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Name
Case 1 Fazio Pump Corporation.
CASE 2 National Food Corporation.
CASE 3 Capital Structure at Marriott.
CASE 4 Morley Industries, Inc.
CASE 5 Financial Ratios and Industries.
CASE 6 Caceres Semilla S A de C V.
CASE 7 Dougall and Gilligan Global Agency.
CASE 8 Rayovac Corporation.
Ch01_Goals and Functions Of Finance.
Ch02_ Regulatory Environment.
Ch03_Time Value of Money.
Ch04_Concepts in Valuation.
Ch05_Market Risk and Returns.
Ch06_Multivariable and Factor Valuation.
Ch07_Option Valuation.
Ch08_Principles of Capital Investment.
Ch09_Risk and Real Options in Capital Budgeting.
Ch10_Creating Value through Required Returns.
Ch11_Theories of Capital Structure.
Ch12_Making Capital Structure Decisions.
Ch13_Dividends and Share Repurchase Theory and Practice.
Ch14_Financial Ratio Analysis.
Ch15_Financial Planning.
Ch16_Liquidity,Cash and Marketable Securities.
Ch17_Management of accounts Receivable.
Ch18_Management of Inventories.
Ch19_Liability Management and Short Medium Term Financing.
Ch20_Foundations for Longer-Term Financing.
Ch21_Lease Financing.
Ch22_Issuing Securities.
Ch23_Fixed Income Financing.
Ch24_Hybrid Financing Through Equity.
Ch25_ Emerging Methods of Financing.
Ch26_Managing Financial Risk.
Ch27_ Mergers and the Market for Corporate Control.
Ch28_Corporate and Distress Restructuring.

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Ch29_International Financial Management.


Ch30_ Corporate Governance.

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CASE: FAZIO PUMP CORPORATION TEACHING NOTE


Purpose of Case
This case exposes the student to the important task of setting up cash flows for purposes of
analyzing a capital-budgeting project. It embeds inflation assumptions and MACRS depreciation. The case
allows the instructor to discuss payback, internal-rate-of-return, and new-present value methods for
evaluating the profitability of a project. Simulations from a spreadsheet afford insight into the risk of the
project. It also allows exploration of inflation premiums in required rates of return.
Questions
1.

How do you set up the cash flows in order to analyze them? (Assume the purchase of a new pump
is entirely incremental, with no consideration to the continuation of older pumps).

2.

What is the payback period? Implications?

3.

What is the net-present value of the project is the discount rate is 13 percent? Implications?

4.

What is its internal rate of return? Reconcile with the results using NPV.

5.

If no allowance were made for inflation, what would be the cash-flows? Would the project be
acceptable at a 13 percent required rate of return?

6.

What happens when you change assumptions as to project savings, inflation and discount rate?
Simulate.

Analysis of Case
With 4 percent; inflation assumed L in the savings after year I, the cash flows for the base case
are:
Year 0
Year 1
Year 2
Year 3
Year 4
260,000

Cost
Savings

60,000

62,400

64,896

67,492

Depreciation

52,000

83,200

49,920

29,952

14,976

37,540

5,691

14,265

B.T. Profit

8,000

(20,800)

Taxes (38%)

3,040

(7,904)

Savings less taxes

56,960

70,304

59,205

53,227

56,960

70,304

59,205

53,227

Salvage value A.T.


Net cash flow

260,000

Year 5

Year 6

Year .7

Year 8

Cost
Savings

70,192

72,999

75,919

78,956

Depreciation

29,952

14,976

B.T. Profit

40,240

58,023

75,919

78,956

Taxes (38%)

15,291

22,049

28,849

30,003

Savings less taxes


Salvage value A.T.
Net cash flow

54,900

50,950

47,070

54,900

50,950

(47,070)

48,953
18,600
67,553

In reviewing these cash flows, I go through the effect, of depreciation lowering the tax bite in the first
6years, but all savings being subject to taxes in the last 2 years. I also review the tax treatment of salvage
value. For year 2, the above assumes the tax loss can be used elsewhere in the company, or that there is a tax
loss carryback. Otherwise there is a carryforward situation, and the net cash flows are changed so as to push
them somewhat further out.
The payback period is 4.37 years. For the first four years, net cash flows total $239,696. $260,000

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less this amount equals $20,304. Interpolating for the year 5 net cash flow, we have $20,304/$ 54,900 =
.37.It is useful to review some of the problems with the payback period as a measure of profitability and
risk. Still it is widely used and affords some insight into the liquidity of a project.
The NPV of the project is $18,831, whereas the IRR is 15.14 percent . Both measures indicate the
project La -acceptable. I review some of the problems with the IRR vis a vis the NPV method (see Chapter
6) , but indicate the IRR is widely used in practice.
If no inflation is assumed, savings become $60,000 in each year. If the required return remains at
13 percent, the NPV is -$3,204 and the IRR is 12.61 percent, indicating the project should be rejected. This
1eads-into a discussion of inflation premiums embedded in required rates of return. If no inflation
adjustments are made to the cash flows, but an inflation premium is embraced in the 13 percent required
rate of return, there is a bias towards project rejection. One is comparing apples with oranges. The cash
flows are in real terms whereas the discount rate is in nominal terms. The easiest way to avoid the difficult,
and theoretically unsettled, task of determining a real discount rate is to use inflation- adjusted cash flows
and the assumed nominal discount rate of 13 percent.
With respect to changing assumptions, I often ask .the question that if you wanted to price the pump
so as to drive the NPV down to zero what would be the price? Some students will say $260,000 + the NPV
of $18,831 = $278,831. However, a higher price means more depreciation, which is a favorable effect. When
you rework the base case cash flows, you find that at a price of $285,944, the NPV becomes zero and the
IRR is 13.00 percent.
Other scenarios I use and their effect are the following.

Scenario
$50,000 initial savings
$55,000 initial savings
4 2 percent tax rate
2 percent inflation
$55,000 initial savings

NPV
($14,594)

IRR
11.28%

Rejection.

$2,118

13.24%

Acceptable, but less so.

14.50%

Lower profit -ability.

$7,416

13.87%

Lower results; question of discount rate.

($8,345)

12.01%

Rejection, but discount-rate question.

$12,944

Comments

& 2 percent inflation


These and other simulations lead into a discussion of how risk can be quantified, using what if types of
questions and attaching probabilities to such.
Decision in Case
Unless risk is felt to be great, most students feel that a $260,000 price tag should result in an
acceptable return to the customer. This assumes that 13 percent is a reasonable required return, which at the
time of the case it was. Even at 15 percent the project would be acceptable, but barely. It is possible to
preprogram a spreadsheet format in a laptop computer for the sales representatives. In this way they can
tailor their presentations to the customer based on the appropriate assumptions like tax rate, etc.

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CASE: NATIONAL FOOD CORPORATION TEACHING NOTE

Purpose of Case
The National Foods case provides a means for exposing students to the CAPM and its application to
required rates of return. Calculations are involved, and assumptions can be questioned by the instructor. The
central issue in the case is whether the company should use an overall required return or individual required
returns for each of its three divisions. Another important issue is whether the Restaurants Division should be
entitled to a higher proportion of cheaper debt funds than the other two divisions. The case also exposes the
student to the question of how you take account of mandated environmental projects in the returns you
require for other projects.
Questions
1.

Determine the weighted average cost- of capital for National Foods Corporation.

2.

On the basis of the information in the case, determine weighted average costs of capital for each of
the divisions before and after taking account of profit sustaining projects.

3.

How should profit sustaining projects be treated? Is a gross up approach appropriate? Should the
same gross up factor be applied to all divisions?

4.

Does the weighted average of the proxy company betas for the divisions approximate that for the
overall company? What weights should be used?

5.

Should multiple hurdle rates be used by the company? As Laura Atkinson, what would you
recommend?

Analysis of Case
The after-tax cost of debt funds is:
Rd = 8.00% (1 .40) =4.80%
If the risk-free rate is taken to be five years, consistent with the average duration of projects, and the required
return on the market portfolio is 11 percent, the cost of equity capital using the CAPM is:
Re = 5.4% + (11% 5.4%) 1.05 = 11.28%
As taken up in Chapters 3, 4, and 8, there is controversy as to the maturity of Treasury security to
use as the risk-free rate as well as controversy as to the employment of the CAPM in preference to other
models. It may be appropriate to take up these issues at this juncture in the case. Using the CAPM, however,
the weighted average cost of capital for the company is:
WACC = .40 (4.80%) + .60 (11.28%) = 8.69%
It is appropriate to use this rate for allocating capital if the company in. fact intends to finance at the margin
with 4 parts of debt for every 6 parts of equity and if the assumptions of the CAPM hold. Grossing up the
required return for profit sustaining projects, the required return for profit adding projects is:
Required Return = 8.69% (1.25) =10.86%
This required return is substantially less than the 13 percent now used, which suggests the company is
rejecting projects it should be accepting.
To determine required returns for three divisions, a proxy company approach is used based on the
Exhibit 4 information. It is useful to review whether the companies in the samples are representative of the
businesses of the divisions. Usually the arithmetic average is skewed by outliers, but in this case it makes
little difference whether the median or the arithmetic average is employed. The average long-term liabilities
-to capitalization ratios for the three industries, .42, .38, and .40, are very close to that which National Foods
intends to employ, .40. Therefore, it does not seem necessary to adjust the betas for leverage using the
Hamada beta adjustment formula in Chapter 8. Even if you wanted to adjust, there is not sufficient
information. The total debt/equity ratios, for the proxy companies are not given, or are their tax rates.
The required rates of return on equity capital for the three divisions using the averages in Exhibit 4 are:
Rag. = 5.4% + (11% 5.4%). 98 =10.89%
Rbk. = 5.4% + (11% 5.4%).82 = 9.99%
Rrs. = 5.4% + (11% 5.4%) 1.27 = 12.51%
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If the debt ratios of 30 percent for the first two divisions and 50 percent for the last are used, the required
returns for the divisions would be:
Agricultural = .30(4.80%) + .70 (10.89%) = 9.06%
Bakery

= .30 (4,80%) + .70 (9.99%) = 8.43%

Restaurants = .50 (4.80%) + .50 (12.51%) = 8.65%


In order to allow for profit sustaining projects, these figures need to be grossed up by 1.25. The required
returns for profit adding projects would be
Agricultural = 1.25 (9.06%) = 11.33%
Bakery

=1.25 (8.43%) = 10.54%

Restaurants =1.25 (8.65%) = 10.81%


The procedure is to adjust upward required returns for the fact that profit sustaining projects are presumed to
provide no returns. Therefore, other projects, profit adding ones as defined in the case, must carry the freight.
The procedure is an appropriate one, and occurs in many corporations. If the divisions are markedly different
in the proportions of profit sustaining projects, different gross-up factors should be employed. Otherwise,
there will be in equities. While the lower WACC figure is used to judge a divisions performance, the higher
grossed up figure is used as the hurdle rate for profit adding projects.
A check for internal consistency compares the sum of the beta parts with the whole, 1.05 for
National Foods. Using various weighting devices, we have
By Sales:
Agricultural
Bakery .
Restaurants

Weight

Beta

Product

.193
.405
.402

.98
.82
1.27

.189
.332
.501
1.02

.158
.340
.502

.98
.82
1.27

.155
.279
.638
1.07

.148
.362
.490

.98
.82
1.27

.145
.297
.623
1.07

By Operating Profits:
Agricultural
Bakery
Restaurant s
By Identifiable Assets:
Agricultural
Bakery
Restaurants

The ideal weight are market value weights, and we use the above as surrogates. As they are close to the
companys overall beta, confidence can be placed in the proxy company approach. If the sum of the parts
were significantly out of line with the whole, this would call into question the use of this approach. Either
faulty measurement or weighting would be involved, and one would want to investigate the cause.
The critical issue in this case is the wide difference in leverage between the Restaurants Division
and the other two. Without this, Restaurants would have the highest required return. If 40 percent debt
proportions are used throughout, we have as required returns for the three divisions
Required
Return

Grossed
up 1. 25

Agricultural = .40 (4.80%) + :60 (10.89%)

= 8.45%

10.56%

Bakery = .40 (4.80%) + .60 (9.99%)

= 7.91%

9.89%

Restaurants = .40 (4.80%) + .60 (12.51%)

= 9.43%

11.78%

Inasmuch as the proxy companies for the Restaurants Division employ on average 40 percent long-term
liabilities to capitalization, it is difficult to make a case for the use of 50 percent. Should one division be
entitled to a lower required return simply because it is allowed more debt? National Foods is obligated for

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that debt. If the tax shield were lost or reduced because of poor earnings caused by the Restaurants Division,
this would raise the effective cost of debt for the overall company. Larger leverage for the division increases
the variance of returns to stockholders of National Foods resulting in a higher beta and higher overall
required return. Restaurants are risky, as attested to by the large number of failures. Finally, the debt costs of
the Restaurants Division would be higher if it were a stand alone company.
These factors make the true cost of debt funds for the Restaurants Division higher than shown.
While subjective, it may be appropriate to make some kind of adjustment. This can be done in the cost of
debt funds for that division and/or in the weighting.
Decision in Case
The decision to use multiple required returns can be justified on the basis of better allocating
capital. If 40 percent debt is used for all three divisions, there is almost a 2 percent difference in required
returns for the most risky division, Restaurants, from the least risky, Bakery. For all of the reasons in
Chapter 8, it makes sense to require different returns for different risks. The approach shown uses the proxy
companies only to determine equity costs. An alternative approach is to use the proxy companys weighted
average costs of capital for required returns. This approach is explained in the chapter.
In teaching this case, I also get into what gives rise to projects providing expected returns in excess of those
required by the financial markets. The focus is on industry attractiveness and competitive advantage.

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CASE: RESTRUCTURING THE CAPITAL STRUCTURE AT MARRIOTT


Purpose of Case
The Marriott case provides a springboard for general discussion of corporate restructuring and the
creation destruction of value. The central issue is the transfer of wealth from bondholders to stockholders,
and whether it is proper for a company to exploit bondholders in such a manner. This may lead into a
discussion of corporate objectives and whether the only stakeholder who matters is the stockholder. The
ability of Host Marriott to service the debt also is a topic of interest. The case invariably ends up with a
heated discussion of what bondholders and management, in behalf of stockholders, should do.
Questions
1. What are the features of the restructuring plan and how creative is it?
2. Why did the bond and stock prices react the way they did? What information is being conveyed?
3. If you take the security price movements as representative, was there a net creation of value around
the time of the announcement? Assume the company has outstanding $2.3 billion in fixed-rate,
long-term debt and 95.5 million shares of common stock.
4. What actions would you recommend that bondholders take? How should management, respond?
Analysis of Case
The expropriation of bondholder wealth occurs because the creditworthiness of Host Marriott,
where most of the debt will reside, is lower than the pre-restructured Marriott Corporation. This is seen in
the bond rating going from BBB to B. While the numbers are rough, the pre-restructured company had
approximately $3.2 billion in debt to service with $800 million in operating cash flow before interest and
taxes. After the proposed restructuring, Host Marriott would have about $2.9 billion in debt and somewhat
over $300 million in operating cash flow. Although very crude, this change in relationship tells the story of
bondholders being expropriated.
Other sources of value creation/rearrangement include a possible information effect. If the
announcement conveys an impression of more aggressive management and value maximization, it could
have a favorable impact on share price. Although the stock performed very well during 1993, the share price
impact around, the time of the announcement would not suggest an effect other than wealth transfer. The
spin-off creates two separate public companies where only one existed before. There are new agency costs of
auditors and other monitoring devices, together with the ongoing costs of servicing two separate sets of
stockholders. It is possible certain synergy will be lost with splitting Marriott in two, but this probably will
not be significant.
As to net value creation or destruction, the maximum price effect for bonds occurred from Friday,
October 2, 1992 to Wednesday, October 7. The announcement was on Monday, October 5. The price decline
for the first bond in Exhibit 3 was 28.5 percent, whereas for the second it was 23.6 percent. If we assume
that 25 percent approximates the actual price decline for al1 fixed-rate debt and that $2.3 billion is
outstanding, the value loss would be $575 million. Share price went from $171/8 on October 2 to $191/8
on October 7, a gain of $2. With 95.5 million shares outstanding, this amounts to a total gain of $191
million. If these crude calculations approximate the truth, we would have:
Debt holder loss
$575 million
Stockholder gain
191
$384 million
It would seem that there was either an over adjustment by debt holders or an under adjustment by
stockholders. By October 30, bond prices and stock prices had increased. The bonds were down about 20
percent and the stock had risen to $20, a $2-7/8 gain over October 2. At October 30, we have
Debt holder loss
$460 million
Stockholder gain
275
$185 million
It makes sense for bondholders to challenge the legality of the restructuring plan. If somehow they
can keep the company from being split, the creditworthiness of their obligations will not lowered. Another
strategy is to insist that better security occur or that a higher interest rate occur in keeping with junk bonds.
With significant recontracting, value could be restored to bondholders. Management, on the other hand, will
want to give assurances of servicing all debt and hope any furor blows over. After all, public bondholders in
other situations have been expropriated and, in final analysis, they were unable to prevent it. Having gone to
market with a bond issue in April, 1992, Marriott's management has 1ittle credibility with bondholders.
Another issue is the reputation effect. Is it necessary that the two companies have good relations
with investors? For Host Marriott, it will likely be important. Some of the notions of Douglas Diamond and
others can be brought into play. As suggested earlier in the teaching note, I use the case as a platform for
general discussion of corporate restructuring. One aspect is whether it was ethically wrong for Marriott
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management to propose the plan.


Aftermath
The corporate bond investment community responded with a vengeance to the restructuring plan.
Investors were concerned not only with Marriott bonds, but with the precedent it would establish for other
expropriations. A number of large institutional investors, including All state, CALPEFLS, IDS, Kemper,
PPM, and TIAA banned together to bring a law suit through Wachtell, Lipton, Rosen & Katz. Eventually
the suit involved a charge of securities fraud. In addition, there were a half dozen other law suits including
one later from preferred stockholders.
Pressure was brought against Merrill Lynch for selling the bonds of Marriott on the one hand, and
then engaging in a restructuring plan to expropriate their value. The threat of not buying securities through
Merrill was compelling. On November 17, 1992, Merrill resigned from the Marriott restructuring plan.
However, they still kept Marriott as a client. At about the same time, Tom Piper, a long-time director
resigned from the Board in protest.
Recognizing the resolve of bondholders, management reluctantly entered into negotiations at the
end of 1992. The bondholders wanted a higher interest rate. Other bargaining points revolved around
Marriott International assuming some of the Host Marriott debt and around transfer payments from Host IV
Marriott to Marriott International for services. Eventually Marriott settled with many of the bondholder
groups. Among other things, approximately $450 million of debt and assets were transferred from Host
Marriott to IV Marriott International, the credit line from Marriott International to Host Marriott was
extended to the year 2007, the interest rate on the bonds offered in exchange was increased by
approximately 1 percent (but with a maturity extension of about four years), and there was to be a $70
million issue of stock to retire bonds. There were other minor concessions as well.
In final analysis, Marriott caved in to do the deal. It is one of the few times that bondholder resolve
had a meaningful impact. With these changes, the bonds have risen in price. At the time of the settlement the
two issues in Exhibit 3 traded above $100, near their prices before the restructuring announcement.
However, interest rates declined over this time frame, so the opportunity loss is greater.

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CASE: MORLEY INDUSTRIES, INC.

Purpose of Case
This case requires a student to prepare a monthly cash budget for a seasonal business as well as a
year-end proforma income statement and balance sheet. On the basis of this information, one is able to plan
the financing of the firm. Also, it is useful to explore the flow of funds through receivables and inventories
when demand for the product is seasonal but production is level.
Questions
1. Prepare a cash budget along with estimates of total bank credit required at the end of each month for
the year 2000. Note: to calculate collections and payments for purchases, assume each month has 30
days and that sales and purchases per day are the same for each day of the month.
2. Prepare a pro-forma income statement for the year 2000 and a pro-forma balance sheet at December
31, 2000.
3. Is this a sound credit situation? What would you recommend?
Analysis of Case
In sizing up the company, it is useful to explore in general the implications of seasonal demand for
the product and level production. There will be a build-up in inventories that is greater than that which
would occur, with seasonal production. As a result, the peak need for credit will be greater. The company
will be less flexible, and may find itself with excess inventories at the end of the season. In the case of
Morley, the inventory risk of obsolescence is only moderate. The product is not faddish and not subject to
physical deterioration if stored properly. The main problem of inventory carryover is the cost of storage
and of financing. At this juncture I find it useful to discuss why a bank requires a period of clean-up for a
seasonal credit facility, where the loan is paid off for one or two months. The reason is that a clean up
indicates that the credit facility is used to finance seasonal funds needs and not more permanent needs.
A source and use of funds statement spanning the 19971999 period reveals:
Sources
Profits
Depreciation
Bank loan
Accounts payable
Accruals
Decrease cash

$3,783
4,692
4,478
199
30

Uses
Dividends
Additions to PP&E
Accounts receivable
Inventories
Other assets
Mortgage payments

8,040
$21,222

$2,160
13,464
1,146
2,648
304
1,500
$21,222

The permanent nature of the funds requirements is evident, as the company financed its plant
investment out of cash, which probably was built up in anticipation of the expenditure, as well as with
the bank line of credit. The bank seemed unaware that this was happening, despite the clean-up period,
where Morley was out of bank debt, shortening to 1 months.
Going over the cash, budget assumptions, receipts are comprised solely of collections. With a
40-day average collection period, and the assumptions of even daily sales across the month and 30-day
months, this means that 2/3rds of the sales during a month is collected in following month and-l/3rd is
collected two months latter December, 1999 sales were $3,218 (in thousands), so $2,145 would be expected
to be collected in January 2000, and $1,073 in February.
As to disbursements, the payment for purchases has a 33-day average lag. This means that 90
percent of purchases in a month is paid for in cash in the subsequent month, while 10 per cent is paid for
in the second month following the month of purchase. Labor & overhead is $1,480 each month in

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January, as well as in July through December, and is $l,512 each month in February through June .
General & administrative expenses are level throughout the year, and are $10,632/12 = $886 per month
Equipment expenditures of $640 each month from March through July are expected. Advertising &
promotion expenditures are scheduled as follows: $50 in January and February; $30,000 each month
from March through August; and $65,000 each month from September through December. The total tax
payment for the year is $3,997 in expected before-tax profit times 35 percent = $1,399. Taking one
quarter of this means that $349 would be payable in March, and $350 in June, September and December.
Mortgage principal payments of $375 are required in June and in December. Mortgage interest is
$10,500 (LTD plus the current portion of LTD) times .05 = $525 in June and $10,125 times .05 = $506
in December. Common stock dividends of $300 are scheduled to be paid in March, June, September and
December.
These are the assumptions involved in preparing a cash budget. Two things should be mentioned.
Interest payments on bank borrowings are ignored. These are assumed to be embraced in the G&A
estimates. Whi1e they could be figured separately, for ease of computation they are not. Also ignored is
interest income on cash equivalents in the flush months of late Summer and early Autumn. This too is
assumed to be embraced in the G&A estimates.
With these assumptions, we are able to produce the cash budget shown in the exhibit which
follows. I find it useful to trace through the seasonal funds needs month by month, exploring the cash
shortfall and cash throw-off. Expected year 2000 compares with actual 1999 in the following ways:
Peak borrowings
Trough
Clean up
Year-end borrowings
Cash peak

2000-Expected
$6,580 (Mar.)
0
5 months
$5,380
$3,761(Aug)

1999 Actual
$8,100 (Mar)
0
2 months
$4,418
n.a.

The implication is that things are improving as far as the seasonal credit facility goes. With capital
expenditures only modestly in excess of depreciation, the dependence on the line of credit is lessened.
Peak borrowings are less, $8,100 versus $6,580, and the period of clean up is longer, 5 months versus 2
months.
The pro-forma income statement for the year 2000 and the pro-forma balance sheet for December
31, 2000 are shown in the two exhibits which follow the cash budget. The income statement is relatively
straight forward. The balance sheet involves one assumption that may cause students difficulty. For ease of
preparation, it is assumed that the depreciation burden is allocated entirely to inventory. In practice there
will be allocation to certain G&A facilities, but indirectly, though not directly, this too could be allocated to
inventory.
Comparing the pro-forma balance sheet with the 1999 actual, the major uses of funds are:
receivables up $451; inventories up $560; net PP&E up $600; and the mortgage payable down $750. The
major sources of funds are retained earnings, up $1,401 and the bank loan up $902. While peak borrowings
are expected to be less in 2000 than they were in 1999, year-end borrowings are expected to be higher due
to significantly higher sales.
Decision in case
The company is coming back to a true seasonal credit after the use of the line of credit to fund
capital expenditures. The year 2000 is a digestion period. One can simulate the cash budget for such things
as lower sales, a cost-price squeeze, a 50-day collection period etc. Under most scenarios, there is a clean
up. For example, if sales and purchases were down 10 percent, but labor & overhead and general &
administrative were down only 5 percent (a cost/price squeeze), peak borrowings of $7,311 would occur at
the December year-end, and there would be a two month clean-up in July and August. This is a more-thanreasonable bank credit, and competition among banks would assure the accommodation of the company at
some institution should the companys present bank decline to renew its line. The company has been
consistently profitable, and it has a reasonably conservative balance sheet. Business risk is present; it is,

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after all, a cyclical industry. However, inventory risk is only moderate. For these reasons, most bankers
would be eager to do business with Morley Industries.

MORLEY INDUSTRIES
Original Cash Budget

Receipts:
Sales Collections
2 months prior
1 month prior
Total receipts
Disbursements:
Purchases
Payment, 2 months prior
Payment, 1 month prior
Labor and overhead
General & administrative
Equipment expenditures
Advertising & promotion
Tax payments
Mortgage principal
Mortgage interest
Dividends
Total disbursements
Inflow or (outflow)
Beginning cash without
Beginning cash without additional
financing.
Ending cash without additional
financing
Ending credit required for
$1500 cash
Ending cash with additional
financing

Financial Management and Policy, 12/e

Jan
3,720
561
2,145
2,706

Feb
5,250
1,073
2,480
3,553

Mar
7,410
1,240
3,500
4,740

Apr
7,650
1,750
4,940
6,690

May
8,550
2,470
5,100
7,570

1,503
143
1,326
1,480
866

1,583
147
1,353
1,512
866

1,583
150
1,425
1,512
866

1,583
158
1,425
1,512
866

1,583
158
1,425
1,512
866

50

50

640
30
349

640
30

640
30

3,885

3948

300
5,292

4651

4,651

(1,179)
1,524

(395)
345

(552)
(50)

2,039
(602)

2,919
1,437

345

(50)

(602)

1,437

4,356

5,633

6,028

6,580

4,541

1,622

1,500

1,500

1,500

1,500

1,500

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MORLEY INDUSTRIES
Original Cash Budget (cont)

Jun
4,830
2,550
5,700
8,250
1,583
158
1,425
1,512
886
640
30
350
375
525
300
6,201
2,049
4,356
6,405
0
1,927

Jul
4,020
2,850
3,220
6,070
1,503
158
1,425
1,480
886
640
30

Aug
3,360
1,610
2,680
4,290
907
158
1,353
1,480
886

Sep
1,920
1,340
2,240
3,580
1,503
150
816
1,480
886

Oct
1,800
1,120
1,280
2,400
1,503
91
1,353
1,480
886

Nov
1,890
640
1,200
1,840
1503
150
1,353
1,480
886

Dec
3,600
600
1,260
1,860
1503
150
1,353
1480
886

30

65
350

65

65

_________
4,469
1,451
6,405
7,856
0
3,378

__________
3,907
383
7,856
8,239
0
3,761

300
4,048
(468)
8,239
7,772
0
3,294

_________
3,874
(1,474)
7,772
6,297
0
1,819

_________
3,934
(2,094)
6,297
4,203
1,775
1,500

65
350
375
506
300
5,465
(3,605)
4,203
598
5,380
1,500

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Morley Industries
PROFORMA INCOME STATEMENT - 2000

Sales
Costs of goods sold
Gross Profit
General and administrative expenses
Advertising & Promotion Expenses
Mortgage interest expense
Profit before taxes
Taxes (35%)
Profit after taxes
Dividends

$54,000
37,800
$16,200
10,632
540
1,031
$3,997
1,399
$2,598
$1,200

Change in retained earnings

$1,398
Morley Industries

PROFORMA BALANCE SHEET DECEMBER 31, 2000

Cash (CB)
Receivables*
Inventories**
Current Assets
Net PP&E.***

$1,500
4,230
7,840
$13,570
27,579

Other Assets (NC)

1,110
$42,259

Bank Loan (CB)


Accounts Payable
Accruals (NC)
Mortgage, current
Current Liabilities
Mortgage
Common Stock (NC)
Retained Earnings

$5,38
1,65
86
75
$8,65
9,00
6,00
18,60
$42,25

*Nov. sales (1,890) + Dec. sales (3,600) Dec. Collections of Nov. sales (1,260) = 4,230
** Start + Additions CofGS

2, 600 Depreciation

17,840
Materials

- 37,800 = 7,840
7, 280 +
17,920 Labor and Overhead

38,360

***26,979 + 3,200 Additional Equipment 2,600 Depreciation


Nov. purchases (1,503) + Dec. purchases (1,503) Dec. payment for Nov. purchases (150) =
1,653.

17,211 + 1,398 (Proforma Income Statement) = 18,609

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CASE: FINANCIAL RATIOS AND INDUSTRIES


Purpose of Case
The purpose of this cases is to demonstrate that financial ratios often take on industry characteristics. It also
provides a fun format for students in taking up a rather dry topic
Questions
1.

Which industries are likely to have the greatest proportions of property, plant &
equipment? Receivables? Inventories? Accounts payable and accruals? Long-term debt
and leases? The least proportions of these items?

2.

Which industries are likely to have the fastest turnovers of assets, receivables and
inventories? The slowest turnovers?

3.

Which industries are likely to have the highest net profit margin? Highest dividend
payout? The-lowest net profit margin and dividend payout?

4.

Match the financial ratios with the industry.

Analysis of Case
Before identifying the industries, I ask students which industries are likely to be outliers, or
extremes, with respect to balance-sheet proportions and various financial ratios. In general, we might expect
the following:

Proportions:

Greatest

Least

PP&E

Airline, utility, oil company, laundry


detergents & food retailer.

Employment service, advertising,


bank & electronic wholesaler.

Receivables

Advertising, employment service,


bank, electronic wholesaler & hotel
supply.

Airline, utility & food retailer.

Inventories

Food retailer, hotel supply &


electronics wholesaler.

Airline, utility, bank,


employment service, news &
info. publisher, advertising, &
computer software.
Airline, utility, oil company,
news & info. publisher, &
computer software.

Accounts
accruals

payable&

LTD & leases

Turnovers:

Advertising, bank, employment


service, hotel supply & electronic
wholesaler.
Airline, utility & aluminum
producer.
Fastest

Employment service, bank,


computer software &
pharmaceuticals.
Slowest

Asset

Employment service, food retailer


& electronic wholesaler.

Utility & bank.

Receivables

Food retailer, airline & utility.

Employment service, bank & hotel


supply.

Inventories

Airline,
food
retailer,
oil
company & computer software.

Hotel
supply
pharmaceuticals.

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Percentages:

Highest

Lowest

Net margin

Pharmaceuticals,
computer
software, bank & utility.

Employment service, electronic


wholesaler, food retailer & hotel
supply.

Dividend
payout

Utility, bank, pharmaceuticals, oil


company, laundry detergents &
aluminium .

Computer software, electronic


wholesaler & airline.

Decision in Case
The key to industry and the lettered columns is:

Letter
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O

Industry
Tools & process/
environmental controls
Electric & gas utility
Employment services
Laundry detergents
News & info. publishing
Commercial banking
Advertising
Aluminum/packaging
Computer software,
Food retailing
Wholesaler of electronic
products
Airline
Hotel supply business
Pharmaceuticals
Integrated oil production

Company
Danaher Corporation

&

computer

Wisconsin Energy Corp.


