1. Finance Concept: Sherpas in the mountains of Nepal often plant crops (mainly potatoes and barley) in several small plots at different elevations and exposures. They seem to forgo the efficiency of a single large plot near their home for plots sometimes separated by many miles and thousands of feet of elevation. What theory or concept from our class would help explain this apparently inefficient method of production?
2. Convertible debt: Convertible debt is considered a win-win security for the issuing firm. If the bonds never convert then the company has issued debt at a lower interest rate than if it had issued straight (non-convertible) debt. If the bonds convert they do so at a stock higher than if the company had issued stock initial. If a security is win-win for the issuing company, is it lose-lose for investors? Explain why or why not.
3. Cash Flow: An MBA student taking finance is asked to compute the cash flow associated with a project which will have EbDT of $1,000,000 and associated depreciation expense of $300,000 if the company’s tax rate is 35%. He quickly computes the following answer: 1,000,000x.65 + 300,000x.35 + 300,000 = $1,055,000. Comment on this solution. If it is incorrect (it might not be) fix it.
4. Source of Positive NPVs: Suppose you are evaluating capital budgeting proposals in a technology company. One product group submits a proposal for a product with a 10-year life and an extremely large NPV. What questions would you have for the manager of this group, and, if the NPV analysis is to be believed, what answers would you expect? In other words, what are the possible sources of a large and long-lived positive NPV?
5. Agency: Our daughter will go to college (we think) in the fall of 2015. We will be paying a large portion of her costs. Identify an agent-principal relationship in this arrangement, and give some examples of how th
e agent might perform sub-optimally compared to the principal’s desires.
6. Consumer finance: Four years ago you bought a condo using a 15-year mortgage. The mortgage had an interest rate of 6% (or 0.50% per month) and the original loan amount was $120,000. Your monthly payments are $1,012.63. Today you have 132 monthly payments remaining. You got a bonus at work (or a gift or something) so in addition to you next monthly payment you will send in $3,500 to reduce the principal on the loan.· How much will this shorten the life of the loan? How much will you reduce the total interest you will pay over the life of the loan?
7. Lease-to-own: A lease-to-own store offered a 55” flat screen TV for $99.99 per month for 24 months. An identical TV was priced at $1,499.99 at Aaron Rents. What is the implied annual interest rate of the lease-to-own offer?
8. Required Rates of Return in MBOs
Leveraged or management buyouts (LBO/MBO) often are financed with 75% or 80% debt. Typically the rest of the purchase is financed by the buyout or private equity firm (75% to 80% of the remainder) and the new management team (20% to 25% of the remainder). The company is taken private, so the stock is no longer traded on any stock exchange. Once private the new owners usually sell some assets to repay some of the debt. Good buyout candidates have strong stable cash flow and limited growth opportunities. Initially most to all of the company’s cash flow goes to debt reduction. Buyout firms often have a portfolio of dozens of companies, so each company is being added to a somewhat diversified portfolio. To simplify thinking about this question assume that the buyout firm either has a very well-diversified portfolio of companies.
Buyout firms have a very high hurdle rate, 30% to 40%. They evaluate deals assuming that they will exit after about 4 years. Often the exit strategy is to take the company public again through an IPO (Initial Public Offering). If the average asset beta (that is the average beta of an unlevered firm) is about 0.80, can you explain the high hurdle rate buyout firms apply to their deals? Think about what type of risk is priced and what problems would occur if a buyout firm just picked a number as its hurdle rate. In your answer I would like you give me an explanation based on the theory we have discussed in this class for hurdle rates in the 30% to 40% range.
Hint: Suppose the historic risk-free rate is about 6.5% and the historic market risk premium is 7.4%.
Assume it is January 1, 2014. Compute the WACC for Luxury Electronics (LUXE) using the following information:
LUXE has three debt issues outstanding. All pay interest semi-annually and have $1,000 face values. The December 31 interest payments have just been paid. The tax rate is 30%.
