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Solutions Guide

for
Case Studies in Finance
Written by
Dr. Michael J. Seiler
Associate Professor of Finance
Hawaii Pacific Uniersity
Case !
"nsider #radin$
Purpose: This case discusses a new and potentially alarming trend in the area of illegal
insider trading. The Internet is giving people a false sense of anonymity which does not
discourage them from sharing private corporate information. This case also makes
students aware of how easy it is becoming to gain access to illegal inside information and
how to avoid breaking securities law when the information comes to them.

1. This question is not as straightforward as it may seem on the surface. But an acceptable
definition is as follows: Information becomes public when a company representative
officially makes an announcement via a maor media.
!. "bsolutely anyone can come into contact with inside information. #ou do not have to
work for the firm to have private information. In fact$ it seems that private information is
often readily volunteered these days.
%. If someone conveys to you information that could be useful in making buy or sell
decisions$ that information would be illegal to trade upon. Private information only
becomes illegal trading when &1' you actually trade on the information$ or when &!' you
convey the information to someone else and they trade on the information. (o matter
how long the chain of passing along information gets$ if you are identified as one of the
links in the chain$ in the eyes of the court you are ust a guilty as the one who eventually
trades.
). *or some reason people think the Internet is a secure place to discuss secretive issues.
+espite reports that your employer monitors your e,mail and Internet usage$ and despite
the fact that the persons responsible for sending out the -I love #ou. virus were tracked
down on the other side of the world in a matter of days$ people still think there is no way
to learn of the Internet user/s identity.
0. If you come in contact with non,public information$ the best thing to do is ignore it.
#ou can/t help what you hear$ but you can control what you do$ or do not do$ with the
information.
2
Case %
#he #obacco "ndustry
Purpose: 1veryone knows that ethics are a part of business decision making. In
classroom discussions$ students find the unethical hypothetical debate to be rather clear,
cut. 2owever$ in the real world$ when ethical decisions hurt one party to help another$
there are no easy answers. This case centers around the tobacco industry3s alleged
increase in nicotine levels in cigarettes in an attempt to induce addiction amongst
smokers. This case also addresses the government3s role in regulating smoking in the
work place.
1thics questions are possibly the most difficult to answer. 4ne must consider all
sides of the argument and attempt to remain obective. Instead of stating my personal
opinions$ I will try to obectively present both sides of each argument.
1. "ny time a consumer purchases a product he5she has a right to know the ingredients of
the product. If tobacco companies alter nicotine levels &either with the intent to induce
addiction or without' without notifying consumers$ most people feel this would be
e6tremely unethical.
!. "s long as customers know what they are smoking$ the practice of providing high or
low nicotine cigarettes is generally deemed acceptable by most. The alcoholic beverage
industry sells various types of beers based on the level of alcohol or the fullness of the
beer$ etc. 2ence$ it is reasonable to allow tobacco firms to market different strengths of
cigarettes. 7ince nicotine is argued by the tobacco industry to be the source of flavor$
cigarette manufacturers could easily ustify the need for various nicotine levels.
%. *ine print warnings on the side of cigarette packs have been frowned upon because
they are hard to notice and even harder to read. 8ost people do not read their product3s
container$ although in the case of cigarettes$ most people are fully aware of the inherent
dangers of smoking.
). 7mokers will argue that they have a right to engage in an activity that does not affect
others. (on,smokers will argue that smoking in not one such activity.
0. The government will never agree to help pay for the installation of ventilation systems
for smokers. Therefore$ a problem will most surely rise when small business owners
argue that the smoking ban will adversely affect their business relative to other forms of
ownership. This is a maor problem because 9:; of all firms are small businesses.
<. The result that small businesses &and large businesses to a lesser e6tent' will find
employing smokers too costly will surely cause firms to prefer non,smokers over
smokers$ everything else constant. This is discrimination$ pure and simple.
There is a difference$ however$ between unwarranted and warranted
discrimination. =arranted discrimination is based on an economic or otherwise rational
reason for preferring one type of worker over another. This is clearly a case of warranted
3
discrimination. "s economically rational as it may be$ law suits are sure to be a result of
the ban.
4
Case &
Connect Cable Contractors
Purpose: This case allows students to work on the typical small business situation where
no e6isting model or framework is available. That is$ the student cannot ust plug
numbers into an e6isting formula. They must devise a plan themselves that will get the
ob done.
1.
#able !
Calculations Wor'sheet for (ew Prices
#y)e of *ob
+!,
-ob.s )rice
+%,
Stee.s )rice
+&, / 01+%,2+!,+!2.!%,34 +!,+!2.!%,56!77
Percenta$e increase in )ay
4verhead Install >1).0: >1%.?< @?.A;
Bnderground Install >1).0: >1%.!0 @%.A;
"54&unwired,w5' >0.0: >0.0: @1!.:;
"54& wired,w5' >0.0: >).?0 ,1.9;
CDE &w5 install' >1.0: >1.0: @1!.:;
Fong +rop >1:.:: >1:.:: @1!.:;
Eeplace +rop >1).0: >1%.:: @!.:;
EelocateG "54 4nly:
=ired >1:.:: >9.:: @!.%;
Bnwired >1:.:: >9.0: @A.:;
Eeconnect >1:.0: >9.?0 @0.0;
CDE &w5 reconnect' >1.0: >1.0: @1!.:;
CDE 2ook,Bp 4nly ><.0: ><.!0 @9.%;
Bpgrades ><.0: ><.!0 @9.%;
Trip Dharge >0.:: >).0: @!.%;
The numbers in column four of this table are somewhat subective. There are$ however$
specific guidelines which must be followed. *irst$ there must be a significant price
differential between overhead installs$ underground installs$ and replaced drops.
"dditionally$ there must be a difference in pay between the wired and unwired outlets in
order to encourage e6tra work by the sub,contractors. 7econdly$ there must be an overall
increase in real pay of between ?;,A; for both Burt and Dhris.
!. Bnder Bob3s old system$ Dhris would have earned >0<9.)9 &ust multiply Bob3s real
price by the average number of obs Dhris performs per week'. Burt would have earned
>01).??.
%. *rom Table !$ add the numbers in the third column to find the average increase in pay
5
per week for Dhris. +oing this yields an answer of >)1.:!. *rom Table %$ Burt3s increase
in pay per week under the new system would be >%A.)%.
#able %
Calculations Wor'sheet for "ncreases in Wee'ly 8arnin$s
Under the (ew Pricin$ Syste9 for Chris
#y)e of *ob
"verage number of
each ob per week
+ollar increase
in pay per ob
Total dollar increase
In pay per type of ob
4verhead Install A.1 >:.99 >A.:!
Bnderground Install ?.< >:.)9 >%.?!
"54&unwired,w5' 1A.0 >:.<< >1!.!1
"54& wired,w5' 9.9 ,>:.:9 ,>:.A9
CDE &w5 install' 11.9 >:.1A >!.1)
Fong +rop %.? >1.!: >).))
Eeplace +rop :.9 >:.!) >:.!!
EelocateG "54 4nly:
=ired :.A >:.!: >:.1<
Bnwired A.) >:.?: >0.AA
Eeconnect ?.! >:.01 >%.<?
CDE &w5 reconnect' %.A >:.1A >:.<A
CDE 2ook,Bp 4nly :.: >:.0% >:.::
Bpgrades 1.: >:.0% >:.0%
Trip Dharge !.) >:.1: >:.!)
#able &
Calculations Wor'sheet for "ncreases in Wee'ly 8arnin$s
Under the (ew Pricin$ Syste9 for -urt
#y)e of *ob
"verage number of
each ob per week
+ollar increase
in pay per ob
Total dollar increase
In pay per type of ob
4verhead Install 11.A >:.99 >11.<A
Bnderground Install 1.< >:.)9 >:.?9
"54&unwired,w5' 1?.< >:.<< >11.<!
"54& wired,w5' 11.< ,>:.:9 ,>1.:)
CDE &w5 install' 11.< >:.1A >!.:9
Fong +rop ).< >1.!: >0.0!
Eeplace +rop !.A >:.!) >:.<A
EelocateG "54 4nly:
=ired :.) >:.!: >:.:A
Bnwired %.) >:.?: >!.%A
Eeconnect <.A >:.01 >%.)?
CDE &w5 reconnect' !.A >:.1A >:.01
CDE 2ook,Bp 4nly :.: >:.0% >:.::
6
Bpgrades 1.: >:.0% >:.0%
Trip Dharge 1.! >:.1: >:.1!
). 8ultiplying the >)1.:! by 0!$ results in a forecasted increase in pay per year for Dhris
of >!$1%%.:). Burt3s annual increase in pay would be >!$::: &>%A.)% times 0!'.
0. 7ince Dhris had 19 of the !: week3s records$ the analysis is almost as accurate as
possible. Burt$ on the other hand$ only kept records for 0 out of !: weeks$ thus
e6trapolating those few weeks into predictions concerning the rest of the year may led to
a low level of reliability.
<. By hiring more sub,contractors$ each person would save money because they would
not have to cover nearly as large of a geographic area. "lso$ since the contractors would
not have to spend as much time traveling$ they could opt to install more additional outlets
and perform other additional obs that in the past they would bypass due to time
constraints imposed by the time windows.
If the work load for which 7teve is responsible does not increase as additional
workers are hired$ it is probable that as the same siHed pie is cut into more pieces$ each
worker will be earning less. Thus$ the answer to this question depends on the relative
strength of these two competing effects.
?. 4nly data dating back to Ianuary of this year has been used to perform the analysis
because this is when the new time windows were invoked. Bsing data before this period
would be good in that a larger sample of weeks would lead to more reliable results$
everything else constant. The problem with using data prior to Ianuary is that since the
windows have been in use$ the number of obs each sub,contractor performs has been
greatly altered.
=hile it is clear that only post Ianuary data should be used$ there still e6ist other
biases in the numbers. *or e6ample$ the data used in this study is for winter. =hile the
cable industry is not e6tremely seasonal$ there are fluctuations associated with people
spending winters in the south.
A. The reason for asking this question is to provoke the students to generate suggestions
instead of ust responding to the suggestions made in the case. 4ne of the reasons why
Bob lost the contract was because his workers were not happy and this dissatisfaction
showed in their work. Therefore$ it is important that 7teve ensures that the sub,
contractors are paid fairly. 7teve should$ therefore$ perform periodic analyses to see that
each sub,contractor continues to make more than they did under Bob3s contract and more
importantly that they get the same percentage raise.
7
Case :
"-P
Purpose: The purpose of this case is to provide students with the practice of constructing
a Balance 7heet.
"-P;s -alance Sheet
Assets
Current Assets
Cash and cash equivalents $ 27,254
Marketable securities 1,400
Accounts receivable 5,
!nventories 405,41"
#e$erred inco%e ta& bene$its 51,7"1
're(aid e&(enses 10,"3
)otal Current Assets 1,06,"15
Property, plant, and equipment
*and and i%(rove%ents 106,42
+uildin,s and stock-ards 544,711
.qui(%ent 1,06,571
1,747,774
Accu%ulated de(reciation and a%orti/ation 0"43,371
03,"37
Construction in (ro,ress 16",256
2et 'ro(ert-, (lant, and equi(%ent 1,072,03
Other assets
3ood4ill 724,0"
5ther 115,0
)otal other assets "3,06
Total Assets $3,00",06
"
Liabilities and Stockholder's Equity
Current Liabilities
Accounts (a-able and accrued e&(enses $ 565,517
2otes (a-able to banks 140,67
6ederal and 7tate inco%e ta&es 152,122
de$erred inco%e ta&es 1,"1"
other 5,3""
)otal current liabilities "65,"12
)otal *on,8ter% 5bli,ations 575,522
#e$erred credits and other liabilities
de$erred inco%e ta&es 17,037
other 14","11
)otal de$erred credits and other liabilities 165,"4"
Commitments and Contingencies
Stockholders' Equity
're$erred stock 0
Co%%on stock, $905 (ar value (er share 4,750
Additional (aid8in ca(ital 405,27"
:etained earnin,s 1,067,725
5ther 016,4561
)reasur- stock 060,3"31
Total Stockholder's Equity 1,400,14
Total Liabilities and Stockholder's Equity $3,00",06

