Suggested Answers to

Odd-Numbered Problems

Chapter 1
1. a. It means that the company’s operating activities consumed cash. A
combination of two things can cause this: operating losses, and
in- creases in accounts receivable and inventories. Operating losses
can obviously be dangerous. Rising receivables and inventories need
not be dangerous provided they are growing in step with sales, and
pro- vided the company is able to finance the cash shortfalls.
Rising re- ceivables and inventories relative to sales suggests
slackening man- agement control of important operating assets, a
potential danger.
b. This means that the company’s investing activities consumed
cash, that the company purchased more property, plant,
equipment, or marketable securities than it disposed of during
the year. ffor most growing, stable companies, cash flows from
investing activities are negative as firms build production capacity
and replace used equip- ment. Positive cash flows from investing
activities can signal prob- lems, suggesting the firm has no
attractive investment opportuni- ties or that it might be liquidating
productive assets due to financial difficulties.
c. Negative cash flows from financing activities means that the firm
is paying out more money to investors (in the form of debt
principal repayment, interest payments, dividends and share
repurchases) than it is raising from investors. Usually, negative
cash flows from financing activities are associated with mature
companies generat- ing more than enough cash from operations to
fund future activi- ties. It is not necessarily bad news. Conversely,
early-stage firms, rapidly growing firms, and those in financial
distress typically have positive cash flows from financing
activities.
3. a. ffalse. Shareholders’ equity is on the liabilities side of the balance
sheet. It represents owners’ claims on company assets. Or said
dif- ferently, the money contributed by owners and
supplemented by retained profits has already been spent to
acquire company assets.
b. ffalse. Book value of equity is simply the “plug” number that
makes the book value of assets equal the sum of the book value of
liabili- ties and the book value of equity. If the book value of
liabilities is
405
406 Suggested Answers to Odd-Numbered

greater than the book value of assets, then (by definition) book
value of equity must be negative. This does not automatically
spell bankruptcy. Bankruptcy occurs when a firm cannot pay its bills
in a timely manner and creditors force it to seek, or it voluntarily
seeks, court protection.
c. ffalse. Earnings are allocated to either dividends or retained earn-
ings after net income is calculated. Increasing the dividend will
re- duce retained earnings, but will not affect net income.
d. True. By comparing a balance sheet from the beginning of 2014
(year-end 2013) with a balance sheet from the end of 2014, it is pos-
sible to construct a sources and uses statement for 2014.
e. ffalse. Goodwill arises when one firm acquires another at a price
above its book value. ffor example, if one firm acquires another
for
$10 million in cash but the target has a book value of only $8 mil-
lion, the accountants record a $10 million reduction in the ac-
quirer’s cash, an $8 million increase in assets, and a $2 million in-
crease in goodwill to balance the accounts.
f. ffalse. It’s just the reverse. As an asset account decreases, cash is
made available for other uses. Thus, decreases in assets are sources
of cash. In order to decrease a liability account, the firm must use
cash to lower the liability. Thus, decreases in liability accounts
are uses of cash.
5. Because the accountant’s primary goal is to measure earnings, not
cash generated. She sees earnings as a fundamental indicator of viabil-
ity, not cash generation. A more balanced perspective is that over
the long run successful companies must be both profitable and
solvent; that is, they must be profitable and have cash in the bank to
pay their bills when due. This means that you should pay attention
to both earnings and cash flows.
7. The General Secretary has confused accounting profits with eco-
nomic profits. Earning $300 million on a $7.5 billion equity invest-
ment is a return of only 4 percent. This is poor performance and is
too low for the company to continue attracting new investment nec-
essary for growth. The company is certainly not covering its cost of
equity.
9. Acadia, Inc. generated $480,000 of cash during the year. The
$500,000 net income ignores the fact accounts receivable rose
$150,000, a use of cash. It also treats $130,000 depreciation as an
ex- pense, whereas it is a non-cash charge. The $25,000 increase in
mar- ket value of assets adds to the market value of the business,
but is not
 Suggested Answers to Odd-Numbered Problems

a cash flow. Here are the figures:

Accounting income $500,000
Depreciation (a non-cash charge) + $130,000
Increase in accounts receivable — $150,000
Cash generated $480,000
11. a. In 2014, company sales were $782 million, but accounts
receivable rose $30 million, meaning the company received only
$752 million in cash. (This ignores possible changes in bad debt
reserves.) Let- ting bop stand for beginning of period, and eop for
end of period, the relevant equation is
Accounts receivableeop = Accounts receivablebop
+ Sales — Collections
Collections = Sales — Change in
accounts receivable
$752 million = $782 million — $30 million
b. During 2014, the company sold $502 million of merchandise at
cost, but finished goods inventory fell $10 million, indicating that the
com- pany produced only $492 million of merchandise. The
equation is
Inventoryeop = Inventorybop + Production — Cost of sales
Production = Cost of sales + Change in inventory
$492 million = $502 million — $10 million
c. Net fixed assets rose $78 million, depreciation reduced net fixed as-
sets $61 million, so capital expenditures must have been $139
mil- lion (ignoring asset sales or write-offs).
Net fixed assetseop = Net fixed assetsbop + Capital expenditures
— Depreciation
Capital expenditures = Change in net fixed assets + Depreciation
$139 million = $78 million + $61 million
d. There are two ways to derive cash flow from operations. If there
were no financing cash flows for the year, then changes in the
year- end cash balance must be due to cash flows from operations
and in- vesting activities. The capital expenditures of $139 million
repre- sent the investing cash flows of the firm. Thus, we can use
the change in the cash balance from 2013 to 2014 ($49 million) and
the cash flows from investing to obtain cash flow from
operations.
Change in cash balance = Cff from ops + Cff from investing
+ Cff from financing
$49 million = Cff from ops + (— $139 million) + 0 Cff
from operations = $49 + 139 = $188 million
408 Suggested Answers to Odd-Numbered

Alternatively, you can calculate the cash flow from operations

from the items in the table. Begin with net income, remove any
non-cash items (such as depreciation), and add any cash
transactions that are not captured by the income statement (such
as changes to working capital accounts). We can see that accounts
receivable increased by
$30 million, finished goods inventory decreased by $10 million,
and accounts payable increased by $5 million. Depreciation was
$61 million.
Cff from operations = Net income — increase in acct. receivable
+ decrease in inventory + increase in
acct. payable + depreciation
Cff from operations = 142 — 30 + 10 + 5 + 61 = $188 million
13. a. Stock price per share = $25 million/800,000 shares = $31.25 per
share. Book value per share = $15 million/800,000 = $18.75 per
share.
b. Telluride Mining will pay $31.25 per share for the 160,000 shares it
repurchases. This reduces the book value of equity by
$5,000,000. Assuming all else remains the same, the new book
value will be
$10,000,000.
c. Since nothing else has changed, investors do not change their
per- ceptions of the firm, and there are no taxes or transaction
costs, the market value should fall by exactly the amount of the
cash paid in the transaction. The new market value should be
$20,000,000. An- other way to think about the question is to note
that repurchase of the shares will reduce cash by $5,000,000 or
increase liabilities by the same amount if they finance the
repurchase with debt. Either way the firm is worth $5,000,000
less to owners after the repur- chase, or $20,000,000. With
640,000 shares outstanding after re- purchase, the price per share
remains $31.25 ($20,000,000/640,000 shares). (In practice share
repurchases often have a positive price effect at the time of
announcement. There are several explanations for this effect,
some of which we will cover in later chapters.)
d. Shares outstanding increase 10 percent, or 80,000 shares. At
$31.25 per share, Telluride would raise $2,500,000. Assuming all
else remains the same, the new book value of equity will be
$17,500,000 ($15 million + $2,500,000).
e. Due to the same reasoning as in part (c), the market value should
rise by $2,500,000. In essence the sale raises company cash by
$2,500,000, increasing the value of the firm by just this amount.
The new market value should be $27,500,000. The price per
share should remain $31.25 ($27,500,000/880,000 shares). (In
 Suggested Answers to Odd-Numbered Problems
practice,
410 Suggested Answers to Odd-Numbered

such equity sales often cause investors to be less optimistic about

the firm’s future performance and thus generate negative price
effects at the time of announcement. We will discuss this topic
more in Chapter 6.)