4.0% Notes, maturing December 31, 2020 ($250 million face value) Market price $908.395.0% Bonds, maturing December 31, 2024 ($300 million face value) Market price $943.37
6.0% Bonds, maturing December 31, 2030 ($200 million face value) Market price $1,021.44
LUXE also has 5 million shares of preferred stock outstanding. The preferred stock pays an annual $4.00 dividend and current sells for $40 per share.
Last week LUXE’s stock closed at $25.25 per share. There are 30 million shares of common stock outstanding. Use a 4% risk-free rate and a 7.0% market risk premium to compute LUXE’s cost of equity. The table shows the weekly closing prices for LUXE and the S&P 500 Index.
Data for WACC problem
Weekly closing prices for LUXE and SP500
Date LUXE SP500
7/7/14 25.25 1967.5
6/30/14 26.5 1985.5
6/23/14 25.5 1961
6/16/14 25.75 1962.75
6/9/14 25.5 1936.25
6/2/14 25.75 1949.5
5/27/14 25 1923.5
5/19/14 24.25 1900
5/12/14 23.75 1877.75
5/5/14 23.5 1878.5
4/28/14 25 1881.25
4/21/14 23.5 1863.5
4/14/14 24.25 1864.75
4/7/14 24.5 1815.75
3/31/14 24 1842.75
3/24/14 25 1857.5
3/17/14 23.5 1866.5
3/10/14 23.5 1841.25
3/3/14 25.5 1878
2/24/14 23.75 1859.5
2/18/14 24 1836.25
2/10/14 24.75 1838.75
2/3/14 23.5 1797
1/27/14 22.5 1782.5
1/21/14 22.5 1790.25
1/13/14 24.75 1838.75
1/6/14 23.25 1842.25
1/2/14 22.75 1831.25
You have just been promoted to be the assistant to the VP in charge of corporate strategy at Rawlins Oil, a NASDAQ listed company with annual revenues of about $250 million. This is a high-profile position working with a person known for her intelligence, integrity and concern about creating shareholder value. In addition to the promotion and its accompanying raise, like all other managerial level employees, you have just received your recent bonus and a special grant of stock. Because oil prices have been reached new highs the bonuses were equal to your annual salary and you received restricted shares equal to twice your annual salary!
Your first assignment is to accompany your boss to a presentation by the company's CEO, Rob 'Red' Rawlins, and Executive VP, Rick 'Rock' Rawlins, brothers and sons of the founder of the company, the late Rollo Rawlins. The brothers have been trying come out from under their father's shadow and leave their own mark on the company. Red and Rock have announced they have a great acquisition idea that they want to present to the management team. Your boss (who admired Rollo but has some doubts about Red and Rock) wants you to take notes then put together a short (one-page maximum) critique of the plan. This memo will be for her eyes only, so you may state things strongly if need be (though still maintaining standard business protocol, since things do leak sometimes). Later in the day she will take part in a discussion of the acquisition and wants you to identify benefits, pitfalls and questions regarding the acquisition that need to be discussed.
After the meeting you are in your office and begin to organize your thoughts about the memo for your boss. At the meeting you were nervous, so your notes are a little sketchy.
Red: We are preparing our proposal for the upcoming board meeting. The company is doing great. Our stock is at a new high. This is our best year and we want to capitalize on it with one or two key acquisitions. Rock and I have been doing a lot of reading and thinking, and we think we need to diversify. Computers. Oil is good but computers not oil will run the 21st century. Rock is a visionary, and he and I agree that we need to diversify, and computers are where it is at and where it is going to be for a long time.
Obviously, our results prove that we have a skilled management team that is driving our success. We want to exploit this skill set into new areas and develop some new core competencies. Everybody does well if we grow. We'll need new VPs in the acquired units.
We've identified a computer game company in California, Dega, which is ripe for the picking. It stock price is down some, but Rock says that the company makes great games. He has been doing a lot of research.
We can add a lot of value to the operation of that company. It would do well to have some of our discipline. We can get those software geeks to work at 8 in the morning and really increase production. Just moving the headquarters from California to Texas will save about million bucks a year.