Case <
Chrysler
Purpose: The purpose of this case is to familiariHe students with the calculations and
interpretation of basic financial ratio analysis.
1. #his year =ast year
Liquidity
2et ;orkin, Ca(ital $,527 $",321
Current :atio 194" 1944
<uick :atio 0Acid )est1 1926 1926
Actiity
!nventor- )urnover 92 11932
Avera,e A,e o$ !nventor- 9026 9031
Avera,e Collection 'eriod 13956 1196"
6i&ed Asset )urnover 4922 4972
)otal Asset )urnover 9 1905
!ebt
#ebt :atio "0= 7"=
)i%es !nterest .arned 4947 7922
Pro"itability
3ross 'ro$it Mar,in 22= 27=
2et 'ro$it Mar,in 39= 697=
:eturn on )otal Assets 39"= 791=
:eturn on .quit- 1"9= 3297=
!.
Fiquidity
Dhrysler has lower than average liquidity ratios. Their inventory levels appear to
be in line with industry standards$ but their current assets are a bit too low relative to their
liabilities.
"ctivity
Dhrysler3s inventory and asset turnover ratios are much higher than the industry
average$ which is good. This may be due in part to their fast collection period.
+ebt
The debt ratio seems to be right in line with industry figures$ but the times interest
earned ratio is lower than average. 7till$ the number is high enough to relieve concern
over Dhrysler3s ability to meet its debt obligations.
10
Profitability
Jross and (et Profit 8argins are slightly lower than average. Eeturns are lower
as well. But$ the differences are small enough not to cause concern.
%. The answer to this question is much deeper than the knowledge that can be gained by
performing a financial analysis. But$ based on the analysis$ Dhrysler was not in any
financial trouble nor were they out performing their competitors to the e6tent that
attention should be drawn to them.
). Kerkorian held a large stake in Dhrysler3s common stock. =henever rumors surface
that a company is undergoing a merger or acquisition$ the stock price of that company
tends to increase. It is possible that Kerkorian intended to sell his holdings of Dhrysler
and ust wanted the stock3s price to be higher when he did sell. Therefore$ he could fake
a buyout and sell his holdings at a higher price.
11
Case >
Moo$
Purpose: The purpose of this case is to have students practice constructing the
Donsolidated 7tatement of 1arnings.
M??G
Consolidated State9ent of 8arnin$s
(et 7ales >?:)$%?A
Dost of 7ales >)9%$!%0
Jross Profit >!11$1)%
Eesearch and +evelopment >!<$)<1
7elling$ general and administrative >11:$<?9
Interest >%!$:0)
4ther &><)'
1arnings Before Income Ta6es >)!$:1%
Income Ta6es >1)$:?0
(et 1arnings >!?$9%A
(et 1arnings Per 7hare
Basic >!.1%
+iluted >!.11
12
Case @
Aate Myers
Purpose: The time value of money is a fundamental concept that must be understood by
all business students. This case emphasiHes the important variables to consider when
saving for a down payment on a house and shows how these variables should dictate the
actions of an individual.
1. Fet$
PC L >9A$:::$
n L A years$
i L );.
7olving for future value via a calculator yields >1%)$119.??. !:; of this amount is
Kate3s required down payment.
&>1%)$119.??'&.!:' L >!<$A!%.90.
!. Fet$
*C L >!<$A!%.90$ the answer from question 1$
i L .<<<<; &A;51!'$ the monthly return from the 8errill Fynch account$
n L 9<$ &AM1!'$ A years times 1! payments per year.
7olving for payment yields an answer of >!::.%A per month.
%. This is the same procedure as question ! with the e6ception that the compounding
frequency has changed.
Fet$
*C L >!<$A!%.90$ the answer from question 1$
i L A;$ the annual return from the 8errill Fynch account$
n L A$ A years of payments.
7olving for payment yields an answer of >!$0!1.A0 per year. This amount is greater than
1! times the monthly payment because when Kate deposits funds at the end of each
month$ those funds are earning interest throughout the year$ while funds deposited only at
year3s end are not accumulating interest.
*or e6ample$ &1!'&>!::.%A' L >!$):).0:.
>!$0!1.A0 , >!$):).0: L >11?.%0. This additional amount represents the interest that the
eleven >!::.%A deposits would accrue throughout the year.
),0. " table will better represent the sensitivity analysis performed in questions ) and 0.
13
The calculations are the same as those from question !.

2ome
"ppreciation
Eeturn on 8errill
Fynch account
1nd,of,8onth
Eequired +eposit
!; ); >!:%.%?
!; A; >1?1.00
!; 1!; >1)%.09
); ); >!%?.00
); A; >!::.%A
); 1!; >1<?.?%
<; ); >!?<.<0
<; A; >!%%.%<
<; 1!; >190.%)

This sensitivity analysis clearly demonstrates the relationship among the three
variables. &1' The more Fakewood home prices appreciate$ the more Kate will have to
raise to make a down payment in the future. &!' The greater the return on her 8errill
Fynch account$ the lower the monthly deposit required.
14
Case B
Cuilici Fa9ily
Purpose: The time value of money is a fundamental concept that must be understood by
all business students. This case emphasiHes the important variables to consider when
saving up for a child3s education and shows how these variables should dictate the actions
of an individual striving to achieve this goal.
1. " simple future value calculation is necessary to determine the amount of tuition and
living e6penses per year when Brady is ready to attend.
7tanford
To find the future costs of tuition$
Fet$
n L 1%$
i L 0;$
PC L >!:$:::.
7olve for *C. *C L >%?$?1!.9A
To find the future costs of living e6penses$
Fet$
n L 1%$
i L %;$
PC L ><$:::.
7olve for *C. *C L >A$A11.!:
Total 16penses L >%?$?1!.9A @ >A$A11.!: L D:>E<%:.!B
B(D
To find the future costs of tuition$
Fet$
n L 1%$
i L 0;$
PC L >!$0::.
7olve for *C. *C L >)$?1).1!
To find the future costs of living e6penses$ the calculation is the same as above by
assumption.
Fet$
15
n L 1%$
i L %;$
PC L ><$:::.
7olve for *C. *C L >A$A11.!:
Total 16penses L >)$?1).1! @ >A$A11.!: L D!&E<%<.&%
!. 7tanford

tuition
#ear 1: >%?$?1!.9A &1.:0'
:
L >%?$?1!.9A
#ear !: >%?$?1!.9A &1.:0'
1
L >%9$09A.<%
#ear %: >%?$?1!.9A &1.:0'
!
L >)1$0?A.0<
#ear ): >%?$?1!.9A &1.:0'
%
L >)%$<0?.)9
living e6penses
#ear 1: >A$A11.!: &1.:%'
:
L >A$A11.!:
#ear !: >A$A11.!: &1.:%'
1
L >9$:?0.0)
#ear %: >A$A11.!: &1.:%'
!
L >9$%)?.A:
#ear ): >A$A11.!: &1.:%'
%
L >9$<!A.!)
Total 16penses
#ear 1: >%?$?1!.9A @ >A$A11.!: L D:>E<%:.!B
#ear !: >%9$09A.<% @ >9$:?0.0) L D:BE>@:.!@
#ear %: >)1$0?A.0< @ >9$%)?.A: L D<7EF%>.&>
#ear ): >)%$<0?.)9 @ >9$<!A.!) L D<&E%B<.@&
B(D
tuition
#ear 1: >)$?1).1! &1.:0'
:
L >)$?1).1!
#ear !: >)$?1).1! &1.:0'
1
L >)$9)9.A%
#ear %: >)$?1).1! &1.:0'
!
L >0$19?.%!
#ear ): >)$?1).1! &1.:0'
%
L >0$)0?.1A
living e6penses
#ear 1: >A$A11.!: &1.:%'
:
L >A$A11.!:
#ear !: >A$A11.!: &1.:%'
1
L >9$:?0.0)
#ear %: >A$A11.!: &1.:%'
!
L >9$%)?.A:
#ear ): >A$A11.!: &1.:%'
%
L >9$<!A.!)
Total 16penses
#ear 1: >)$?1).1! @ >A$A11.!: L D!&E<%<.&%
#ear !: >)$9)9.A% @ >9$:?0.0) L D!:E7%<.&@
16
#ear %: >0$19?.%! @ >9$%)?.A: L D!:E<:<.!%
#ear ): >0$)0?.1A @ >9$<!A.!) L D!<E7B<.:%
%. To determine the monthly payment to cover college e6penses$ the present value &i.e. at
the time Brady starts college' of the four year e6penses must be calculated. Bsing the
answers from question !$ combine both costs and find the present value keeping in mind
that the stream of payments to Brady is a monthly annuity.
7tanford
#ear 1 #ear ! #ear % #ear )
*C >)<$0!).1A >)A$<?).1? >0:$9!<.%< >0%$!A0.?%
i 1 1 1 1
n 10< 1<A 1A: 19!
P8T NNN >1!).99 >11!.<0 >1:1.9) >9!.0?
"dding all four amounts yields: D:&%.!<
B(D
#ear 1 #ear ! #ear % #ear )
*C >1%$0!0.%! >1)$:!0.%
?
>1)$0)0.1! >10$:A0.)!
i 1 1 1 1
n 10< 1<A 1A: 19!
P8T NNN >%<.%) >%!.)< >!9.11 >!<.!1
adding all four amounts yields: D!%:.!%
). This is the same problem as number three with the e6ception that the interest rate is
different. The only adustment is in the interest rate used.
i L 1:51! L .A%%%%%%%%
7tanford
#ear 1 #ear ! #ear % #ear )
*C >)<$0!).1A >)A$<?).1? >0:$9!<.%< >0%$!A0.?%
i .A%%% .A%%% .A%%% .A%%%
n 10< 1<A 1A: 19!
P8T NNN >1)<.%% >1%%.?9 >1!!.A? >11%.!?
17
"dding all four amounts yields: D<!>.%>
B(D
#ear 1 #ear ! #ear % #ear )
*C >1%$0!0.%! >1)$:!0.%
?
>1)$0)0.1! >10$:A0.)!
i .A%%% .A%%% .A%%% .A%%%
n 10< 1<A 1A: 19!
P8T NNN >)!.0) >%A.00 >%0.:9 >%!.:?
"dding all four amounts yields: D!:B.%<
0. There is clearly a positive relationship between the amount the parents must invest and
the increases in future tuition and living e6penses.
1"
Case F
WalMart
Purpose: The purpose of this case is to teach the student to calculate actual returns for an
individual stock from past stock price and dividend data. The risk of the company will
also be determined as pro6ied by the standard deviation. The student must then calculate
the required rate of return on the stock to determine if the stock is over or under,valued.
1. To calculate the quarterly returns$ the following formula should be used:
where$
k
t
L return during period t$
P
t
L price of asset at time t$
P
t,1
L price of asset at time t,1$
+
t
L dividends received throughout the quarter.
Iune !::!:
&>00.:1 , ><1.!! @>:.:A' 5 ><1.!! L ,1:.:1;
8arch !::!:
&><1.!! , >0?.)1 @>:.:A' 5 >0?.)1 L ?.!0;
+ecember !::1:
&>0?.)1 , >)9.%! @>:.:?' 5 >)9.%! L 1<.00;
7eptember !::1:
&>)9.%! , >)A.0) @>:.:?' 5 >)A.0) L 1.?0;
Iune !::1:
&>)A.0) , >0:.1< @>:.:?' 5 >0:.1< L ,%.:9;
8arch !::1:
&>0:.1< , >0!.<9 @>:.:?' 5 >0!.<9 L ,).<?;
+ecember !::::
&>0!.<9 , >)?.<? @>:.:<' 5 >)?.<? L 1:.<<;
!. The standard deviation is a measure of dispersion about a mean. In an investing
conte6t$ it refers to a measure of total risk. To calculate the standard deviation$ use any
calculator or spreadsheet$ such as 16cel. The standard deviation is 9.%<;.
P
D
+
P
-
P
=
k
1 - t
t 1 - t t
t
1
%. "ssuming Beta L 1.!G E
f
L 0.!0;G E
m
L 1!.!;$ the required rate of return can be
determined by employing D"P8.
k

L E
f
@ Ob

6 &k
m
, E
f
'P
L 0.!0; @ 1.! &1!.!; , 0.!0;'
L 0.!0; @ A.%);
L 1%.09;
). If =al8art had an e6pected rate of return of 1);$ 8arv should buy =al8art3s stock
because it is e6pected return an amount in e6cess of what is required based on its risk
level. "s long as =al8art is e6pected to return a rate of greater than 1%.09;$ 8arv
should buy the stock. In a perfectly efficient market$ the e6pected return always equals
the required rate of return.
0. The time period studied here is very short. Eeturns considered over such a short time
period are not as reliable because the sample siHe is much too small. *urthermore$ the
economy goes in cycles. Therefore$ while =al8art may have performed well or poorly
in the short,run is not necessarily indicative of their long,run performance. " better
performance time period would be over the last ten years or more. That way we would
be able to observe how =al8art performed during both e6pansions and contractions in
the economy.
20
Case !7
"ntel
Purpose: The purpose of this case is to teach the student to calculate actual returns for an
individual stock from past stock price and dividend data. The risk of the company will
also be determined as pro6ied by the standard deviation. The student must then calculate
the required rate of return on the stock to determine if the stock is over or under,valued.
1. The e6pected return on a portfolio is equal to the weighted average of the return from
each component in the portfolio. 8athematically$
#ear
1 & <.!'&.!:' @ & :.1'&.%0' @ &,).!'&.)0' L , .<!;
! & ?.A'&.!:' @ & !.A'&.%0' @ & <.<'&.)0' L 0.01;
% & <.9'&.!:' @ &,1.9'&.%0' @ &1!.!'&.)0' L <.!1;
) &,).1'&.!:' @ & !.9'&.%0' @ & ?.A'&.)0' L %.?1;
0 & A.9'&.!:' @ & ?.?'&.%0' @ & ).%'&.)0' L <.)1;
< &1:.!'&.!:' @ &10.1'&.%0' @ &,!.1'&.)0' L <.%A;
? &10.%'&.!:' @ &19.%'&.%0' @ & A.)'&.)0' L 1%.<:;
A & 9.!'&.!:' @ &1).!'&.%0' @ &1:.!'&.)0' L 11.):;
!. =ith Intel included$
#ear
1 &.?1)'&,:.<!' @ &.!A0?'& ).A' L .9%;
! &.?1)'& 0.01' @ &.!A0?'&1:.!' L <.A0;
% &.?1)'& <.!1' @ &.!A0?'&11.%' L ?.<<;
) &.?1)'& %.?1' @ &.!A0?'&1A.1' L ?.A%;
0 &.?1)'& <.)1' @ &.!A0?'& <.<' L <.)<;
< &.?1)'& <.%A' @ &.!A0?'&,1.A' L ).:);
? &.?1)'&1%.<:' @ &.!A0?'& !.?' L 1:.)A;
A &.?1)'&11.):' @ &.!A0?'&1:.9' L 11.!<;
%. The standard deviation of a portfolio is equal to the square root of: the sum of each
term minus the average return quantity squared divided by n,1.
8athematically$
k w
=
k j j
n
j=1
p

