Principles of Corporate FinanceChapter 28 Financia Analysis 783) L. Revsine, D. Collins, B. Johnson, and F, Mittelstuedt, Financial Reporting and Analysis, 4th ced. (New Yorks McGraw-Hill/rwin, 2008). '. Penman, Financial Statement Anajss and Secerity Valuation, 4th ed. (New York: McGraw. Hill“rwi, 2009). connect ‘Select problems are available in McGraw-Hill Connect. a Please sce the preface for more information. BASIC 1. Construct a balance sheet for Galactic Enterprises given the following data: Cash balances: $25,000 Inventories _smg00 ‘Net plant and equipment ‘$140,000 ‘Accounts recehvable $35,000 ‘Accounts payanie ‘$24,000 Long-term debt $130,000 _ ‘What is shareholder equity? V2 Table 28.11 on the following page gives abbreviated balance sheets and income statements a Retum on aisets ‘b. Operating profit margin. © Sdlertoaten ratio, A. aventory tumowé. e. Debt-equity ratio. £ Catent ratio. & Quick ratio ‘Look again at Table 28.11. Calculate a common-size balance sheet and income statement for Bate Laude. ‘Look again at Table 28.11. At the end of fiscal 2008 Estée Lauder had 195 million shares cutstanding” with a share price of $45.50. The company’s weighted-averae cost of coptal ‘wat about 10%, Calculate 2 Mache vale add. 'b. Market-to-book ratio. ¢. Economic-value added. @ Retum on capital. ‘ratios are clearly incarrect. Substitute the correct definitions. Debe-equity ratio = (ong-tm debt + value of lessesVdongtern debt + vale of leases + equity) r i, Retum on equity = (EBIT-tas)/avernge equity Tear oemandingincide «clave emal numberof da B sar754 Part Nine Financial Planning and Working Capital Management ome: mn) ‘income statement for Estée Lauder Companies, fiscal 2008 (figures in $ milions). eXcel ‘rewninecontns Tota ose ad Shareholder [Curent ibis Debt ce for Accounts pablo “Total rent isoiee perm Sab ‘Other ong ter Eas Tet apie Taal dahalde “ota labile ad shareholdon! Troms Wet aler Gon of good so Seling, general, and soins Escnngs befor tarot ood tas (EI Interest expense Taxable income Net income Baad Aastion eed earn « Profit margin = net income/sales . Days in inventory = sales/inventory/365) € Current ratio = current liabilites/current assets f Sales-to-net-working-capital = average sales/average net working capital & Quick ratio = (current assets ~ inventories)/current liabilities 4h, Timesinterest-eamed = interest eared X long-term debt 6 True or false? 4 A.company’s debt-equity ratio is always less than 1 b. The quick ratio is always less than the current rato. © The retum on equity is aways less than the return on assets.Part One Vaive 7. Suppose you have the following investment opportunities, but only $90,000 available for investment. Which projects should you take? a. Ifthe opportunity cost of capital is 10%, which projects have a postive NPV? '. Calculate the payback period for each project. © Which project(s) would a firm using the payback rule accept ifthe cutoff period were three years? 4. Calculate the discounted payback period for each project. ‘ Which projects) would a firm using the discounted payback rule accep ifthe cutof? period were three years? 9. Respond to the following comments: 3 "Tlike the IRR rule. Ican ws it to rank projects without having to specify a discount rate” i, “Tike the payback rule. As long as the minimum payback period is shor, the rule ‘makes sure thar the company takes no borderline projects. That reduces risk 410. Calculate the IRR (or IRRs) forthe following project: 3000 +3500, For what range of discount rates does the project have positive NPV? Consider the following two mutually exclusive projects: ‘+ Calculate the NPV of each project for discount rates oF 0, 10, and 20%. Plot these on a ‘Saph with NPV on the vertical axis and discount rate on the horizontal ax, 'b, What is the approximate IRR for each project?‘Chapter & Net Present Value and Other investment Criteria, 151-— ¢ Inwhat circumstances should the company accept project A? 4. Caculate the NPV of the incremental invesement (B ~ A) for discount rates of 0,10, SSd 20m. Plot these on your graph. Show thatthe circumstances in which you would seceot A are also those ia which the IRR onthe incremental investment isles than the ‘opportunity cos of capital (B. Me Gyrus Clos, she president of Giant Emeriss to make «cic betwen wo possible investments: “The opportunity cost of capital is 9%. Mr. Clops is tempted to take B, which has the higher IRR. ‘4. Explain to Mr. Clops why this is not the correct procedure. '. Show him how to adapt the IRR rule to choose the best project. ‘¢ Show him that this project also has the higher NPV. 13. The Titanic Shipbuilding Company has 2 noncancelable contract to build + small cargo vesiel. Construction involves a cash outlay of $250,000 at the end of each of the next two years. At the end of the third year the company will receive payment of '$650,000, The company can speed up construction by working an extra shift. In this ‘ase there will be a cash outlay of $550,000 at the end of the first year followed by a ‘ath payment of $650,000 at the end of the second year. Use the IRR rule to show the ‘Gpproximate) range of opportunity costs of capital at which the company should work the extra shift. 