Rock: Integration will be easy. We are an easy-going bunch here and we'll make those folks feel at home. This acquisition could be pretty cheap for us because we can use some of our stock. There is talk that some other company is interested Dega, but we can out bid them. We have plenty of cash. Since we don't pay dividends the company's cash is growing fast with these high oil prices.
The URL for the article is:
11. Capital Budgeting topics
Demand for smaller cars is increasing (see, for example: http://www.washingtonpost.com/wp-dyn/content/article/2005/09/27/AR2005092701812.html). A US automaker is considering retro-fitting an assembly plant currently producing large SUVs, so it will produce several models of smaller cars. The plant can be converted in one of two ways. For $19 million the plant (Type I) will be able to produce three models of a compact car (The Froogo), which all rely on the same chassis and share some body and drive train assemblies. For an extra $3 million (total initial investment of $22 million) the plant (Type II) can be equipped with assembly machinery that would allow it produce a much larger range of models from sub-compact to intermediate sized automobiles. Analysts at the company believe that there is a 60% chance that demand for the Froogo will be high and 40% that demand will be low. The after-tax incremental cash flows for the Froogo are shown in the following table. All amounts are in thousands (000s) and arrive at year end.
Year 1 2 3 4 5 6
High Demand (60%) cash flow 5000 7000 9000 9000 9000 9000
Low Demand (40%) cash flow 1200 1200 1200 1200 1200 1200
Weighted average after-tax cash flow 3480 4680 5880 5880 5880 5880
For $500,000 the Type II plant can be switched between automobile size categories. If demand for the Froogo is low during the first year, the plant can be modified to one of the company's flagship intermediate sized cars. The cash flows presented in the bottom row below show the $500,000 switching cost at the end of Year 1 ($1.2 million from low Froogo sales less the $500,000 switching cost and a series of $4 million cash flows for Years 2 through 6. All amounts are in thousands, so 5000 is $5 million.
Year 1 2 3 4 5 6
Froogo Low Demand CFs 1200 1200 1200 1200 1200 1200
Cash flows after switching 700 4000 4000 4000 4000 4000
A. Compute the NPV of the Type I plant using a 12% discount rate.
B. Compute the NPV of the Type II plant using a 12% discount rate and assuming that if Froogo demand is low that the plant switches to the production of intermediate size cars after Year 1.
C. Using your answers in A and B recommend which type of plant to build.
D. In a very brief essay (150 words maximum) explain the option the Type II provides and why or why not this option creates value for the company.
12. Capital Structure
You are a new associate at a well-known financial consulting firm. As part of the firm’s in-house training program you have just visited two client companies. Next week you will present your financial recommendations to best enhance shareholder value for each client. Recommend a financing plan for each firm and then explain why your plan is the best way to enhance shareholder value. Do not make suggestion like firing the CEO. I want purely financial recommendtaions.
A. Company A is a multi-divisional company in a mature industry. The company generates fairly large cash flows each year but has limited growth prospects. The long-time CEO is a very charismatic individual, but has a tendency to treat the company as his own rather than shareholders’. One example of this is an acquisition he pushed the company to make that was later sold at a loss. A second example is a company plane that internal auditors complain is not used often enough to justify its cost. The CEO is 63 years old, but has not named a successor yet. He owns about 1% of the company’s stock. The CEO has hired some very talented younger executives. Although this group of managers has been rewarded well with stock, they are a little frustrated that stock price has not risen very much over the past few years. As a group they own (or have in-the-money options on) about 4% of the company’s shares.
The company, largely because of the personal experiences of the CEO during the depression, has almost no debt. Despite having a large and growing cash and marketable securities account, the company has never distributed dividends.
Employee wages are competitive within the industry, but the company gives generous benefits so total labor costs are slightly above average. Employee turnover is very low and morale is very high. Since many jobs in the company are technical in nature (e.g., machinists, etc.) low turnover is considered of high value.
The board of directors, which includes two new directors, has asked your consulting firm for suggestions on how the company’ can create more value for shareholders.
B. Company B is a small, publicly-traded technology company. Company B is close to completing development of a new software/hardware product for schools that uses voice recognition to quickly translate a lecture into written notes that are projected onto a screen. The lecturer can then annotate the notes with a drawing pad linked to the computer projection system.