Manpower, Inc.
Clorox Company
Dow Jones & Co
Banc One Corporation
Interpublic Group, Inc.
Reynolds Metals Co.
Microsoft Corporation
Hannaford Bros. Co.
Arrow Electronics ,Inc.
South west Airlines Co.
Guest Supply, Inc.
Merck & Co., Inc.
Chevron Corporation

The most difficult to identify are A., tools and environmental / process controls, D., laundry detergents, and
H., aluminum / packaging. These companies, all manufacturers, are in the middle. The other companies are
outliers along one or more dimensions and can be more easily identified.

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CASE: CACERES SEMILLA S.A. de C.V.

Purpose of Case
The focus of this case is upon funds flows through assets in a seasonal business and upon the best method of financing.
The student is required to complete the pro-forma balance sheet as to the expected cash position and the bank loan necessary,
going forward month by month. A critical issue is the deteriorating trend in inventory turnover, and the large amounts of money
likely to be tied up in this asset. Also, there are questions of growing in a sustainable way and the diversion of funds away from
the business.
Questions
1.

Analyze the company's past financial condition and performance.

2.

Complete the pro-forma balance sheet. What are the projected funds flows though receivables and inventories? through
payables and accruals? What is the pattern of projected borrowing requirements?

3.

As to financing, what should the company seek? As the banker, would you accommodate the company's projected
borrowing requirements? What, if anything, causes you concern?

Analysis of Case
A source and use of funds statement for the 1996-1999 period reveals the following (in thousands of pesos):

Sources
Profits
Depreciation
Accounts payable
Accruals
Bank loan

Uses
1,830
1 ,014
714
462
900

Dividends
Gross Addn. PP&E
Receivables
Inventories
other assets

120
1,740
732
1,770
348

Cash - decrease

510 Long-term debt


720
5,430
5,430
The major uses are inventories, capital expenditures in excess of depreciation, receivables and the pay down of debt. The major
sources are retained earnings, payables and accruals, and the bank loan. The inventory problem is particularly noteworthy at this
juncture of the case discussion.
The past financial ratios are shown in the first exhibit of this teaching note. The current and quick ratios decline over
time, what with the increase in accounts payable and in the bank loan. The average collection period increased in fiscal year 1999,
indicating more funds being tied up in inventories. Particularly disturbing is the slowdown in inventory turns, from 5.9 x to 4.9 x
to 4.2x. It is worth pointing out that the worsening turnover of receivables and inventories has caused most of the growth in
current assets, as opposed to them being sales propelled. The debt/equity ratio declined from FY1996 to FY1998, and then
increased with the jump in payables, accruals, and in the bank loan. The average payable period increased in FY1999, which may
have repercussions for producer relations. As to trends in gross and net profit margin, both ratios fluctuated over time. The jump
in G&A to sales from FY1996 should be a matter of concern.
There are a number of business risks. Agricultural cycles are cyclical. There are considerable price fluctuations in both
corn and alfalfa. With seasonality, there is inventory risk. The product is subject to spoilage if held over to the next selling
season. The quality of the seed is always an issue, particularly if the company has to purchase seed in the spot market to meet
demand. The industry itself is competitive, though-Caceres enjoys. Good market share, 19%, in the Province of Santa Fe.
Past financing has consisted of the bank loan and an insurance company long-term loan to rebuild the Esperanza plant in
1993. The latter loan is fixed rate, at 13%, with principal payments of P60,000 required semi annually. The bank loan is under a
line of credit at the reference rate, presumably for the purpose-of funding seasonal-funds needs. However, the company is
financing underlying build-ups in receivables and inventories with this facility. The 4.8 million peso line was exceeded the
previous August. The need is being driven by slower turnovers of these two current assets, as well as by capital expenditures in
excess of depreciation.
Assumptions behind the pro formats are questionable. Sales growth of 22.7 percent is projected, which is very large
given what has happened over the past 4 years. Also, the 30-day average collection period and 60-day average payable period
assumptions seem a bit optimistic. Given the pro-formas produced, however, the following patterns are evident :

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Peak

Trough

Inventories
Receivables

June

January

Sep. (Jan, lesser peak)

April, May

Payables
Accruals

April

October
April

Sep. (Jan, lesser peak)

The built-in methods of financing partially support the seasonal patterns in inventories and receivables. Payables partially
supports the bulge in inventories early in the fiscal year, and the second receivable bulge in January, while accruals supports the
receivable bulges in September and in January.
The completed performs of Exhibits 3 and 4 of the case constitute the last two pages of this teaching note. The
borrowings that are projected reflect a peak of 5,572 pesos in August, with high borrowing in June through October as well. The
trough is 510 pesos in March, with no clean-up, and year-end borrowings of 1,906 pesos are projected. The peak requirements are
in excess of the 4.8 million peso line, there is no clean up, and year-end borrowings are some 1 million pesos higher than at the
previous year-end. While the company is projected to be profitable, it clearly will use the bank line to finance underlying, as
opposed to seasonal, funds needs. Inventories are projected to increase by 1,284 pesos from one year-end to the next. This huge
increase represents 38 percent, versus only a 23 percent increase in sales being projected. No explanation is given by management
as to this increase.
As to character, the company has built a tradition of over 110 years in business, is consistently profitable, has a high
quality product and is family run so control is not an issue. Negatives include inventory management, the bank overdraft in July,
1998, the overage on the line in August, with no consultation with the bank, the diversion of 105,000 pesos to Joaquin Estaban
without notification of the bank, the doubling of the dividend, the leaning on growers with a 60-day payment lag, and, perhaps,
Juan Pablo's fascination with mules!
Decisions
The focus of management needs to be on-inventory. It needs to get a handle on the situation. The banker needs to force
management focus on this. If inventories were to grow only with sales, year-end projected borrowings would be some half-million
pesos less. Inventory management is the key to financial health. Apart from this, it may be desirable to slow the growth of the
company to low-double digit, as opposed to 23 percent. This would allow the company to concentrate on its more profitable
business. The banker should consider constraining, through-protective covenants, the following: dividends, future capital
expenditures in relation to depreciation, and further investments in the steer manure or any other outside businesses. If some of
these problems can be addressed, the company is a bankable credit. If not, the company will be financially strained.
Caceres Financial Ratios
Current ratio
Quick ratio
Ave. collection period
Inventory turns
Debt/equity
Ave. payable period*
Gross profit margin
Net profit margin
P & Store/sales
S & delivery/sales
G & A/sales

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1996
1.5
0.8
27.8

1.4

1997
1.4
0.7
30.9
5.9
1.2
53.9

1998
1.4
0.6
30.7
4.9
1.0
53.7

1999
1.3
0.5
37.4
4.2
1.2
60.7

38.7%

38.1%

41.2 %

40.6%

3.9
11.0
12.5
7.5

3.3
11.1
12.4
8.1

3.1
12.2
13.6
9.1

3.5
11.9
12.7
8.9

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Exhibit 3
Caceres Semilla S.A. de C.V.
Pro forma Income Statements FY 2000
Net sales
Cost of goods sold
Gross profit
Depreciation
Procession & storing exp.
Selling & delivery exp.
General & admin. exp.
Profits before taxes
Income taxes
Profits after taxes
Dividends

Mar.
1,680
1,008
672

April
1,260
756
504

May
1,260
756
504

June
1,680
1,008
672

July
1,680
1,008
672

31
150
216
151
124
96
28

31
150
162
158
3

31
204
162
185
(78)

32
288
216
200
(64)

(78)

32
204
216
199
21
110
(89)
120

(64)

Exhibit 4
Pro forma Balance Sheets for FY 2000
Cash
Account receivable
Inventories
Total Current Assets
Net fixed assets
Other Assets
Total Assets
Accounts payable
Accruals
Current portion, LTD
Bank loan
Total Currents Liabilities
Long-term debt
Common stock
Paid-in-capital
Retained earnings
Total Liabs. & Equity

Mar.
200
1,626
5,877
7,703

April
200
1,206
6,888
8,294

May
200
1,206
7,434
8,840

June
200
1,626
7,728
9,554

July
200
1,626
7,557
9,383

4,385
654
12,742

4,366
654
13,314

4,479
654
13,973

4,459
660
14,673

4,439
660
14,482

4,713
1,059
120
510
6,402

4,794
954
120
1,103
6,971

2,619
1,059
120
3,910
7,708

2,154
1,164
120
5,239
8,667

1,689
1,326
120
5,415
8,550

1,440
192
534
4,174
12,742

1,440
192
534
4,177
13,314

1,440
192
534
4,099
13,973

1,380
192
534
3,890
14,673

1,380
192
534
3,826
14,482

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Exhibit 3- continued
Pro forma Income Statements
Aug.
2,400
1,440
960

Sep.
3,300
1,980
1,320

Oct.
3,000
1,800
1,200

Nov.
1,320
792
528

Dec.
2,100
1,260
840

Jan.
3,000
1,800
1,200

Feb.
2,520
1,512
1,008

FY2000
25,200
15,120
10,080

32
396
312
202
18

32
360
432
201
295
110
185

33
156
390
192
429

33
252
174
175
(106)

34
300
390
171
305

35
240
330
164
239

429

(106)

34
360
276
174
(4)
110
(114)
120

305

239

390
3,060
3,276
2,172
1,182
426
756
240

18

Exhibit 4 continued
Pro forma Balance Sheets
Aug.
200
2,346
6,954
9,500

Sep.
200
3,246
5,811
9,257

Oct,
200
2,946
4,848
7,994

Nov.
200
1,266
4,893
6,359

Dec.
200
2,046
4,935
7,181

Jan.
200
2,946
4,437
7,583

Feb.
200
2,466
4,692
7,358

4,419
670
14,589

4,399
670
14,326

4,498
680
13,172

4,597
680
11,636

4,695
680
12,556

4,793
680
13,056

4,770
680
12,808

1,224
1,723
120
5,572
8,639

759
1,885
120
5,427
8,191

387
1,408
120
4,693
6,608

852
1,176
120
3,030
5,178

1,689
1,583
120
3,000
6,392

2,154
1,688
120
2,625
6,587

2,619
1,455
120
1,906
6,100

1,380
192
534
3,844
14,589

1,380
192
534
1,029
14,326

1,380
192
534
4,458
13,172

1,380
192
534
4,352
11,636

1,320
192
534,
4,118
12,556

1,320
192
534
4,423
13,056

1,320
192
534
4,662
12,808

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CASE: DOUGALL & GILLIGAN GLOBAL AGENCY

Purpose of Case
Dougall & Gilligan (D&G) is a case involving long - term financing. The company used a number
of types of such financing in past, which affords a discussion of the features of bank lines, privateplacement term loans, convertible debentures and equity financing. The four new financing alternatives
involve analyses and a decision. The case can be used as a comprehensive introductory case on long-term
financing or as a more detailed subsequent case on this subject matter.
Questions
1.

What are the companys financial condition and performance, its funds requirements, and
its business risk?

2.

Do the existing means of financing unduly restrict the company?

3.

Analyze the financing alternatives as to which best fits D&Gs situation.

4.

As CFO, what means of financing would you recommend?

Analysis of Case
The financial ratios of consequence are the following:
1991

1992

1993

1994

1.1

1.1

1.1

1.1

51.4

45.7

38.5

42.2

70

6.2

7.4

6.9

.6

.6

.6

.6

4.7%

5.3%

5.7%

5.6%

Salaries & ben./sales

54.4

52.5

53.5

52.7

Office & general/sales

33.8

34.5

33.5

34.8

Current ratio
Ave. collection period
Debt/equity ratio
Interest-bearing debt to capitalization
Net profit margin

The unusual aspect of an advertising agency is that it is a conduit for funds flows. It has a large amount of
receivables, which represent billings to its clients. At the same time it has a large amount of payables, owed
mostly to the media. The receivable versus payable lag is very important-, as small changes can have a
large effect on the companys funds requirements. The average commission is but 13 percent, so it is
necessary to multiply the average collection period found in the usual manner by 13 percent. The favorable
trends are a moderate improvement in the average collection period and in the net profit margin, when
compared with 1991 as the base year. The company is marked by a relatively high degree of leverage. The
industry also uses extensive debt, but the average debt/equity ratio in 1994 was only 4.5x. However, D&G
has a higher profit margin.
As to business risk, the company is in a cyclical industry with rapidly changing trends. There is the
danger of creative obsolescence, and there is considerable client turnover. Interactive communications and
the Internet threaten older forms of advertising. There is pressure on margins, and the industry is very
competitive. All in all, there is a good deal of business risk.
The means of financing in. the past allow discussion of the features of: 1) the bank lines of credit
(interest rate and nature); 2) the term loans by institutional investors (range of interest rates, maturities,
restrictive covenants on acquisitions and further debt, the credit rating of BBB, and flexibility of the
borrowing arrangement); 3) the convertible subordinated debentures (interest rate, conversion price,
conversion premium, the nature of delayed equity financing and forcing conversion, the call price
translating into a share price of $124.75, which with a cushion means forcing conversion only if $143 or
above, and with a share price of $64, the issue overhangs the markets which clouds future equity-linked
financing); and 4) equity issue in 1992 (price of $71.50, rights offering with a very small ratio of 1 for 25,
and a-beta of 1.3 versus 1.1 for the industry reflecting higher leverage).
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The immediate financing needs are assumed to be $300 million. The question is what is the best
financing alternative. I have students briefly review the features of the four alternatives: further bank
borrowings; additional term loans; 20-year debentures; and equity,. The bank loan is only a partial answer,
as it will not cover the full financing needs. If the company were to sell equity, it wi11 need to be
underpriced from the current share price of $64. If one assumes a price of $58, this translates into 5,172,414
new shares of stock, compared with 26,860,000 now outstanding. Even though the share price has declined,
the present price/earnings ratio ($2.77 eps) is 23x, which compares favorably with other major companies in
the industry.
An EBIT/ EPS analysis (described in Chapter 10) suggests an indifference point between the
debentures (10.75%) or term loan (10.50%) and common stock issuance of $238 million in EBIT. This
assumes existing 1994 interest of $36.3 million, new interest, the interest reset described in the case, and
5,172,414 new shares for the common-stock alternative. The present level of EBIT is $167.3 million, so the
company is below the indifference point where debt dominates with respect to earnings per share: At 15
percent growth in EBIT it will take about 2-1/2 years to reach the indifference point. This analysis favors a
common-stock offering.
The immediate effect on the debt ratios is as follows:
1994 actual Pro forma
Total liabilities

$1,879

$2,179

Interest-bearing debt

$440 273

$740

Shareholders equity

713

273

$440 273

1,013

6.9

8.0

0.62

0.73

Capitalization
Debt/equity ratio
Interest-bearing debt to capitalization

The immediate effect on the coverage ratio of times interest earned if debentures are used is:
EBIT

$167.3

$167.3

Interest

36.3

68.9

Times interest earned

4.6x

2.4x

This represents a sharp reduction, but debt service still is possible as long as long as earnings hold up.
The combination of effects on the debt ratio and on the coverage ratio will likely result in a down grade
of credit rating from BBB to BB. Very few companies are rated investment grade with a times interest
earned of less than 3.0. Once a company is downgraded into the speculative grade category, it is difficult to
regain an investment grade. This will affect the companys interest costs and availability of credit,
particularly in any flight to quality.
Financial flexibility has to do with a decision now impacting future financing. It is hard to tell if the
company will have future external financing needs. The more likely this becomes, the stronger the, case for
keeping the top open for debt financing in the future and building your equity base now. Another aspect
of flexibility concern s not being able to repay the term loan.
The timing of debt and equity issues needs to be factored in. Interest rates appear to be heading further
up, after rising in 1994. This proved not to be the case in 1995, when they declined, but the general
expectation at the time of the case was that interest rates would rise further. The stock market gives the
company a P/E ratio of 23, which is better than other large companies in the industry. The president, Drew
Waitley, wants to postpone any stock offering. He believes the company is on a roll and that if stock is to
be used in financing it can be done on much more favorable terms in the future. This argument can be
viewed in the context of the option value of equity in a levered situation (see Chapter 9)

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Decision in Case
Most of the analyses above, as well as the underlying business risk in the case, argue for common-stock
financing and building the equity base. If one goes with one of the two methods of long-term debt, it must
be predicated upon confidence in your growth forecast after fully considering business risk. Moreover, you
must be willing to give up an investment-grade credit rating. Postponing a decision by further reliance on
bank lines of credit is only possible for a short while, given the ultimate $300 million in external financing
required. I have found that most students decide upon the common - stock alternative but some do not want
to sell stock and suffer dilution, being inclined to bear the risk.

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CASE: RAYOVAC CORPORATION


Purpose of Case
The Rayovac case deals with exit strategy from a previous leveraged buyout and the timing of such. It,
allows exploration into: leveraged buyouts in general, the hallmarks of a good candidate, the sources of
value, and management execution once a buyout has occurred. Finally, one can investigate the question of
whether an IPO is the best exit strategy.
Questions
1.

Was Rayovac a good LBO candidate in September, 1996? What were the positives? the negatives?

2.

Was the valuation appropriate from the standpoint of the LBO firm? Was the structure of the deal
typical?

3.

What did-management do? Did they create value?

4.

Is it appropriate to consider an exit strategy only one year after the LBO? Would you exit at this time
and, if so, what would be the vehicle?

Analysis of Case
With respect to the first question of whether, ex ante, Rayovac was a good LBO candidate, the positives
are impressive. It is a long standing company with a well known brand name, even though it has only a 10
percent overall market share. It has market dominance in several niches: hearing aid, lithium, wafer,
lantern, heavy duty, and rechargeable. While a mature industry, the market is growing at about 5 percent,
as new electronic devices require specialized batteries and miniaturization. Rayovacs manufacturing
facilities are modern and efficient, so cash flow can be dedicated to debt service-There are reasonable
barriers to entry; the manufacturing process is complicated and capital intensive. With respect to
advertising, Michael Jordan is a real plus. Finally, David Jones is a dynamic CEO with a proven track
record.
A major negative is that Rayovac is very much a number 3 player behind Duracell and Eveready.
Rayovac must compete on the basis of price, with approximately a 10 percent discount from the two
market leaders. The product mix is weighted in the direction of heavy duty, which is declining in volume
as customers prefer alkaline. The need to advertise means that part of the discretionary cash flow must be
used for this purpose. A significant existing debt burden, $81.3 million, limits flexibility in financing.
Finally, the business deteriorated to some extent during the time the previous owner was trying to sell it.
On balance, the positives seem to outweigh the negatives so it is not surprising that on the basis of
qualitative considerations Thomas H. Lee (THL) considered the situation.
The next issue is valuation. The price at September, 1996 was $326.5 million to retire Rayovac
common stock, which would be used to pay of existing debt and to cover fees, etc. This is far less than the
$500 million Merrill Lynch initially suggested in their role of advisor to the seller. It is 7.5 times trailing
EBITDA (earnings before interest, taxes, depreciation and amortization). This compares favorably to the
companies in Exhibit V of the case. Gillette paid 15.1 times EBITDA for Duracell. The enterprise value
(interest bearing debt + preferred stock + market capitalization of common stock - cash when significant)
to sales ratio is only 0.8x.This is much less than the 3.5x for Duracell , and less than the other companies
shown in Exhibit V, which range from 1.2x to 3.1x. On a relative basis, the price paid seemed favorable
from the standpoint of the LBO firm, THL. In retrospect, it bought cheaply and that was a major source of
value.
The structure of the LBO was (in millions):
Revolving credit facility
Term loan
Bridge loan
THL investment
Pyle continuing equity
Foreign debt and capital leases
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$26
105
100
72
18
5.5
$326.5
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At the end of the day, Mr. Pyle, the seller, had 9.9 percent of the "Newco" stock, existing management, 9.9
percent , and THL and David Jones, 80.2 percent . Mr. Pyle insisted upon the bridge loan as opposed to the
promise by THL to raise the debt capital. The structure consisted of debt and common equity, there being
no mezzanine layer of financing.
The new management team created value by their actions. Efficiency gains .occurred through rationalizing
manufacturing, getting better plant utilization, and increasing productivity through better training, new
information systems, and new equipment . Plants were reduced from 8 to 4, purchasing and other things
were centralized and a number of other actions occurred. Jones changed the corporate culture towards
decision making at lower levels, accountability, better communication, and the encouragement of risk
taking. For fiscal-year 1997, costs were reduced by $6.3 million, and $8.6 million in savings going forward
appeared to be possible. The product mix changed slightly towards somewhat more alkaline, and less
heavy duty and rechargeable. Hearing aid and other products were up some in the mix.
The following occurs a cross the two fiscal years:
FY 1997
FY 1998
Gross profit margin
43.5%
45.8%
Operating income to-sales
7.2
8.0
SG&A-to-sales
35.0
36.4
Sales
+2.2%
EBITDA
+8.5%
While certainly not striking, solid improvement is evidenced in these figures. The exception is SG&A, but
here some of the increase is due to a reclassification of expenses.
To exit one year after an LBO is unusual; the typical horizon is 4 years or more. However, a lot of progress
has occurred and the "low hanging fruit" has been picked. Now it is a matter of grinding it out. The stock
market is booming and consumer product stocks are relatively hot. Probably most importantly, THL wants
to liquefy part of their investment and reduce its exposure to Rayovac in its portfolio.
I like to explore next how attractive the company is for an IPO. This considers the things previously
discussed. As to valuation, the goal of the company is to increase sales by 10 percent and EBITDA by 20
percent. If this were to occur, sales for FY1998 would be $476 million, EBITDA would be $55 million,
and EBIT would be $41.4 million, if it too increased by 20 percent. With $24.9 million in interest and
other expenses (the same as in FY1997) and a tax rate of 35 percent, profit after taxes for FY1998 would
be $10.7 million. The following valuation ranges then might be in order (in millions):
Sales multiple:
1.0x
1.4
1. 8
2 .2
EBITDA multiple:
7.5x
8.5
9.5
10:5
11.5
12.5
P/E multiple:
16x
18
20
22
24
26
28
30

Enterprise value
$476
666
857
1,047

Financial Management and Policy, 12/e

Equity value = enterprise value -debt of $207


$269
459
650
840

$413
468
523
578
633
688

$206
261
316
371
426
481
$171
193
214
235
257
278
300
321
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The medians for the companies in Exhibit IV of the case are 2.3x for sales multiple, 11.8x for EBITDA
multiple, and 23x for P/E multiple. It is useful to go over the companies as comparables. Most students
come up with an equity valuation of $300 million to $400 million in the "hot" market that existed at the
time.
Decisions in Case
The first decision is whether to exit now or to wait until further results are demonstrated. Much can be
said for seizing the opportunity now, as the window is open and there is the risk that something may go
wrong with future operations. Although the exit is early, it is not pre-mature.and would be built upon a
solid foundation.
The vehicles for exit reduce to two - an IPO or the sale to a strategic buyer. A leveraged build -up is a
non-starter, not only because of THL's reluctance but because no battery business of reasonable size is
available. After Duracell, Eveready, and Rayovac, no other manufacturer has even a 2 percent market
share. As to a strategic buyer, Duracell and Eveready would not be feasible for anti -trust reasons. The
buyer would have to be from outside the battery industry, so significant economies would not be possible.
This leaves an initial public offering as the most feasible exit. The window is open and, at the time of
the case, the market is likely to be receptive to a consumer products company.
Aftermath
On November 21, 1991, Rayovac had an IPO of 6.7 million shares, with a Green shoe option for
another 1.0 million, at $14 per share. The offering, led by Merrill Lynch, Bear Stearns, DLJ, and Smith
Barney, went well and the shares closed at $16.50 the first day. With 27.4 million shares outstanding, the
equity value (market capitalization) was $452 million at the end of the day ($385 million at $14 share
price). After underwriting fees, the company realized $87.9 million in net proceeds. These proceeds were
used to reduce debt. In FY1998, the company continued to deliver, and earnings per share grew 64 percent.
It increased its market share in alkaline batteries from 8 to 16 percent and in hearing-aid batteries from 46
to 60 percent.
On June 3, 1998, THL and some members of management completed a secondary stock offering of
6.4 million shares at $21 per share- Afterwards, THL's ownership was reduced to approximately 40 percent
and management from 9.6 percent to 5.8 percent.

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Chapter-1
GOALS AND FUNCTIONS OF FINANCE
Case : Vision and objectives of Indian Oil Corporation Limited
Hints:
1. Stakeholders of IOCL customers, dealers, suppliers, employees, community, defence
services. No mention has been made of shareholders and government as stakeholders.
2. Stockholders wealth maximization as legitimate objective
No as there are other stakeholders as well.
Yes stockholders bear the risk and are the last one to receive any thing.
Maximizing their wealth would mean that all other stakeholders have been
taken care of.
3. Financial objectives of IOCL
Instead of maximizing return and dividends adequate return and reasonable
dividend.
Focus on cost reduction and economy in expenditure.
Silent about the management of working capital and capital structure.
Solutions
1-1.

Maximizing wealth takes into account all factors which influence the market price of
the stock. Maximizing earnings is not "all inclusive" because it does not take account of
the timing of earnings, of the business arid financial risk of the firm, and of dividend
policy. While shareholder wealth and corporate profitability tend to be closely
correlated over time, the two can deviate for the reasons cited. As shareholder wealth is
more inclusive, we should use it.

1-2.

If capital is allocated on a risk-adjusted return basis, it will flow to the most productive
investment opportunities. In this way, the economic growth of society will be
maximized as the most efficient investment projects are undertaken. As shareholder
wealth is determined by the risk-return nature of the company, only a wealth
maximization objective will result in savings in our society being efficiently allocated
to productive investment opportunities.

1-3.

The first project is expected to provide $350,000 in annual profits over 8 years or $2.8
million in total. The second project is expected to have the following after-tax profits:

Year
1
2
3
4
5
6
7
8
9
10
11

Financial Management and Policy, 12/e

Profit
0
0
$40,000
80,000
120,000
160,000
200,000
240,000
280,000
320,000
320,000

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12
13
14
15
Total

320,000
320,000
320,000
320,000
$3,040,000

While the second project is expected to provide greater total profits, these profits are
received further in the future than are the profits for the first project. Also, there may be
more uncertainty associated with the second project. Because of these factors, most
people prefer the first proposal.
1-4.

The major functions of the financial manager are the investment decision, the financing
decision, and the dividend decision. The subsets under each are given in the chapter.
These decisions share the common thread that they affect the value of the company's
stock. Together they determine the stock's value.

1-5.

If managers have sizable stock positions in the company, they will have a greater
understanding for the valuation of the company. Moreover, they may have a greater
incentive to maximize shareholder wealth than they would in the absence of stock
holdings. However, to the extent persons have not only their human capital but also
most of their financial capital tied up in the company, they may be more risk averse
than is desirable. If the company deteriorates because a risky decision proves bad, they
stand to lose not only their jobs but have a drop in the value of their assets. Excessive
risk aversion can work to the detriment of maximizing shareholder wealth as can
excessive risk seeking if the manager is particularly risk prone.

1-6.

Regulations imposed by the government constitute constraints against which


shareholder wealth can still be maximized. It is important that wealth maximization
remain the principal goal of firms if economic efficiency is to be achieved in society
and people are to have increasing real standards of living. The benefits of regulations to
society must be evaluated relative to the costs imposed on economic efficiency. Where
benefits are small relative to the costs, businesses need to make this known through the
political process so that the regulations can be modified. Presently there is considerable
attention being given to deregulation. Many things have been done to make regulations
less onerous and to allow competitive markets to work more effectively.

1-7.

As in other things, there is a competitive market for good managers. A company must
pay them their opportunity cost, and indeed this is in the interest of stockholders. To the
extent managers are paid in excess of their economic contribution, the returns available
to investors will be less. However, stockholders can sell their stock and invest
elsewhere. Therefore, there is a balancing force that works in the direction of
equilibrating managers' pay across business firms for a given level of economic
contribution.

1-8.

In competitive and efficient markets, greater rewards can be obtained only with greater
risk. The financial manager is constantly involved in decisions involving a tradeoff
between the two. For the company, it is important that it do well what it knows best. If
it gets into a new area in which it has no expertise, there is little reason to believe that
the rewards will be commensurate with the risk that is involved. The risk-reward
tradeoff will become increasingly apparent to the reader as this book unfolds.

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Chapter 2 : Solutions
Problem 1:
Taxable Income = INR 1,580,300
Income
Tax Rate
Upto 160,000
0
160,001-500,000
10%
500001 800,000
20%
More than 800,000
30%
Total
Add: Education Cess
3% of Tax

Tax
0
34,000
60,000
234,090
328,090
9,843
337,933

Problem 2
Depreciation 25% of INR 4 million = 1 million
Tax Saves 30% of 1 million = 300,000
Plus surcharge @ 7.5% =
22,500
Plus education cess =
9,675
Total Saving (tax shield)
332,175
If depreciation rate is 40% the tax shield will increase to INR 531,480.

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Chapter-3
Time Value and Money

3.1. a)

(1) $133.10

(2) $800

b)

(1) $134.49

(2) $1,455.19

c)

The more times a year interest is paid, the greater the terminal value. It is particularly
important when the interest rate is high, as evidenced by the difference in solutions between
a) (2) and b) (2)

d)

(1)$259.37

3.2. a)

(2) $265.33

(3) $100

(3) $268.51

(4) $271.83

(1) $100 x .75131 = $75.13


$100 $100
=
= $12.50
3
8

(2)

[2]
(3) $100

b)

c)

(1)

$500 x 2.7751

$1,387.55

(2)

$500 x 1.9520

$976.00

(1)

$100 x .96154

$96.15

500 x .92456

462.28

1,000 x .88900

889.00
$1,447.43

(2)

$100 x .80000

$80.00

500 x .64000

320.00

1,000 x .51200

512.00
$912.00

d)

(1)

$1,000

x.96154

$961.54

500

x.92456

462.28

100

x.88900

88.90
$1,512.72

(2)

$1,000

x .80000

$800.00

500

x .64000

320.00

100

x .51200

51.20
$1,171.20

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3.3. a)

7.18 percent

b)

23.38 percent

c)

40.62 percent

d)

IRR = $60/$1,000 = 6 percent (a perpetuity).

3.4

3.5. a)

Annuity of $10,000 per year for 15 years at 5 percent. The discount factor in Table B at the end
of the book is 10.3796.
Purchase price = $10,000 x 10.3796 = $103,796.

b) Discount factor for 10 percent for 15 years is 7.6061.


Purchase price = $10,000 x 7.6061 = $76,061.
As the insurance company is able to earn more on the amount put up, it requires a lower
purchase price.
c)

Annual annuity payment for 5 percent = $30,000/10.3796 = $2,890.28.


Annual annuity payment for 10 percent = $30,000/7.6061 = $3,944.20.
The higher the interest rate embodied in the yield calculations, the higher the annual payments.

3.6.

$50,000/$25,000 = 2.0 or a doubling in 6 years. The reciprocal of this is .50. Looking in Table A at
the back of the book, the discount factor for 12 percent is. 50663 and that for 13 percent is .48032.
Interpolating, we have

12% +

(.50663 - .50000)
= 12.25%
(.50663 - .48032)

as the interest rate implied in the contract in going from the end of year 6 to the end of year 12.

