Potential investors who look only at 2003 ratios will be misled, and a return to normal conditions


in 2005 could hurt the firm's stock price.


13-10 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.


2. Accounts payable = Debt Long-term debt = $150,000 - $60,000


= $90,000


Total liabilities


3. Common stock = - Debt - Retained earnings


and equity


= $300,000 - $150,000 - $97,500 = $52,500.


4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.


5. Inventory = Sales/5 = $450,000/5 = $90,000.


6. Accounts receivable = (Sales/365)(DSO) = ($450,000/365)(36.5)


= $45,000.


7. Cash + Accounts receivable = (0.80)(Accounts payable)


Cash + $45,000 = (0.80)($90,000)


Cash = $72,000 - $45,000 = $27,000.


8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)


= $300,000 - ($27,000 + $45,000 + $90,000) = $138,000.


9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75)


= $337,500.



Answers and Solutions: 13 - 282 13-11 a. Here are the firm's base case ratios and other data as compared to the industry:


Firm Industry Comment


Quick 0.8 1.0


Weak


Current 2.3 2.7


Weak


Inventory turnover 4.8 7.0 Poor


Days sales outstanding 37 days 32 days Poor


Fixed assets turnover 10.0 13.0 Poor


Total assets turnover 2.3 2.6 Poor


Return on assets 5.9% 9.1% Bad


Return on equity 13.1 18.2 Bad


Debt ratio 54.8 50.0 High


Profit margin on sales 2.5 3.5 Bad


EPS $4.71 n.a. --


Stock Price $23.57 n.a. --


P/E ratio 5.0 6.0 Poor


P/CF ratio 2.0 3.5 Poor


M/B ratio 0.65 n.a. --


The firm appears to be badly managed--all of its ratios are worse than the industry averages, and


the result is low earnings, a low P/E, P/CF ratio, a low stock price, and a low M/B ratio. The


company needs to do something to improve.


b. A decrease in the inventory level would improve the inventory turnover, total assets turnover, and


ROA, all of which are too low. It would have some impact on the current ratio, but it is difficult


to say precisely how that ratio would be affected. If the lower inventory level allowed the


company to reduce its current liabilities, then the current ratio would improve. The lower cost of


goods sold would improve all of the profitability ratios and, if dividends were not increased,


would lower the debt ratio through increased retained earnings. All of this should lead to a


higher market/book ratio and a higher stock price.




Answers and Solutions: 13 - 283 SOLUTION TO SPREADSHEET PROBLEM


13-12 The detailed solution for the


problem is available both on the instructor's resource CD-ROM (in the file Solution to FM11 Ch 13


P12 Build a Model.xls) and on the instructor's side of the web site, http://brigham.swcollege.com.




Answers and Solutions: 13 - 284 MINI CASE



The first part of the case, presented in chapter 3, discussed the situation that Computron Industries was in after an expansion program. Thus far, sales have not been up to the forecasted level, costs have been higher than were projected, and a large loss occurred in 2004, rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm's survival.


Donna Jamison was brought in as assistant to Fred Campo, Computron's chairman, who had the task of getting the company back into a sound financial position. Computron's 2003 and 2004 balance sheets and income statements, together with projections for 2005, are shown in the following tables. Also, the tables show the 2003 and 2004 financial ratios, along with industry average data. The 2005 projected financial statement data represent Jamison's and Campo's best guess for 2005 results, assuming that some new financing is arranged to get the company "over the hump."


Jamison examined monthly data for 2004 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data looked somewhat worse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were longer than Computron's managers had anticipated. For these reasons, Jamison and Campo see hope for the company--provided it can survive in the short run.


Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.




Answers and Solutions: 14 - 285 Balance Sheets


Assets 2003 2004 2005e Cash $ 9,000 $ 7,282 $ 14,000 Short-Term Investments. 48,600 20,000 71,632 Accounts Receivable 351,200 632,160 878,000 Inventories 715,200 1,287,360 1,716,480


Total Current Assets $ 1,124,000 $ 1,946,802 $ 2,680,112 Gross Fixed Assets 491,000 1,202,950 1,220,000 Less: Accumulated Depreciation 146,200 263,160 383,160


Net Fixed Assets $ 344,800 $ 939,790 $ 836,840 Total Assets $ 1,468,800 $ 2,886,592 $ 3,516,952


Liabilities And Equity 2003 2004 2005e Accounts Payable $ 145,600 $ 324,000 $ 359,800 Notes Payable 200,000 720,000 300,000 Accruals 136,000 284,960 380,000


Total Current Liabilities $ 481,600 $ 1,328,960 $ 1,039,800 Long-Term Debt 323,432 1,000,000 500,000 Common Stock (100,000 Shares) 460,000 460,000 1,680,936 Retained Earnings 203,768 97,632 296,216


Total Equity $ 663,768 $ 557,632 $ 1,977,152 Total Liabilities And Equity $ 1,468,800 $ 2,886,592 $ 3,516,952


Income Statements


2003 2004 2005e Sales $ 3,432,000 $ 5,834,400 $ 7,035,600 Cost Of Goods Sold 2,864,000 4,980,000 5,800,000 Other Expenses 340,000 720,000 612,960 Depreciation 18,900 116,960 120,000


Total Operating Costs $ 3,222,900 $ 5,816,960 $ 6,532,960


EBIT $ 209,100 $ 17,440 $ 502,640 Interest Expense 62,500 176,000 80,000


EBT $ 146,600 $ (158,560) $ 422,640 Taxes (40%) 58,640 (63,424) 169,056 Net Income $ 87,960 $ (95,136) $ 253,584


Other Data 2003 2004 2005e Stock Price $ 8.50 $ 6.00 $ 12.17 Shares Outstanding 100,000 100,000 250,000 EPS $ 0.880 $ (0.951) $ 1.014 DPS $ 0.220 $ 0.110 $ 0.220 Tax Rate 40% 40% 40% Book Value Per Share $ 6.638 $ 5.576 $ 7.909 Lease Payments $ 40,000 $ 40,000 $ 40,000




Answers and Solutions: 14 - 286 Ratio Analysis 2003 2004 2005e Industry Average Current 2.3 1.5 2.58 2.7 Quick 0.8 0.5 0.93 1.0 Inventory Turnover 4.8 4.5 4.10 6.1 Days Sales 37.4 39.5 45.5 32.0 Outstanding Fixed Assets Turnover 10.0


6.2 8.41 7.0 Total Assets Turnover


2.3 2.0 2.00 2.5 Debt Ratio 54.8% 80.7% 43.8% 50.0% TIE 3.3 0.1 6.3 6.2 EBITDA Coverage 2.6 0.8 5.5 8.0 Profit Margin 2.6% -1.6% 3.6% 3.6% Basic Earning Power 14.2% 0.6% 14.3% 17.8% ROA 6.0% -3.3% 7.2% 9.0% ROE 13.3% -17.1% 12.8% 17.9% Price/Earnings (P/E) 9.7 -6.3 12.0 16.2 Price/Cash Flow 8.0 27.5 8.1 7.6 Market/Book 1.3 1.1 1.5 2.9



a. Why are ratios useful? What are the five major categories of ratios?


Answer: Ratios are used by managers to help improve the firm's performance, by lenders to help evaluate


the firm's likelihood of repaying debts, and by stockholders to help forecast future earnings and


dividends. The five major categories of ratios are: liquidity, asset management, debt


management, profitability, and market value.




Answers and Solutions: 14 - 287 b. Calculate the 2005 current and quick ratios based on the projected balance sheet


and income statement data. What can you say about the company's liquidity


position in 2003, 2004, and as projected for 2005? We often think of ratios as


being useful (1) to managers to help run the business, (2) to bankers for credit


analysis, and (3) to stockholders for stock valuation. Would these different


types of analysts have an equal interest in the liquidity ratios?


Answer: Current Ratio05 = Current Assets/Current Liabilities


= $2,680,112/$1,039,800 = 2.58.


Quick Ratio05 = (Current Assets Inventory)/Current Liabilities


= ($2,680,112 - $1,716,480)/$1,039,800 = 0.93.


The company's current and quick ratios are higher relative to its 2003 current and quick ratios;


they have improved from their 2004 levels. Both ratios are below the industry


average, however.


c. Calculate the 2005 inventory turnover, days sales outstanding (DSO), fixed


assets turnover, and total assets turnover. How does Computron's utilization


of assets stack up against other firms in its industry?


Answer: Inventory Turnover05 = Sales/Inventory


= $7,035,600/$1,716,480 = 4.10.


DSO05 = Receivables/(Sales/365)


= $878,000/($7,035,600/365) = 45.5 Days.


Fixed Assets Turnover05 = Sales/Net Fixed Assets


= $7,035,600/$836,840 = 8.41.


Total Assets Turnover05 = Sales/Total Assets


= $7,035,600/$3,516,952 = 2.0.


The firm's inventory turnover ratio has been steadily declining, while its days sales


outstanding has been steadily increasing. While the firm's fixed assets turnover ratio is below its


2003 level, it is above the 2004 level. The firm's total assets turnover ratio is below its 2003


level and equal to its 2004 level.


The firm's inventory turnover and total assets turnover are below the industry average. The


firm's days sales outstanding is above the industry average (which is bad); however, the firm's


fixed assets turnover is above the industry average. (This might be due to the fact that


Computron is an older firm than most other firms in the industry, in which case, its fixed assets


are older and thus have been depreciated more, or that Computron's cost of fixed assets were


lower than most firms in the industry.)




Answers and Solutions: 14 - 288 d. Calculate the 2005 debt, times-interest-earned, and EBITDA coverage ratios.


How does Computron compare with the industry with respect to financial


leverage? What can you conclude from these ratios?


Answer: Debt Ratio05 = Total Liabilities/Total Assets


= ($1,039,800 + $500,000)/$3,516,952 = 43.8%.


Tie05 = EBIT/Interest = $502,640/$80,000 = 6.3.


Lease Loan Lease


EBITDA Coverage05 = EBITDA +


/ Interest +


+


Payments Repayments Payments


= ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5.


The firm's debt ratio is much improved from 2004, and is still lower than its 2002 level and the


industry average. The firm's TIE and EBITDA coverage ratios are much improved


from their 2003 and 2004 levels. The firm's TIE is better than the industry average,


but the EBITDA coverage is lower, reflecting the firm's higher lease obligations.



e. Calculate the 2005 profit margin, basic earning power (BEP), return on assets


(ROA), and return on equity (ROE). What can you say about these ratios?


Answer: Profit Margin05 = Net Income/Sales = $253,584/$7,035,600 = 3.6%.


Basic Earning Power05 = EBIT/Total Assets = $502,640/$3,516,952


= 14.3%.


ROA05 = Net Income/Total Assets = $253,584/$3,516,952 = 7.2%.


ROE05 = Net Income/Common Equity = $253,584/$1,977,152 = 12.8%.


The firm's profit margin is above 2003 and 2004 levels and is at the industry average. The


basic earning power, ROA, and ROE ratios are above both 2003 and 2004 levels, but below the


industry average due to poor asset utilization.




Answers and Solutions: 14 - 289 f. Calculate the 2005 price/earnings ratio, price/cash flow ratios, and market/book


ratio. Do these ratios indicate that investors are expected to have a high or low


opinion of the company?


Answer: EPS = Net Income/Shares Outstanding = $253,584/250,000 = $1.0143.


Price/Earnings05 = Price Per Share/Earnings Per Share


= $12.17/$1.0143 = 12.0.


Check: Price = EPS P/E = $1.0143(12) = $12.17.


Cash Flow/Share05 = (NI + DEP)/Shares


= ($253,584 + $120,000)/250,000


= $1.49.


Price/Cash Flow = $12.17/$1.49 = 8.2.



BVPS = Common Equity/Shares Outstanding


= $1,977,152/250,000 = $7.91.


Market/Book = Market Price Per Share/Book Value Per Share


= $12.17/$7.91 = 1.54x.


Both the P/E ratio and BVPS are above the 2003 and 2004 levels but below the industry average.


g. Perform a common size analysis and percent change analysis. What do these analyses tell


you about Computron?


Answer: For the common size balance sheets, divide all items in a year by the total assets for that year.


For the common size income statements, divide all items in a year by the sales in that year.




Answers and Solutions: 14 - 290 Common Size Balance Sheets


Assets


2003 2004 2005e Ind.


Cash 0.6% 0.3% 0.4% 0.3%


Short Term Investments 3.3% 0.7% 2.0% 0.3%


Accounts Receivable 23.9% 21.9% 25.0% 22.4%


Inventories 48.7% 44.6% 48.8% 41.2%


Total Current Assets 76.5% 67.4% 76.2% 64.1%


Gross Fixed Assets 33.4% 41.7% 34.7% 53.9%


Less Accumulated Depreciation 10.0% 9.1% 10.9% 18.0%


Net Fixed Assets 23.5% 32.6% 23.8% 35.9%


Total Assets 100.0% 100.0% 100.0% 100.0%


Liabilities And Equity 2003 2004 2005e Ind.


Accounts Payable 9.9% 11.2% 10.2% 11.9%


Notes Payable 13.6% 24.9% 8.5% 2.4%


Accruals 9.3% 9.9% 10.8% 9.5%


Total Current Liabilities 32.8% 46.0% 29.6% 23.7%


Long-Term Debt 22.0% 34.6% 14.2% 26.3%


Common Stock (100,000 Shares) 31.3% 15.9% 47.8% 20.0%


Retained Earnings 13.9% 3.4% 8.4% 30.0%


Total Equity 45.2% 19.3% 56.2% 50.0%


Total Liabilities And Equity 100.0% 100.0% 100.0% 100.0%



Common Size Income Statement 2003 2004 2005e Ind.


Sales 100.0% 100.0% 100.0% 100.0%


Cost Of Goods Sold 83.4% 85.4% 82.4% 84.5%


Other Expenses 9.9% 12.3% 8.7% 4.4%


Depreciation 0.6% 2.0% 1.7% 4.0%


Total Operating Costs 93.9% 99.7% 92.9% 92.9%


EBIT 6.1% 0.3% 7.1% 7.1%


Interest Expense 1.8% 3.0% 1.1% 1.1%


EBT 4.3% -2.7% 6.0% 5.9%


Taxes (40%) 1.7% -1.1% 2.4% 2.4%


Net Income 2.6% -1.6% 3.6% 3.6%



Computron has higher proportion of inventory and current assets than industry.


Computron has slightly more equity (which means less debt) than industry.


Computron has more short-term debt than industry, but less long-term debt than


industry. Computron has lower COGS than industry, but higher other expenses.


Result is that Computron has similar EBIT as industry.




Answers and Solutions: 14 - 291 For the percent change analysis, divide all items in a row by the value in the first year of the analysis.


Percent Change Balance Sheets


Assets


2003 2004 2005e


Cash 0.0% -19.1% 55.6%


Short Term Investments 0.0% -58.8% 47.4%


Accounts Receivable 0.0% 80.0% 150.0%


Inventories 0.0% 80.0% 140.0%


Total Current Assets 0.0% 73.2% 138.4%


Gross Fixed Assets 0.0% 145.0% 148.5%


Less Accumulated Depreciation 0.0% 80.0% 162.1%


Net Fixed Assets 0.0% 172.6% 142.7%


Total Assets 0.0% 96.5% 139.4%


Liabilities And Equity 2003 2004 2005e


Accounts Payable 0.0% 122.5% 147.1%


Notes Payable 0.0% 260.0% 50.0%


Accruals 0.0% 109.5% 179.4%


Total Current Liabilities 0.0% 175.9% 115.9%


Long-Term Debt 0.0% 209.2% 54.6%


Common Stock (100,000 Shares) 0.0% 0.0% 265.4%


Retained Earnings 0.0% -52.1% 45.4%


Total Equity 0.0% -16.0% 197.9%


Total Liabilities And Equity 0.0% 96.5% 139.4%



Percent Change Income Statement 2003 2004 2005e


Sales 0.0% 70.0% 105.0%


Cost Of Goods Sold 0.0% 73.9% 102.5%


Other Expenses 0.0% 111.8% 80.3%


Depreciation 0.0% 518.8% 534.9%


Total Operating Costs 0.0% 80.5% 102.7%


EBIT 0.0% -91.7% 140.4%


Interest Expense 0.0% 181.6% 28.0%


EBT 0.0% -208.2% 188.3%


Taxes (40%) 0.0% -208.2% 188.3%


Net Income 0.0% -208.2% 188.3%



We see that 2005 sales grew 105% from 2002, and that NI grew 188% from 2003. So


Computron has become more profitable. We see that total assets grew at a rate of 139%, while


sales grew at a rate of only 105%. So asset utilization remains a problem.




Answers and Solutions: 14 - 292 h. Use the extended Du Pont equation to provide a summary and overview of


Computron's financial condition as projected for 2005. What are the firm's


major strengths and weaknesses?


Profit Total Assets Equity Answer: Du Pont Equation =


Margin Turnover Multiplier


= 3.6% 2.0 ($3,516,952/$1,977,152)


= 3.6% 2.0 1.8 = 13.0%.


Strengths: The firm's fixed assets turnover was above the industry average. However, if the


firm's assets were older than other firms in its industry this could possibly account for the higher


ratio. (Computron's fixed assets would have a lower historical cost and would have been


depreciated for longer periods of time.) The firm's profit margin is slightly above the industry


average, despite its higher debt ratio. This would indicate that the firm has kept costs down, but,


again, this could be related to lower depreciation costs.


Weaknesses: The firm's liquidity ratios are low; most of its asset management ratios are poor


(except fixed assets turnover); its debt management ratios are poor, most of its profitability ratios


are low (except profit margin); and its market value ratios are low.


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


Answer: Some potential problems are listed below:


1. Comparison with industry averages is difficult if the firm operates many different divisions.


2. Different operating and accounting practices distort comparisons.


3. Sometimes hard to tell if a ratio is "good" or "bad."


4. Difficult to tell whether company is, on balance, in a strong or weak position.


5. "Average" performance is not necessarily good.


6. Seasonal factors can distort ratios.


7. "Window dressing" techniques can make statements and ratios look better.




Answers and Solutions: 14 - 293 j. What are some qualitative factors analysts should consider when evaluating a


company's likely future financial performance?


Answer: Top analysts recognize that certain qualitative factors must be considered when evaluating a


company. These factors, as summarized by the American Association Of Individual Investors


(AAII), are as follows:


1. Are the company's revenues tied to one key customer?


2. To what extent are the company's revenues tied to one key product?


3. To what extent does the company rely on a single supplier?


4. What percentage of the company's business is generated overseas?


5. Competition


6. Future prospects


7. Legal and regulatory environment




Answers and Solutions: 14 - 294 Chapter 14


Financial Planning and Forecasting Pro Forma Financial


Statements


ANSWERS TO END-OF-CHAPTER QUESTIONS


14-1 a. The operating plan provides detailed implementation guidance designed to accomplish corporate


objectives. It details who is responsible for what particular function, and when specific tasks are


to be accomplished. The financial plan details the financial aspects of the corporation's


operating plan. In addition to an analysis of the firm's current financial condition, the financial


plan normally includes a sales forecast, the capital budget, the cash budget, pro forma financial


statements, and the external financing plan. A sales forecast is merely the forecast of unit and


dollar sales for some future period. Of course, a lot of work is required to produce a good sales


forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the


economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to


good financial planning.


b. A pro forma financial statement shows how an actual statement would look if certain assumptions


are realized. With the percent of sales forecasting method, many items on the income statement


and balance sheets are assumed to increase proportionally with sales. As sales increase, these


items that are tied to sales also increase, and the values of these items for a particular year are


estimated as percentages of the forecasted sales for that year.


c. Funds are spontaneously generated if a liability account increases spontaneously (automatically)


as sales increase. An increase in a liability account is a source of funds, thus funds have been


generated. Two examples of spontaneous liability accounts are accounts payable and accrued


wages. Note that notes payable, although a current liability account, is not a spontaneous source


of funds since an increase in notes payable requires a specific action between the firm and a


creditor.




Answers and Solutions: 14 - 295 d. Additional funds needed (AFN) are those funds required from external sources to increase the


firm's assets to support a sales increase. A sales increase will normally require an increase in


assets. However, some of this increase is usually offset by a spontaneous increase in liabilities


as well as by earnings retained in the firm. Those funds that are required but not generated


internally must be obtained from external sources. Although most firms' forecasts of capital


requirements are made by constructing pro forma income statements and balance sheets, the AFN


formula is sometimes used to forecast financial requirements. It is written as follows:


Additional Required Spontaneous Increase in


funds = increase - increase in - retained


needed in assets liabilities earnings


A


AFN = S - L S - MS1 (1 - d ).


S S



Capital intensity is the dollar amount of assets required to produce a dollar of


sales. The capital intensity ratio is the reciprocal of the total assets turnover


ratio.


e. "Lumpy" assets are those assets that cannot be acquired smoothly, but require large, discrete


additions. For example, an electric utility that is operating at full capacity cannot add a small


amount of generating capacity, at least not economically.


14-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with


sales. Retained earnings increase, but not proportionately.


14-3 The equation gives good forecasts of financial requirements if the ratios A*/S and L*/S, as well as M


and d, are stable. Otherwise, another forecasting technique should be used.


14-5 a. +.


b. +. It reduces spontaneous funds; however, it may eventually increase retained earnings.


c. +.


d. +.




Answers and Solutions: 14 - 296 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


14-1 AFN = (A*/S0)S - (L*/S0)S - MS1(1 - d)


$3,000,000 $500,000


= $1,000,000 - $1,000,000 - 0.05($6,000,000)(1 - 0.7)


$5,000,000 $5,000,000


= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)


= $600,000 - $100,000 - $90,000


= $410,000.



$4,000,000 14-2 AFN = $1,000,000 (0.1)($1,000,000) ($300,000)(0.3)


$5,000,000


= (0.8)($1,000,000) - $100,000 - $90,000


= $800,000 - $190,000


= $610,000.


The capital intensity ratio is measured as A*/S0. This firm's capital intensity ratio is higher than


that of the firm in Problem 14-1; therefore, this firm is more capital intensive--it would require a


large increase in total assets to support the increase in sales.


14-3 AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1 - 0)


= $600,000 - $100,000 - $300,000


= $200,000.


Under this scenario the company would have a higher level of retained earnings which would


reduce the amount of additional funds needed.




Answers and Solutions: 14 - 297 14-4 S2004 = $2,000,000; A2004 = $1,500,000; CL2004 = $500,000;


NP2004 = $200,000; A/P2004 = $200,000; Accruals2004 = $100,000;


PM = 5%; d = 60%; A*/S0 = 0.75.


AFN = (A*/S0)S - (L*/S0)S - MS1(1 - d)


$300,000


= (0.75)S - S -(0.05)(S1)(1 - 0.6)


$2,000,000


= (0.75)S - (0.15)S - (0.02)S1


= (0.6)S - (0.02)S1


= 0.6(S1 - S0) - (0.02)S1


= 0.6(S1 - $2,000,000) - (0.02)S1


= 0.6S1 - $1,200,000 - 0.02S1


$1,200,000 = 0.58S1


$2,068,965.52 = S1.


Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional funds being


needed.


14-5 a. AFN = (A*/S)(S) (L*/S)(S) MS1(1 d)


$122.5 $17.5 $10.5


= ($70) - ($70) - ($420)(0.6) = $13.44 million.