414 Look again at projects D and E in Section 5.3. Assume that the projects are mutually exclu- sve and that the opportunity cost of capital is 10%. a. Calculate the profitability index for each project. b. Show how the profitabilty-index rule can be used to sclect the superior project. 15, Borghia Pharmaceuticals bat $1 million allocated for capital expenditures. Which of the following projects should the company accept to stay within the $1 million budget? How ‘much does the budget limit cost the company in terms of its market value? The opports- nity cost of capital for each project i 11%. (CHALLENGE 16. Some people believe firmly, even passionately, that ranking projects on IRR is OK if each ‘projec’ cash flows can be reinvested at the project's IRR. They also say that the NPV ruleChapter 9 Riskand the Cost Cpt = 263-—= 13,) The following table shows estimates of the risk of two well-known Canadian stocks: Toronto Dominion Bank canadian Pai 8 20 104 ‘What proportion of each stock's risk was market risk, and what proportion was specific tisk? 3. What isthe variance of Toronto Dominion? What isthe specific variance? What isthe confidence interval on Canadian Pacific's beta? J, If the CAPM is correct, what is the expected retum on Toronto Dominion? Assume a risk-free interest rate of 5% and an expected market return of 12%, Suppose that next year the market provides a zero return, Knowing this, what return ‘would you expect from Toronto Dominion? You are given the following information for Golden Fleece Financial ‘Long-term debt outstanding $200,000 (Curse ye o maturity (ane) 8% ‘Number ot shares of common stock 10,900 Price por share: $50 ‘Book value per share 325 Expected rat of return on sto (rag 15% Calculate Golden Fleece’s company cost of capital. Ignore taxes. Look again at Table 9.1. This time we will concentrate on Burlington Northern. a. Calculate Burlington’s cost of equity from the CAPM using its own beta estimate and the industry beta estimate. How different are your answers? Assume a risk-free rate of 5% and a market risk premium of 7%, ‘Can you be confident that Burlington's true beta is wor the industry average? ¢. Under what circumstances might you advise Burlington to calculate its cost of equity based on its own beta estimate? ‘What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step. Binomial Tree Farm’s financing includes $5 million of bank loans. Its common equity is shown in Binomial’s Annual Report at 6.67 million. It has 500,000 shares of common stock outstanding, which trade on the Wichita Stock Exchange at $18 per share. What debt ratio should Binomial use to calculate its WACC or asset beta? Explain. You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues. These cost are variable—they are always proportional to revenues. There are no other operating costs. The cost of capital is 9%. Your firm's long-term borrowing rate is 6%. Now you are approached by Studebaker Capital Corp, which proposes a fixed-price contract to supply raw materials at $10 million per year for 10 years. a. What happens to the operating leverage and business risk of the encabulator machine if you agree to this fixed-price contract? . Calculate the present value of the encabulator machine with and without the fixed- price contract.| a Chapter 9 Risk and the Cost of Capital eat estimated beta in the most recent period is about .16. Thus the confidence interval for Disney's beta is .96 plus or minus 2 X .16. If you state that the true beta for Disney is | between .64 and 1.28, you have a 95% chance of being right. Notice that we can be | _ equally confident of our estimate of Campbell Soup's beta, but much less confident of © Amazon's. Usually you will have more information (and thus more confidence) than this simple, and somewhat depressing, calculation suggests. For example, you know that Campbell Soup’s estimated beta was well below 1 in two successive five-year periods. Amazon's esti- ‘mated beta was well above 1 in both periods. Nevertheless, there is always a large margin | _ forerror when estimating the beta for individual stocks. : Fortunately, the estimation errors tend to cancel out when you estimate betas of port- folios That is why financial managers often turn to industry betas. For example, Table 9.1 | shows estimates of beta and the standard errors of these estimates for the common stocks | of six large railroad companies. Five of the standard errors are above 2. Kansas City Southem’s is 29, large enough to preclude a price estimate of that railroad’s beta. How- ‘ever, the table also shows the estimated beta for a portfolio of all six railroad stocks. Notice that the estimated industry beta is somewhat more reliable, This shows up in the Suppose that in early 2009 you had been asked to estimate the company cost of capital of | Union Pacific. Table,9.1 provides two clues about the true beta of Union Pacific’ stock: the direct estimate of 1.16 and the average estimate forthe industry of 1.24. We will use the | direct estimate of 1.162 The next issue is what value to use for the risk-free interest rate. By the first months of | 2009, the U.S. Federal Reserve Board had pushed down Treasury bill rates to about 29 in 4an attempt to reverse the financial crisis and recession. The one-year