Chapter 2
1. The CEO is correct that ROE is the product of profit margin, asset
turnover and financial leverage, but an increase in prices will not
nec- essarily increase ROE because increased prices will likely reduce
sales. If operating costs are fixed, the profit margin could actually fall
when prices rise. Even if operating costs are variable, a decrease in
sales will reduce the asset turnover, and thus reduce ROE. It is
uncertain whether the effect of the increase in profit margin on ROE
will out- weigh the effect of the decrease in asset turnover. When
thinking about the levers of performance, it is important to
remember that changes in company strategy can affect multiple
levers, often in different directions.
3. a. True. Let L = liabilities, E = equity, and A = assets. Does A/E =
1 + L/E? Does A/E = (E + L)/E? Yes.
b. True. The numerators of the two ratios are identical. ROA can ex-
ceed ROE only if assets are less than equity, which implies that
lia- bilities would have to be negative.
c. ffalse. A payables period longer than the collection period would be
nice because trade credit would finance accounts receivable.
How- ever, payables periods and collections periods are typically
deter- mined by industry practice and the relative bargaining power
of the firms involved; depending on a company’s circumstances, it
may have to gracefully put up with a collection period longer
than its payables period.
d. True. The two ratios are the same except that inventory, which is
never negative, is subtracted from the numerator to calculate the
acid test.
e. True. Decomposing ROE shows that a higher asset turnover ratio
increases ROE. Thus, a firm wants to maximize asset turnover (all
else being equal, of course).
f. ffalse. Earnings yields and price-to-earnings ratios are the inverse
of one another. If two firms have identical earnings yields, they
will have identical price-to-earnings ratios.
g. ffalse. Ignoring taxes and transactions costs, unrealized gains can
always be realized by the act of selling, so must be worth as much
as a comparable amount of realized gains.
 Suggested Answers to Odd-Numbered Problems

5. a.
Year 1 Year 2
Current ratio 9.70 2.80
Quick ratio 9.61 2.31

Amberjack’s short-run liquidity has deteriorated considerably, but

from a high initial base.
b.
Year 1 Year 2
Collection period (days) 28.3 28.1
Inventory turnover (X) 38.5 4.7
Payables period (days) 42.3 24.3
Days’ sales in cash 919.3 243.7
Gross margin 8% 25%
Profit margin —57% —88%

c. The company lost money in both years, more in the second year
than the first. Cash flow from operations is negative in both years
— but has improved. Liquidity has fallen and the inventory turnover
is down sharply. The more than 10-fold increase in inventory
suggests that Amberjack was either wildly optimistic about potential
sales or completely lost control of its inventory. A third possibility is
that the company is building inventory in anticipation of a major
sales increase next year. In any case, the inventory investment
warrants close scrutiny. In general, these numbers look like those
of an unstable, startup operation.
7. a.
Atlantic Corp. Pacific Corp.
ROE 28.1% 56.9%
ROA 21.3% 11.3%
ROIC 22.5% 15.2%

b. Pacific’s higher ROE is a natural reflection of its higher financial

leverage. It does not mean that Pacific is the better company.
c. This is also due to Pacific’s higher leverage. ROA penalizes
levered companies by comparing the net income available to
equity to the capital provided by owners and creditors. It does
not mean that Pacific is a worse company than Atlantic.
d. ROIC abstracts from differences in leverage to provide a direct
comparison of the earning power of the two companies’ assets.
On this metric, Atlantic is the superior performer, although both
412 Suggested Answers to Odd-Numbered

percentages are quite attractive. Before drawing any firm conclu-

sions, however, it is important to ask how the business risks
faced by the companies compare and whether the observed
ratios re- flect long-run capabilities or transitory events.
9. Collection period = Accounts receivable/Credit sales per day
Credit Sales = 0.75 × $420 million = $315 million

Accounts receivable = Collection period × Credit sales per day

= 55 × $315 million/365 = $47.5 million.
Inventory turnover = COGS / Ending inventory
COGS = Sales × (1 — Gross margin) = $420 million
× (1 — 0.40) = $252 million

Inventory = COGS/Inventory turnover

= $252 million/8 = $31.5 million

Payables period = Accounts payable/Purchases per day

(Since information is not available on Purchases, use COGS.)

Accounts payable = Payables period × COGS per day

= 40 × $252 million/365
= $27.6 million

11. Sales = (Cash/Days’ sales in cash) × 365 = (1,100,000/34) × 365

= $11,808,824

Accounts receivable = Collection period × credit sales per day

= Collection period × (Sales/365)
= 71 × 11,808,824/365 = $2,297,059

Cost of goods sold = Inventory turnover × Ending inventory

= 5 × 1,900,000 = $9,500,000

Accounts payable = Payables period  (Cost of goods sold/365)

= 36 × 9,500,000/365= $936,986

Total liabilities = Assets × Liabilities to assets

= 8,000,000 × 0.75 = $6,000,000

Shareholders’ equity = Total assets — Total liabilities

= 8,000,000 — 6,000,000 = $2,000,000

Current liabilities = Current assets/Current ratio

= 5,297,059/2.6 = $2,037,330
 Suggested Answers to Odd-Numbered Problems

Assets
Current assets:
Cash $1,100,000
Accounts receivable 2,297,059
Inventory 1,900,000
Total current assets 5,297,059
Net fixed assets 2,702,941
Total assets 8,000,000

Liabilities and shareholders’ equity

Current liabilities:
Accounts payable 936,986
Short-term debt 1,100,344
Total current liabilities 2,037,330
Long-term debt 3,962,670
Shareholders’ equity 2,000,000
Total liabilities and equity $8,000,000

13. Suggested answers to Connect problems are available from McGraw-

Hill’s Connect or your course instructor (see Preface for more infor-
mation).

Chapter 3
1. A negative value implies that the company has excess cash above its
desired minimum. You can confirm this on the balance sheet by set-
ting the external financing requirement to zero and adding the
figure for external financing required to cash. You will find that assets
equal liabilities plus owners’ equity in this circumstance; in other
words, the balance sheet balances.
3. This would tell me I had erred in constructing one or both of the
fore- casts. Using the same assumptions and avoiding accounting and
arith- metic errors, estimated external financing required should
equal esti- mated cash surplus or deficit for the same date.
5. The company needs a certain level of cash in order to operate effi-
ciently. Operating cash flows can be volatile and difficult to predict
from day to day. Companies rely on a cash cushion to cover periodic
cash flow imbalances. The amount of cushion depends on many
things, including the volatility of the cash flows and the availability
of other sources of liquidity, such as unused bank credit lines. While
one might argue that the company could get by with less than 18 days’
sales in cash as implied in the forecast, this figure is a good bit less
than the recent median for nonfinancial firms in the S&P 500 of
about 40 days.
414 Suggested Answers to Odd-Numbered