$350 $350 $350




Answers and Solutions: 14 - 298 b. Upton Computers


Pro Forma Balance Sheet


December 31, 2005


(Millions of Dollars)


Forecast Pro Forma


Basis %


after


2004 2005 Sales Additions Pro Forma Financing Financing


Cash $ 3.5 0.0100 $ 4.20 $ 4.20


Receivables 26.0 0.7430 31.20 31.20


Inventories 58.0 0.1660 69.60 69.60


Total current


assets $ 87.5 $105.00 $105.00


Net fixed assets 35.0 0.100 42.00 42.00


Total assets $122.5 $147.00 $147.00


Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80


Notes payable 18.0 18.00 +13.44 31.44


Accruals 8.5 0.0243 10.20 10.20


Total current


liabilities $ 35.5 $ 39.00 $ 52.44


Mortgage loan 6.0 6.00 6.00


Common stock 15.0 15.00 15.00


Retained earnings 66.0 7.56* 73.56 73.56


Total liab.


and equity $122.5 $133.56 $147.00


AFN = $ 13.44


*PM = $10.5/$350 = 3%.


Payout = $4.2/$10.5 = 40%.


NI = $350 1.2 0.03 = $12.6.


Addition to RE = NI - DIV = $12.6 - 0.4($12.6) = 0.6($12.6) = $7.56.




Answers and Solutions: 14 - 299 14-6 a. Stevens Textiles


Pro Forma Income Statement


December 31, 2005


(Thousands of Dollars)


Forecast Pro Forma


2004 Basis


2005


Sales $36,000 1.15 Sales04 $41,400


Operating costs $32,440 0.9011 Sales05 37,306


EBIT $ 3,560 $ 4,094


Interest 460 0.10 Debt04 560


EBT $ 3,100 $ 3,534


Taxes (40%) 1,240 1,414


Net income $ 1,860 $ 2,120


Dividends (45%) $ 837 $ 954


Addition to RE $ 1,023 $ 1,166


Stevens Textiles


Pro Forma Balance Sheet


December 31, 2005


(Thousands of Dollars)


Forecast Pro Forma


Basis % after


2004 2005 Sales Additions Pro Forma Financing Financing


Cash $ 1,0800 0.0300 $ 1,242 $ 1,242


Accts receivable 6,480 0.1883 7,452 7,452


Inventories 9,000 0.2005 10,350 10,350


Total curr.


assets $16,560 $19,044 $19,044


Fixed assets 12,600 0.3500 14,490 14,490


Total assets $29,160 $33,534 $33,534


Accounts payable $ 4,320 0.1200 $ 4,968 $ 4,968


Accruals 2,880 0.0800 3,312 3,312


Notes payable 2,100 2,100 +2,128 4,228


Total current


liabilities $ 9,300 $10,380 $12,508


Long-term debt 3,500 3,500 3,500


Total debt $12,800 $13,880 $16,008


Common stock 3,500 3,500 3,500


Retained earnings 12,860 1,166* 14,026 14,026


Total liabilities


and equity $29,160 $31,406 $33,534



Answers and Solutions: 14 - 300 AFN = $ 2,128


*From income statement.



14-7 a. & b. Garlington Technologies Inc.


Pro Forma Income Statement


December 31, 2005


Forecast


2004


Basis Additions 2005


Sales $3,600,000 1.10 Sales04 $3,960,000


Operating costs 3,279,720 0.911 Sales05 3,607,692


EBIT $ 320,280 $


352,308


Interest 18,280 0.13 Debt04 20,280


EBT $ 302,000 $ 332,028


Taxes (40%) 120,800 132,811


Net income $ 181,200 $ 199,217


Dividends: $ 108,000 Set by management $ 112,000


Addition to RE: $ 73,200 $ 87,217




Answers and Solutions: 14 - 301 Garlington Technologies Inc.


Pro Forma Balance Statement


December 31, 2005


Forecast


Basis % AFN With AFN


2004 2005 Sales Additions 2005 Effects 2005 Cash $ 180,000 0.05 $ 198,000 $ 198,000 Receivables 360,000 0.10 396,000 396,000 Inventories 720,000 0.20 792,000 792,000


Total current


assets $1,260,000 $1,386,000 $1,386,000 Fixed assets 1,440,000 0.40 1,584,000 1,584,000


Total assets $2,700,000 $2,970,000 $2,970,000


Accounts payable $ 360,000 0.10 $ 396,000 $ 396,000 Notes payable 156,000 156,000 +128,783 284,783 Accruals 180,000 0.05 198,000 198,000


Total current


liabilities $ 696,000 $ 750,000 $ 878,783 Common stock 1,800,000 1,800,000 1,800,000 Retained earnings 204,000 87,217* 291,217 291,217


Total liab. and equity $2,700,000 $2,841,217 $2,970,000


AFN = $ 128,783


Cumulative AFN = $ 128,783


*See income statement.




Answers and Solutions: 14 - 302 Total liabilities Accounts Long - term Common Retained 14-8 a. = + + + .


and equity Payable debt stock earnings


$1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000


Long-term debt = $105,000.


Total debt = Accounts payable + Long-term debt


= $375,000 + $105,000 = $480,000.


Alternatively,


Total


Total debt = liabilities - Common stock - Retained earnings


and equity


= $1,200,000 - $425,000 - $295,000 = $480,000.


b. Assets/Sales (A*/S) = $1,200,000/$2,500,000 = 48%.


L*/Sales = $375,000/$2,500,000 = 15%.


2002 Sales = (1.25)($2,500,000) = $3,125,000.


AFN = (A*/S)(S) - (L*/S)(S) - MS1(1 - d) - New common stock


= (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000


= $300,000 - $93,750 - $112,500 - $75,000 = $18,750.


Alternatively, using the percentage of sales method:


Forecast


Basis % Additions (New


2004 2005 Sales Financing, R/E) Pro Forma


Total assets $1,200,000 0.48 $1,500,000


Current liabilities $ 375,000 0.15 $ 468,750


Long-term debt 105,000 105,000


Total debt $ 480,000 $ 573,750


Common stock 425,000 75,000* 500,000


Retained earnings 295,000 112,500** 407,500


Total common equity $ 720,000 $ 907,500


Total liabilities


and equity $1,200,000 $1,481,250


AFN = Long-term debt = $ 18,750


*Given in problem that firm will sell new common stock = $75,000.


**PM = 6%; Payout = 40%; NI2005 = $2,500,000 x 1.25 x 0.06 = $187,500.


Addition to RE = NI x (1 - Payout) = $187,500 x 0.6 = $112,500.




Answers and Solutions: 14 - 303 14-9 Cash $ 100.00 2 = $ 200.00


Accounts receivable 200.00 2 = 400.00


Inventories 200.00 2 = 400.00


Net fixed assets 500.00 + 0.0 = 500.00


Total assets $1,000.00 $1,500.00


Accounts payable $ 50.00 2 = $ 100.00


Notes payable 150.00 150.00 + 360.00 = 510.00


Accruals 50.00 2 = 1 00.00


Long-term debt 400.00


400.00


Common stock 100.00


100.00


Retained earnings 250.00 + 40 = 290.00


Total liabilities


and equity $1,000.00


$1,140.00


AFN


$ 360.00


Capacity sales = Sales/0.5 = $1,000/0.5 = $2,000.


Target FA/S ratio = $500/$2,000 = 0.25.


Target FA = 0.25($2,000) = $500 = Required FA. Since the firm currently has $500 of


fixed assets, no new fixed assets will be required.


Addition to RE = M(S1)(1 - Payout ratio) = 0.05($2,000)(0.4) = $40.




Answers and Solutions: 14 - 304 SOLUTION TO SPREADSHEET PROBLEM



14-10 The detailed solution for the spreadsheet problem is available both on the instructor's resource


CD-ROM (in the file Solution to FM11 Ch 14 -10 Build a Model.xls) and on the instructor's side of


the web site, http://brigham.swcollege.com.




Answers and Solutions: 14 - 305 MINI CASE



Betty Simmons, the new financial manager of Southeast Chemicals (SEC), a Georgia producer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 2005. SEC's 2004 sales were $2 billion, and the marketing department is forecasting a 25 percent increase for 2005. Simmons thinks the company was operating at full capacity in 2004, but she is not sure about this. The 2004 financial statements, plus some other data, are shown below.


Assume that you were recently hired as Simmons' assistant, and your first major task is to help her develop the forecast. She asked you to begin by answering the following set of questions.



Financial Statements And Other Data On SEC


(Millions Of Dollars) A. 2004 Balance Sheet % of % of


sales sales


Cash & Securities $ 20 1% Accounts Payable


And Accruals $ 100 5%


Accounts Receivable 240 12 Notes Payable 100


Inventory 240 12 Total Current Liabilities $ 200


Total Current Assets $ 500 Long-Term Debt 100


Net Fixed Assets 500 25 Common Stock 500


Retained Earnings 200


Total Assets $1,000 Total Liabilities And Equity $1,000


B. 2004 Income Statement % of


sales


Sales $2,000.00


Cost Of Goods Sold (COGS) 1,200.00 60%


Sales, General, And Administrative Costs 700.00 35


Earnings Before Interest And Taxes $ 100.00


Interest 10.00


Earnings Before Taxes $ 90.00


Taxes (40%) 36.00


Net Income $ 54.00


Dividends (40%) $ 21.60


Addition To Retained Earnings $ 32.40




Answers and Solutions: 15 - 306 C. Key Ratios Sec Industry


Profit Margin 2.70 4.00


Return On Equity 7.71 15.60


Days Sales Outstanding (365 Days) 43.80 Days 32.00 Days


Inventory Turnover 8.33 11.00


Fixed Assets Turnover 4.00 5.00


Debt/Assets 30.00% 36.00%


Times Interest Earned 10.00 9.40


Current Ratio 2.50 3.00


Return On Invested Capital


(NOPAT/Operating Capital) 6.67% 14.00%


a. Describe three ways that pro forma statements are used in financial planning.


Answer: Three important uses: (1) forecast the amount of external financing that will be required, (2)


evaluate the impact that changes in the operating plan have on the value of the firm, (3) set


appropriate targets for compensation plans


b. Explain the steps in financial forecasting.


Answer: (1) forecast sales, (2) project the assets needed to support sales, (3) project internally generated


funds, (4) project outside funds needed, (5) decide how to raise funds, and (6) see effects of plan


on ratios and stock price.



c. Assume (1) that SEC was operating at full capacity in 2004 with respect to all assets, (2) that


all assets must grow proportionally with sales, (3) that accounts payable and accruals will


also grow in proportion to sales, and (4) that the 2004 profit margin and dividend payout


will be maintained. Under these conditions, what will the company's financial


requirements be for the coming year? Use the AFN equation to answer this question.


Answer: SEC will need $184.5 million. Here is the AFN equation:


AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)


= (A*/S0)(g)(S0) - (L*/S0)(g)(S0) - M(S0)(1 + g)(1 - payout)


= ($1,000/$2,000)(0.25)($2,000) - ($100/$2,000)(0.25)($2,000)


- 0.0270($2,000)(1.25)(0.6)


= $250 - $25 - $40.5 = $184.5 million.


d. How would changes in these items affect the AFN? (1) sales increase, (2) the dividend


payout ratio increases, (3) the profit margin increases, (4) the capital intensity ratio


increases, and (5) SEC begins paying its suppliers sooner. (Consider each item separately


and hold all other things constant.)


Answer: 1. If sales increase, more assets are required, which increases the AFN.



Answers and Solutions: 15 - 307 2. If the payout ratio were reduced, then more earnings would be retained, and this would reduce


the need for external financing, or AFN. Note that if the firm is profitable and has any


payout ratio less than 100 percent, it will have some retained earnings, so if the growth rate


were zero, AFN would be negative, i.e., the firm would have surplus funds. As the growth


rate rose above zero, these surplus funds would be used to finance growth. At some point,


i.e., at some growth rate, the surplus AFN would be exactly used up. This growth rate where


AFN = $0 is called the "sustainable growth rate," and it is the maximum growth rate which


can be financed without outside funds, holding the debt ratio and other ratios constant.


3. If the profit margin goes up, then both total and retained earnings will increase, and this will


reduce the amount of AFN.


4. The capital intensity ratio is defined as the ratio of required assets to total sales, or a*/s0. Put


another way, it represents the dollars of assets required per dollar of sales. The higher the


capital intensity ratio, the more new money will be required to support an additional dollar of


sales. Thus, the higher the capital intensity ratio, the greater the AFN, other things held


constant.


5. If SEC begins paying sooner, this reduces spontaneous liabilities, leading to a higher AFN.


e. Briefly explain how to forecast financial statements using the percent of sales approach. Be


sure to explain how to forecast interest expenses.


Answer: Project sales based on forecasted growth rate in sales. Forecast some items as a percent of the


forecasted sales, such as costs, cash, accounts receivable, inventories, net fixed assets, accounts


payable, and accruals. Choose other items according to the company's financial policy: debt,


dividend policy (which determines retained earnings), common stock. Given the previous


assumptions and choices, we can estimate the required assets to support sales and the specified


sources of financing. The additional funds needed (AFN) is: required assets minus specified


sources of financing. If AFN is positive, then you must secure additional financing. If AFN is


negative, then you have more financing than is needed and you can pay off debt, buy back stock,


or buy short-term investments.


Interest expense is actually based on the daily balance of debt during the year. There are three


ways to approximate interest expense. You can base it on: (1) debt at end of year, (2) debt at


beginning of year, or (3) average of beginning and ending debt.


Basing interest expense on debt at end of year will over-estimate interest expense if debt is added


throughout the year instead of all on January 1. It also causes circularity called financial


feedback: more debt causes more interest, which reduces net income, which reduces retained


earnings, which causes more debt, etc.


Basing interest expense on debt at beginning of year will under-estimate interest expense if debt


is added throughout the year instead of all on December 31. But it doesn't cause problem of


circularity.


Basing interest expense on average of beginning and ending debt will accurately estimate the


interest payments if debt is added smoothly throughout the year. But it has the problem of


circularity.


Answers and Solutions: 15 - 308 A solution that balances accuracy and complexity is to base interest expense on beginning debt,


but use a slightly higher interest rate. This is easy to implement and is reasonably accurate.


See FM11 Ch 14 Mini Case Feedback.xls for an example basing interest expense on average


debt.


f. Now estimate the 2005 financial requirements using the percent of sales approach. Assume


(1) that each type of asset, as well as payables, accruals, and fixed and variable costs, will be


the same percent of sales in 2005 as in 2004; (2) that the payout ratio is held constant at 40


percent; (3) that external funds needed are financed 50 percent by notes payable and 50


percent by long-term debt (no new common stock will be issued); (4) that all debt carries an


interest rate of 10 percent; and (5) interest expenses should be based on the balance of debt


at the beginning of the year.


Answer: See the completed worksheet. The problem is not difficult to do "by hand," but we used a


spreadsheet model for the flexibility such a model provides.


Income Statement (In Millions Of Dollars) Actual Forecast


2004 Forecast Basis 2005 Sales $ 2,000.0 Growth 1.25 $ 2,500.0 COGS $ 1,200.0 % Of Sales 60.00% $ 1,500.0 SGA Expenses $ 700.0 % Of Sales 35.00% $ 875.0 EBIT $ 100.0 $ 125.0 Less Interest $ 10.0 Interest Rate X Debt04 $ 20.0 EBT $ 90.0 $ 105.0 Taxes (40%) $ 36.0 $ 42.0 Net Income $ 54.0 $ 63.0 Dividends $ 21.6 $ 25.2 Add. To Retained Earnings $ 32.4 $ 37.8




Answers and Solutions: 15 - 309 2005 2005 Balance Sheet Forecast Forecast (In Millions Of Dollars) Without With


Forecast


2004 Basis AFN AFN AFN Assets 0 Cash $ 20.0 % Of Sales 1.00% $ 25.0 $ 25.0 Accounts Receivable $240.0 % Of Sales 12.00% $300.0 $300.0 Inventories $240.0 % Of Sales 12.00% $300.0 $300.0 Total Current Assets $500.0 $625.0 $625.0 Net Plant And Equipment $500.0 % Of Sales 25.00% $625.0 $625.0 Total Assets $1,000.0 $1,250.0 $1,250.0


Liabilities And Equity Accounts Payable & Accruals $100.0 % Of Sales 5.00% $125.0 $125.0 Notes Payable $100.0 Carry-Over $100.0 $93.6 $193.6 Total Current Liabilities $200.0 $225.0 $318.6 Long-Term Bonds $100.0 Carry-Over $100.0 $93.6 $193.6 Total Liabilities $300.0 $325.0 $512.2 Common Stock $500.0 Carry-Over $500.0 $500.0


RE04 + Retained Earnings $200.0 RE04 $237.8 $237.8 Total Common Equity $700.0 $737.8 $737.8 Total Liabilities And Equity $1,000.0 $1,062.8 $1,250.0


Required Assets = $1,250.0 Specified Sources Of Financing = $1,062.8 Additional Funds Needed (AFN) $187.20



g. Why does the percent of sales approach produce a somewhat different AFN than the


equation approach? Which method provides the more accurate forecast?


Answer: The difference occurs because the AFN equation method assumes that the profit margin remains


constant, while the forecasted balance sheet method permits the profit margin to vary. The


balance sheet method is somewhat more accurate, but in this case the difference is not very large.


The real advantage of the balance sheet method is that it can be used when everything does not


increase proportionately with sales. In addition, forecasters generally want to see the resulting


ratios, and the balance sheet method is necessary to develop the ratios.


In practice, the only time we have ever seen the AFN equation used is to provide (1) a "quick


and dirty" forecast prior to developing the balance sheet forecast and (2) a rough check on the


balance sheet forecast.




Answers and Solutions: 15 - 310 h. Calculate SEC's forecasted ratios, and compare them with the company's 2004 ratios and


with the industry averages. Calculate SEC's forecasted free cash flow and return on


invested capital (ROIC).


Answer:


Actual Forecast


Key Ratios 2004 2005 Industry


Profit Margin 2.70% 2.52% 4.00%


ROE 7.71% 8.54% 15.60%


DSO 43.80 43.80 32.00


Inventory Turnover 8.33 8.33 11.00


Fixed Asset Turnover 4.00 4.00 5.00


Debt/Assets 30.00% 40.98% 36.00%


TIE 10.00 6.25 9.40


Current Ratio 2.50 1.96 3.00



Free Operating Gross Investment in


= -


Cash Flow Cash Flow Operating Capital


= NOPAT - Net Investment In Operating Capital


FCF = NOPAT - (Operating Capital2005 - Operating Capital2004)


= $125(1 - 0.4) + [($625 - $125 + $625) - ($500 - $100 + $500)


= $75 - ($1,125 - $900) = $75 - $225 = -$150.


Note: Operating Capital = Net Operating Working Capital + Net Fixed Assets.


ROIC = NOPAT / Capital = $75 / $1,125 = 0.067 = 6.67%.




Answers and Solutions: 15 - 311 i. Based on comparisons between SEC's days sales outstanding (DSO) and inventory turnover


ratios with the industry average figures, does it appear that SEC is operating efficiently with


respect to its inventory and accounts receivable? Suppose SEC was able to bring these


ratios into line with the industry averages and reduce its SGA/sales ratio to 33%. What


effect would this have on its AFN and its financial ratios? What effect would this have on


free cash flow and ROIC?


Answer: The DSO and inventory turnover ratio indicate that SEC has excessive inventories and receivables.


The effect of improvements here would reduce asset requirements and AFN. See the results


below based on the spreadsheet FM11 Ch 14 Mini Case.xls.


Inputs Before After


DSO 43.20 32.01


Accounts Receivable/Sales 12.0% 8.77%


Inventory Turnover 8.33 11.00


Inventory/Sales 12.0% 9.09%


SGA/Sales 35.0% 33.0%


Outputs


AFN $187.2 $15.7


FCF -$150.0 $33.5


ROIC 6.7% 10.8%


ROE 8.5% 12.3%


j. Suppose you now learn that SEC's 2004 receivables and inventories were in line with


required levels, given the firm's credit and inventory policies, but that excess capacity


existed with regard to fixed assets. Specifically, fixed assets were operated at only 75 percent


of capacity.


j. 1. What level of sales could have existed in 2004 with the available fixed assets?


Actual sales $2,000 Answer: Full Capacity Sales = = = $2,667.


% of capacity at which 0.75


fixed assets were operated


Since the firm started with excess fixed asset capacity, it will not have to add as much fixed assets


during 2005 as was originally forecasted:


j. 2. How would the existence of excess capacity in fixed assets affect the additional funds needed


during 2005?


Answer: We had previously found an AFN of $184.5 using the balance sheet method. The fixed assets


increase was 0.25($500) = $125. Therefore, the funds needed will decline by $125.


k. The relationship between sales and the various types of assets is important in financial


forecasting. The percent of sales approach, under the assumption that each asset item



Answers and Solutions: 15 - 312 grows at the same rate as sales, leads to an AFN forecast that is reasonably close to the


forecast using the AFN equation. Explain how each of the following factors would affect


the accuracy of financial forecasts based on the AFN equation: (1) economies of scale in


the use of assets, and (2) lumpy assets.


Answer: 1. Economies of scale in the use of assets mean that the asset item in question must increase less


than proportionately with sales; hence it will grow less rapidly than sales. Cash and


inventory are common examples, with possible relationship to sales as shown below:



Inventories


Cash




0 Sales


0 Sales



Inventories




Base


Stock



0 Sales




2. Lumpy assets would cause the relationship between assets and sales to look as shown below.


This situation is common with fixed assets.


Answers and Solutions: 15 - 313 Fixed assets




0 Sales




Answers and Solutions: 15 - 314 Chapter 15


Corporate Valuation, Value-Based Management, and


Corporate Governance


ANSWERS TO END-OF-CHAPTER QUESTIONS


15-1 a. Assets-in-place, also known as operating assets, include the land, buildings, machines, and


inventory that the firm uses in its operations to produce its products and services. Growth


options are not tangible. They include items such as R&D and customer relationships.


Financial, or nonoperating, assets include investments in marketable securities and


non-controlling interests in the stock of other companies.


b. Operating current assets are the current assets used to support operations, such


as cash, accounts receivable, and inventory. It does not include short-term


investments. Operating current liabilities are the current liabilities that are a


natural consequence of the firm's operations, such as accounts payable and


accruals. It does not include notes payable or any other short-term debt that


charges interest. Net operating working capital is operating current assets


minus operating current liabilities. Operating capital is sum of net operating


working capital and operating long-term assets, such as net plant and equipment.


Operating capital also is equal to the net amount of capital raised from investors.


This is the amount of interest-bearing debt plus preferred stock plus common


equity minus short-term investments. NOPAT is the amount of net income a


company would generate if it had no debt and held no financial assets. NOPAT


is a better measure of the performance of a company's operations because debt


lowers income. In order to get a true reflection of a company's operating


performance, one would want to take out debt to get a clearer picture of the


situation. Free cash flow is the cash flow actually available for distribution to


investors after the company has made all the investments in fixed assets and


working capital necessary to sustain ongoing operations. It is the most


important measure of cash flows because it shows the exact amount available to


all investors.


c. The value of operations is the present value of all the future free cash flows that


are expected from current assets-in-place and the expected growth of


assets-in-place when discounted at the weighted average cost of capital:



FCFt


Vop(at time 0) = .


t =1 (1 + WACC)


t


The terminal, or horizon value, is the value of operations at the end of the


explicit forecast period. It is equal to the present value of all free cash flows


beyond the forecast period, discounted back to the end of the forecast period at


the weighted average cost of capital:


FCFN +1 FCFN (1 + g)


Vop(at time N) = = .