interest rate was only 2 file higher, at about 7%. Yields on longer-maturity U.S. Treasury bonds were higher still, at about 3.3% on 20-year bonds. | The CAPM is a short-term model. It works period by period and calls for a short-term Interest rate. But could a 2% three-month risk-free rate give the right discount rate for cash Bows 10 or 20 years in the future? Well, now that you mention it, probably not. Financial managers muddle through this problem in one of two ways. The first way ‘simply uses a long-term riskffee rate in the CAPM formula. If this short-cut is used, then | lower standard error. The Expected Return on Union Pacific Corporation's Common Stock January 2004 to December 2008. ‘The portoio beta is more reliable ‘han the betas ofthe indivi ‘companies, Note the lower stan- ‘ard eror forthe portoio.Chapter 30 Working Capt Management 815-——., INTERMEDIATE 17) Listed below are some common terms of sale. Can you explain what each means? 4. 2/30, net 60. . 2/5, BOM, net 30. « COD. 18) Some of the items in Problem 17 involve a cash discount. For each of these, calculate the rte of interest paid by customers who pay on the due date instead of taking the cash discount. 19) Phoenix Lambert currently ells its goods cash-on-delivery. However, the financial manager believes that by offering credit terms of 2/10 net 30 the company can increase sales by 496, without significant additional cost. Ifthe interest rate is 6% and the profit margin is ‘5%, would you recommend offering credit? Assume frst that all customers take the cash discount. Then assume that they all pay on day 30. 120) As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his bad debt ratio, which is currently running at 6%. He belicves that imposing a more stringent ‘credit policy might reduce sales by 5% and reduce the bad debt ratio to 4%. Ifthe cost of goods sold is 80% of the selling price, should Mr. Procrustes adopt the more stringent policy? 21) Jim Khana, the credit manager of Velcro Saddles, is reappraising the company’s credit policy. Velcro sells on terms of net 30. Cost of goods sold is 85% of sales, and fixed costs fare a farther 5% of sales. Velcro clasifes customers on a scale of 1 to 4. During the past five years, the collection experience was a follows: ‘The average interest rate was 154%. ‘What conclusions (f any) can you draw about Velcro's credit policy? What other fac- tors should be taken into account before changing this policy? . 22, Look again at Problem 21. Suppose (a) that it costs $95 to classify each new credit applicant and (b) that an almost equal proportion of new applicants falls into each ofthe four catego- ries. In what circumstances should Mr. Khana not bother to undertake a credit check? 23 Until recently, Augean Cleaning Products sold its products on terms of net 60, with an average collection period of 75 days. In an attempt to induce customers to pay more promptly, it has changed its terms to 2/10, EOM, net 60. The initial effect of the changed terms is a follows: Percent of Sales with Cash Discount Cash Discount o 30" “som cstrrs Gch cash acount even hgh ny pyaar he spain cat Calculate the effect of the changed terms. Assume + Sales volume is unchanged. + The intrest rate is 12%.o: Part Mine Financial Planning and Working Capital Management = + There are no defaults. + Cost of goods sold is 80% of sales. 24 Look back at Problem 23. Assume that the change in credit terms results in a 2% increase in sales. Recalculate the effect of the changed credit terms. 25. Knob, Inc, isa nationwide distributor of furniture hardware. The company now uses acen- ‘ral billing system for credit sales of $180 million anally, First National, Knob's principal bank, offers to establish a new concentration banking system for a lt fee of $100,000 per year. The bank estimates that mailing and collection time can be reduced by three days. By hhow much will Knob’s cash balances be increased under the new system? How much extra interest income will the new system generat ifthe extra funds are used to reduce borrow. ing under Knob's lin of credit with First National? Assume thatthe borrowing rate it 1296. Finally, should Knob accept First National's offer if collection costs under the old system ate $40,000 per year? 26) Anné Teak, the financial manager ofa furniture manufacturer, s considering operating a lockbox system. She forecasts that 300 payments a day will be made to lockboxes, with an average payment size of $1,500. The bane’ charge for operating the lockboxes is either $40 a check or compensating balances of $800,000, a. Ifthe interest ate is 9%, which method of payment is cheaper? >. What reduction in the time to collect and process each check is needed to justify use of the lockbox system? (22) A parent company stles the collection account balances of its subsidiaries once a meek (Thatis, each week it transfers any balances in the accounts to a central account) The cost of 4 wire transfers $10, A check costs §.80, Cash transferred by wire i avilable the same day, but the parent must wait three days for check to clear. Cash canbe invested at 128 per year How much money must be in a collection account befor it pays to use a wire transfer? 