7. Pro forma forecast for R&E Supplies 2016:

Income Statement Forecast

Net sales $33,496
Cost of goods sold 28,807
Gross profit 4,689
General, selling, and administrative expense 3,685
Interest expense 327
Earnings before tax 678
Tax 305
Earnings after tax 373
Dividends paid 187
Additions to retained earnings $ 187
Balance Sheet Forecast
Current assets $ 9,714
Net fixed assets 270
Total assets 9,984
Current liabilities 4,823
Long-term debt 560
Equity 1,995
Total liabilities & shareholders’ equity $ 7,378
External Financing Required $ 2,606

a. Projected external financing required in 2016 is $2.606 million,

over $1 million more than in 2015. R&E Supplies needs to get off
this treadmill as soon as possible.
b. External financing required falls to $2.416 million, down 7.3 percent.
c. External financing required rises to $2.977 million, up 14.2 percent
in this recession scenario.
9.
Westmark Industrial, Inc. Income Statement
January 1, 2015–March 31, 2015 ($ thousands)
Net sales $1,080
Cost of sales 540
Gross profit 540
Selling and administrative expense 540
Interest 90
Depreciation 30
Net profit before tax (120)
Tax at 33% (40)
Net profit after tax (80)
Dividends 300
Additions to retained earnings $ (380)
 Suggested Answers to Odd-Numbered Problems

Balance Sheet March 31, 2015 ($ thousands)

Assets
Cash $ 150
Accounts receivable 192
Inventory 1,800
Total current assets 2,142
Gross fixed assets 900
— Accumulated depreciation 180
Net fixed assets 720
Total assets $2,862
Liabilities
Bank loan $1,362
Accounts payable 240
Miscellaneous accruals 60
Current portion long-term debt 0
Taxes payable 80
Total current liabilities 1,742
Long-term debt 990
Shareholders’ equity 130
Total liabilities & equity $2,862
Comments:
Inventory is estimated as follows:
Beginning inventory Jan. 1. $1,800
+ 1st quarter purchases 540
— 1st quarter cost of goods sold 540
Ending inventory March 31 $1,800

Taxes payable are estimated as follows:

Taxes payable Dec. 31, 2014 $ 300
— payments 180
+ 1st quarter taxes accrued —40
Taxes payable March 31 $ 80

a. Estimated external financing need on March 31: $1,362,000.

b. Yes, they are the same. If they weren’t it would indicate I had
made a mistake or used different assumptions for the two
forecasts.
c. Yes, the pro forma forecasts can be analyzed in the usual manner to
assess the firm’s financial health.
d. They say little about financing needs at any time other than the
forecast date.
11. a. Negative numbers for taxes mean the company’s tax liability will
fall by this amount. If the company does not have an accrued tax
li- ability but has paid taxes in the recent past, it can file for a
rebate of past taxes paid.
416 Suggested Answers to Odd-Numbered

b. Cash balances exceed the minimum required level because the

company has excess cash in these quarters. Cash balances are
determined in these periods by first noting that external
financing required is negative when cash is set at the minimum
level. Exter- nal financing required is then set to zero and cash
becomes the balancing item equating assets to liabilities and
owners’ equity.
c. When greater than zero, external financing required becomes the
balancing item equating assets to liabilities and owners’ equity.
d. The company should easily be able to borrow the money. The
amounts required are less than one-quarter of accounts
receivable in each quarter.
13. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).
15. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).

Chapter 4
1. This statement is incorrect and evidences a basic misunderstanding of
the chapter. A correct statement would be “An important top-
management job is to anticipate differences between their
company’s actual and sustainable growth rates and to have a plan in
place to pru- dently manage these differences.” Constraining a
rapidly growing company’s actual growth rate to approximate its
sustainable rate risks needlessly sacrificing valuable growth, while
boosting the growth rate of a slow-growth business risks promoting
value-destroying growth.
3. a. ffalse. In addition to issuing new equity, companies can grow at
rates above their current sustainable rate by increasing any of the
four ratios comprising the sustainable growth rate: their profit
margin, asset turnover, financial leverage, or retention ratio. The
problem is that there are limits to a company’s ability to increase
these ratios.
b. ffalse. Glamorous companies such as Twitter with an exciting
story to tell can raise equity despite operating losses. More
traditional companies have much more difficulty.
c. True. Repurchases reduce the number of shares outstanding, which
contributes to increasing earnings per share. At the same time,
the money used to repurchase the shares has a cost, which
reduces earnings and tends to reduce earnings per share. In most
instances,
 Suggested Answers to Odd-Numbered Problems

the former outweighs the latter and earnings per share rise when
shares are repurchased.
d. True. Survey evidence suggests that most managers, most of the
time, believe their shares are undervalued. Repurchasing undervalued
stock is a productive use of company resources benefiting remaining
share- holders.
e. ffalse. A major theme of this chapter has been that slow-growth
companies have subtle and often more serious growth management
problems than their rapidly growing neighbors.
f. ffalse. Good growth yielding returns above cost increases stock
price. Bad growth at returns below cost destroys value and will
reduce stock price sooner or later.
5. In most years since 1985, net equity issuance has been negative,
mean- ing U.S. corporations have retired more shares measured in
terms of value than they have issued. In aggregate, then, new equity
has been a use of capital to U.S. corporations, not a source. (At the
same time, ffig- ure 4.6 illustrates that new equity has been an
important source to a cer- tain subset of companies characterized
primarily by high growth.)
7. a. Medifast’s sustainable growth rates are

2006 2007 2008 2009 2010

Sustainable growth rate (%) 12.8 23.9 13.9 16.9 31.2

ffor example, in 2006 g* = 6.0% × 99.5% × 1.33 × 1.61 = 12.8%.

b. Medifast’s actual growth rate exceeded its sustainable growth rate
by a wide margin in every year except 2008. The company was
growing at a rate well above its sustainable growth rate. Its chal-
lenge was how to manage this growth without growing broke.
c. Between 2006 and 2010, Medifast increased every ratio,
especially its asset turnover. Had Medifast not improved its
operating per- formance, as reflected in profit margin and asset
turnover, the fi- nancial leverage required to generate the
company’s sustainable growth rate would have been about four
times as high as observed.
9. a. Jos. A. Bank’s sustainable growth rates are

2006 2007 2008 2009 2010

Sustainable growth rate (%) 28.1 24.0 22.4 22.1 21.8

ffor example, in 2010 g* = 10.0% × 100.0% × 1.30 × 1.68 = 21.8%.

b. Jos. A. Bank does have a sustainable growth problem. Its actual
growth rate is much lower than its sustainable growth rate.
418 Suggested Answers to Odd-Numbered

c. Jos. A. Bank used excess cash to reduce financial leverage, and this
helps to reduce the sustainable growth rate. The steady decline in
asset turnover helps to decrease the sustainable growth rate as well,
but it also signals a potentially troubling decrease in efficiency.
Despite the decreases in these ratios, the spread between the
sustain- able growth rate and the actual growth rate is still
substantial in 2010.
11. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).