WACC - g WACC - g The corporate valuation model defines the total value of a company as the value of


operations plus the value of nonoperating assets plus the value of growth


options.


Answers and Solutions: 15 - 315 d. Value-based management is the systematic application of the corporate value


model to a company's decisions. The four value drivers are the growth rate in


sales (g), operating profitability (OP=NOPAT/Sales), capital requirements


(CR=Capital/Sales), and the weighted average cost of capital (WACC). Return


on Invested Capital (ROIC) is NOPAT divided by the amount of capital that is


available at the beginning of the year.


e. Managerial entrenchment occurs when a company has such a weak board of


directors and has such strong anti-takeover provisions in its corporate charter


that senior managers feel there is very little chance that they will be removed.


Non-pecuniary benefits are perks that are not actual cash payments, such as


lavish offices, memberships at country clubs, corporate jets, and excessively


large staffs.


f. Targeted share repurchases, also known as greenmail, occur when a company


buys back stock from a potential acquiror at a higher than fair-market price.


In return, the potential acquiror agrees not to attempt to take over the company.


Shareholder rights provisions, also known as poison pills, allow existing


shareholders in a company to purchase additional shares of stock at a lower than


market value if a potential acquiror purchases a controlling stake in the


company. A restricted voting rights provision automatically deprives a


shareholder of voting rights if the shareholder owns more than a specified


amount of stock.


g. A stock option allows its owner to purchase a share of stock at a fixed price,


called the exercise price, no matter what the actual price of the stock is. Stock


options always have an expiration date, after which they cannot be exercised.


A restricted stock grant allows an employee to buy shares of stock at a large


discount from the current stock price, but the employee is restricted from selling


the stock for a specified number of years. An Employee Stock Ownership Plan,


often called an ESOP, is a type of retirement plan in which employees own stock


in the company. 15-2 The first step is to find the value of operations by discounting all expected future free cash flows at the


weighted average cost of capital. The second step is to find the total corporate value by summing the


value of operations, the value of nonoperating assets, and the value of growth options. The third step


is to find the value of equity by subtracting the value of debt and preferred stock from the total value


of the corporation. The last step is to divide the value of equity by the number of shares of common


stock.


15-3 A company can be profitable and yet have an ROIC that is less than the WACC if the company has


large capital requirements. If ROIC is less than the WACC, then the company is not earning enough


on its capital to satisfy its investors. Growth adds even more capital that is not satisfying investors,


hence, growth decreases value.


15-4 Entrenched managers consume to many perquisites, such as lavish offices, excessive staffs, country


club memberships, and corporate jets. They also invest in projects or acquisitions that make the firm


larger, even if they don't make the firm more valuable.



Answers and Solutions: 15 - 316 15-5 Stock options in compensation plans usually are issued with an exercise price equal to the current


stock price. As long as the stock price increases, the option will become valuable, even if the stock


price doesn't increase as much as investors expect.



SOLUTIONS TO END-OF-CHAPTER PROBLEMS



15-1 NOPAT = EBIT(1 - T)


= 100(1 - 0.4) = $60.


Net operating WC04 = ($27 + $80 + $106) - ($52 + $28)


= $213 - $80 = $133.


Operating capital04 = $133 + $265 = $398.


Net operating WC05 = ($28 + $84 + $112) - ($56 + $28)


= $224 - $84 = $140.


Operating capital05 = $140 + $281 = $421.


FCF = NOPAT - Net investment in operating capital


= $100(0.6) - ($421 - $398)


= $37.0.


15-2 Value of operations = Vop = PV of expected future free cash flow


FCF (1 + g) $400,000(1.05)


Vop = = = $6,000,000.


WACC - g 0.12 - 0.05



$108 ,000 15-3 a. Vop2 = = $2,700,000.


0.12 - 0.08


b. 0 1 2 3


WACC = 12% g = 8%


N


| | | | |


$80,000 $100,000 $108,000


$ 71,428.57


79,719.39


2,152,423.47


$2,303,571.43




Answers and Solutions: 15 - 317 $40 (1.07) 15-4 a. Vop 3 = = $713.33.


0.13 - 0.07


b. 0 1 2 3


4 WACC = 13% N


g = 7%


| | | | | |


-20 30 40


($ 17.70)


23.49 Vop 3 = 713.33


522.10 753.33


$527.89


c. Total valuet=0 = $527.89 + $10.0 = $537.89.


Value of common equity = $537.89 - $100 = $437.89.


$437.89


Price per share = = $43.79.


10.0 15-5 The growth rate in FCF from 2006 to 2007 is g=($750.00-$707.55)/$707.50 = 0.06.


$707.55 (1.06)


VOp at 2006 = = $15,000.


0.11 - 0.06


$200,000,000 15-6 Vop = $200,000,000 + [0.09 - 0.10]


0.098 - 0.05


=$200,000,000 + (-$40,000,000)= $160,000,000.


MVA = $160,000,000 - $200,000,000 = -40,000,000.


15-7 Capital2008 = Sales2008 (0.43)= $129,000,000.


$300,000,000 (1 + 0.05) 0.43


VOp at 2008 = $129,000,000 + 0.06 - (0.098) 1 + 0.05


0.098 - 0.05


= $129,000,000 + [$6,562,500,000][0.020]


= $129,000,000 + $130,375,000 = $259,375,000.


15-8 Total corporate value = Value of operations + marketable securities


= $756 + $77 = $833 million.


Value of equity = Total corporate value debt Preferred stock


= $833 ($151 + $190) - $76 = $416 million.


15-9 Total corporate value = Value of operations + marketable securities


= $651 + $47 = $698 million.


Value of equity = Total corporate value debt Preferred stock


= $698 ($65 + $131) - $33 = $469 million.


Price per share = $469 / 10 = $46.90.




Answers and Solutions: 15 - 318 15-10 a. NOPAT2005 = $108.6(1-0.4) = $65.16


NOWC2005 = ($5.6 + $56.2 + $112.4) ($11.2 + $28.1) = $134.9 million.


Capital2005 = $134.9 + $397.5 = $532.4 million.


FCF2005 = NOPAT Investment in Capital = $65.16 ($532.4 - $502.2)


= $65.16 - $30.2 = $34.96 million.


b. HV2005 = [$34.96(1.06)]/(0.11-0.06) = $741.152 million.


c. VOp at 12/31/2004 = [$34.96 + $741.152]/(1+0.11) = $699.20 million.


d. Total corporate value = $699.20 + $49.9 = $749.10 million.


e. Value of equity = $749.10 ($69.9 + $140.8) - $35.0 = $503.4 million.


Price per share = $503.4 / 10 = $50.34.




Answers and Solutions: 15 - 319 SOLUTION TO SPREADSHEET PROBLEM



15-11 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file "Solution for FM11 Ch 15-11 Build a Model.xls") and on the instructor's side of the web site,


http://brigham.swcollege.com.




Answers and Solutions: 15 - 320 MINI CASE



You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is


seeking to increase its value. KFS has asked you to estimate the value of two privately


held companies that KFS is considering acquiring. But first, the senior management of


KFS would like for you to explain how to value companies that don't pay any dividends.


You have structured your presentation around the following questions.


a. List the three types of assets that companies own.


Answer: Assets-in-place, growth options, and nonoperating, or financial, assets.



b. What are assets-in-place? How can their value be estimated?


Answer: Assets-in-place are tangible, such as buildings, machines, inventory. Usually they are expected


to grow. They generate free cash flows. The PV of their expected future free cash flows,


discounted at the WACC, is the value of operations.



c. What are growth options? How can their value be estimated?


Answer: Growth options are not tangible. They include R&D, such as at drug companies and genetic


engineering companies, and building customer relationships, such as at amazon.com. Growth


options are valued using option pricing techniques in Chapter 17.


d. What are nonoperating assets? How can their value be estimated?


Answer: Nonoperating assets are marketable securities and ownership of non-controlling interest in another


company. The value of nonoperating assets usually is very close to figure that is reported on


balance sheets.



e. What is the total value of a corporation? Who has claims on this value?


Answer: Total corporate value is sum of value of operations, value of nonoperating assets, and value of


growth options. (No examples in this chapter have a growth option-- this is deferred until


chapter 17). Debt holders have first claim. Preferred stockholders have the next claim. Any


remaining value belongs to stockholders.



. Answers and Solutions: 16 - 321 f. 1. The first acquisition target is a privately held company in a mature industry. The


company currently has free cash flow of $20 million. Its WACC is 10% and it is


expected to grow at a constant rate of 5%. The company has marketable securities


of $100 million. It is financed with $200 million of debt, $50 million of preferred


stock, and $210 million of book equity. What is its value of operations?


Answer:


FCF0 (1 + g )


VOp =


(WACC - g )


20 (1 + 0.05)


VOp = = 420


(0.10 - 0.05)


f. 2. What is its total corporate value? What is its value of equity?


Answer: Total Corporate Value = VOP + MKT. SEC.


= $420 + $100


= $520 million


Value Of Equity = Total - Debt - Pref.


= $520 - $200 - $50


= $270 million



f. 3. What is its MVA (MVA = total corporate value total book value)?


Answer: MVA = total corporate value of firm minus total book value of firm


total book value of firm = book value of equity + book value of debt


+ book value of preferred stock


MVA = $520 - ($210 + $200 + $50)


= $60 million



. Answers and Solutions: 16 - 322 g. 1. The second acquisition target is a privately held company in a growing industry.


The target has recently borrowed $40 million to finance its expansion; it has no other


debt or preferred stock. It pays no dividends and currently has no marketable


securities. KFS expects the company to produce free cash flows of -$5 million in


one year, $10 million in two years, and $20 million in three years. After three years,


free cash flow will grow at a rate of 6%. Its WACC is 10% and it currently has 10


million shares of stock. What is its horizon value (i.e., its value of operations at year


three)? What is its current value of operations (i.e., at time zero)?


Answer: 0 rc = 10% 1 g = 6% 2 3


4 N


| | | | | |


-5 10 20


$ -4.545


8.264


15.026


398.197 Vop 3 = 530 = 20 (1 + 0.06)


0.10 - 0.06 $416.942 = Value Of Operations



g. 2. What is its value of equity on a price per share basis?


Answer:


Value of equity = value of operations - debt


= $416.94 - $40 = $376.94 million.


price per share = $376.94/10 = $37.69.



h. KFS is also interested in applying value-based management to its own divisions.


Explain what value-based management is.


Answer: VBM is the systematic application of the corporate valuation model to all corporate decisions and


strategic initiatives. The objective of VBM is to increase market value added (MVA).



i. What are the four value drivers? How does each of them affect value?


Answer: MVA is determined by four drivers: sales growth, operating profitability (OP=NOPAT/sales),


capital requirements (CR=operating capital / sales, and the weighted average cost of capital.


MVA will improve if WACC is reduced, operating profitability (OP) increases, or the capital


requirement (CR) decreases. See the next question for an explanation of the impact of growth.




. Answers and Solutions: 16 - 323 j. What is return on invested capital (ROIC)? Why is the spread between ROIC and


WACC so important?


Answer: ROIC is the return on the capital that is in place at the beginning of the period:


NOPATt +1


ROIC =


t +1 Capital t


If the spread between the expected return, ROICt+1, and the required return,


WACC, is positive, then MVA is positive and growth makes MVA larger. The


opposite is true if the spread is negative.



k. KFS has two divisions. Both have current sales of $1,000, current expected growth


of 5%, and a WACC of 10%. Division A has high profitability (OP=6%) but high


capital requirements (CR=78%). Division B has low profitability (OP=4%) but low


capital requirements (CR=27%). What is the MVA of each division, based on the


current growth of 5%? What is the MVA of each division if growth is 6%?


Answer:


Sales t (1 + g) CR


MVA t = OP - WACC (1 + g )


WACC - g


Division A Division B


OP 6% 6% 4% 4%


CR 78% 78% 27% 27%


Growth 5% 6% 5% 6%


MVA (300.0) (360.0) 300.0 385.0




l. What is the ROIC of each division for 5% growth and for 6% growth? How is this


related to MVA?



Answer:


Division A Division B


Capital0 $780 $780 $270 $270


Growth 5% 6% 5% 6%


Sales1 $1,050 $1,060 $1,050 $1,060


Nopat1 $63 $63.6 $42 $42.4


Roic1 8.1% 8.2% 15.6% 15.7%


Mva (300.0) (360.0) 300.0 385.0


. Answers and Solutions: 16 - 324 The expected ROIC of division A is less than the WACC, so the division should


postpone growth efforts until it improves ROIC by reducing capital requirements (e.g.,


reducing inventory) and/or improving profitability.


The expected ROIC of division b is greater than the WACC, so the division should continue with


its growth plans.



m. The managers at KFS have heard that corporate governance can affect shareholder


value. List for them the three mechanisms of corporate governance.


Answer: The three mechanisms are provisions in the charter that affect takeovers, composition of the board


of directors, and compensation plans.


n. Why is entrenched management potentially harmful to shareholders?


Answer: Entrenchment occurs when there is little chance that poorly performing managers will be replaced.


There are two causes: anti-takeover provisions in the charter and a weak board of directors. Management consumes perks: lavish offices, corporate jets, excessively large staffs,


memberships at country clubs Management accepts projects (or acquisitions) to make firm larger, even if MVA goes


down. This is because salary and prestige are highly correlated with size.



o. List three provisions in the corporate charter that affect takeovers.


Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights provisions (i.e.,


poison pills), and restricted voting rights plans.




p. Explain the difference between insiders and outsiders on the board of directors.


What are interlocking boards?


Answer: Weak boards have many insiders (i.e., those who also have another position in the company)


compared with outsiders. Interlocking boards are weaker (CEO of company A sits on board of


company B, CEO of B sits on board of A).



q. What is a stock option in a compensation plan?


Answer: Gives owner of option the right to buy a share of the company's stock at a specified price (called


the exercise price) even if the actual stock price is higher. Usually can't exercise the option for


several years (called the vesting period). Can't exercise the option after a certain number of years


(called the expiration, or maturity, date).



. Answers and Solutions: 16 - 325 Chapter 16


Capital Structure Decisions: The Basics


ANSWERS TO END-OF-CHAPTER QUESTIONS


16-1 a. Capital structure is the manner in which a firm's assets are financed; that is, the right-hand side of


the balance sheet. Capital structure is normally expressed as the percentage of each type of


capital used by the firm--debt, preferred stock, and common equity. Business risk is the risk


inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the


uncertainty inherent in a total risk sense, future operating income, or earnings before interest and


taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales


variability and operating leverage. Financial risk is the risk added by the use of debt financing.


Debt financing increases the variability of earnings before taxes (but after interest); thus, along


with business risk, it contributes to the uncertainty of net income and earnings per share.


Business risk plus financial risk equals total corporate risk.


b. Operating leverage is the extent to which fixed costs are used in a firm's operations. If a high


percentage of a firm's total costs are fixed costs, then the firm is said to have a high degree of


operating leverage. Operating leverage is a measure of one element of business risk, but does


not include the second major element, sales variability. Financial leverage is the extent to which


fixed-income securities (debt and preferred stock) are used in a firm's capital structure. If a high


percentage of a firm's capital structure is in the form of debt and preferred stock, then the firm is


said to have a high degree of financial leverage. The breakeven point is that level of unit sales at


which costs equal revenues. Breakeven analysis may be performed with or without the inclusion


of financial costs. If financial costs are not included, breakeven occurs when EBIT equals zero.


If financial costs are included, breakeven occurs when EBT equals zero.


c. Reserve borrowing capacity exists when a firm uses less debt under "normal" conditions than


called for by the tradeoff theory. This allows the firm some flexibility to use debt in the future


when additional capital is needed.


16-2 Business risk refers to the uncertainty inherent in projections of future ROEU.


16-3 Firms with relatively high nonfinancial fixed costs are said to have a high degree of operating


leverage.


16-4 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage has no effect on


EBIT--it only affects EPS, given EBIT.


16-5 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary.


Such a firm is said to have high business risk. Consequently, there is a relatively large risk that the


firm will be unable to meet its fixed charges, and interest payments are fixed charges. As a result,


firms in unstable industries tend to use less debt than those whose sales are subject to only moderate


fluctuations.


16-6 Public utilities place greater emphasis on long-term debt because they have more stable sales and


profits as well as more fixed assets. Also, utilities have fixed assets which can be pledged as


collateral. Further, trade firms use retained earnings to a greater extent, probably because these firms


. Answers and Solutions: 16 - 326 are generally smaller and, hence, have less access to capital markets. Public utilities have lower


retained earnings because they have high dividend payout ratios and a set of stockholders who want


dividends.


16-7 EBIT depends on sales and operating costs. Interest is deducted from EBIT. At high debt levels,


firms lose business, employees worry, and operations are not continuous because of financing


difficulties. Thus, financial leverage can influence sales and costs, and hence EBIT, if excessive


leverage is used.


16-8 The tax benefits from debt increase linearly, which causes a continuous increase in the firm's value


and stock price. However, financial distress costs get higher and higher as more and more debt is


employed, and these costs eventually offset and begin to outweigh the benefits of debt.



. Answers and Solutions: 16 - 327 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


16-1 a. Here are the steps involved:


(1) Determine the variable cost per unit at present, V:


Profit = P(Q) - FC - V(Q)


$500,000 = ($100,000)(50) - $2,000,000 - V(50)


50(V) = $2,500,000


V = $50,000.


(2) Determine the new profit level if the change is made:


New profit = P2(Q2) - FC2 - V2(Q2)


= $95,000(70) - $2,500,000 - ($50,000 - $10,000)(70)


= $1,350,000.


(3) Determine the incremental profit:


Profit = $1,350,000 - $500,000 = $850,000.


(4) Estimate the approximate rate of return on new investment:


ROI = Profit/Investment = $850,000/$4,000,000 = 21.25%.


Since the ROI exceeds the 15 percent cost of capital, this analysis suggests that the firm should go


ahead with the change.



. Answers and Solutions: 16 - 328 b. If we measure operating leverage by the ratio of fixed costs to total costs at the expected output,


then the change would increase operating leverage:


FC $2,000,000


Old: = = 44.44%.


FC + V(Q) $2,000,000 + $2,500,000


FC 2 $2,500,000


New: = = 47.17%.


FC 2 + V2 (Q 2 ) $2,500,000 + $2,800,000


The change would also increase the breakeven point:


F $2,000,000


Old: QBE = = = 40 units.


P-V $100,000 - $50,000


$2,500,000


New: QBE = = 45.45 units.


$95,000 - $40,000


However, one could measure operating leverage in other ways, say by degree of operating


leverage:


Q( P - V ) 50($50,000)


Old: DOL = = = 5.0.


Q( P - V ) - F 50($50,000) - $2,000,000


New: The new DOL, at the expected sales level of 70, is


70($95,000 - $40,000)


= 2.85.


70($55,000) - $2,500,000


The problem here is that we have changed both output and sales price, so the DOLs are not really


comparable.


c. It is impossible to state unequivocally whether the new situation would have more or less business


risk than the old one. We would need information on both the sales probability distribution and


the uncertainty about variable input cost in order to make this determination. However, since a


higher breakeven point, other things held constant, is more risky, the change in breakeven


points--and also the higher percentage of fixed costs--suggests that the new situation is more


risky.



. Answers and Solutions: 16 - 329 16-2 a. Expected ROE for Firm C:


ROEC = (0.1)(-5.0%) + (0.2)(5.0%) + (0.4)(15.0%)


+ (0.2)(25.0%) + (0.1)(35.0%) = 15.0%.


Note: The distribution of ROEC is symmetrical. Thus, the answer to this problem could have


been obtained by simple inspection.


Standard deviation of ROE for Firm C:



0.1( -5.0 - 15.0) 2 + 0.2(5.0 - 15.0) 2 + 0.4(15.0 - 15.0) 2 +


C =


0.2( 25.0 - 15.0) 2 + 0.1(35.0 - 15.0) 2


= 0.1( -20) 2 + 0.2( -10) 2 + 0.4(0) 2 + 0.2(10) 2 + 0.1( 20) 2


= 40 + 20 + 0 + 20 + 40 = 120 = 11.0%.


b. According to the standard deviations of ROE, Firm A is the least risky, while C is the most risky.


However, this analysis does not take into account portfolio effects--if C's ROE goes up when


most other companies' ROEs decline (that is, its beta is negative), its apparent riskiness would be


reduced.


c. Firm A's ROE = BEP = 5.5%. Therefore, Firm A uses no financial leverage and has no financial


risk. Firm B and Firm C have ROE > BEP, and hence both use leverage. Firm C uses the most


leverage because it has the highest ROE - BEP = measure of financial risk. However, Firm C's


stockholders also have the highest expected ROE.


16-3 a. Original value of the firm (D = $0):


V = D + S = 0 + ($15)(200,000) = $3,000,000.


Original cost of capital:


WACC = wd rd(1-T) + wers


= 0 + (1.0)(10%) = 10%.


With financial leverage (wd=30%):


WACC = wd rd(1-T) + wers


= (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%.


Because growth is zero, the value of the company is:


FCF ( EBIT)(1 - T ) ($500,000)(1 - 0.40)


V= = = = $3,348,214.286. .


WACC WACC 0.0896


Increasing the financial leverage by adding $900,000 of debt results in an increase in the firm's


value from $3,000,000 to $3,348,214.286.


. Answers and Solutions: 16 - 330 b. Using its target capital structure of 30% debt, the company must have debt of:


D = wd V = 0.30($3,348,214.286) = $1,004,464.286.


Therefore, its debt value of equity is:


S = V D = $2,343,750.


Alternatively, S = (1-wd)V = 0.7($3,348,214.286) = $2,343,750.


The new price per share, P, is:


P = [S + (D D0)]/n0 = [$2,343,750 + ($1,004,464.286 0)]/200,000


= $16.741.


c. The number of shares repurchased, X, is:


X = (D D0)/P = $1,004,464.286 / $16.741 = 60,000.256 60,000.


The number of remaining shares, n, is:


n = 200,000 60,000 = 140,000.


Initial position:


EPS = [($500,000 0)(1-0.40)] / 200,000 = $1.50.


With financial leverage:


EPS = [($500,000 0.07($1,004,464.286))(1-0.40)] / 140,000


= [($500,000 $70,312.5)(1-0.40)] / 140,000


= $257,812.5 / 140,000 = $1.842.


Thus, by adding debt, the firm increased its EPS by $0.342.




EBIT EBIT


d. 30% debt: TIE = = .


I $70,312.5


Probability TIE


0.10 ( 1.42)


0.20 2.84


0.40 7.11


0.20 11.38


0.10 15.64


The interest payment is not covered when TIE < 1.0. The probability of this occurring is 0.10, or


10 percent.


. Answers and Solutions: 16 - 331 16-4 a. Present situation (50% debt):


WACC = wd rd(1-T) + wers


= (0.5)(10%)(1-0.15) + (0.5)(14%) = 11.25%.


FCF ( EBIT)(1 - T ) ($13.24)(1 - 0.15)


V= = = = $100 million.


WACC WACC 0.1125


70 percent debt:


WACC = wd rd(1-T) + wers


= (0.7)(12%)(1-0.15) + (0.3)(16%) = 11.94%.


FCF ( EBIT)(1 - T ) ($13.24)(1 - 0.15)


V= = = = $94.255 million.


WACC WACC 0.1194


30 percent debt:


WACC = wd rd(1-T) + wers


= (0.3)(8%)(1-0.15) + (0.7)(13%) = 11.14%.