21
The average return L 0!.<5A L <.0A;
The terms &6
i
, 6'
!
$ are generated as follows:
&,.<! , <.0A'
!
@ &0.01 , <.0A'
!
@ ... @ &11.) , <.0A'
!
L 1%%.9)
O&1%%.9)'5&A,1'P
15!
L ).%?); L Q
p
). Bsing the same equation$ the standard deviation with Intel included L %.%!!; L Q
p
0. The beta of a portfolio is equal to the weighted average of the betas for each asset.
=ithout Intel
b
p
L &.!'&.?' @ &.%0'&1.<' @ &.)0'&1.:' L 1.10
=ith Intel
b
p
L &.?1)'&1.10' @ &.!A<'&1.1' L 1.1)
<. Beta tends not to be constant over time. *or the eight year period under consideration$
it would be unlikely that each firm3s beta would be the same year after year. =hen betas
vary$ however$ they do not normally ump around. Instead$ there will normally be a
gradual trend. *or shorter periods of time$ beta can be assumed to be stable.
?. 7tandard deviation is a measure of total risk$ whereas beta is a measure of systematic
risk. In portfolio theory$ beta is the relevant measure because with proper diversification$
all unsystematic risk can be removed. Therefore$ investors are not compensated for
taking unsystematic or diversifiable risk.
1 - n
) k -
k
(
=
2
i
n
1 = i
k

i i
n
=1 i
p
b w =
b

22
Case !!
A9ber Plan'
Purpose: Interest rates affect everyone in the economy whether it be on an individual
level or through the workplace. This case gives one such e6ample to which all students
can relate.
1. +efault risk$ liquidity$ ta6 considerations$ and time to maturity.
!. " #ield Durve shows the yield to maturity for similar &same risk$ liquidity$ and ta6
considerations' types of bonds$ but with different times to maturity at a specific point in
time.
%. The 16pectations 2ypothesis states that today3s long,term rates are an average of
future short,term rates. Therefore$ if rates in the future are e6pected to increase$ then
today3s yield curve will be upward sloping. Based on Table 1$
Time To
8aturity
Today3s
Fong,term Eates
*uture
7hort,term Eates
1 year ?.:; ?.:; &same'
! years ?.0; A.:;
% years A.:; 9.:;
) years A.0; 1:.:;
0 years A.<; 9.:;

Today3s short,term rate is already given$ so no calculation is needed.
To calculate the second year3s short,term rate$ solve the equation: &? @ 6'5! L ?.0;.
2ere G / BH
To calculate the third year3s short,term rate$ solve the equation: &? @ A @ 6'5% L A.:;.
2ere G / FH
To calculate the fourth year3s short,term rate$ solve the equation: &? @ A @ 9 @ 6'5) L
A.0;. 2ere G / !7H
To calculate the fifth year3s short,term rate$ solve the equation: &? @ A @ 9 @ 1: @ 6'50 L
A.<;. 2ere G / FH
). The Fiquidity Preference 2ypothesis states that today3s long,term rates are an average
of future short,term rates PFB7 a premium$ or reward$ for holding a less liquid asset.
16actly how much the premium amounts to is unknown. 8oreover$ the premium
23
changes over time. *or this reason$ each student will likely have a different set of future
short,term interest rate forecasts. There should$ however$ be consistency between their
answers to questions % and ). The answers to question ) should be lower than those for
question % because the Rliquidity premiumsR need to be removed from all of the
estimates. *or e6ample$
Time To
8aturity
Today3s
Fong,term Eates
*uture
7hort,term Eates
1 year ?.:; ?.:; &same'
! years ?.0; A.: S :.!0 L ?.?0;
% years A.:; 9.: S :.0: L A.0:;
) years A.0; 1:.: S :.?0 L 9.!0;
0 years A.<; 9.: S 1.:: L A.::;
0. The 8arket 7egmentation 2ypothesis states that 7upply and +emand in different term
to maturity markets are responsible for determining interest rates and these markets are
separate from each other. *or e6ample$ insurance companies invest primarily in long,
term markets because of the maturity matches with their liabilities or pay,outs$ whereas
banks tend to invest short,term so as to match short,term deposits. Bnfortunately$ this
hypothesis does little in the way of inferring future short,term rates from today3s long,
term rates.
24
Case !%
Fruit of the =oo9
Purpose: The purpose of this case is to introduce students to bond rating systems and to
show them the effect it has on the corporation.
1. Pecking 4rder refers to the chain of priority that stakeholders in a company have on
the company3s assets. The order is as follows: senior debenture holders$ unior debenture
holders$ preferred stockholders$ and finally$ common stockholders. This order represents
which investor group has first through last claim when it comes to receiving coupon or
dividend payments and even in the event of collecting in liquidation.
!. The A.A?0; bonds received a downgrade because it effectively slipped down in the
Pecking 4rder. This is important because these bondholders cannot receive coupon
payments or the return of principle in the event of maturity or default until all of the other
debt holders receive their money first. This lowers the probability that these bondholders
will receive their promised payments which effectively increases the risk of the bonds.
2igher risk translates into a lower bond rating.
%. "s the case states$ since this represents a mere shuffling within the pecking order$ *ruit
of the Foom3s overall corporate credit rating remained at BB,. Therefore$ it is unlikely
that the stock price will be affected. 8oreover$ even if the overall company were to be
downgraded$ financial studies have shown that rating companies take time to make
changes to corporate bond ratings. Therefore$ by the time a rating change has been made$
the change was already anticipated by the stock market$ and therefore$ its effect is already
imbedded into the stock3s price.
). Dapital structure and level of 1arnings Per 7hare &1P7' will definitely affect a
corporation3s bond ratings. 2owever$ what the question did not include is the volatility in
1P7. *irms with more stable earnings$ like utility companies$ can afford to take on more
debt than firms in a less stable industry$ like the technology sector$ and still have the
same bond rating. It is all a function of the probability of default.
25
Case !&
(ations -an'
Purpose: The purpose of this case is to calculate a stock3s price using its past dividends
as an indicator of future dividend growth rates. The student must determine the stock3s
required rate of return &D"P8' and future e6pected dividend growth rate and use the
Jordon Jrowth 8odel to calculate a current price.
1. The equation for D"P8 is k

L E
f
@ Ob

6 &E
m
, E
f
'P
where$
k

L required return on asset $


E
f
L risk,free rate of return$
b

L beta coefficient for asset $


E
m
L market return.
k

L <; @ 1.?0&1:; , <;'


k

L 1%;
!. The equation for the Jordon Jrowth 8odel is$
where$
P
:
L price of the common stock$
+
1
L per share dividend e6pected at the end of year 1$
+
:
L most recently paid dividend$
K
s
L required return on common stock$
g

L growth rate in dividends.
To calculate g$ we have to assume that future dividend payments will grow at a constant
rate into the future forever. This constant rate can be estimated by e6amining the average
growth rate in the past. 4n a calculator$
Fet$
PC L > .A<$
*C L >!.::$
n L A.
7olve for i. i L the average growth rate. In this case i L g L 11.1%;.
g) -
k
(
g) + (1
D
=
g) -
k
(
D
=
P
s
0
s
1
0
26
Plugging this growth rate into the Jordon Jrowth 8odel$
P
:
L >!.::&1 @ .111%' L >11A.A<
.1% , .111%
%. This time$
Fet$
PC L >1.)!$
*C L >!.::$
n L 0.
7olve for i. i L g L ?.:9;.
Plugging this growth rate into the Jordon Jrowth 8odel$
P
:
L >!.::&1 @ .:?:9' L >%<.!)
.1% , .:?:9
). The Jordon Jrowth 8odel$ or any other dividend based pricing model$ has maor
drawbacks in that we are not sure what the true future growth rate in dividends is. "s we
have ust demonstrated$ depending on the period we consider$ the stock3s price can
fluctuate wildly.
0. The required rate of return calculation has an enormous effect on the stock3s price
using these types of models. If we assume that (ations Bank3s required rate of return on
its common stock is 1!; instead of 1%;$ the Jordon Jrowth 8odel will yield a price of
P
:
L >!.::&1 @ .:?:9' L >)%.<!
.1! , .:?:9
This value is not much different$ but consider the result when the growth rate in
dividends is near the required rate of return on the common stock as is the case from
19A?,1990.
P
:
L >!.::&1 @ .111%' L >!00.)?
.1! , .111%
In general$ the calculated stock price will be e6tremely sensitive to the required rate of
return when the required rate of return is close to g.
<. This would be an e6ample of a Hero growth stock. The stream of payments would be
constant &annuity' and they would last forever &perpetuity'. =hen this special case
occurs$ a simplified equation can be used.
P
:
L +
1
5K
s
L >!.::5.1% L >10.%A
27
?. The further out into the future the dividend payments are received$ the less valuable
they are in today3s dollars. Bsing a dividend amount of >1.:: and a discount rate of .1%$
the present value of these three dividends are >.AA$ >.!9$ and >.:::::)9!!$ respectively.
2"
Case !:
AMI 2 A9erican Airlines
Purpose: The purpose of this case is to help the student to understand the behavior of
bonds. *or e6ample$ they will learn of the relationship between interest rates and time to
maturity &TT8' and the sensitivity of a bond3s price to TT8.
1. To calculate the price of the bond$ use the equation:
where$
B
:
L value of the bond at time Hero$
I L annual bond coupon payment$
I5! L semi,annual bond coupon payment$
PCI*"
kd5!$!n
L present value of the coupon payments$
8 L par value of bond$
PCI*
kd5!$!n
L present value of par which will be received by the bondholder when
the bond matures.
Plugging into the equation$
B
:
L >1::5! 6 1!.<)! @ >1$::: 6 .%??
L ><%!.1: @ >%??
L >999.1: >1$:::
Because this method of looking up values in a table suffers from rounding errors$ the
amount is slightly different from >1$:::$ but when a calculator is used$ the answer is
e6actly >1$:::.
Bsing a calculator$
Fet$
*C L >1$:::$
P8T L >0:$
i L 0; &1:;5! because we want the interest rate per period'$
n L !: &1: years times ! payments per year'$
PC L NNN L >1$:::
)
, PVIF
( M + )
, PVIFA
(
2
I
=
B
n k n k
0
d d
! !
! 5 ! 5
2
=hen the maturity is increased to !: and %: years$ the answers also come out to be
>1$:::.
!,). The answers from questions ! through ) are better represented in a table. The
calculation procedure is the same as that shown in question 1.
Interest rates
8aturity A; 1:; 1!;
1: years >1$1%0.9: >1$::: >AA0.%:
!: years >1$19?.9% >1$::: >A)9.0)
%: years >1$!!<.!% >1$::: >A%A.%9
0. "s the time to maturity increases$ the sensitivity of a bond3s price to changes in
interest rates increases. It is not actually the time to maturity that is driving the bond3s
sensitivity. It is the bond3s duration. The longer a bond3s duration$ the more sensitive its
price will be to changes in interest rates.
<. =henever the current market interest rate equals the coupon rate$ bonds will sell at
par. The time to maturity will have nothing to do with the price of the bond in this very
specific situation.
30
Case !<
Mira$e Iesorts
Purpose: =hen interest rates decrease after the issuance of a corporate bond$ the firm
may find it advantageous to recall the issue and refund the old bonds with new bonds that
have a lower coupon rate. The student is given information necessary for the refunding
analysis. They must decide if and when the old issue should be refunded with a new
issue.
1. *loatation Dosts:
>1!:$::: @ O&.::) @ .::%'&>):$:::$:::'P L >)::$:::
!. Initial Investment:
*loatation Dosts >)::$:::
4verlapping interest before ta6es
&.11'&!51!'&>):$:::$:::' >?%%$%%%
minus ta6es
&.%0'&>?%%$%%%' >!0<$<<<
after ta6es >)?<$<<?
Dall Premium before ta6es
&>1$11: , >1$:::'&):$::: bonds' >)$)::$::
:
minus ta6es
&.%0'&>)$)::$:::' >1$0):$::
:
after ta6es >!$A<:$:::
BnamortiHed discount on old bond
O&?5!:'&>):$:::$:::,>%9$:<0$:::'&.%0'P &>11)$0%A'
BnamortiHed floatation cost of old bond
O&?5!:'&>!::$:::'&.%0'P &>!)$0::'
Initial Investment >%$09?$<!9
%. "nnual cash flows from the old issue:
Interest costs before ta6es
&.11'&>):$:::$:::' >)$)::$::
31
:
minus ta6es
&>)$)::$:::'&.%0' >1$)::$::
:
after ta6es >%$:::$:::
Ta6 savings from amortiHation of *.D.
O&>!::$:::'5&!:'P 6 &.%0' &>1<$%<%'
Ta6 savings from amortiHation of discount
O&>9%0$:::'5&!:'P 6 &.%0' &>%$0::'
Total annual after ta6 cash flow >!$9A:$1%?
). "nnual cash flows from the new issue:
Interest costs before ta6es
&.:A0'&>):$:::$:::' >%$)::$::
:
minus ta6es
&>%$)::$:::'&.%0' >1$19:$::
:
after ta6es >!$!1:$:::
Ta6 savings from amortiHation of *.D.
O&>)::$:::'5&1%'P 6 &.%0' &>1:$?<9'
Total annual after ta6 cash flow >!$199$!%1
0. "nnual cash flow savings:
>!$9A:$1%? , >!$199$!%1 L >?A:$9:<
<. Present value of annual cash flow savings:
&>?A:$9:< ' 6 PCI*"
kL<;$nL1%
&>?A:$9:< ' 6 A.A0% L ><$91%$%<1
?. 8irage Eesorts should refund the bond issue because the present value of the savings
e6ceeds the costs involved with issuing the new bonds.
><$91%$%<1 , >%$09?$<!A L >%$%10$?%%
A. Interest rates$ in general$ have decreased over this seven year period. Therefore$ it
32
makes sense that new bond issues can have lower coupon rates$ everything else constant.
8irage is wise to invest in new hotels5proects independent of current interest rates
because a firm cannot ust stop investing because they feel interest rates are too high.
Interest rates are somewhat unpredictable$ especially the further out in time you try to
predict them.
9. There are several factors that affect the refunding decision. The movement in the
interest rates is likely the most important. " small change in interest rates causes a large
change in the annual cash flow from a new issue. "lso$ the after,ta6 cost of debt &which
is used to calculate the present value of the annual cash flows' is e6tremely critical. Try
assuming the after,ta6 cost of debt is only 0; and you will see that the present value of
the savings has increased to >?$%%0$A%1. *inally$ the floatation costs$ both fi6ed and
variable$ will affect the refunding decision. The greater the floatation costs$ the less
likely the firm will be to refund the old issue.
33
Case !>
e-ay
Purpose: The degree of efficiency in the stock market is an area of debate that has gone
on for as long as the stock market has been open. "ssumed knowledge of inefficiencies
are the building blocks on which some investors base their entire trading strategies. (o
single study or a single case will ever resolve this issue. 2owever$ this case provides an
account of events that will invoke plenty of discussion amongst students concerning the
degree of market efficiency.
1. The fact that the first public announcement of a relevant piece of information caused
an immediate and non,over reacting effect in a stock3s price is consistent with an efficient
market.
!. 1ither &1' no investors were aware of the crash until the public announcement at 1!::1
P.8. or &!' investors did not anticipate that the reaction would be enough to make selling
or short selling stocks worth while. That is$ the profit derived from such actions would
not e6ceed transaction costs.
If no investors were aware of the crash until it was publicly announced at 1!::1
P.8.$ then there is no way they could have reacted to the news. The fact that millions of
people use the site each day coupled with the fact that it was down for four hours before
the stock price reacted makes this e6planation e6tremely difficult to believe.
If the second e6planation was the case$ why would investors not fully anticipate
the adverse affect this would have on eBay3s stock priceN 4ne possible e6planation is
that web sites do go down from time to time. In addition to being normal$ when an
outage does occur$ the eBay backup system is supposed to work within two or three
hours$ not right away. 8aybe investors felt the site would be up and running again very
soon. This e6planation is weak as well.
If you are a person who still holds on to the notion that the 7emi,7trong form of
the 1fficient 8arket 2ypothesis &182' holds all the time$ ask yourself this question$ RIf
the +ow Iones (ews=ire reported the crash 10 minutes earlier or 10 minutes later$
would the announcement effect have been any differentNR (o one can say with 1::;
certainty$ but we have to believe that it wasn3t the 1!::1 P.8. that made the stock price
drop so immediately$ but instead it was the fact that the announcement was made over the
+ow Iones (ews=ire.
%. "ny person who was aware of the eBay web site crash before 1!::1 P.8. and who
anticipated that this news would result in a severe drop in eBay3s stock price could have
avoided losing money by selling their shares in eBay or could have made money in the
stock market by short selling shares of eBay3s common stock.
34
Case !@
Aether Syste9s
Purpose: The purpose of this case is to have students work through the Cariable Jrowth
8odel. "long the way$ they will have to use the Jordon Jrowth 8odel. "n additional
wrinkle is thrown in here. The stream of dividends will not start right way.