3.7.

a)

$10,000 = 2.9137x
x=

$10, 000
= $3, 432
2.9137

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b)

End of Year

Installment

Principal at Year End

Annual Interest

Principal Payment

$10,000

$3,432

7,968

$1,400

$2,032

3,432

5,652

1,116

2,316

3,432

3,011

791

2,641

3,432

421

3.011

3.8
Month

Payment

Interest

Principal Repayment

Remaining Balance

$8,000.00

$265.71

$80.00

$185.71

7,814.29

265.71

78.14

187.57

7,626.72

265.71

76.27

189.44

7,437.28

265.71

74.37

191.34

7,245 .94

265.71

72.46

193.25

7,052.69

265.71

70.53

195.18

6,857.51

265.71

68.58

197.13

6,660.37

265.71

66.60

199.11

6,461.27

265.71

64.61

201.10

6,260.17

10

265.71

62.60

203.11

6,057.06

11

265.71

60.57

205.14

5,851.92

12

265.71

58.52

207.19

5,644.73

13

265.71

56.45

209.26

5,435.47

14

265.71

54.35

211. 36

5,224.11

15

265.71

52.24

213.47

5,010.65

16

265.71

50.11

215.60

4,795.04

17

265.71

47.95

217.76

4,577.28

18

265.71

45.77

219.94

4,357.35

19

265.71

43.57

222.14

4,135.21

20

265.71

41.35

224.36

3,910.85

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21

265.71

39.11

226.60

3,684.25

22

265.71

36.84

228.87

3,455.38

23

265.71

34.55

231.16

3,224.23

24

265.71

32.24

233.47

2,990.76

25

265.71

29.91

235.80

2,754.96

26

265.71

27.55

238.16

2,516.79

27

265.71

25.17

240.54

2,276.25

28

265.71

22.76

242.95

2,033.31

29

265.71

20.33

245 .38

1,787.93

30

265.71

17.88

247.83

1,540.10

31

265.71

15.40

250.31

1,289.79

32

265.71

12.90

252 .81

1,036.98

33

265.71

10.37

255.34

781.64

34

265.71

7.82

257.89

523.74

35

265.71

5.24

260.47

263.27

36

265.90

2.63

263.27

$5 million
= $2, 009,388
3-9. a)
5
(1.20)

b)

c)

d)

$5 million
10

(1.10)

$5 million
20

(1.05)

= $1,927, 715

= $1,884, 443

$5 million
(.2)(5)

2.71828

$5 million
= $1,839,398
2.71828

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Chapter-4
Case 1 Bond Issue by NABARD
1.

YTM for 2009 issue


8250 x (1+YTM) ^ 10 = 20,000
(1+YTM) ^ 10 = 20,000 / 8250 = 2.424
Looking for the factor 2.424 in Table A (Future Value) in row 10, the YTM is between 9% to
10%. By intrapolation YTM=9.25%.

2.

YTM for 2010 issue


9500 x (1+YTM) ^ 10 = 20,000
(1+YTM) ^ 10 = 20,000 / 9500 = 2.105
Looking for the factor 2.105 in Table A (Future Value) in row 10, the YTM is between 7% to
8%. By intrapolation YTM=7.73%.
Fair Price = Present Value of Maturity Amount
= 20000 / (1+YTM)^9
As the YTM on current issue is 7.73%, the same should be used as the discount factor
Fair Price = 20000 / (1 +0.0773)^9 = INR 10233

3.

Case 2 Mark to Market Loss to the Banks


Hints:
1. The banks invest a certain % of their deposits in approved securities. These investments are shown
in the Balance Sheet at the Lower of Cost or Market principle. If the market value of the securities
decline below the acquisition cost, the banks suffer mark to marker loss.
2. Increase in yield results in decline in the market value of the fixed income securities as there is an
inverse relationship between yield and market price.
3. If the maturity of the portfolio is longer, the mark to market loss will be higher due to any increase in
yield as long term securities are more sensitive to change in YTM.
Concepts in Valuation

4.1.

a)

(1) If yield to maturity equals 11.6%, market price = $92.47


(2) If yield to maturity equals 9.2%, market price = $104.06

b) (1) If market price equals $1.10, yield to maturity = 8.10%


(2) If market price equals $94, yield to maturity = 11.26%
4.2.

$38 =

$100

[1+(/2)]16

Solving for r, the yield to maturity is found to be 12.47 percent.


4.3

(a)

Issued shares

1,532,000

Treasury shares

(b)

63.000

Outstanding shares

1,469,000

Authorized shares

1,750,000

Outstanding shares

1,469,000

Available shares

281,000

281,000 shares x $19 =

$5,339.000

Common Stock ($1 par)

$1,750,000

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Paid-in Capital*

10,372,000

*consists of $18 x 281,000 shares plus $5,314,000.

r
4.4. =

4.5.

$23 + 1 20 4
= = 20%
$20
20

(a) Market price per=


share

$1.50
= $37.50
.12 .08

(b) Market price per=


share

$1.50
= $30.00
.15 .10

(c) Market price per=


share

$1.50
= $37.50
.13 .09

The present strategy and strategy C result in the same market price per share.
4.6

Year

Dividend

$1.92

2.30

2.76

3.32

3.75

4.24

4.79

5.41

5.79

P8 at 16%

P8 at 17%

$64.33*

$57.90**

PV of 8 years of dividends and P8 (16%) = $33.46


PV of 8 years of dividends and P8 (17%) = $29.81
3.46
.16 +
=
16.95%
IRR =
33.46 29.81

* P8 = $5.79/(.16 .07) = $64.33


** P8 = $5.79/(.17 .07) = $57.90

4.7

Time

EPS

Dividend Payout

DPS

$2.000

2.400

.25

$0.600

2.880

.25

0.720

3.456

.25

0.864

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4.147

.25

1.037

4.645

.40

1.858

5.202

.40

2.081

5.827

.40

2.331

6.526

.40

2.610

6.917

Price 8 = $6.917 x 8.5 = $58.797


a)

Price 0 = present value at 14 percent discount rate of years 1 8 dividends plus the present value
of $58.797 at the end of year 8 = $26.65.

b)

Rate of discount that equates the present value of the expected dividend stream and price 8 with
$30, the present market price per share, is 12.18 percent.

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4.8

a)

Prob.

Return

0.1

10%

1%

0.2

0.3

10

3
6

0.3

20

0.1

30

Expected value

11%

Standard deviation = [0.1(10 11)2 + 0.2(20 11)2


+ 0.3(10 11)2 + 0.3(20 11)2 + 0.1(30 11)2]1/2
= 11.36 percent
(b) There is a 30 percent probability that the actual return will be zero or less. Also, we see that the
distribution is skewed to the left.
4.9

(a) Standardized deviation = (mean 0)/S.D.


= 20%/15% = 1.333
In Table C at the back of the book there is a .0968 probability for 1.30 standard deviaitions and
.0885 for 1.35 standard deviations. Interpolating for 1.333, we find the probability to be .0913 or
9.13 percent.
(b) 10%:

Standardized deviation = 10%/15% = .667.


Probability of 10% or less = 25.3%. Probability of a 10% or more return = 100%
25.3% = 74.7 percent.

20%:

50 percent probability of return being above 20 percent.

30%:

Standardized deviation = 10%/15% = .667. Probability of 30% or more return = 25.3


percent.

40%:

Standardized deviation = 20%/15% = 1.333. Probability of 40% or more return = 9.1


percent, the same as in (a)

50%: Standardized deviation = 30%/15% = 2.00. Probability of 50 percent or more


return = 2.3 percent.

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Chapter-5
MARKET RISK AND RETURNS
5.1
a)
Security
Morek
Kota
Fazio
No. Calif.
Grizzle
Pharlap
Excell

Amount, in
thousands

$6
11
9
7
5
13
9
$60
The expected portfolio return is 16.02 percent.
b)

Expected
Return

Proportion

Morck
Kota
Fazio
No. Calif
Grizzle
Pharlap
Excell

.100
.183
.150
.117
.083
.217
.150

$6
11
9
7
20
13
9

Weighted
Return
14%
16
17
13
20
15
18

1.12%
2.35
2.04
1. 21
5.33
2.60
2:16
16.81%
The expected portfolio return increases to 16.81 percent, because the additional funds are invested in the
highest expected return stock. Presumably this also is the most risky.
5.2. Expected value of return for portfolio = .333(.08) + .333(.15) + .333(.12) = .117
Standard deviation = [(.333).2 (l.00) (.02)2 +
2(.333) (.333) (.4) (.02) (.16) +
2(.333) (.333) (.6) (.02) (.08) + (.333)2 (1.00) (.16)2 +
2(.333) (.333) (.8) (.16) (.08) + (.333) (1.00) (.08)2]1/2
Standard deviation = .08
5.3
a)
Sierra
Dot
Portfolio
Pacific
Thermal Expected
Standard
Portfolio Proportion Proportion Return
Deviation
#1
#2
#3
#4
#5
#6
#1
#8
#9
#10
#11

1.0
.9
.8
.7
.6
.5
.4
.3
.2
.1
0

.080
.147
.120
.093
.267
.173
.120

1.40%
2.93
2.55
1.52
1.67
3.25
2.70
16.02%

0
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.0

12.0%
12.8
13.6
14.4
15 .2
16.0
16.8
17.6
18.4
19.2
20.0

14%
16
17
13
20
15
18

11.00%
10.77
10.96
11.55
12.48
13.69
15.11
16.69
18.38
20.16
22.00

b) The minimum variance portfolio consists of approximately .90 in Sierra Pacific Electric and .10 in Dot
Thermal Controls. The opportunity set curve is backward bending up to .10 in Dot Thermal Controls. The
efficient set is between this point and that where all funds are invested in Dot Thermal Controls.

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c)

Sierra
Pacific
Portfolio Proportion
#1
#2
#3
#4
#5
#6
#7
#8
#9
#10
#11

5.4.

b)

1.0
.9
.8
.7
.6
.5
.4
.3
.2
.1
0

Dot
Portfolio
Thermal
Expected Standard
Proportion Return
Deviation
0
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.0

12.0%
12.8
13.6
14.4
15.2
16.0
16.8
17.6
18.4
19.2
20.0

11.00%
11.55
12.29
13.19
14.22
15.36
16.58
17.87
19.20
20.58
22.00

Comparing the results in c) with those in a), there clearly is less reduction in standard deviation for
all combinations of investments. That is, there is less diversification effect. The minimum variance
portfolio is 1.0 invested in Sierra Pacific Electric and 0 in Dot Thermal Controls. There is no
backward bend in the opportunity set curve.
a) Plotting the risk-return tradeoff, we have:

The choice of portfolio depends upon the individual's indifference curve.


The efficient frontier is now described by the dashed line which emanates from 6 percent on the
vertical axis and passes through portfolio E.
Again, the selection of the best position depends upon the individuals utility function. The expected
return for the portfolio is
w(.06) + (l w) (.11)
where w is the proportion of the risk-free security which is held. (Negative if the individual borrows)
The standard deviation is
(1 w) .05

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5.5

All risk-free assets


Half and half
All market portfolio
One & one-half market portfolio

Expected return

Standard
deviation

10%
15
20
25*

0%
7.5
15
22.5**

*1.5 (market return)


.5 (risk-free rate)
**1.5 (market standard deviation)
5.6. Expected return = .08 + (.14 .08)1.67 = .1802 or approximately 18 percent.
5.7 a)

b)

The beta is approximately 1.4, as measured by the slope of the characteristic line. Answers will vary
depending on how the line is fitted. This beta indicates that the stock has significantly more risk than the
market in general.

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c)

Unsystematic risk is measured by the dispersion of the observations about the characteristic line. While
there is dispersion about the characteristic line in this case, such dispersion is only moderate as these
types of fittings go. Most of the risk of the stock is comprised of systematic risk and not unsystematic
risk.
Weighting Factor
0.60
0.70
0.80
Red Rocker Homes
1.56
1.52
1.48

Zaleski Electronics
1.34
1.38
1.42
Fairgold Foods
0.96
0.97
0.98
Pottsburg Water Distilling
0.92
0.89
0.86
5.9. Using Equation (3 7), security js expected return
.13 .07
= .07 +
(.08)(.20 )(.15)
2
(.15)
.13 .07
=
.07 +
13.4 percent
(.024 ) =
.0225
Thus, a return of 13.4 percent is required.
a) The required return would increase.
b) The required return would decrease.
c) The relationship is linear throughout and is called the security market line. The important point to
stress is that in market equilibrium, an expected return relationship with the market portfolio is
implied for all securities.
5.10. Perhaps the best way to visualize the problem is to plot excess returns (expected return minus the
risk-free rate), against the beta. This is done below. A security market line, then is drawn from zero
through the excess return for the market portfolio which has a beta of 1.0. (This excess return is
15% 10% = 5%.) The a) panel, for a 10% risk-free rate and a 15% mkt. return, indicates that stocks 1
and 2 are undervalued while stock 4 is overvalued. Stock 3 is priced so its expected return exactly
equals the return required by the market; it is neither overpriced nor under-priced.
With respect to the b) panel, for a 12% risk-free rate and a 16% market return, all of the stocks are
overvalued. It is important to point out that the relationships are expected ones. Also, with a change in
the risk-free rate, the betas are likely to change.
5.11. Required return = 10% + (15% 10%) 1.08 = 15.4%
Using the perpetual growth dividend model, we have
D1
$2
=
p0 =
= $45.45
k g (.154 .11)
5.12. The beta of a portfolio is a weighted average of the betas of the individual securities which make up
the portfolio.
Portfolio Beta = .20(1.40) + .20(.80) + .20(.60)
+ .20(1.80) + .10 (1.05) + .10 (.85)
= 1.11
The expected return for the portfolio is
Portfolio R = .08 + (.14 .08)1.11 = 14.66%

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Chapter 6
MULTIVARIABLE AND FACTOR VALUATION
6-1. a) The dividend yield is $3/$40 = 7.5%
R pp = .05 + .07(.80) + .10(.075 .05) = 10.85%
b)

R pp = .05 + .08(.80) + .25(.075 .05) = 12.03%


This might happen for the b coefficient if there were greater risk aversion among investors
and for the d coefficient if the capital gains tax rate were lowered relative to the tax rate on
dividend income.

6-2. R nf = .08 + .075(1.40) .03 ( .25) 17.75%


The covariance with inflation is an attractive feature and lowers the return that investors
require. That is, investors place a positive utility on a security that will provide a higher nominal
return in an inflationary environment. It helps stabilize the real rate of return that they realize
from holding the security.
If the covariance with inflation were negative instead of positive, the required return would be
greater. In this case it would be more than
R nf = .08 + .075(1.40) = 18.50%
Negative covariance would be an undesirable characteristic.
6-3. a) R tt = .09 + .08(1.10) .002(2) = 17.40%
b) R tt = .09 + .08(1.12) .002(9) = 16.16%
Cooper Chemical Company is very large while Tobias Tire Company is relatively small with
respect to market capitalization. Despite Cooper Chemical's slightly higher beta, the size effect
makes its expected return less than that of Tobias Tire Company. The beta does not capture all the
risk involved, and size in this problem adds explanatory power.
6-4. The price/earnings ratio is $27.20/$3.40 = 8 times.
R fb = .06 + .08(.90) .001(8 12) .002(6)
= 12.40%
Because the company has a lower price/earnings ratio than that of the market portfolio, the P/E
ratio effect is positive while the size effect is negative.
The formulas and coefficients presented for the extended CAPM are hypothetical. They are
indicative of the direction of likely effect, but not necessarily of the magnitude.
6-5. a) R lk = .14 + .8(.05) + 1.2(.02} + .3(.10) = 12.6%
During the period, the non factor related return, a, was high 14 percent. This was offset by negative
unanticipated changes in factors 2 and 3. Thus, the actual return for the period, with a zero error
term, was 12.6 percent.
b) (E )R lk = .08 + .04(.8) + .02(1.2) + .06(.3) = 15.4%
The expected return is found by multiplying the market prices of risk, the lambdas, times the
reaction coefficients, the bs, summing the products, and adding to this sum, which represents
the total risk premium, the risk-free rate. Thus, the expected return for the stock is 15.4 percent.
6-6.

R x = .05 + .10(.06) + 1.20(.07) + .90(.08) = 21.20%


R y = .05 + .80(.06) + .20(.07) + .40(.08) = 14.40%

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Security y has less systematic, factor risk than security x. In particular its reaction coefficients to
factors 2 and 3 are much less than those for security x. Although its reaction coefficient to factor 1 is
much higher, this does not offset the much lesser sensitivity to factors 2 and 3.
6-7. a) The required returns, using the two-factor model, are the following:
1) Bosco = .07 + .12(.80) + .04(.20) = 17.4%
This security has a required return in excess of that presently expected, 16 percent.
Bosco shares are over priced.
2) Target = .07 + .12(.10) + .04(1.10) = 12.6%
Here the required return is less than the return presently expected, 14 percent. Target
shares are underpriced.
3) Selby = .07 + .12(1.20) .04(.40) = 23.0%
The required return for Selby is greater than that presently expected, 20 percent. The
shares are overpriced.
b)

The arbitrager should sell of sell short the shares of Bosco Enterprises and Selby Glass, and
buy the shares of Target Markets. These actions, together with those of other arbitragers, will
drive down the share prices of Bosco and Selby, causing their expected returns to rise, and
drive up the share price of Target, causing its expected return to fall. These actions will
continue until the expected returns, based on current share price, equal the required returns
generated by the factor model. This assumes, of course, that the model accurately depicts the
equilibration mechanism. The lack of arbitrage opportunities reflects an efficient market in
the APT context.

6-8. The expected monthly return for Sawyer Coding Company is:

(E )R sc = .00412 .00013(1.4) .00063(2.0) + .01359(0.7) + .00721(.1.2)


.00521(0.8)
= .0167
The stock is highly sensitive to default risk in society, as depicted by the bond risk premium, factor
#4. It also is sensitive to industrial production.
6-9. The arbitrage pricing theory (APT) is an equilibrium model of asset pricing where the equilibrium
is driven by arbitragers eliminating arbitrage profits across multiple factors. The APT per se does
not tell us what factors are relevant. However, various financial economists have specified factors
which they believe are theoretically correct. The APT allows for multiple risks affecting security
returns. In contrast, the capital asset pricing model (CAPM) is a one factor model where the only
relevant risk is beta.
In both models, there a risk free return plus a premium, or premiums in the case of the APT, to
compensate for systematic (unavoidable) risk. Unsystematic risk is assumed to be diversified away.
The APT will be consistent with the CAPM as long as the covariance matrix for the CAPM can be
explained by the factors used in the APT.

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Chapter-7
OPTION VALUATION

7-1.

Option

Value of Option at
Expiration

$0

7-2. The difference in option prices for the two companies may be due to differences in two factors the length
of time to expiration of the option; and the volatility of the stock. More specifically, X-Theta Company's
option would be expected to have a longer period of time to expiration and/or its stock would be more
volatile than that of X-Gamma Company.
7-3. She will make money as long as the share price is $63.74 or below. For prices up to and including $60 per
share, she will make the full premium of $3.75 per option written. Her profit then declines proportionally
with stock price increases through $63.75. At that point she begins to lose money with subsequent share
price increases. The stock would have to rise to $68.75 for her to lose $5 per option written and to $73.75
for her to lose $10.
7-4. a) Expected value of share price:
Carson Can Company

$40

Tahoe Forest Products Company

36
.3(40 38) + .2(4238)

b) Option value for Carson Can =

+ . 15(46 38) = $2.60


Option value for Tahoe Forest Products = .2(44 -38)
+ .15 (50 38) = $3.00
c)

7-5. a)

The stock of Tahoe Forest Products Company has a much greater variance. As volatility is what gives
an option value, the option of Tahoe Forest Products has a greater expected value at the expiration date
than that of Carson Can. This occurs despite the fact that the stock has a lower expected value of market
price per share.
Hedge ratio =

$9 - $0
= .75
$50 - $38

One would purchase .75 shares of stock for every option that was written.
b)

Stock
Price

Value of Long Position


in Stock

$50

.75($50) = $37.50

$9

$28.50

38

.75 ($38) = $28.50

$28.50

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Options Short
Position Value

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Hedged Position
Value

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7-6.

[.75($40) V OB ] 1.05 = $28.50


1.05 OB = $31.50 $28.50
V OB = $3.00/1. 05 = $2 .857
The equilibrium value of the option at the beginning of the period is $2.857. If the actual market price is
above this amount, the rational individual would borrow as much as possible at 5 percent and invest in the
hedged position. By so doing, he/she would make a return on a riskless investment in excess of the risk-free
rate. If the actual market value of the option were below $2.857, he/she would buy the option, sell .75 shares
of stock short, and invest the proceeds of the short sale at the risk-free rate. By so doing the individual can
earn a return in excess of the risk-free rate on a risk-free investment.
The action of a number of individuals engaging in these transactions will drive the price of the option toward
$2.857, and such actions will continue as long, as there is opportunity for an excess return. At $2.857, the
return on a hedged position will equal the risk-free rate of 5 percent.

7-7. a)

2
ln (23 / 18)+
.06 + 1 / 2 (.05)
.25

= 1.165
d1 =
1/ 2
.50 [.25]
2
ln (23 / 18)+
.06 - 1 / 2 (.05)
.25

= .915
d2 =
1/ 2
.50 [.25]

n (d1 ) = N (1.165) = 1- .1221 = .8779


n (d 2 ) = N (.915) = 1- .1802 = .8198

v 0 = $23(.8779)b)

7-8. a)

$18
(.8198) = $5.65
(.06)(.25)

At $5.30, the option is undervalued according to the Black-Scholes formula. The rational individual
would buy one option and sell .8779 shares of stock short. He/she-would invest the proceeds of the
short sale at the short-term interest rate. In this way one could earn more than the shortterm interest rate
on a hedged position. (This solution assumes that there are no restrictions on the use of the proceeds of
the short sale).

d1 =

2
ln (23 / 18)+
.06 + 1/ 2 (.05)
1.0

1/ 2

.50 [1.0]

= .860

2
ln (23 / 18)+
.06 - 1/ 2 (.05)
1.0

= .360
d2 =
1/ 2
.50 [1.0]

n (d1 ) = N (.860) = 1- .1950 = .8050

n (d 2 ) = N (.360) = 1- .3595 = .6405

v 0 = $23(.8050)-

$18
(.6405) = $7.66
(.06)(1.0)

This compares with $5.65 when the length of time to expiration was 3 months. An increase in the
length of time to expiration widens the distribution of possible stock prices at expiration as well as
lowers the present value of the exercise price. Both impact favorably on the value of the option.
b)

2
ln (23 / 18)+
.08 + 1/ 2 (.05)
.2

= 1.185
d1 =
1/ 2
.50 [.25]

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2
ln (23 / 18)+
.08 - 1/ 2 (.05)
.25

= .935
d2 =
1/ 2
.50 [.25]

n (D1 ) = N (1.185) = 1- .1181 = .8819


n (D2 ) = N (.935) = 1- .175 = .8250

V0 = $23(.8819)-

$18

(.8250) = $5.73
(.08)(.25)

This compares with $5.65 before, so there is a slight increase in value. This occurs primarily because the
greater the interest rate, the less the present value of the exercise price.
2
ln (23 / 18)+
.06 + 1/ 2 (.10)
.25

= 5.227
d1 =
1/ 2
.10 [.25]

c)

2
ln (23 / 18)+
.06 - 1/ 2 (.10)
.25

= 5.177
d2 =
1/ 2
.10 [.25]

n (d1 ) = N (5.227) = 1.0


n (d 2 ) = N (5.177) = 1.0

V0 = $23(1.0)-

$18 - (1.00)
e(

.06)(.25)

= $5.27

This compares with $5.65 before. A decrease in the volatility of the stock lowers the value of the option
because it is extreme outcomes which make the option valuable.

7-9.

a)

2
ln (25 / 30)+
.08 + 1/ 2 (.20)
.50

= - .936
d1 =
1/ 2
.20 [.50]
2
ln (25 / 30)+
.08 - 1/ 2 (.20)
.50

= - 1.077
d2 =
1/ 2
.20[.50]

n (d1 ) = N (- .936) = .175


n (d 2 ) = N (- 1.077) = .141

v 0 = $25 (.175)-

$30
(.08)(.50)

(.141) = $0.31

or 31 cents per call option.


b)

Going through the same calculations as in a), but with share price at $30 and at $35 instead of at $25,
we find:
V 0 ($30) = $2.31
V 0 ($35) = $6.35
The theoretical lower boundary value at $25 is Max ($25 $30, 0) = 0. The theoretical lower
boundary at $30 is Max. ($30 $30, 0) = 0, and at $35 it is Max. ($35 $30, 0) = $5. The three
premiums over theoretical value are: $0.31 0 =$0.31; $2.31 0 = $2.31; and $6.35 $5.00 = $1.35.
At a $25 share price, the option is deep out of the money.

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At a $30 share price, the option is at the money, and at $35 per share it is in the money. In general,
an option is more valuable on a relative basis, as characterized by its premium over theoretical value,
when it is approximately at the money. The premium tends to decline as the option goes deeper into
the money or deeper out of the money. This is illustrated in Figure 5 6 in chapter 5, and is
confirmed in the problem solution here.
c) Solving for the implied standard deviation, we find it to be .476. This can be confirmed by setting the
standard deviation at .476, share price at $25, expiration at one-half year, and the interest rate at 8 percent
and solving for the option value in the usual manner. It is found, of course, to be $2.00. Much higher
volatility is necessary to justify an option price of $2, when the option is so far out of the money.
APPENDIX Problem Solution
a)

V c = 9 + 2 9.70 = $1. 30

b)

V s = 4 1 + 9.70 = $12.70

c)

V p = 12 + 5 + 9.70 = $2.70

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Chapter-8
PRINCIPLES OF CAPITAL INVESTMENT
Case: Expansion Plan
Hints:
Key Issues:
1. Should we consider consultants fees No. As the fee has already been incurred it is a sunk
cost, to be ignored.
2. Should cost of land be considered No. As the new project would be housed in existing
complex, there is no incremental cost, However the opportunity cost (benefit forgone) of
loss of rent @ Rs.2 million per month should be considered.
3. Overhead allocation Rs.500,000 per annum being the incremental overhead must be
considered. Overhead allocation of Rs.2 million can be ignored unless it is expected that the
new project would lead to proportionate cost of overhead.
4. Working capital @ 10% of first year sale would be taken as initial outflow in period 0. In
subsequent years incremental working capital requirement would be considered. The entire
working capital is assumed to be recovered at the end of the project life.
5. First years annual fixed costs are taken as:
Manpower cost
24,00,000
Maintenance
50,00,000
Other Expenses
24,00,000
Overheads
5,00,000
Opportunity Cost (Rent)
240,00,000
Total
343,00,000
The costs are assumed to increase by 3% per annum.
6. It is assumed that it is a new project of an existing profit making company. Hence the loss
from the project will be set off against the profits of the company resulting in tax savings.
7. It is assumed that the loan would be repaid at the end of the project life.
8. The discount rate is taken as 16% i.e. the cut-off rate.
9. Depreciation Schedule (Rs. 000)
Depreciation Schedule

Years
1

Equipment Depreciation Rate

25.0%

25.0%

25.0%

25.0%

25.0%

25.0%

25.0%

25.0%

25.0%

Depreciation

12500

9375

7031

5273

3955

2966

2225

1669

1251

Book Value (Cost - Depreciation)

37500

28125

21094

15820

11865

8899

6674

5006

3754

2816
20%

Site & Building Depreciation Rate

10
25.0%
939

20%

20%

20%

20%

20%

20%

20%

20%

20%

4,000

3,200

2,560

2,048

1,638

1,311

1,049

839

671

537

Book Value (Cost - Depreciation)

16,000

12,800

10,240

8,192

6,554

5,243

4,194

3,355

2,684

2,147

Total Annual Depreciation

16,500

12,575

9,591

7,321

5,593

4,277

3,273

2,507

1,923

1,475

Depreciation

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Projected Net Cash Flow

Years
0

Investment:
Long-Term Assets
Investment: Working
Capital
Annual Sale (Number'000)

-2170

-2506

-2895

-3344

-3862

-4460

-5152

-5950

-6873

-70000
-14000

(C) Pearson Education 2012

10

10000

11000

12100

13310

14641

16105

17716

19487

21436

23579

Sale Price per unit

14000

14700

15435

16207

17017

17868

18761

19699

20684

21719

Variable Cost per unit


Contribution Margin per
unit

11500

11845

12200

12566

12943

13332

13732

14144

14568

15005

2500

2855

3235

3640

4074

4536

5030

5556

6117

6714

Annual Sale

140000

161700

186764

215712

249147

287765

332369

383886

443388

512113

Total Variable Cost

115000

130295

147624

167258

189504

214708

243264

275618

312275

353807

Total Contribution Margin

25000

31405

39139

48454

59644

73057

89105

108268

131113

158306

Less : Annual Fixed Cost

34300

35329

36389

37481

38605

39763

40956

42185

43450

44754

Less : Depreciation

16500

12575

9591

7321

5593

4277

3273

2507

1923

1475

-25800

-16499

-6841

3652

15445

29017

44876

63576

85740

112076

EBIT
Interest
Profit Before Tax
Less : Taxes (25%)

5040

5040

5040

5040

5040

5040

5040

5040

5040

5040

-30840

-21539

-11881

-1388

10405

23977

39836

58536

80700

107036

-7710

-5385

-2970

-347

2601

5994

9959

14634

20175

26759

Profit After Taxes

-23130

-16154

-8911

-1041

7804

17983

29877

43902

60525

80277

Add :Depreciation

16500

12575

9591

7321

5593

4277

3273

2507

1923

1475

3780

3780

3780

3780

3780

3780

3780

3780

3780

3780

-2850

201

4461

10060

17177

26040

36930

50189

66228

85533

Add :Interest (1-T)


Operating cash flow
Terminal Cash Flow
Working Capital

51211

Net Cash Flow

-84000

-5020

-2306

1566

6717

13316

21580

31778

44239

59355

136744

Cumulative Cash Flow

-84000

-89020

-91326

-89760

-83043

-69728

-48148

-16370

27869

87225

223969

10. Cash Flow Estimates

(Rs.000)

11. NPV/ IRR Calculations


The NPV of the project is positive or IRR is greater than the cut off rate of 16%, therefore the
project is acceptable. The NPV is positive even after considering the opportunity cost i.e. rent
on the land. The payback period is over seven years which may be a cause of concern.
Period

Cash Flow

0
1
2
3
4
5
6
7
8
9
10

PVIF

(84,000)
(5,020)
(2,306)
1,566
6,717
13,316
21,580
31,778
44,239
59,355
136,744

1.0000
0.8621
0.7432
0.6407
0.5523
0.4761
0.4104
0.3538
0.3050
0.2630
0.2267

Net Present Value


IRR

Present
Value
(84,000)
(4,328)
(1,713)
1,003
3,710
6,340
8,857
11,244
13,494
15,608
30,998
1,212

16.19%

Pay Back Period

7 years
Solutions:

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8-1.

Average rate of return:


Project A = $1, 000/ $9,000 = 11.11%
Project B =

($1, 000 + $1, 000 + $4, 000) 3


$12, 000

= 16.67%

Payback period:
Project A = 2 years
Project B =2.25 years, or 2 years, 3 months
Net present value:
Project A = $345
Project B = $1,389
8-2. Average rate-of return ignores the time value of money and it is based on accounting income
rather than on cash flows.
The payback method ignores the time value of money and ignores cash flows after the
payback period.
8-3. Cash Flows:
Project A
Savings
Depreciatio
n Profit Bt
Taxes
(34%)
Cash flow
(Svgs - taxes)
$5,280

$8,000 $8,000 $8,000


5, 600 8,960 5,376
2, 400 (960) 2, 624
816

$7,184

Project B
Savings
Depreciation
Profit BT
Taxes (34%)
Cash flow
(Svgs taxes)
a)

(326)

$8,326

$8,000
3, 226
4, 774

$8,060 $8,000 $8,000


3, 225 1, 613
4, 775 6,387 8, 000

1,623

1,624 2,172

892

$7,108

$6,377

$5,000 $5,000 $6,000 $6,000


4, 000 6, 400 3,840 2,304
1, 000 (1, 400) 2,160 3, 696
340
$4,660

(476)

734

1,257

$6,376 $5,828

$7,000
2,304
4, 696
1,597

$5,476 $5,266 $4,743 $5,403

2,720

$7,000 $7,000
1,152
5,848 7, 000
1,988

2,380

$5,012 $4,620

Payback project A = 3.84 years to recover $28,000


Payback project B = 3.97 years to recover $20,000

b)

NPV project A = $1,358


NPV project B = $1,600

c)

PI project A = $29,358/$28, 000 = 1.05


PI project B = $21,600/$20,000 = 1.08

d)

IRR project A = 15.68 percent


IRR project B = 16.58 percent

Project B dominates on all measures except payback.