FCF ( EBIT)(1 - T ) ($13.24)(1 - 0.15)


V= = = = $101.023 million.


WACC WACC 0.1114



16-5 a. BEA's unlevered beta is bU=bL/(1+ (1-T)(D/S))=1.0/(1+(1-0.40)(20/80)) = 0.870.


b. bL = bU (1 + (1-T)(D/S)).


At 40 percent debt: bL = 0.87 (1 + 0.6(40%/60%)) = 1.218.


rS = 6 + 1.218(4) = 10.872%


c. WACC = wd rd(1-T) + wers


= (0.4)(9%)(1-0.4) + (0.6)(10.872%) = 8.683%.


FCF ( EBIT)(1 - T ) ($14.933)(1 - 0.4)


V= = = = $103.188 million.


WACC WACC 0.08683



. Answers and Solutions: 16 - 332 16-6 Tax rate = 40% rRF = 5.0%


bU = 1.2 rM rRF = 6.0%


From data given in the problem and table we can develop the following table:


D/A E/A D/E rd rd(1 T) Leveraged r sb WACCc


betaa


0.00 1.00 0.0000 7.00% 4.20% 1.20 12.20% 12.20%


0.20 0.80 0.2500 8.00 4.80 1.38 13.28 11.58


0.40 0.60 0.6667 10.00 6.00 1.68 15.08 11.45


0.60 0.40 1.5000 12.00 7.20 2.28 18.68 11.79


0.80 0.20 4.0000 15.00 9.00 4.08 29.48 13.10


Notes:


a


These beta estimates were calculated using the Hamada equation,


b = bU[1 + (1 T)(D/E)].


b


These rs estimates were calculated using the CAPM, rs = rRF + (rM rRF)b.


c


These WACC estimates were calculated with the following equation:


WACC = wd(rd)(1 T) + (wc)(rs).


The firm's optimal capital structure is that capital structure which minimizes the firm's


WACC. Elliott's WACC is minimized at a capital structure consisting of 40% debt and


60% equity. At that capital structure, the firm's WACC is 11.45%.



. Answers and Solutions: 16 - 333 SOLUTION TO SPREADSHEET PROBLEM


16-7 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 16 P7 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.



. Answers and Solutions: 16 - 334 MINI CASE



Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company's EBIT was $500,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock, and the stock is traded in the over-the-counter market.


The firm is currently financed with all equity; it has 100,000 shares outstanding; and P0 = $25 per share. When you took your MBA Corporate Finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:


% Financed With Debt Rd


0% ---


20 8.0%


30 8.5


40 10.0


50 12.0


If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent.


a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which


capital structure can affect the weighted average cost of capital and free cash flows.


Answer: The basic definitions are:


(1) V = Value Of Firm


(2) FCF = Free Cash Flow


(3) WACC = Weighted Average Cost Of Capital


(4) Rs And Rd are costs of stock and debt


(5) We And Wd are percentages of the firm that are financed with stock and debt.


The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF.


Debt holders have a prior claim on cash flows relative to stockholders. Debt holders' "fixed"


claim increases risk of stockholders' "residual" claim, so the cost of stock, rs, goes up.


Firm's can deduct interest expenses. This reduces the taxes paid, frees up more cash for


payments to investors, and reduces after-tax cost of debt



Answers and Solutions: 17 - 335 Debt increases the risk of bankruptcy, causing pre-tax cost of debt, rd, to increase.


Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the


percent financed with high-cost equity (we).


The net effect on WACC is uncertain, since some of these effects tend to increase WACC and


some tend to decrease WACC.


Additional debt can affect FCF. The additional debt increases the probability of bankruptcy.


The direct costs of financial distress are legal fees, "fire" sales, etc. The indirect costs are lost


customers, reductions in productivity of managers and line workers, reductions in credit (i.e.,


accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost


customers and drop in productivity and causes the investment in capital to go up due to increases


in net operating working capital (accounts payable goes up as suppliers tighten credit).


Additional debt can affect the behavior of managers. It can cause reductions in agency costs,


because debt "pre-commits," or "bonds," free cash flow for use in making interest payments.


Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.


But it can cause increases in other agency costs. Debt can make managers too risk-averse,


causing "underinvestment" in risky but positive NPV projects.


There are also effects due to asymmetric information and signaling. Managers know the firm's


future prospects better than investors. Thus, managers would not issue additional equity if they


thought the current stock price was less than the true value of the stock (given their inside


information). Hence, investors often perceive an additional issuance of stock as a negative


signal, and the stock price falls.


b. (1) What is business risk? What factors influence a firm's business risk?


Answer: Businsess risk is uncertainty about EBIT. Factors that influence business risk include:


uncertainty about demand (unit sales); uncertainty about output prices; uncertainty about input


costs; product and other types of liability; degree of operating leverage (DOL). b. (2) what is operating leverage, and how does it affect a firm's business risk? Show the


operating break even point if a company has fixed costs of $200, a sales price of $15, and


variables costs of $10.


Answer: Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the


proportion of fixed costs within a firm's overall cost structure, the greater the operating leverage.


Higher operating leverage leads to more business risk, because a small sales decline causes a


larger EBIT decline.


Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit.


Operating Breakeven = QBE


QBE = F / (P V)


Example: F=$200, P=$15, AND V=$10:


Answers and Solutions: 17 - 336 QBE = $200 / ($15 $10) = 40.



c. Now, to develop an example which can be presented to PizzaPalace's management to


illustrate the effects of financial leverage, consider two hypothetical firms: firm U, which


uses no debt financing, and firm L, which uses $10,000 of 12 percent debt. Both firms have


$20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000.


1. Construct partial income statements, which start with EBIT, for the two firms.


Answer: Here are the fully completed statements:


Firm U Firm L


Assets $20,000 $20,000


Equity $20,000 $10,000


EBIT $ 3,000 $ 3,000


INT (12%) 0 1,200


EBT $ 3,000 $ 1,800


Taxes (40%) 1,200 720


NI $ 1,800 $ 1,080



c. 2. Now calculate roe for both firms.


Answer: Firm U Firm L


BEP 15.0% 15.0%


ROI 9.0% 11.4%


ROE 9.0% 10.8%


TIE 2.5


c. 3. What does this example illustrate about the impact of financial leverage on ROE?


Answer: Conclusions from the analysis:


The firm's basic earning power, BEP = EBIT/total assets, is unaffected by financial


leverage.


Firm L has the higher expected ROI because of the tax savings effect:


o ROIU = 9.0%.


o ROIL = 11.4%.



Answers and Solutions: 17 - 337 Firm L has the higher expected roe:


o ROEU = 9.0%.


o ROEL = 10.8%.


Therefore, the use of financial leverage has increased the expected profitability to


shareholders. The higher roe results in part from the tax savings and also


because the stock is riskier if the firm uses debt.


At the expected level of EBIT, ROEL > ROEU.


The use of debt will increase roe only if ROA exceeds the after-tax cost of debt.


Here ROA = unleveraged roe = 9.0% > rd(1 - t) = 12%(0.6) = 7.2%, so the use of debt


raises roe.


Finally, note that the TIE ratio is huge (undefined, or infinitely large) if no debt is


used, but it is relatively low if 50 percent debt is used. The expected tie would be


larger than 2.5 if less debt were used, but smaller if leverage were increased.



d. Explain the difference between financial risk and business risk.


Answer: Business risk increases the uncertainty in future EBIT. It depends on business factors such as


competition, operating leverage, etc. Financial risk is the additional business risk concentrated


on common stockholders when financial leverage is used. It depends on the amount of debt and


preferred stock financing.


e. Now consider the fact that EBIT is not known with certainty, but rather has the following


probability distribution:


Economic State Probability EBIT


Bad 0.25 $2,000


Average 0.50 3,000


Good 0.25 4,000


Redo the part A analysis for firms U and L, but add basic earning power (BEP), return


on investment (ROI), [defined as (net income + interest)/(debt + equity)], and the


times-interest-earned (TIE) ratio to the outcome measures. Find the values for each


firm in each state of the economy, and then calculate the expected values. Finally,


calculate the standard deviation and coefficient of variation of ROE. What does this


example illustrate about the impact of debt financing on risk and return?


Answer: Here are the pro forma income statements:



Answers and Solutions: 17 - 338 Firm U Firm L


Bad Avg. Good Bad Avg. Good


Prob. 0.25 0.50 0.25 0.25 0.50 0.25


EBIT $2,000 $3,000 $4,000 $2,000 $3,000 $4,000


Interest 0 0 0 1,200 1,200 1,200


EBT $2,000 $3,000 $4,000 $ 800 $1,800 $2,800


Taxes (40%) 800 1,200 1,600 320 720 1,120


NI $1,200 $1,800 $2,400 $ 480 $1,080 $1,680


BEP 10.0% 15.0% 20.0% 10.0% 15.0% 20.0%


ROIC 6.0% 9.0% 12.0% 6.0% 9.0% 12.0%


ROE 6.0% 9.0% 12.0% 4.8% 10.8% 16.8%


TIE 1.7 2.5 3.3


E(BEP) 15.0% 15.0%


E(ROIC) 9.0% 9.0%


E(ROE) 9.0% 10.8%


ROIC 2.12% 2.12%


ROE 2.12% 4.24%


This example illustrates that financial leverage can increase the expected return to


stockholders. But, at the same time, it increases their risk.


Firm L has a wider range of ROEs and a higher standard deviation of ROE,


indicating that its higher expected return is accompanied by higher risk. To be


precise:


ROE (Unleveraged) = 2.12%, and ROE (Leveraged) = 4.24%.


Thus, in a stand-alone risk sense, firm L is twice as risky as firm U--its business risk is 2.12


percent, but its stand-alone risk is 4.24 percent, so its financial risk is 4.24% - 2.12% =


2.12%.


f. What does capital structure theory attempt to do? What lessons can be learned from


capital structure theory? Be sure to address the MM models.


Answer: MM theory begins with the assumption of zero taxes. MM prove, under a very restrictive set of


assumptions, that a firm's value is unaffected by its financing mix:


VL = VU.


Therefore, capital structure is irrelevant. Any increase in roe resulting from financial leverage is


exactly offset by the increase in risk (i.e., rs), so WACC is constant.


MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity


financing. With corporate taxes, the benefits of financial leverage exceed the risks because more


EBIT goes to investors and less to taxes when leverage is used. MM show that:


VL = VU + TD.


If T=40%, then every dollar of debt adds 40 cents of extra value to firm.


Miller later included personal taxes. Personal taxes lessen the advantage of corporate debt.


Answers and Solutions: 17 - 339 Corporate taxes favor debt financing since corporations can deduct interest expenses, but personal


taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are


taxed at a lower rate. Miller's conclusions with personal taxes are that the use of debt financing


remains advantageous, but benefits are less than under only corporate taxes. Firms should still


use 100% debt. Note: however, miller argued that in equilibrium, the tax rates of marginal


investors would adjust until there was no advantage to debt.


MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.


At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs


outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.


This is the trade-off theory.



MM assumed that investors and managers have the same information. But managers often have


better information. Thus, they would sell stock if stock is overvalued, and sell bonds if stock is


undervalued. Investors understand this, so view new stock sales as a negative signal. This is


signaling theory.


One agency problem is that managers can use corporate funds for non-value maximizing purposes.


The use of financial leverage bonds "free cash flow," and forces discipline on managers to avoid


perks and non-value adding acquisitions.


A second agency problem is the potential for "underinvestment". Debt increases risk of financial


distress. Therefore, managers may avoid risky projects even if they have positive NPVs.


g. With the above points in mind, now consider the optimal capital structure for PizzaPalace.


g. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity,


and the WACC.



Answer: MM theory implies that beta changes with leverage. Bu is the beta of a firm when it has no debt


(the unlevered beta.) Hamada's equation provides the beta of a levered firm: BL = BU [1 + (1 -


T)(D/S)]. For example, to find the cost of equity for wd = 20%, we first use Hamada's equation


to find beta:


BL = BU [1 + (1 - T)(D/S)]


= 1.0 [1 + (1-0.4) (20% / 80%)]


= 1.15


Then use CAPM to find the cost of equity:


RS = RRF + BL (RPM)


= 6% + 1.15 (6%) = 12.9%


We can repeat this for the capital structures under consideration.


WD D/S BL RS


0% 0.00 1.000 12.00%


20% 0.25 1.150 12.90%


30% 0.43 1.257 13.54%


40% 0.67 1.400 14.40%


Answers and Solutions: 17 - 340 50% 1.00 1.600 15.60%



Next, find the WACC. For example, the WACC for wd = 20% is:


WACC = wd (1-T) rd + we rs


WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%)


WACC = 11.28%


Then repeat this for all capital structures under consideration.



wd rd rs WACC


0% 0.0% 12.00% 12.00%


20% 8.0% 12.90% 11.28%


30% 8.5% 13.54% 11.01%


40% 10.0% 14.40% 11.04%


50% 12.0% 15.60% 11.40%


g. (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting


market value of equity.


Answer: For example the corporate value for wd = 20% is:


V = FCF / (WACC-G)


G=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). In this example, NOPAT


= ($500,000)(1-0.40) = $300,000.


Using these values, V = $300,000 / 0.1128 = $2,659,574.


Repeating this for all capital structures gives the following table:


wd WACC Corp. Value


0% 12.00% $2,500,000


20% 11.28% $2,659,574


30% 11.01% $2,724,796


40% 11.04% $2,717,391


50% 11.40% $2,631,579


As this shows, value is maximized at a capital structure with 30% debt.



g. (3) Calculate the resulting price per share, the number of shares repurchased, and the


remaining shares.


Answers and Solutions: 17 - 341 Answer: First, find the dollar value of debt and equity. For example, for wd = 20%, the dollar value of


debt is:


d = wd V = 0.2 ($2,659,574) = $531,915.


We can then find the dollar value of equity:


S=VD


S = $2,659,574 - $531,915 = $2,127,659.


We repeat this process for all the capital structures.


wd Debt, D Stock Value, S


0% $0 $2,500,000


20% $531,915 $2,127,660


30% $817,439 $1,907,357


40% $1,086,957 $1,630,435


50% $1,315,789 $1,315,789


Note: these are rounded; see FM11 Ch 16 mini case.xls for full calculations.


Notice that the value of the equity declines as more debt is issued, because debt is used to


repurchase stock. But the total wealth of shareholders is the value of stock after the recap plus


the cash received in repurchase, and this total goes up (it is equal to corporate value on earlier


slide).


The firm issues debt, which changes its WACC, which changes value. The firm then uses debt


proceeds to repurchase stock. The stock price changes after debt is issued, but does not change


during actual repurchase (or arbitrage is possible). The stock price after debt is issued but before


stock is repurchased reflects shareholder wealth, which is the sum of the stock and the cash paid


in repurchase.


For example, to find the stock price for wd = 20%, let D0 and N0 denote debt and outstanding


shares before the recap. D - D0 is equal to cash that will be used to repurchase stock. S + (D -


D0) is the wealth of shareholders' after the debt is issued but immediately before the repurchase.


We can express the stock price per share prior to the repurchase, P, for wd = 20%, as:


P = [S + (D D0)]/N0.


P = [$2,127,660 + ($531,915 0)] / 100,000


P = $26.596 per share.


The number of shares repurchased is:


# repurchased = (D - D0) / P


# rep. = ($531,915 0) / $26.596


= 20,000.



The number of remaining shares after the repurchase is:


# remaining = N = S / P


Answers and Solutions: 17 - 342 N = $2,127,660 / $26.596


= 80,000.




We can apply this same procedure to all the capital structures under consideration.


# Shares # Shares


Wd P Repurch. Remaining


0% $25.00 0 100,000


20% $26.60 20,000 80,000


30% $27.25 30,000 70,000


40% $27.17 40,000 60,000


50% $26.32 50,000 50,000


h. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital


structure?


Answer: The optimal capital structure is for wd = 30%. This gives the highest corporate value, the lowest


WACC, and the highest stock price per share. But notice that wd = 40% is very similar to the


optimal solution; in other words, the optimal range is pretty flat.


i. What other factors should managers consider when setting the target capital structure?


Answer: Managers should also consider the debt ratios of other firms in the industry, pro forma coverage


ratios at different capital structures under different economic scenarios, lender and rating agency


attitudes (i.e., the impact on bond ratings), reserve borrowing capacity, the effects on control (i.e.,


does the capital structure make it easier of harder for an outsider to take over the firm), the firm's


types of assets (i.e., are they tangible, and hence suitable as collateral?, and the firm's projected


tax rates.




Answers and Solutions: 17 - 343 Chapter 17


Capital Structure Decisions: Extensions


ANSWERS TO END-OF-CHAPTER QUESTIONS


17-1 a. MM Proposition I states the relationship between leverage and firm value. Proposition I without


taxes is V = EBIT/rsU. Since both EBIT and rsU are constant, firm value is also constant and


capital structure is irrelevant. With corporate taxes, Proposition I becomes V = Vu + TD. Thus,


firm value increases with leverage and the optimal capital structure is virtually all debt.


b. MM Proposition II states the relationship between leverage and cost of equity. Without taxes,


Proposition II is rsL = rsU + (rsU rd)(D/S). Thus, rs increases in a precise way as leverage


increases. In fact, this increase is just sufficient to offset the increased use of lower cost debt.


When corporate taxes are added, Proposition II becomes rsL = rsU + (rsU rd)(1 T)(D/S).


Here the increase in equity costs is less than the zero-tax case, and the increasing use of lower cost


debt causes the firm's cost of capital to decrease, and again, the optimal capital structure is


virtually all debt.


c. The Miller model introduces personal taxes. The effect of personal taxes is, essentially, to


reduce the advantage of corporate debt financing.


d. Financial distress costs are incurred when a leveraged firm facing a decline in earnings is forced


to take actions to avoid bankruptcy. These costs may be the result of delays in the liquidation of


assets, legal fees, the effects on product quality from cutting costs, and evasive actions by


suppliers and customers.


e. Agency costs arise from lost efficiency and the expense of monitoring management to ensure that


debtholders' rights are protected.


f. The addition of financial distress and agency costs to either the MM tax model or the Miller


model results in a trade-off model of capital structure. In this model, the optimal capital


structure can be visualized as a trade-off between the benefit of debt (the interest tax shelter) and


the costs of debt (financial distress and agency costs).


g. The value of the debt tax shield is the present value of the tax savings from the interest payments.


In the MM model with taxes, this is just interest x tax rate / discount rate = iDT/r, and since i = r


in the MM model, this is just TD. If a firm grows and the discount rate isn't r, then the value of


this growing tax shield is rdTDg/(1+rTS) where rd is the interest rate on the debt and rTS is the


discount rate for the tax shield.




Answers and Solutions: 17 - 344 h. When a firm has debt outstanding it can choose to default if the firm is not worth more than the


face value of the debt. This decision to default when the value of the firm is low is like the


decision not to exercise a call option when the stock price is low. If management (and hence


the stockholders) make the debt payment, they get to keep the company. This makes equity like


an option on the underlying value of the entire firm, with a strike price equal to the face value of


the debt. If D is the face value of debt maturing in one year and S is the value of the entire firm


(the firm's debt plus equity) then the payoff to the stockholder when the debt matures is: Payoff


= max(S-D, 0). This is the same payoff as a call option on S with a strike, or exercise, price of


D.


17-2 Modigliani and Miller show that the value of a leveraged firm must be equal to the value of an


unleveraged firm. If this is not the case, investors in the leveraged firm will sell their shares


(assume they owned 10%). They will then borrow an amount equal to 10% of the debt of the


leveraged firm. Using these proceeds, they will purchase 10% of the stock of the unleveraged


firm (which provides the same return as the leveraged firm) with a surplus left to be invested


elsewhere. This arbitrage process will drive the price of the stock of the leveraged firm down


and drive up the price of the stock of the unleveraged firm. This will continue until the value of


both stocks are equal.


The assumptions of the MM model are:


Firms must be in a homogeneous business risk class. If the firms have varying


degrees of risk, the market will value the firms at different rates. The earnings


of the firms will be capitalized at different costs of capital.


Investors have homogeneous expectations about expected future EBIT. If


investors have different expectations about future EBIT then individual investors


will assign different values to the firms. Therefore, the arbitrage process will not


be effective.


Stocks and bonds are traded in perfect capital markets. Therefore, (a) there are


no brokerage costs and (b) individuals can borrow at the same rate as corporations.


Brokerage fees and varying interest rates will, in effect, lower the surplus


available for alternative investment.


Investors are rational. If by chance, investors were irrational, then they would


not go through the entire arbitrage process in order to achieve a higher return.


They would be satisfied with the return provided by the leveraged firm.


There are no corporate taxes. With the existence of corporate taxes the value of


the leveraged firm (VL) must be equal to the value of the unleveraged firm (VU)


plus the tax shield provided by debt (TD). 17-3 MM without taxes would support AT&T, although if AT&T really believed MM, they should not


object to Gordon's 50 percent debt ratio. MM with taxes would lead ultimately to 100 percent


debt, which neither Gordon nor AT&T accepted. In effect, Gordon and AT&T seemed to be


taking a "traditional" or perhaps a "compromise" view, but with different conclusions about the


optimal debt ratio. We might note, in a postscript, that AT&T did raise its debt ratio, but not to


the extent that Gordon recommended.




Answers and Solutions: 17 - 345 17-4 The value of a growing tax shield is greater than the value of a constant tax shield. This means


that for a given initial level of debt a growing firm will have more value from the debt tax shield


than a non-growing firm. Thus for a given face value of debt, D, and unlevered value of equity,


U, a growing firm will have a smaller wD, a larger levered cost of equity, reL, and a larger WACC.


So the MM model will underestimate the value of the levered firm and its cost of equity and


WACC.


17-5 If equity is viewed as an option on the total value of the firm with a strike price equal to the face


value of debt then the equity value should be affected by risk in the same way that an option is


affected by risk. An option is worth more if the underlying asset is more risky, so a manager


wanting to maximize the option value of the firm might want to switch investment decisions to


make the firm more risky. Of course bondholders will not like this, since the increase in equity


value comes at their expense. They will write covenants in to the bonds specifying how the


proceeds can be used, and if management still manages to engage in this "bait and switch" tactic,


the firm will find it difficult to raise capital through bond issues in the future.




Answers and Solutions: 17 - 346 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


17-1 a. bL = bU[1 + (1 - T)(D/S)].


bL 1.8 1.8


bU = = = = 1.125.


1 + (1 - T )( D / S) 1 + (1 - 0.4)(0.5 / 0.5) 1.6


b. rsU = rRF + (rM - rRF)bU = 10% + (5%)1.125 = 10% + 5.625% = 15.625%.



c. $2 Million Debt: VL = VU + TD = $10 + 0.25($2) = $10.5 million.


rsL = rsU + (rsU - rRF)bU(1 - T)(D/S)


= 15.625% + (15.625% - 10%)(0.75)($2/$8.5)


= 15.625 + 5.625% (0.75)($2/$8.5) = 16.62%.


$4 Million Debt: VL = $10 + 0.25($4) = $11.0 million.


rsL = 15.625% + 5.625%(0.75)($4/$7) = 18.04%.


$6 Million Debt: VL = $10 + 0.25($6) = $11.5 million.


rsL = 15.625% + 5.625% (0.75)($6/$5.5) = 20.23%.


d. $6 Million Debt: VL = $8.0 + 0.40($6) = $10.4 million.


rsL = 15.625% + 5.625%(0.60)($6/$4.4) = 20.23%.