1. 7tarting with the dividend of >!.0:$ simply multiply by &1 @ i'
n

t L 1: >!.0:&1.:9'
:
L >!.0:
t L 11 >!.0:&1.:9'
1
L >!.?%
t L 1! >!.0:&1.:9'
!
L >!.9?
t L 1% >!.0:&1.:9'
%
L >%.!)
t L 1) >!.0:&1.:9'
)
L >%.0%
t L 10 >!.0:&1.:9'
0
L >%.A0
!. >%.A0&1.:)'5&.1%,.:)' L >)).)0. This represents the present value equivalent at time t L
10 of all the dividends starting at time t L 1< and going through to infinity.
%. +iscounting all < amounts$ then adding them together yields a &t L :' stock price of
>11.1?.
>!.0: 5&1.1%'
1:
L >:.?)
>!.?% 5&1.1%'
11
L >:.?1
>!.9? 5&1.1%'
1!
L >:.<9
>%.!) 5&1.1%'
1%
L >:.<<
>%.0% 5&1.1%'
1)
L >:.<)
>%.A0 5&1.1%'
10
L >:.<!
>)).)05&1.1%'
10
L >?.11
D!!.!@
). 7ince the intrinsic value of >11.1? is greater than the market price of >1:$ this
represents a buy signal. 7hares should be purchased up until the point where the present
value of the dividends is e6actly equal to the trading price of the stock.
35
Case !B
(etJ.co9
Purpose: This solution reflects the environment that e6isted when the case was originally
written. This case addresses a growing$ and to many$ alarming trend in the B.7. stock
market. 8any corporations today are considered -ghost firms. who command a high
stock price$ but deliver nothing in return.
1. There have been a number of firms that have gone public based on the promise of
future success. The Internet is the primary launching pad for such companies. =hile the
=orld =ide =eb has been around for years$ it wasn/t until recently that its potential uses
have been recogniHed.
Dompanies being created in this industry have convinced investors that they can
be successful in a short period of time. 8ore importantly$ they have convinced investors
that they have an immediate need for cash in order to be successful.
1very investor would like to own the ne6t 8c+onalds$ =al8art or 8icro7oft
before everyone else in the market identifies it as a star. "s such$ investors are willing to
buy up the newcomers hoping that somewhere in the basket of firms will be the golden
egg.
!. The answer to this question e6tends the answer from the first. The price of any asset is
the present value of all future benefits the asset generates. It is not the current earnings
that are attracting investors. It is the potential to generate earnings in the future.
%. =hile there certainly are drawbacks to merging with this type of firm$ the primary
benefit is avoiding the e6tremely lengthy and e6pensive IP4 process. If a private firm can
circumvent the process$ it can achieve all the benefits of going public$ while mitigating
many of the disadvantages.
). The answer to this question is elusive to say the least. 8any have argued that we are
resting on the largest bubble ever. 4thers say the Internet has brought about profit
potential never seen before by any market. "s such$ proponents argue the current price
levels are ustified by the continued economic e6pansion and prosperous times that lie
ahead.
36
Case !F
?#C--
Purpose: This solution reflects the environment that e6isted when the case was originally
written. The purpose of this case is to introduce students to some of the risk factors to
consider when investing in one type of market versus another. It is not only the asset
class that matters. It is also the market in which each asset trades that matters.
1. Investors have enoyed such a tremendous run,up in stock prices in recent years that
many think they can do no wrong. Investors understand the concept of the risk,return
tradeoff$ but have not e6perienced its downward bite for several years now. *or this
reason$ many investors view high,risk companies as high,return companies. Instead they
should remember that high,risk companies have the potential for e6tremely low and even
negative returns as well. Therefore$ riskier is definitely not necessarily better.
!. 8any would argue that if investors wish to trade in the 4TDBB market for any reason$
+atek might as well be the firm to offer the brokerage service. If they don/t someone else
will. 4thers will argue on the side of ethics and say that if one market was found to be
inferior to another$ then a brokerage firm should not offer the sale of those stocks.
%. This question dates back to the Jreat +epression. In 19%%$ the 7ecurities and 16change
Dommission &71D' was created to ensure full disclosure of relevant company
information to the public. =hile the 71D still has regulatory control over the 4TDBB
market &*or e6ample$ it could halt trading$ it oversees illegal insider trading$ etc.'$
4TDBB stocks certainly do not enoy the same level of market efficiency that the
("7+"T and organiHed e6changes do.
). If we assume that 8att wishes to invest in highly speculative stocks$ there are still
plenty of high risk5e6pected return opportunities available in other markets. This is not to
say that 8att should not invest in 4TDBB stocks$ only that he must seriously consider
the e6tensive limitation of such a market compared to other markets in which he could
invest.
37
Case %7
Pittston
Purpose: This solution reflects the environment that e6isted when the case was originally
written. This case introduces students to an increasingly popular way firms are accessing
the hot IP4 market. It also addresses several managerial compensation and conflict of
interest concerns that arise.
1. The fundamentals of financial valuation would state that since the management of the
two has remained completely the same$ none of the merger5divestiture reasons should
apply here. =hile it may be a stretch$ it could be argued that the introduction of new
stockholders might increase monitoring and therefore reduce the potential for agency
costs.
Perhaps we need look no further than the psychology of market participants. 8any
would argue that we are currently e6periencing an irrational stock market bubble. If this
is correct$ firms are e6ploiting it wisely by representing their -bubble. divisions
separately from the rest of their firm$ which is rationally priced. "s such$ the rational
parent price plus the irrational tracking division price sum to an amount greater than the
price of the two when trading under one ticker symbol.
!. The reason why there are so many more tracking stocks in the technology sector is
likely due to the fact that this is where most firms believe the -bubbles. e6ist. *irms$ or
divisions$ in this sector do not have to show any success today to have an astronomically
high stock price. 7o if investors are willing to pay higher prices for operations in this
industry$ firms should feel free to accept them.
%. It should not take a market slowdown to attract the attention of the potentially severe
drawbacks associated with tracking stocks. #et$ it is human nature to let the good times
roll when things are going well. Fike any problem$ it will not go away by ignoring it.
Instead$ it will probably get worse because the tracking stock trend is on the rise.
). The board should ma6imiHe the value of both stocks since their position is designated
as such. 4f course$ the concept of -agency cost. would not e6ist if management acted in
accordance with what they were hired to doUma6imiHe the firm/s value as opposed to
their own.
0. This is a question that requires a very involved answer. =hile future research in the
area of financial management will certainly provide a better$ more complete answer$ the
short answer today might include making sure management has the same percentage or
absolute ownership in both stocks. There will also likely have to be established some
legal boundaries on the allocation of the conglomerate/s corporate resources between the
parent and the tracking division. These are ust a few of the issues to consider.
3"
Case %!
Jan$uard
Purpose: This case discusses the too often swept under the rug problems associated with
inde6 mutual fund investing. In most classes$ students are e6plained the concept of inde6
investing$ but are never told of the ta6 related dangers.
1. =hile I understand Canguard/s desire to maintain the fund/s obective$ it is
unacceptable to manage their portfolio with a complete disregard for the ta6 ramifications
it will have on their clients.
The problem is that mutual funds report performance based on pre,ta6 total
returns. *or this reason$ they are not affected when their clients are stuck with a huge ta6
bill. They simply blame it on small investor sentiment and move on.
! V %. There is an old adage on =all 7treet that says$ -If you want to know what to do$
do the e6act opposite of what the small investor does.. 7tated another way$ money chases
performance$ it does not drive it.
7mall investors are known for umping on the bandwagon S usually long after it is
a good idea to do so. By the time the market makes a large enough run up to catch
sufficient media attention$ it is usually time for a correction. This is when the uninformed
investor gets in.
The problem with being a disciplined mutual fund investor is that the people
whose funds have been pooled with yours are typically very poor market timing decision
makers. This affects you because in bad times$ they will pull all their money out$ the fund
will be forced to sell off shares$ and you will be left with a huge ta6 bill.
). This is a tough problem to correct. Fet/s illustrate through an e6ample. "ssume a
mutual fund buys Jeneral 8otors &J8' for >!: per share. They hold the stock for ):
years and eventually have to sell it for liquidity purposes. "t that time$ the stock is
trading for >%::. The ta6 basis is only >!:$ so the realiHed capital gain is >!A: &>%:: ,
>!:'. Fogically$ that amount should be pro rated and allocated to each investor who
owned shares in the mutual fund during the ): years. 2owever$ this does not work from a
practical perspective.
2ow will the mutual fund locate the investor who bought %A years ago and sold
all her shares %0 years agoN =here will they mail the noticeN 2as the person passed away
in the last %0 yearsN If so$ does their estate now owe the ta6esN
(ow consider you are that old investor. #ou are now 90 years old living on a
fi6ed and e6tremely tight budget. =ill you have the money to pay a ta6 bill on an
investment you owned %0 years agoN =ill you ever remember even owning the mutual
fundN
7ince there is no reasonable way to locate many of the historical investors and
because it would seem unreasonable to ask them to pay ancient ta6 bills even if you could
find them$ this is not how ta6es are determined. Instead$ they are spread out over the
current mutual fund shareholders. The implicit argument being made is that the fund is
3
using new money over time to purchase new shares. 8oreover$ you$ the new investor$
will likely cash out before those issues are ever sold. 7o$ in a way$ you are in turn
sticking the ta6 burden to the ne6t generation of investors. The idea is that it will all
balance out in the long run.
Bnfortunately$ for you in the short run$ events like drops in the stock market cause
investors to panic and pull out funds. This sticks you with an unfairly high portion of the
historical ta6 bill. In short$ no system is perfect.
0. The 7impsons have a long term buy and hold strategy. 7ince the mutual fund and the
investors within the fund are messing up the profitability of their strategy$ they should
seriously consider investing their money directly into stocks.
Presumably$ their portfolio value is large enough to create a well,diversified
portfolio on their own. "s such$ they can sell off the shares and use the proceeds
accordingly. "nother option is to maintain their Canguard account and devote new
money strictly to purchasing individual shares.
40
Case %%
Florida Power K =i$ht
Purpose: "t some point in time$ firms will be faced with the decision to either replace or
fi6 up a piece of machinery$ a building$ or any other physical asset. This case makes the
student consider the cost and intangible advantages and disadvantages associated with the
two alternatives.
1.
"lternative 1
Initial investment
Dost of asset >A:$::
:
Installation costs
>0$:::
Total cost of installation >A0$:::
Dhange in net working capital >!:$:::
Total Initial Investment >1:0$:::
"lternative !
Initial investment
Dost of asset >1::$:::
Installation costs >0$:::
Total cost of installation >1:0$:::
Proceeds from sale of old asset &>1:$:::
'
Ta6 on sale of asset >)$:::
Total after,ta6 proceeds &><$:::'
Dhange in net working capital >10$:::
Total Initial Investment >11)$:::
!. (et after,ta6 cash flows: "ll cash flows are in units of >1$:::.
"lternative 1
#ear
(et increase
in profits +epreciation
Ta6able
increase in
profits
(et profit
before ta6es
4perating net
cash flows
1 ><0: >1<.: ><%).: >!0%.< >%9<.)
41
! >)!0 >!0.< >%99.) >109.A >!<0.!
% >%1? >10.! >%:1.A >1!:.? >19<.%
) >!!: >9.< >!1:.) >A).! >1%0.A
0 >1!9 >9.< >119.) >)?.A >A1.!
< >: >).: ,>).: ,>1.< >1.<
"lternative !
#ear
(et increase
in profits +epreciation
Ta6able
increase in
profits
(et profit
before ta6es
4perating net
cash flows
1 >%0: >!: >%%: >1%!.: >!1A.:
! >%0: >%! >%1A >1!?.! >!!!.A
% >%0: >19 >%%1 >1%!.) >!1?.<
) >%0: >1! >%%A >1%0.! >!1).A
0 >%0: >1! >%%A >1%0.! >!1).A
< >: >0 ,>0 ,>!.: >!.:
%.
"lternative 1
Proceeds from sale of asset >0$:::
Ta6es on sale &>!$:::
'
"fter,ta6 proceeds >%$:::
Dhange in net working capital >!:$:::
"dditional year 0 cash flow >!%$:::
"lternative !
Proceeds from sale of asset >1:$:::
Ta6es on sale &>)$:::
'
"fter,ta6 proceeds ><$:::
Dhange in net working capital >10$:::
"dditional year 0 cash flow >!1$:::
). The present value of each cash flow is found by discounting each future cash flow at
1:;. The stream of cash flows for each proect is:
"lternative 1
42
#ear (et cash flow
: &>1:0$:::'
1 >%9<$)::
! >!<0$!):
% >19<$!A:
) >1%0$A):
0 >A1$!): @ >!%$:::
< >1$<::
The net present value of this stream at 1:; is >?A:$))<.A<.
"lternative !
#ear (et cash flow
: &>11)$:::'
1 >!1A$:::
! >!!!$A::
% >!1?$<::
) >!1)$A::
0 >!1)$A:: @ >!1$:::
< >!$:::
The net present value of this stream at 1:; is >?!<$:0%.<).
7ince the (PC of alternative 1 is higher than the (PC of alternative !$ Paul
should chose to renew the e6isting reactimeter instead of replacing it with a new one.
0. 8any computer e6perts would argue that a new computer which is built for e6panded
memory is better than an old computer that has been e6panded. " bigger issue to
consider is the fact that our analysis is based on numerous assumptions. *or e6ample$ we
are assuming that five years from now we will be able to sell the renewed or new
reactimeter for >0$::: and >1:$:::$ respectively. 7ince these two amounts are so far off
into the future$ how certain are weN
"nother e6ample is our estimates concerning the increase in profitability for both
alternatives. If any of these very large amounts are wrong$ our decision may change.
The further out into the future we try to predict$ the less accurate we will be.
<. The (PC3s of the two alternatives are only separated by >0)$%9%.!!. =hile this
sounds like a large difference$ when we consider the magnitude of the cash flows$ it
really is not. =ith such a small amount separating the two choices$ Paul is more likely to
allow the qualitative issues to weigh on his decision.
43
Case %&
Southwest Airlines
Purpose: This basic case requires that the student calculate the payback period$ the
internal rate of return$ the modified internal rate of return$ and the net present value of a
proposed proect. The student must chose to either accept or reect the proect based on
the above criteria which will conflict. They therefore must also decide which criteria has
priority over the others.
(PC L ,>!$<%?$0<:
(PC is the present value of all future net cash flows associated with a proect
minus the initial investment. If the (PC is greater than :$ the firm will increase its value
by accepting the proect. In this case$ the (PC is negative which means that if the firm
accepts the proect$ the overall value of 7outhwest will decrease by >!.<%? million.
!. The IEE is the discount rate that makes the present value of the future net cash flows
equal to the initial investment. The calculated solution is ).??;. This measure differs
from the (PC methods in two maor ways. *irst$ IEE is a percentage$ while (PC is a
dollar amount. 8anagers often prefer to think in terms of percentages instead of absolute
dollars. 7econd$ IEE assumes that when the cash flows are received year after year$ they
can be reinvested at the IEE. The (PC method assumes these intermediate cash flows
can be reinvested at the discount rate.
%. The Payback Period is the number of years it takes to recoup the proect3s initial
investment.
PP L ) years @ :.95!.1
PP L ).)% years
). 7ince the proect3s payback period is less than the 0 year ma6imum$ based on PP$ the
proect should be accepted. 2owever$ because the calculated IEE is below the hurdle
rate$ the IEE criterion indicates that the proect should not be accepted. *inally$ the (PC
of the proect is negative. Therefore$ based on (PC$ it should not be accepted. =hen the
criteria conflict$ the (PC should be most trusted , followed by the IEE$ then PP.
0. Donflicts between the PP and either (PC or IEE can occur at any time. This is
because PP suffers from three mathematical flaws. It does not consider the timing of the
cash flows$ the time value of money$ and any cash flows beyond the payback period.
1.
) (1.1
$0.
+
) (1.1
$1.!
+
) (1.1
$2.1
+ ... +
) (1.1
$".!
+
) (1.1
$#.
+ -$20.$ = %PV
& " 2 1
44
Both IEE and (PC take into consideration these concepts. 2owever$ IEE may
lead to the wrong accept5reect decision if the proects under consideration are mutually
e6clusive and if any of the future net cash flows are negative or if the magnitude of the
cash flows from one proect are greatly different from the magnitude of the cash flows
from other proects.
<. 8IEE is similar to IEE in that it e6presses a proect3s attractiveness in terms of a
percentage. The difference is that like the (PC$ 8IEE assumes that the proect3s
intermediate cash flows are re,invested at the discount rate. This assumption is
methodologically preferred. 8IEE is found by taking the future value of each
intermediate cash flow to a terminal point &the last year of the proect'. It compounds
based on the discount rate as shown below.
#ear (et Dash
flow
*uture Calue of (et
Dash flow
: ,>!:.A
1 >).0 >?.9? &nL<$ iL1:;'
! ><.% >1:.10 &nL0$ iL1:;'
% >0.! >?.<1 &nL)$ iL1:;'
) >%.9 >0.19 &nL%$ iL1:;'
0 >!.1 >!.0) &nL!$ iL1:;'
< >1.% >1.)% &nL1$ iL1:;'
? >:.0 >.:0: &nL:$ iL1:;'
7um L >%0.09
Plugging into a calculator$
Fet$
*C L >%0.%9$
PC L ,>!:.A$
n L ?.
7olve for i. i L ?.9A;. This is the proect3s 8IEE.
?. =ith normal cash flows$ the 8IEE will always fall between the discount rate and the
IEE. =hyN =hen the IEE is below the discount rate$ 8IEE assumes the intermediate
cash flows are returning a higher amount &discount rate' than the IEE. Donversely$ when
the IEE e6ceeds the discount rate$ IEE is actually over estimating the true yield. 8IEE
maintains that the IEE is too high and assumes that the intermediate cash flows are
returning a level only equal to the discount rate.
45
Case %:
Acclai9 8ntertain9ent
Purpose: This case considers a firm3s decision to accept or reect multiple proposed
proects. Both independent and mutually e6clusive proects will be considered. *urther$
the proects will have unequal lives. Therefore$ it is necessary to understand the concept
of annualiHed net present value.
1. Payback Period is defined as the time required to recover a proect/s initial
investment.
7D1
PP L 1 @ ><$:::5>1:$::: L 1.<: years
(intendo
PP L >):$:::5>))$::: L .91 years

