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Contents
- Chapter 1 The Corporation
- Chapter 2 Introduction to Financial Statement Analysis
- Chapter 3 Arbitrage and Financial Decision Making
- Chapter 4 The Time Value of Money
- Chapter 5 Interest Rates
- Chapter 6 Investment Decision Rules
- Chapter 7 Fundamentals of Capital Budgeting
- Chapter 8 Valuing Bonds
- Chapter 9 Valuing Stocks
- Chapter 10 Capital Markets and the Pricing of Risk
- Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model
- Chapter 12 Estimating the Cost of Capital
- Chapter 13 Investor Behavior and Capital Market Efficiency
- Chapter 14 Capital Structure in a Perfect Market
- Chapter 15 Debt and Taxes
- Chapter 16 Financial Distress, Managerial Incentives, and Information
- Chapter 17 Payout Policy
- Chapter 18 Capital Budgeting and Valuation with Leverage
- Chapter 19 Valuation and Financial Modeling: A Case Study
- Chapter 20 Financial Options
- Chapter 21 Option Valuation
- Chapter 22 Real Options
- Chapter 23 Raising Equity Capital
- Chapter 24 Debt Financing
- Chapter 25 Leasing
- Chapter 26 Working Capital Management
- Chapter 27 Short-Term Financial Planning
- Chapter 28 Mergers and Acquisitions
- Chapter 29 Corporate Governance
- Chapter 30 Risk Management
- Chapter 31 International Corporate Finance
1-8. You have decided to form a new start-up company developing applications for the iPhone. Give examples of the three distinct types of financial decisions you will need to make. As the manager of an iPhone applications developer, you will make three types of financial decisions. i. You will make investment decisions such as determining which type of iPhone application projects will offer your company a positive NPV and therefore your company should develop. ii. You will make the decision on how to fund your iPhone application investments and what mix of debt and equity your company will have. iii. You will be responsible for the cash management of your company, ensuring that your company has the necessary funds to make investments, pay interest on loans, and pay your employees.
1-9. Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than their own. What strategies are available to shareholders to help ensure that managers are motivated to act this way? Shareholders can do the following. i. Ensure that employees are paid with company stock and/or stock options. ii. Ensure that underperforming managers are fired. iii. Write contracts that ensure that the interests of the managers and shareholders are closely aligned. iv. Mount hostile takeovers.
1-10. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent while the company that owns the apartment can be viewed as the principal. What principal- agent conflicts do you anticipate? Suppose, instead, that you work for the apartment company. What features would you put into the lease agreement that would give the renter incentives to take good care of the apartment? The agent (renter) will not take the same care of the apartment as the principal (owner), because the renter does not share in the costs of fixing damage to the apartment. To mitigate this problem, having the renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces the renter to share in the costs of fixing any problems that are caused by the renter.
1-11. You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations? There is an ethical dilemma when the CEO of a firm has opposite incentives to those of the shareholders. In this case, you (as the CEO) have an incentive to potentially overpay for another company (which would be damaging to your shareholders) because your pay and prestige will improve.
1-12. Are hostile takeovers necessarily bad for firms or their investors? Explain. No. They are a way to discipline managers who are not working in the interests of shareholders.
1-13. What is the difference between a public and private corporation? The shares of a public corporation are traded on an exchange (or "over the counter" in an electronic trading system) while the shares of a private corporation are not traded on a public exchange.
1-14. Explain why the bid-ask spread is a transaction cost. Investors always buy at the ask and sell at the bid. Since ask prices always exceed bid prices, investors “lose” this difference. It is one of the costs of transacting. Since the market makers take the other side of the trade, they make this difference.
1-15. The following quote on Yahoo! Stock appeared on February 11, 2009, on Yahoo! Finance:
If you wanted to buy Yahoo!, what price would you pay? How much would you receive if you wanted to sell Yahoo!? You would buy at $12.54 and sell for $12.53.