The mathematics of MM result in the required return, and, thus, the same financial risk premium.


However, the market value debt ratio has increased from $6/$11.5 = 52% to $6/$10.4 = 58% at


the higher tax rate. Hence, a higher tax rate reduces the financial risk premium at a given market


value debt/equity ratio. This is because a higher tax rate increases the relative benefits of debt


financing.




Answers and Solutions: 17 - 347 EBIT $2 million 17-2 a. VU = = = $20 million.


rsU 0.10


b. rsU = 10.0%. (Given)


rsL = rsU + (rsU - rd)(D/S) = 10% + (10% - 5%)($10/$10) = 15.0%.


EBIT - rd D $2 - 0.05($10)


c. SL = = = $10 million.


rsL 0.15


SL + D = VL = VU + TD.


$10 + $10 = $20 = VL = $20 + (0)$10 = $20 million.



d. WACCU = rsU = 10%.


For Firm L, we know that WACC must equal rsU = 10% according to Proposition I. But, we can


demonstrate this as follows:


WACCL = (D/V)rd + (S/V)rs = ($10/$20)5% + ($10/$20)15%


= 2.5% + 7.5% = 10.0%.


e. VL = $22 million is not an equilibrium value according to MM. Here's why. Suppose you


owned 10 percent of Firm L's equity, worth 0.10($22 million - $10 million) = $1.2 million.


You could (1) sell your stock, (2) borrow an amount (at 5%) equal to 10 percent of Firm L's debt,


or 0.10($10 million) = $1 million, and (3) end up with $1.2 million + $1 million = $2.2 million.


You could spend $2 million to buy 10% of Firm U's stock, and invest $200,000 in risk-free debt.


Your cash stream would now be 10 percent of Firm U's flow, or 0.10(EBITU) = 0.10($2 million) =


$200,000, plus the return on the $200,000 of risk-free debt, minus the 0.05($1 million) = $50,000


interest expense for $150,000 plus the return on the extra $200,000. Before the arbitrage, your


return was 10 percent of the $2 million - 0.05($10 million) = $1.5 million, or $150,000.


Investors would do this arbitrage until VL = VU = $20 million.



EBIT(1 - T ) $2(1 - 0.4) 17-3 a. VU = = = $12 million.


rsU 0.10


VL = VU + TD = $12 + (0.4)$10 = $16 million.


b. rsU = 0.10 = 10.0%.


rsL = rsU + (rsU - rd)(1 - T)(D/S)


= 10% + (10% - 5%)(0.6)($10/$6) = 10% + 5% = 15.0%.




Answers and Solutions: 17 - 348 ( EBIT - rd D)(1 - T ) [$2 - 0.05($10)]0.6


c. SL = = = $6 million.


rsL 0.15


VL = SL + D = $6 + $10 = $16 million.


d. WACCU = rsU = 10.00%.


WACCL = (D/V)rd(1 - T) + (S/V)rs = ($10/$16)5%(0.6) + ($6/$16)15%


= 7.50%.



EBIT(1 - TC )(1 - Ts ) EBIT(1 - TC ) $2(0.6) 17-4 a. VU = = = = $12 million.


rsU (1 - Ts ) rsU 0.10


(1 - TC )(1 - Ts )


b. VL = VU + 1 - D = $12 +


(1 - Td )


(0.6)(0.8) 1 - (0.72) $10



= $12 + [1 - 0.67]$10 = $12 + 0.33($10)


= $15.33 million.


VL = $15.93 million. Gain from leverage = $3.33 million.


c. The gain from leverage under Miller is 0.33($10) = $3.33 million. The gain from leverage in


Problem 17-3 is 0.4($10) = $4 million. Thus, the addition of personal tax rates reduced the value


of the debt financing.


d. VU = VL = $20 million. Gain from leverage = $0.00.


e. VU = $12 million. VL = $16 million. Gain from leverage = $4 million.


f. VU = $12 million. VL = $16 million.


Gain from leverage = $4.0 million. Note that the gain from leverage is the same as in Part (e)


and will be the same value, as long as Td = Ts.




Answers and Solutions: 17 - 349 17-5 a. VU = $500,000/(rsU g) = $500,000/(0.13 - 0.09) = 12,500,000.


0.07 x 0.40 x 5 million


b. VL = $12.5 million + = $16.0 million . So since


0.13 - 0.09


D = 5, S = 16 5 = $11.0 million.


5


rsL = 0.13 + (0.13 - 0.07) = 15.7%


11



c. Under MM, VL = VU + TD = $12.5 million + (0.40)(5 million)


= $14.5 million. S = $14.5 5 = $9.5 million. rsL = 0.13+(0.13-0.07)(1-.40)(5/9.5) = 14.9%


d. VL is greater under the extension that incorporates growth than under MM because MM assumes


0 growth. A positive growth rate gives a larger value to the tax shield. In this case the value of


the tax shield under MM is 2.0 million and is $3.5 million if growth is included. The cost of


capital when growth is included is higher because the relative weight of equity is higher and the


relative weight of debt is lower than when growth is ignored.




EBIT $1,600,000 17-6 a. VU = SU = = = $14,545,455.


rsU 0.11



Answers and Solutions: 17 - 350 VL = VU = $14,545,455.


b. At D = $0:


rs = 11.0%; WACC = 11.0%


At D = $6 million:


rsL = rsU + (rsU rd)(D/S)


$6,000,000


= 11% + (11% - 6%) = 11% + 3.51% = 14.51%.


$8,545,455



WACC = (D/V)rd + (S/V)rs


$6,000,000 $8,545,455


= 6% + 14.51%


$14,545,455 $14,545,455


= 11.0%.


At D = $10 million:


$10,000,000


rsL = 11% + 5% = 22.00%.


$4,545,455


$10,000,000 $4,545,455


WACC = 6% + 22%


$14,545,455 $14,545,455


= 11.0%.


Leverage has no effect on firm value, which is a constant $14,545,455 since WACC is a constant


11%. This is because the cost of equity is increasing with leverage, and this increase exactly offsets


the advantage of using lower cost debt financing.



c. VU = [(EBIT - I)(1 - T)]/rsU = [($1,600,000 - 0)(0.6)]/0.11 = $8,727,273.


VL = VU + TD = $8,727,273 + 0.4($6,000,000) = $11,127,273




Answers and Solutions: 17 - 351 d. At D = $0:


rs = 11.0%. WACC = 11.0%.


At D = $6 million:


VL = VU + TD = $8,727,273 + 0.4($6,000,000) = $11,127,273.


rsL = rsU + (rsU - rd)(1 - T)(D/S)


= 11% + (11% - 6%)(0.6)($6,000,000/$5,127,273) = 14.51%.


WACC = (D/V)rd(1 - T) + (S/V)rs


=($6,000,000/$11,127,273)(6%)(0.6) + ($5,127,273/$11,127,273)(14.51%)


= 8.63%.



At D = $10 million:


VL = $8,727,273 + 0.4($10,000,000) = $12,727,273.


rsL = 11% + 5%(0.6)($10,000,000/$2,727,273) = 22.00%.


WACC = ($10,000,000/$12,727,273)(6%)(0.6) + ($2,727,273/$12,727,273)(22%)


=7.54%.


Summary: (in millions)


D V D/V rs WACC


$0 $ 8.73 0% 11.0% 11.0%


6 11.13 53.9 14.5 8.6


10 12.73 78.6 22.0 7.5


Value (Millions of Dollars)


15


14


13


12


11


10


9


8




25 50 75 100


D/V (%)



Answers and Solutions: 17 - 352 e. The maximum amount of debt financing is 100 percent. At this level


D = V, and hence


VL = VU + TD = D


$8,727,273 + 0.4D = D


D - 0.4D = $8,727,273


0.6D = $8,727,273


D= $8,727,273/0.6 = $14,545,455 = V.



Since the bondholders are bearing the same risk as the equity holders of the unleveraged firm, rd is


now 11 percent. Now, the total interest payment is $14,545,455(0.11) = $1.6 million, and the


entire $1.6 million of EBIT would be paid out as interest. Thus, the investors (bondholders)


would get $1.6 million per year, and it would be capitalized at 11 percent:


$1,600,000


VL = = $14,545,455.


0.11



Cost of Capital (%)


25 ks


rS



20



15



10


WACC


5



kd(1-T)


r (1-T)


d



25 50 75 100


D/V (%)




f. (1) Rising interest rates would cause rd and hence rd(1 - T) to increase, pulling up WACC.


These changes would cause V to rise less steeply, or even to decline.


(2) Increased riskiness causes rs to rise faster than predicted by MM. Thus, WACC would


increase and V would decrease.




Answers and Solutions: 17 - 353 17-7 a.The inputs to the Black and Scholes option pricing model are P = 5, X = 2, rRF =


6%,


= 50%, and t = 2 years. Given these inputs, the value of a call option is calculated as:


ln( P / X ) + [ rRF + 2 / 2]t ln(5 / 2) + [0.06 + 0.52 / 2]2


d1 = = = 1.819


t 0.5 2


d 2 = d1 - t = 1.819 - 0.5 2 = 1.112



Using Excel's Normsdist function N(d1) = 0.9656, and N(d2) = 0.8669. This gives a


value of the call option equal to:


V = P[N(d 1)] - Xe -rRF t [N(d 2 )] = 5[1.819] - 2e -0.06( 2) [1.112] = 3.29 .


b. The debt must therefore be worth 5-3.29 = $1.71 million. Its yield is


2.0 / 1.71 - 1 = 0.81 = 8.1% .


c. At a volatility of 30% d1 = 2.566 and N(d1) = 0.996. d2 = 2.230 and N(d2) = 0.987.


This gives an option value of $3.32 million. The debt value is then 5.0 3.23 =


$1.77 million. Its yield is 6.8%. The value of the stock goes down and the


value of the debt goes up because with lower risk, Fethe has less of a chance of a


"home run."




Answers and Solutions: 17 - 354 SOLUTION TO SPREADSHEET PROBLEM


17-8 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 17 P8 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.




Solution to Spreadsheet Problem: 15 - 355 MINI CASE



David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30 percent debt, and Mr. Lyons wonders why they use so much more debt, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:


a. Business Week recently ran an article on companies' debt policies, and the names Modigliani


and Miller (MM) were mentioned several times as leading researchers on the theory of


capital structure. Briefly, who are MM, and what assumptions are embedded in the MM


and Miller models?


Answer: Modigliani and Miller (MM) published their first paper on capital structure (which assumed zero


taxes) in 1958, and they added corporate taxes in their 1963 paper. Modigliani won the Nobel


Prize in economics in part because of this work, and most subsequent work on capital structure


theory stems from MM. Here are their assumptions:


Firms' business risk can be measured by EBIT, and firms with the same degree of


risk can be grouped into homogeneous business risk classes.


All investors have identical (homogeneous) expectations about all firms' future


earnings.


There are no transactions (brokerage) costs, either to individuals or to firms.


All debt is riskless, and both individuals and corporations can borrow unlimited


amounts of money at the same risk-free rate.


All cash flows are perpetuities. This implies that firms and individuals issue


perpetual debt, and also that firms pay out all earnings as dividends, hence have


zero growth. Additionally, this implies that expected EBIT is constant over time,


although realized EBIT may turn out to be higher or lower than was expected.


In their first paper (1958), MM also assumed that there are no corporate or


personal taxes.



Mini Case: 17 - 356 These assumptions--all of them--were necessary in order for MM to use the arbitrage


argument to develop and prove their equations. If the assumptions are unrealistic,


then the results of the model are not guaranteed to hold in the real world.


b. Assume that firms U and L are in the same risk class, and that both have EBIT = $500,000.


Firm U uses no debt financing, and its cost of equity is rsU = 14%. Firm L has $1 million of


debt outstanding at a cost of rd = 8%. There are no taxes. Assume that the MM


assumptions hold, and then:


1. Find v, s, rs, and WACC for firms U and L.


Answer: First, we find Vu and VL:


EBIT $500,000


VU = = = $3,571,429.


rsU 0.14


VL = VU = $3,571,429.


To find rsL, it is necessary first to find the market values of firm L's debt and equity. The value


of its debt is stated to be $1,000,000. Therefore, we can find s as follows:


D + SL = VL


SL = VL - D = $3,571,429 - $1,000,000 = $2,571,429.




Mini Case: 17 - 357 Now we can find L's cost of equity, rsL:


rsL = rsU + (rsU - rd)(D/S)


= 14.0% + (14.0% - 8.0%)($1,000,000/$2,571,429)


= 14.0% + 2.33% = 16.33%.


We know from Proposition I that the WACC must be WACC = rsU = 14.0% for all firms in this


risk class, regardless of leverage, but this can be verified using the WACC formula:


WACC = wdrd + wcers = (D/V)rd + (S/V)rs


= ($1,000/$3,571)(8.0%) + ($2,571/$3,571)(16.33%)


= 2.24% + 11.76% = 14.0%.



b. 2. Graph (a) the relationships between capital costs and leverage as measured by D/V,


and (b) the relationship between value and D.


Answer: Figure 1 plots capital costs against leverage as measured by the debt/value ratio. Note that,


under the MM no-tax assumption, rd is a constant 8 percent, but rs increases with leverage.


Further, the increase in rs is exactly sufficient to keep the WACC constant--the more debt the firm


adds to its capital structure, the riskier the equity and thus the higher its cost. Figure 2 plots the


firm's value against leverage (debt). With zero taxes, MM argue that value is unaffected by


leverage, and thus the plot is a horizontal line. (Note that we should not really extend the graphs


to D/V = 100% or D = $2.5 million, because at this amount of leverage the debtholders become


the firm's owners, and thus a discontinuity exists.)




Mini Case: 17 - 358 Figure 1



25% Without Taxes


20%


Cost of Capital


15%


rs


10% WACC


rd


5%


0%


0% 20% 40% 60%


Debt/Value Ratio


Figure 2


Value of Firm, V


($)



4


VU VL


3


Firm Value ($3.6 Million)


2




1




0 0.5 1.0 1.5 2.0 2.5


Debt ($)


(Millions of $)



c. Using the data given in part B, but now assuming that firms L and U are both subject


to a 40 percent corporate tax rate, repeat the analysis called for in B(1) and B(2)


under the MM with-tax model.


Answer: With corporate taxes added, the MM propositions become:


Proposition I: VL = VU + TD.


Proposition II: rsL = rsU + (rsU rd)(1 - T)(D/S).



Mini Case: 17 - 359 There are two very important differences between these propositions and the zero-tax propositions:


(1) when corporate taxes are added, VL does not equal VU; rather, V L increases as debt is added to


the capital structure, and the greater the debt usage, the higher the value of the firm. (2) rsL


increases less rapidly when corporate taxes are considered. This is seen by noting that the


Proposition II slope coefficient changes from (rsU rd) to (rsU rd)(1 t), so at any positive T, the


slope coefficient is smaller.


Note also that with corporate taxes considered, VU changes to


EBIT(1 - T ) $500,000(0.6)


VU = = = $2,142,857 versus $3,571,429.


rsU 0.14


This represents a 40% decline in value, and it is logical, because the 40% tax rate takes


away 40% of the income and hence 40% of the firm's value.


Looking at VL, we see that:


VL = VU + TD = $2,142,857 + 0.4($1,000,000)


VL = $2,142,857 + $400,000 - $2,542,857 versus $2,142,857 for VU.


Thus, the use of $1,000,000 of debt financing increases firm value by T(D) = $400,000


over its leverage-free value.


To find rsL, it is first necessary to find the market value of the equity:


D + SL = VL


$1,000,000 + SL = $2,542,857


SL = $1,542,857.


now,


rsL = rsU + (rsU - rd)(1 - T)(D/S)


= 14.0% + (14.0% - 8.0%)(0.6)($1,000/$1,543)


= 14.0% + 2.33% = 16.33%.




Mini Case: 17 - 360 Firm L's WACC is 11.8 percent:


WACCL = (D/V)rd(1 - T) + (S/V)rs


= ($1,000/$2,543)(8%)(0.6) + (1,543/$2,543)(16.33%)


= 1.89% + 9.91% = 11.8%.


The WACC is lower for the leveraged firm than for the unleveraged firm when corporate taxes are considered.


Figure 3 below plots capital costs at different D/V ratios under the MM model with corporate taxes. Here the WACC declines continuously as the firm uses more and more debt, whereas the WACC was constant in the without-tax model. This result occurs because of the tax deductibility of debt financing (interest payments), which impacts the graph in two ways: (1) the cost of debt is lowered by (1 - T), and (2) the cost of equity increases at a slower rate when corporate taxes are considered because of the (1 - T) term in Proposition II. The combined effect produces the downward-sloping WACC curve.


Figure 4 shows that, when corporate taxes are considered, the firm's value increases continuously as more and more debt is used.



Figure 3



rs


With Taxes


WACC


50%


rd x (1-T)


45%


40%


Cost of Capital




35%


30%


25%


20%


15%


10%


5%


0%


0% 20% 40% 60% 80% 100%


Debt/Value Ratio




Mini Case: 17 - 361 Figure 4


Value of Firm, V


($)


4




VL


3



TD


2 VU




1




0 0.5 1.0 1.5 2.0 2.5


Debt ($)


(Millions of $)



d. Now suppose investors are subject to the following tax rates:


TD = 30% and TS = 12%.


1. What is the gain from leverage according to the miller model?


Answer: To begin, note that Miller's Proposition I is stated as follows:


(1 - TC )(1 - TS )


VL = VU + 1 - D.


(1 - TD )


Here the bracketed term replaces T in the earlier MM tax model, and


Tc = corporate tax rate, Td = personal tax rate on debt income, and


Ts = personal tax rate on stock income.


If there are no personal or corporate taxes, then Tc = Ts = Td = 0, and Miller's model


simplifies to


VL = VU,


Which is the same as in MM's 1958 model, which assumed zero taxes.


If there are corporate taxes, but no personal taxes, then Ts = Td = 0, and Miller's model


simplifies to


VL = VU + TCD,


Which is the same as MM obtained in their 1963 article, which considered only corporate taxes.



Mini Case: 17 - 362 We can now analyze the firm's value numerically, using Miller's model: if Tc = 40%, Td =


30%, and Ts = 12%, then Miller's model becomes


(1 - TC )(1 - TS )


VL = VU + 1 - D


(1 - TD


(1 - 0.40)(1 - 0.12


= VU + 1 - D = VU + (1 - 0.75) D = VU + 0.25D.


(1 - 0.30)


d. 2. How does this gain compare to the gain in the MM model with corporate taxes?


Answer: If only corporate taxes were considered, then


VL = VU + TCD = VU + 0.40D.


The net effect depends on the relative effective tax rates on income from stocks and bonds, and on


corporate tax rates. The tax rate on stock income is reduced vis--vis the tax rate on debt income


if the company retains more of its income and thus provides more capital gains. If Ts declines,


while Tc and Td remain constant, the slope coefficient, which shows the benefit of debt in a graph


like figure 4, is increased. Thus, a company with a low payout ratio gets greater benefits under


the miller model than a company with a high payout.


Note that the effects of leverage as computed by Miller's model were much more important


before 1987, because in earlier years capital gains were taxed at only 40 percent of the rate


imposed on dividends (Ts 20% and Td 50%). Now the advantages of capital gains are (1) the


fact that taxes on them are deferred, and (2) individuals in the higher tax brackets obtain an


advantage because the tax rate imposed on long-term capital gains is 20 percent.




Mini Case: 17 - 363 d. 3. What does the Miller model imply about the effect of corporate debt on the value of


the firm, that is, how do personal taxes affect the situation?


Answer: The addition of personal taxes lowers the value of debt financing to the firm. The underlying


rationale can be explained as follows: the U.S. corporate tax laws favor debt financing over


equity financing, because interest expense is tax deductible while dividends are not. This


provides an incentive for firms to use debt financing, and this was the message of the mm 1963


paper. At the same time, though, the U.S. personal tax laws favor investment in equity securities


over debt securities, because equity income is effectively taxed at a lower rate. Thus, investors


require higher risk-adjusted before-tax returns on debt to be induced to buy debt rather than equity,


and this reduces the advantage to issuing debt.


The bottom line conclusion we reach from an analysis of the Miller model is that personal


taxes lower, but do not eliminate, the value of debt financing.



e. What capital structure policy recommendations do the three theories (MM without


taxes, MM with corporate taxes, and Miller) suggest to financial managers?


Empirically, do firms appear to follow any one of these guidelines?


Answer: In a zero tax world, MM theory says that capital structure is irrelevant--it has no impact on firm


value. Thus, one capital structure is as good as another. With corporate but not personal taxes


considered, the MM model states that firm value increases continuously with financial leverage,


and hence firms should use (almost) 100 percent debt financing. Miller added personal taxes to


the analysis, and the value of debt financing is seen to be reduced but not eliminated, so again


firms should use (almost) 100 percent debt financing.


The Miller model is the most realistic of the three, but if it were really correct, we would


expect to see firms using almost all debt financing. However, on average, firms use only about


40 percent debt. Note, though, that debt ratios increased all during the 1980s, so companies


were moving toward the miller position. However, in the 1990s we see firms reducing their


debt.



f. How is the analysis in part C different if firms U and L are growing? Assume that


both firms are growing at a rate of 7 percent and that the investment in net operating


assets required to support this growth is 10 percent of EBIT.



Answers and Solutions: 18 - 364 Answer: If a firm is growing, the assumptions that MM made are violated. The extension to


the MM model shows how growth affects the value of the debt tax shield and the cost


of capital. The first difference in this situation is that the appropriate discount rate


for the debt tax shield is the unlevered cost of equity, not the cost of debt. The


second difference is that a growing debt tax shield is more valuable than a constant


debt tax shield.


First, calculate expected free cash flow:


NOPAT = EBIT X (1-T) = 500,000 X (1 0.40) = $300,000


Investment In Net Operating Assets = 0.10 X EBIT = $50,000


Free Cash Flow = NOPAT Investment In Net Operating Assets


= $300,000 - $50,000 = $250,000


(Note that this is an expected value for the coming year since EBIT is an expected value


for the coming year.)


Next, note that WACC = unlevered cost of equity if there is no debt so


WACC = rsU = 14%


The Value Of U = Expected FCF/(WACC g)


= 250,000/(0.14 0.07) = $3,571,429


Which is greater than in part C because the firm is growing.


If there is $1,000,000 in debt then:


The value of l = the value of U + value of debt tax shield


The value of the (growing) debt tax shield = rdTD/(rsU g)


= 0.08(0.40)(1,000,000)/(0.14 0.07)


= $457,143


Therefore, the value of the firm = $3,571,429 + $457,143 = $4,028,571.


The value of the equity is the value of the firm less the value of the


debt = $4,028,571 - $1,000,000 = $3,028,571.


In this case the increase in the firm's value due to the debt tax shield as a percent of its


zero debt value is $457,143/$3,571,429 = 12.80%


This is less than the increase in the non-growing firm's value as calculated using the MM


model: $400,000/$2,142,857 = 18.7%.


To calculate the new levered cost of equity:


rsL = rsU + (rsU rd)(D/S)


= 14% + (14% - 8%)(1,000,000/3,028,571)


= 15.98%


And the new levered WACC:


WACCL = (D/V)rd(1 - T) + (S/V)rs


= (1,000,000/4,028,571)8%(1-.40)


+ ($3,028,571/4,028,571)15.98%


= 13.2%.