Chapter 5
1. Common stocks are more risky than U.S. government bonds. Risk-
averse investors demand higher returns on common stocks than
gov- ernment bonds as compensation for the added risk. If returns
on gov- ernment bonds were, on average, as high as those on
common stocks, prices of government bonds would rise and prices
of common stocks would fall as investors fled to the safer but
equally promising bonds. This would result in lower expected
returns on bonds for new in- vestors and higher expected returns on
stocks until the tradeoff of risk for return reappeared.
3. The value of shareholdings owned is most important to the investor.
A company can arbitrarily change its stock price, and the number of
shares outstanding, by splitting its stock. The stock price and the
num- ber of shares owned are of interest only to the extent that they
help the investor calculate more meaningful dollar ownership
numbers.
5. a. The holding period return is —4.76 percent [($60 — $110)/$1,050].
b. The bond’s price might have fallen because investor perceptions
of its risk rose or because interest rates rose. The price of a bond is
the present value of future cash receipts. As interest rates rise, the
pres- ent value of future cash flows falls, as does the price of the
bond. See Chapter 7 for details.
7. a.
Stock price $75.00
— 8% underpricing 6.00
Issue price 69.00
— 7% spread 4.83
Net to company $64.17

Number of shares = $500 million/$64.17 = 7.79 million

b. Investment bankers’ revenue = $4.83 × 7.79 million = $37.63
million.
 Suggested Answers to Odd-Numbered Problems

c. Underpricing is not a cash flow. It is, however, an opportunity cost

to current owners because it means that more shares must be
sold to raise $500 million and each existing share will represent a
smaller ownership interest in the company. P.S. Opportunity
costs are just as real as cash flow costs.
9. While intriguing, this is not evidence of market inefficiency. Think of
flipping a coin and trying to get “heads.” If skill is involved, you
would expect to get heads more than 50 percent of the time. But if
coin-flip- ping is just luck, you would only get heads, on average, half
of the time. Thus, if mutual fund returns were random, you would
expect to see about half of all mutual funds outperform the market each
year. Of these “winning” mutual funds, about half would again
outperform the market in the subsequent year (in coin-flipping
terms, when you flip heads, the next flip will result in heads
approximately half of the time). After five years, you would expect
that roughly 1/32 of the original sample of mutual funds would
have outperformed the market each year [(1/2)5 = 1/32]. When you
start with 5,600 mutual funds, one would expect that, if no skill is
involved, about 175 would have out- performed the market each
year for five years (5,600/32 = 175). Given that only 104 have done
so, it seems that luck (and not skill) is the likely cause of their
success.
11. a. Suppose Liquid fforce shares sell for $40 and it has announced a
$6 per share dividend. Buy Liquid fforce stock immediately prior
to the announced dividend date for $40, receive the $6 dividend,
and immediately sell the stock for $37. You invest $40 and
immediately after the sale have $43 in cash. Easy money.
b. Liquid fforce’s stock price would rise prior to the dividend and
fall more when the dividend is paid. As more and more investors
pursue this strategy, the price drop will become larger and larger
until the decline equals the dividend, ignoring any taxes or
transaction costs.
c. Suppose Liquid fforce stock sells for $40 before the dividend and
the dividend is $6. You want to sell Liquid fforce’s stock short. Bor-
row Liquid fforce stock from a shareholder and sell it
immediately prior to the dividend for $40, pay the $6 dividend to
the person from whom you borrowed the stock, and buy the
stock for $28. Cover the short sale by returning the stock to the
lender. You invest
$34 ($28 + $6) and, immediately after the transaction, you have
$40 cash. Again, easy money.
d. Liquid fforce’s stock price would fall prior to the dividend and fall
less when the dividend is paid. As more and more investors
pursue this strategy, the price drop will equal the dividend (in the
420 Suggested Answers to Odd-Numbered
absence of transaction costs and taxes).
 Suggested Answers to Odd-Numbered Problems

e. Such trading guarantees that the stock price will drop by an

amount equal to the dividend payment.
f. Ignoring taxes and transactions costs, a $1 increase in dividends
results in a $1 decline in stock price and thus a $1 reduction in
capital appreciation. Rational investors are indifferent to whether
they receive their return as dividends or price appreciation, so in-
creasing the dividend cannot not benefit investors.
13. The observed financing pattern can be attributed to several causes.
ffirst, there are significant fixed costs in selling bonds that make it
un- economical to raise the modest sums usually sought by small
firms. Second, small firms, especially privately held small firms, face
infor- mation asymmetry problems. Most investors know
comparatively lit- tle about small firms and have little incentive to
spend the resources necessary to learn more. This creates a market
niche for local banks that are often familiar with local borrowers via
other business rela- tions and community activities. The banks are
able to capitalize on this information advantage by charging a
premium over public mar- ket interest rates. A danger to banks is that
this information advantage appears to be dwindling over time as
information technology im- proves.
15. The analogy is an appropriate one. Think of equity as a call option
on the company’s assets with a strike price equal to the value of debt
out- standing. When the value of company assets is very low, equity
hold- ers’ call option is out of the money. If they wish they can walk
away, leaving their option unexercised and firm assets in the hands
of cred- itors. When the value of company assets exceeds the value of
debt, the owners’ call option is in the money. They can exercise their
option by paying the value of the debt to creditors and owning the
assets free and clear. The value of equity relative to the value of the
firm looks like the payoff diagram for a call option.

Chapter 6
1. Public utilities have very stable cash flows. ffew of us turn off our
lights or take cold showers during recessions. Stable cash flows are
just what are needed to support large interest obligations. In addition,
utilities have large investments in land and fixed assets, excellent
sources of loan collateral.
Information technology companies, on the other hand, have
highly uncertain cash flows, the kind ill-suited to servicing interest
obliga- tions. Many also aspire to rapid growth, meaning that
maintaining the flexibility necessary to assure access to financial
markets is important. They are thus wary of “closing off the top” by
borrowing aggressively.
422 Suggested Answers to Odd-Numbered

3. Because all firms face business risk, company EBIT varies over
time. Debt is a fixed income security, meaning interest expense
does not vary with EBIT. As a result, all of the variability in EBIT
is borne by equity investors, who hold a residual income security.
As leverage increases, the same variability in EBIT is borne by a
smaller equity investment, causing variability per dollar invested to
rise. This results in increased volatility in shareholder returns—or
increased risk. Also, as evident from the range of earnings chart,
leverage increases the slope of the line relating EBIT to ROE, and
the steeper the slope, the greater the variability in EPS, and ROE,
for any given variability in EBIT.
5. a. There are several reasons. ffirst, companies with promising invest-
ment opportunities typically have valuable intangible assets whose
value would decline sharply if the company got into financial dif-
ficulty; that is, the resale value of their assets is low. Second, it is
important for such companies to maintain the financial flexibility
that comes with a conservative capital structure to assure
funding for future investment opportunities. They are making
money on the asset side of the business and are thus ill-advised
to do any- thing on the liability side to jeopardize future
investments.
b. Most would follow this recommendation if they could, but lack of
sufficient operating cash flow and the inability to raise additional
equity force many small businesses to an extensive reliance on debt
financing. ffor these companies, it is either grow with debt or do
not grow. Also, many entrepreneurs view debt as a way to stretch
their limited equity to gain control over more assets. In essence,
they like playing with someone else’s chips.
7. a. EBIT = Income before tax + Interest expense = 70/(1 — 0.3) + 15
= $115.
Interest expense = 15 + 0.06(70) = $19.2. Times
interest earned = 115/19.2 = 6.0 times.
b. Times burden covered = EBIT/[Interest expense + Principal pay./
(1 — Tax rate)]
= 115/[19.2 + 27/(1 — 0.3)] = 2.0 times. c.
EPS = (115 — 19.2)(1 — 0.3)/25 = $2.68.
d. Times interest earned = 115/15 = 7.7 times.
Times burden covered = 115/[15 + 20/(1 — 0.3)] = 2.6 times.
EPS = (115 — 15)(1 — 0.3)/(25 + 2) = $2.59.
9. a. An increase in the interest rate would lower the debt financing line
in the range of earnings chart. This would reduce the EPS
advantage
 Suggested Answers to Odd-Numbered Problems