2-4. Consider the following potential events that might have occurred to Global Conglomerate on December 30, 2009. For each one, indicate which line items in Global’s balance sheet would be affected and by how much. Also indicate the change to Global’s book value of equity. a. Global used $20 million of its available cash to repay $20 million of its long-term debt. b. A warehouse fire destroyed $5 million worth of uninsured inventory. c. Global used $5 million in cash and $5 million in new long-term debt to purchase a $ million building. d. A large customer owing $3 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment. e. Global’s engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%. f. A key competitor announces a radical new pricing policy that will drastically undercut Global’s prices. a. Long-term liabilities would decrease by $20 million, and cash would decrease by the same amount. The book value of equity would be unchanged. b. Inventory would decrease by $5 million, as would the book value of equity. c. Long-term assets would increase by $10 million, cash would decrease by $5 million, and long- term liabilities would increase by $5 million. There would be no change to the book value of equity. d. Accounts receivable would decrease by $3 million, as would the book value of equity. e. This event would not affect the balance sheet. f. This event would not affect the balance sheet.
2-5. What was the change in Global Conglomerate’s book value of equity from 2008 to 2009 according to Table 2.1? Does this imply that the market price of Global’s shares increased in 2009? Explain. Global Conglomerate’s book value of equity increased by $1 million from 2008 to 2009. An increase in book value does not necessarily indicate an increase in Global’s share price. The market value of a stock does not depend on the historical cost of the firm’s assets, but on investors’ expectation of the firm’s future performance. There are many events that may affect Global’s future profitability, and hence its share price, that do not show up on the balance sheet.
2-6. Use EDGAR to find Qualcomm’s 10K filing for 2009. From the balance sheet, answer the following questions: a. How much did Qualcomm have in cash and short-term investments? b. What were Qualcomm’s total accounts receivable? c. What were Qualcomm’s total assets? d. What were Qualcomm’s total liabilities? How much of this was long-term debt? e. What was the book value of Qualcomm’s equity? a. $2,717 million (cash) and $8,352 million (short-term investments/marketable securities) for a total of $11,069 million b. $700 million c. $27,445 million d. 7,129 million, nothing
e. $20,316 million
2-7. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the following questions from their balance sheet: a. How much cash did Peet’s have at the end of 2008? b. What were Peet’s total assets? c. What were Peet’s total liabilities? How much debt did Peet’s have? d. What was the book value of Peet’s equity? a. At the end of 2008, Peet’s had cash and cash equivalents of $4.719 million. b. Peet’s total assets were $176.352 million. c. Peet’s total liabilities were $32.445 million, and it had no debt. d. The book value of Peet’s equity was $143.907 million.
2-8. In March 2005, General Electric (GE) had a book value of equity of $113 billion, 10.6 billion shares outstanding, and a market price of $36 per share. GE also had cash of $13 billion, and total debt of $370 billion. Four years later, in early 2009, GE had a book value of equity of $ billion, 10.5 billion shares outstanding with a market price of $10.80 per share, cash of $ billion, and total debt of $524 billion. Over this period, what was the change in GE’s a. market capitalization? b. market-to-book ratio? c. book debt-equity ratio? d. market debt-equity ratio? e. enterprise value? a. 2005 Market Capitalization: 10.6 billion shares x $36.00/share = $381.6 billion. 2009 Market Capitalization: 10.5 billion shares x $10.80/share = $113.4. The change over the period is $113.4 - $381.6 = -$268.2 billion.
b. 2005 Market-to-Book
= =. 2009 Market-to-Book
= =. The change over the
period is: 1.08 – 3.38 = -2.3.
c. 2005 Book Debt-to-Equity
= =. 2009 Book Debt-to-Equity
= =. The change
over the period is: 4.99 – 3.27 = 1.72.
d. 2005 Market Debt-to-Equity
= =. 2009 Market Debt-to-Equity
= =. The
change over the period is: 4.62 – 0.97 = 3.65. e. 2005 Enterprise Value = $381.6 - 13 + 370 = $738.6 billion. 2009 Enterprise Value = $113.4 - 48
- 524 = $589.4 billion. The change over the period is: $589.4 – 738.6 = - $149.2 billion.