Answers and Solutions: 18 - 365 g. What if L's debt is risky? For the purpose of this example, assume that the value of L's


operations is $4 million--which is the value of its debt plus equity. Assume also that its


debt consists of 1-year zero coupon bonds with a face value of $2 million. Finally, assume


that L's volatility is 0.60 ( = 0.60) and that the risk free rate is 6 percent.


Answer: L's equity can be considered as a call option on the total value of l with an exercise price of $2


million, and an expiration date in one year. If the value of L's operations is less than $2 million


in a year, then L's management will not be able to make its required payment on the debt, and the


firm will be bankrupt. The debtholders will take over the firm and the equity holders will


receive nothing. If L's value is greater than $2 million in one year, then management will repay


the debt and the stockholders will keep the company.




This option can be valued with the Black-Scholes Option Pricing Model:



V = PN(D1) Xe-RTN(D2)


where


D1 = [ln(P/X) + (r + 0.52)T]/[T0.5]


D2 = D1 - T0.5


And n() is the cumulative normal distribution function, from either appendix a in the back of the


text, or the NORMSDIST() function in excel.



in this case, P = $4


X = $2


= 0.60


T = 1.0


R = 0.06



and calculating,


D1 = 1.552


D2 = 0.9552


N(D1) = 0.9491


N(D2) = 0.8303


Answers and Solutions: 18 - 366 and V = $2.1964 million.



This leaves debt value of $4 million - $2.1964 million = $1.8036 million.



The yield on this debt is calculated as



Price = (Face Value)/(1+Yield)N


so that


Yield = [Face Value/Price]1/N 1.0


= [2.0/1.8036] 1.0


= 10.89%



In this case, the value of the debt must be $1.8036 million, and it is yielding 10.89%. The value


of the equity is $2.1964 million.



h. What is the value of L's stock for volatilites between 0.20 and 0.95? What


in-centives might the manager of L have if she understands this relationship? What


might debtholders do in response?


Answer: The mini case model shows the calculations for the table below.


Value of Stock and Debt for


Different Volatilities


Volatility Equity Debt


0.20 2.12 1.88


0.25 2.12 1.88


0.30 2.12 1.88


0.35 2.12 1.88


0.40 2.13 1.87


0.45 2.14 1.86


0.50 2.16 1.84


0.55 2.17 1.83


0.60 2.20 1.80


0.65 2.22 1.78


0.70 2.25 1.75


0.75 2.28 1.72


0.80 2.31 1.69


0.85 2.34 1.66


0.90 2.38 1.62


0.95 2.41 1.59



Answers and Solutions: 18 - 367 The value of the equity increases as the volatility increases--and the value of the debt decreases as well. A manager who knows this may choose to invest the proceeds from borrowing in assets that are riskier than usual. This is called "bait and switch." This action decreases the value of the debt, because now its claim is riskier. It increases the value of equity because the worse the stockholders can do is default on the bonds, but the best they can do is potentially unlimited.


Bondholders who face this possibility will write covenants into their bond contracts limiting management's ability to invest in assets other than originally planned. If this isn't possible, then bondholders will demand a higher rate of return in order to compensate them for the possibility that management will switch investments.




Answers and Solutions: 18 - 368 Chapter 18


Distributions to Shareholders:


Dividends and Repurchases


ANSWERS TO END-OF-CHAPTER QUESTIONS


18-1 a. The optimal distribution policy is one that strikes a balance between dividend yield and capital


gains so that the firm's stock price is maximized.


b. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a


firm's stock or its cost of capital. The principal proponents of this view are Merton Miller and


Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict


assumptions, some of which are clearly not true in the real world. The "bird-in-the-hand" theory


assumes that investors value a dollar of dividends more highly than a dollar of expected capital


gains because the dividend yield component, D1/P0, is less risky than the g component in the total


expected return equation rS = D1/P0 + g. The tax preference theory proposes that investors


prefer capital gains over dividends, because capital gains taxes can be deferred into the future, but


taxes on dividends must be paid as the dividends are received.


c. The information content of dividends is a theory which holds that investors regard dividend


changes as "signals" of management forecasts.


Thus, when dividends are raised, this is viewed by investors as recognition by


man-agement of future earnings increases. Therefore, if a firm's stock price


increases with a dividend increase, the reason may not be investor preference for


dividends, but expectations of higher future earnings. Conversely, a dividend


reduction may signal that management is forecasting poor earnings in the future.


The clientele effect is the attraction of companies with specific dividend policies


to those investors whose needs are best served by those policies. Thus,


companies with high dividends will have a clientele of investors with low


marginal tax rates and strong desires for current income. Similarly, companies


with low dividends will attract a clientele with little need for current income, and


who often have high marginal tax rates. d. The residual distribution model states that firms should make distributions only


when more earnings are available than needed to support the optimal capital


budget. An extra dividend is a dividend paid, in addition to the regular


dividend, when earnings permit. Firms with volatile earnings may have a low


regular dividend that can be maintained even in low-profit (or high capital


investment) years, and then supplement it with an extra dividend when excess


funds are available.




Answers and Solutions: 18 - 369 e. The declaration date is the date on which a firm's directors issue a statement declaring a dividend.


If a company lists the stockholder as an owner on the holder-of-record date, then the stockholder


receives the dividend. The ex-dividend date is the date when the right to the dividend leaves the


stock. This date was established by stockbrokers to avoid confusion and is 2 business days prior


to the holder of record date. If the stock sale is made prior to the ex-dividend date, the dividend


is paid to the buyer.


If the stock is bought on or after the ex-dividend date, the dividend is paid to the seller. The


date on which a firm actually mails dividend checks is known as the payment date.


f. Dividend reinvestment plans allow stockholders to automatically purchase shares of common


stock of the paying corporation in lieu of receiving cash dividends. There are two types of


plans--one involves only stock that is already outstanding, while the other involves newly issued


stock. In the first type, the dividends of all participants are pooled and the stock is purchased on


the open market. Participants benefit from lower transaction costs. In the second type, the


company issues new shares to the participants. Thus, the company issues stock in lieu of the


cash dividend.


g. In a stock split, current shareholders are given some number (or fraction) of shares for each stock


owned. Thus, in a 3-for-1 split, each shareholder would receive 3 new shares in exchange for


each old share, thereby tripling the number of shares outstanding. Stock splits usually occur


when the stock price is outside of the optimal trading range. Stock dividends also increase the


number of shares outstanding, but at a slower rate than splits. In a stock dividend, current


shareholders receive additional shares on some proportional basis. Thus, a holder of 100 shares


would receive 5 additional shares at no cost if a 5 percent stock dividend were declared. Stock


repurchases occur when a firm repurchases its own stock. These shares of stock are then


referred to as treasury stock. The higher EPS on the now decreased number of shares


outstanding will cause the price of the stock to rise and thus capital gains are substituted for cash


dividends.




Answers and Solutions: 18 - 370 18-2 a. From the stockholders' point of view, an increase in the personal income tax rate would make it


more desirable for a firm to retain and reinvest earnings. Consequently, an increase in personal


tax rates should lower the aggregate payout ratio.


b. If the depreciation allowances were raised, cash flows would increase. With higher cash flows,


payout ratios would tend to increase. On the other hand, the change in tax-allowed depreciation


charges would increase rates of return on investment, other things being equal, and this might


stimulate investment, and consequently reduce payout ratios. On balance, it is likely that


aggregate payout ratios would rise, and this has in fact been the case.


c. If interest rates were to increase, the increase would make retained earnings a relatively attractive


way of financing new investment. Consequently, the payout ratio might be expected to decline.


On the other hand, higher interest rates would cause rd, rs, and firm's MCCs to rise--that would


mean that fewer projects would qualify for capital budgeting and the residual would increase


(other things constant), hence the payout ratio might increase.


d. A permanent increase in profits would probably lead to an increase in dividends, but not


necessarily to an increase in the payout ratio. If the aggregate profit increase were a cyclical


increase that could be expected to be followed by a decline, then the payout ratio might fall,


because firms do not generally raise dividends in response to a short-run profit increase.


e. If investment opportunities for firms declined while cash inflows remained relatively constant, an


increase would be expected in the payout ratio.


f. Dividends are currently paid out of after-tax dollars, and interest charges from before-tax dollars.


Permission for firms to deduct dividends as they do interest charges would make dividends less


costly to pay than before and would thus tend to increase the payout ratio.


g. This change would make capital gains less attractive and would lead to an increase in the payout


ratio.


18-3 The difference is largely one of accounting. In the case of a split, the firm simply increases the


number of shares and simultaneously reduces the par or stated value per share. In the case of a stock


dividend, there must be a transfer from retained earnings to capital stock. For most firms, a 100


percent stock dividend and a 2-for-1 split accomplish exactly the same thing; hence, investors may


choose either one.


18-4 a. The residual distribution policy is based on the premise that, since new common stock is more


costly than retained earnings, a firm should use all the retained earnings it can to satisfy its


common equity requirement. Thus, the distribution under this policy is a function of the firm's


investment opportunities.


b. Yes. A more shallow plot implies that changes from the optimal capital structure have little


effect on the firm's cost of capital, hence value. In this situation, dividend policy is less critical


than if the plot were V-shaped.




Answers and Solutions: 18 - 371 18-5 a. True. When investors sell their stock they are subject to capital gains taxes.


b. True. If a company's stock splits 2 for 1, and you own 100 shares, then after the


split you will own 200 shares.


c. True. Dividend reinvestment plans that involve newly issued stock will increase the amount of


equity capital available to the firm.


d. False. The tax code, through the tax deductibility of interest, encourages firms to use debt and


thus pay interest to investors rather than dividends, which are not tax deductible. In addition,


due to a lower capital gains tax rate than the highest personal tax rate, the tax code encourages


investors in high tax brackets to prefer firms who retain earnings rather than those that pay large


dividends.


e. True. If a company's clientele prefers large dividends, the firm is unlikely to adopt a residual


dividend policy. A residual dividend policy could mean low or zero dividends in some years


which would upset the company's developed clientele.


f. False. If a firm follows a residual dividend policy, all else constant, its dividend payout will tend


to decline whenever the firm's investment opportunities improve.




SOLUTIONS TO END-OF-CHAPTER PROBLEMS


18-1 70% Debt; 30% Equity; Capital Budget = $3,000,000; NI = $2,000,000;


PO = ?


Equity retained = 0.3($3,000,000) = $900,000.


NI $2,000,000


-Additions 900,000


Earnings Remaining $1,100,000


$1,100,000


Payout = = 55%.


$2,000,000


18-2 P0 = $90; Split = 3 for 2; New P0 = ?


$90


P0 New = = $60.


3/ 2



18-3 Retained earnings = Net income (1 - Payout ratio)


Answers and Solutions: 18 - 372 = $5,000,000(0.55) = $2,750,000.


External equity needed:


Total equity required = (New investment)(1 - Debt ratio)


= $10,000,000(0.60) = $6,000,000.


New external equity needed = $6,000,000 - $2,750,000 = $3,250,000.


18-4 The company requires 0.40($1,200,000) = $480,000 of equity financing. If the


company follows a residual dividend policy it will retain $480,000 for its capital


budget and pay out the $120,000 "residual" to its shareholders as a dividend. The


payout ratio would therefore be $120,000/$600,000 = 0.20 = 20%.


18-5 Equity financing = $12,000,000(0.60) = $7,200,000.


Dividends = Net income - Equity financing


= $15,000,000 - $7,200,000 = $7,800,000.


Dividend payout ratio = Dividends/Net income


= $7,800,000/$15,000,000 = 52%.


18-6 DPS after split = $0.75.


Equivalent pre-split dividend = $0.75(5) = $3.75.


New equivalent dividend = Last year's dividend(1.09)


$3.75 = Last year's dividend(1.09)


Last year's dividend = $3.75/1.09 = $3.44.


18-7 Capital budget should be $10 million. We know that 50% of the $10 million should be equity.


Therefore, the company should pay dividends of:


Dividends = Net income - needed equity


= $7,287,500 - $5,000,000 = $2,287,500.


Payout ratio = $2,287,500/$7,287,500 = 0.3139 = 31.39%.




Answers and Solutions: 18 - 373 18-8 a. 1. 2005 Dividends = (1.10)(2004 Dividends)


= (1.10)($3,600,000) = $3,960,000.


2. 2004 Payout = $3,600,000/$10,800,000 = 0.33 = 33%.


2005 Dividends = (0.33)(2005 Net income)


= (0.33)($14,400,000) = $4,800,000.


(Note: If the payout ratio is rounded off to 33%, 2005 dividends are then calculated as


$4,752,000.)


3. Equity financing = $8,400,000(0.60) = $5,040,000.


2005 Dividends = Net income - Equity financing


= $14,400,000 - $5,040,000 = $9,360,000.


All of the equity financing is done with retained earnings as long as they are available.


4. The regular dividends would be 10% above the 2004 dividends:


Regular dividends = (1.10)($3,600,000) = $3,960,000.


The residual policy calls for dividends of $9,360,000. Therefore, the extra dividend, which


would be stated as such, would be


Extra dividend = $9,360,000 - $3,960,000 = $5,400,000.


An even better use of the surplus funds might be a stock repurchase.


b. Policy 4, based on the regular dividend with an extra, seems most logical. Implemented properly,


it would lead to the correct capital budget and the correct financing of that budget, and it would


give correct signals to investors.


18-9 a. Capital Budget = $10,000,000; Capital structure = 60% equity, 40% debt.


Retained Earnings Needed = $10,000,000 (0.6) = $6,000,000.


b. According to the residual dividend model, only $2 million is available for dividends.


NI - Retained earnings needed for cap. projects = Residual dividend.


$8,000,000 - $6,000,000 = $2,000,000.


DPS = $2,000,000/1,000,000 = $2.00.


Payout ratio = $2,000,000/$8,000,000 = 25%.


c. Retained Earnings Available = $8,000,000 - $3.00 (1,000,000)


Retained Earnings Available = $8,000,000 - $3,000,000


Retained Earnings Available = $5,000,000.


d. No. If the company maintains its $3.00 DPS, only $5 million of retained earnings will be


available for capital projects. However, if the firm is to maintain its current capital structure, $6


million of equity is required. This would necessitate the company having to issue $1 million of


Answers and Solutions: 18 - 374 new common stock.


e. Capital Budget = $10 million; Dividends = $3 million; NI = $8 million.


Capital Structure = ?


RE Available = $8,000,000 - $3,000,000


= $5,000,000.


$5,000,000


Percentage of Cap. Budget Financed with RE = = 50%.


$10,000,000


$5,000,000


Percentage of Cap. Budget Financed with Debt = = 50%.


$10,000,000


f. Dividends = $3 million; Capital Budget = $10 million; 60% equity, 40% debt; NI = $8 million.


Equity Needed = $10,000,000(0.6) = $6,000,000.


RE Available = $8,000,000 - $3.00(1,000,000)


= $8,000,000 - $3,000,000


= $5,000,000.


External (New) Equity Needed = $6,000,000 - $5,000,000


= $1,000,000.


g. Dividends = $3 million; NI = $8 million; Capital structure = 60% equity, 40% debt.


RE Available = $8,000,000 - $3,000,000


= $5,000,000.


We're forcing the RE Available = Required Equity to find the new capital budget.


Required Equity = Capital Budget (Target Equity Ratio)


$5,000,000 = Capital Budget(0.6)


Capital Budget = $8,333,333.


Therefore, if Buena Terra cuts its capital budget from $10 million to $8.33 million, it can maintain


its $3.00 DPS, its current capital structure, and still follow the residual dividend policy.



h. The firm can do one of four things:


(1) Cut dividends.


(2) Change capital structure, that is, use more debt.


(3) Cut its capital budget.


(4) Issue new common stock.


Realize that each of these actions is not without consequences to the company's cost of


capital, stock price, or both.



Answers and Solutions: 18 - 375 Answers and Solutions: 18 - 376 SPREADSHEET PROBLEM


18-10 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 18 P10 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.




Answers and Solutions: 18 - 377 MINI CASE



Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC's founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they own all of the shares. However, SSC has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy.


Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions.


a. 1. What is meant by the term "distribution policy"?


Answer: Distribution policy is defined as the firm's policy with regard to (1) the level of distributions, (2)


the form of distributions (dividends or stock repurchases), and (3) the stability of distributions.



a. 2. The terms "irrelevance," "bird-in-the-hand," and "tax preference" have been


used to describe three major theories regarding the way dividend payouts affect a


firm's value. Explain what these terms mean, and briefly describe each theory.



Answer: Dividend irrelevance refers to the theory that investors are indifferent between dividends and



Answers and Solutions: 19 - 378 capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm.


"Bird-in-the-hand" refers to the theory that a dollar of dividends in the hand is preferred by


investors to a dollar retained in the business, in which case dividend policy would affect a firm's


value.


The dividend irrelevance theory was proposed by MM, but they had to make some very


restrictive assumptions to "prove" it (zero taxes, no flotation or transactions costs). MM argued


that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends,


because new stock will have to be sold to replace the capital paid out as dividends. Under their


assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore,


according to MM, stockholders should be indifferent between dividends and capital gains.


The "bird-in-the-hand" theory is identified with Myron Gordon and John Lintner, who argued


that investors perceive a dollar of dividends in the hand to be less risky than a dollar of potential


future capital gains in the bush; hence, stockholders prefer a dollar of actual dividends to a dollar


of retained earnings. If the bird-in-the-hand theory is true, then investors would regard a firm


with a high payout ratio as being less risky than one with a low payout ratio, all other things equal;


hence, firms with high payout ratios would have higher values than those with low payout ratios.


MM opposed the Gordon-Lintner theory, arguing that a firm's risk is dependent only on the


riskiness of its cash flows from assets and its capital structure, not by how its earnings are


distributed to investors.


The tax preference theory recognizes that there are two tax-related reasons for believing that


investors might prefer a low dividend payout to a high payout: (1) taxes are not paid on capital


gains until the stock is sold. (2) if a stock is held by someone until he or she dies, no capital


gains tax is due at all--the beneficiaries who receive the stock can use the stock's value on the


death day as their cost basis and thus escape the capital gains tax.




a. 3. What do the three theories indicate regarding the actions management should


take with respect to dividend payout?


Answer: If the dividend irrelevance theory is correct, then dividend payout is of no consequence, and the



Answers and Solutions: 19 - 379 firm may pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm should


set a high payout if it is to maximize its stock price. If the tax preference theory is correct, the


firm should set a low payout if it is to maximize its stock price. Therefore, the theories are in


total conflict with one another.



a. 4. What results have empirical studies of the dividend theories produced? How


does all this affect what we can tell managers about dividend payouts?


Answer: Unfortunately, empirical tests of the theories have been inconclusive (because firms don't differ


just with respect to payout), so we cannot tell managers whether investors prefer dividends or


capital gains. Even though we cannot determine what the optimal dividend policy is, managers


can use the types of analyses discussed in this chapter to help develop a rational and reasonable, if


not completely optimal, dividend policy.



b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect,


and (3) their effects on distribution policy.


Answer: 1. Different groups, or clienteles, of stockholders prefer different dividend payout policies.


For example, many retirees, pension funds, and university endowment funds are in a low (or


zero) tax bracket, and they have a need for current cash income. Therefore, this group of


stockholders might prefer high payout stocks. These investors could, of course, sell some of


their stock, but this would be inconvenient, transactions costs would be incurred, and the sale


might have to be made in a down market. Conversely, investors in their peak earnings years


who are in high tax brackets and who have no need for current cash income should prefer low


payout stocks.




Answers and Solutions: 19 - 380 2. Clienteles do exist, but the real question is whether there are more members of one clientele


than another, which would affect what a change in its dividend policy would do to the


demand for the firm's stock. There are also costs (taxes and brokerage) to stockholders who


would be forced to switch from one stock to another if a firm changes its policy. Therefore,


we cannot say whether a policy change to appeal to one particular clientele or another would


lower or raise a firm's cost of equity. MM argued that one clientele is as good as another, so


in their view the existence of clienteles does not imply that one dividend policy is better than


another. Still, no one has offered convincing proof that firms can disregard clientele effects.


We know that stockholder shifts will occur if policy is changed, and since such shifts result in


transaction costs and capital gains taxes, policy changes should not be taken lightly. Further,


dividend policy should be changed slowly, rather than abruptly, in order to give stockholders


time to adjust.


3. It has long been recognized that the announcement of a dividend increase often results in an


increase in the stock price, while an announcement of a dividend cut typically causes the


stock price to fall. One could argue that this observation supports the premise that investors


prefer dividends to capital gains. However, MM argued that dividend announcements are


signals through which management conveys information to investors. Information


asymmetries exist--managers know more about their firms' prospects than do investors.


Further, managers tend to raise dividends only when they believe that future earnings can


comfortably support a higher dividend level, and they cut dividends only as a last resort.


Therefore, (1) a larger-than-normal dividend increase "signals" that management believes the


future is bright, (2) a smaller-than-expected increase, or a dividend cut, is a negative signal,


and (3) if dividends are increased by a "normal" amount, this is a neutral signal.




Answers and Solutions: 19 - 381 c. 1. Assume that SSC has an $800,000 capital budget planned for the coming year.


You have determined that its present capital structure (60 percent equity and 40


percent debt) is optimal, and its net income is forecasted at $600,000. Use the


residual distribution model approach to determine SSC's total dollar distribution.


Assume for now that the distribution is in the form of a dividend. Then, explain


what would happen if net income were forecasted at $400,000, or at $800,000.


Answer: We make the following points:


a. Given the optimal capital budget and the target capital structure, we must now determine the


amount of equity needed to finance the projects. Of the $800,000 required for the capital


budget, 0.6($800,000) = $480,000 must be raised as equity and 0.4($800,000) = $320,000


must be raised as debt if we are to maintain the optimal capital structure:


Debt $320,000 40%


Equity 480,000 60%


$800,000 100%


b. If a residual exists--that is, if net income exceeds the amount of equity the company


needs--then it should distribute the residual amount out as either dividends or stock


repurchases. For now, we assume all payouts are in the form of dividends. Since $600,000


of earnings is available, and only $480,000 is needed, the residual is $600,000 - $480,000 =


$120,000, so this is the amount which should be paid out as dividends. Thus, the payout


ratio would be $120,000/$600,000 = 0.20 = 20%.


c. If only $400,000 of earnings were available, the theoretical break point would occur at BP =


$400,000/0.6 = $666,667. Assuming the intersection of the investment opportunity set and


marginal cost of capital was still at $800,000, the firm would still need $480,000 of equity.


It should then retain all of its earnings and also sell $80,000 of new stock. The residual


policy would call for a zero payment.


d. If $800,000 of earnings was available, the dividend would be increased to $800,000 -


$480,000 = $320,000, and the payout ratio would rise to $320,000/$800,000 = 40%.



c. 2. In general terms, how would a change in investment opportunities affect the


payout ratio under the residual payment policy?


Answer: A change in investment opportunities would lead to an increase (if investment opportunities were


good) or a decrease (if investment opportunities were not good) in the amount of equity needed,


Answers and Solutions: 19 - 382 hence in the residual dividend payout.


c. 3. What are the advantages and disadvantages of the residual policy? (Hint:


don't neglect signaling and clientele effects.)


Answer: The primary advantage of the residual policy is that under it the firm makes maximum use of


lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital.


Also, whatever negative signals are associated with stock issues would be avoided.