7ega
PP L >):$:::5>)1$::: L .9A years
"ssuming a required payback period of 1 year$ (intendo would be the preferred carrier
of 8ortal Dombat since it has the shortest PP S less than 1 year.
!. (PC is defined as the present value of all future net cash flows minus the initial
investment. =hen the (PC is greater than :$ investing in the proect will add value to
the firm. 8athematically$
=here D*
t
is the net cash flow during the given year and k is the appropriate discount
rate. Bsing a discount rate of 1:;$
7D1
(PC L >%$<1%
(intendo
(PC L >1%$!!%
. .I -I
) k + (1
'F
= %PV
t
t
n
=1 t

46
7ega
(PC L >10$10)
Based on (PC$ 8ortal Dombat should be sold through the 7ega system because the (PC
under 7ega is the greatest amount.
%. Internal Eate of Eeturn &IEE' is the discount rate that forces the (PC to equal Hero.
The higher IEE$ the better. If the IEE e6ceeds the company3s hurdle rate$ the proect
should be accepted. IEE can be solved through trial and error$ by using an
appro6imation formula$ or via a calculator. The calculator provides the most accurate
answer. Therefore$ the following solutions were obtained from a financial calculator.
7D1
IEE L 1?.:);
(intendo
IEE L %A.A!;
7ega
IEE L %9.A:;
Based on IEE$ all three have acceptable IEEs. The highest is 7ega.
). =ith mutually e6clusive proects$ only Hero or one proect can be chosen. =ith
independent proects$ any number of proects can be selected. In this case "cclaim could
sell through none$ one$ two$ or all three companies. Based on the payback period
criterion$ (intendo and 7ega would be chosen because both have payback periods under
the required 1 year ma6imum while 7D1 does not.
Based on (PC$ all three carriers would be used since they all have a positive
(PC. 7imilarly$ all three marketers have an IEE in e6cess of "cclaim3s hurdle rate of
1:;.
0. 7ince the life of 8ortal Dombat is proected to be different under each of the three
hardware systems$ the traditional (PC measure will possibly lead to the wrong
accept5reect decision. Instead$ the "nnualiHed (et Present Calue &"(PC' measure
should be used. "(PC is calculated by dividing the (PC by the present value interest
factor of an annuity at a given discount rate and for a given number of years &i.e. the life
of the proect'. 8athematically$
7D1
"(PC L (PC5PCI*"
kL1:;GnL)
L >%$<1%5%.1?: L >1$1):
)
PVIFA
(
%PV
=
A%PV
n k,
47
(intendo
"(PC L (PC5PCI*"
kL1:;GnL!
L >1%$!!%51.?%< L >?$<1?
7ega
"(PC L (PC5PCI*"
kL1:;GnL%

L >10$10)5!.)A? L ><$:9%
Based on "(PC$ the decision has changed. It is now clear that (intendo is the hardware
company through which "cclaim should distribute 8ortal Dombat. =ithout considering
this more appropriate measure$ "cclaim would have lost money by choosing the wrong
interactive hardware company &7ega'.
4"
Case %<
Phili) Morris
Purpose: This case considers a firm3s decision to accept or reect multiple proposed
proects. The proects in question are not of similar risk. Therefore$ traditional net
present value techniques cannot be used. Instead$ the use of Eisk "dusted +iscount
Eates &E"+Es' and Dertainty 1quivalents are necessary.
1. To calculate the (PC of the Jourmet 2aHel (ut$
The (PC of the Post Blueberry 8orning is
7ince the proects are independent and both have a positive (PC$ both proects should be
accepted.
!. Bsing the E"+E of 1!;$ the (PC of the Jourmet 2aHel (ut$
=ith the more appropriate E"+E$ the Jourmet 2aHel (ut is no longer a positive (PC
proect and should therefore be reected.
%.
#ear (et cash flow
Jourmet 2aHel (ut
D.1. Dertain
cash flow
: ,>)$:::$::: 1.:: ,>)$:::$:::
1 >1$:::$::: .A: >A::$:::
! >1$!::$::: .?: >A):$:::
% >?0:$::: .<: >)0:$:::
) >90:$::: .0: >)!0$:::
$#&,!# =
) (1.10
$20",000
...+ +
) (1.10
$1,000,000
+ 0 -$#,000,00 = %PV
& 1
%)9 $ %1 $ =
) (1.10
$1(,000
+ ... +
) (1.10
$$0!,000
+ 0 -$2,00,00 = %PV
& 1
$1"&,0($ =
) (1.12
$20",000
+ ... +
) (1.12
$1,000,000
+ 0 -$#,000,00 = %PV
& 1

