CH-1-4 Introduction to Corporate Finance – Corporate Finance : Book Guide

This Document Contains Chapters 1 to 4 Chapter 1 Introduction to Corporate Finance 1. Finance relates to the decision-making and strategies of corporations. It is composed of three main elements. a. The investment decision. b. The financing decision. c. Short-term capital management. Each decision is framed within the general objective of maximising firm value while ensuring that risk is appropriately managed. Think a family, with one parent earning the monthly salary and the other looking after the children. Every month, money comes into the house and there will be times when the family needs to spend money on items like furniture. This will usually come from savings. However, sometimes, the family will want to buy a car or a house and will need to take out a loan for the investment. At all times, the family must have enough cash and this applies every single day. This example concerns a family, but if you change the object to a corporation, the same decisions need to be made. When we talk about financial decisions relating to families, this is known as personal finance, whereas when we talk about corporations, we call this corporate finance. 2. The statement assumes that the market is efficient and markets fully reflect the true value of the firm. In this context, the goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions. 3. The financial markets facilitate the interaction of economic units (households, companies, governments) who require funding and those who have excess cash to invest. The corporate form allows the entity to borrow on its own identity (e.g. a company can borrow funds or issue equity in its own name, not its owners), and the financial markets allow the company to access these markets. If the financial markets are efficient, they can be of other use to companies. For example, share price performance will reflect the performance of the company. Customers and suppliers will see this performance and act accordingly. 4. This is quite a difficult task for students but it is useful in getting them to read through news stories and to familiarise them with financial websites. The expectations of the instructor should not be too great and the question is very useful for a first lecture in a Corporate Finance class. This answer to this question is very much up to the student. Give them websites that they can visit to collect This Document Contains Chapters 1 to 4 data including Google, Yahoo! Finance, Reuters, and FT.Com. As an introductory question, it is an excellent way to get students to practically engage with the material and do their own research. You can even get them to prepare a presentation or do the question in groups. 5. Equity = Total Assets – Total Liabilities = €1,403 – €1,253 = €150 million Non-Current Assets = Total Assets – Current Assets = €1,403 - €619 = €784 million Non-Current Liabilities = Total Liabilities – Current Liabilities = €1,253 - €338 = €915 million 6. Step 1: Determine liability/equity ratio: Step 2: To find the current weightings of debt and equity in the new funding, you must actually calculate a new ratio, liability/assets. Step 3: The debt that is raised is thus €178.6 million and equity is €21.4 million. Step 4: Check the new liability/equity ratio. The new level of liabilities is €1,431.62 million and the new level of equity is €171.38 million. The new ratio is: This is the same as the original liability/equity ratio. 7. There are three components to this transaction: a. Cash outflow of £100 million will appear in cash flow statement. Current assets (cash) will fall by £100 million. b. We now owe £3.4 billion. Given that it must be paid in 3 months, the amount will show up as an increase in current liabilities of £3.4 billion. c. Non-current assets will increase by £3.5 billion. 8. The payment of £1,200,000 in twelve months is less because the cash flow is after the majority of £100,000 monthly payments. An example can show the intuition behind this. Assume the monthly interest rate is 1 percent (it can be anything as long as it is above 0 percent). The present value of cash flows is thus: 1253 8.35 150 liability equity = = 1253 0.8930 1403 liability Assets = = 1,342.31 8.35 160.69 liability equity = = Annuity PV(CF) One Payment PV(CF) 1 100000 99009.9 2 100000 98029.6 3 100000 97059.01 4 100000 96098.03 5 100000 95146.57 6 100000 94204.52 7 100000 93271.81 8 100000 92348.32 9 100000 91433.98 10 100000 90528.7 11 100000 89632.37 12 100000 88744.92 1200000 1064939.07 PV 1125508 PV 1064939.07 9. You would choose the less risky project because both have the same expected value. In this case you would choose Project B, because the risk of losing and gaining money is less than in Project A. 10. Their goals are consistent with the goals of financial management as long they don’t interfere with the maximisation of firm value. In fact, if investors value this type of behaviour in corporations, they may even pay a premium for it. 11. As the answer to question 6 suggests, the main reason firms choose different forms of financing relates to their cost. The financial manager should choose the funding flow that is cheapest and less risky. When firms are small, they are not able to list on stock exchanges and therefore they will only have access to private investment, be it a bank or a