However, if it were applied exactly, the residual model would result in dividend payments


which fluctuated significantly from year to year as capital requirements and internal cash flows


fluctuated. This would (1) send investors conflicting signals over time regarding the firm's


future prospects, and (2) since no specific clientele would be attracted to the firm, it would be an


"orphan." These signaling and clientele effects would lead to a higher required return on equity


which would more than offset the effects of lower flotation costs. Because of these factors, few if


any publicly owned firms follow the residual model on a year-to-year basis.


Even though the residual approach is not used to set the annual dividend, it is used when


firms establish their long-run dividend policy. If "normalized" cost of capital and investment


opportunity conditions suggest that in a "normal" year the company should pay out about 60


percent of its earnings, this fact will be noted and used to help determine the long-run policy.



d. What are stock repurchases? Discuss the advantages and disadvantages of a firm's


repurchasing its own shares.


Answer: A firm may distribute cash to stockholders by repurchasing its own stock rather than paying out


cash dividends. Stock repurchases can be used (1) somewhat routinely as an alternative to


regular dividends, (2) to dispose of excess (nonrecurring) cash that came from asset sales or from


temporarily high earnings, and (3) in connection with a capital structure change in which debt is


sold and the proceeds are used to buy back and retire shares.


Advantages of repurchases:


1. A repurchase announcement may be viewed as a positive signal that management believes the


shares are undervalued.


2. Stockholders have a choice--if they want cash, they can tender their shares, receive the cash,


and pay the taxes, or they can keep their shares and avoid taxes. On the other hand, one


must accept a cash dividend and pay taxes on it.



Answers and Solutions: 19 - 383 3. If the company raises the dividend to dispose of excess cash, this higher dividend must be


maintained to avoid adverse stock price reactions. A stock repurchase, on the other hand,


does not obligate management to future repurchases.


4. Repurchased stock, called treasury stock, can be used later in mergers, when employees


exercise stock options, when convertible bonds are converted, and when warrants are


exercised. Treasury stock can also be resold in the open market if the firm needs cash.


Repurchases can remove a large block of stock that is "overhanging" the market and keeping


the price per share down.


5. Repurchases can be varied from year to year without giving off adverse signals, while


dividends may not.


6. Repurchases can be used to produce large-scale changes in capital structure.


Disadvantages of repurchases:


1. A repurchase could lower the stock's price if it is taken as a signal that the firm has relatively


few good investment opportunities. On the other hand, though, a repurchase can signal


stockholders that managers are not engaged in "empire building," where they invest funds in


low-return projects.


2. If the IRS establishes that the repurchase was primarily to avoid taxes on dividends, then


penalties could be imposed. Such actions have been brought against closely held firms, but


to our knowledge charges have never been brought against publicly held firms.


3. Selling shareholders may not be fully informed about the repurchase; hence they may make


an uninformed decision and may later sue the company. To avoid this, firms generally


announce repurchase programs in advance.


4. The firm may bid the stock price up and end up paying too high a price for the shares. In


this situation, the selling shareholders would gain at the expense of the remaining


shareholders. This could occur if a tender offer were made and the price was set too high,


or if the repurchase was made in the open market and buying pressure drove the price above


its equilibrium level.


e. Describe the series of steps that most firms take in setting dividend policy in


practice.



Answers and Solutions: 19 - 384 Answer: Firms establish dividend policy within the framework of their overall financial plans. The steps


in setting policy are listed below:


1. The firm forecasts its annual capital budgets and its annual sales, along with its working


capital needs, for a relatively long-term planning horizon, often 5 years.


2. The target capital structure, presumably the one which minimizes the WACC while retaining


sufficient reserve borrowing capacity to provide "financing flexibility," will also be


established.


3. With its capital structure and investment requirements in mind, the firm can estimate the


approximate amount of debt and equity financing required during each year over the planning


horizon.


4. A long-term target payout ratio is then determined, based on the residual model concept.


Because of flotation costs and potential negative signaling, the firm will not want to issue


common stock unless this is absolutely necessary. At the same time, due to the clientele


effect, the firm will move cautiously from its past dividend policy, if a new policy appears to


be warranted, and it will move toward any new policy gradually rather than in one giant step.


5. An actual dollar dividend, say $2 per year, will be decided upon. The size of this dividend


will reflect (1) the long-run target payout ratio and (2) the probability that the dividend, once


set, will have to be lowered, or, worse yet, omitted. If there is a great deal of uncertainty


about cash flows and capital needs, then a relatively low initial dollar dividend will be set, for


this will minimize the probability that the firm will have to either reduce the dividend or sell


new common stock. The firm will run its corporate planning model so that management can


see what is likely to happen with different initial dividends and projected growth rates under


different economic scenarios.


f. What are stock dividends and stock splits? What are the advantages and


disadvantages of stock dividends and stock splits?


Answer: When it uses a stock dividend, a firm issues new shares in lieu of paying a cash dividend. For


example, in a 5 percent stock dividend, the holder of 100 shares would receive an additional 5


shares. In a stock split, the number of shares outstanding is increased (or decreased in a reverse


split) in an action unrelated to a dividend payment. For example, in a 2-for-1 split, the number


of shares outstanding is doubled. A 100% stock dividend and a 2-for-1 stock split would


produce the same effect, but there would be differences in the accounting treatments of the two



Answers and Solutions: 19 - 385 actions.


Both stock dividends and stock splits increase the number of shares outstanding and, in effect,


cut the pie into more, but smaller, pieces. If the dividend or split does not occur at the same time


as some other event which would alter perceptions about future cash flows, such as an


announcement of higher earnings, then one would expect the price of the stock to adjust such that


each investor's wealth remains unchanged. For example, a 2-for-1 split of a stock selling for $50


would result in the stock price being cut in half, to $25.


It is hard to come up with a convincing rationale for small stock dividends, like 5 percent or


10 percent. No economic value is being created or distributed, yet stockholders have to bear the


administrative costs of the distribution. Further, it is inconvenient to own an odd number of


shares as may result after a small stock dividend. Thus, most companies today avoid small stock


dividends.


On the other hand, there is a good reason for stock splits or large stock dividends.


Specifically, there is a widespread belief that an optimal price range exists for stocks. The


argument goes as follows: if a stock sells for about $20-$80, then it can be purchased in round lots,


hence at reduced commissions, by most investors. A higher price would put round lots out of the


price range of many small investors, while a stock price lower than about $20 would convey the


image of a stock that is doing poorly. Thus, most firms try to keep their stock prices within the


$20 to $80 range. If the company prospers, it will split its stock occasionally to hold the price


down. (Also, companies that are doing poorly occasionally use reverse splits to raise their price.)


Many companies do operate outside the $20 to $80 range, but most stay within it.


Another factor that may influence stock splits and dividends is the belief that they signal


management's belief that the future is bright. If a firm's management would be inclined to split


the stock or pay a stock dividend only if it anticipated improvements in earnings and dividends,


then a split/dividend action could provide a positive signal and thus boost the stock price.


However, if earnings and cash dividends did not subsequently rise, the price of the stock would


fall back to its old level, or even lower, because managers would lose credibility.


Interestingly, one of the most astute investors of the 20th century, Warren Buffett, chairman of


Berkshire-Hathaway, has never split his firm's stock. Berkshire currently sells for over $34,000


per share, and its performance over the years has been absolutely spectacular. It may be that


Berkshire's market value would be higher if it had a 425:1 stock split, or it may be that the


conventional wisdom is wrong.



g. What is a dividend reinvestment plan (drip), and how does it work?




Answers and Solutions: 19 - 386 Answer: Under a dividend reinvestment plan (DRIP), shareholders have the option of automatically


reinvesting their dividends in shares of the firm's common stock. In an open market purchase


plan, a trustee pools all the dividends to be reinvested and then buys shares on the open market.


Shareholders use the drip for three reasons: (1) brokerage costs are reduced by the volume


purchases, (2) the drip is a convenient way to invest excess funds, and (3) the company generally


pays all administrative costs associated with the operation.


In a new stock plan, the firm issues new stock to the DRIP members in lieu of cash dividends.


No fees are charged, and many companies even offer the stock at a 5 percent discount from the


market price on the dividend date on the grounds that the firm avoids flotation costs that would


otherwise be incurred. Only firms that need new equity capital use new stock plans, while firms


with no need for new stock use an open market purchase plan.




Answers and Solutions: 19 - 387 Chapter 19


Initial Public Offerings, Investment Banking, and Financial


Restructuring


ANSWERS TO END-OF-CHAPTER QUESTIONS


19-1 a. A closely held corporation goes public when it sells stock to the general public. Going public


increases the liquidity of the stock, establishes a market value, facilitates raising new equity, and


allows the original owners to diversify. However, going public increases business costs, requires


disclosure of operating data, and reduces the control of the original owners. The new issue


market is the market for stock of companies that go public, and the issue is called an initial public


offering (IPO).


b. A public offering is an offer of new common stock to the general public; in other words, an offer


in which the existing shareholders are not given any preemptive right to purchase the new shares.


A private placement is the sale of stock to only one or a few investors, usually institutional


investors. The advantages of private placements are lower flotation costs and greater speed,


since the shares issued are not subject to SEC registration.


c. A venture capitalist is the manager of a venture capital fund. The fund raises most of its capital


from institutional investors and invests in start-up companies in exchange for equity. The


venture capitalist gets a seat on the companies' boards of directors. Before an IPO, the senior


management team and the investment banker make presentations to potential investors. They


make presentations in tent to twenty cities, with three to five presentations per day, over a two


week period. The spread is the difference between the price at which an underwriter sells the


stock in an IPO and the proceeds that the underwriter passes on to the issuing firm. In other


words, it is the fee collected by the underwriter, and it usually is seven percent of the offering


price.


d. The Securities and Exchange Commission (SEC) is a government agency which regulates the


sales of new securities and the operations of securities exchanges. The SEC, along with other


government agencies and self-regulation, helps ensure stable markets, sound brokerage firms, and


the absence of stock manipulation. Registration of securities is required of companies by the


SEC before the securities can be offered to the public. The registration statement is used to


summarize various financial and legal information about the company. Frequently, companies will


file a master registration statement and then update it with a short-form statement just before an


offering. This procedure is termed shelf registration because companies put new securities "on the


shelf" and then later sell them when the market is right. Blue sky laws are laws that prevent the


sale of securities that have little or no asset backing. The margin is the percentage of a stock's


price that an investor has borrowed in order to purchase the stock. The SEC sets margin


requirements, which is the maximum percentage of debt that can be used to purchase a stock.


The SEC also controls trading by corporate insiders, who are the officers, directors, and major


stockholders of the firm.


e. A prospectus summarizes information about a new security issue and the issuing company. A


"red herring," or preliminary prospectus, may be distributed to potential buyers prior to approval


of the registration statement by the SEC. After the registration has become effective, the


securities, accompanied by the prospectus, may be offered for sale.



Answers and Solutions: 19 - 388 f. The National Association of Securities Dealers (NASD) is an industry group primarily concerned


with the operation of the over-the-counter (OTC) market.


g. A best efforts arrangement versus an underwritten sale refers to two methods of selling new stock


issues. In a best efforts sale, the investment banker is only committed to making every effort to


sell the stock at the offering price. In this case, the issuing firm bears the risk that the new issue


will not be fully subscribed. If the issue is underwritten, the investment banker agrees to buy


the entire issue at a set price, and then resells the stock at the offering price. Thus, the risk of


selling the issue rests with the investment banker.


h. Refunding occurs when a company issues debt at current low rates and uses the proceeds to


repurchase one of its existing high coupon rate debt issues. Often these are callable issues,


which means the company can purchase the debt at a lower-than-market price. Project


financings are arrangements used to finance mainly large capital projects such as energy


explorations, oil tankers, refineries, utility power plants, and so on. Usually, one or more firms


(sponsors) will provide the equity capital required by the project, while the rest of the project's


capital is supplied by lenders and lessors. The most important aspect of project financing is that


the lenders and lessors do not have recourse against the sponsors; they must be repaid from the


project's cash flows and the equity cushion provided by the sponsors. Securitization is the


process whereby financial instruments that were previously thinly traded are converted to a form


that creates greater liquidity. Securitization also applies to the situation where specific assets are


pledged as collateral for securities, and hence asset-backed securities are created. One example


of the former is junk bonds; an example of the latter is mortgage-backed securities. Maturity


matching refers to matching the maturities of debt used to finance assets with the lives of the


assets themselves. The debt would be amortized such that the outstanding amount declined as


the asset lost value due to depreciation.


19-2 No. The role of the investment banker is more important if the stock demand curve has a steep slope


and the negative signaling effect is substantial. Under such conditions, the investment banker will


have a harder time holding up the stock price.


19-3 No. The real value of a security is determined by the equilibrium forces of an efficient market.


Assuming that the information provided on newly issued securities is accurate, the market will


establish the value of a security regardless of the opinions rendered by the SEC, or, for that matter,


opinions offered by any advisory service or analyst.



19-4 a. Going public would tend to make attracting capital easier and to decrease flotation costs.


b. The increasing institutionalization of the "buy side" of the stock and bond markets should


increase a firm's ability to attract capital and should reduce flotation costs.


c. Financial conglomerates can offer a variety of financial services and types of investments, thus it


seems a company's ability to attract capital would increase and flotation costs would decrease.




Answers and Solutions: 19 - 389 d. Elimination of the preemptive right would likely not affect a large company where percentage


ownership is not as important. Indeed, the trend today seems to be for companies to eliminate


the preemptive right.


f. The introduction of shelf registration tended to speed up SEC review time and lower the costs of


floating each new issue. Thus, the company's ability to attract new capital was increased.


19-5 Investment bankers must investigate the firms whose securities they sell, simply because, if an issue is


overvalued and suffers marked price declines after the issue, the banker will find it increasingly


difficult to dispose of the new issue. In other words, reputation is highly important in the investment


banking industry.




Answers and Solutions: 19 - 390 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


19-1 a. $5 per share


Gross proceeds = (3,000,000)($5) = $15,000,000.


Net profit = $15,000,000 - $14,000,000 - $300,000 = $700,000.


b. $6 per share


Gross proceeds = (3,000,000)($6) = $18,000,000.


Net profit = $18,000,000 - $14,000,000 - $300,000 = $3,700,000.


c. $4 per share


Gross proceeds = (3,000,000)($4) = $12,000,000.


Net profit = $12,000,000 - $14,000,000 - $300,000 = -$2,300,000.


19-2 Net proceeds per share = $22(1 - 0.05) = $20.90.


Number of shares to be sold = ($20,000,000 + 150,000)/$20.90 = 964,115 shares.


19-3 a. If 100 shares are outstanding, then we have the following for Edelman:


1999 2004


Earnings per share $8,160 $12,000


Dividends per share 4,200 6,000


Book value per share 90,000


b. Using the following two equations, the growth rate for EPS and DPS can be


determined.


(1 + gEPS)5 EPS99 = EPS04.


(1 + gDPS)5 DPS99 = DPS04.


gEPS


gDPS


Kennedy 8.4% 8.4%


Strasburg 6.4 6.4


Edelman 8.0 7.4


c. Based on the figures in Part a, it is obvious that Edelman's stock would not sell in the range of


$25 to $100 per share. The small number of shares outstanding has greatly inflated EPS, DPS,


and book value per share. Should Edelman attempt to sell its stock based on the EPS and DPS


above, it would have difficulty finding investors at the economically justified price.




Answers and Solutions: 19 - 391 d. Edelman's management would probably be wise to split the stock so that EPS, DPS, and book


value were closer to those of Kennedy and Strasburg. This would bring the price of the stock into


a more reasonable range.


e. A 4,000-for-1 split would result in 400,000 shares outstanding. If Edelman has 400,000 shares


outstanding, then we would have the following:


1999 2004


Earnings per share $2.04 $ 3.00


Dividends per share 1.05 1.50


Book value per share 22.50


f. ROE


Kennedy 15.00%


Strasburg 13.64


Edelman 13.33


g. Payout Ratio


1999 2004


Kennedy 50% 50%


Strasburg 50 50


Edelman 51 50


All three companies seem to be following similar dividend policies, paying out about 50 percent


of their earnings.


h. D/A is 43 percent for Kennedy, 37 percent for Strasburg, and 55 percent for Edelman. This


suggests that Edelman is more risky, hence should sell at relatively low multiples.


i. P/E


Kennedy $36/$4.50 = 8.00


Strasburg $65/$7.50 = 8.67


These ratios are not consistent with g and ROE; based on gs and ROEs, Kennedy should have


the higher P/E. Probably size, listing status, and debt ratios are offsetting g and ROE.




Answers and Solutions: 19 - 392 j. The market prices of Kennedy and Strasburg yield the following multiples:


Multiple of Multiple of Multiple of Book


EPS, 2004 DPS, 2004 Value per Share, 2004


Kennedy 8.00 16.00 1.20


Strasburg 8.67 17.33 1.18


Applying these multiples to the data in Part e, we obtain the following market prices:


Indicated Market Price


for Edelman Stock


Based on Data of:


Kennedy Strasburg


Based on earnings, 2003 $24.00 $26.01


Based on dividends, 2003 24.00 26.00


Based on book value per share 27.00 26.55


D 0 (1 + g)


k. r = + g.


P0


$2.25(1.084)


Kennedy r= + 8.4% = 15.18.


$36


$3.75(1.064)


Strasburg r= + 6.4% = 12.54%.


$65


^ D1


Edelman P0 = .


r-g


1.50(1.077)


Based on Kennedy: P0 = = $21.54.


0.152 - 0.077


1.50(1.077)


Based on Strasburg: P0 = = $33.66.


0.125 - 0.077 l. The potential range, based on these data, is between $21.54 and $33.66 a share.


The data suggest that the price would be set toward the low end of the range:


(1) Edelman has a high debt ratio, (2) Edelman is relatively small, and (3)


Edelman is new and will not be traded on an exchange. The actual price would


be based on negotiations between the underwriter and Edelman; we cannot say


what the exact price would be, but the price would probably be set below $21.54,


with $20 being a reasonable guess.




Answers and Solutions: 19 - 393 19-4 a. Since the call premium is 11 percent, the total premium is 0.11($40,000,000) = $4,400,000.


However, this is a tax deductible expense, so the relevant after-tax cost is $4,400,000(1 - T) =


$4,400,000(0.60) = $2,640,000.


b. The dollar flotation cost on the new issue is 0.04($40,000,000) = $1,600,000. This cost is


not immediately tax deductible, and hence the after-tax cost is also $1,600,000. (Note that


the flotation cost can be amortized and expensed over the life of the issue. The value of this


tax savings will be calculated in Part e.)


c. The flotation costs on the old issue were 0.06($40,000,000) = $2,400,000. These costs were


deferred and are being amortized over the 25-year life of the issue, and hence $2,400,000/25


= $96,000 are being expensed each year, or $48,000 each 6 months. Since the bonds were


issued 5 years ago, (5/25)($2,400,000) = $480,000 of the flotation costs have already been


expensed, and (20/25)($2,400,000) = $1,920,000 remain unexpensed.


If the issue is refunded, the unexpensed portion of the flotation costs can be immediately


expensed, and this would result in a tax savings of T($1,920,000) = 0.40($1,920,000) =


$768,000.


d. The net after-tax cash outlay is $3,472,000, as shown below:


Old issue call premium $2,640,000


New issue flotation cost 1,600,000


Tax savings on old issue


flotation costs (768,000)


Net cash outlay $3,472,000


e. The new issue flotation costs of $1,600,000 would be amortized over the 20-year life of the


issue. Thus, $1,600,000/20 = $80,000 would be expensed each year, or $40,000 each 6


months. The tax savings from this tax deduction is (0.40)$40,000 = $16,000 per semiannual


period.


By refunding the old issue and immediately expensing the remaining old issue flotation


costs, the firm forgoes the opportunity to continue to expense the old flotation costs over


time. Specifically, $2,400,000/25 = $96,000 each year, or $48,000 semiannually. The


value of each $48,000 deduction forgone is 0.40($48,000) = $19,200.


f. The interest on the old issue is 0.11($40,000,000) = $4,400,000 annually, or $2,200,000


semiannually. Since interest payments are tax deductible, the after-tax semiannual amount is


0.6($2,200,000) = $1,320,000.


The new issue carries an 8 percent coupon rate. Therefore, the annual interest would be


0.08($40,000,000) = $3,200,000, or $1,600,000 semiannually. The after-tax cost is thus


0.6($1,600,000) = $960,000. Thus, the after-tax net interest savings if refunding takes place


would be $1,320,000 $960,000 = $360,000 semiannually.




g. The net amortization tax effects are $3,200 per year for 20 years, while the net interest


savings are $360,000 per year for 20 years. Thus, the net semiannual cash flow is $356,800,


as shown below.


Answers and Solutions: 19 - 394 Semiannual Flotation Cost Tax Effects:


Semiannual tax savings on new flotation: $16,000


Tax benefits lost on old flotation: (19,200)


Net amortization tax effects ($ 3,200)


Semiannual Interest Savings Due To Refunding:


Semiannual interest on old bond: $1,320,000


Semiannual interest on new bond: (960,000)


Net interest savings $ 360,000


Semiannual cash flow: $ 356,800


The cash flows are based on contractual obligations, and hence have about the same amount


of risk as the firm's debt. Further, the cash flows are already net of taxes. Thus, the


appropriate interest rate is GST's after-tax cost of debt. (The source of the cash to fund the


net investment outlay also influences the discount rate, but most firms use debt to finance this


outlay, and, in this case, the discount rate should be the after-tax cost of debt.) Finally,


since we are valuing future flows, the appropriate debt cost is today's cost, or the cost of the


new issue, and not the cost of debt floated 5 years ago. Thus, the appropriate discount rate is


0.6(8%) = 4.8% annually, or 2.4 percent per semiannual period.


At this discount rate, the present value of the semiannual net cash flows is $9,109,425:


PV = $356,800(PVIFA2.4%,40) = $9,109,425.


Alternatively, using a financial calculator, input N = 40, I = 2.4, PMT = -356800, FV = 0, PV


= ? PV = $9,109,413.


h. The bond refunding would require a $3,472,000 net cash outlay, but it would produce


$9,109,413 in net savings on a present value basis. Thus, the NPV of refunding is


$5,637,413:


PV of net benefits $9,109,413


Cost (3,472,000)


Refunding NPV $5,637,413


The decision to refund now rather than wait till later is much more difficult than finding


the NPV of refunding now. If interest rates were expected to fall, and hence GST would be


able to issue debt in the future below today's 8 percent rate, then it might pay to wait.


However, interest rate movements are very difficult, if not impossible, to forecast, and hence


most financial managers would probably take the "bird-in-the-hand" and refund now with


such a large NPV. Note, though, that if the NPV had been quite small, say $1,000,


management would have undoubtedly waited, hoping that interest rates would fall further,


and the cost of waiting ($1,000) would not have been high enough to worry about.


19-5 a. Investment outlay required to refund the issue:


Call premium on old issue: $5,400,000


New flotation cost: 5,000,000


Answers and Solutions: 19 - 395 Tax savings on old flotation: (1,666,667)


Additional interest on old issue: 450,000


Interest earned on investment: (225,000)


Total investment outlay: $8,958,333


Annual Flotation Cost Tax Effects:


Annual tax savings on new flotation: $ 80,000


Tax benefits lost on old flotation: (66,667)


Amortization tax effects $ 13,333


Annual Interest Savings Due to Refunding:


Annual interest on old bond: $5,400,000


Annual interest on new bond: (4,500,000)


Net interest savings $ 900,000


Annual cash flows: $ 913,333


NPV of refunding decision: $2,717,128


Using a financial calculator, enter the cash flows into the cash flow register, I = 6, NPV = ?