4
0 >AA:$::: .): >%0!$:::
< >0::$::: .%: >10:$:::
? >!:<$::: .!: >)1$!::
The (PC of the certain net cash flows is calculated by discounting these cash flows at the
risk,free rate of 0;.
#ear (et cash flow Post
Blueberry 8orning
D.1. Dertain
cash flow
: ,>!$0::$::: 1.:: ,>!$0::$:::
1 >A:%$::: .90 >?<!$A0:
! >0!1$::: .9: >)<A$9::
% >!%0$::: .A0 >199$?0:
) >)::$::: .A: >%!:$:::
0 >)9A$::: .?0 >%?%$0::
< ><1!$::: .?: >)!A$)::
? >019$::: .<0 >%%?$%0:
(PC L ,>!$0::$::: @ >?<!$A0: @...@ >%%?$%0: L >%9:$?0:
4n a certainty equivalents basis$ only Post Blueberry 8orning has a positive (PC.
). Dertainty equivalents can be defined as the percentage of the cash flow in each period
that the manager would be willing to accept if the amount was 1::; certain. *or
e6ample$ the manager might be indifferent between receiving a somewhat uncertain >1::
two years into the future or a certain >A: two years into the future.
0. Dertainty equivalents adust cash flows for risk and time separately. E"+Es do not.
They lump the adustment in together. E"+Es are easier to interpret conceptually$ but
can be less accurate.
1 -$1,!20,$0 =
) (1.0
$#1,200
...+ +
) (1.0
$$00,000
+ 0 -$#,000,00 = %PV
& 1
50
Case %>
Co9)uteriLed -usiness Syste9s
Purpose: The purpose of this case is to find the weighted average cost of capital
&="DD' for a firm. The ="DD is an essential number to determine because it is the
appropriate discount rate used in net present value &(PC' calculations for all similar,risk$
equal,life proects.
1. The Dost of Preferred 7tock:
where$
k
p
L cost of preferred stock$
+
p
L annual preferred stock dividend$
(
p
L net proceeds from the preferred stock issue.
here$
+
p
L >1:: M 11; L >11.::
(
p
L >90.0:$
Therefore$ k
p
L >11.::5>90.0: L !!.<H. 7ince preferred stock dividends are paid from
after,ta6 earnings$ this is the after,ta6 cost of preferred stock.
!. The Dost of Fong,Term +ebt:
k
d
L cost of long,term debt. Two methods can be used to find k
d
.
+!, The first is the calculator method:
Fet$
PC L >9?: &>1::0 , >%0'
*C L >1$:::
P8T L >)0 O&>1$::: M 9;'5!'P
( L ): &!: M !'
where$
PC L Present Calue &the amount the firm receives upon issuing the debt'$
*C L *uture Calue &the amount the firm returns to the bondholder when the bond
matures'$
P8T L Payment &this is the amount the bondholder receives at the end of every
si6 month period until the bond matures'$
( L number of periods in which a coupon payment was received.
"fter plugging these four variables into a financial calculator$ solve for Ri$R the interest
%
D
=
k
p
p
p
51
rate. +oing so will yield an answer of ).<<?;. This is the interest rate on a semi,annual
basis. To annualiHed it$ simply multiply by two to yield a before ta6 cost of debt of
9.%%);.
+%, The second method is to employ a formula such as the following and use financial
tables to generate the answer:
PC L P8T&PCI*"
k;$):
' @ *C&PCI*
k;$):
'
2ere$ PCI*"
k;$):
is the present value interest factor of an annuity for ): <,month
periods at an interest for which we are trying to solve. PCI*
k;$):
is the present value
interest factor. This portion of the equation will convert the bond3s par value from >1$:::
!: years into the future to its present value equivalent. Bnder either method$ the answer
should be the same. 4ne problem does arise$ however$ with the second method. 8ost
financial tables do not list non,integer interest rates.
Doupon payments are deducted from corporate earnings before ta6es are paid.
Therefore$ to find the after,ta6 cost of long,term debt$ we must multiply K
d
by &1,t'$
where t L the corporate ta6 rate.
k
i
L 9.%%) M &1 , .):' L <.>H.
%. Dost of Eetained 1arnings:
7ince the dividends in this case are e6pected to grow at a constant rate into the
future$ the constant growth &Jordon Jrowth' model should be used.
where$
k
re
L cost of retained earnings$
+
1
L ne6t year3s dividend$
P
:
L current price of the stock$
g L growth rate in dividends$
+
:
L most recent dividend paid.

*unds from retained earnings have already been e6posed to corporate ta6es$ so no
adustment is needed.
). Dost of Dommon 7tock:
The same formula as was used in question %$ is used here$ with one minor
alteration. =hen new common stock is issued$ the full ><A.!0 is not received. "fter
g +
P
g) + (1
D
= g +
P
D
=
k
0
0
0
1
)*
1%.<%; = .10 +
"$.2
2.2(1.10)
=
k)*
52
floatation costs$ the company only receives ><!.?0. Plugging into the equation:
"gain$ no ta6 adustment is needed.
0. The ="DD can be defined by the following equation:
where$
w
a
L weight of each type of fund$
k
a
L after,ta6 cost of each type of fund.
To calculate the weights of each type of fund$ simply divide each proportion by the sum
of all the four sources.
"sset Dlass 8arket Calue =eight
Fong,term +ebt >%%$)::$::: 5 >9!$)::$::: L .%<1)?
Preferred 7tock >?$:::$::: 5 >9!$)::$::: L .:?0?0
Dommon 7tock >)!$:::$::: 5 >9!$)::$::: L .)0)00
Eetained 1arnings >1:$:::$::: 5 >9!$)::$::: L .1:A!%
"pplying the formula$
="DD L &.%<1)?'&0.<;' @ &.:?0?0'&11.0;' @ &.)0)00'&1%.9);' @ &.1:A!%'&1%.<%;' L
!7.@!H
<. The same procedure is used again e6cept now the weights will be slightly altered.
"sset Dlass Book Calue =eight
Fong,term +ebt >%0$:::$::: 5 >9:$:::$::: L .%AAAA
Preferred 7tock >0$:::$::: 5 >9:$:::$::: L .:0000
Dommon 7tock >):$:::$::: 5 >9:$:::$::: L .)))))
Eetained 1arnings >1:$:::$::: 5 >9:$:::$::: L .11111
7o$ ="DD L &.%AAAA'&0.<;'@&.:0000'&11.0;'@&.)))))'&1%.9);'@&.11111'&1%.<%;'
="DD L !7.<%H$ using book values.
1%.9); = .10 +
"2.&
2.2(1.10)
=
kn
k w
+
k w
+
k w
+
k w
=
k w
= +A'' =
k
) ) n n p p i i ,
,
A
=1 ,
,

53
?. Bsing target ratios$
="DD L &.%0'&0.<;' @ &.:0'&11.0;' @ &.):'&1%.9);' @ &.!:'&1%.<%;'
="DD L !7.B:H$ using target ratios. The firm3s target ratio will not be e6actly
maintained because when a firm goes to the financial markets to raise funds$ they usually
do so by issuing only one type of security. This choice is primarily a function of
floatation costs.
A. In the industry$ market weights are typically preferred because financial managers are
concerned more with market values. Book values are usually preferred by the accounting
department. *inally$ target weights are more of an idealistic goal$ but it is not attempted
or e6pected to be the e6act percentage of weight for each type of funds. The financial
manager wants only to stay relatively close to the target weights over time.
9.
Bsing market weights:
(PC L D!BB.:B. Therefore$ the company should buy the DB7 system. #es$ the discount
rate makes a big difference. It will cause us to accept or reect the proect depending on
which rate we use. This is why we need to be as accurate as possible when calculating
the ="DD.
="DD (PC
1:.A); ,>!$)<:.1A
1:.?1; >1AA.)A
1:.0!; >)$1:1.):
. .I I -
k) + (1
'F
= %PV
t
t
n
=1 t

) (1.10&1
$10,000
+ ... +
) (1.10&1
$$0,000
+ $#$0,000 - = %PV
11 1 1:
' 1:?1 . 1 &
::: $ A: >
+
54
Case %@
Mc=eodUSA
Purpose: The goal of any firm is to ma6imiHe shareholder wealth. To do so$ they must
determine their optimal capital structure. This case is important not only because it gives
students a chance to approach this very elusive optimiHation problem$ but also because
"FF firms must decide on the level of debt they will carry.
1.

+ebt
Eatio
&1'
16pected
1P7
&!'
7tandard +eviation
of 1P7
&%' L &!'5&1'
Doefficient of
Cariation
:; >:.%A >:.!1 :.00
1:; >:.)% >:.!< :.<:
!:; >:.)9 >:.%% :.<?
%:; >:.00 >:.)0 :.A!
):; >:.<: >:.<! 1.:%
0:; >:.0! >:.A) 1.<!
<:; >:.)1 >1.:A !.<%
!. The formula is stated as follows:

+ebt
Eatio
&1'
16pected
1P7
&!'
1stimated
Eequired Eeturn
&%' L &1'5&!'
1stimated
7tock Price
:; >:.%A 1:.%; >%.<9
1:; >:.)% 1:.<; >).:<
!:; >:.)9 11.); >).%:
%:; >:.00 1!.!; >).01
):; >:.<: 1%.); >).)A
0:; >:.0! 1<.?; >%.11
<:; >:.)1 !:.<; >1.99
k
-P.
=
P
s
0
%. The Jordon Jrowth model for pricing stocks is as follows:
g +
k
DP.
=
P
s
0
55
In order for the two equations to be equal to each other$ the following two conditions
must hold:
1P7 L +P7$ and
g L :.
It is almost never the case that a firm will pay out all of its earnings in dividends.
Dertainly it is not possible in the long,run &which is the way these models value a stock ,
by finding the present value of all future dividends' to have a 1::; payout ratio.
Doncerning the g L : assumption$ RgR refers to the growth rate in dividends. It is
e6tremely unlikely that a company would never increase the dividend payment.
Therefore$ this model is an over,simplification of reality.
). Based on the Hero,growth valuation model$ 8cFeod3s optimal level of debt is %:;
because this is the amount of debt that results in the greatest e6pected stock price.
0. Dlearly the two models do not agree as to the optimum amount of debt that 8cFeod
should employ. "lthough the goals of profit ma6imiHation and stock price ma6imiHation
are highly positively correlated in the long,run$ they certainly do not have to be in the
short,run. There many ways managers can ma6imiHe short,term profits at the e6pense of
long,run performance &and therefore stock price'.
7ince the goal of every corporation is to ma6imiHe stockholder wealth$ achieving
the highest stock price should be the focus of 8cFeod. " note of caution should be taken
here$ however$ since we have ust learned$ from question %$ that this e6pected stock price
estimation is not without its flaws.
56
Case %B
=ancaster Colony
Purpose: The purpose of this case is to discuss the different dividend payment policy
alternatives and how they might affect stockholders.
1. The Eesidual Theory of +ividends states that all available cash flow should be
invested in proects with a positive net present value. Then any money left over should
be paid out to stockholders in the form of a dividend so that no free cash flow &*D*' is
left. 7ince we are not given an investment opportunity set in the case$ it is not possible to
say with 1::; certainty that Fancaster is not following this policy. 2owever$ given the
stable and steady increase in dividend payments$ it is certainly unlikely to be the policy
chosen by Fancaster.
!. " Donstant Payout Eatio means the company will keep the ratio R+P7 divided by
1P7R at the e6act same level each year. Table 1 shows that although the number has
been consistent and stable over the last 0 years$ it certainly is not the same. 8oreover$
there are several drawbacks associated with the Donstant Payout Eatio policy and it is
therefore not often used by firms.
%. The *i6ed,+ollar or REegularR dividend payment policy maintains that the firm would
pay the e6act same dollar amount every dividend payment period and would only
increase the dividend payment when it was very certain that the new$ higher dividend
could be sustained in the long,run as subsequent dividend cuts send a severely negative
signal to the market. In the case of Fancaster Dolony$ the dividend payment amount is
clearly different each year so this policy is not being followed.
). The Fow,Eegular,and,16tra +ividend policy holds that the firm will pay the same
dollar dividend over the first three quarters &dividends in the B7 are typically paid every
quarter$ not ust at year3s end'$ then pay a fourth quarter dividend that is at least the same
as$ but likely higher than that paid for each of the first three quarters. The amount of the
year end dividend is a function of how well the company has done during the year and
also a function of their investment opportunity set in the near future.
"lthough the data given in the case does not breakdown dividend payments by
quarter$ it is very likely that Fancaster follows this policy coupled with the very
conscience decision to ensure that the annual amount of dividends continues to increase
each year. =e can also safely assume that both the firm3s investment opportunity set and
how well they performed have also been taken into consideration given that their
dividends do not always increase at the same rate or by the same dollar amount.
0,<. If Fancaster cut its dividend for the first time in %9 years$ it would certainly send a
negative signal to the market causing the stock price to drop. 2owever$ Fancaster could
mitigate this reaction by coupling their dividend cut announcement with an e6planation
that the reason for the cut is to allow the company to earn an even greater rate of return
57
by investing in internal proects that are highly profitable. 1ven still$ the investor base or
investor composition might change from income seeking conservatives to more
aggressive growth,oriented investors. This will cause e6tra volatility in Fancaster3s stock
as investors buy and sell their shares to transfer ownership.
5"
Case %F
Anheuser2-usch
Purpose: The Baumol 8odel is used to determine the optimal amount of cash a business
should keep on hand to minimiHe the tradeoff between non,interest bearing cash and the
opportunity costs associated with not having ample cash on hand.
1.
1DT is used to minimiHe the costs associated with the tradeoff between keeping cash on
hand &that does not earn interest' and making sure the firm does not have a liquidity
problem.
!. >!$:::$:::5>%?$?9<.)0 L 0!.9! times per year. In practice$ "nheuser will round off
and liquidate funds once a week.
%. >%?$?9<.)05! L >1A$A9A.!%. "gain this assumes the cash will be used on a continuous
and smooth basis. In practice$ salary e6penses typically cause cash outflows to be
e6tremely lumpy.
). The total cost associated with managing the funds is given by the following formula:
TD L &conversion costs'&W of conversions' @ &opportunity costs'&average cash balance'
TD L &>!0'&0!.9!' @ &.:?'&>1A$A9A.!%'
L >1$%!%.:: @ >1$%!!.AA
L >!$<)0.AA
#ou can be sure this is the minimum amount because the two components of the cost are
equal. 7tated another way$ the TD equation will determine the minimum total costs by
considering the tradeoff between keeping unproductive cash balances on hand and
transaction costs associated with liquidating money market accounts.
0. 7afety stock is very important because when a firm runs out of money$ it cannot
purchase inventory to produce its goods. It cannot pay its employees. It cannot meet its
/0)1) 1,2 30sts(d*3i 4 0pp0)t5nit
3,s6) /0) ,nd 30sts)(d*1 si0n (2)(30n7*)
= -'8
$!&,&(".# =
.0&
,000,000) (2)(2)($2
= -'8
5
debt payment obligations. *or all these reasons$ safety stock is added to the 1DT as a
fudge factor or as a security against une6pected cash needs. The chosen level of safety
stock for each firm is a function of the penalties associated with not being able to meet
their financial obligations. The more severe the penalty$ the more safety stock the firm
should keep on hand.
60
Case &7
Pe)si
Purpose: The cash conversion cycle measures the amount of time that a firm3s cash is
tied up and is therefore wasting company resources. 7tudents will learn how to reduce
the cash conversion cycle to save a firm money.
Fet$
""I L "verage "ge of Inventory$
"DP L "verage Dollection Period$
"PP L "verage Payment Period$
DDD L Dash Donversion Dycle$
4D L 4perating Dycle.
4D L ""I @ "DP L "PP @ DDD
1. 4D L ""I @ "DP L )! @ %9 L A1 days
4D L A1 L "PP @ DDD L !9 @ DDD
DDD L 0! +ays
*inancing needs L &total annual outlays'5&%<0' 6 DDD