of the increased leverage, or increase the disadvantage if EBIT is

below the crossover point. It would also increase the crossover EBIT.
Both changes would reduce the attractiveness of increased
financial leverage.
b. An increased stock price would reduce the number of shares the
company would need to sell to raise targeted funds. This would
in- crease EPS at all EBIT levels under the equity financing
alternative, making increased leverage less attractive. Said
differently, a higher stock price would raise the equity financing
line at all EBIT values, making debt financing less attractive
relative to equity financing.
c. The range of earnings chart will be unchanged, but increased
uncertainty will increase the probability that EBIT will fall below
the crossover point. Such increased business risk will make debt
financing riskier and hence less attractive.
d. Increased common dividends will not affect the range of earnings
chart. The increased dividends will require paying out a greater
proportion of earnings per share under both options. But because
there are more shares outstanding with the equity issue, the higher
dividend will make a debt issue relatively more attractive.
e. An increase in the amount of debt already outstanding will
increase interest expense and lower EPS under both options. This
will lower both lines in the range of earnings chart by the same
amount, but will not affect the attractiveness of the one option
relative to the other, at least as far as the range of earnings chart
is concerned. In- terest coverage obviously falls as existing debt
rises, which makes additional debt financing riskier and thus less
attractive.
11. a. Each year sources of cash must equal uses. Sources are earnings
plus new borrowing. Uses are investment and dividends. So each
year the following equation applies: E + 1.2(E — D) = I + D,
where E is earnings, 1.2 is the target debt-to-equity ratio, D is div-
idends, and I is investment. [The target debt-to-equity ratio is
Debt = 1.2 × Equity. Annual additions to equity = Retained prof-
its = E — D. Annual new borrowing thus equals 1.2(E — D).] Solv-
ing for D, D = E — I/2.2. The following table presents the result-
ing annual dividend and payout ratio.
b. Summing dividends and dividing by total earnings, the stable
pay- out ratio is $219/$930 = 24 percent. Substituting this into
the sources and uses equation, E + 1.2(E — .24E) = I + .24E + CM,
where CM is the change in the marketable securities portfolio.
Solving for CM, CM = 1.67E — I. The resulting values for CM and
the year-end marketable securities portfolio appear in the
424 Suggested Answers to Odd-Numbered

following table. (Had I carried out the calculations with more ac-
curacy, the ending marketable securities would have equaled the
beginning value, $200.)
($ millions)
Year 1 2 3 4 5
Dividends 20 —6 34 71 100
Payout ratio% 20 —5 20 31 33
Stable payout ratio% 24 24 24 24 24
Stable dividend 24 31 41 55 72
Change in marketable securities —8 —83 —16 34 61
Marketable securities 192 109 93 127 188

c. The company can do any or some combination of the following:

reduce marketable securities, increase leverage, sell new equity, cut
dividends.
d. The pecking-order theory predicts a company will favor internal
financing sources over external and among external sources it
will favor lower risk assets, such as bonds, over equity. The
options are ranked according to the pecking order as they appear in
the answer to part (c). Although cutting dividends is technically
an internal source of financing, the adverse signaling associated
with cutting dividends when the firm has a history of stable
dividends is so strong I expect firms would list it behind selling
new equity in their pecking-order. ffeel free to ignore cutting
dividends in grading your answer to this question.
e. The pecking-order theory follows from the desire to avoid
negative signaling (or lemon) effects of new equity issues,
supplemented by the desire to maintain access to financial
markets. If these goals are important to managers, they will
naturally follow the pecking order.
13. The annual interest tax shield is the annual interest expense times
the tax rate. In Haverhill’s case this is 6% × $5 million × 35% =
$105,000.
15. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).

Chapter 7
1. a. PV = $735.03. The Excel formula to solve the problem is given by:

=PV(.08,4,0,1000) = ($735.03)
PV(rate, nper, pmt, [fv], [type])
 Suggested Answers to Odd-Numbered Problems

The problem can also be solved using a financial calculator as

follows:
Input: 4 8 ? 01,000
n i PV PMTffV
Output: —735.03
Note: The following answers will present only the Excel method,
but in each case the problem can be solved equally well with a fi-
nancial calculator.
b. PV = $540.27. The present value is less because the present sum
has more time to grow into $1,000.

=PV(.08,8,0,1000) = ($540.27)
PV(rate, nper, pmt, [fv], [type])

c. ffV = $20,565.89.

=ffV(.08,7,0,—12000) = $20,565.89
ffV(rate, nper, pmt, [pv], [type])

d. PV = $13,503.65.

=NPV(.08,5000,4000,0,0,8000) = 13,503.65
NPV(rate, value1, [value2],...)

e. Nine years.

=NPER(.08,0,-2000,4000) = 9.01
NPER(rate, pmt, pv, [fv], [type])

f. ffV = $45,761.96

=ffV(.08,20,—1000) = $45,761.96
ffV(rate, nper, pmt, [pv], [type])
426 Suggested Answers to Odd-Numbered

g. PMT = $6,675.52

=PMT(.08,18,0,250000) = ($6,675.52)
PMT(rate, nper, pv, [fv], [type])

h. If the stream lasted forever, PV = 600/0.08 = $7,500.00. Hence,

the stream must be a perpetuity. If the stream lasted only five years,
the salvage value would have to be $7,500. This is the amount re-
quired to be invested at 8 percent to generate $600 per year in
per- petuity from year 5 on.
i. NPV = $133.22

=NPV(.08,50,75,110,110,80) - 200 = $133.22

NPV(rate, value1, [value2],...)

Rate of Return Problems

j. IRR = 8%.

=RATE(50,0,-1300,61000) = 8.00%
RATE(nper, pmt, pv, [fv], [type], [guess])

k. IRR = 12.28%.

=RATE(22,0,-900000,11500000) = 12.28%
RATE(nper, pmt, pv, [fv], [type], [guess])

l. IRR = 18%. Paying less than $22,470 implies an IRR greater than
18 percent, and vice versa.

=RATE(10,5000,-22470) = 18.00%
RATE(nper, pmt, pv, [fv], [type], [guess])

m. IRR = 14.87%. Assume you invest $1 today and receive $2 in

5 years. (Any other amount for which double is received in 5
years will give the same answer.)
 Suggested Answers to Odd-Numbered Problems

=RATE(5,0,-1,2) = 14.87%
RATE(nper, pmt, pv, [fv], [type], [guess])

n. IRR = 10.36%. ffirst enter the investment cash flows in row 1,

columns A through ff on your spreadsheet.

=IRR(A1:ff1) = 10.36%
IRR(values, [guess])

o. IRR = 14.9%. (Note that Excel requires you to enter a guess for
this particular problem in order to solve it.) Once again we see
the power of compound interest. This does not suggest that
investing in fine art is especially attractive. It ignores the costs of
maintain- ing, insuring, and protecting a valuable painting, and
the return on a Picasso can be expected to be much higher than
the return on a typical fine art investment.

=RATE(72,0,-7000,155000000,,.15) = 14.9%
RATE(nper, pmt, pv, [fv], [type], [guess])

Bank Loan, Bond, and Stock Problems

p. PV = $932.90.

=PV(.08,10,70,1000) = ($932.90)
PV(rate, nper, pmt, [fv], [type])

q. PV = 5/0.08 = $62.50.
r. PMT = $14.1 million.