NPV = $2,717,128.


b. The company should consider what interest rates might be next year. If there is a high


probability that rates will drop below the current rate, it may be more advantageous to refund


later versus now. If there is a high probability that rates will increase, the firm should act


now to refund the old issue. Also, the company should consider how much ill will is created


with investors if the issue is called. If Tarpon is highly dependent on a small group of


investors, it would want to avoid future difficulty in obtaining financing. However, bond


issues are callable after a certain time and investors expect them to be called if rates drop


considerably.




Answers and Solutions: 19 - 396 SOLUTION TO SPREADSHEET PROBLEM


19-6 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the


file Solution for FM11 Ch 19 P6 Build a Model.xls) and on the instructor's side of the web site,


http://brigham.swcollege.com.




Answers and Solutions: 19 - 397 MINI CASE



Randy's, a family-owned restaurant chain operating in Alabama, has grown to the point where expansion throughout the entire southeast is feasible. The proposed expansion would require the firm to raise about $15 million in new capital. Because Randy's currently has a debt ratio of 50 percent, and also because the family members already have all their personal wealth invested in the company, the family would like to sell common stock to the public to raise the $15 million. However, the family does want to retain voting control. You have been asked to brief the family members on the issues involved by answering the following questions:


a. What agencies regulate securities markets?


Answer: The main agency that regulates the securities market is the Securities And Exchange Commission.


Some of the responsibilities of the SEC include: regulation of all national stock


exchanges--companies whose securities are listed on an exchange must file annual reports with


the SEC; prohibiting manipulation by pools or wash sales; controls over trading by corporate


insiders; and control over the proxy statement and how it is used to solicit votes.


The Federal Reserve Board controls flow of credit into security transactions through


margin requirements. States also have some control over the issuance of new


securities within their boundaries. The securities industry itself realizes the


importance of stable markets, therefore, the various exchanges work closely with the


sec to police transactions and to maintain the integrity and credibility of the system.




Mini Case: 19 - 398 b. How are start-up firms usually financed?


Answer: The first financing comes from the founders. The first external financing comes from angels,


who are wealthy individuals. The next external financing comes from a venture capital fund.


The fund raises capital from institutional investors, usually around $70 to $80 million. The


managers of the fund are called venture capitalists. The fund invests in ten to twelve companies,


and the venture capitalist sits on their boards.


c. Differentiate between a private placement and a public offering.


Answer: In a private placement stock is sold directly to one or a small group of investors rather than being


distributed to the public at large. A private placement has the advantage of lower flotation costs;


however, since the stock would be bought by a small number of outsiders, it would not be actively


traded, and a liquid market would not exist. Further, since it would not have gone through the


SEC registration process, the holders would be unable to sell it except to a restricted set of


"sophisticated" investors. Further, it might be difficult to find investors willing to invest large


sums in the company and yet be minority stockholders. Thus, many of the advantages listed


above would not be obtained. For these reasons, a public placement makes more sense in


Randy's situation.


d. Why would a company consider going public? What are some advantages and


disadvantages?


Answer: A firm is said to be "going public" when it sells stock to the public for the first time. A


company's first stock offering to the public is called an "initial public offering (IPO)." Thus,


Randy's will go public if it goes through with its planned IPO. There are several advantages and


disadvantages to going public:




Mini Case: 19 - 399 Advantages to going public:


Going public will allow the family members to diversify their assets and reduce the


riskiness of their personal portfolios.


It will increase the liquidity of the firm's stock, allowing the family stockholders to


sell some stock if they need to raise cash.


It will make it easier for the firm to raise funds. The firm would have a difficult


time trying to sell stock privately to an investor who was not a family member.


Outside investors would be more willing to purchase the stock of a publicly held


corporation which must file financial reports with the sec.


Going public will establish a value for the firm.


Disadvantages to going public:


The firm will have to file financial reports with the SEC and perhaps with state


officials. There is a cost involved in preparing these reports.


The firm will have to disclose operating data to the public. Many small firms do


not like having to do this, because such information is available to competitors.


Also, some of the firm's officers, directors, and major stockholders will have to


disclose their stock holdings, making it easy for others to estimate their net worth.


Managers of publicly-owned corporations have a more difficult time engaging in


deals which benefit them personally, such as paying themselves high salaries,


hiring family members, and enjoying not-strictly-necessary, but tax-deductible,


fringe benefits.


If the company is very small, its stock may not be traded actively and the market


price may not reflect the stock's true value.


The advantages of public ownership would be recognized by key employees, who would most


likely be granted stock options, which would certainly be more valuable if the stock


were publicly traded.




Mini Case: 19 - 400 e. What are the steps of an initial public offering?


Answer: Select an investment banker, file the S-1 registration document with the SEC, choose a price range


for the preliminary, or "red herring," prospectus, go on a roadshow, set final price on final


prospectus.


f. What criteria are important in choosing an investment banker?


Answer: (1) reputation and experience in the industry. (2) existing mix of institutional and retail (i.e.,


individual) clients. (3) support in the post-IPO secondary market, especially the reputation of


the analyst who will cover the stock.



g. Would companies going public use a negotiated deal or a competitive bid?


Answer: The firm would almost certainly use a negotiated deal. The competitive bid process for setting


investment bankers' fees is feasible only for large, well-established firms on large issues, and even


here the use of bids is rare for equity issues. This is because the process of making a bid is


costly (mainly for the research necessary to establish the price, but also because of the need for


sec registration), and investment bankers simply would not incur these costs unless they were


assured of getting the deal or the issue was so large that a huge fee awaited the winner.


h. Would the sale be on an underwritten or best efforts basis?


Answer: Most stock offerings are done on an underwritten basis, but the price is not set until the


investment banker has checked investors for interest in the stock, and has received oral assurances


of commitments at a price that will virtually guarantee the success of the offering barring a major


stock market collapse. So, there is little effective difference between a best efforts and an


underwritten deal.




Mini Case: 19 - 401 i. Without actually doing any calculations, describe how the preliminary offering range for the


price of an IPO would be determined?


Answer: Since the firm is going public for the first time, there is no established price for its stock. The


firm and its investment banker would project future earnings and free cash flows. The banker


would then compare the firm with other restaurant firms of similar size. The banker would try to


determine a price range for the firm's stock by applying the price/earnings ratios, price/dividends


ratios, and price/book value ratios of similar firms to the firm's earnings, dividends, and book


value data. The banker would also determine the price at which the firm's stock would have to


sell to earn the same rate of return as other firms in its industry. On the basis of all these factors,


the investment bankers would determine a ballpark price. They would then specify a range (i.e.,


$10 to $12) in the preliminary prospectus.



j. What is a roadshow? What is bookbuilding?


Answer: The senior management team, the investment banker, and the lawyer make presentations to


potential institutional investors. They usually visit ten to twenty cities, and make three to five


presentations in each city. Management can't say anything that is not in the registration


statement, because the SEC imposes a "quiet period" from the time it makes the registration


effective until 25 days after the stock begins trading. The purpose is to prevent select investors


from getting information that is not available to other investors.


During the roadshow, the investment bankers asks the investors to indicate how many shares


they plan on buying. The banker records this in his book. The banker hopes for


oversubscription. Based on demand, the banker sets the final offer price on the evening before


the stock is issued.




Mini Case: 19 - 402 k. Describe the typical first-day returns of an IPO and the long-term returns to IPO investors.


Answer: First-day returns average 14.1%, with many stocks having much higher returns. The investment


banker has an incentive to set a low price, both to make its brokerage customers happy and to


make it easy to sell the issue, whereas the firm would like to set as high a price as possible.


Returns over the two-year period following the IPO are generally lower than for comparable firms,


indicating that the offering price is too low, but that the first-day run-up is too high.


l. What are the direct and indirect costs of an IPO?


Answer: The underwriter usually charges a 7% fee, based on the offer price. In addition, there are direct


costs to lawyers, accountants, printers, etc. That can easily total $400,000.


Indirect costs include the money left on the table, which is equal to the difference between the


offer price and end-of-first-day price, multiplied by the number of shares. Also, much of


management's time and attention is consumed by the IPO in the months preceding the IPO.


m. What are equity carve-outs?


Answer: Equity carve-outs are a special type of IPO in which a public company creates a new public


company from one of its subsidiaries by issuing public stock in the subsidiary. The parent


usually retains a controlling interest.


n. In what other ways are investment banks involved in issuing securities?


Answer: Investment bankers help companies with shelf registration (SEC rule 451) in which securities are


registered but not all of the issue is sold at once. Instead, the company sells a percentage of the


issue each time it needs to raise capital.


Investment bankers also help place private and public debt issues. They also help in seasoned


equity offers, in which a public firms issues additional shares of stock.



o. What is meant by going private? What are some advantages and disadvantages?


Answer: Going private is the reverse of going public. Typically, the managers of a firm team up with a


small group of outside investors, who furnish most of the equity capital, and purchase all of the


Answers and Solutions: 20 - 403 publicly held shares of the company. The new equity holders usually use a large amount of debt


financing, up to 90 percent, to complete the purchase. Such a transaction is called a "leveraged


buyout (LBO)."


Going private gives the managers greater incentives and more flexibility in running the


company. It also removes the burden of sec filings, stockholder relations, annual reports, analyst


meetings, and so on. The major disadvantage of going private is that it limits significantly the


availability of new capital. Since the stock is not publicly traded, a new stock issue would not be


practical, and, since such firms are normally leveraged to the hilt, it is tough to find additional


debt financing. For this reason, it is common for firms that have recently gone private to sell off


some assets to quickly reduce the debt burden to more conventional levels to give added financial


flexibility.


After several years of operating the business as a private firm, the owners typically go


public again. At this time, the firm is presumably operating at its peak, and it will


command top dollar compared to when it went private. In this way, the equity


investors of the private firm are able to recover their investment and, hopefully, make


a tidy profit. So far LBOs have, on average, been extremely profitable--since the


1970s, when LBO firms such as Kohlberg Kravis Roberts (KKR) began operating,


their annual rates of return are reported to have averaged over 50 percent annually.


However, Wall Street is becoming increasingly concerned about the use of debt, and


in the beginning of the nineties the number of new LBOs has fallen dramatically and


some old ones have had major financial difficulties.



p. How do companies manage the maturity structure of their debt?


Answer: In discussing this question, we emphasize that, if markets are truly efficient and conditions are


stable, the type of debt instrument will be immaterial, as the cost of each will be commensurate


with its risk. However, if markets are not totally efficient (perhaps because management has


information which investors do not have), if the company's tax position changes, if some new


security innovation is developed, or the like, then some types of securities might truly be less


expensive, on a risk-adjusted basis, than others.



Answers and Solutions: 20 - 404 Factors that influence the decision to issue long-term bonds rather than short-term debt:


Maturity matching (assets to be financed)


Information asymmetries. If managers know that the firm has strong prospects,


they will issue short-term debt and refinance later when the market recognizes


their prospects.


q. Under what conditions would a firm exercise a bond's call provision?


Answer: Refunding decisions involve two separate questions: (1) is it profitable to call an outstanding


issue in the current period and replace it with a new issue; and (2) if refunding is currently


profitable, would the value of the firm be increased even more if the refunding were postponed to


a later date? If these two conditions are true, a company would exercise their bond's call


provision.


r. Explain how firms manage the risk structure of their debt with: (1) project financing,


and (2) securitization.


Answer: 1. Project financings are arrangements used to finance mainly large capital projects such as


energy explorations, oil tankers, refineries, utility power plants, and so on. Usually, one or


more firms (sponsors) will provide the equity capital required by the project, while the rest of


the project's capital is supplied by lenders and lessors. The most important aspect of project


financing is that the lenders and lessors do not have recourse against the sponsors; they must


be repaid from the project's cash flows and the equity cushion provided by the sponsors.


2. Securitization is the process whereby financial instruments that were previously thinly traded


are converted to a form that creates greater liquidity. Securitization also applies to the


situation where specific assets are pledged as collateral for securities, and hence asset-backed


securities are created. One example of the former is junk bonds; an example of the latter is


mortgage-backed securities.




Chapter 20


Lease Financing


ANSWERS TO END-OF-CHAPTER QUESTIONS


Answers and Solutions: 20 - 405 20-1 a. The lessee is the party leasing the property. The party receiving the payments from the lease


(that is, the owner of the property) is the lessor.


b. An operating lease, sometimes called a service lease, provides for both financing and


maintenance. Generally, the operating lease contract is written for a period


considerably shorter than the expected life of the leased equipment, and contains


a cancellation clause. A financial lease does not provide for maintenance


service, is not cancelable, and is fully amortized; that is, the lease covers the


entire expected life of the equipment. In a sale and leaseback arrangement, the


firm owning the property sells it to another firm, often a financial institution,


while simultaneously entering into an agreement to lease the property back from


the firm. A sale and leaseback can be thought of as a type of financial lease.


A combination lease combines some aspects of both operating and financial


leases. For example, a financial lease that contains a cancellation


clause--normally associated with operating leases--is a combination lease. A


synthetic lease is an arrangement between a company and a special purpose


entity that it creates to borrow money and purchase equipment. Although the


"lease" amounts to actually borrowing money guaranteed by the lessee, it


doesn't appear on the company's books as an obligation. A special purpose


entity (SPE) is a company set up to facilitate the creation of a synthetic lease. It


borrows money that is guaranteed by the lessee, purchases equipment, and


leases it to the lessee. Its purpose is keep the lessee from having to capitalize


the lease and carry its payments on its books as a liability.


c. Off-balance sheet financing refers to the fact that for many years neither leased assets nor the


liabilities under lease contracts appeared on the lessees' balance sheets. To correct this problem,


the Financial Accounting Standards Board issued FASB Statement 13. Capitalizing means


incorporating the lease provisions into the balance sheet by reporting the leased asset under fixed


assets and reporting the present value of future lease payments as debt.


d. FASB Statement 13 is the Financial Accounting Standards Board statement (November 1976) that


spells out in detail the conditions under which a lease must be capitalized, and the specific


procedures to follow.


e. A guideline lease is a lease that meets all of the IRS requirements for a genuine lease. A


guideline lease is often called a tax-oriented lease. If a lease meets the IRS guidelines, the IRS


allows the lessor to deduct the asset's depreciation and allows the lessee to deduct the lease


payments.


f. The residual value is the market value of the leased property at the expiration of the lease. The


estimate of the residual value is one of the key elements in lease analysis.


g. The lessee's analysis involves determining whether leasing an asset is less costly than


buying the asset. The lessee will compare the present value cost of leasing the


asset with the present value cost of purchasing the asset (assuming the funds to


purchase the asset are obtained through a loan). If the present value cost of the


lease is less than the present value cost of purchasing, the asset should be leased.


The lessee can also analyze the lease using the IRR approach. The IRR of the


incremental cash flows of leasing versus purchasing represents the after-tax cost


Answers and Solutions: 20 - 406 rate implied in the lease contract. If this rate is lower than the after-tax cost of


debt, there is an advantage to leasing. Finally, the lessee might evaluate the


lease using the equivalent loan method, which involves comparing the net


savings at Time 0 if the asset is leased with the present value of the incremental


costs of leasing over the term of the lease. If the Time 0 savings is greater than


the present value of the incremental costs, there is an advantage to leasing.


The lessor's analysis involves determining the rate of return on the proposed lease. If the


rate of return (or IRR) of the lease cash flows exceeds the lessor's opportunity cost of capital, the


lease is a good investment. This is equivalent to analyzing whether the NPV of the lease is


positive.


h. The net advantage to leasing (NAL) gives the dollar value of the lease to the lessee. It is, in a


sense, the NPV of leasing versus owning.


i. The alternative minimum tax (AMT), which is figured at about 20 percent of the profits reported


to stockholders, is a provision of the tax code that requires profitable firms to pay at least some


taxes if such taxes are greater than the amount due under standard tax accounting. The AMT has


provided a stimulus to leasing for those firms paying the AMT because leasing lowers profits


reported to stockholders.



20-2 An operating lease is usually cancelable and includes maintenance. Operating leases are, frequently,


for a period significantly shorter than the economic life of the asset, so the lessor often does not


recover his full investment during the period of the basic lease. A financial lease, on the other hand,


is fully amortized and generally does not include maintenance provisions. An operating lease would


probably be used for a fleet of trucks, while a financial lease would be used for a manufacturing plant.



20-3 You would expect to find that lessees, in general, are in relatively low income-tax brackets, while


lessors tend to be in high tax brackets. The reason for this is that owning tends to provide tax


shelters in the early years of a project's life. These tax shelters are more valuable to taxpayers in


high brackets. However, current tax laws (1998) have reduced the depreciation benefits of owning,


so tax rate differentials are less important now than in the past.



20-4 The banks, when they initially went into leasing, were paying relatively high tax rates. However,


since municipal bonds are tax-exempt, their heavy investments in municipals lowered the banks'


effective tax rates. Similarly, when the REIT loans began to sour, this further reduced the bank's


income, and consequently cut the effective tax rate even further. Since the lease investments were


predicated on obtaining tax shelters, and since the value of these tax shelters is dependent on the


banks' tax rates, when the effective tax rates were lowered, this reduced the value of the tax shelters


and consequently reduced the profitability of the lease investments.


20-5 a. Pros:



Answers and Solutions: 20 - 407 The use of the leased premises or equipment is actually an exclusive right, and the


payment for the premises is a liability that often must be met. Therefore, leases


should be treated as both assets and liabilities.


A fixed policy of capitalizing leases among all companies would add to the


comparability of different firms. For example, Safeway Stores' leases should be


capitalized to make the company comparable to A&P, which owns its stores


through a subsidiary.


The capitalization highlights the contractual nature of the leased property.


Capitalizing of leases could help management make useful comparisons of


operating results; that is, return on investment data.


b. Cons:


Because the firm does not actually own the leased property, the legal aspect can


be cited as an argument against capitalization.


Capitalizing leases worsens some key credit ratios; that is, the debt-to-equity ratio


and the debt-to-total capital ratio. This may hamper the future acquisition of


funds.


There is a question of choosing the proper discount rate at which to capitalize the


leases.


Some argue that other items should be listed on the balance sheet before leases;


for example, service contracts, property taxes, and so on.


Capitalizing leases violates the principle that liabilities should be recorded only


when assets are purchased. 20-6 Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset were


depreciated over a 20-year life, depreciation charges would be 1/20 per year (more if MACRS were


used). However, if the asset were leased for, say, 3 years, tax deductions would be 1/3 each year for


3 years. Thus, the tax deductions would be greatly accelerated. The same total taxes would be


paid over the 20 years, but because of the high deductions in the early years, taxes would be deferred


more under the lease, and the PV of the future taxes would be reduced under the lease.


20-7 In fact, Congress did this in 1981. Depreciable lives were shorter than before; corporate tax rates


were essentially unchanged (they were lowered very slightly on income below $50,000); and the


investment tax credit had been improved a bit by the easing of recapture if the asset was held for a


short period. As a result, companies that were either investing at a very high rate or else were only


marginally profitable were generating more depreciation and/or investment tax credits than they could


use. These companies were able to "sell" their tax shelters through a leasing arrangement, being


"paid" in the form of lower lease charges. A high-bracket lessor could earn a given after-tax return


with lower rental charges, after the 1981 tax law changes, than previously because the lessor would


get (1) the larger tax credits and (2) faster depreciation write-offs.


20-8 A cancellation clause would reduce the risk to the lessee since the firm would be allowed to terminate


the lease at any point. Since the lease is less risky than a standard financial lease, and less risky than


Answers and Solutions: 20 - 408 straight debt, which cannot usually be prepaid without a prepayment charge, the discount rate on the cost of leasing might be adjusted to reflect lower risk. (Note that this requires increasing the discount rate since cash outflows are being discounted.) The effect on the lessor is just the opposite--risk is increased. (Note that this would also require an increase in the lessor's discount rate.)




Answers and Solutions: 20 - 409 SOLUTIONS TO END-OF-CHAPTER PROBLEMS


20-1 a. (1) Reynolds' current debt ratio is $400/$800 = 50%.


(2) If the company purchased the equipment its balance sheet would look like:


Current assets $300 Debt (including lease) $600


Fixed assets 500


Leased equipment 200 Equity $400


Total assets $1,000 Total claims $1,000


Therefore, the company's debt ratio = $600/$1,000 = 60%.


(3) If the company leases the asset and does not capitalize the lease, its debt ratio = $400/$800 =


50%.


b. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the


loan) is no different whether the equipment is leased or purchased.


20-2 Cost of owning:


0 1 2


| | |


Cost (200)


Depreciation shield 40 40


(200) 40 40


PV at 6% = -$127.


Cost of leasing:


0 1 2


| | |


After-tax lease payment (66) (66)


PV at 6% = -$128.


Reynolds should buy the equipment, because the cost of owning is less than the cost of leasing.




Answers and Solutions: 20 - 410 20-3 Year_________________


0 1 2 3 4____


I. Cost of Owning:


Net purchase price ($1,500,000)


Depr. tax savingsa $198,000 $270,000 $ 90,000 $ 42,000


Net cash flow ($1,500,000) $198,000 $270,000 $ 90,000 $ 42,000


PV cost of owning at 9% ($ 991,845)


II. Cost of Leasing:


Lease payment (AT) (240,000) (240,000) (240,000) (240,000)


Purch. option priceb (250,000)


Net cash flow $ 0 ($240,000) ($240,000) ($240,000) ($490,000)


PV cost of leasing at 9% ($ 954,639)


III. Cost Comparison


Net advantage to leasing (NAL)= PV cost of owning - PV cost of leasing


= $991,845 - $954,639


= $37,206.


a


Cost of new machinery: $1,500,000.


MACRS Deprec. Tax Savings


Year Allowance Factor Depreciation T (Depreciation)


1 0.33 $495,000 $198,000


2 0.45 675,000 270,000


3 0.15 225,000 90,000


4 0.07 105,000 42,000


b


Cost of purchasing the machinery after the lease expires.


Note that the maintenance expense is excluded from the analysis since Big Sky Mining will have to


bear the cost whether it buys or leases the machinery. Since the cost of leasing the machinery is


less than the cost of owning it, Big Sky Mining should lease the equipment.




Answers and Solutions: 20 - 411 20-4 a. Balance sheets before lease is capitalized:


Energen


Balance Sheet


(Thousands of Dollars)


Debt $100


Equity 100


Total assets $200 Total claims $200


Debt/assets ratio = $100/$200 = 50%.


Hastings Corporation


Balance Sheet


(Thousands of Dollars)


Debt $ 50


Equity 100


Total assets $150 Total claims $150


Debt/assets ratio = $50/$150 = 33%.


b. Balance sheet after lease is capitalized:


Hastings Corporation


Balance Sheet


(Thousands of Dollars)


Assets $150 Debt $ 50


Value of leased asset 50 PV of lease payments 50


Equity 100


Total assets $200 Total claims $200


Debt/assets ratio = $100/$200 = 50%.


c. Yes. Net income, as reported, would probably be less under leasing because the


lease payment would be larger than the interest expense, both of which are


income statement expenses. Additionally, total assets are significantly less


under leasing without capitalization.


The net result is difficult to predict, but we can state positively that both ROA


Answers and Solutions: 20 - 412 and ROE are affected by the choice of financing.



20-5 a. Borrow and buy analysis:


Year 0 Year 1 Year 2 Year 3


Loan payments (430,731) (430,731) (430,731)


Interest tax savings 47,600 33,761