2-9. In July 2007, Apple had cash of $7.12 billion, current assets of $18.75 billion, current liabilities of $6.99 billion, and inventories of $0.25 billion. a. What was Apple’s current ratio? b. What was Apple’s quick ratio?
c. The diluted earnings per share in 2008 was $0.80. The number of shares used in this calculation of diluted EPS was 13.997 million.
2-12. Suppose that in 2010, Global launches an aggressive marketing campaign that boosts sales by 15%. However, their operating margin falls from 5.57% to 4.50%. Suppose that they have no other income, interest expenses are unchanged, and taxes are the same percentage of pretax income as in 2009. a. What is Global’s EBIT in 2010? b. What is Global’s income in 2010? c. If Global’s P/E ratio and number of shares outstanding remains unchanged, what is Global’s share price in 2010? a. Revenues in 2009 = 1.15 × 186.7 = $214.705 million EBIT = 4.50% × 214.705 = $9.66 million (there is no other income) b. Net Income = EBIT – Interest Expenses – Taxes = (9.66 – 7.7) × (1 – 26%) = $1.45 million
c.
Share price = (P/E Ratio in 2005) × (EPS in 2006) = 25.2 × = $10.
2-13. Suppose a firm’s tax rate is 35%.
a. What effect would a $10 million operating expense have on this year’s earnings? What effect would it have on next year’s earnings? b. What effect would a $10 million capital expense have on this year’s earnings if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year’s earnings? a. A $10 million operating expense would be immediately expensed, increasing operating expenses by $10 million. This would lead to a reduction in taxes of 35% × $10 million = $3.5 million. Thus, earnings would decline by 10 – 3.5 = $6.5 million. There would be no effect on next year’s earnings. b. Capital expenses do not affect earnings directly. However, the depreciation of $2 million would appear each year as an operating expense. With a reduction in taxes of 2 × 35% = $0.7 million, earnings would be lower by 2 – 0.7 = $1.3 million for each of the next 5 years.
2-14. You are analyzing the leverage of two firms and you note the following (all values in millions of dollars):
a. What is the market debt-to-equity ratio of each firm? b. What is the book debt-to-equity ratio of each firm? c. What is the interest coverage ratio of each firm? d. Which firm may have more difficulty meeting its debt obligations? Explain.
a. Firm A:
Market debt-equity ratio 1. 400
Firm B:
Market debt-equity ratio 2. 40
b. Firm A:
Book debt-equity ratio 1. 300
Firm B:
Book debt-equity ratio 2. 35
c. Firm A:
Interest coverage ratio 2. 50
Firm B:
Interest coverage ratio 1. 7
d. Firm B has a lower coverage ratio and will have slightly more difficulty meeting its debt obligations than Firm A.
2-15. Quisco Systems has 6.5 billion shares outstanding and a share price of $18. Quisco is considering developing a new networking product in house at a cost of $500 million. Alternatively, Quisco can acquire a firm that already has the technology for $900 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80. a. Suppose Quisco develops the product in house. What impact would the development cost have on Quisco’s EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco’s tax rate is 35%, and the number of shares outstanding is unchanged. b. Suppose Quisco does not develop the product in house but instead acquires the technology. What effect would the acquisition have on Quisco’s EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the firm was acquired at the start of the year and has no revenues or expenses of its own, so that the only effect on EPS is due to the change in the number of shares outstanding.) c. Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain. a. If Quisco develops the product in-house, its earnings would fall by $500 × (1 – 35%) = $ million. With no change to the number of shares outstanding, its EPS would decrease by $ $0. 6500
= to $0.75. (Assume the new product would not change this year’s revenues.)
b. If Quisco acquires the technology for $900 million worth of its stock, it will issue $900 / 18 = 50 million new shares. Since earnings without this transaction are $0.80 × 6.5 billion = $5.2 billion,
its EPS with the purchase is
c. Acquiring the technology would have a smaller impact on earnings. But this method is not cheaper. Developing it in-house is less costly and provides an immediate tax benefit. The earnings impact is not a good measure of the expense. In addition, note that because the acquisition permanently increases the number of shares outstanding, it will reduce Quisco’s earnings per share in future years as well.