=PMT(.08,8,0,150) = ($14.10)
PMT(rate, nper, pv, [fv], [type])

If the money is deposited at the beginning of each year, set the

“type” equal to one for beginning-of-year payments. The answer
is $13.06 million.
428 Suggested Answers to Odd-Numbered

=PMT(.08,8,0,150,1) = ($13.06)
PMT(rate, nper, pv, [fv], [type])

s. PMT = $25,958.

=PMT(.08,6,120000) = ($25,958)
PMT(rate, nper, pv, [fv], [type])

3. The effective interest rate on the time purchase plan is the discount rate
that makes the seller indifferent to a cash sale for $48,959 and a time
payment sale for $10,000 now and $10,000 for each of the next five
years plus $2,000 fees. Subtracting the initial $12,000 (fees and first
payment) from $48,959, the remaining annual payments would have
to have a present value of $36,959. The interest rate at which the
present value of a $10,000 annual payment for 5 years equals $36,969
is 11 percent.

=RATE(5,10000,-36959) = 11.00%
RATE(nper, pmt, pv, [fv], [type], [guess])

5. The present value of a constant stream of cash flows one year before
the first cash flow can be determined using the perpetuity formula.
The present value of the scholarship fund at time 2 is PV =
$45,000/0.05 = $900,000. In order to have $900,000 in the scholarship
fund in 2 years, it would be necessary to contribute $816,327 today.

=PV(.05,2,0,900000) = ($816,327)
PV(rate, nper, pmt, [fv], [type])

7. This is a straightforward replacement problem.

Old Roasters New Roasters
Gross profit $600,000 $1,200,000
— Depreciation 300,000 450,000
Profit before tax 300,000 750,000
Tax at 45% 135,000 338,000
Profit after tax 165,000 412,000
+ Depreciation 300,000 450,000
After tax cash flow $465,000 $862,000
 Suggested Answers to Odd-Numbered Problems

If the company keeps the old roasters, NPV = $2.857 million.

=PV(.1,10,465) = ($2,857)
PV(rate, nper, pmt, [fv], [type])

The present value of the after tax cash flows from the new roasters is
$5,297 million. If they sell the old roasters and buy the new ones,
NPV = —4.500 + 1.500 + 5.297 = $2.297 million. Therefore, keep
the old roasters.

=PV(.1,10,862) = ($5,297)
PV(rate, nper, pmt, [fv], [type])

Alternatively, one can look at the difference in cash flows between

the two alternatives. This amounts to analyzing the incremental cash
flows. Subtracting the old roasters’ cash flows from the new
roasters’ cash flows,

=PV(.1,10,397) = ($2,439)
PV(rate, nper, pmt, [fv], [type])

and NPV = —3.000 + 2.439 = —0.561 million, indicating that

spending an incremental $3 million to buy the new roasters is not
at- tractive. It should not surprise you to learn that this NPV equals
the difference in the NPVs of the two options. That is, —0.561
million =
$2.297 million — $2.857 million. The IRR of the incremental cash
flows is 5.4 percent, which because it is below 10 percent again indi-
cates the incremental investment is unwarranted.
9. The after tax flows from the investment are:
Year 0 1 2 3 4 5
Initial cost $ 15,000
Revenue $20,000 $20,000 $20,000 $20,000 $20,000
Operating expense 13,000 13,000 13,000 13,000 13,000
Depreciation 3,000 3,000 3,000 3,000 3,000
Income before tax 4,000 4,000 4,000 4,000 4,000
Tax @ 40% 1,600 1,600 1,600 1,600 1,600
Income after tax 2,400 2,400 2,400 2,400 2,400
+ Depreciation 3,000 3,000 3,000 3,000 3,000
After tax cash flow $ (15,000) $ 5,400 $ 5,400 $ 5,400 $ 5,400 $ 5,400
430 Suggested Answers to Odd-Numbered

The investment is quite attractive. Its internal rate of return is

23.4 percent, well above the minimum target of 10 percent.

=RATE(5,5400,-15000) = 23.4%
RATE(nper, pmt, pv, [fv], [type], [guess])

11. What’s wrong with this picture?

a. Add back depreciation to calculate after tax cash flow. We are in-
terested in the cash generated by the project, not the accounting
profits. Using a salvage value less than initial cost captures the real-
ity of depreciation. To also subtract an annual amount would be
double-counting.
b. Do not subtract interest expense. The opportunity cost of money
in- vested is captured in the discount rate. To also subtract
financing costs would again be double-counting. More broadly,
you should separate the investment and the financing decision
whenever possi- ble. If you must mix the two, it is possible to analyze
the project from a purely equity perspective, but then you must also
subtract principal payments to determine cash flows to equity. As we
will see in the next chapter, this equity perspective can be tricky to
apply in practice.
c. A 15 percent annual growth in earnings is not an appropriate cor-
porate goal because it is not necessarily consistent with
increasing shareholder value, or anyone else’s value for that
matter. Account- ing numbers can easily be manipulated to create
apparent growth even when none exists. Blind pursuit of growth
biases management in favor of retaining income to invest in even
very low return proj- ects because they generate growth while
dividends do not. The ap- propriate corporate objective is to
create shareholder value, to un- dertake projects promising a
positive NPV.
d. Thirty percent is the accounting rate of return, not the correct in-
ternal rate of return.
e. Increases in accounts receivable and “stuff like that” are relevant.
True, much of the investment in working capital is recovered at the
end of the project’s life, but because money has a time value, the
present value of the recovered working capital investment is less
than the original outlay, and thus constitutes a relevant cash flow.
f. Extra selling and administrative costs are relevant if they are in-
cremental to the project. Remember the with-without principle.
If surplus employees would be laid off in the absence of this proj-
ect, retaining them to work on this project generates incremental
 Suggested Answers to Odd-Numbered Problems

costs. If surplus employees would be retained and remain idle in

the absence of this project, the costs would exist even without
this project and would thus be irrelevant. The former situation
appears more likely. I agree with Natalie: Dump David as rapidly
as possible.
13. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).
15. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).

Chapter 8
1. a. ffalse. ffuture cash flows are discounted more than near cash flows
for risk because the discount rate in the denominator is raised to
a higher power. A constant discount rate assumes risk increases
at a constant geometric rate as the cash flow recedes in time.
b. True. The WACC is the appropriate discount rate to use for
projects that have the same risk as existing assets of the firm. If a
project is either safer (riskier) than average, it should be
evaluated at a discount rate below (above) the firm’s WACC.
c. ffalse. This is yet another example of the marginal cost of capital
fallacy. A company may be able to borrow the entire cost of a
proj- ect. However, this does not imply that the cost of capital for
the in- vestment equals the borrowing rate. Increasing leverage
increases the risks borne by shareholders, which increases the
cost of equity capital. Alternatively, the discount rate for an
investment is an op- portunity cost reflecting the return available
on same-risk invest- ments elsewhere in the economy; it is not
the cost of any particular funding source.
d. ffalse. Interest expense reflects the coupon rate on debt outstand-
ing when payments were made. There are several reasons interest
expense/end-of-period debt outstanding may be a poor estimate
of a firm’s cost of debt. ffirst, the amount of debt outstanding may
vary over time, so the end-of-period debt does not equal the debt
outstanding when payments were made. Second, we want the cost
of new debt, and interest expense/end-of-period debt outstanding
is a historical number. If market interest rates, or the company’s
creditworthiness, have changed since existing debt was issued, the
historical cost will differ from the cost of new debt. Third, debt
coupon rates may not equal the full return expected by the
lender.
432 Suggested Answers to Odd-Numbered