private investor. As they get bigger, stock exchanges become a viable option for funding and hence it can also be used. 12. Cash is a double-edged sword. Whereas a firm needs a minimum level cash to pay for bills, expenses, creditors, etc., having too much cash could tell investors that the firm is not investing in profitable new projects. Some questions will be asked of the management: a) why are you not investing the money? B) Why are you not give the cash back to shareholders? C) are you wasting the cash in activities that are not value-maximising? Many companies that have lots of cash are targeted by other firms because there is a concern that the management of the cash-rich firm is not creating value. As a financial manager, you must have a very strong plan for why you are keeping cash and for what it is going to be used. 13. As a financial manager, the need to balance between the short and long term objectives of the firm is important. When the company is in trouble, the financial manager should manage financial planning to enhance short term liquidity to meet the firm’s obligations. Therefore, in this case the objective of the firm will change from maximising shareholders’ wealth to firm survival and bankruptcy avoidance. However, other options such as asset sell-off can also be undertaken in order to pay creditors. This is consistent with maximising firm value over the longer term if the manager can ensure that the firm survives. 14. The primary goal of the financial manager is to increase shareholder value. However, the firm can have many constraints that it operates within. For example, if the major shareholder wishes the company to avoid investing in weapons, then the company will maximise shareholder wealth conditional on avoiding weapons investments. The underlying principle remains the same. 15. The main financial goal of any company must be to increase shareholder value, not profit. Profit is an accounting measure that reflects a notional level of business performance in the past. It includes non-cash allowances to account for depreciation in value of many large assets such as property, machinery, automobiles, etc. It also includes allowances for bills that have been received but not paid yet. Finally, it records sales as at the point of sale even though no cash has changed hands. Although accounting data is exceptionally important, for making financial decisions it should be secondary to cash flow information. 16. The objective of the firm will remain the same, which is to maximise the market value of existing owners’ equity. Principally, the goal does not change whether the company is private or public since good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. 17. The manager can argue on the basis of cost implications, since redundancy packages may be expensive. In addition, there could also be lawsuits, union activity all having a negative effect on firm image. Furthermore, redundancies may adversely affect the production process which will not only affect the firm’s sales but also its loyal customers. Instead the new owners can identify other cost centres where cost savings can be made. 18. a. Adding cost of living to retired employees will increase the cost to the company of the pension liability. This would reduce profitability and earnings per share. However, the cost of living adjustment may ensure that the workers value the company more and in turn become more productive. b. As long as the return on the additional investment is greater than the return that the company currently makes on its operations, the decision is a good one. c. Research and development investment is important in any new project. However, these expenditures tend to be high at the beginning and it is not certain whether the firm will reap any benefits from the investment. Research has shown that countries with high levels of technological innovation are likely to experience higher economic growth and so in general the benefits from R&D will be positive. The specificity of the R&D investment is also important. d. Redundancies will reduce costs although their negative impact can be many-fold. For example, the company may have to deal with unions, strikes, and exceptionally poor publicity. 19. Dealers market are those markets where firms make continuous quotations of prices for which they stand ready to buy and sell money market instruments on their own inventory and at their own risk. Agency markets are those in which stockbrokers act as agents for customers in buying or selling shares on most stock exchanges; an agent does not actually acquire the securities. A well-functioning financial system will utilise both systems. 20. A cut in costs will increase profit in the statement of earnings/income. This is because expenses will decrease. The additional profit would appear in the statement of financial position or balance sheet as an increase in equity or retained earnings. 21. Google decided to issue two classes of shares with different voting rights. The founders assigned to themselves the shares that gave them more rights so that they effectively control the company. 