2-16. In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8 billion. British
2-18. Repeat the analysis of parts (a) and (b) in Problem 17 for Starbucks Coffee (SBUX). Use the DuPont Identity to understand the difference between the two firms’ ROEs.
Net profit margin 3.04% 10,383.
Asset Turnover 1. 5, 672.
Asset Multiplier 2. 2, 490.
Starbucks’s ROE (DuPont) = 3.04% x 1.83% x 2.28% = 12.67% The two firms’ ROEs differ mainly because the firms have different asset multipliers, implying that the difference in the ROE might be due to leverage.
2-19. Consider a retailing firm with a net profit margin of 3.5%, a total asset turnover of 1.8, total assets of $44 million, and a book value of equity of $18 million. a. What is the firm’s current ROE? b. If the firm increased its net profit margin to 4%, what would be its ROE? c. If, in addition, the firm increased its revenues by 20% (while maintaining this higher profit margin and without changing its assets or liabilities), what would be its ROE? a. 3.5 x 1.8 x 44/18 = 15.4% b. 4 x 1.8 x 44/18 = 17.6% c. 4 x (1.8*1.2) x 44/18 = 21.1%
2-20. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the following questions from their cash flow statement: a. How much cash did Peet’s generate from operating activities in 2008? b. What was Peet’s depreciation expense in 2008? c. How much cash was invested in new property and equipment (net of any sales) in 2008? d. How much did Peet’s raise from the sale of shares of its stock (net of any purchases) in 2008? a. Net cash provided by operating activities was $25.444 million in 2008. b. Depreciation and amortization expenses were $15.113 million in 2008. c. Net cash used in new property and equipment was $25.863 million in 2008. d. Peet’s raised $3.138 million from sale of shares of its stock, while it spent $20.627 million on the purchase of common stock. Net of purchases Peet’s raised –$17.489 million from the sale of its shares of stock (net of any purchases).
2-21. Can a firm with positive net income run out of cash? Explain.
A firm can have positive net income but still run out of cash. For example, to expand its current production, a profitable company may spend more on investment activities than it generates from operating activities and financing activities. Net cash flow for that period would be negative, although its net income is positive. It could also run out of cash if it spends a lot on financing activities, perhaps by paying off other maturing long-term debt, repurchasing shares, or paying dividends.