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8-4. a) A = 34.90% B = 31 .61%


b)

NPV of Project A = $5,849


NPV of Project B = $10,490

c)

On theoretical grounds, B is preferred because it provides a greater net-present value in


absolute terms. This assumes that the appropriate reinvestment rate is the discount rate of
10 percent. The different answers given are due to different implied compounding rates
for the IRR and NPV methods.

8-5. a)

Amount of Cash Outflow

Salvage 8
PV of Cash
Outflows 8%

Time

Patterbilt

Bulldog

Best

$74,000

$59,000

$44,000

2,000

3,000

4,000

2,000

4,500

5,000

2,000

6,000

6,000

2,000

22,500

44,000

13,000

9,000

5,000

4,000

10,500

6,000

4,000

12,000

7,000

4,000

13,500

8,000

9,000

5,000

18,000

$91,625

$111,273

$94,960

The Patterbilt bid should be accepted as the lower maintenance and rebuilding expenses more
than offset its higher cost.

b) PV of Cash
Outflows 15%

$87,772

$98,125

$84,804

With a higher discount rate, more distant cash outflows become less important relative to
the initial outlay. As a result, the bid with the lowest initial investment, Best, should now
be accepted.

8-6.

Cash flows:
Cost
Savings
Depreciation
Profit BT
Taxes (38%)
Net Cash Flow
Svgs. Taxes

0
60,000

60,000

20,000
19,998
2
1

20,000
26, 670
- 6, 670
2,535

20,000
8,886
11,114
4,223

19,999

22,535

15,777

20,000 20,000
4, 446
15,554 20, 000
5,911
7,600
14,089

12,400

Net Present Value of Project at 15% = -$976


The project is not acceptable.
8-7 a)
0

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60,00

Cost

Savings

20,000

21,200

22,472

23,820

Depreciation

19,998

26,670

8,886

4,446

Profit BT

5,470

13,586

19,374

25,250

Taxes (38%)

2,079

5,163

7,362

9,595

19,999

23,279

17,309

16,458

15,655

Net Cash Flow


Svgs. -Taxes

60,000

25,250

Net present value of project at 15% = $3,567


The project is now acceptable where before it was not. This assumes the discount rate is
the same as before, 15 percent, and does not vary with inflation.
b)

Cash outflow at time 0 = $60,000 + $10,000 = $70,000


Present value of cash inflows

63,567

Present value of $10,000 received at the end of year 5 (working capital recovered) 4,972
Net present value
1,461

8-8.a)
Project

Selecting those projects with the highest index values would indicate:
Amount

P.I.

Net Present Value

$500,000

1.21

$105,000

350,000
$850,000

1.20

70,000
$175,000

However, utilizing the full budget will be better, even though the most profitable project
is foregone.
3
5
4

$350,000
200,000
450,000
$1,000,000
b)

1.20
1.20
1.18

$70,000
40,000
81,000
$191,000

No. The resort should accept all projects with a positive NPV. If capital is not available
to finance them at the discount rate used, a higher discount rate should be used which
more adequately reflects the costs of financing.

8-9. Most likely outcome:


Year
1
$2
3
5
5
0

Net Income
Depreciation
Cash Flow
Less Investment
Free Cash Flow
Present Value 15%

2
$3
4
7
5
2
1.512

3
$4
4
8
4
4
2.630

4
$5
4
9
4
5
2.859

5
$5
4
9
4
5

6
$5
4
9
4
5

2.486

2.162

7 on
$6
4
10
4
6
*17.293

*Value at end of year 6 of $6 million annually forever = $6 million/ 15 = $40 million. Present value
of $40 million at the end of year 6 = $17,293 million.
Present value of the acquisition = $28.942 million.

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For each series of estimates of net income, depreciation and investment, one can compute the
present value of the acquisition in the manner described. However, one may wish to use the
risk-free rate as the discount rate in order to avoid the double counting of risk as described in
the chapter. The expected value of the probability distribution of possible present values is
simply the weighted average (probability of occurrence times the adjusted P.V.) of the
possible present values. The standard deviation of the distribution is calculated in the manner
described earlier. With this information, one can judge the acquisition.
8-10. This problem is the same as that shown in the appendix for dual rates of return except the
numbers have been halved. Setting the problem up using the quadratic formula:
- 5, 000 5, 000
+
- 800 = 0
2
(1 + r ) (1 + r )

- b b 2 - 4ac
1
=
2a
(1 + r )
- 5, 000
1
=
(1 + r )
1

(1 + r )

25, 000, 000 - 16, 000, 000


- 10, 000

- 5, 000 3, 000
- 10, 000

1
= .20,.80
(1 + r )
1 + r = 1 / .20 = 5, 1 / .80 = 1.25
r = 400 percent and 25 percent
Thus, the problem does not have a unique IRR, but dual rates of return.
With an initial outlay of $1,250, we have

- 5000
1
=
(1 + r )

25, 000, 000 - 25, 000, 000


- 10, 000

- 5, 000
1
=
(1 + r ) - 10, 000
1

(1 + r )
1+ r =

= .5
1
= 2
.5

r = 100 percent
Thus, a unique IRR is implied here. If students obtain 25 percent in the first case, it is
useful to question them on a higher initial outlay resulting in a higher IRR. The problem
serves to illustrate the pitfalls of multiple internal rates of return and of financing projects
in general.
8-11.

At 0 percent discount rate:


present value of inflows = $600
present value of outflows = .300
$300
At 25 percent discount rate:
present value of inflows = $456
present value of outflows = 240
$216
At 100 percent discount rate:

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present value of inflows = $300


present value of outflows =150
$150
At 400 percent discount rate:
present value of inflows = $216
present value of outflows = 60
$156
At all interest rates, the present value of inflows exceeds the present value of outflows.
Therefore, there is no internal rate of return.

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Chapter-9
RISK AND REAL OPTIONS IN CAPITAL
BUDGETING
9 1.

The standardized difference for a given amount is:


x - NPV
S=
SD
For zero or less: S = (0 20,000)/10,000 = 2.0
For $30,000 or more: S = (30,000 - 10,000)/10,000 =1.0
For $5,000 or less: S = (5,000 20,000)/10,000 = 1.5
From Appendix Table C at the back of the book, one finds that these standardized differences
correspond to probabilities of .0228, .1577, and .0668 respectively.

9.2. a) Expected value Period 1 = $3,000


Expected value Period 2 = $2,400
Expected value Period 3 = $2,100
Present value of cash flows at 7% = $6, 614
Net present value = $5,000 + $6,614 = $1,614
b) Standard deviation about the expected value =
(1,000)2 ( 917)2 ( 943)2

+
+
Square Root of
2
4
6
(1.07)
(1.07) (1.07)
= $1,452
The standard deviations of the three distributions of possible cash flows are computed in the usual manner with
Eq. (2 1), giving 1,000, 917, and 943 respectively.
c)

$1,614/$1,452 =1.11 standard deviations


Probability of 1.11 standard deviations = .134.
The probability of the NPV being zero or less is .134.

d)

1.000 .134 = .866

e)

Profitability index = 1.00 if the NPV is zero. Thus, the probability is .134.

f)

If the P.I. = 2.00, the NPV is $5,000.

Thus,

5,000 1,614 3,386


= = 2.33
1,452
1,452

The probability of 2.33 standard deviations is 01, or 1 percent.


9.3 . a) Branch
1
2
3
4
5
Joint Probability
.12
.16
.12
.24
.24
b) Present value of cash flows at 10%: (with rounding)
Year 0

Year 1
$1,364

6
.12

Year 2
$$826
1,240
1,653

Branch
1
2
3

NPV
$810
396
17

1,653

926

Total
1.00

$3,000
2,273

2,066
5
1,339
2,479
6
1,752
NPV = .12(810) + .16(396 + .12(17) + .24(926) + .24(1,339) + .12(1,752) = $595
SD = [.12(810 595)2 + .16(396 595) 2 + .12(17 595) 2 + .24(926 595) 2 + .24(1,339 595) 2 +
.12(1,752 595)2] = $868

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c)

Standardizing the difference from zero, we have 595/868 = .685. Looking in Appendix Table C at the
back of the book, we-find that .685 corresponds to an area of approximately. 25. Therefore, there is
approximately one chance out of four that the NPV wi11 be zero or less.
9.4. a)
Period 0
Period 1
Period 2
Period 3
Overall
Cash
Cash
Cond.
Cash
Cond.
Cash
Joint
Net
Flow
Prob.
Flow
Prob.
Flow
Prob.
Flow
Prob.
Present
Value
0.4
1.0
0
0.2
$300
$1,272
0.5
0
0.6
0
1.0
0
0.3
$1,000
0.5
$800
0.05
$1,550
0.2
$1,000
$1,000
0.5
$1,200
0.05
$1,896
0.5
$1,200
0.15
$2,259
0.5 $1,000
0.6
$1,400
0.5
$1,600
0.15
$2,604
0.5
$1,600
0.05
$2,967
0.2
$1,800
0.5
$2,000
0.05
$3,313
b)

The expected value of net present value of the project is found by multiplying together the last two
columns above and totaling them. This is found to be $661.
c)
The standard deviation is:
[. 2(l,272 661)2 + .3(1,000 661)2
+ .05(1,550 661)2 + .05(1,896 . 661)2
+ .15(2,259 661)2 + .15(2,604 661)2
+.05(2,967 661)2 + .05(3,313 66l)2] = $1.805
Thus the dispersion of the probability distribution of possible net present values is very wide. In turn, this is
due to a 50 percent probability of a zero outcome or less.
9 5.
a) Project
P.I.
SD/(Cost + NPV)
A
1.100
0.18
B
1.200
0.50
C
1.125
0.04
D
1.500
0.67
E
1.150
0.13
b)
Project A is dominated by both E and C. Project B is dominated by A, C, and E. Project C is dominated
by none of the others. Project D is dominated by all of the other projects. Project E is dominated by C.
c)
Not in any realistic system.
d)

e)

Project
NPV/SD
Probability Greater Than
A
.50
.692
B
.33
.629
C
2.50
.994
D
.50
.692
E
1.00
.841
No solution recommended, although most people would want Project C.

9-6. Net present values:


1 and 2 = $10,000
+
$8,000 = $18,000
1 and 3 = 10,000
+
6,000 = 16,000
2 and 3 = 8,000
+
6,000 = 14,000
Standard deviations:
1 and 2 = [(4,000)2 + 2 (0.6) (4,000) (3,000) + (3,000)2] = $6,277
1and 3 = [(4,000)2 + 2 (0.6) (4,000) (4,000) + (4,000)2] = $6,693
2 and 3 = [(3,000)2 + 2 (.7) (4,000) (3,000) + (4,000) 2] = $6,465
Combination 1 and 2 dominates the other two combinations.

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9-7.a)

b) E, J, H, and G dominate the rest .


9.8.

a)

NPV of initial project at 18 percent required return $13,443. The project is not acceptable.

b) Cost of expansion = 100 cages x $200 = $20,000


NPV at time 0 of $20,000 in year 4 and $17,000 in years 5 through 15 = $30,510.
Option value = 0.5 ($30, 510) + 0.5(0) = $15,255.
Project worth = $ 13,443 + $15,255 = $1,812.
The option value enhances the project sufficiently to make it acceptable.
9-9
Branch
Continue statewide

1
2

Distribute regionally
Branch EPV = $18,908

NPV
$14, 032
23 ,821
7,443

3
Statewide
EPV = $12,978
Continue statewide

4
5

859
8,902

6
7
8

5,203
44,376
153

Distribute regionally
Branch EPV= $2,382

Regionally
EPV = $26,687

Immediate regional distribution has a higher expected present value and less risk as measured by the
probability of loss (none in this case.)
9.10.

a) Net present value of cash flows:

NPV
$1,729

Joint
Prob.
.09

2
3

872
15

.15
.06

911

.12

1,769

.16

2,626

.12

Branch

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3,551

8
4,408
9
5,266
Mean net present value = $1,769.
b)

.06
. 15
.09

The present value of abandonment value at the end of year 1 is $4,167. Therefore, the project would be
abandoned if the period l cash flow turned out to be $6,000. (The mean of present value for period 2 is
lower than the abandonment value.) It would not be worthwhile to abandon the project if either of the
other year 1 outcomes occurred.
The present values of cash flows are the same as in the a) solution, except for the first branch which has
a mean NPV of $723.
The mean net present value of the overall project is now
.3($723) + .12($911) + .16($l,769) + .12($2,626) + .06($3,551) + .15 ($4,408) + .09($5,266) = $2,273.
Thus, the mean net present value is increased when the possibility of abandonment is considered in the
evaluation. Part of the downside is eliminated.

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Chapter 10
CREATING VALUE THROUGH REQUIRED RETURNS
Case: WACC of HUL
Hints:

1. WACC is dependent upon the cost of debt, cost of equity and the proportion of debt
and equity. In the last 10 years the cost of debt for HUP has ranged from 3.38% to
8.61% and cost of equity has ranged from 12.95% to 19.7%. The proportion of debt
has been very low as a result the WACC is closer to cost of equity.
2. In case of HUL the use of market value weights would not have major impact as the
proportion of debt is close to zero. Otherwise if market value weights are used the
WACC would increase.
3. Reduce cost of debt, cost of equity and use of higher proportion of debt to reduce
WACC. Cost of equity could be reduced by lowering the beta more stable the
earnings stream is, lower will be the beta.
Solutions
r = .10 + (.15 .10)1.10 = 15.5%

10.1 a)
b)
c)

minimum r = .10 + (.15 .10) 1.00

= 15.0%

maximum r = .10 + (.15.10) 1.40

= 17.0%

r for beta of 1.20 = .10 + (.15 .10) 1.20

= 16.0%

r for beta of 1.30 = .10 + (.15 .10) 1.30

= 16.5%

Expected Value of r = 0.2(15.0%) + 0.3(15.5%) + 0.2(16.0%) + 0.2(16.5%) + 0.1(17.0%)


=15.85%
10.2. a)

Peerless unlevered beta =

Beta
[1 + ( D / S )(1- T )]

1.15
= 1.00
[1 + 0.25(1- .4)]

Adjusted beta for Willie Sutton using its debt ratio of 0.75:
1.00 [1 + 0.75 (1.4)] = 1.45
An adjusted beta of 1.45 is appropriate for the new venture if the assumptions of the CAPM
hold, save for corporate taxes.
b) After-tax cost of debt = 15% (l .4) = 9.00%
Cost of equity = 13% + (17% 13%) 1.45 = 18.8%
Weighted average required return for the project:

9%
10.3. k e =

[0.75]

[1.00]
+ 18.8%14.6%
=
0.75 + 1.00
0.75 + 1.00

3
+ .20 = 21.0%
300

P = $3/(.21 .15) = $50


This problem allows the instructor to illustrate the problems involved in the use of the perpetual
growth model and the extreme sensitivity of it to the growth assumption.
10.4. End of Year
1
2

Dividend
per share
$2.240
2.509

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PV at 12 Percent
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2.000

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3
4
5
6 on

2.810
2.978
3.157
3.347

2.000
1.893
1.791
15.826 *
$25.510

1.947
1.826
1.713
13.974 **
$23.407

k e = .12 +.510/(25.510 23.407) = 12.24%


*

Implied value at end of year 5 = 3.347/.12 = $27.89. PV of $27.89 at end of year 5 = $27.89 x
.56743 = $15.826.

** Implied value at end of year 5 = 3.347/.13 = $25.75. PV of $25.75 at end of year 5 = $25.75 x
.54276 = $13.974.
10.5. a)

k i = k(l t)
k i = 10.40% (1-.30) = 7.28%

b) k p = 10 +
c)

.2(110 - 100) 12
=
= 11.43%
.5(210)
105

K e = D/P = 2/16 = 12.5%

d) K e = D 1 /P 0 + g = 2/16 +.05 = 17.5%


10.6. a)
Method
Debentures
Preferred
Stock

After-Tax Cost
Weights
Weighted Cost
7.8%
.375
2.93%

12.0
Common
Stock

17 .0
Weighted average cost

.125

1.50

.500

8.50
12.93%

b) It is appropriate under the following conditions:


(1) The costs have been accurately measured and they represent marginal future costs. With
respect to the cost of equity, residual risk is not a factor of importance. (The CAPM
implies that only systematic risk is important.)
(2) The firm intends to finance in the above proportions in the future.
(3) The investment projects of the firm are homogeneous with respect to systematic risk, and
the investment proposals under consideration have the same relative systematic risk.
10.7. Flotation costs of debt = $200,000 x .02 = $4.000
Flotation costs of stock = $200,000 x .15 =

30000
$34, 000

NPV = ($90,000/.145) $600,000 $34,000 = $13,310


The proposal should be rejected. Without flotation costs, however, the NPV would have been
positive and the proposal acceptable.
10.8. a)

Schedule of interest payments and present values:


Year
1
2
3
4
5
6

(1)
Beginning debt level
$18,000
15,000
12,000
9,000
6,000
3,000

(2)
Interest (1) 12%
$2,160
1,800
1,440
1,080
720
360

(3)
Tax shield (2) 30%
$648
540
432
324
216
108

Present value of column (3) at 12% = $1,700


Present value of after-tax operating cash flows of $10,000 per year for six years discounted at

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16% = $36,847.
APV = $30,000 + $36,847 + $1,700 $1,000 = $178
The project is acceptable.
b) If cash flows are $8,000 per year instead of $10,000 the present value of after-tax operating
cash flows becomes $29,478.
APV = $30,000 + $29,478 + $1,700 $1,000 = $178
The project is still acceptable, but barely.
10.9. a)

Required rates of return:


Leisure = .07 + (.13 .07) 1.16 = 13.96%
Graphics = .07 + (.13 .07) 1.6 4 =16.84%
Paint = .07 + (.13 .07) 0.70 = 11.20%
Projects #1, #2, #4, #6 and #7 would be accepted, as their expected returns are above the
divisions required rate of return. Projects #3, #5 and #8 would be rejected. It is interesting 'to
note that project #5 (13% expected return) and project #8 (16% expected return) are rejected
and yet they have higher expected returns than project #2 (12% expected return) which is
accepted by the paint division. The reason is the lower systematic risk of the paint division,
which makes the acceptance of this project appropriate.

b) All of the assumptions of CAPM model must be invoked. In addition, the investment
proposals and existing investment projects of each division must be homogeneous with respect
to risk.
10.10. a) Required rates of return:
Leisure = 6% (0.4) + 13.96% (0.6) = 10.78%
Graphics = 6% (0.4) + 16.84% (0.6) =12.50%
Paint = 6% (0.4) + 11.20% (0.6) = 9.12%
All of the projects are now acceptable, with these lower required returns.
b) If residual risk were important, the required return would be higher. How much higher will be
subjective in practice, though theoretical models will give precise answers, with assumptions
of course. Some of the projects may no longer be acceptable with the higher required returns.
10.11. a) Plotting the 16 possible portfolios of assets, we obtain:

b) The preferred portfolio depends upon the risk preferences of the student. It is useful to note
that the frontier consists of portfolios 1, 3, 7, 9, 12, and 16.
c)

A risk neutral individual would choose portfolio #12. as is apparent if you superimpose 45

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degree indifference lines.


10.12. a) Present value without the acquisition using the perpetual dividend growth model:

$600, 000
= $7,500, 000
.14 - .06
Present value with the acquisition =
$600, 000 + $125000
= $8, 055,556
.15 - .06
Difference = $8,0,55,556 $7,500,000 = $555,556
As this amount is less than the acquisition price of $750,000, Red Wilson Rod, Inc. should not
be acquired. It raises the required rate of return not only for the incremental cash flows, but for
the cash flows before the merger as well.
b)

$600, 000 + $125, 000


= $9, 062,500
.14 - .06
Difference = $9,062,500 $7,500,000 = $1,562,500
Under these circumstances, the acquisition would be worthwhile.

c)

$600, 000 + $125, 000


= $10,357,142
.15 - .08
Difference = $10,357,142 $7,500,000 = $2,857,142
The acquisition would be very worthwhile if this increase in growth occurred.

10-13. a) The average annual return for the market index over the last ten years is 13 percent, and the
average risk-free rate is 7 percent. The following can be derived:
(1)
Year

(2)

(3)

Excess Market Excess Market Returns 2 Excess Project


Return (M)
Squared (M)2(1)2
Return (K)

Cross Product Excess


Returns (MK)(1) (3)

19_0

.06

.0036

.09

.0054

19_1

.10

.0100

14

.0l40

19_2

(.08)

.0064

(.12)

.0096

19_3

.17

.0289

.22

.0374

19_4

.12

.0144

. 18

.0216

19_5

.21

.0441

.27

.0567

19_6

(.15)

.0225

(.19)

.0285

19_7

.18

.0324

.23

.0414

19_8

.07

.0049

.12

.0084

19_9

(.08)

.0064

(.18)

.0144

.60

.1736

.76

.2374

Totals
Average
Return
Beta =

.06

MK M 2

.076

nMK
nM

= ss
The beta also can be determined (and more easily) with a regression routine where the excess
project return is regressed against the excess market return.
b) The estimated cost of capital of the project is

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Rk = i + ( R m - i )bk = 7% + (13% - 7%) 1.39 = 15.34


percent

The critical assumption is that the relationship between future returns for the spinning project
and market returns will be roughly the same as that depicted over the last ten years for Super
Splash Spinning Company and the market index. The usual assumptions of the capital-asset
pricing model also are important. (See Chapter 3).

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Chapter 11
THEORY OF CAPITAL STRUCTURE
11.1. a)

NOI

$10,000,000

Overall required return

.09091

Total market value of firm

90,910,000

Market value of debt

20.000.000

Market value of stock

$70,910,000

Implied required return on equity = E/S


=

$8, 600, 000


= 12.1%
70,910, 000

b) Total market value of firm

$90,910,000

Market value of debt

30,000,000

Market value of stock

$60,910,000

Implied required return on equity = E/S


=
11.2. a)

$7,900, 000
= 13.0%
60,910, 000

(1)

Sell Green stock for $22,500.

(2)

Borrow $20,000 at 12 percent interest.

(3)

Buy $40,000 of Kelly stock.


Return on Kelly stock (1% ownership) $6,000
Interest on personal loan

2,400

Net return

$3,600

This is the same dollar return as his return from holding 1 percent of Green Company
stock. However, the net funds involved are less. $40,000 minus a loan of $20,000 =
$20,000. This compares with an investment outlay of $22,500 in the case of the Green
Company.
(b)

11-3 .

a)

When there is no further opportunity for employing fewer funds and achieving the same
total dollar return. At this point, the total value of the two firms must be the same, as must
their average costs of capital.
$400,000 debt,

b)
# Shares

Amount of
Debt

100,000

EBIT

250,000

EBT

EAT

EPS

EPS
= ke
P

250,000

125,000

$1.25

12.5%

90,000

100,000

250,000

10,000

240,000

120,000

1.33

12.7%

80,000

200,000

250,000

20,000

230,000

115,000

1.44

13.3%

70,000

300,000

250,000

31,500

218,500

109,250

1.56

14.2%

60,000

400,000

250,000

44.000

103,000

1.72

15.4%

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206,000

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50.000

500.000

250,000

60,000

190.000

95.000

1.90

18.1%

40,000

600,000

250 .000

84,000

166,000

83,000

2.08

21.95%

ko = we ke + wi ki
1.0 x 12.5%

+ 0 x 0%

= 12.5%

0% =.12.5%

.9 x 12.7

+.

1x5

=11.4

0.5 =11.9

.8 x 13.3

+.

2x5

=10.6

1.0 = 11.6

.7 x 14.2

+.

3 x 51/4

= 9.9

1.6 =11.5

.6 x 15-4

+.

4 x 51/2

= 9.2

2.2 = 11.4

.5 x 18.1

+.

5x6

= 9.0

3.0 = 12.0

.4 x 21.9

+.

6x7

= 8.8

4.2 = 13.0

c) Yes. The optimal capital structure involves $400,000 in debt .

11.4. a)
All
Equity
EBIT (in thousands)
$1,000
Interest to debtholders
0
Profit before taxes
1,000
Taxes (.40)
400
Income available to
common stockholders
$600
Income to debtholders plus
income to stockholders
$600
b) Present value of tax shield (in thousands) = 0.40 ($3,000) = $1,200.

Debt &
Equitv
$1,000
450
550
220
$330
$780

c) Value of all equity financed firm (in thousands) $600/0.20 = $3,000.


Value of recapitalized company (in thousands) $3,000 + $1,200 = $4,200.
11.5. a) Tax advantage - t c B = (.35) $4,000,000 = $1,400,000
b) Tax advantage = 1

(1.35)(1.25)

$4

1.30

= $1,214,286

The tax advantage is reduced because investors must pay personal taxes that differ according
to whether income is common stock income or debt income. The lower the tax on the former in
relation to that on the latter, the less the tax advantage of corporate leverage to investors
overall. Because investors overall hold both debt and common stock, an increase in corporate
leverage will increase the personal taxes that they must pay.
c) Tax advantage = 1

(1.35)(1.30)

$4

1.30

= (.35)$4 million = $1,400,000

When the personal tax rate on stock income equals that on debt income, the tax advantage
becomes the corporate tax shield, the same as computed in a)
Tax advantage = 1

(1.35)(1.20)
1.30

= $1,028,571

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The greater the differential between the personal tax rate on stock income and that on
debt income, the lower the tax advantage .
11.6.
(1)
Debt
level
$0
1
2
3
4
5
6
7
8

(2)
Value of
unlevered firm
$10
10
10
10
10
10
10
10
10

(3)
PV of Tax Shield
(1) x .22
0
.22
.44
.66
.88
1.10
1.32
1.54
1.76

(4)
PV of
Bankruptcy Costs
0
0
.05
.10
.20
.40
.70
1.10
1.60

(5)
Value of Firm
(2) + (3) (4)
$10.00
10.22
10.39
10.56
10.68
10.70*
10.62
10.44
10.16

The optimal amount of debt is $5 million.


11.7.
a) Debt
Debt + Eq.

(1)
After Tax
Debt Cost

(2)
Debt
Weight

(3)
Weighted
Cost Debt

(4)
Equity
Cost

(5)
Equity
Weight

(1) (2)
0
.10
.20
.30
.40
.50
*.60
.70
.80
b)
0
.10
.20
.30
*.40
.50
.60
.70
.80

(6)
(7)
Weighted
Weighted
Cost
Average Cost of
Equity Capital (3) + (6)
(4) x (5)

0
4%
4
41/4
41/2
5
51/2
61/4
71/4

0
.1
.2
.3
.4
.5
.6
.7
.8

0
0.4%
0.8
1.275
1.8
2.5
3.3
4.375
6.0

10%
101/2
11
111/2
121/4
131/4
141/2
16
18

1.0
.9
.8
.7
.6
.5
.4
.3
.2

10.0%
9.45
8.8
8.05
7.35
6.63
5.8
4.8
3.6

10.0%
9.85
9.6
9.325
9.15
9.13
9.1
9.175
9.6

0
4%
4
41/4
41/2
5
51/2
61/4
71/2

0
.1
.2
.3
.4
.5
.6
.7
.8

0
0.4%
0.8
1.275
1.8
2.5
3.3
4.375
6.0

10%
101/2
111/4
12
13
141/2
161/4
181/2
21

1.0
.9
.8
.7
.6
.5
.4
.3
.2

10.0%
9.45
9.00
8.4
7.8
7.25
6.5
5.55
4.2

10.0%
9.85
9.8
9.675
9.6
9.75
9.8
9.925
10.2

With bankruptcy and agency costs, the optimal capital structure (*) is 40 percent debt in
contrast to 60 percent without them.
11.8 .a)

ln (8 / 4)+
.06 - 1 / 2(.2) 2

3 = .93315 = 2.69
d1 =
.2 Sq. root of 3
.34641
2
ln (8 / 4)+
.06 + 1/ 2 (.2)
3 .81315

d2 =
=
= 2.35
.2 Sq. root of 3
.34641

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n (d1 ) = 1- .0036 = .9964


n (d 2 ) = 1- .0094 = .9906
Value of stock = $8 million (.9964) -

$4 million
(.9906) = $4, 661,525
e(.06)(3)

Value of Debt = $8,000,000 $4,661,525 = $3,338,475


b)

d1 =

2
ln (8 / 4)+
.06 + 1 / 2(.5)
3 1.24815

=
= 1.44
.5 Sq. root of 3
.86603

2
ln (8 / 4)+
.06 - 1/ 2 (.5)
3

= .49815 = 0.58
d2 =
.5 Sq. root of 3
.86603

n (d1 ) = 1- .0750 = .9250


n (d 2 ) = 1- .2811 = .7189
Value of stock = $8 million (.9250) -

$4 million
(.7189)
e(.06)(3)

= $4,998, 096
Value of Debt =$8,000,000 - $4,998,096 = $3,001,904
c) The stockholders gain at the expense of the debt holders by virtue of decisions which make the
firm more risky. As with any option, increased volatility of the underlying asset increases the
value of the option, all other things the same. The debt holders can protect themselves by
imposing protective covenants at the time the loan is made which restrict changes in the risk
complexion of the company.
11.9. a) d1 =

2
ln (8 / 6)+
.06 + 1 / 2(.5)
3 .84286

= .97
=
.5 Sq. root of 3
.86603

2
ln (8 / 6)+
.06 + 1/ 2 (.5)
3

= .09268 = .11
d2 =
.5 Sq. root of 3
.86603

n (d1 ) = 1- .1657 = .8343


n (d 2 ) = 1- .4562 = .5438
Value of stock = $8 million (.8343) -

$6 million
(.5438) = $3,949, 080
e(.06)(3)

Value of Debt =$8,000,000 $3,949,080 = $4,050,920


b)
Old Level

New level

Percent Increase

Face value of debt

$4,000,000

$6,000,000

50%

Value of debt

3,001,904

4,050,920

35

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Due to the increased default risk, the debt increases in value by a lower percent than does
its face value. The old debt holders suffer. If the face value per bond were $1,000, there
would be 4,000 bonds outstanding. Before, a bond is worth $3,001,904/4,000 = $750.48.
After the increase in debt, each bond is worth $4,050,920/6,000 = $675.15. Again the
existing debt holders can protect themselves against this occurrence with protective
covenants in the contract.
11.10. According to the notion of asymmetric information between management and investors, the
company should issue the overvalued security, or at least the one that is not undervalued. This
would be debt in the situation described in the problem. Investors would be aware of
managements likely behavior and would view the event as good news. The stock price might
rise, all other things the same, if this information was not otherwise conveyed.
In contrast, if the stock were believed to be overvalued, management would want to issue the
stock. This assumes it wishes to maximize the wealth of existing stockholders. Investors would
regard this announcement as bad news, and the stock price might decline. Information effects
through financing imply that the information is not otherwise known by the market. Management
usually has a bias in thinking the stock of the company is undervalued.