22. We go into Financial Statement Analysis in a lot more detail in Chapter 3. In this question, we will look at the statements of ABB Ltd in a very basic way. The main insight is that the firm has accumulated a lot of assets in relation to its liabilities. There is also a significant increase in current liabilities in relation to long-term liabilities. However, the level of current assets has increased at the same level. Investigation would be required to determine what is actually driving the increase in current liabilities. 2010 2009 2008 2007 2006 Current Assets 18,327 18,241 17,523 16,734 12,692 Non-Current Assets 7,915 6,868 6,344 5,680 5,485 Total Assets 26,241 25,108 23,867 22,414 18,178 Current Liabilities 12,102 10,541 11,499 10,468 9,027 Non-Current Liabilities 3,378 4,598 4,301 4,023 4,786 Total Liabilities 15,479 15,138 15,800 14,492 13,812 Total Equity 10,762 9,970 8,067 7,922 4,365 Total Liabilities plus Equity 26,241 25,108 23,867 22,414 18,178 Total Assets/Total Liabilities 1.695265 1.658607 1.51057 1.546646 1.316102 Total Current Assets/Total Non-Current Assets 2.315477 2.655941 2.762137 2.946127 2.313947 Total Current Liabilities/Total Non-Current Liabilities 3.582593 2.292518 2.673564 2.602038 1.886126 Total Current Assets/Total Current Liabilities 1.514378 1.730481 1.523872 1.598586 1.406004 23. The net investment is Sfr500 million and this could be funded by an issue of equity or debt. 24. Several things could happen to ABB’s statement of financial position and is determined by how we treat the Sfr500 million payment. In the first instance (2011), total non-current assets and non-current liabilities will increase by Sfr500 million. In 2013, the Sfr500 million will be paid off meaning that non-current liabilities will decrease by Sfr500 million as will current assets. The statement of financial position looks like this for 2009 and 2011: 2011 2013 Current Assets 18,327 17,827 Non-Current Assets 8,415 8,415 Total Assets 26,742 26,242 Current Liabilities 12,602 12,602 Non-Current Liabilities 3,378 2,878 Total Liabilities 15,980 15,480 Total Equity 10,762 10,762 Total Liabilities plus Equity 26,742 26,242 25. An analysis of ABB debt/equity ratios show that they have been decreasing year on year from 1.10 (2006) to 0.31 in 2010. Assume that the desired debt/equity ratio is 0.31. This would mean that 0.31 or Sfr157 million of the Sfr500 million investment would be funded by debt and Sfr343 million would be funded by equity. In this situation the statement of financial position would be: 2011 Current Assets 18,327 Non-Current Assets 8,415 Total Assets 26,742 Current Liabilities 12,102 Non-Current Liabilities 3,535 Total Liabilities 15,637 Total Equity 11,105 Total Liabilities plus Equity 26,742 26. Yes. The main theme of UK and Germany regulation is similar which is on addressing investor protection and protection of quality of the information that market participants receive. The later will ensure that investors are informed before making decisions and enhance confidence which is crucial element for any well- functioning financial market. 27. The balance sheet model of Merck for 2010 and 2011 is given below: 2010 Assets €million Liabilities €million Current Assets 5664.20 Current Liabilities 3,359.60 Non-Current Assets 16,723.80 Non-Current Liabilities 8,656.60 Shareholder Equity 10,371.80 Total Assets 22,388.00 22,388.00 Net Working Capital 2,304.60 2011 Assets €million Liabilities €million Current Assets 6397.2 Current Liabilities 4,362.20 Non-Current Assets 15,722.90 Non-Current Liabilities 7,264.50 Shareholder Equity 10,493.40 Total Assets 22,120.10 22,120.10 Net Working Capital 2,035.00 The company has stayed rather stable between the two years. Total assets are similar. However, a closer look shows that there has been a shift from non-current assets and liabilities to shorter term current assets and liabilities. Current liabilities have increased by more than current assets and so net working capital has fallen. 28. Students should be encouraged to explore potential scenarios and solutions. There are, of course, many solutions to the YPF problem and no single solution dominates all others. The purpose of this question is to get students to put themselves in the shoes of a financial manager to understand that corporate finance is not mechanistic but inherently risky. 29. There is no one correct way to structure a stock exchange system and the exact structure is endogenously determined by the participants and liquidity of the exchange. The London Stock Exchange attempts to cover all bases by capturing the liquidity provided by dealers for small illiquid companies and the liquidity provided by public traders on the electronic order book for large high volume companies. 30. This is another question that gets students to undertake their own research. Instructors should give every encouragement to creative choices of companies. Chapter 2 Corporate Governance 1. A sole proprietorship is a business owned by one person, a partnership is a business with shareholder-managers called partners. Most partners will have unlimited liability although some partners will have limited liability. A corporation is a business with limited liability shareholders who do not normally manage the firm. The weaknesses and strengths of each business form are as follows: Corporation Partnership Liquidity and marketability Shares can be exchanged without termination of the corporation. Shares can be listed on a stock exchange. Shares are subject to substantial restrictions on transferability. There is usually no established trading market for partnership