2-22. See the cash flow statement here for H. J. Heinz (HNZ) (in $ thousands):
a. What were Heinz’s cumulative earnings over these four quarters? What were its cumulative cash flows from operating activities? b. What fraction of the cumulative cash flows from operating activities was used for investment over the four quarters? c. What fraction of the cumulative cash flows from operating activities was used for financing activities over the four quarters? a. Heinz’s cumulative earnings over these four quarters was $871 million. Its cumulative cash flows from operating activities was $1.19 billion b. Fraction of cash from operating activities used for investment over the 4 quarters: 29-Oct-08 30-Jul-08 30-Apr-08 30-Jan-08 4 quarters Operating Activities 227,502 –13,935 717,635 254,534 1,185, Investing Activities –196,952 –35,437 –251,331 –96,848 –580, CFI/CFO 86.57% –254.30% 35.02% 38.05% 48.96% c. Fraction of cash from operating activities used for financing over the 4 quarters: 29-Oct-08 30-Jul-08 30-Apr-08 30-Jan-08 4 quarters Operating Activities 227,502 –13,935 717,635 254,534 1,185, Financing Activities 462,718 –13,357 –526,189 –96,044 –1,050, CFF/CFO –203.39% –95.85% 79.32% 37.73% 14.58%
2-25. The balance sheet information for Clorox Co. (CLX) in 2004–2005 is shown here, with data in $ thousands:
a. What change in the book value of Clorox’s equity took place at the end of 2004? b. Is Clorox’s market-to-book ratio meaningful? Is its book debt-equity ratio meaningful? Explain. c. Find online Clorox’s other financial statements from that time. What was the cause of the change to Clorox’s book value of equity at the end of 2004? d. Does Clorox’s book value of equity in 2005 imply that the firm is unprofitable? Explain. a. The book value of Clorox’s equity decreased by $2.101 billion compared with that at the end of previous quarter, and was negative. b. Because the book value of equity is negative in this case, Clorox’s market-to-book ratio and its book debt-equity ratio are not meaningful. Its market debt-equity ratio may be used in comparison. c. Information from the statement of cash flows helped explain that the decrease of book value of equity resulted from an increase in debt that was used to repurchase $2.110 billion worth of the firm’s shares. d. Negative book value of equity does not necessarily mean the firm is unprofitable. Loss in gross profit is only one possible cause. If a firm borrows to repurchase shares or invest in intangible assets (such as R&D), it can have a negative book value of equity.
2-26. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the following questions from the notes to their financial statements: a. What was Peet’s inventory of green coffee at the end of 2008? b. What property does Peet’s lease? What are the minimum lease payments due in 2009? c. What was the fair value of all stock-based compensation Peet’s granted to employees in 2008? How many stock options did Peet’s have outstanding at the end of 2008?
d. What fraction of Peet’s 2008 sales came from specialty sales rather than its retail stores? What fraction came from coffee and tea products? a. Peet’s coffee carried $17.732 million of green coffee beans in their inventory at the end of 2008. b. Peet’s leases its Emeryville, California, administrative offices and its retail stores and certain equipment under operating leases that expire from 2009 through 2019. The minimum lease payments due in 2009 are $15.222 million. c. The fair value of all stock-based compensation Peet’s granted to its employees in 2008 is $2. million. Peet’s had 2,696,019 stock options outstanding at the end of 2008. d. 34.1% of Peet’s 2008 sales came from specialty sales rather than its retail stores. 53% of Peet’s 2008 sales came from coffee and tea products.
2-27. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008.
a. Which auditing firm certified these financial statements? b. Which officers of Peet’s certified the financial statements? a. Deloitte & Touche LLP certified Peet’s financial statements. b. The CEO, Patrick J. O’Dea, and the CFO, Thomas P. Cawley certified Peet’s financial statements.
2-28. WorldCom reclassified $3.85 billion of operating expenses as capital expenditures. Explain the effect this reclassification would have on WorldCom’s cash flows. ( Hint: Consider taxes.) WorldCom’s actions were illegal and clearly designed to deceive investors. But if a firm could legitimately choose how to classify an expense for tax purposes, which choice is truly better for the firm’s investors? By reclassifying $3.85 billion operating expenses as capital expenditures, WorldCom increased its net income but lowered its cash flow for that period. If a firm could legitimately choose how to classify an expense, expensing as much as possible in a profitable period rather than capitalizing them will save more on taxes, which results in higher cash flows, and thus is better for the firm’s investors.
b. Suppose that if you receive the stock bonus, you are required to hold it for at least one year. What can you say about the value of the stock bonus now? What will your decision depend on? a. Stock bonus = 100 × $63 = $6, Cash bonus = $5, Since you can sell (or buy) the stock for $6,300 in cash today, its value is $6,300 which is better than the cash bonus. b. Because you could buy the stock today for $6,300 if you wanted to, the value of the stock bonus cannot be more than $6,300. But if you are not allowed to sell the company’s stock for the next year, its value to you could be less than $6,300. Its value will depend on what you expect the stock to be worth in one year, as well as how you feel about the risk involved. You might decide that it is better to take the $5,000 in cash then wait for the uncertain value of the stock in one year.