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Chapter12
MAKING CAPITAL STRUCTURE DECISIONS
Case : Debt policy of Asahi India Glass Limited
Hints:
1. The company has expanded its operations in the last ten years. The assets of the company
increased at the rate of 39% per annum whereas the shareholder funds have increased @ 23%
per annum largely because of retained earnings. The company has used a retained earnings
and borrowed funds for funding its expansion (pecking order theory). Till 2006 the
shareholders funds were around 30% of the capital employed (debt : equity ratio around 2:1)
however continuous expansion using retained earnings and borrowed funds lead to the
proportion of shareholders funds to capital employed declining to 11% by 2009 leading to
substantial increase in interest burden. The company did not tap the equity market after its
maiden issue in the year 1987. The company rewarded its shareholders by regular dividend till
2007 and also issued bonus shares in the ratio of 1:1 on two occasions.
The total income of the company increased at a CAGR of 22% per annum however interest
burden during the same period increased by 37% per annum on a compound basis. The
financial leverage that worked to the benefit of the company in the past has started hurting the
company once the operating profits came under pressure. Increased interest burden lead the
company to losses in the year 2009. Due to decline in operating profit to Rs.1428 million and
increased interest burden of Rs.1243 million, the company first time in its history reported a
loss. It appears that initially the company followed a debt equity ratio of 2:1 but in later years
increased the financial leverage.
As a large portion of borrowings are foreign currency denominated, the depreciation in the
value of Indian rupee vis--vis other currencies lead to foreign exchange losses to the
company further aggravating the problems for Asahi.

Many Indian companies have borrowed overseas in foreign currency to take advantage of lower interest
rates. However if the Indian currency depreciates during the period of the loan, the real cost of the
foreign currency loan would be higher than the stated cost. For example if a company borrows $100
million for one year @ 5% interest rate at a time when $ = Rs.50. After one year at the time of
repayment the $ has appreciated to Rs.54. In rupee terms the company received Rs.5000 million ($100
million x 50) but the repayment in rupee term would amount to Rs.5670 million ($105 million x 54). In
rupee term the company has incurred Rs. 670 million on a borrowing of Rs. 5000 million giving an
effective rate of 13.4%. The effective cost is much higher than the coupon rate of 5% due to rupee
depreciation. To assess the real cost the company should consider the coupon rate as well as the cost of
hedging the risk of rupee depreciation
12.1. a) Using a hypothetical level of EBIT of $1 million, earnings per share for the 4 plans are:

1
EBIT (000)

$1,000

$1,000

$1,000

$1000

240

400

400

1000

760

600

600

Taxes

300

228

180

180

Profit AT

700

532

420

420

Interest
Profit BT

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Preferred dividend

150

Earning to common

700

532

420

270

Number of shares

250

175

125

75

$2.80

$3.04

$3.36

$3.60

E.P.S

The intercepts on the horizontal axis for the four plans are 0; $240,000; $400,000; and $614,286
[400,000 + 150,000/ (1 .3)] respectively. With this information, the indifference graph is:

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b & c) The relevant financing plans are #1, #3, and #4. For the EBIT indifference point between plans
#1 and #3, we have

( EBIT*

0 )(.7 )

250, 000

( EBIT*

400,000 )(.7 )

125, 000

.7(EBIT*) (125,000) = 7 (EBIT*) (250,000)


.7(400,000) (250,000)
87,500 EBIT* = 70,000,000,000
EBIT* = $800,000
For the indifference point between plans #3 and #.4, we have

EBIT* - 400,000 (.7)


125, 000

(EBIT* - 614,286)(.7)
75, 000

.7(EBIT*) (75,000) .7 (400,000) (75,000) =


7(EBIT*) (125,000) .7(614,286) (125,000)
35,000 EBIT* = 32,750,025,000
EBIT* = $935,715
d) Plan #1 (all equity) dominates up to $800,000 in EBIT; plan #3 (half debt, half equity) from
$800,000 to $935,715 in EBIT; and plan #4 (debt, preferred, and equity) after $935, 715 in EBIT.
The best plan depends upon the likely level of EBIT and the likelihood of falling below an
indifference point.
12-2.a) Before financing EPS = $200,000/100,000 = $2.00
After financing EPS:

b) EBIT

EBIT

$333,333

Interest

30,000

Profit BT

303,333

Taxes

121,333

Profit AT

182,000

Shares

100,000

EPS

$1.82

$500,000

Interest

30,000

Profit BT

470,000

Faxes

188.000

Profit AT

282,000

Shares
100,000
EPS
$2.82
Absolute increase is $1.00 per share while the percentage increase is $1.00/$1.82 = 54.95%.
12 3. a) (in thousands)

EBIT

Present
All
Capital
Commo
Structure
n
$1,000 $1,000

Interest
Profit BT

Financial Management and Policy, 12/e

120
880

All 8%
Bonds

120
880

Horne/ Dhamija

All Preferred Half Common


& .5 Bonds

$1,000

$1,000

$1,000

360
64 0

120
880

240
760

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Taxes
Profit AT

440
440

440
440

320
320

440
440

380
380

210

Earnings to Common Stock

440

440

320

.230

380

Shares

100

150

100

100

125

Pref. Dividend

EPS
$4.40
$2.93
$3.20
$2.30
$3.04
b) The important thing in graphing the alternatives is to include the $120,000 in interest on existing
bonds.
Using Equation (10-1) and comparing the all common with the all bonds alternative, we have

(EBIT* - 120,000)(0.5) (EBIT* - 360,000)(0.5)


150, 000

100, 000

(0.5 EBIT* 60,000) 100,000 = (0.5 EBIT* 180,000) 150,000


50,000 EBIT* 75,000 EBIT* = 6,000,000,000 27,000,000,000
25,000 EBIT* = 34,500,000,000
EBIT* = $840,000
Above $840,000 in EBIT, debt is more favorable below, common is more favorable.
Similarly, one can solve for the indifference points for other combinations, and they are:
All Common vs. All Preferred

$1,380,000

All Common vs. Half Common Half Bonds

840,000

Half Common Half Bonds vs. All Bonds

840,000

All Preferred vs. Half and Half`

1,740,000

For the All Preferred vs. the All Bond comparison, the bond alternative dominates the preferred
alternative by 90 cents per share for all levels of EBIT.
These exact indifference points can be used to check graph approximations.
12-4. a)

The level of expected EBIT is only moderately above the indifference point of $840,000.
Moreover, the variance of possible outcomes is great and there is considerable probability
that the actual EBIT will be below the indifference point. A two-thirds probability
corresponds to one standard deviation on either side of the mean of a normal distribution.
If the distribution is approximately normal, SD = $400,000. The standardized difference
from the mean to the indifference point is

$1, 000, 000 - $840, 000


= 0.4
$400, 000
Looking at Appendix Table C at the back of the book we find that this corresponds to a
34.5 percent probability that the actual EBIT will be below $840,000. While the choice of
alternatives depends upon one's risk preferences, the level and variability of EBIT point to
the all common stock alternative.
b)

Here the level of expected EBIT is significantly above the indifference point and the
variability is less. The standardized difference is

$l,500, 000 - $840, 000


=
3.3
$200, 000
The probability of actual EBIT falling below the indifference point is negligible. The
situation in this case favors the all bond alternative.

12.5 (a)

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Common
$6,000,000
800,000

Debt
$6,000,000
800,000
550,000

Preferred
$6,000,000
800,000

Profit before taxes


Taxes (Enter rate below)
Profit after taxes
Dividends on existing
preferred stock
Dividends on new
preferred stock

5,200,000
1,820,000
3,380,000
0

4,650,000
1,627,500
3,022,500
0

5,200,000
1,820,000
3,380,000
0

Earnings available to
common stockholders
Number of coason shares
outstanding

3,380,000

3,022,500

2,880,000

1,350,000

1,100,000

1,100,000

Earnings per share (EPS)

$2.50

$2.75

$2.62

EBIT assumed
Interest on existing debt
Interest on new debt

500,000

b) (1)
Common
$3,000,000
800,000

Debt
$3,000,000
800,000
550,000

Preferred
$3,000,000
800,000

Profit before taxes


Taxes (Enter rate below)

2,200,000
770,000

1,650,000
577,500

2,200,000
770,000

Profit after taxes


Dividends en existing
preferred stock
Dividends on new
preferred stock

1,430,000

1,072,500

1,430,000

EBIT assumed
Interest on existing debt
Interest on new debt

Earnings available to
coason stockholders
Member of callan shares
outstanding
Earnings per share (EPS)

500,000

1,430,000

1,072,500

1,430,000

1,350,000

1,100,0,00

1,100,000

$1.06

$0.98

$0.85

b) (2)
Common
Debt
Preferred
EBIT assumed
$4,000,000
$4,000,000
$4,000,000
Interest on existing debt
800,000
800,000
800,000
Interest on new debt
550,000
Profit before taxes
3,200,000
2,650,000
3,200,000
Taxes (Enter rate below)
1,120,000
927,500
1,120,000
Profit after taxes
2,080,000
1,722,500
2,080,000
Dividends on existing
preferred stock
0
0
0
Dividends on new
500,000
preferred stock
Earnings available to
Coason stockholders
2,060,000
1,722,500
1,580,000
Number of Coason shares

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outstanding

1,350,000

1,100,000

1,100,000

$1.54

$1.57

$1.44

Earnings per share (EPS)


b) (3)
EBIT assumed
interest on existing debt
Interest on new debt
Profit before taxes
Taxes (Enter rate below)
Profit after taxes
Dividends on existing
preferred stock
Dividends on new
preferred stock
Earnings available to
Coason stockholders
Number of couson shares
outstanding
Earnings per share (EPS)
c) (1)
EBIT assumed
Interest on existing debt
Interest on new debt
Profit before taxes
Taxes (Enter rate below)
Profit after taxes
Dividends on existing
preferred stock
Dividends on new
preferred stock
Earnings available to
common stockholders
Number of callan shares
outstanding
Earnings per share (EPS)
c) (2)
EBIT assumed
Interest on existing debt
Interest on new debt
Profit before taxes
Taxes (Enter rate below)
Profit after taxes
Dividends en existing
preferred stock
Dividends on new
preferred stock
Earnings available to
common stockholders
Number of Coason shares
outstanding
Earnings per share (EPS)

Financial Management and Policy, 12/e

Common
$8,000,000
800,000

Preferred
$8,000,000
800,000

7,200,000
2,520,000
4,680,000

Debt
$8,000,000
800,000
550,000
6,650,000
2,327,000
4,322,500

7,20,000
2,520,000
4,680,000

500,000

4,680,000

4,322,500

4,680,000

1,350,000
$3.47

1,100,000
$3.93

1,100,000
$3.80

Coason

Debt

$6,000,000
800,000

Preferred
$6,000,000
800,000

5,200,000
2,392,000
2,808,000

$6,000,000
800,000
550,000
4,650,000
2,139,040
2,511,000

5,200,000
2,392,000
2,808,000

500,000
2,808,000

2,511,000

2,308,000

1,350,000
12.08

1,100,000
12.28

1,100,000
12.10

Common

Debt

Preferred

$6,000,000
800,000

5,200,000
1,820,000
3,380,000

$6,000,000
800,000
400,000
4,800,000
1,680,000
3,120,000

$6,000,000
800,000

5,200,000
1,820,000
3,380,000

350,000
3,380,000

3,120,000

3,030,000

1,350,000
$2.50

1,100,000
$2.84

1,100,000
$2.75

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c) (3)

Coason

EBIT assumed
Interest on existing debt
Interest on new debt
Profit before taxes
Taxes (Enter rate below)
Profit after taxes
Dividends on existing
preferred stock
Dividends on new preferred
stock
Earnings available to
coason stockholders
Number of Coason shares
outstanding
Earnings per share (EPS)

Debt

$6,000,000
800,000

Preferred
$6,000,000
800,000

5,200,000
1,820,000
3,380,000

$6,000,000
800,000
550,000
4,450,000
1,427,500
3,022,500

5,260,000
1,820,000
3,380,000

500,000
3,380,000

3,022,500

2,880,000

1,225,000
$2.74

1,100,000
$2.75

1,100,000
$2.42

12. 6.
EBIT (000 omitted)
Interest
Profit BT
Taxes
Profit AT
Shares
EPS

Debt
$4,000
500
3,500
1,750
1,750
2,000
$0,875

Common Stock
$4,000

4,000
2,000
2,000
2,250
$0,888

For the expected EBIT, the common-stock alternative is superior. The student can determine the
indifference point by using an EBIT-EPS chart, or by

(EBIT * - 500)(0.5) (EBIT *)(0.5)


2, 000

2, 250

(0.5 EBIT* 250) 2,250 = (0.5 EBIT*) 2,000


1,125 EBIT* 1,000 EBIT* = 562,500
EBIT* = $4,500
Standardizing the deviation, we have:
$4,500 - $4, 000
= 0.25
$2, 000

where the $2,000 is the standard deviation of the probability distribution (again the 000's are omitted).
When we turn to Appendix Table C at the back of the book, we find a probability of .4013 that the
actual outcome will be greater than 0.25 standard deviations. Therefore, there is approximately a 40
percent chance that earnings per share under the debt alternative will be greater than earnings per share
under the stock alternative.
12.7 Cornwell:
Times interest earned = $5,000/ $l,600 = 3.13
Debt service coverage =

$5, 000
= 1.01
$2, 000
$1, 600 +
(1- .40)

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Northern California:
Times interest earned = $100,000/ $45,000 = 2.22
Debt service coverage =

$100, 000
= 1.00
$35, 000
$45, 000 +
(1- .36)

The question of which company is better depends on the business risk of each. Inasmuch as an electric
utility has stable cash flows and Northern California is large, it no doubt is the safer loan despite the
lower coverage ratios. The fact that the debt service coverage ratio is only 1.0 may mean that some of
the debt will have to be renewed or rolled over" at maturity. However, this is typical for an electric
utility.
12.8. The expected value of ending cash balance at the end of a recession without any debt financing is
CB r = CB 0 + NCF r = $1 million + $3 million = $4 million
With a standard deviation of $2 million the standardized difference for running out of cash is 2.0.
In Appendix Table C at the back of the book, one finds that this corresponds to a probability of
2.28 percent. Therefore, the company could take on some fixed interest charges and bring the
probability up to 5 percent.
In Table C, one finds that a 5 percent probability corresponds to approximately 1.65 standard
deviations from the mean. Therefore,
1.65 x $2 million = $3,300,000
This implies that the company could take on $4,000,000 $3,300,000 = $700,000 in fixed
interest charges and still leave only a 5 percent probability of running out of cash. Thus, the
amount of debt which can be used is:
Amounts

Interest Cost

Cumulative Interest Cost

First $3 million

$300,000

$300,000

Next $2 million

220,000

520,000

Next $1.5 million

180,000

700,000

The maximum debt to be used is $6.5 million.

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Chapter13
DIVIDENDS AND SHARE REPURCHASE: THEORY AND PRACTICE
Case 1: Dividend Policy of Hero Honda Motors Limited
Hints:

1. Dividend policy of HHML can be divided in two phases up to 2001 and thereafter.
In the first phase, low payout ratio high retention followed. Company used the
retained earnings to fund its expansion plans as well as for servicing and repayment
of loans. Fixed assets grew significantly during this phase without corresponding
increase in borrowings. Post 2001 the company has significantly increased the
dividend rate and is paying dividend at the rate of 1000% or near about. However in
view of increased profits the payout ratio has come down to 37% in 2009 after
touching 75% in 2002. The company is following residual dividend policy i.e. after
retaining cash for expansion and other strategic purposes whatever is left out the
same is disbursed to the shareholders by way of dividend. Company has not used
buy back as an option so far.
2. Buy back is a good option as it results in reduction in share capital and thereby
increasing the EPS and also the market price. However it does not reward all the
shareholders equitably as only those shareholders that opt for buy back gets the
cash. It also results in reduction in floating stock in the market adversely affecting
the liquidity.
3. Bonus and stock split only result in increase in number of shares without any change
in the fundamentals of the company. Due to increase in the number of shares the
EPS decline and the share price also come down proportionately. There is no change
in ROE or promoters stake. It helps by increasing the number of shares and thereby
liquidity of the stock in the market. The reduction in share price brings them in the
comfort zone of many investors.

Case 2: Dividend Payout Ratio of SENSEX Companies


Hints:

1. The Dividend Payout Ratio of 28% indicates that the companies are retaining large
proportion (72%) of their profits for funding their expansion plans and other
purposes and only 28% of profit is being paid out as dividends and tax on dividend.
2. Companies like Bharati and Reliance Communication have low payout ratio as they
are in expansion mode and would like to use the retained profits for part funding
their investment requirement. Whereas companies which are mature and not very
capital intensive (ITC, Hindustan Lever, ONGC etc) are retaining less and paying
more. The variation is largely due to the funding requirements of these companies.
3. The investors earn a part of return from dividend and large part from capital
appreciation. Dividend yield of 1% may not be significant but any reduction in the
dividend is viewed adversely by the investors due to the information content. Any
reduction in dividend is viewed as if the management is not confident about the
future prospects of the company.
Solutions

13.1

a)

Dividends = $500,000

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b)

Dividends = 0

c)

Dividends = 0. The company should also raise an additional $1 million through an


issue of common stock.

13.2. =
a) P0

1
( D1 + P1 )
1+ p

P 0 (1 + p) = D 1 = P 1
Dividend is not paid:

P 1 = $100 (1.15) 0 = $115

Dividend is paid:

P 1 = $100 (1.15) $5 = $110

b)

mP 1 = I (X nD 1 )
$110 m = $2,000,000 (1,000,000 500,000)
m = $1,500,000/$110
m = 13,636 shares

c)

The conclusions of the MM model follow from the assumptions. As outlined in the text, however,
there is some question as to how realistic it is to assume investor indifference as to the timing of
dividends, independence of the value of the firm from its capital structure, perfect capital markets,
no flotation or transactions costs, and no taxes.

13.3 As the University pays no taxes, it should purchase the stock of IVM Corporation before it goes
ex-dividend. In this way, it can avail itself of somewhat higher overall return. Since the avoidance
of dividends in favor of capital gains by taxable investors causes the stock-price behavior
described in the problem, a tax-free investor should take advantage of the situation and seek the
dividend.
13.4 Some will be tempted to recommend a substantial change in dividend policy, arguing that the
lucrative investment opportunity in the southeastern market augers growth for the company and
the greater retention of earnings to support such growth. However, this initial response is not
correct. For one thing, the investment in the southeastern market represents only one major
project. There will not be a continuing flow of like investment opportunities. While the company
has found a lucrative market in the Southeast, the basic non-growth nature of the firm has not
changed. Furthermore, the firm can finance the proposed investment by floating a stock issue.
Increasing retention substantially in 19X5, only to increase the payout in a couple of years, would
result in a discontinuous dividend pattern and might adversely affect the price of the stock.
An appropriate policy recommendation might be:
a)

Maintain the 67 percent payout in 19X5, paying a dividend of $3.20.

b)

Finance the proposed expansion with an issue of common stock.

The alert student will raise the point that maintaining an optimal capital structure, assuming X
avier has one now, might necessitate a combination debt/equity flotation. Since future flotations
seem unlikely, the combination approach has appeal.
13.5. a)

p* =

(1,800, 000 $37)


(1,800, 000 - 100, 000)

= $39.18

Tendering shareholders had considerable incentive to accept the repurchase offer of


$42.50 per share.
b)

13.6. a)

Stockholders whose shares were repurchased gained at the expense of stockholders who
continued to hold shares.

p* =

(14, 000, 000 $91)


(14, 000, 000 - 1, 000, 000)

= $98

The share repurchase offer price is correct, according to the standard formula.

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b)

13.7.

The most likely explanation is a signaling effect, where the share repurchase
announcement conveys positive information about future earnings. Previously, this
information was private and unknown to investors, In other words, there was asymmetric
information between management and investors. The share repurchase announcement
reduced this disparate information.
Effect of the split:
Common stock ($50 par)
Paid-in capital
Retained earnings
Shareholders equity

$30,000,000
15,000,000
55,000,000
$100,000,000

Effect of the stock dividend:


10% x 600,000 shares = 60,000 shares
60,000 shares x $250 = $15,000,000
Common stock ($50 par)
Paid-in capital
Retained earnings
Shareholders' equity
13.8 a) (1)
Common stock
Par value
Paid-in capital
Retained earnings
Shareholders' equity
Number of Shares
a) (2)
Common stock
Par value
Paid-in capital
Retained earnings
Shareholders equity
Number of Shares
b) (1)
Common stock
Par value
Paid-in capital
Retained earnings
Shareholders equity
Number of Shares
b) (2)
Common stock
Par value
Paid-in capital
Retained earnings
Shareholders' equity
Number of Shares
b) (3)
Common stock
Par value
Paid - in capital
Retained earnings
Shareholders equity
Number of Shares
c) (1)
Common stock
Par value

Financial Management and Policy, 12/e

$33,000,000
27,000,000
40,000,000
$100,000,000
Original Condition
4,800,000
2.00
5,900,000
87,300,000
98,000,000
2,400,000
Original Condition
4,800,000
2.00
5,900,000
87,300,000
98,000,000
2,400,000
Original Condition
4,800,000
2.00
5,900,000
87,300,000
98,000,000
2,400,000
Original Condition
4,800,000
2.00
5,900,000
87,300,000
98,000,000
2,400,000
Original Condition
4,800,000
2.00
5,900,000
87,300,000
98,000,000
2,400,000
Original Condition
4,800,000
2.00

Horne/ Dhamija

New Condition
5,376,000
2.00
15,692,000
76.932,000
98,000,000
2,688,000
New Condition
5,040,000
2.00
9,980,000
82,980,000
98,000,000
2,520,000
New Condition
4,800,000
1.333
5,900,000
87,300,000
98,000,000
3,600,000
New Condition
4,800,000
1,00
5,900, 00
87,300,000
98,000,000
4,800,000
New Condition
4,800,000
0.667
5,900,000
87,300,000
98,000,000
7,200,000
New Condition
4,800,000
12.00

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Paid-in capital
Retained earnings
Shareholders' equity
Number of Shares
13.9.

a)

5,900,000
87,300,000
98,000,000
2,400,000

5,900,000
87,300,000
98,000,000
400,000

$50. The value of the stock adjusts on the date of record. This sale occurs before that date.

b)

160 shares x 1.25

= 200 shares

c)

$50/1.25 = $40

d)

Before: $50 x 160

= $8,000

After: $40 x 200

= $8,000'

The stock dividend in itself does not affect the value of the company.
e)

13.10 a)

b)

The stock dividend would likely be regarded as a positive signal and the total value of
your holdings would increase.
Year

Policy 1

Policy 2

Policy 3

$0.68

$0.80

$0.68

.73

.80

.68

.58

.80

.68

.75

.80

.80

.87

.87

.80

.93

.93

.80

.74

.80

.80

.89

.89

1.00

1.00

1.00

1.00

10

1.09

1.09

1.00

Policy 1 and, to a much lesser extent, policy 2 result in fluctuating dividends over time, as the
company is cyclical. Because of the $0.80 minimum regular dividend, policy 2 results in an
average payout ratio in excess of 40 percent. Stockholders may come to count on the extra
dividend and be disappointed when it is not paid, such as in year 7. To the extent investors
value stable dividends and periodic rising dividends over time, and 40 percent is an optimal
average payout ratio, dividend policy 3 would be preferred and would likely maximize share
price.

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13.11.

We would expect Forte Papers to have the higher dividend payout ratio. As a percent of
expected annual cash flows, the two companies have the following ratios:
Standard deviation
Capital expenditures
Cash & marketable sec.
Long-term debt
Unused bank lines

Forte
0.60
0.84
0.10
2.00
0.50

Great Southern
0.71
1.14
0.20
2.43
0.29

Forte has a lower standard deviation of cash flows, lower relative capital expenditures, lower
relative long-term debt, and greater relative unused bank lines. Its expected capital
expenditures are less than its expected cash flow, which would imply residual funds, whereas
the opposite occurs with Great Southern. With inflation, the increased capital investment costs
will be felt more by Great Southern in the future than by Forte. Finally, Great Southern has a
higher cost associated with f1oating common stock to replace dividends. As a result, we
would expect Forte to have a higher dividend payout. The only factor working in the other
direction is that Great Southern has a higher relative as well as absolute level of liquidity.

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Chapter 14
FINANCIAL RATIO ANALYSIS
Case 1 : Common Size Financial Statements of Apollo Tyres Limited
Hints:
1.Though the total income has increased but the profits have not increased. The common size profit and
loss account reveals that the net margin (profit for the year as a % of net turnover) has come down from
7.46% in 2003 to 2.66% in 2009. The increase in turnover has been completely offset by decline in
profitability. Raw material and components as a % of net revenue has increased from 57.08% to 68.66%
during the same period.
2. The profitability of the company has been adversely affected because of the increase in raw material
cost. The company has achieved cost reduction in other components of cost and internal efficiencies. The
employees costs, power and fuel and other expenses have come down from 7.15%, 5.34% and 6.35% to
5.10%, 3.67% and 5.12% respectively. The interest cost has also been contained at the same level.
Blockage of funds in inventories and sundry debtors has been reduced from 27.59% and 9.48% of the
Balance Sheet in 2003 to 18.89% and 3.95% in 2009 respectively.
3. The proportion of shareholders funds has increased from 53.45% to 61.42% in the last six years
whereas the loan funds have come down from 36.29% to 31.51% resulting in a lower debt equity ratio.
Share capital has come down from 4.63% to 2.28%.
4. Proportion of net current (current assets minus current liabilities) has declined from 33.74% of the
balance sheet to 21.97% signifying better management of the current assets. The proportion of fixed
assets and investments has increased from 65.47% to 77.93% implying higher investments in producing
assets. The investments have increased from 3.25% to 13.48%. It implies that the company is growing
through making investments in subsidiaries and joint ventures.
Case 2: Ratio Analysis of Cipla Limited
2007

2008

2009

Liquidity Ratios

Current Ratio (Times)

Current Assets / Current


Liabilities

2.77

2.10

1.92

Quick Ratio (Times)

(Current Assets-Inventories) /
Current Liabilities

1.85

1.48

1.32

3.43

2.93

2.73

106.28

124.44

133.53

3.61

3.65

3.59

101.10

100.03

101.64

Debtor Turnover Ratio (Times)

Sales / Debtors

Average Collection Period (days)

365/Debtor Turnover

Inventory Turnover Ratio (Times)

Sales/ Inventory

Average Payable Period (Days)

365/ Inventory Turnover

Debt Ratios
Total Debt to Shareholders Equity
(Times)

Total Liabilities /
Shareholders' Funds

0.44

0.71

0.83

Long Term Debt to Shareholders Equity


(Times)

Long Term Liabilities /


Shareholders Funds

0.03

0.04

0.04

0.49

0.23

0.20

Cash Flow to Total Liabilities (Times)

EBITDA/ Total Liabilities

Enterprise Value to EBITDA (Times)

Market Cap + Loan /


EBITDA

Interest Coverage Ratio (Times)

(EBIT+ Other Income) /


Interest

39.282
116.43

75.19

28.40

Profitability Ratios
Operating Margin Ratio (%)

EBIT / Net Sales

17.0%

12.7%

11.5%

Net Margin Ratio (%)

PAT / Net Sales

19.4%

17.5%

15.7%

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Material Cost to Net Sales Ratio (%)

50.2%

51.1%

47.3%

5.0%

4.9%

4.8%

S,G&A Expenses / Net Sales

19.4%

23.0%

27.9%

Return on Assets (%)

PAT/ Total Assets

15.1%

12.2%

11.3%

Return on Equity (%)

PAT / Shareholders' Funds

20.6%

18.7%

17.9%

Operating Profit Rate of Return (%)

EBIT / Total Assets

13.2%

8.9%

8.3%

Assets Turnover Ratio (Times)

Sales/ Total Assets

0.78

0.70

0.72

Dividend / No of Shares

2.00

2.00

2.00

(Dividend + Tax on
Dividend) / PAT

27.2%

25.9%

23.4%

PAT / No of Shares

8.59

9.02

9.99

Manufacturing Expenses to Net Sales


Ratio (%)

Material Cost / Net Sales


Manufacturing Expenses /
Sales

S,G & A Expenses to Net Sales Ratio (%)

Return Ratios

Dividend Ratios
Dividend Per Share (Rs.)
Dividend Payout Ratio (%)
Market Value Ratios
Earnings Per Share (Rs.)
Market Capitalization (Rs. Millions)

No of Shares x Current
Market Price

Dividend Yield (%)

Dividend Per Share / Current


Market Price

0.6%

P/E Ratio (Times)

Current Market Price /


Earnings Per Share

34.62

Market Value to Book Value Ratios


(Times)

Current Market Price / Book


Value Per Share

268946

6.18

Solutions:

14 l.a) Current ratio =

b) Acid-test ratio =

c)

$3,800
= 2.26
$1, 680

$3,800 $2,100
= 1.01
$1, 680

Average collection period =

d) Inventory turnover =

$1,300 365
= 37.4 days
$12, 680

$8,930
= 4.58
( $1,800 + $2,100 ) 2

$1, 680 + $2, 000


= 1.07
$3, 440

e)

Debt-to-equity =

f)

LTD-total-capitalization =

Financial Management and Policy, 12/e

$2, 000
= 0.37
$2, 000 + $3, 440

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g) Gross profit margin =

$3, 750
= 29.57%
$12, 680

h) Net profit margin =

$670
= 5.28%
$12, 680

i)

$670
= 19.48%
$3, 440

j)

Return on equity =

Cash flow LTD = $2,000/$2,000 = 1.00

14-2.a) Current ratio = $1,000,000 / $600,000 = 1.67

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b)
(1)
(2)
(3)
(4)
(5)

Current assets after change. Current liabilities after change


Current Ratio
$900,000
$600,000
1.50
1,120,000
720,000
1.56
950,000
550,000
1.73
1,000,000
600,000
1.67
1,100,000
500,000
2.20

14.3.a) CGS = $400,000 .8 = $320,000


Inventory turnover = CGS/Average inventory
4 = $320,000/Average inventory
Average inventory = $80,000
b) Receivable turnover = Credit sales/Receivables
$400,000/$50,000 = 8
If a 360 day year is assumed, the average collection period is:
360/8 = 45 days
If a 365-dayyear is assumed, the average collection period becomes:
365/8 = 45.6 days
14.4.

Company
A
B
C
D
E
F

Turnover
1.25
2.00
1.33
2.00
3.00
2.12

Margin
7.0%
10.0
10.0
10.0
12.5
5.88

Earning Power
8.75%
20.00
13.33
20.00
37.50
12.50

14.5 a) Interest on each issue:


Coupon
9 1/4s
12 3/8s
10 1/4s
14 1/2s

Outstanding
$2,500,000
1,500,000
1,000,000
1,000,000

Annual Interest
$231,250
185,625
102,500
145,000
$664,375

Coverage Ratio = $l,500,000/$664,375 = 2.26


b) Coverage ratio for each issue:
Coupon
9 1/4s $1,500,000/$231,250

= 6.49

12 3/8s

= 3.60

$1,500,000/$416,875

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10 1/4s

$1,500,000/$519,375

= 2.89

14 l/2s $1,500,000/$664,375

14.6 a) (1) Current ratio =

(2) Acid test ratio =

= 2.26

$6.500, 000
= 1.63
$4, 000, 000

$6,500, 000 $3,500, 000


$4, 00, 000
= 0.75

(3) Receivable turnover = $8,000,000/$2,500,000


= 3.2x
(4) Inventory turnover = $6,000,000/$2,500,000
= 2.4x

(5) Long-term debt/Total capitalization =

$6, 000, 000


= .545
$6, 000, 000 + $2, 000, 000 + $3, 000, 000

(6) Gross profit margin = $4,000,000/$10,000,000


= 40.0%
(7) Net profit margin = $1,000,000/$10,000,000
= 10.0%
(8)

Return on equity = $880,000/$3,000,000 =29.3%

(9)

Return on assets = $1,000,000/$14,000,000


= 7.1%

(10) Asset turnover = 10, 000, 000 / 14, 000, 000


= 0.71x
(11) Overall interest coverage = $2,200,000/$3,00,000
= 7.33x
(12)

Cash flow to long-term debt


= $2,900,000/$6,000,000 = 0.48x

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b) (1) Ratios 1 4 uniformly indicate that liquidity is deteriorating.

c)

(2)

The gross profit margin (#6) is remaining constant and in line with the industry, while the net profit
margin (#7) is declining. This indicates that interest, depreciation, and selling and administrative
expenses are rising relative to sales.