An extreme example is zero-coupon debt where all of the return

is in the form of price appreciation. The cost of debt is best
approximated by the yield to maturity on the existing debt; this is
the rate of return investors demand today on new debt.
e. ffalse. A firm’s equity beta depends on two factors: the business risk
of the firm and the financial risk imposed by the firm’s capital
structure. While firms in the same industry should have similar
business risks, there is no guarantee that the firms will have similar
financial risk.
3. The lowest rate of return the entrepreneur should be willing to
accept has nothing to do with the presence of an interest-free loan.
The low- est acceptable rate is the rate the entrepreneur could expect
to earn on the next best alternative investment at the same risk. The
cost of cap- ital is an opportunity cost determined by the attractiveness
of alterna- tive investment opportunities.
5. The WACC should be based on the risk of the project being consid-
ered, not of the firm doing the valuation. Both firms should use a
beta for the cost of equity that reflects the risk in food processing,
regard- less of the volatility of their own industries. So no difference
should be expected in the appropriate WACC each firm would use.
7. Equation 8.1 is used to calculate the weighted-average cost of capital:
(1 - t)KDD + KEE
KW
D + E
In the case of SKYE Corporation, D is the book value of debt be-
cause the market value of debt is unknown ($10 million). E is the
market value of equity, given by the stock price times the number of
shares outstanding ($30 × 1 million = $30 million). KD is the yield to
maturity on SKYE’s debt (7.68%). ffinally, KE is found using Equation
8.2: KE = 6% + 0.75(6.3%) = 10.7%. Putting all this to- gether gives
SKYE’s weighted-average cost of capital as 9.2%, as shown
below.
(1 - 0.4)(7.68%)10 + (10.7%)30
KW 10 + 30 = 9.2%

9. Increasing financial leverage increases the risk borne by equity in-

vestors and hence increases the cost of equity capital. The
company’s equity beta will rise as well. Indeed, the rising equity
beta causes the cost of equity to rise. ffigure 6.1 shows the
relationship graphically.
11. a. IRR of perpetuity = Annual receipt/Initial investment. We want
IRR = 20% = ($3 million — (1 — .50)8%X)/($25 million — X),
where X = Required loan. X = $12.5 million. So the investor can
 Suggested Answers to Odd-Numbered Problems

pay $25 million for the property financed with a $12.5 million
loan and earn an expected 20 percent return on her investment.
b. 90% = ($3 million — (1 — .50)8%X)/($25 million — X).
X = $22.67 million. All she needs to do is to borrow $22.67 million
of the required $25 million investment.
c. Make certain you understand this answer. It’s important. An investor
would settle for a lower return because it takes less debt financing to
achieve it. Leverage increases expected return to equity but also
the risk to equity. Indeed, if the investor can borrow at 8 percent
on her own, the broker is not making this investment any more
attractive by borrowing more to increase the return to equity. See
Chapter 6.
13. a. The annual debt service payment = $83.09 million. [$83.09 =
PMT(.06,5,350)].
b. The equity investor invests $50 million at time 0 and receives
$16.91 million annually for five years ($100 — $83.09 = $16.91).
The internal rate of return on this cash flow is 20.5 percent.
c. This is a poor investment. Discounting the company’s free cash
flows at its cost of capital, its enterprise value is only $379.08
mil- lion. Buying the company for $400 million implies a negative
NPV of —$20.92 million. (If the problem had not instructed us to
ignore taxes, an additional source of value would be the present
value of interest tax shields. But that term is not relevant here.) A
20.5 per- cent return to equity looks attractive, but this is just
leverage talk- ing. The return to equity is not sufficient to justify
the risk borne. The investment is below the market line.
15. a. It is a call option. It gives General Design the option to “purchase”
the expansion.
b. The strike price is the price at which General Design can purchase
the expansion.
17. In addition to the discussion below, see suggested answers available
from McGraw-Hill’s Connect or your course instructor (see Preface
for more information).
a. Stage 2 is identical to stage 1, but five times as large. The invest-
ment will take place 2 years from today and cost $425 million
($85 × 5). The following table summarizes expected future cash
flows if the project succeeds and if it fails. Cash flows are all five
times larger than the stage 1 analysis in Table 8.6(b) and delayed
two years to reflect the later starting date of stage 2. If the project
fails, cash flows reflect the option to abandon and earn five times
the sales proceeds for the plant.
434 Suggested Answers to Odd-Numbered

Expected After-Tax Cash Flows ($ millions)

Present Value 1 2 3 4 5 6 7
Success $634 0 0 250 250 250 250 250
Failure $63 0 0 (50) (50) 250 0 0

The present value of the future payoffs to the project is $634 mil-
lion if it succeeds and $63 million if it fails. The present value of
the initial investment is $321 million [$321 = 425/(1 + 0.15)2].
b. If General Design were to evaluate stage 2 before learning
whether this technology is successful, the probability of success
would still be the same as for stage 1 at 50 percent. The stage 2
decision is parallel to stage 1, so General Design would again
abandon the project if it fails. The decision tree (for stage 2 only)
is:

Invest
—$321
Success
$634
p = .50
Failure/Abandon

$0 $63
Do not invest p=
.50

The present value of the expected cash flows for stage 2 therefore
equals $348 and, after subtracting $321 present value of the cost
of the stage 2 investment, the NPV of stage 2 is $27 million ($27
=
.50 × $634 + .50 × $63 — $321).
c. i. If General Design waits to learn whether stage 1 is successful,
the full decision tree for both stages is:
Success
$634
Expand p = .90
Success $168 —$321
p = .50 Failure
Invest $63
p = .10
—$85 $0
Failure Do not expand
$17
p = .50
Do not invest $0

The main differences relative to part (b) are that stage 2 will only
be undertaken if stage 1 is successful, and the probability of
suc- cess for stage 2 is now 0.90.
The present value of the expected cash flows for stage 2 equals
$577 and, after subtracting $321 present value of the cost of the
 Suggested Answers to Odd-Numbered Problems

stage 2 investment, the NPV of stage 2 is $256 million ($256 =

.90 × $634 + .10 × $63 — $321).
ii. Recognizing that there is only a 50 percent chance the stage 2
investment will ever be made, its expected NPV is $128
million ($128 = 0.50 × $256). Adding this figure to the $7
million NPV from stage 1 generates a combined NPV for both
stages of
$135 million.
iii. Explicit consideration of the option to expand adds $128 mil-
lion ($128 million = $135 million — $7 million) to an already
attractive project.
19. In addition to the discussion below, see suggested answers available
from McGraw-Hill’s Connect or your course instructor (see Preface
for more information).
a. The present value of “success” cash flows at time 2 discounted at
10 percent is $948. The corresponding figure for “failure” cash flows
is $101 million. At a 90 percent chance of success, the expected
present value of cash inflows is $863 million ($863 = 0.90 × $948
+ 0.10 × $101). Subtracting the initial cost of $425 million (al-
ready in year 2 dollars) yields $438 million.
b. As seen from the present, General Design’s decision to invest in stage
1 gives it a 50 percent chance at a follow-on investment worth
$438 million in two years. Because the next two years are higher
risk, it makes sense to value stage 2 today by discounting this
sum to the present at the original 15 percent discount rate, for a
present value of
$331 [$331 = $438/(1+.15)2]. Applying a 50 percent probability, the
revised stage 2 NPV today is $166 million ($166 = $331 × 0.5).
Adding this to the original stage 1 NPV of $7 million [Table
8.6(b)] produces a revised total NPV for both stages equal to
$173 million, $38 million higher than the value of the project
using the constant 15 percent discount rate throughout (from
Problem 17).
21. Suggested answers to Connect problems are available from McGraw-
Hill’s Connect or your course instructor (see Preface for more infor-
mation).
23. The annual interest tax shield is the interest expense times the tax
rate ($1,000,000 × 0.1 × 0.5 = $50,000). The present value of the tax
shields is found by summing the discounted annual tax shield for
each of the three years [$50,000/1.1 + $50,000/(1.12) +
$50,000/(1.13) = $124,343]. Then the APV is the sum of the NPV
of the free cash flows ($500,000) and the present value of the tax
shields, or $624,343.
436 Suggested Answers to Odd-Numbered