L &>!A$:::$:::'5&%<0' 6 0! L >%$9A9$:)1
!. 4D L ""I @ "DP L )! @ !? L <9 days
4D L <9 L "PP @ DDD L !9 @ DDD
DDD L ): +ays
*inancing needs L &total annual outlays'5&%<0' 6 DDD
L &>!A$:::$:::'5&%<0' 6 ): L >%$:<A$)9%
%. To calculate the annual cost savings$ we need to use the answers from questions 1 and
!. Pepsi is charged 1!; for short,term funds. Therefore$ to determine their annual cost
to cover their DDD$ simply multiply the answer from 1 and ! by .1!.
4ld 7ystem >%$9A9$:)1 6 .1! L >)?A$<A0
Bar Dode 7ystem >%$:<A$)9% 6 .1! L >%<A$!19
"nnual 7avings L >)?A$<A0 , >%<A$!19 L >11:$)<<
61
). The bar code system will cost >0:$::: to implement. Therefore$ it should be used
because an additional profit of ><:$)<< &>11:$)<< , >0:$:::' will result.
0. 1ven if the bar code system did work out to be more e6pensive$ we still have ignored
the reduction in labor costs. These savings$ while e6tremely difficult to estimate$ will far
e6ceed any additional cost of financing.
<. The cash conversion cycle is the amount of time the firm3s cash is tied up. That is$ the
firm has paid for the goods$ but has yet to receive payment for the goods. The lower the
cash conversion cycle$ the better because short,term funds cannot be used for otherwise
productive resources. Dash conversion cycles are very different from industry to
industry. 8anufacturing firms tend to have longer cash conversion cycles because their
average age of inventory tends to be much greater. 7ervice firms$ on the other hand$ tend
to have very short and even negative cash conversion cycles.
?. There are three ways to speed up the cash conversion cycle. " firm can increase its
average payment period or decrease either its average collection period or its average age
of inventory. In most cases$ the production process is naturally as stream,lined as
possible. Jreat strides can be made$ however$ by considering different terms of sales
procedures for both accounts receivable and accounts payable.
62
Case &!
"nn2Ioo9 Safe
Purpose: *irms have numerous options to consider when establishing their policy on
accounts receivable. 7hould discounts be given to buyers who pay within 1: or 10 daysN
=hen should accounts be due even when no discount is offeredN These questions are
important to a business because if their terms of sale are favorable$ buyers will buy
through them. If the terms of sale are too favorable$ they will be losing money by having
their funds tied up at disadvantageous rates of return. This delicate tradeoff directly
affects a firm3s profit from operations.
1. "dditional profit contribution from increased sales
&O1.:? 6 1$?::P S 1$?::' 6 &>!%) , >10?' L DFE!>&
!. Dost of marginal investment in accounts receivable
"verage investment under proposed plan:
&>10? 6 1$A19' 5 &%<:51)' L >11$1:<.:1.
"verage investment under proposed plan:
&>10? 6 1$?::' 5 &%<:5!%' L >1?$:01.9)
.1! 6 &>1?$:01.9) , >11$1:<.:1' L D@!&.<!
%. Dost of marginal bad debts
Bad debt e6pense under new plan:
&.::0 6 >!%) 6 1$A19' L >!$1!A.!%
&.::A 6 >!%) 6 1$?::' L >%$1A!.):
D!E7<:.!@
). Dost of cash discount
&.:! 6 .?: 6 >!%) 6 1$A19' L +D<EF<F.7:,
0. (et profit from implementation of proposed plan
>9$1<%.:: @ >?1%.01 @ >1$:0).1? , >0$909.:) L D:EF@!.>:
<. Inn,Eoom should consider the fact that all of these forecasts about what conditions will
be like under the newly proposed accounts receivable policy are ust estimates. Inn,
Eoom should take the calculations further and perform a sensitivity analysis to determine
how much results might change if their estimates are off. It is important to recogniHe that
63
small changes in assumption inputs can result in large changes in the bottom line.
64
Case &%
Ho9e De)ot
Purpose: Taking or not taking the cash discount offered on a firm3s accounts payable is
ust as important as accepting or not accepting capital budgeting investment proects.
This case directs students to walk through the analysis and learn how to make these very
important decisions.
1. The cost of giving up the discount is equal to:
!. 7ince all of the above figures are far below the cost of giving up the discount$ 2ome
+epot should take the discount. 2owever$ only one of the three figures is relevant to
making this decision. 7tudents might think that the ="DD is the right answer because
the money used to pay the account earlier would have otherwise gone to investing in a
positive net present value proect &we could assume'. The problem here is that we have
ignored risk. The ="DD is the required rate of return on an average risk proect. If a
proect has more or less risk than average$ a risk,adusted discount rate &E"+E' should
be used. =ith "ccounts Payable$ the risk is certainly not the same as a regular proect.
The firm3s decision is made today at no risk at all. If the early payment is not made$ the
future payment is known with 1::; certainty &i.e. no risk'.
The fact that 2ome +epot can borrow from the bank at 9.?; is only partially
relevant. =e know from capital budgeting that the specific source of funds used to
finance a proect is not what should used to discount the associated cash flows to arrive at
a (PC. Instead$ a weighted average of all sources is what matters. That is the reason we
calculate ="DD first. Then we account for risk afterwards. In this case$ we account for
risk by noting from the case that 2ome +epot3s risk,free required rate of return is ?;.
This is the correct benchmark for comparison.
%. The appro6imate cost of giving up the discount is equal to:
). The tables below summariHe the results using the same formulas from questions 1 V %.
=
%
!"0
9
'D) - (100:
'D
!).)9; =
1) - (#
!"0
9
2:) - (100:
2:
=
%
!"0
9 'D
!; 6 &%<:5O)0,10P' L !);
65
"DTB"F Dosts
1; !; %;
%: days !).!)
;
)A.9A
;
?).!%;
)0 days 1!.1!
;
!).)9
;
%?.11;
<: days A.:A; 1<.%%
;
!).?);
17TI8"T1+ Dosts
1; !; %;
%: days !).::
;
)A.::
;
?!.::;
)0 days 1!.::
;
!).::
;
%<.::;
<: days A.::; 1<.::
;
!).::;
A))roGi9ation Method 8rror
1; !; %;
%: days :.!); :.9A; !.!%;
)0 days :.1!; :.)9; 1.11;
<: days :.:A; :.%%; :.?);

"s can be seen from the table$ the larger the cash discount$ the greater the error
when using the appro6imation formula. "lso$ the fewer the number of days between the
cash discount period and the total credit period$ the less accurate the appro6imation
formula.
66
Case &&
Hasbro
Purpose: Feasing has become an e6tremely viable alternative to the traditional
purchasing of machinery$ buildings$ and even land. "ll manufacturing firms have the
opportunity to lease or buy some of their assets. This case will provide the information
necessary for the student to determine which option is preferred for a given situation.
The calculations for this type of decision are quite lengthy.
1. 1ach lease payment is deductible for ta6 purposes. Therefore$ the after,ta6 cost can be
calculated as
>?$::: 6 &1,.)' L >)$!::.
+uring the last year$ however$ the company will purchase the machinery at a price of
><$:::. The five year after,ta6 cash flows are shown in the table below.
#ear "fter,ta6
Dash flow
1 >)$!::
! >)$!::
% >)$!::
) >)$!::
0 >1:$!::
!. To find the amount of interest paid per year$ a table is beneficial.
#ear Payment Beginning
Balance
Payment 1nding
Balance Principle Interest
1 >?$01) >%:$::: >0$11) >!$):: >!)$AA<
! >?$01) >!)$AA< >0$0!% >1$991 >19$%<%
% >?$01) >19$%<% >0$9<0 >1$0)9 >1%$%9A
) >?$01) >1%$%9A ><$))! >1$:?! ><$90<
0 >?$01) ><$90< ><$90A >00< >:
%. +epreciation e6penses are equal to the 8"DE7 rates times the purchase price of the
machinery.
#ear +epreciation 16pense
1 >%:$::: 6 .!: L ><$:::
! >%:$::: 6 .%! L >9$<::
67
% >%:$::: 6 .19 L >0$?::
) >%:$::: 6 .1! L >%$<::
0 >%:$::: 6 .1! L >%$<::
). The total ta6 shield is equal to the sum of the maintenance e6pense$ depreciation
e6pense$ and interest e6pense each year multiplied by the ta6 rate &.):'.
#ear 8aintenance
e6pense
+epreciation
e6pense
Interest
e6pense
Total Ta6
7hield
1 >1$::: ><$::: >!$):: >%$?):
! >1$::: >9$<:: >1$991 >0$:%<
% >1$::: >0$?:: >1$0)9 >%$%::
) >1$::: >%$<:: >1$:?! >!$!<9
0 >1$::: >%$<:: >00< >!$:<!
0. Total after,ta6 net cash flows are equal to the payments of >?$01) plus the
maintenance costs minus each year3s ta6 shield as shown in question ).
#ear Total after,ta6
net cash flow
1 >)$??)
! >%$)?A
% >0$!1)
) ><$!)0
0 ><$)0!
<. To find the present value$ use a discount rate of 0; O&A;'&1 , .)'P. The present value
of the five net after,ta6 cash outflows associated with purchasing the machinery is equal
to >!!$%9A. The present value of the five net after,ta6 cash outflows associated with
leasing the machinery is equal to >!!$AA0. 7ince these figures reflect the present costs
associated with both alternatives$ we would want the one with the lower present cost.
Therefore$ 2asbro should purchase the machinery instead of leasing it.
?. If putting a down payment on an asset is a problem$ leasing is advantageous because it
allows the lessee to finance 1::; of the asset. Feasing can also be an advantage if the
asset you need is in an area that is associated with quick obsolescence$ such as computer
technology. 4f course$ once you have entered into a lease$ if the asset becomes
obsolescent$ you still have to lease it for the remainder of the contract.
In the event your firm goes bankrupt$ the lessor only has a legal right to recover
three years of lease payments &and of course$ they get their asset returned to them'.
*inally$ not all assets &land$ for e6ample' are depreciable unless they are leased.
+isadvantages associated with leasing include an unpublished interest rate that the
lessee is being charged. #ou must calculate it to be sure it is not too high. The salvage
6"
value at the end of the lease belongs to the lessor. The longer the lease$ everything else
constant$ the lower will be the savage value. *inally$ if you are locked into a lease and
you desire to make asset improvements$ it is common that restrictions will be imposed by
the lease.
A. The factor that will determine 2asbro3s decision concerning whether or not to buy the
machinery at the end of the lease will most likely be the success of 8a6ie3s sales. If the
doll does well$ 2asbro will be more likely to either roll the lease over or purchase the
machinery for future production needs.
6
Case &:
Microsoft
Purpose: This basic options case helps students read and understand how options behave
with respect to such factors as time$ stock price$ e6ercise price$ and volatility of the
underlying common stock. The student will also learn the basics of how a put option can
be used to hedge risk.
1. "n investor should buy put options when they need protection against downward
movements in a stock3s price because long put positions make money when stock prices
decrease. 1ach options contract is written on 1:: shares of common stock. Therefore$ 0
put contracts should be purchased. 7ince Dhris feels the downward movement will take
place tomorrow$ he should buy the nearest maturing put option &i.e. +ecember'. +oing
so will allow him to hedge at the lowest possible cost.
!. a' To develop the hedge will cost: >?0: &>1.0: 6 0::'. 7ince the stock price &>9%'
e6ceeds the e6ercise price &>9:'$ Dhris will not e6ercise the put option. Technically$ the
option still has some value$ but this value will decrease dramatically as it ust went out of
the money with only a few days to e6piration. *rom a practical standpoint$ it is
considered to be Hero.
4n the up side$ Dhris3 holding of common stock went up in value by >!$:::
O&>9%,>A9' 6 0::X. 4verall$ he made >1$!0: and his new wealth position is >)0$?0:.

b' If the stock price decreases to >A0$ Dhris will make money on the put options$ but lose
on the stock. 2is put options will be worth roughly >!$0:: O&>9:,>A0' 6 0::P. 2is
underlying shares lost >!$:::. =ith the same options cost of >?0:$ Dhris lost >!0: from
the announcement. 2is new wealth position is down to >))$!0:.
%. (o matter which trading cycle options are on$ they will always be offered in the
current and following month and also on the ne6t two natural months in the trading cycle.
7ince +ecember options contracts had not e6pired by +ecember 10$ options are available
with maturities in +ecember$ Ianuary$ "pril$ and Iuly. 4n Ianuary 1$ options will be
trading with maturities in Ianuary$ *ebruary$ "pril$ and Iuly.
). The nearer the option is to its e6piration$ the greater the trading volume in that option
tends to be. "lso$ the greater the time to maturity of an option$ the greater the value of
the option. Colatility also has a positive relationship with option prices. The above
relationships hold for both puts and calls.
0. Colume tends to be higher when the strike price is above the current stock price
because stock prices tend to increase over time.
<. The further out of the money an option is the cheaper the price should be. This
70
follows since the further out of the money an option is the lower the probability it will
ever be e6ercised. Donversely$ the further in the money an option is the more e6pensive
the price should be because it will most likely be e6ercised. In fact$ in,the,money
"merican options$ by definition$ can be e6ercised immediately for a positive payoff.
71
Case &<
I8"#s
Purpose: This case introduces a type of security that is too often ignored in finance. It is
important to make students aware of E1ITs because they have repeatedly been shown to
warrant inclusion in mi6ed,asset portfolios.