(3)

Part of the margin decline is due to the rapid rise in debt (#5). This increase also explains why the return
on equity (#8) has been rising while the return on assets (#9) has fallen. The impact of the increase in debt
and the overall decline in profitability is also shown in the reduction in coverage (#11) and in the decline
in the ratio of cash flow to long-term debt (#12).

(4)

The intention of this problem is to depict a fundamentally deteriorating situation which is masked by the
use of leverage.

(1)

Primary interest should be in ratios 1 5.The overall reduction in liquidity, together with the large
amount involved and the lengthy terms, would argue against granting the credit. Of course, this argument
would have to balanced against the importance to the, vendor of, this sale and possible repeat sales.

(2)

If this were done, the new capitalization would be:


Debt

66 2/3%

$8 million

Preferred

16 2/3

Tangible
Shareholder equity

16 2/3
100%

2
$12 million

(3) An easy answer would be to point to the high rate of return on equity (#8) and say "buy. On the
other hand, the high degree of leverage (#5) and the declining profitability (#7,9) would indicate
caution. The student should were of the negative factors involved.
14.7

$560
Profit after taxes = $8, 000 7.0% =

Profit before taxes = $560 (1 .44 ) =


$1, 000
Tax = $440
Net profit + depreciation = $560 + $500 = $1,060
Long-term debt = $1,060/.40 = $2,650
Total liabilities = Shareholders' equity, due to the 1 to 1 debt ratio, = $3,750
Current liabilities = $3,750 $2,650 = $1,100
Bank loan = Current assets Payables Accruals
= $1,100 $400 $200 = $500
Total liabilities and shareholders' equity

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= $3,750 + $3,750 = $7,500


Total assets = $7,500
Current assets = Current liabilities current ratio

$3,300
= $1,100 3 =
Net fixed assets "Total assets current assets
= $7,500 - $3,300 = $4,200
Accounts receivable, = $8, 000 ( 45 / 360 ) =
$1, 000
Inventories = Current assets cash receivables
= $3,300 $500 $1,000 = $1,800
Cost of goods sold = Inventories Inventory turnover ratio
= $1,800 3 = $5,400
Gross profit = $8,000 - $5,400 = $2,600
Selling & administrative expenses = Gross profit Interest profit before taxes
= $2,600 $400 $1,000 = $1,200
14.8 .a) With 1.64 million shares outstanding, earnings per share are $4.7 million/1.64 million = $2.87.
P/E ratio = $59/$2.87 = 20.6 times
b) Dividends per share are $1.1 million/1.64 million = $0.67.
Dividend yield = $0.67/$59 = 1.14%
c)

Book value per share is $36.4 million/1.64 million = $22.20.


M/B ratio = $59/$22.20 = 2.66

d)

The company has relatively high price/ earnings and market to - book value ratios, and a relatively low
dividend yield. A great deal of the value of the stock is being placed on growth. The growth option as
opposed to physical asset receives the greater emphasis by the market.

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14.9.
Cash
Receivables
Inventories
Net fixed asset s
Total assets
Accounts payable
Notes payable
Accruals
Long-term debt
Common stock
Retained earnings
Total liabilities & shareholders equity

20X1
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0

20X2
43.5
129.4
137.6
105.7
120.1
139.5
130.0
131.3
160.0
100.0
101.9
120.1

20X3
19.6
152.2
175.0
107.6
138.4
163.4
150.0
196.5
160.0
100.0
111.1
138.4

20X4
17.8
211.2
202.7
121.3
166.2
262.4
150.0
265.7
160.0
100.0
112.0
166.2

In the last three years, the company has increased its receivables and inventories rather dramatically
while net fixed assets jumped in 20X4, changes were only modest in 20X2 and 20X3. The basic problem
is that retained earnings have grown at a slow rate, almost all of which occurred in 20X3.This is due to
inadequate profitability, excessive dividends, or both. Although the company increased its long-term
debt in 20X2, it has not done so since. The burden of financing has fallen on accounts payable and
accruals, together with drawing down the cash position and $50,000 in increased short-term borrowings.
The question is whether payables are past due and whether employees are being paid on time. It is clear
that the company cannot continue to expand its assets without increasing its equity base in a significant
way
14.10.

The z-scores for the two companies are:

Zoom Z = 1.2(10,500/50,000) + 1.4(19,000/50,000)


+ 3.3(12,000/50,000) + 0.6(38,000/22,000)
+ 1.0(86,000/50,000) = 4.33.
Zing Z = 1.2( l,600/ 21,000) + 1.4(3,000/21,000)
+ 3.3(1,300/21,000) + 0.6(5,100/13,000)
+ 1.0(23,000/21,000) = 1.66
Zoom is a much healthier company. If we use Altman's cutoffs, which you might note are based on old
data, below 1.81 represents firms to become bankrupt and above 2.99, non-bankrupt firms. (The area in
between is one of misclassification). Based on these cutoffs, we would say that there was a high
probability that Zing Company would go bankrupt in the near future, but very little probability that Zoom
Company would go bankrupt.

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Chapter 15
FINANCIAL PLANNING
15.1

Cash
Accounts receivable
Inventories
Gross fixed assets
Depreciation
Net fixed assets
Accounts payable
Accruals
Long-term debt
Net profit
Dividends

$100 The residual whose change you


measure
700 Use
300 Source
900
1,000
100 Source
300 Source
100 Use
200 Use
600 Source
400 Use

15.2.a) Kohn Corporation Sources and Uses of Funds on a Cash Basis, December 31, 19X1 to December 31, 19X2
(in , millions )
Sources
Net profit
Depreciation
Decr. Other assets
Incr. Accounts payable
Incr. Accrued taxes
Sale of stock
Bond issue
Decr. cash

Financial Management and Policy, 12/e

$7
5
3
3
2
6
15
2
$43

Uses
Dividends
Additions to plant
Incr. Accounts receivable
Incr. inventory
Repayment of note

$3
10
7
3
20

$43

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b) Accounting Statement of Cash Flows


Cash flows from operating activities:
Net earnings
Adjustments to reconcile net earnings to
cash provided by operating activities:
Depreciation
Changes in assets and liabilities:
Accounts receivable
Inventories
Accounts payable
Accrued taxes

$7

5
(7)
(3)
3
2
$7

Cash flows from investing activities:


Investment in fixed assets
Other assets

(10)
3
($7)

Cash flows from financing activities :


Increase (decrease) in short-term borrowings
Increase (decrease) in long-term debt
Issuance of common stock
Dividends

(20)
15
6
(3)
($2)
(2)
5
$3

Increase (decrease) in cash


Cash at beginning of year
Cash at end of year
c)

Sources and Uses of Working Capital


Sources
Net profit
Depreciation
Decr. Other
assets
Bond issue
Sale of stock

Uses
Dividends
Additions to
plant

$7,000
5,000

3,000
15,000
6,000
$36,000

Incr. Working
capital

$3,000
10,000

23,000
$36,000

15.3. a) Sennet, Corporation Sources and Uses of Funds on a Cash Basis (in millions)
Sources
Profit
Depreciation
Incr. Accounts
Payable
Incr. Accrued
wages

$15
3
2

Uses
Dividends
Additions to plant
Incr. Accounts receivable
Incr. Inventory
Decr. Accrued taxes

1
Incr. Cash
$21

Financial Management and Policy, 12/e

$10
3
3
3
1

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$21

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b) Sources and Uses of Working Capital


Sources
Profit
Depreciation

$15
3
$18

15.4.
Sales
Credit sales
Col1ections 1 mo .
Collections 2 mos..
Total collections
Cash sales
Total receipt

Uses
Dividends
Additions to Plant
Incr. Working capital .

$10
3
5
$18

#1 Schedule of Sales Receipts


January
50,000
25,000

25,000

February
50,000
25,000
12,500
12,500
25,000

March
60,000
30,000
12,500
12,500
25,000
30,000

April
60,000
30,000
15,000
12,500
27,500
30,000

May
70,000
35,000
15,000
15.000
30,000
35,000
65,000

June
80,000
40,000
17,500
15,000
32,500
40,000
72,500

July
100,000
50,000
20,000
17,500
37,500
50,000
87,500

August
100,000
50,000
25,000
20,000
45,000
50,000

#2 Schedule of Expenses
Cost of goods
manufactured
Cash payment 1 mo.
Cash payment--2 mos.
Total payment
Sales & adm. expenses
Total cash expenses

35,000

15,000

Financial Management and Policy, 12/e

35,000

42,000

42,000 49,000

56,000

70,000

70,000

31,500

31,500
31,500
16,000

44,100
4,200
48,300
18,000
66,300

50,400
4,900
55,300
20,000
75,300

63,000
5,600

15,000

37,800 37,800
3,500 4,200
42,000
16,000 17,000
59,000

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#3 Schedule of Cash Disbursements


May
Total cash expenses
Interest payment
Sinking fund payment
Dividend
Capital expenditures
Taxes

June

July

$66,300

$75,300
18,000
50,000
10,000

$59,000

40,000
$59,000

1,000
$154,300

$106,300

#4 Net Cash Flow and Cash Balance


Total cash receipts
Cash disbursements
Net cash flow
Beginning cash without
financing
Ending cash without
financing
Cumulative borrowing
Cash balance

$65,000
59,000
$6,000

$72,500
106,300
($33,800)

20,000

26,000

26,000

(7,800)
27,800
$20,000

$87,500
154,300
($66,800)
(7,800)
(74,600)
94,600
$20,000

15-5. Downeast Nautical Company Pro Forma Income Statement (000 omitted)
Sales

$2,400

Cost of goods sold


Gross profit
Expenses
Profit before taxes
Taxes
Profit after taxes

Financial Management and Policy, 12/e

1,440
$960
576
$384
192
$192

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Pro Forma Balance Sheet (000 omitted)


Cash
Accounts receivable (1)
Inventories (2)

$96
400
180

Current assets

$ 676

Net fixed assets

500

Total assets

$1,176

Accounts payable (3)

$60

Accruals

72

Bank borrowings (4)

27

Current liabilities

$159

Long-term debt

225

Common stock

100

Retained earnings (5)

692

Total liabilities & equity

$1,176

(1)

Sales/(360/6) = $2.4 million/6 = $400,000

(2)

Cost of goods sold/8 = ($2.4 million 0.6) /8


= $180, 000

(3)

(Cost of goods sold 0.5)/12


= ($2.4 million 0.6 0.5)/12 = $60,000

(4)

Total assets minus accounts payable, accruals, long-term debt, common stock and retained earnings=$27,000
(5)

Beginning retained earnings plus net profits = $692,000

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Work Sheet

Sales
Credit sales
Collections
60%
30%
10%
Cash sales
Total: collection
Purchases

October November
300,000 350,000
225,000 262,500

75,000

December
400,000
300,000

January
150,000
112,500

135,000

157,500
67,500

180,000
78,750
22,500

87,500

100,000

37,500
318,750
160,000

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February March
200,000 200,000
150,000 150,000

April
300,000
225,000

May
250,000
187,500

June
200,000
150,000

90,000
33,750
30,000

90,000
45,000
11,250

135,000
45,000
15,000

112,500
67,500
15,000

50,000 50,000
233,750 203,750
160,000 240,000

75,000
221,250
200,000

62,500
257,500
160,000

50,000
245,000
240,000

67,500
90,000
26,500

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Central City Department Store Cash Budget


Receipts Total collections Payments:

January
February
318,750
233,750

Purchases
Rent
Wages and salaries
Tax payments
Capital additions
Interest on, debt

March
203,750

May
257,500

June
245,000

200,000
2,000
50,000
50,000

160,000
2,000
40,000

202,000

240,000
2,000
35,000

30,000
7,500
314,500

160,000
2,000
30,000

160,000
2,000
40,000

Total

192,000

202,000

7,500
299,500

Net monthly cash gain


Cash bal. BOM
without financing
Cash balance EOM

126,750

31,750

95,750)

(80,750)

55,500

(69,500)

100,000

226,750

258,500

162,750

82,000

137,500

82,000
20,000

137,500
0

68,000
35,000

without financing
Cumulative borrowings

Financial Management and Policy, 12/e

226,750
0

258,500
0

Horne/ Dhamija

240,000
2,000
50,000

Apri1
221,250

162,750
0

302,000

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15.7. Central City Department Store Pro Forma Income Statement for Six Months ending June
30, 19X2
Sales
Cost of goods sold
Gross profit

$1,300,000
1,040,000
$260,000

Operating expenses:
Rent
Interest
Depreciation
Wages and salaries
Profit before taxes

$12,000
15,000
12,500
245,000

284,500
($24,500)

If a tax refund of 40 percent were possible, taxes would be ($9,800), and profit after taxes
would become ($14,700).
* 0.8(Sales for six months) =$1,040,000
60 (.07 )(1.05 )

40 ( 60 )(.07 )(1.50 )
15.8-a) SGR =
=18.69%
( 40 5)(1.45)( 2.381)
1

(.06 )(1.45 )( 2.381) 150


b) SGR =
-1 =1.60 %
Moving to lower relative profitability and a lower debt ratio, which may be a one-shot occurrence, lowers
dramatically the sustainable growth rate. The change in debt ratio affects the level of overall assets, not just
the growth component .

15.9. a) S/A =

(1.35)( 30 )
[1.60] 12 + 0.5 + (.08)(1.35)( 30 ) = 1.6082
A/S = 1/ (S/A) = 1/(1 6082) = .621 8

b)

NP/S =
D/E =

c)

(12 + 0.5)
1

=
11.01%
(1.60 )(1.4925) (1.35)( 30 )

(1.35)( 30 )
12 + 0.5 + (.08 )(1.35 )( 30 )(1.4925 )
1

= .724
In order to achieve a sales growth rate of 35 percent next year, one or both of the
profitability ratios must improve and/or the. debt ratio must increase.

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Chapter16
LIQUIDITY, CASH AND MARKETABLE SECURITIES
Case: Problem of plenty Investment of excess cash
Hints:
1. Companies maintain cash for meeting their day to day transactions and meeting their payment
obligations (transaction motive), as a contingency against unforeseen circumstances
(precautionary motive) and to take advantage of changes in the business environment
(speculative motive). Large cash balances are usually for the last two motives. Cash balances
invested in interest bearing deposits also help the companies in augmenting their `other income
as well.
2. Surplus cash do generate other income for the company and thereby increasing profit and EPS
for the company. However it is a low yielding asset. The return on unused cash is usually lower
than the normal business of the company as a result it has an adverse impact on the return ratios
of the company. For example the Return on Equity is given as:
ROE =

Using Dupont analysis the same may be broken as


ROE =

If the company with surplus cash uses it for say payment of large dividend it would improve the
ROE by increasing the middle component as well as the third component in the above equation.
Getting rid of surplus cash will reduce the first component (margin) due to reduction in other
income, improve the second component (asset utilization) due to reduction in asset base and
also increase the third component (leverage) leading to overall increase in ROE.

Solutions
16-l.

a) $420,000 x 6 = $2,520,000
b) Funds released = $420,000 x 2 = $840,000
Value of funds released on an annual basis
= $840,000 x 9 percent
= $75,600
The company should not inaugurate the plan.
c) Value of funds released on an annual basis
= $420,000 x 9 percent
= $37,800
The company should undertake the plan.

16-2.

a) $3 million per day x day $1.5 million saved in collections.


$2million + $1million $ 2million = $1 million in increased balances.
$500, 000 net savings in cash
.07
$35, 000 annual savings

b) At7% interest, the above can be viewed as:

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$105,000 value of day faster collections


210,000 cost of $3 mil. compensating bals.
$105,000 maximum charge by New Orleans bank
(or) $2 million x .07 = $140,000 cost of balance at N.O. bank
35,000 savings on new system
$105,000 maximum charge by N.O. bank
16-3.

If the company were certain of the pattern shown, it would wish to have the following on deposit
in its payroll account in order to cover the checks which were cashed.

Friday

$30,000

Monday

60,000

Tuesday

37,500

Wednesday

15,000

Thursday

7,500
$150,000

If employee check cashing behavior is subject to fluctuations, the company will need to maintain
"buffer" cash in the account. The greater the uncertainty, the greater the buffer that will be needed.

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16-4.

(a) Average cost of each method:


Incremental
Cost above DTC

Wire transfer

250 x $5 = $1,250

Automatic clearing house

250 x $3 = $750

Depository transfer check

$1,175
675

250 x $0.30 = $75

Days saved:
1) Wire transfer versus DTC

3 days

2) Automatic clearing house versus DTC

2days

Funds released and opportunity savings:


Alternative 1

Restaurant

Alternative 2

Funds

x .10

Funds

x .10

Released

Savings

Released

Savings

$9,000

$900

$6,000

$600

13,800

1,380

9,200

920

8,100

810

5,400

540

15,600

1,560

10,400

1,040

12,300

1 ,230

8,200

820

10,500

1,050

7,000

700

11,400

1,140

7,600

760

Incremental Profits:
Restaurant

Alternative1

Alternative2

Savings $1,175

Savings $6 75

$275

$75

205

245

365

135

385

365

55

145

125

25

35

85

The following would be optimal for each of the restaurants, based on the greatest incremental savings or
lack thereof:
Restaurant

Method

DTC

ACH

DTC

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WT

ACH

ACH

ACH

In only the case of the restaurant with the largest average remittance, #4, is cost of the wire transfer
worthwhile. The larger the average daily remittance the greater the advantage of wire transfer and
automatic clearing house transfers.
b) Opportunity savings and incremental profits:

Alternative 1

Alternative 2

Opportunity
saving

Saving
$1,175

Opportunity

Savings

Restaurant

savings

$450

$725

$300

$675

690

485

460

215

405

770

270

405

780

395

520

155

615

560

410

265

525

650

350

325

570

605

380

295

$375

In all cases, the opportunity profits are negative. Therefore, the company should stick with depository
transfer checks throughout. Part b) illustrates how sensitive the outcome is to the opportunity cost of
funds. At low interest rates, the savings from the released funds do not offset the fixed charges of wire
transfers or automatic clearing house transfers.
16-5. No solution recommended.

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Chapter 17
MANAGEMENT OF ACCOUNTS RECEIVABLE

17-1
Credit policy
B
C

A
(000 omitted)
Incremental sales
Incremental profitability
Receivable turnover
Additional receivables
Add1, investment (0.9)
Carrying cost (30%)

$2,800
280
8
$350
315
94.5

$1,800
180
6
$300
270
81.0

$1,200
120
4
$300
270
81.0

$600
60
2.5
$240
216
64.8

The company should adopt credit policy C because the incremental profitability exceeds the
increased carrying costs for policies A, B, and C, but not for policy D.
17.2

(000 omitted)
Incremental sales
Percent default
Incremental bad
debt losses Carrying cost (from 1.5)

A
$2,800
3%
$84
94.5
$178.5
$280.0

Incremental profitability (from 15-1)

Credit Policy
B
C
$1,800
$1,200
6%
10%
$108
$1.20
81.0
81.0
$189.0
$201.0
$180.0
$120.0

D
$600
15%
$90
64.8
$154.8
$60.0

Credit policy A is the only one where incremental profitability exceeds carrying costs plus bad debt
losses.
Credit Policy
(000 omitted)

$2,800

$1,800

$1,200

$600

1.5%

3%

5%

7.5%

$42

$54

$60

$45

Carrying costs (from 16-1)

94.5
$136.5

81.0
$135.0

81.0
$141.0

64.8
$109.8

Incremental profitability (from 16-1)

$280.0

$180.0

$120.0

$60.0

Incremental sales
Percent default
Incremental bad
debt losses

Credit policy B now would be best.

17.4
Present Terms
Credit sales

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Turnover of receivables
Average receivables
Reduction in receivables from present
level
Return on reduction in receivables

6
1,333,333

9
888,889
444,444
$53,333

Cost of discount being taken = $8,000,000 x .6 x .02


= $96,000
On the basis of these data, it is not appropriate to change. Changes in bad-debt losses, etc.,
should also be investigated.
17.5
(000 omitted)
1.Annual sales
2.Receivable turnover
3.Receivable level
4.Reduction from present level
5.Return on reduction
6.Bad debt percentage
7.Bad debt losses (annual )
8.Reduction in bad debt losses
9(5) + (8)

Present
Program

New Prog..
20% Disc.

New Prog.
10% Disc.

$12,000

$ 12,000

$12,000

4.8
$2,500

6.0
$2,000
500
$100
3%
$360
120
$220

6.0
$2,000
500
$50
3%
$360
120
$170

4%
$480

As the sum of the return on the reduction in receivables with a 20% opportunity cost plus the reduction
in-bad debt losses exceeds the increased collection expense of $180,000, the intensified collection
program should be undertaken. If the opportunity cost is 10 percent, however, the program is not
worthwhile as shown in the last column.

17.6. Positive factors:


(1)

The firm has maintained a reasonably good cash position over the period.

(2)

The company has reduced by 50 percent its out-standing long-term debt.

(3)

The firm has been increasing its shareholders' equity by $1 million annually.

(4)

The company has taken cash discounts when offered.

Negative factors:
(1)

The firm has only a fair D & B rating.

(2)

It has been a slow payer to trade creditors which do not offer a discount.

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(3)

The liquidity of the firm has been reduced over the past 3 years, as the acid-test ratio
went from 1.28 to 1.05 to 0.92. Short-term debt and trade payables have increased
significantly, while inventory turnover and receivable turnover have decreased.

(4)

The age of trade payables has increased dramatically (by about 400%)

(5)

The profitability of the firm has declined over the past 3 years.

(6)

The firm passed its dividend in 19X3, which may indicate financial problems.

17.7. a) Present value of $2 million receivable to paid at the end of one year:
PV =

$2.3 million
= $2 million
(1.15)

Expected present value of the receivable allowing for the bad debt loss:
EPV = $2 million (0.8) = $1.6 million
Cost of the order to Quigley:
C = $2.3 mi11ion (0.696) = $1.6 million
As costs approximately equal the expected present value, Quigley should be indifferent
as to whether or not the order is accepted.
b)

C = $2.3 million (0.74) = $1.7 million


As costs exceed the expected present value, the order should be rejected.
C = $2.3 million (0.65) = $1.5 million
Here the order clearly should be accepted.

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Chapter18
MANAGEMENT OF INVENTORIES
Case: Inventory management in Retail Industry Pantaloon Retail (India) Limited and Vishal
Retails Limited
Hints:
Retail industry typically has a low profit margin due to high overhead costs. In order to generate a good
return on investments notwithstanding low margins, a high inventory turnover ratio is critical. High
turnover ratio indicate ability of the company to rotate its inventories faster resulting in higher ROI. The
Gross Margin Return on Investments (GMROI) is gives as:

The first component is the Gross margin whereas the second component is the inventory turnover. A low
gross margin may still result in high GMROI if the inventory turnover is high. For example if the gross
margin for Pantaloon and Vishal is say 30%. With inventory turnover of 3.73 times and 2.09 times
respectively, the GMROI for Pantaloon and Vishal would work out to be 111.90% and 62.70%.
However a very high inventory turnover ratio may also indicate that the company is under-stocking the
goods and therefore losing potential sales.
Solutions
18-1.a) TC = CO/2 + SO/Q
(1)

TC = ($1) (5,0000/2 + (5,000) ($100)/5,000 = $2,600

(2)

TC = ($1) (2,500)/2 + (5,000) ($100)/2,500 = $1,450

(5)

TC = ($1) (1,000)/2 + (5,000) ($100)/1,000 = $1,000

(10)

TC = ($1) (500)/2 + (5,000) ($100)/500 = $1,250

(20)

TC = ($l) (2 50)/2 + (5,000) ($100)/250


= $2,125

b)

Q = Sq. Root of

(2) (5, 000) ($100)


1

= 1,000

Five times a year as per #5 above.


18.2.a)

Total number of dints required=150,000 x 12 = 1,800,000


Q = Sq. Root of
b)

(2) (1,800, 000) (200)


8

= 9,487

TC = CQ/2 + SO/Q
TC = (8)(9,487)/2 + (1,800,000) (200)/9,487
= $75,895

c)

1,800,000/9,487 = 190,or approximately every two days.

18.3a) Q = Sq. Root of

(2)(50, 000)($100)
.40

= 5,000

b) Additional carrying cost:

(Q1- Q*)C
2

(10, 000 - 5, 000)0.40


2

= 5, 000

Savings in ordering cost:

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SO/Q* SO/Q=

(50, 000)($100) (50, 0000)($100)


5, 000

10, 000

= $500
Total increase in costs=$1,000-$500 = $500
Savings available due to lower purchase price
Discount per unit x usage =.02 x 50,000
=$1,000
As the savings exceed the total cost increase, the company should take the quantity
discount.

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18.4.

Safety Stock
Level (Gallons)

Cost of
Carrying Safety
Stock

Incremental
Cost

Incremental
Stock out Cost
Savings

50,000

$3,250

7,500

4,875

$1,625

$12,000

10,000

6, 500

1,625

7,000

12,500

8,125

1,625

4,000

15,000

9,750

1,625

2,000

17,500

11,375

1,625

1,000

The level of safety stock should be increased to 15,000 gallons from 5,000 gallons.

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Chapter 19
LIABILITY MANAGEMENT AND SHORT/ MEDIUM TERM FINANCING
19.1 a)
Quarter
(000 omitted)

1st

2nd

3rd

4th

Total

Alternative 1:
Incremental
borrowings

$300

$1,000

$1,400

$500

30

42

15

Bank loan
cost*

$96.0

Alternative 2:
Term 1oan
$ 67.5

($500 at 13.5%)

cost
Incremental
borrowings

$500

$900

15

27

Bank 1oan
cost*

42.0
$109.5

Alternative 3-:
Term loan
$135.0

($1,000at 13.5%)

cost

Incremental
0

borrowings

$400

Bank loan
12

cost *

12.0
$147.0

*(11% + l %) / 4 = 3 % per quarter.


Alternative 1 is lowest in cost because the company borrows at a lower rate, 12%
versus 13.5%, and because it does not pay interest on funds employed when they are
not needed.
b)

While alternative 1 is cheapest it entails financing the expected build up in permanent


funds requirements ($500,000) on a short-term basis. There is a risk consideration in
that if things turn bad the company is dependent on its bank for continuing support.
There is risk of renewal and of interest rates changing.

Alternative 2 involves borrowing the expected increase in permanent funds requirements on


a term basis. As a result, only the expected seasonal component of total needs would be
financed with short-term debt. Alternative 3, the most conservative financing plan of the
three, involves financing on a term basis more than the expected buildup in permanent
funds requirements. In all three cases, there is the risk that actual total funds requirements
will differ from those that are expected.

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19.2. a)

5 365

= 36.9%
495 10

b)

20 365

= 24.8%
980 30

c)

2 365

= 149.0%
98 5

d)

7.50 365

= 56.4%
242.50 20

19.3.

No. Assume terms of 2/10, net 30. For a $100 invoice, the annual interest cost would be:

2 365

= 37.2%
98 20
For a $500 invoice, the annual interest cost is:

10 365

= 37.2%
490
20
19.4. a)

5 365

= 18.4%
495 20

b)

20 365

= 18.6%
980 40

c)

2 365

= 49.7%
98 15

d)

7.50 365

= 37.6%
242.50 30

The major advantage of stretching is the rather substantial reduction effected in annual interest
cost. The major disadvantages are the cost of cash discount foregone and the possible
deterioration in credit rating.
19.5.

Present average amount of wage accruals = $50,000/2


= $25,000
Change in average amount of wage accruals
= $25,000 .10 = $2,500

19.6.

Interest per year

$100,000

Placement costs

12,000

Less: Tax savings (40%)

($3,000 4)

$112,000

Net cost

44,800
$67,200

Funds raised

$1,000,000

Less: compensating balances

100,000
$ 900,000

Cost of funds = $67,200/$900,000 = 7.47%

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19.7.

a)

( $500/$24,500) (365/60) = 12.41%

b)

($3,500/$96,500) (365/180) =7.35%

c)

($1,200/$48,800) (365/90) = 9.97%

d)

($3,700/$71,300) (365/30) = 7.02%

e)

($900/$99,100) (365/30) = 11.05%

19.8.

(1)

(3/97) (365/20) =56.44%

(2)

$1,500, 000
= 17.05%
8,800, 000

(3)

$1, 200, 000 + $100, 000 + $100, 000


=14.0%
$10, 000, 000

The bank financing is approximately 3 percent more expensive than the paper; the latter,
therefore, should be issued.
19.9.

a)

$9,000/$100,000 = 9.00 percent. This is lowest.

b)

$8,400/$91,600 = 9 17 percent.

c)

The initial face value of the instrument on an add on basis is $106,000, indicating
quarterly payments of $26,500. Castellanos receives $100,000 in initial loan proceeds
and must pay back $26,500 each quarter. Solving for the discount rate with quarterly
compounding, it is found to be 9.49 percent on an annualized basis. While the company
pays 6 percent on $100,000, it has the use of that amount only in the first quarter.

19.10.
Item
Fork lift truck

Appraised
%
Value
Advance
$13,000
75%

Back hoe truck

Amount
Advance
$9,750

Interest
Rate
18%

Annual
Interest Cost
$1,755

19,000

80

15,200

18

2,736

6,000

50

3,000

20

600

38,

40

15,200

22

3,344

24,000.

60

14,400

20

2,880

Drill
press
Bottle
filler
Turret
lathe

$57,550

$11,315

The total amount the company may borrow against its used equipment is $57,550 and its, total annual
interest cost will be $11,315. The overall percentage cost is $11,315/$57,550 = 19.66 percent.
19-11.
a)

Interest cost ($200,000 0.10)(90/365)

$4,932

Warehousing cost

3,000

Efficiency cost

5,000
$12,932

b) Interest cost ($200,000 x 0.23) (90/365)

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Alternative b, the floating lien loan, is


Preferred.
19.12.

Factoring cost (monthly):

Purchase of receivables (.02) (.70) (500,000)

$7,000

Lending (.015) (100,000)

1,500
$8,500

Bank financing (monthly):


Interest (.0125) (100,000)

$1,250

Processing (.02) (100,000)

2,000

Credit department

2,000

Bad debt expense

3,500
$8,750

19.13.

The firm should continue its factoring arrangement.


The differential interest cost (finance company minus bank) is 7.5% 2.5% = 5%. The
quarterly differential becomes 1.25 percent.
Interest cost savings:

Quarter

Inventories

1
2
3
4
Annual savings

Inventories x 1.25%
$20,000
26,250
18,750
40,000
$105,000

$1,600,000
2,100,000
1,500,000
3,200,000

Annual servicing costs of the trust receipt loan:


$20,000 x 4 = $80,000.
As the savings exceed the increased costs, the company should utilize the. trust receipt
financing arrangement .
19.14. Balance sheet under growth assumptions (000 omitted):

Current assets
Fixed assets
Total assets
Current
liabilities*
Long-term debt
Shareholders '
equity**

Years in future
2
3
$15,376
$19,066
15,376
19,066
30,752
38,132

Now
$10,000
10,000
20,000

1
$12,400
12,400
24,800

4
$23,642
23,642
47,284

3,000
8,000

6,300
8,000

10,502
8,000

15,882
8,000

25,784
5,000

9,000

10,500

12,250

14,250

16,500

*The current liabilities row is a resideal and is found by subtracting long term debt and
shareholders' equity from total assets. In the fourth year, the term loan becomes a current
liability.

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**Increased by the amount of expected profits.


Protective Covenant

Years in future
Now

Working capital
Liabs to total assets

$7,000

$6,100

$4,874

$3,184

-$2,142

.550

577

.602

626

.651

Long-term debt does not increase. All growth is financed with short-term liabilities and retained earnings.
Net addition
fixed assets

$2,400

$2,976

$3,690

$4,576

3,100

3,844

4,767

5,911

$5,500

$6,820

$8,457

$10,487

$6,100

$6,844

$7,767

$8,911

Plus depreciation
Capital expenditures
Total available = $3 million + depr.