3-5. You have decided to take your daughter skiing in Utah. The best price you have been able to find for a roundtrip air ticket is $359. You notice that you have 20,000 frequent flier miles that are about to expire, but you need 25,000 miles to get her a free ticket. The airline offers to sell you 5000 additional miles for $0.03 per mile. a. Suppose that if you don’t use the miles for your daughter’s ticket they will become worthless. What should you do? b. What additional information would your decision depend on if the miles were not expiring? Why? a. The price of the ticket if you purchase it is $t. Price if you purchase the miles $p x 5000. So you should purchase the miles. b. In part a, the existing miles are worthless if you don’t use them. Now, they are not worthless, so you must add in the cost of using them. Because there is no competitive market price for these miles (you can purchase at 3¢ but not sell for that price) the decision will depend on how much you value the existing miles (which will depend on your likelihood of using them in the future).
3-6. Suppose the risk-free interest rate is 4%.
a. Having $200 today is equivalent to having what amount in one year? b. Having $200 in one year is equivalent to having what amount today? c. Which would you prefer, $200 today or $200 in one year? Does your answer depend on when you need the money? Why or why not? a. Having $200 today is equivalent to having 200 × 1.04 = $208 in one year. b. Having $200 in one year is equivalent to having 200 / 1.04 = $192.31 today. c. Because money today is worth more than money in the future, $200 today is preferred to $200 in one year. This answer is correct even if you don’t need the money today, because by investing the $200 you receive today at the current interest rate, you will have more than $200 in one year.
3-7. You have an investment opportunity in Japan. It requires an investment of $1 million today and will produce a cash flow of ¥ 114 million in one year with no risk. Suppose the risk-free interest rate in the United States is 4%, the risk-free interest rate in Japan is 2%, and the current competitive exchange rate is ¥ 110 per $1. What is the NPV of this investment? Is it a good opportunity? Cost = $1 million today
Benefit ¥114 million in one year ¥1.02 in one year ¥114 million in one year ¥111.76 million today ¥ today 110¥ ¥111.76 million today $1.016 million today $ today
= ÷ =
= ÷ =
NPV = $1.016 million − $1 million =$16,
The NPV is positive, so it is a good investment opportunity.
3-8. Your firm has a risk-free investment opportunity where it can invest $160,000 today and receive $170,000 in one year. For what level of interest rates is this project attractive? 160,000 x (1+r) = 170,000 implies r = 170,000/160,000 – 1 = 6.25%
3-9. You run a construction firm. You have just won a contract to build a government office building. Building it will take one year and require an investment of $10 million today and $5 million in one year. The government will pay you $20 million upon the building’s completion. Suppose the cash flows and their times of payment are certain, and the risk-free interest rate is 10%. a. What is the NPV of this opportunity? b. How can your firm turn this NPV into cash today?
a. NPV = PVBenefits −PVCosts
Benefits
$1.10 in one year PV = $20 million in one year ÷ $ today = $18.18 million
PV This year's cost = $10 million today
Next year's cost
$1.10 in one year PV = $5 million in one year ÷ $ today = $4.55 million today
NPV = 18.18 − 10 − 4.55 =$3.63 million today
b. The firm can borrow $18.18 million today, and pay it back with 10% interest using the $20 million it will receive from the government (18.18 × 1.10 = 20). The firm can use $10 million of the 18. million to cover its costs today and save $4.55 million in the bank to earn 10% interest to cover its cost of 4.55 × 1.10 = $5 million next year. This leaves 18.18 – 10 – 4.55 = $3.63 million in cash for the firm today.
3-10. Your firm has identified three potential investment projects. The projects and their cash flows are shown here:
Suppose all cash flows are certain and the risk-free interest rate is 10%.