The company needs about $12 million to complete development and begin production and marketing of this product. The company is profitable with one other product that generates about $500,000 in cash flow annually. For many reasons the company has been very secretive about its new product so its stock price is quite low, being based on the modest cash flows of its existing product. Company officials and outside consultants agree that it is too early to reveal the new product’s details given what they know of competing products.
The company is reluctant to issue more stock at this low price because management is certain that the new product will be successful and stock price will rise dramatically once the product is introduced. They feel that selling stock now would be giving away the unrealized value of current shareholders, including themselves.
Current interest rates on bonds or notes for companies of this type are in the range of 8% to 10%, which would very likely exceed the company’s debt service capabilities. Convertible debt would probably have a coupon rate of 3% to 5% depending on the conversion price. The higher the conversion price the higher the coupon rate. The company’s tax rate is about 28%.
13. NPV analysis of wind energy
A large wind farm is being proposed for eastern Colorado. As designed it will produce 5.5 billion kWh of electricity per year, which is contracted to be sold for $0.10 per kWh. The Federal Production Tax Credit (PTC) will add $0.021 per kWh of revenue, and selling Renewable Energy certificates will add another $0.01 per kWh. The initial investment for the wind turbines, site preparation, linking to the grid, etc. will be $4.2 billion. The project is expected to last for 25 years. Any salvage value from the turbines will exactly offset site rehabilitation costs.
Annual operating costs will be $90 million per year (maintenance, land leases, insurance, GA&S). These costs are tax deductible. They do not include depreciation expense.
The project qualifies for accelerated depreciation. The entire $4,200,000,000 will be depreciated evenly over 7 years ($600 million per year) to zero book value.
Please show detailed calculation of the Year 1 and Year 8 after-tax cash flows for NPVs with accelerated depreciation, and Year 1 and Year 15 after-tax cash flows for NPVs without accelerated depreciation. This should present the two different cash flows used in the NPV analysis.
A. Using a 30% tax rate and a 10% discount rate compute the NPV, IRR and payback of this investment. Show the Year 1 and Year 8 calculations of your after-tax cash flows.
B. The PTC is scheduled to expire in the next few months if Congress doesn’t renew it. The timing of the Congressional decision would mean that the project would not receive the PTC in any of its years of existence. If the PTC is NOT renewed, what will the NPV be? Use a 30% tax rate, a 25-year life and a 10% discount rate. Show the Year 1 and Year 8 calculation of your after-tax cash flows.
C. Suppose that lobbyists from the fossil fuel industry are putting pressure on politicians to not renew the PTC and to eliminate the accelerated depreciation available for renewable energy. Advocates for renewable energy can probably salvage one or the other (the PTC or the 10-year depreciation benefit). If the accelerated depreciation benefit is eliminated, depreciation would be spread evenly over 14 years. As an advocate for renewable energy if only one benefit is politically feasible (the PTC or accelerated depreciation) which would you argue for? Support your decision with numbers.
14. Cash Budget
It is December 2013. You are a budget analyst for ACME Manufacturing Inc. ACME makes a variety of garden supplies for home gardeners, tools, sprinklers, tomato frames, hoop greenhouse kits, etc. Create a cash budget for the months January through June, 2014, using the sales estimates and other information about the company given below. All numbers are in thousands. A form is provided for your cash budget.
Complete the cash budget for the first half of 2014 (January through June) on the form provided.
What will the Accounts Receivable balance be at the end of June, 2014?
Assume everything occurs exactly as the cash budget predicts, and ACME gets the loans forecast on the cash budget. Given the minimum cash balance of $50 is ACME assured that there will never be a cash shortfall at anytime during the forecast period of January through June, 2014? Explain why or why not.
Why must this profitable company borrow money for a few months each year?
ACME Sales Forecasts
Month Sales ($ 000s)
November 2013 200
December 2013 200
January 2014 300
February 2014 600
March 2014 900
April 2014 1,000
May 2014 1,000
June 2014 800
July 2014 300
|Due By (Pacific Time)||07/30/2014 07:00 pm|
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