The company will breach the total liabi1ities- to- total assets ratio restriction in
the second year, the capital expenditures restriction in the third year, and the
working capital requirement in the fourth year, This is a classic example of a
company which wishes to grow at a rate faster than the growth in its retained
earnings The protective covenants will restrict this growth. Apart from the three
binding covenants, there is a serious question of whether the company can obtain
the large amount of additional short-term debt that is necessary to finance the
growth.
19.15. a)

d1 =

d2 =

1n (10 / 7 ) + [ . 06 + 1 / 2(.3) 2 ]4
.3 sq.Root of 4

= 1.29

1n (10 / 7 ) + [ . 06 + 1 / 2(.3) 2 ]4
.3 sq.Root of 4

n (d 1 ) = 1 .0968 = .9032 1
n (d 2 ) = 1 .2452 = .7548
Value of stock = $10 million (.9032)

$7 mi11ion
e(.06)( 4)

(.7548)

= $4,875,773
Value of debt = $10 million $4,875,773 = $5,124,227

ln (10 / 7 ) + .0 6 + 1 / 2 (. 5 ) 4

=
1.10
.5 of sq. Root of 4
2

b)
=
d1

ln (10 / 7 ) + [.0 6 + 1/ 2 (. 5 ) ] 4
2

d 2 =

.5 of sq.Root of 4

= 0.10

n(d 1 ) = 1 .1357 = .8643


n(d 2 ) = 1 .4602 = .5398

$7 million
Value of = $10 million (. 8643) .5398
(
)
e(.06)( 4)
= $5,670,648

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Value of = $10 million $5,670,648 = $4,329,352 debt


c)

The debt holders can protect themselves by imposing protective covenants which deal with the
investment in assets and with other covenants, such as a working capital restriction, which
constrain the riskiness of the company. If the company were permitted to increase the S.D. from
.30 to .50, there would be a $794,875 decline in the value of the debt. This problem points to the
importance of protective covenants to the lender and to the desire of stockholders to increase the
riskiness of the firm to take advantage of their option.

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Chapter 20
FOUNDATIONS FOR LONGER-TERM FINANCING

20.1 a) Business firms and governments are savings deficit sectors. In the case of business firms, the investment
in real assets exceeds retained earnings for the year. In the Case of governments, there is a budget deficit.
The household sector is a savings surplus sector because investment in real assets is substantially less
than savings.
b) The household sector provides net financing to the business firm and government sectors. This is evident
in the fact that its financial assets increase by a greater magnitude than its financial liabilities.
20.2

For a zero-coupon bond, the interest rate is embraced in the discount from the face value of $100.With
semiannual compound in, the present value of $100 twenty years hence is
Market Price =

$100
40

.085

1 +

= $18.92

20.3

A zero-coupon bond and a coupon bond, both of 20 years maturity, are different instruments with respect
to duration. The zero-coupon bond has a considerably longer duration. It is comparing apples with
oranges, so the same yield does not necessarily prevail. With arbitrage efficiency, the zero-coupon bond
rate must exceed the coupon bond rate if the yield curve is upward sloping and be less than the coupon
bond rate if it is downward sloping. Only if the yield curve is horizontal will the two yields be the same.

20.4

To the Treasury yield for 15 year s too maturity you add the credit yield spread that a single A corporate
must incur.

20.5

Approximate 15-year Treasury yield (from Figure 17-1)

6.2%

Approximate yield spread, single A Corporate versus Treasury (from Figure 17-4)

1.3%

Estimated yield for Fernando Bactra Company

7.5%

First of all, there must be an underlying demand for the new product. For this to happen, the financial
marketplace must be incomplete. In other words, there must be an unsatisfied demand for a security with
the features of the one being proposed. The demand must be sufficient to cover the cost of the
intermediary process, the costs of the computer application and provision of t he information system, and
to provide a profit to the promoter. Particularly with respect to the computer application, there will be a
lot of start-up costs. The expected spread and volume must be sufficient to cover these costs within a
reasonable period of time. (This is after variable costs have been covered.) Both a product and a process
are in-valued. In summary, demand must be of sufficient strength to cover costs of intermediation and
delivery if the idea is to be successful.

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Chapter 21
LEASE FINANCING
21.1. a) $260,000 = x + 2.9745x
x = $260,000/3.9745
x = $65,417.03
b) $138,000 = x + 6.2098x + $20,000 (.59190)
x = ($138,000 $11,838)/7.2098
x = $17,498.68
c)

$773,000 = x + 5.9852x
x = $773,000/6.9852
x = $110,662.54

21.2. a)

After the initial lease payment, there are five remaining payments. The lower cost discount
rate is the 11 percent cost of borrowing. The present value discount factor for an even
stream of cash flows for five years at 11 percent is 3,6959.

b) Principal amount during the first year for accounting purposes = $110,877.
Interest expense = $110,877 x 11% =

$12,196

Amortization expense

16,332

First year accounting lease expense

$28,528

21.3 Schedule of Cash Outflows: Lease Alternative


(1)

(2)

(3)

(4)

End of Year Lease Payment Tax Shield (1) x .35 Cash Outflow A.T. Present Value of Cash Flows
(1) (2)
0

$16,000

17

16,000

(7.8%)

$16,000

$16,000

$5,600

10,400

54,519

5,600

(5,600)

(3,071)
$67,448

The discount rate of 7.8 percent is the product of the cost of borrowing of 12 percent times one minus
the tax rate of 35 percent. For the lease alternative, the present value of cash outflows is $67,448.
Annual debt payment using a rearranged Eq. (181) is $100,000/5.5638 = $17,973.
End of Year

Debt Payment

Principal Owing

Annual Interest

$17,973

$82,027

$0

17,973

73,897

9,843

17,973

64,792

8,868

17,973

54,594

7,775

17,973

43,172

6,551

17,973

30,380

5,181

17,973

16,052

3,646

17.978

1,926

The principal amount of $1,00,000 is reduced by the initial debt payment of $17,973 to get the
principal amount owing at time 0 of $82,027. Interest on this in year 1 is found by multiplying it by 12

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percent. The debt payment in the last year is slightly larger due to previous rounding.
Schedule of Cash Outflows: Debt Alternative
(1)
End of Year Debt Payment

(2)

(3)

(4)

(5)

Interest

Depreciation

Tax Shield

Cash Outflow

.35 x [(2) + (3)]

A.T. (1) (4)

$17,973

$0

$17,973

17,973

9,843

$20,000

$10,445

7,528

17,973

8,868

32,000

14,304

3,669

17,973

7,775

19,200

9,441

8,532

17,973

6,551

11,520

6,325

11,648

17,973

5,18

11,520

5,845

12,128

17,973

3,646

5,760

3,292

14,681

17,978

1,926

674

17,299

Present value of cash outflows at 7.8% = $71,461.


Because the present value of lease payments, $67,448, is less than the present value of debt payments,
$71,461, the lease alternative dominates.
21.4 The after tax cost of leasing is given by Eq. (18 2). Setting up the problem this way, we have:

End of
Year

(1)

(2)

(3)

(4)

(5)

Cost

Lease
Payment

Depreciation

Tax Shield

(6)

Residual
Cash Flow
Value
.35 x [(2 t) 3]
(1) (2) + (4) (5)
A.T.

0 100,000

16,000

84,000

16,000

20,000

(1,400)

(17,400)

16,000

32,000

(5,600)

(21,600)

16,000.

19,200

(1,120)

(17,120)

16,000

11,520

1,568

(14,432)

16,000

11,520

1,568

(14,432)

16,000

5,760

3,584

(12,416)

16,000

5,600

(10,400)

5,600

9,100

(3,500)

The internal rate of return for the last column is 8.16 percent. As this rate is slightly higher than the
after tax cost of debt financing, 7.80 percent, the buy/borrow alternative now would be preferred. The
residual value of $14,000 times one minus the tax rate, $9,100, is a value foregone by the lessee. This
opportunity cost is sufficient to tip the scales in favor of buy/borrow. The same would be the case if the
present value method of analysis were employed.

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21.5. a)

Lease Alternative:

End of Year

(1)

(2)

(3)

(4)

Lease Payment

Tax Shield

Cash Out Flow A.T.

PV of Cash Outflows

(1) x .30

(1) (2)

(7%)

$19,000

$0

$19,000

$19,000

14

19,000

5,700

13,300

45,050

5,700

(5,700)

(4,064)

$59,986
The discount rate of 7 percent is the product of the cost of borrowing (10%) times one minus the tax
rate of, 30 percent. The present va1ue of cash outflows is $59,986.
Debt Alternative:
Annual debt payments are:
$80,000 = x + 3.1699 x (3.1699 = PV factor f or 4 year annuity at 10%)
x = $80,000/4.1699
x = $19,185

End of Year

Debt Payment

Principal Amount Owing Annual Interest

$19,185

$60,815

$0

19,185

47,712

6,082

19,185

33,298

4,771

19,185

17,443

3,330

19,187

1,744

The principal amount of $80,000 is reduced by the amount of the first payment of $19,185 to give
$60,815 at time 0. The last debt payment is slightly higher due to rounding.
Schedule of Cash Outflows: Debt Alternative:
(1)
End of Year

(2)

(3)

Debt Payment Interest Depreciation

(4)

(5)

(6)

Tax Shield

Outflows

PV Cash Outflows

.30 x (2)+(3)]

(1) (4)

(7%)

$19,185

$0

$0

$0

$19,185

$19,185

19,185

6,082

16,000

6,625

12,560

11,738

19,185

4,771

16,000

6,231

12,954

11,315

19,185

3,330

16,000

5,799

13,386

10,927

19,187

1,774

16,000

5,323

13,862

10,575

16,000

4,800

(4,800)

(3,422)

(7,000)

(4,991)

Residual value times (1 .30)

$55,327
As the present value of cash outflows for the debt alternative is lower, $55,327 wears us $59,986, it
would be preferred.
b)

Schedule of Cash Flows: IRR Analysis of Lease

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End of
Year
0

(1)

(2)

(3)

(4)

Cost

Lease
Payment

Depreciation

Tax Shield

$80,000

(5)

.30 x (Lt 1 Pt)

(6)

Residual Value PV Cash Flows


A.T.
(4) (5)

$19,000

$0

$0

$61,000

19,000

16,000

900

(18,100)

19,000

16,000

900

(18,100)

19,000

16,000

900

(18,100)

19,000

16,000

900

(18,100)

16,000

900

$7,000

Solving for the internal rate of return for the last column, we find it to be 10.11 percent. The after tax
cost of borrowing of 7 percent is lower, and it dominates. The answer is the same as in the present
value method of analysis, as we would expect.
21.6. Present value of lease payments:
x = $200,000 (1 + 2.5313) = $706,260
(2.5313 is the present value factor for a 3 year annuity at 9%)
Net present value of the project based upon the cash equivalent method:
NPV = $706, 260 +

$180, 000 $250, 000 $320, 000 $240, 000


+
+
+
= - $55, 621
2
3
4
(1.18)
(1.18)
(1.18)
(1.18)

As the net present value of the project is negative, it should be rejected (port facility not leased).
21.7. For equipment costing $80,000 with quarterly payments of $4,400 payable at the beginning of each
quarter for 5 years, and a residual value of $20,000, the problem can be set up as follows:

19
$4, 400
$20, 000
80, 000 = SUM
+
4
20
R R

t=0 1 +
1
+

Solving for R, it is found to be 11.23 percent.

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Chapter 22
ISSUING SECURITIES
Case: Reliance Power IPO
Hints:
1. There is no quantitative justification of the issue price company has a very low EPS, book value per
share is Rs.10, promoters holding 90% of the post issue share capital were allotted shares at par, other
companies in the same sector are trading at a P/E multiple of around 18 times and companys projects are
still at the planning stage. Issue price was justified purely on qualitative factors.
2. Management decided to issue bonus shares to pacify the investors who lost money on listing below the
issue price. As Reliance is a big conglomerate they would be required to tap the capital market again and
again and therefore it is important for the group to maintain an investor friendly posture.
3. Bonus issue does not really help in reducing the cost to the non-promoter investors. However as the
bonus shares were not issued to the promoters, it did help the investors in IPO. Their shareholding
increased from 10% to 15%. Had bonus shares were also issued to the promoters, there would have been
no change in the shareholding pattern as all the investors would have received the bonus shares in
proportion of their holdings in the company.
Solutions
22.1. Number of bonds = $75 mil1ion/$1,000 = 75,000 bonds
Total selling concession = 75,000 x $6 = $450,000
Administrative expenses

115,000
$565,000

Management fee plus underwriting commission = 40%


a)

The total spread is found by solving the following equation for x.


$565, 000 100% - 40%
=
x
100%
x = $941,667
Spread per bond = $941,667/75,000 = $12.56

b) $75,000,000 $941,667 = $74,058,333


c)

$450,000/$941,667 = 47.79%

d) $941,667/$74,058,333 = 1.27%
22.2 a)

Number of bonds issued = $1.8 bil1ion/$1,000


= 1,800,000 bonds
Total underwriting spread 1.8 million bonds x
$7.50 = $13,500,000
Total out-of - pocket expenses = 6 underwritings x
$350,000 = $2,100,000
Total flotation costs $13,500,000 + $2,100,000 = $15,600,000.

b) Total underwriting spread = 1.8 million bonds x


$3.00 = $5,400,000
Total out of pocket expenses = 24 underwritings
(i.e., $1.8 billion/$75 million) x $40,000 = $960,000
Total flotation costs = $5,400,000 + $960,000
= $6,360,000

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c)
22.3. a)

The shelf registration method has the lower costs.


Company Y has the larger issue relatively. It is issuing one new share for each four shares that
are outstanding, or an increase of 25 percent. Company X is issuing one new share for each 14
that are outstanding, which represents an increase of 7.14 percent. One cannot say whether
Company Y has the larger offering in absolute terms. That depends on the number of shares
for Company X. For example, if Company Y had one million shares outstanding while
Company X had four million shares outstanding, we would have the following:
Company X = 4 million shares (1/14) = 285,714 new shares
Company Y = 1 million shares (1/4) = 250,000 new shares

b) The theoretical value of one share of stock when it goes ex-rights is:
Company X =

($48 14) + $42


= $47.60
14 + 1

Company Y =

($48 4) + $41.50
= $46.70
4 +1

The lower theoretical value of Company Y is due to its having a larger relative offering. Its
exrights theoretical value is somewhat closer to the subscription price, $46.70 - $41.50 =
$5.20, than is the case for Company X, $47.60 - $42.00 = $5.60. If all other things were the
same, there would be a greater risk of the market price falling below the subscription price for
Company Y than for X.
22.4. a)

R0 = P S =

$50 $40
= $1.67
5 +1

0
N =1
b)

( $50 5) + $40
Px =
P N + S =
$48.33
=
6
0
N =1

c)

Rx = P S =

$50 $40
= $2.00
5

x
N
d) (1) $1,000/$50 = 20 shares x $60 = $1,200
$1,200 $1,000 = $200
(2) $1,000/$2 = 500 rights x $4* = $2,000
$2,000 $1,000 = $1,000
*R x = (60 40)/5 = $4
22.5. a)

(1)

Rights offering: 200,000 shares


= $40
EPS = $4.8 million/l.2 million shares
= $4.00
DPS = $4.8 .million/1.2 million shares
= $4.00
Market price per share $4 x 12.5

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= $50
(2)

Public offering: $8 million/($45 x .94) = 189,125 shares


EPS = DPS = $4.8 million/1,189,125 = $4.04
Market price per share = $4.04 12.5
= $50.50

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b) Rights offering: $4.00/$48 = 8.33%


$2.00 price gain on investment, assuming Brown is' a perpetual holder.
Public offering: $4.04/$48 = 8.08%
$0.50 gain in price.
22.6. a)

Most likely true worth at the end of six years is $50 million.
Venture capitalists' share = .70 $50 million
= $35 million
Proceeds realized = $35 million .80
= $28 million, after discount of 20 percent in initial public offering.
The rate of discount that equates $28 million the end of year 6 with a cash outflow of
$5.8 million at time 0 is 30.77 percent.

b) Profanity distribution of possible cash flows at the end of year 6:


(1)
Probability

(2)
True
Worth

.3
.5
.2

$0
50
80

(3)
(4)
(5)
Venture Capitalist After under- pricing Expected cash flow
Portion (.7)
(4) x .8
(1) (4)
$0
35
56

$0
28
44.8

$0
14.00
8.96
$22.96

The rate of discount that equates the expected cash flow of $22.96 million at the end of year 6 with
a cash outflow of $5.6 million at time 0 is 26.51 percent.
22.7. The stock issue is likely to be interpreted as bad news by investors and the stock price will decline,
all other things the same. A debt issue may be interpreted either as a neutral thing or as good news
with a positive stock price effect. The causes may be a cash-flow information interpretation and/or
asymmetric information. With the former, the security sale may be associated with lower than
expected cash flows, particularly for stock sales which are less anticipated than debt, sales. With
asymmetric information between management and investors, the company is presumed to sell
common when management believes the stock is overvalued and debt when it is believed to be
undervalued. These two actions would be interpreted as bad news and good news respectively by
investors.

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Chapter 23
FIXED-INCOME FINANCING AND PENSION FUND LIABILTY
Case: Impact of put and call option Deep Discount Bonds issued by IDBI and Sardar Sarovar Narmada
Nigam Limited
Hints:

1. As these bonds have a long maturity and dont carry any coupon interest, they are issued at
a discounted price and redeemed at par. Due to long maturity the discount is substantial
hence the name deep discount bonds.
2. Due to long maturity period it is very important to keep flexibility if the interest rates in the
economy changes, the issuer must be able to react appropriately. For example IDBI kept that
flexibility by way of a call option i.e. right to call back the bonds before maturity whereas
SSNL failed to insert a call option clause in the offer document.
3. Call option i.e. right to call back works in favour of the issuer as they have a right to call back
the bonds if the interest rate declines. Put option on the other hand works for the investor in
case rate of interest in general increase.
4. No it is neither legal nor ethical as the investors have subscribed to the bonds based upon
the terms and conditions mentioned in the offer document. The regulator and court would
not permit SSNNL to go against their contractual obligations.

Solutions
23.1 If the yield to maturity is 12.21 percent, the bonds will sell at a sizable premium. (Without the maturity
date, one cannot calculate the magnitude of the premium.) As a result, the company should deliver $1
million in cash to the trustee. If the .yield is 14.60 percent, the bonds will sell at a discount from their face
value. Here the company should buy bonds in the market and deliver them to the trustee, as, the outlay
involved to purchase 1,000 bonds will be less than $1 million. This assumes that accumulators do not
squeeze the company.
23.2 The mortgage holders receive $5 million from the sale of mortgaged assets, leaving them with $5 million
in unsatisfied claims. There is $10 million realized from the sale of other assets which will be divided
among other creditors as well as the mortgage holders. The mortgage holders have a claim for their unsets
fixed $5 million as well as for the $5 million in claims of the subordinated debenture holders. Therefore,
they are entitled to ($5 + ($5)/($5 + $5 + $15) = 40 percent of the $10 million realized from the sale of
other assets, bringing their total distribution to $9 million. General creditors receive the remaining, $6
million, and subordinated debenture holders receive nothing, having forfeited their claim in bankruptcy to
the mortgage holders.
23.3 a)

Total interest payments for the non-callable bonds = $10 million x 11.40% x 10 = $11.4 million.
Interest payments for callable bonds the first five years = $10 million x 12.00% x 5 = $6 million.
Interest payments the next five years:
(1)
(2)
(3)
Interest Rate 5-Year Cost
Issuing Expenses
9%
$4.5 mil
$0.2 mil
10
5.0
0.2
11
5.5
0.2
12*
6.0
0
13*
6.0
0
Expected value of interest and issuing expenses

(4)
(2) + (3)
$4.7 mil
5.2
5.7
6.0
6.0

(5)
Probability
0.1
0.2
0.4
0.2
0.1

(6 )
(4 ) x ( 5)
$0.47 mil
1. 04
2.28
1.20
0.60
$5.59 mil

*The company would not call its bonds and would continue to pay 12 percent interest on the original
issue.

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Expected value of total interest and other costs over the ten years for the callable bonds = $6.0
million + $5.59 million = $11.59million. As this total cost exceeds that for the non-callable bonds,
$11.4 million, the company should issue non-callable bonds.
b)
(1)
(2)
(3)
Interest Rate 5-Year Cost
Issuing Expenses
7%
$3.5 mil
$0.2 mil
9
5
0.2
11
5.5
0.2
13*
6.0
0
15*
6.0
0
Expected value of interest and issuing expenses

(4)
(2) + (3)
$3.7 mil
3.7
5.7
6.0
6.0

(5)
Probability
0.2
0.2
0.2
0.2
0.2

(6 )
(4 ) x ( 5)
$0.74 mil
0.94
1.14
1.20
1.20
$5.22 mil

*The company would not call its bonds and would continue to pay 12 percent interest on the original
issue.
Expected value of total interest and other costs over the ten years = $6 .0 million + $5.22 million =
$11.22 million. As total costs are now less than that for the non-callable bonds, $11.4 million, the
company should issue callable bonds.
The problem illustrates that the greater the variance of future interest rates, the greater the value of the
call option to the corporate issuer. (The expected value of interest rates five years hence stays the
same at 11 percent.)
23.4 a)

After five years, the call price is $1,060 per bond. Solving for the rate of discount that equates the
present value of a stream of $100 in interest payments each year for five years and $1,060 at the end
of that time with the $990 paid for the bond at the beginning, we find it to be 11.23 percent.

b) The cash flow stream now is $100 in interest payments for 5 years, $1,060 in call price minus the
$1,000 paid for the new bond or $60 at the end of year 5, $80 each year from year 6 through year 25,
and $1,000 in principal received. at the end of year 25. Solving for the discount rate that equates the
present value of this stream with the $990 initially paid for the bond, we find it to be 9.33 percent.
This compares with a yield of slightly more than 10 percent (10.11% to be exact) if the original bond
could be held to maturity. The point to be made is that the investor suffers an opportunity loss in
having to invest in a bond providing a lower return.
23.5
Cost of calling old bonds (@114)
Net proceeds of new issue ($990 per bond)
Difference
Expenses:
Issuing of new bonds
Net interest expense of old bonds during overlap
Gross cash outlay
Less tax savings:
Interest expense during overlap
Call premium
Unamortized discount
Unamortized issuing expense of old, bonds
Tax savings (40%)
Net cash outflow

$200,000
583,333

783,333
$8,283,333

583,333
7,000,000
1,000,000
100,000
$8,683,333
3,473,333
$4,810,000

Annual cash outflow of old bonds interest


expense (14%)

Financial Management and Policy, 12/e

$57,000,000
49,500,000
$7,500,000

$7,000,000

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Less tax savings:


Interest expense

$7,000,000

Amortization of discount

40,000

Amortization of issuing expense

4,000
$7,044,000

Tax savings (40%)

2,817,600

Annual cash outflow on old bonds

$4,182,400

Annual cash outflow of new bonds interest


expense (12%)

$6,000,000

Less tax savings:

$6,000,000

Interest expense

20,000

Amortization of discount

8,000

Amortization of issuing expense

$6,028,000

Tax savings (40%)

2,411,200

Annual cash outflow on new bonds

$3,588,800

Difference in annual cash flow = $4,182,400 $3,588,800 = $593,600.


The discount rate is 12% (1 .4) = 7.2%. The present value of $593,600 for 25 years at a 7.2% rate of
discount is $6,794,699. As this amount exceeds the cash outflow of $4,810,000, the refunding is worth
while. In other words, the NPV = $1,984,699.
23.6. a)

$8.00/.09 = $88.89

b) Gross amount that must be raised to net the railroad $9.5 million:
$9.5 mi11ion (1 .05) = $10 mi11ion.
$10 million/$88.89 = 112,499
23.7. a)

b)

c)

Preferred

Common

(1)

$5.00

$0

(2)

3.00

(3)

13.00

(1)

$7.00

$0.60

(2)

7.00

1.00

(3)

8.00

3.00 (participating feature effect)

(1)

$5.00

(2)

9.00

0.70 (cumulative feature effect)

(3)

8.50

4.00 (participating feature effect)

0.40 (cumulative feature effect)

$0

While the participating feature in preferred stock is seldom used it has been used in the past, particularly
with companies that have been reorganized under circumstances of financial distress.

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23.8. a)

The PV of expected its for future service rises by the present value of $25,000 per year from
retirement (20 years hence) through Mr. Zambrano's life expectancy. The unfunded liability would
increase unless offset by an increase in the PV of expected future contributions, which would likely
be the case.

b) The PV of existing pension fund assets increases by $400,000, and the unfunded liability decreases
by that amount.
c) The PV of expected benefits to retired employees increases and the unfunded liability increases by
that amount.
d) The PV of all expected benefits declines as does the PV of expected future contributions. Assuming
the company has significant existing pension fund assets, the unfunded liability would decline.

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Chapter.24
HYBRID FINANCING THROUGH EQUITY-LINKED SECURITIES
Case: Rights Issue of CCCPS by Tata Steel Limited
Hints:

1. If the amount was raised by issuing equity shares, there would not have been any fixed charge on the profit
and loss. However due to equity expansion, EPS would have declined and also dividend would have been
payable on the enlarged equity base. As equity is perpetual, there would have been no cash flow on account
of repayment of principal.
In case of debentures, the interest on debentures is a charge on profit and had to be paid irrespective of
profit made. The interest though is tax deductible. In addition the principal amount would be repaid on
maturity.
CCPS on the other hand is a hybrid instrument. The dividend is paid out of profits and on maturity the
preference shares are converted into equity shares. The equity expansion therefore is not immediate but
delayed.
2. To avoid immediate equity expansion the company did not issue direct equity. Debenture issue would have
lead to increase in interest cost and large cash outflow on maturity, through CCPS both the problems were
avoided.

Solutions
24.1. TV = NPs
a)

TV = (5) (100) - 400 = $100

b) TV = (10) (10) - 60 = $40


c)

TV = (2.3)(4) - 10 = -$0.80, or zero

d) TV = (3.54) (27.125) - 35.40 = .$60.62


24.2 a)

3 ($18) - $60 = -$6, or zero as the warrant cannot have a negative price.

b) .15($16) + .20($18) + .30($20) + .20($22) +.15($24) = $20


c)

For market prices per share of $20 or less, the theoretical value of the warrant will be zero. Therefore, the expected
value of the oretical value of the warrant six months hence is :
.15(0) + .20(0) + .30(0) + .20($66 - $60) + .15($72 - $60) = $3.00

d) As this amount is positive, we would expect the warrant to sell at some positive price, presumably less than $3.00., In
other words, the investor has the possibility of the warrant having some positive stock value, and a 0.15 probability for
a $12 value. Therefore, the warrant is worth more than its current theoretical value of zero.
24.3 a)

Capitalization
Before
Financing
Debentures

b)

Convertible
Before
Conversion

Debentures
After
Conversion

$10,000,000

Debentures With Warrants


Before
After Exercise
Exercise
$10,000,000

$10,000,000

Common stock
Paid-in capital

$5,000,000
10,000,000

5,000,000
10,000,000

$6,000,000
19,000,000

5,000,000
10,000,000

5,200,000
11,800,000

Retained earnings

15,000,000

15,000,000

15,000,000

15,000,000

15,000,000

Net worth
Total capitalization

30,000, 000
$30,000,000

30,000,000
$40,000,000

40,000,000
$40,000,000

30,000,000
$40,000,000

32,000,000
$3,200,000

1,000,000

1,000,000

1,200,000

1,000,000

1,040,000

Number of shares
Earnings

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EBIT

$6,000,000

$8,000,000

$8.000,000

$8,000,000

$8,400,000

Less: Interest
Net income before taxes

6,000,000

800,000
7,200,000

8,000,000

1,000,000
7,000,000

1,000,000
7,400,000

Less taxes
Net income

6,000,000
3,000,000

3,600,000
$3,600,000

4,000,000
$4,000,000

3,500,000
3,500,000

3,700,000
$3,700,000

$3.00

$3.60

$3.33

$3.50

$3.56

Earnings per share


c)

T.V = NP S E = 4(75) 200 = $100

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24-4 a)
EPS

$2.50
16

P/E ratio
Price per share

$40.00

Premium (20%)

8.00

Conversion price
b) Face value per bond

$48.00
$1,000

Divide by conversion price


Conversion ratio

48
20.833 shares per bond

c)

Conversion value = 20.833 $40 = $833,30

d)

100, 000 debentures ($1,000 face value) 20.833 = 208,333 new shares.

e)
(000 omitted)
Operating earnings
Less interest
Profit before tax
Taxes
Profit after tax
Less dividends (2/3)
Earnings retained
Earnings per share

Before
Original Conversion After
$5,000 $6,000
$6,000
900

5,000 5,100
6,000
2,500 2,550
3,000
$2,500 $2,550
$3,000
1,667 1,700
2,000
833
850
1,000
$2.50

$2.55

$2.48

24-5.
(000 omitted)
Operating earnings
Less interest
Profit before tax
Taxes
Profit after tax
Less dividends
Earnings retained
Earnings per share
24-6.

$6,000
1,200
4,800
2,400
2,400
1,600
$800
$2.40

The straight bond value can be determined using Equation (24 3), or a bond yield table. Using semi annual compounding
and rounding:

40
$40
$1, 000
a) B = Sum
+
= $646
t
40
1.065) (1.065)
(
t=1
30
$50
$1, 000
b) B = Sum
+
= $862
t
30
1.06) (1.06)
(
t=1

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24.7. a) Premium over conversion value:


Observation
1
2
3
4
5
Market Price of convertible
$1,065
$1,140
$890
$740
$640
Conversion value Shr. Price x 25 premium
1,000
1,125
800
575
450
Premium
$65
$15
$90
$165
$190
Straight bond value
$690
$700
$650
$600
$550
Premium over bond value
$375
$440
$240
$140
$90
At high common stock prices, the convertible debenture sells at a substantial premium over its bond value, but only at a
slight premium over its conversion value. Here the convertible sells mainly for its common stock attraction, and the bond
feature is of negligible importance. Also, there is the danger of a call, where the security will be worth only its conversion
value. As share price declines from a high of $45, the premium over conversion value increases. The option feature remains
a factor, but increasingly the straight bond value becomes important as the premium over bond value declines. As share price
drops, particularly below $32, the bond value falls in keeping, with the greater default risk. At an $ 18 share price, the
premium over bond value is relatively small. The security sells in an important way for its bond value protection, though the
stock option still has some value.

b)

24.8.

At $10 per share, the conversion value is $250 and the premium over conversion value is $190. The premium over bond
value is $30. As the stock price has weakened, due to probable financial difficulty, the bond value floor has fallen. Much
less downside protection is given. While some of the variation in bond value may be due to changing interest rates in the
bond market, most is due to changing perceptions of default risk. At $10 a share, the convertible sells mainly for its bond
feature. The stock option has some value, but $30 is a very small premium over the security's straight bond value.

24.9.

The exchange price is $1,000/16-2/3 =$60


Premium = ($60/$50) - 1 = 20%
If Malyasian Palm oil stock is more volatile than Singapore Enterprises stock, the option value will be greater with an
exchangeable offering than it will be with a convertible issue. If the two companies are unrelated, diversification of
bond value and stock value may hold advantage as well.

24.10. a)

2
1n (39 / 32)+
.05 + 1 / 2 (.20)
3

= 1.177
d1 =
.20 of Sq. root of 3
2
1n (39 / 32)-
.05 + 1 / 2 (.20)
3

= .831
d2 =
.20 of Sq. root of 3

n (d1 ) = N (1.177) = 1- .1197 = .8803


n (d 2 ) = N (.831) = 1- .2031 = .7969
v w = $39 (.8803)-

$32
e(

.05)(3)

(.7969) = $12.38 2

= $24.76

b)

2
1n (39 / 32)+
.05 + 1 / 2 (.40)
3

= .848
d1 =
.40 of Sq. root of 3
2
1n (39 / 32)+
.05 - 1 / 2 (.40)
3

= .1556
d2 =
.40 of Sq. root of 3

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N (d1 ) = N (.848) = 1- .1983 = .8017


N (d 2 ) = N (.1556) = 1- .4382 = .5618

v w = $39 (.8017)-

$32
e(

.05)(3)

(.5618) = $15.79 2

= $31.58
Increased volatility of the underlying asset enhances the value of the option, all other things the same. This is because the
downside risk is bounded at zero while t here is unlimited upside potential. As a result, increased volatility increases the
value of the option.