Chapter 9
1. a. ffalse. Taking into account the gains to stockholders of both the ac-
quiring firm and the target firm, acquisitions create value, on
aver- age, but that virtually all of it accrues to selling
shareholders. See chapter citations by Robert ff. Bruner and by
Dinava Bayazitova, Mathias Kahl, and Rossen I. Valkanov.
b. ffalse. A discounted cash flow valuation of a target company
discounts the target’s estimated free cash flows at the target’s cost of
capital. The basic principle is: The discount rate should reflect the
risk of the cash flows discounted. Here the risk of the cash flows
discounted is that of the target.
c. ffalse. Acquirers make money by buying poorly run companies
and improving their performance. When a company is well run,
the likelihood of materially improving performance is small, and
the control premium should be correspondingly modest.
d. ffalse. The liquidation decision is in the hands of controlling
shareholders—or if ownership is widely dispersed, incumbent
management. These parties are under no obligation to liquidate,
even when the firm is worth more dead than alive. If controlling
parties are optimistic about the firm’s prospects or if they are re-
ceiving large non-pecuniary firm rewards, they may elect to con-
tinue operations even when others believe the firm is worth more
in liquidation.
e. True. Say a company’s stock price is $30, while management be-
lieves it is worth $80. Buying an $80 asset for $30—usually with the
financial help of a buyout firm—has got to be an attractive invest-
ment. It can also create a major conflict of interest as
management realizes they can get an even better price if they run
down the com- pany before buying it.
3. a. The value of the bid to News Corp.’s shareholders is the value of the
assets acquired in the merger. This includes the value of the
equity acquired plus the liabilities assumed by the buyer. The
estimated cost of the acquisition was thus ($60 × 82 million shares)
+ $1.46 billion
= $6.38 billion. This is an estimate because the book value of Dow
Jones’s debt only approximates the preferred market value, although
the approximation is probably reasonably close.
b. The value of control is the difference between the bid price per share
and the price per share immediately prior to the bid, times the num-
ber of shares outstanding, or $2.21 billion ([$60 – $33] × 82 million
shares).
 Suggested Answers to Odd-Numbered Problems

5. ffree cash flow = EBIT(1 — Tax rate) + Depreciation — ffixed

investment — Working capital investment.
EBIT = Income before tax + Interest = 1,800 + 570
= $2,370.
Tax rate = 612/1,800 = 0.34
ffree cash flow = 2,370(1 — 0.34) + 800 — 510 — 340 = $1,514.20.
7. a. Any time one company acquires another, its sales and assets
increase. ffurther, if the acquired company’s earnings exceed the
interest cost of any debt issued in the acquisition, earnings will
in- crease as well. This is no surprise.
b. Value per share before proposal = $12/0.15 = $80.
c. Value per share after proposal = $6/(1+.15) + ($12.75/.15)/
(1+.15) = $79.13.
d. Clearly, owners of fflatbush should oppose the president’s plan. It
may result in a larger company, but it will destroy shareholder
value; that is, the stock price will fall under the plan. The problem
with the president’s plan is that it takes money with an opportunity
cost of 15 percent to owners and invests it in a venture yielding
only 12.5 percent ($0.75 per year added dividend in perpetuity
for a $6 investment yields 12.5 percent return).

9. a.
Company P V1 P + V1 V2 P + V2
Earnings after tax ($ millions) 2 1 3 1 3
Price to earnings ratio (X) 30 8 35
Market value of equity ($ millions) 60 8 35
Number of equity shares (millions) 1 1 1.5 1 1.5
Earnings per share ($) 2 1 2 1 2
Price per share ($) 60 8 35
Maximum new shares issued (millions) 0.5 0.5
Value of new shares issued ($ millions) 30 30
Maximum acquisition premium (%) 275% —14%

b. This problem illustrates why concern with earnings per share

dilution or accretion is shortsighted. Here, Procureps is tempted
to pay a huge premium to buy V1 but is disinclined to even look
at V2. Yet V2 is the exciting firm with future potential.
11. a. ffMV = PV{ffCff, ’15—’18} + PV{Terminal value}. PV{ffCff, ’15
—’18} = $155.9 million. Terminal value = EBIT(1 — Tax
rate)/0.11 = $120/0.11 = $1,090.9 million. PV{Terminal value} =
$1,090.9 million/(1+0.11)4 = $718.6 million. Summing, ffMV =
$874.5 million.
438 Suggested Answers to Odd-Numbered

b. ffMV of equity = ($874.5 — $250)/40 = $15.61 per share.

c. Terminal value = ffCff in 2019/(0.11 — 0.05). ffCff in 2019 =
$200(1.05)(1 — 0.4) — 30 — 15 = $81. So terminal value = $81/
(0.11 — 0.05) = $1,350. Present value of terminal value = $889.3.
ffMV of company = $155.9 + $889.3 =$1,045.2 million. ffMV of
equity per share = ($1,045.2 — $250)/40 = $19.88
d. Terminal value = Value of equity + Value of interest-bearing
liabilities. Value of equity = 12 × Net income in 2018 = 12 × (200
— 0.10 × 250)(1 — .40) = $1,260 million. Terminal value =
$1,260 million + $250 million = $1,510. Present value of terminal
value = $994.7. Therefore, ffMV of company on valuation date
= $155.8 + $994.7 = $1,150.5 million. Value per share =
($1,150.5 million — $250 million)/40 = $22.51.
13.
Employee ownership at time 5 20.0%
Round 2 VC’s ownership at time 5 11.0%
Round 2 VC’s retention ratio = (1 — .20) 0.80
Round 2 VC’s ownership at time 2 = 0.11/0.80 13.8%
Touchstone ownership at time 5 62.9%
Touchstone retention ratio = (1 — .20)(1 — .138) 0.69
Touchstone ownership at time 0 = 0.629/0.69 91.2%
Confirmation of answer
Let X equal total shares outstanding at time 5 and recall that the founders own 2 million
shares. Then 0.20X + 0.11X + 0.629X + 2 million = X.
Total shares at time 5 32.79 million
Touchstone ownership at time 5 = 0.629 × 32.79 20.62 million
Price per share at time 5 = $100 million/32.79 $3.05
Value of Touchstone shares at time 5 = 20.62 million × $3.05 $62.9 million
IRR to Touchstone See Table 9.A2 60%
Round 2 VC’s ownership at 5 = 0.11 × 32.79 3.61 million
Value of Round 2 VC’s shares at time 5 = 3.61 million × $3.05 $11.0 million
IRR to Round 2 VC See Table 9.A2 40%
Value of options = 20% × $100 million $20 million
Value of founders’ ownership = 2 million × $3.05 $6.1 million
Note that the founders effectively pay for the employee options. Touchstone and the
second round VC still get their target returns of 60 percent and 40 percent, respec-
tively, while the value of the founders’ time 5 ownership falls from $26.1 million (see
Table 9.A2) to $6.1 million, with the missing $20 million going to employee options.

15. Suggested answers to Connect problems are available from McGraw-

Hill’s Connect or your course instructor (see Preface for more infor-
mation).