1. *or commercial properties$ rents are determined based on supply and demand in the
local economy. =hen the economy is good$ businesses flourish and office space is
demanded. This higher demand allows the building owners to keep rents at a very high
level as firms are competing for space. The E1ITs that own these building are therefore
receiving higher revenues and are thus more profitable.
=hen the economy is bad$ businesses trim down or even go out of business$
which frees up office space. The widely available space gives renters &lessees' the upper
hand. Fandowners compete for tenants by lowering rents. These lower rents mean lower
revenues for E1IT shareholders.
!. E1ITs have historically returned ?.:;,A.:; in dividends and a more modest %;,0;
in capital gains. +ue to ta6 consequences$ the individuals who own E1ITs are same
investor class as those who own utility stocks S retirees.
Ta6,e6empt institutional investors$ like pension funds$ also own E1ITs. 7ince
they do not pay ta6es$ all they care about is total return$ not whether the total return came
from dividends or capital gains. E1ITs have been shown to generate sufficient returns on
a risk,adusted basis to warrant inclusion in mi6ed,asset portfolios.
%. The correlation between asset classes is typically measured by e6amining inde6es
&benchmarks'. *or e6ample$ to calculate the correlation between large cap stocks and
E1ITs$ the 7VP 0:: would be compared to the ("E1IT &(ational "ssociation of Eeal
1state Investment Trusts' inde6. In 199A,1999$ technology stocks soared in value which
caused their weight to be very high in the 7VP 0:: inde6. 7o as the technology stocks
went through the roof$ they drug the 7VP 0:: inde6 along with them. E1ITs$ on the other
hand$ continued their steady returns. Donversely$ after the technology stocks crashed$ so
too did the 7VP 0::.
The appearance$ therefore$ is that E1ITs had a low correlation with the stocks in
the 7VP 0::. The reality was that E1ITs had a low correlation with technology stocks
and a much higher correlation with the other stocks in the market which showed the same
general return pattern throughout that E1ITs did.
+o to these e6treme events$ it is likely that E1ITs will be observed to have a
higher correlation in the future.
). =hile it is impossible to measure directly or with a high degree of accuracy$ the total
market value of all commercial real estate in the Bnited 7tates is around >0 trillion. 2alf
of this is owned directly by corporations$ leaving the other half available for ownership.
Durrently$ only >!0: billion of this real estate is controlled by E1ITs. 7ince the average
72
E1IT has roughly a ):; debt ratio$ the total market capitaliHation of all E1ITs sums to
>1)1.A billion. Thus$ only a small percentage &appro6imately 1:;' of commercial real
estate is securitiHed.
Jiven that there are numerous property types &"partments$ Industrial$ 4ffice$
Eetail$ =arehouse$ etc.'$ the ability of a portfolio manager to find enough E1ITs to make
a significant rebalance in a portfolio is dubious. 8oreover$ while it is far beyond the
scope of this simple case$ E1ITs are not e6actly unsecuritiHed real estate. Thus$ using
them as substitutes can be misleading. 7everal researchers have found them to be so
different that they should be considered a separate asset class.
73
Case &>
H?=DIs
Purpose: This case introduces a new type of security that is being traded on the "merican
7tock 16change. It is important to make students aware of new offerings as quickly as
possible not only because they will soon be entering the work force$ but also because they
may want to use them in their portfolios.
1. =hen a firm like 8errill Fynch offers a new security$ it is usually out of customer
demand$ or at least perceived customer demand. Fike any product$ however$ if consumers
are not interested in buying it$ 24F+Es would stop trading and eventually go away. *or
this reason$ a firm offering a new security should feel very confident that it will have
staying power.
!. +ay traders are defined as traders who enter and e6it trades within one trading session
&day'. 7ince BITs$ like mutual funds$ only calculate their price once each day$ day traders
would not include them as part of their portfolio. 24F+Es$ however$ have intrinsic price
changes as soon as any of their underlying securities change in price. "s such$ they can
and likely will be used by day traders who wish to speculate on the direction of a
particular industry.
%. BITs are no different from any other area of finance. Dompetition causes increased
efficiency which is ultimately better for consumers. "n analogy can be drawn from the
former telecommunications industry. =hen the monopoly was broken up and competitors
were allowed to offer long distance services$ prices dropped precipitously. =ith the
advent of 24F+Es$ which offer several advantages to investors$ watch for BITs to
improve upon the transparency and availability of price data.
). (o. 24F+Es are diversified only within a particular industry. Portfolio theory clearly
maintains that to remove all unsystematic risk$ diversification across industry sectors in
necessary. Therefore$ if an investor were to purchase the 24F+E of only one industry$
his portfolio would not be fully diversified.
74
Case &@
Ieynolds
Purpose: 8erger mania is alive and well. In the mid 19A:3s and now again$ firms are
oining forces for all types of strategic reasons. 7tudents should be made aware of the
factors that contribute to merger and acquisition activity and how these activities affect
industries and the overall economy.
1. 4ne of the main reasons is to reduce competition by making the competitors part of the
same company.
!. It is the ob of the regulators to prevent firms from having absolute or virtual
monopolies. This is good for us as customers because monopoly firms eventually raise
prices once they drive out all competitors who can offer the same product at reduced
prices.
%. There are several reasons why firms merge: economies of scale and scope$ growth$
diversification$ ta6 benefits$ greater access to the capital markets$ to tap into unused debt
potential$ to remove inefficient management$ to gain market share$ to gain prestige by
being seen as a larger company$ to be listed on a larger e6change$ and many other
synergistic reasons.
). To avoid a takeover attempt$ firms have the following colorfully named options: seek a
white knight$ take a poison pill$ use a shark repellent$ send greenmail$ organiHe a
leveraged recapitaliHation$ or save at least the management by having them pull the cords
on their golden parachutes.
0. The ways to raise capital for mergers and acquisitions include leveraged buyouts
&FB4'$ a management buyout &8B4'$ a cash offer to tender shares$ leveraged 174Ps$
and stock swaps.
<. Eesearch has shown that the target of a takeover or merger receives a substantial
premium for their shares while bidding firms have Hero and even insignificantly negative
returns from winning the bidding war. "t first glance this seems unreasonable$ but there
are several e6planations that shed light on this surprising result.
&1' Takeover firms must gain voting control in order to elect their own managers.
This means owning shares of the target3s common stock. In order to entice current target
stockholders to sell$ a premium must be paid to them.
&!' The bidding firm must have some value creation potential otherwise the
merger would not be on the table in the first place. Target firm stockholders understand
this and also know that their shares are needed to make the deal happen. Therefore$ they
simply want their piece of the pie.
&%' *inally$ it can be argued that the feeding frenHy that eventually results from a
few sharks swimming around in bloody chum,filled waters turns into a free,for,all where
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rational pricing gives way to the Rwinner3s curseR.
76
Case &B
Ada)tec
Purpose: This case introduces the fundamentals of a corporate spin,off. 8ost introductory
courses do not discuss corporate spin,offs. 2owever$ today more so than ever$ students
already own stocks before they get into class. 7o$ students receive statements in the mail
related to their common stock ownership that discuss concepts of which they are
completely unaware. The purpose of this case is to create that basic awareness.
1. Brian does not have to do anything to own these shares in the new company$ Eo6io$
because effectively$ he already owns them. That is$ Eo6io is currently a wholly,owned
subsidiary of "daptec$ which Brian owns. The analogy is if you take a whole pie and cut
a piece out of it$ the person who owned the whole pie should now own the piece of pie
and the remainder of the pie as well. Dutting a pie into many pieces does not make its
total siHe larger or smaller.
!. 1:: 6 :.1<)< L 1<.)< shares.
%. The leftover or fraction of a share$ :.)<$ cannot be owned by Brian because it is not
possible to own fractional shares in a common stock. The "daptec statement reads$ -The
transfer agent will not deliver any fractional shares of Eo6io common stock in connection
with the spin,off. Instead$ the transfer agent will aggregate all fractional shares and sell
them on behalf of those holders who otherwise would be entitled to receive a fractional
share. 7uch holders will then receive a cash payment in an amount equal to their pro rata
share of the total net proceeds of that sale..
). Ta6 consequences may vary. In this case$ the Information 7tatement for "daptec reads$
-"daptec has received an opinion from Pricewaterhouse Doopers FFP that the
distribution of its shares of Eo6io common stock to the holders of its common stock will
be ta6,free to "daptec and its stockholders for Bnited 7tates federal income purposes..
77
Case &F
IoGio
Purpose: This case is an e6tension of the "daptec case. This case opens the door to the
discussion of corporate spin,offs and may best be used as a conversation5discussion
starter in class as opposed to an assignment.

1. Eo6io/s desire to operate independently is not much different from most other firms.
Eo6io states their reasons for the separation by saying$ -The separation will allow us to
have our own business and strategic opportunities. "fter the separation$ we will be able to
implement a marketing strategy that focuses on our business. *urthermore$ our business
and engineering resources will be dedicated solely to our businessU the motivation of
our employees and the focus of our management team will be strengthened and our
ability to attract and retain qualified personnel will be enhanced. "s a separate company$
we will have direct access to the capital markets$ and we believe that securities analysts
will be more likely to provide research coverage of our business..
!. There are several potential new risks. &1' Eo6io will be operating under a new brand
which does not already carry wide brand name recognition. This could hurt sales. &!'
+eparture from "daptec/s infrastructure and implementation of their own new structure
could hurt efficiency. &%' Eo6io may be required to indemnify "daptec for ta6 liabilities
associated with the distribution of Eo6io common stock. &)' There is a potential increase
in stock return volatility due to difficulty in pricing new shares as well as operating a
smaller business whose sales are reliant on a few large customers within similar markets.
&0' "bility to raise capital is limited as Eo6io is a small firm. 8oreover$ smaller firms
often find it more e6pensive to raise funds because of economies of scale. &<' 8any of
the new Eo6io board members still own a substantial number of shares &or options to buy
shares' in "daptec. This can cause actual or perceived conflicts of interest at least until
all connections to "daptec have been severed. &?' Eo6io stock has never been traded
before. They plan to list on the ("7+"T$ but if they are unable to meet the listing
requirements$ they will be forced to list on the lower perceived quality 4TDBB. This may
result in a lack of analyst coverage$ institutional ownership$ and low trading volume.
%. #es. Because of prior e6ecutive compensation requirements$ "daptec will continue to
hold 19:$9)1 of the 1<$%:9$:09 total Eo6io shares.
). It is e6tremely unlikely that Eo6io will plan to pay a dividend in the foreseeable future.
The primary reason is the growth orientation of Eo6io. " primary benefit of being
publicly listed is to gain access to the capital markets. *or this reason$ it makes no sense
for Eo6io to distribute cash when they are trying so hard to raise cash through the issuing
of securities.
7"
Case :7
#yco
Purpose: "s the world continue to become more globally oriented$ it is important for
students to understand the ramifications of being a multinational firm. This case is a first
step in that direction.
1. The following table will be used to demonstrate the weighted average cost of capital:
7ource of funds "fter,ta6 cost "mount =eight =eighted cost
1quity 11.); ><$0::$::: )).A; 0.11;
+ebt 0.<; ><$0::$::: )).A; !.01;
=orking Dapital <.:; >1$0::$::: 1:.); :.<!;
="DD L A.!);
!. 7ales 6 1?; L profits
>%0$:::$::: 6 .1? L >0$90:$::: per year for the ne6t four years.
PC L >0$90:$::: 6 PCI*"
kLA.!);$nL)

Bsing a calculator$ the present value is
PC L >19$<:!$%%%
%. If the dollar were to appreciate or strengthen relative to the guilder$ the sales revenue
in guilders would be worth less in terms of B.7. dollars. Therefore$ profits from foreign
sales would decrease.
). *rom a financial viewpoint$ the foreign e6change rate risk could be hedged by using
futures or forward contracts. " short position would be taken by Tyco so that if the
dollar strengthened$ it would reduce the profits in the spot market$ but cause offsetting
gains by making money in the futures5forwards market.
0. *rom a production standpoint$ Tyco could purchase more input components with
guilders or sell more units in dollars. They could also finance future cash flow needs
with guilders instead of dollars. =estern 1urope3s financial markets are not nearly as
risky as markets in other parts of the world.
7

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