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Chapter 25 : Emerging methods of financing


Case: Venture Capital Financing by Gujrat Venture Fund Limited
Hints:

Funding to first generation entrepreneurs


Untested technology pioneers in their own field
Yet to merge sectors biotech, IT and auto ancillaries
Capital and Management Support
Long term commitment and relationship
Support in arranging strategic tie ups, strengthening internal systems, corporate governance,
net working with industry experts

As against this the banks usually fund existing profit making, mature companies with proven track
record. Banks only provide finance and no managerial support.

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Chapter 26
MANAGING FINANCIAL RISK
Case: Financial Risk Management by some prominent Indian Companies
Hints:

1. FRM tools being used by GE Shipping matching of foreign exchange earnings and
expenditure, hedging using forward and option contracts. Use of swaps to convert
floating rate liabilities to fixed interest rate.
Hindalco use of derivatives for hedging commodity price risk and foreign exchange
risk, swaps for hedging interest rate risk.
Grasim use of derivatives, backward integration and forward integration as well
setting up of captive power plant as risk mitigation techniques
2. No some risks are being managed by natural hedges like matching inflows and
outflows of foreign exchange, backward integration and forward integration as well
setting up of captive power plant as risk mitigation techniques.
Solutions

26-1. When apples rise by $0.06/$2.00 = 3%, oranges tend to rise by $0.12/$1.50 = 8%. Therefore,
Value apples = a + (3/8) (Value oranges)
and the appropriate hedge ratio is .375. This means for every pound of apples, we would make an
offsetting commitment (opposite in sign) of .375 pounds of oranges.
26-2. a)
b)

Bo Lo Corporation should sell 24 Treasury bond futures contracts to hedge against rising
interest. That is, the hedge rate times $2 million, divided by the contract size of $100,000.
Cash market:

9%,20-year Corporate bond currently sells at


$100

$2,000,000

3 months hence it sells at $94

1,880,000

Loss

($120,000)

Futures market:
Sell 24 Treasury bond futures

$2,400,000

contracts at $100 now


3 months hence buy 24 Treasury bond futures contracts at
$95.5 Gain

2,292,000
$108,000

The gain from the futures market transaction of $108,000 mostly offsets the opportunity loss from the
cash market of $120,000. However, the hedge is less than perfect, and there is a moderate opportunityloss to Bo Lo Corporation.
26-3. Reasons for the less than perfect hedge (basis risk in problem 22-2) are several. Probably the most
important thing at work is the cross hedge. Bo Lo Corporation is using the Treasury market (futures) to
hedge a corporate bond market (cash) transaction. Secondly, even for Treasury bonds, the cash and
futures markets do not move entirely in concert. There are random fluctuations in the two markets
which either are not removed immediately by arbitrage or are within the transactions - cost boundaries
of arbitrage.
In settlement of a futures contract, delivery can be with any Treasury bond from a basket of bonds
with 15 years or more to final maturity. This may result in a maturity mismatch, as well as in a coupon
rate mismatch. The combined effect of these two factors could be a duration mismatch. Because the

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contract size integer is $100,000, it may not be possible to get the hedge ratio entirely correct. A more
technical reason has to do with, differences in settlement procedures between the futures and the cash
markets. All of these things account for basis risk.
26-4. a)

Implied forward rate

= [(1.08)4 /(1.072)3] 1
= 10.44%

b) Implied forward rate

= 8.00%

c)

= 6.51%

Implied forward rate

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When the term structure of interest rates is upward sloping, as in a), the forward rate is in excess
of the two actual rates of interest. When the yield curve is flat throughout, the forward rate
equals actual rates on either side. Finally, when the term structure is downward sloping, the
forward rate is less than the two actual rates of interest. The mathematics for solving for forward
rates is like marginal- costs and average costs in micro-economics.
26-5.The forward and futures markets serve the same economic function when it comes to hedging.
However, the two contracts differ in the detail. A forward contract can be arranged explicitly, or
implicitly for amounts other than the contract size integers of $1 million and $100,000 which
prevail in the futures market. Settlement procedures differ in that futures contracts are settled
daily with the marked-to-market
System that the exchanges use. Forward contracts are settled only at the end, whether it be the
contract's expiration or its reversal. Default risk generally is greater with a forward contract,
because investment banks have somewhat more credit risk than the clearinghouse of a futures
exchange.
26-6. a) By buying a call option, the value of the contract will rise as interest rates fall. This is the
appropriate hedge for the company.
b) $4 million (1.06 - 1.00) =

$240,000

Less premium paid for the call option


($4 million x .02)

80,000
$160,000

Net gain on option

Of the total opportunity loss of $24,000, arising from not being able to invest earlier, the
company recoups two-thirds by hedging with an option.
If interest rates rose, the option would be out of the money and would not be exercised. In. this
case the company will be out the premium, paid for the option of $80,000.
c)

26-7.

If interest rates were expected to decline no more than would cause the futures contract to rise in
value by 2 percent, the company may choose not to hedge. The option cost is 2 percent, so it
would be money ahead as long as the increase in value of the futures contract is less than 2
percent. If only modest fluctuations in interest rates are expected, the company may wish to
write put and call options. For this to be a viable strategy its expectations must be for lower
volatility than what the market expects. With significant volatility, the company will lose. To
write contracts obviously is not hedging, but speculating on volatility.
The use of interest - rate options involves a one sided hedge. It is like insurance, in that one
protects against an adversity. For this protection you pay a premium. Your loss is bounded at
this amount of money paid. Option valuation depends heavily on the volatility of the associated
asset. This valuation was taken up in Chapter 5.
With futures or forward markets, two-sided hedges are involved. Here the position in the cash
market is offset by a position opposite - in sign - in the futures or forward market. The hedger
hopes to largely neutralize the effect of changing interest rates. However, there still remains
basis risk which makes any hedge less than perfect.

26-8. a) As the company wishes to gain if the yield curve flattens, it should buy a put option.
b)

(160 200) x .01 x $1 million = $400,000


From this we subtract the premium of $50,000 to give a net gain of $350,000.

c)

The option would expire out of the money, and Jorrell Company would be out the $50,000 paid
for the put option.

26-9. a)

Excell National Bank loses by borrowing on a floating- rate basis and lending on a fixed-rate
basis when interest rates rise, and gains when they fall. Colossus Corporation gains in an
opportunity sense on its fixed-rate borrowings when interest rates rise, and loses when they fall.

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b) Direct financing costs:


Fixed rate
Floating rate

Colossus

Excell

9.10%

9.70%

LIBOR +

LIBOR +

0.2%
Intermediary cost

0.4%
0.07%

Swap:
Fixed rate
Floating r ate
Savings:

+9.20%

9.27%

LI BOR

+LIBOR

9.10% + 9.00%
+ (LIBOR + 0.2%)
LIBOR
= 0.30%

All in cost

LIBOR 0.1%
floating

9.70% 9.27%
+(LIBOR+0.2%) (LI
BOR+0.4%)
= 0.23%
9.47%
fixed

c)

The savings involve possible differences in credit risk, with Excell National Bank implied to be
the riskier counterparty. Other reasons for savings include: comparative advantage in borrowing
by the two parties (likely to be small if it exists at all in an arbitrage world); incomplete markets
in that the swap market serves a longer maturity hedging area than is served by other devices; tax
and regulatory arbitrage; and possible differences in call risk. Probably differences in credit risk
are the principal explanation for the supposed savings.

26-10.

The company can buy futures contracts or futures options on crude oil or heating oil, whichever
has the lowest basis risk. If the hedge is two-sided through buying a futures contract,
Aluminax will gain on the futures contract if oil prices rise, but lose on its energy costs, and vice
versa if oil prices fall.
With a call option, the company gains on its option position if oil prices rise (less the premium
paid) , and loses on its energy costs.. With this one-sided hedge, it does not exercise its call
option if prices fall. In this situation, the company gains on lower energy costs. However, it is
out the premium paid for the call option.

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Chapter 27
MERGERS AND THE MARKET FOR CORPORATE CONTROL
Case: Tata Steels Acquisition of Corus Group plc
Hints:

1. Organic Growth expansion of capacity, inorganic growth through acquisitions. A series of


acquisitions by Tata Steel.
2. Compelling reasons transformation of TSL form a domestic company to international steel
company with global scale. Corus is almost 4 times TSL in terms of revenue. Strong synergies
would lead the combined entity to be better than the two companies put together. Combined
entity to be sixth largest in the world.
3. Synergies TSL has low cost intermediate products which could be processed by Corus to high
end finished products, TSL would benefit from Coruss R&D, synergies in operations Corus gets
access to high growth markets of Asia and also low cost of production.
Solutions

27-1.a)

Shares offered of Company A=1 million.


Company A

Company B

EPS before the merger

$2.00

$4.00

Market price per share before the merger

$36.00

$40.00

Surviving Company
Earnings (in millions)

$24.0

Shares (in millions)

11.0

Earnings per share

$2.18

Shareholders in Company A experience an improvement in earnings per share while former shareholders in
Company B experience a substantial reduction.
Market value exchange ratio =

$36 1
= 0.9
4

As Company B is being offered stock worth less- than the current market value of its stock, there is
virtually no chance that it will accept the offer.
b)

Shares offered of Company A = 2 million.


Surviving Company
Earnings (in millions)

$24.0

Shares (in millions)

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Earnings per share

$2.00

Company A s stockholders have the same earnings per share as before.


Effective earnings per share for former Company B stockholders = (2) ($2.00) = $4.00, the same as before.
Market value exchange ratio =

$36 2
=1.8
40

This represents a substantial premium to pay for Company B. Unless Company B has great growth
potential and/or synergistic prospects, and its price/earnings ratio would suggest it does not, Company
A would not likely find the merger to be attractive on these terms.
c)

Share offered in Company A = 1.5 million.


Surviving Company
Earnings (in millions)

$24.0

Shares (in millions )

11.5

Earnings per share

$2.087

Company As stockholders experience a modest increase in earnings per share.


Effective earnings per share for former Company B
stockholders = (1.5)($2.087) = $3.13. This is significantly less than the $4.00 EPS before.
Market value exchange ratio =

$36 1.5
= 1.35
$40

The merger provides a significant premium in market price to Company B stockholders. It would seem that
the merger would be worthwhile from their standpoint. While EPS improve s for Company A stockholders,
the ultimate benefit will depend on future earnings and likely synergistic effects. Depending on whether they
exist, a merger might take place on the set terms.
d)

No solution is recommended.

27.2. a) Price per Noor share

$20

plus the 25% premium

Value in Nimbus shares per Noor share

$25

divide by market value per Nimbus share

100

Offer of Nimbus shares per Noor share

0.25

multiply by number of Noor shares

500,000

New Nimbus shares

125,000

Plus old Nimbus shares

1,000,000

Total shares of new Nimbus

1,125,000
Old Nimbus

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Net income (000)

$5,000

1,000

6,000

# Shares (000)

1,000

500

1,125

Earnings per share

$5.00

$2.00

$5.33

Earnings per orig. shr.

$5.33

$1.33

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b)

= x .2 (x 14)

$25
$25

= x .2x + 2.8

.8x

= $22. 20
x = $27.75

$100 .5 $25
=
= 1.25
$20
$20

27-3. a)

b)

Earnings
Per Noor share
Per Nimbus share

Before Merger

After Merger

$2.00

$1.33

5.00

5.33

Nimbus appears to have fared better. Nimbus stock was selling at a P/E ratio of 20, while Noor was only
selling at 10 times earnings. Even with the premium, the exchange price only represents 12.5 times Noor
earnings.
c)

Nimbus could have a P/E ratio of, 20 by virture of either good growth prospects or very high quality and
moderate growth prospects. Noor, on the other hand, may be characterized by mediocre management, or may
be in a declining industry. Noor does not automatically deserve a .P/E of 20 just because Nimbus bought it. If
synergy and better management are not forthcoming, the P/E ratio of Nimbus should decline.

d)

The real point to be made is that while synergy and risk reduction may provide justification for the market
value of the whole being greater than the sum of the parts, a company can only capitalize cement earnings at
an electronics multiple for so long before the market awakens to the decreasing growth rate and reacts
accordingly.

e)

If the merger is a one-shot proposition, it is clear that the growth rate should not be included. The real
problem arises if Nimbus does this sort of thing year after year. If we assume no internal growth at all , it is
possible for a 20 P/E ratio company to demonstrate continual grow in earnings per share by merging with
enough 12 multiple companies every year. However, this growth is an illusion. The market, if efficient , will
not be fooled and the P/E multiple will decline .

f)

The return per Noor share would drop from $1 to $0.75. Since the Noor holders are already giving up
earnings per share, it seems unlikely that they would settle for lower incomes as well. This situation could
be altered by the size of the market premium, but it is likely that a higher-yielding convertible preferred
would be a better vehicle .

27-4. (in millions)

Purchase

Tangible assets Goodwill


Total assets

Liabilities Shareholders
Equity
Total Liabs. & Equity

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Pooling of Interests

$15.0

$15.0

1.0

$16.0

$15.0

6.0

6.09

10.0

9.0

$16.0

$15.0

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27.5. a)

Copper
Tube

Annual earnings, (millions)


Shares (millions)
Earnings per share

Surviving
Company

$10.0

$12.0

40

5.2

$2.50

$2.31

b) Because Copper Tube pays a higher P/E ratio for Brass fitting than its own, ($36/2 = 18 times versus
$30/$2.50 = 12 times) there is an immediate and significant drop in earnings per share. However, the expected
growth rates are different. If we treat the total earnings of the surviving company as a weighted average of
those of Copper Tube with a 5 percent compound annual rate of growth and those of Brass Fitting with a 10
percent rate of growth, we obtain the following for the next 10 years:
27-6.
a)

b)

c)

5,00,001

(1, 000, 000 1)


10 + 1

+ 1 = 90,910

(1) 500,001

(2)

(1, 000, 000 1)


5 +1

+ 1 = 160,668

27.7. a) (1) 2,000,000 shares @ $1.

b)

c)

(2)

Initial payment of $200,000 to the Class A stockholders, or 10 cents a share. The residual
earnings would be available for Class B dividends

(3)

$40,000 or 4 cents per share.

(1)

Equal payment to all shares (8 cents per share) .

(2)

$160,000 or 8 cents per share to Class A stockholders; $80,000, again 8 cents a share, to Joe.

(3)

For control, Joe is giving up $40, 000, or 4 cents a share.

$240,000/.09 = $2,666,667 = the sustainable value of the firm. Therefore, Joe can only take $2,666,667 in
promotional stock. Assuming earnings and dividends are 9 cents a share, Joe receives $60,000 per year.

27.8. a) 1 million shares x $24 =


Synergy gain
Salary and perk gain
Maximum total value

$24,000,000
8,000,000
3,000,000
$35,000,000

Maximum share price = $35 million/1 million shares


= $35

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b)

Total share value for controlling


management is 400,000 shares x $24

= $9,600,000

Value give up of salaries and perks

= 3,000,000
$12,600,000

Minimum price per share that management will accept is $12,600,000/400,000 shares = $31.50.
c)

The boundaries for bidding are $31.50 to $35.00 per share, a tight range. Unless management of Friday Harbor
Lime is unmindful of the private control benefits they will give up, the bid needs to be at least $31.50 per
share. Perhaps a bid of $32 or $33 would be a sufficient inducement to sell, but it leaves little in value creation
for Roche Cement Company.

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Chapter 28
CORPORATE AND DISTRESS RESTRUCTURING
Case: Demerger of Bajaj Auto Limited
Hiints:

1. Yes, due to focused entities. Each business has its own unique business and
therefore requires different skill set. Sum of value of demerged entities will be
greater than that of whole.
2. Yes, they will get shares of demerged entities. The valuation of demerged shares is
likely to be higher that the merged entity as each shareholding will be valued on
pure play basis. Shareholders will also have the flexibility of retaining shares of that
company with which they are comfortable with.

Case: Corporate Debt Restructuring of Noida Toll Bridge Company Limited


Hints:

1. Infrastructure project funded by taking loans rupee as well as foreign currency. Due to
lower revenue than expected, company suffered losses and was finding it difficult to
service the loans. To avoid possible defaults CDR was considered as an option.
2. Primary focus of CDR is concession by the lenders lower interest rates, deferment of
payment period, increased maturity period etc and at the same time equity infusion and
other steps to improve the operational and financial performance of the company to
make it viable.
3. Lenders are willing to make sacrifice to ensure that their dues are recovered. If absence
of the concessions the company may have to be wound up resulting in complete writeoff of their dues.

Solutions

28.1 There is likely to be a wealth transfer from old debt holders to equity holders. The former will be
worse-off and the latter better off. The new company is assuming only $5 million of the old
debt, which with the $20 million in equity value gives a debt -to -total market value ratio of
0.20. The debt to - total market value ratio for the company as a whole is 0.40. Therefore, the
old, remaining debt holders of the Leonard Company lose a portion of the collateral Value of the
company as the debt ratio of the company increases. With the greater default risk, the value of
the remaining debt will decline. Holding total firm value constant, equity value will increase.
28.2 With a 12 percent required return, the present value of $1 million forever is:
PV = $1 million/ .12 = $8,333,333
This is the value of the subsidiary to Lorzo-Perez. The investment of an additional $10 million
would provide a present value of cash inflows of only $8,333,333, resulting in a negative net
present value.
It should be rejected.
The offer of $10 million from Exson Corporation is more than the value of the subsidiary to
Lorzo Perez. The offer should be accepted. Here is a case of a business unit being worth more to
someone else than it is to the company.
28.3 If the only concern were with the return realized by existing stockholders around the
announcement date, the spinoff method would dominate. It has a higher abnormal return
associated with the event than do the other methods. With a selloff and with a spinoff, the
company divests itself entirely of the division, whereas with the equity carveout it must continue
to operate it. This may be a consideration. Moreover, with the selloff and equity carveout the

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company receives cash, where with a spinoff stock is simply distributed to existing stockholders.
If the objective of management is more than simply maximizing shareholder value around the
time of the announcement, these other considerations may come into play. However, they should
be justified in terms of maximizing shareholder wealth over the long run.
After-tax profit increase associated with not being a public company = $800,000 x (1 -,30) =
$560,000.
28.4 After-tax profit increase associated with improved management = $9 million x .10 = $900,000
Total profit increase = $560,000 + $900,000
= $1,460,000
Present market price per share =
($9 million x 12 PE)/10 million shares = $10.80
Maximum price that might be paid to take the company private = [($9,000,000 + $1,460,000) x
12 PE]/ 10. million shares = $12.55
Maximum premium = $12.55 $10.80 = $1.75, or ($1,460,000 x 12 PE)/10 million shares
= $1.75
28.5 Before-tax profits necessary to service annual principal payments on senior debt = $1,400,000/
(1 .3333) = $2,100,000
Before-tax profits necessary to service principal payment at the end of year 6 on the junior
subordinated debt = $2,000,000 (1 .3333) = $3,000,000.

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a)

With a 12 percent prime rate:


Debt service before taxes (in thousands of $)
Year

Senior debt principal

2,100

2,100

2,100

2,100

2,100

Interest (Prime + 2%)


Junior debt principal
Interest (15%)
Total

980

300
3,380

784

300
3,184

588

300
2,988

392

300
2792

196

300
2,596

EBIT

3,400

3,400

3,400

3,700

3,700

The debt can be properly serviced at this level of interest rates. It assumes, however, that the
company achieves the EBIT performance forecasted. If this does not occur, there could be a
shortfall because the margins of safety in the first several years and the last year are thin.
b) With a 12 percent prime rate which goes to 20 percent in year 2:
Debt service before taxes (in thousands of $)
Year
Senior debt principal

2,100

2,100

2,100

2,100

2,100

616

300
3,016

308

300
2,708

3,000
300
3,300

3,700

3,700

3,700

Interest (Prime + 2%)


Junior debt principal
Interest (15%)
Total

980

784

300
3,380

300
3,632

924

300
3,324

EBIT

3,400

3,400

3,400

The enterprise would default in the second year if there were a sharp rise in the prime rate.
More-over, the cushion in the third year would be very thin. The problem illustrates the risks
associated with high leverage. With business risk, the situation is even riskier than illustrated.
28.6

a)

Total assets

$941 million

Total debt

998 million

Shareholders' equity

57 million

For the shares to have value in the face of a deficit book - value net worth, expected cash flows
must be high enough to give a present value, when discounted, well in excess of the book value
of total assets. In other words, book values are a biased and low estimate of the market value of
the expected cash flow stream.
b)

Before the leveraged recap, management owned


1 million/20 million = 5 percent of the company.
After the recapitalization, it owns
9 million/ (9 million + 19 million) = 32.14 percent.

c)

If stockholders and management are indifferent between dollar of cash dividend and a dollar of
share value, the following would hold:
Value per "old" share of cash dividends to public stockholders = $703 million/19 million = $37.
Indifference between public stockholders and management with respect to value is
$37 + 1 share = 9 shares
8 shares = $37

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Implicit share value = $4.625


Thus, the after-recap implicit value per share is $4.625. With 28 million shares outstanding
after the recap, the implicit total equity value of the company is -$4.625 x 28 million = $129.5
million.
28.7.

Out of the $5 million, the trustee's fee of $200,000 and back taxes of $300,000 must be paid
first, leaving $4.5 million for distribution to creditors. The mortgage bondholders would
receive $1.0 million from the sale of the mortgaged equipment and become general creditors
for the balance owed them of $1.0 million. However, there are sufficient proceeds to pay all
mortgage bondholders and general creditors, but this leaves only $750,000 to pay
subordinated debt holders. Stockholders receive nothing. In summary, the distribution is:
Original
Claim

Distribution

$200,000

$200,000

300,000

300, 000

General creditors

l,750,000

1,750,000

Mortgage bonds

2,000,000

2,000,000

Long-term Subordinated debt

1,000,000

750,000

Common stock

5,000,000

$10,250,000

$5,000,000

Trustee
Property taxes

28.8 To solve this problem, one must work down through the various ratios as follows:
EBIT
divide by debenture coverage
Debenture interest
divide by debenture coupon rate
Debentures
EBIT

$1,500,000
5
$300,000
.10
$3,000,000
$1,500,000

divide by overall income bond coverage

Total interest

$750,000

less debenture interest

300,000

Income bond interest

$450,000

divide by income bond coupon rate

.12

EBIT

$1,500,000

less total interest

750,000

Net income BT

750,000

less taxes of 40%

300,000

Net Income before preferred dividend

$450,000

divide by preferred coverage

Preferred dividend

$150,000

Net income before preferred dividend

$450,000

less preferred dividend

150,000

Net income to common

$300,000

multiply by proposed P/E

12

Common stock

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The capital structure of the company would become:


Debentures
Income bonds
Preferred stock
Common stock
28.9

a)
b)

$3,000,000
3,750,000
1,500,000
3,600,000
$11,850,000
The overall value of the company is $800,000 x 5 = $4 million. From this amount,
court-costs of $200,000 must be subtracted to give a total valuation of $3.8 million.
The bank loan and first mortgage bonds are secured, so they simply will be continued
as they are. Given bankruptcy rules, accrued wages must be paid as a, priority item.
Consequently, they will be carried forward in their entirety. Trade creditors (accounts
payable) are general creditors. However, these claims come before the subordinated
debentures, preferred stock, and common stock. To obtain future trade credit as an
ongoing concern, it is import ant that these creditors be paid on a timely basis and that
they not receive a lower-priority security. Therefore, their claims will be

EBIT
divide by overall income
bond coverage
Total interest
less debenture interest
Income bond interest
divide by income bond coupon rate
Income bonds

$1,500,000

EBIT

$1,500,000

2
$750,000
300,000
$450,000
.12
$3,750,000

less total interest


Net income BT

750,000
750,000

less taxes of 40%


Net Income before preferred dividend
divide by preferred coverage
Preferred dividend
divide by preferred return
Preferred stock

300000
$450,000
3
$150,000
.10
$1,500,000

Net income before preferred dividend


less preferred dividend
Net income to common
Multiply by proposed P/E
Common stock
The capital structure of the company would become:

$450,000
150,000
$300,000
12
$3,600,000

Debenturess
Income bonds
Preferred stock
Common- stock

$3,000,000
3,750,000
1,500,000
3,600,000
$11,850,000
28.9 a) The overall value of the company is $800,000 x 5 = $4 million. From this amount, court costs
of $200,000 must be subtracted to give a total valuation of $3.8 million.
b)

The bank loan and first mortgage bonds are secured, so they simply will be continued as they are.
Given bankruptcy rules, accrued wages must be paid as a priority item. Consequently, they will
be carried forward in their entirety. Trade creditors (accounts payable) are general creditors.
However, these claims come before the subordinated debentures, preferred stock, and common
stock. To obtain future trade credit as an ongoing concern, it is important that these creditors be
paid on a timely basis and that they not receive a lower priority security. Therefore, their claims

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will be
c)

Allocation of these securities in keeping would rules of absolute priority would result in the
following:
Old Claim

New Position

Accounts payable

$500,000

$500,000 Same

Accrued wages
Bank 1oan
13% mortgage bonds
15% subord debs

200,000
600,000
500,000
1,700,000

200,000 Same
600,000 Same
500,000 Same
780,000 Cap. Notes
80,000 Preferred
840,000 Common
Common stock
920,000
300,000 Common
$4,420,000
$3,800,000
Only the subordinated debenture holders receive securities different from what they had previously
held. The common stockholders, as residual owners, receive less common stock ownership than they
had before.

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Chapter 29
INTERNATIONAL FINANCIAL MANAGEMENT
29.1. a) $100 x .62

= 62 pounds

b) 50/1.90

= $26.32

c) $40 x 6.40

= 256 krona

d) 200/1.50

= $133.33

e) $10 x 1,300

= 13,000 lira

f) 1,000/140

= $7 14

29.2. a) (98,000) (0.55) = $53,900


b) (100,000) (0.56) = $56,000
c) Time value of money = (100,000 98,000) (0 .56)
= $1,120
Protection from devaluation = (98,000) (0.56 0.55)
= $980
29.3. a)

Cash flows (in millions)


Years

Cash flow(in guilders)


G/$ exchange rate
Cash flows (in $)

1-3

4-6

7-9

10 - 19

26.0

3.0

4.0

5.0

6.0

1.90

1.90

1.90

1.90

1.90

13.68

1.58

2.11

2.63

3.16

NPV at 16 percent = $0.66 million. The project is not acceptable.


b)
Cash flows (in guilders)
G/$-exchange rate
Cash flows (in $)

26.0

3.0

4.0

5.0

6.0

1.90

1.84

1.78

1.72

1.65

13.68

1.63

2.25

2.91

3.64

NPV at 16 percent = $0.51 million. With the guilder appreciating relative to the dollar, cash flows
are greater. The project is now acceptable, but not by a wide margin.
29.4. The French franc strengthening by 5 percent means an exchange rate of 5.70 x .95 = 5.415
French francs to the dollar.
Before: $124,000 x 5.70 =

FF706, 800

After: 124,000 x 5.415 =


Transaction loss

671,460
FF35,340

The French franc weakening by 5 percent means an exchange rate of 5.70 x 1.05 = 5.985
French francs to the dollar.
Before: $124,00q x 5.70

= FF706,800

After: 124,000 x 5.985

Transaction gain

+ FF35,340

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(in millions)

Book
Value

Monetary assets

Market
Value

Exposure
Coef.

Exposure

$24

$24

1.0*

$24

Inventories

16

20

0.5

10

Value of operating capacity

30

50

0.2

10

Total assets

$70

$94

Monetary liabilities

$40

$40

Shareholders' equity

30

54

$70

$94

Total

$44
1.0*

Net aggregate market value exposure

$40

+$4

Aggregate exposure coefficient = $4 / $54 = 7.4%


This is a relatively low exposure of Itoh Selangor Berdad to exchange rate changes between the
ringgit and the dollar.
*Assumed to be 1.0, as is usually the case.
29-6. The U.S. dollar cost to purchase one bushel of Canadian wheat = Can, $4.56/1.2 =$3.80. The Canadian
wheat is cheaper for the U.S. buyer. Therefore, purchasing power parity does not occur. To achieve
PPP, the price of Canadian wheat must rise relative to U.S. wheat and/or the Canadian dollar must
strengthen relative to the U.S. dollar.
29-7.a)

1.01
FY
=
140 1.02
1.02 Fy = 141.40
Fy = 138.63

b)

FY 1.010
=
140 1.015
1.015 Fy = 141.40
Fy = 139.31
The implied forward exchange rate is higher.

29 8. Foreign taxes:
Algerian taxes
Spanish taxes

$200,000 x 0.52 = $104,000


$200,000 x 0.35 = 70,000
$174,000

The company would be able to obtain a tax credit for the full $70,000 paid in Spanish taxes. However,
it would be able to obtain a tax credit of only 0.38 x $200,000 = $76,000 for the Algerian taxes paid
because the Algerian tax rate exceeds the U.S. rate.
U.S. taxes:
$400,000 x 0.38 = $152,000
less tax credits

146,000

Total paid

$6,000

Total taxes paid:


$174,000 + $6,000 = $180,000
This compares with $152,000 if the company were to pay only U.S. taxes on earnings.

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29-9. a) Principal and interest payment due in yen with annual compounding at 10 percent interest:
Y70 million x (1.10)4 = Y102, 487,000
Value of yen at the end of four years is 120 yen to the dollar.
Dollar equivalent of payment = Y102,487,000/120 = $854,058
b)

Principal and interest payment due in dollars with annual compounding at 13 percent interest:
$500,000 x (1.13)4 = $815,237

c)

Yasufuku will be better off, as it makes a dollar equivalent loan of $500,000 and receives the
dollar equivalent of $854,058, whereas McDonnough receives only $815,237.
If the exchange rate stays at 140 yen to the dollar, the dollar equivalent payment to Yasufuku is
Y102,487, 000/140 = $732,050. McDonnough would be better off. The analysis above does not
take account of any difference in credit risk.

29.10. The approximate expected internal rate of return for the investment in the copper mining venture is:
IRR

Probability

Weighted
Amount

100%

0.10

10.0%

40%

0.15

6.0%

0.15

34%

0.60

20.4%

Expected return

4.4%

As the 4.4 percent return is less than the going rate on a risk-free investment such as Treasury bills,
the project should be rejected if one believes that the estimates of the probabilities and returns are
accurate.
It is important to point out that for multi-period investments, the expected value of individual
internal rate of return possibilities usually differs from the true internal rate of return on the cash
flows. However, the former is a close approximation of the true internal rate of return; and the
concepts illustrated in the problem are not affected by this distinction.

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Chapter 30 : Corporate Governance


Case: Satyam Computer Services Limited
Hints:
1. The expression means that once he started manipulating the accounts for the purpose of showing
higher profits etc. it was difficult to stop the practice. Any attempt to stop would have revealed the
window dressing to the market participants due to dramatic fall in profits.
2. Independent directors failed to perform their role and even approved the acquisition of Maytas a
real estate company. Likewise the auditors failed to check the manipulation of accounts for such a
long period of time.
3. Highly unlikely looking at the magnitude of the fraud collusion of other functionaries is obvious.
Even if they were not actively involved, being passive onlookers also implicates them.
4. Yes, the FII holding increased gradually to over 60%. The institutional investors also failed to
question the growth achieved by Satyam. They did however object to the acquisition of Maytas
leading to admission by Raju.

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