28. The financial manager of JAC Cosmetics is considering opening a lockbox in Pittsburgh ‘Checks cleared through the lockbox will amount to $300,000 per month. The lockbox will ‘make cath available to the company three days ealir than is currently the case, 4 Suppose that the bank offers to run the lockbox fora $20,000 compensating balance. Is the lockbox worthwhile? + '. Suppose that the bank offers to nun the lockbox for a fee of $.10 per check cleared instead of a compensating balance. What must the average check size be for the fee altemative to be less costly? Assume an interest rate of 6% per year. ‘& Why did you need to know the interest rate to answer (b) but not to answer ()? 29. A three-month Treasury bill and 2 six-month bill both sell at a discount of 10%. Which offers the higher annual yield? 30. In Section 30-4 we described a three-month bill that was issued on an annually com- Pounded yield of 5.18%. Suppose that one month has passed and the investment still offer the same annually compounded return. What isthe percentage discount? What was yur return over the month? 31. Look again at Problem 30. Suppose another month has passed, so the bill has only one ‘month lef to run, I is now selling at a discount of 3%, What i the yield? What was Your realized retur over the two months? 32. Look up current interest rates offered by short-term investment altematives. Suppose that your firm has $1 million excess cash to invest forthe next two months. How would you invest cis cash? How would your answer change ifthe exces cash were $5,000, $20,000, $100,000, o $100 million? 33. In 2006 agency corporate bonds sold ata yield of 5.32%, while high-grade taxexempts of comparable maturity offered 3.796 annually. [fan investor receives the same aflertax return fom corporates and tax-exempts, what is that investor's marginal rate of tax? What other factors might afect an investor's choice between the two types of securities?Chapter 30 Working Catal Management 817-— 34, The IRS prohibits companies from borrowing money to buy tax-exempts and deducting : the interest payments on the borrowing from taxable income. Should the IRS prohibit such activity? fit didn’t, would you advise the company to borrow to buy taxexempts? 38. Suppose you are a wealthy individual paying 35% tax on income, What is the expected after-tax yield on each of the following investments? ‘4. A municipal note yielding 7.0% pretax. b. A Treasury bill yielding 10% pretax. A floating-rate preferred stock yielding 7.5% pretax. How would your answer change if the investor is a corporation paying tax at 35%? What ‘other factors would you need to take into account when deciding where to invest the cor- poration’s spare cash? 36. You need to borrow $10 million for 90 days. You have the following altematives: Issue high-grade commercial paper, with a backup line of credit costing 39% a year. . Borrow from First Cookham Bank at an interest rate of 25% over LIBOR. c. Borrow from the Test Bank at prime. Given the rates currently prevailing ithe market (se, for example, The Wall Set Journal, @ which alternative would you choose? 37, Suppose that you are a banker responsible for approving corporate loans, Nine firms are seeking secured loans. They offer the following assets as collateral: a, Firm A, a heating oil distributor, offers a tanker load of fuel in transit from the Middle East b, Firm B, a wine wholestler, offs 1,000 cases of Beaujolais Nouveau, located in a warehouse. ¢. Fim G, a stationer, offers an account receivable for office supplies sold to the City of ‘New York. Firm D, a bookstore offers its entire inventory of 15,000 used books. Firm B, a wholesale grocer, offers a boxcar full of bananas. Firm F, an appliance dealer, offers its inventory of electric typewriters. Firm G, a jeweler, offers 100 ounces of gold. Firm H, a government securities dealer, offers its portfolio of Treasury bills Firm I, a boat builder, offers 2 halfcompleted humury yacht. The yacht will take four ‘months more to complete. Which ofthese assets are most likely tobe good collateral? Which are likely to be bad col lateral? Explain. CHALLENGE 38. Reliant Umbrellas has been approached by Plumpton Variety Stores of Nevada. Plumpton hhas expressed interest in an initial purchase of 5,000 umbrellas at $10 each on Reliant’s standard terms of 2/30, net 60. lumpton estimates that ifthe umbrellas prove popular with, customers, its purchases could be in the region of 30,000 umbrellas a year. After deductions for variable cost, this account would add $47,000 per year to Reliant’s profits. Reliant has been anxious for some time to break into the lucrative Nevada market, but its credit manager has some doubis about Plumpton. In the past five years, Plampton ‘had embarked on an aggressive program of store openings. In 2007, however, it went into reverse. The recession, combined with aggresive price competition, caused a cath shortage. Plumpton laid off employees, closed one store, and deferred store openings. The com- pany’s Dun and Bradstreet rating is only fir, and a check with Plumpton's other suppliers reveals that, although Plumpton traditionally took cash discounts, it has recently been paying 30 days slow. A check through Reliant’s bank indicates that Plumpton has unused Pre moe