shares. Voting rights In single-tier board structures, usually each share of equity entitles the holder to one vote per share on matters requiring a vote and on the election of the directors. Directors determine top management. Some voting rights by limited partners. However, general partners have exclusive control and management of operations. Taxation Corporations may have double taxation: Corporate income is taxable, and dividends to shareholders are also taxable. Each country has its own approach to how it deals with double taxation and may give a full or partial rebate on the corporate tax payment. Partnerships are not taxable. Partners pay personal taxes on partnership profits. Reinvestment and dividend payout Corporations have broad latitude on dividend payout decisions. Partnerships are generally prohibited from reinvesting partnership profits. All profits are distributed to partners. Liability Shareholders are not personally liable for obligations of the corporation. Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability. Continuity of existence Corporations may have a perpetual life. Partnerships have limited life. Sole proprietorships have roughly the same weaknesses and strengths as partnerships primarily because shareholders are normally managers and have unlimited liability. 2. Clearly the bidder thinks that the £35 is money well spent and that your firm has untapped value that the market does not appreciate. Managers have many agendas, including job safety. However, it is also possible that they do not believe that the bidding company will be good for the company over the longer term. 3. As firms become more complex, the agreements between shareholders and operational considerations necessarily become more complex and problematic. Clearly, since a sole proprietorship has only one owner, there is no need for an agreement between shareholders. The big difference between partnerships and corporations is the separation of ownership and control. Since partners also tend to manage a partnership, there are less governance problems to deal with. This is not the case in corporations. 4. The ability of corporate executives to trade the shares of their own company impinges upon several principles. Principle 1 is affected because it deals with regulation and the fairness of the governance system. Principle 2 is clearly involved because the trading of shares involves shareholders and their rights. Principle 3 is important because corporate executives who are also shareholders will have more information about the firm than other outside shareholders. Corporate insider trading affects principle 5 because the insider transactions should be promptly disclosed to outside stakeholders. Corporate executives are on the board of directors and this is covered under principle 6. 5. The Corporate Governance document will change every year, so the instructor should go through the document and show what, if any principle, is not covered. 6. A limited company can either be public or private. The main similarities are: • investor liability is limited to the amount of money he or she has invested. • a company is a separate legal person/entity • shares can be transferred without affecting the existence of the company • main goal is to create value to the equity owners The differences between private and public companies are; • Public corporations are permitted to offer shares for sale or advertise to the public. • Public corporations require minimum share capital to be issued and allotted in order to carry out business • Public corporations are subject to rigorous regulatory requirements • In private companies directors are more likely to be major shareholders. A good example of a private corporation is a family firm. In public firms, directors are less likely to be major shareholders. • In public corporations, the shareholders and managers are likely to be two distinct groups. That is, there will be some separation of ownership of the firm and control of the firm. In private corporations, this is significantly less likely to be the case. Public listing is not necessarily an optimal situation for a firm to be in. The costs of listing on an exchange are potentially higher than other forms of financing. In addition, many emerging market countries do not have enough public investment capital to fund lots of publicly listed firms. This is borne out by the small number of public companies that are listed in emerging markets. 7. Corporate behaviour in bank-based financial systems would be different from market-based financial systems because of the nature of financing between the two financial systems. In a bank based financial system, companies will strive to meet the requirements set out by their chief financiers, which are banks. Banks, as a major source of funding, will influence corporate risk taking behaviour and encourage longer investment horizons. On the other hand, corporations in market based environment must satisfy the needs of the investing public, who naturally focus on share price performance. 8. Corporate governance is important to the shareholders of a firm because of different interests between shareholders and management in principal-agent relationship. Corporate governance aligns the interest of these parties, and other groups/ stakeholders. Corporate governance is not a one-shoe-fits-all concept. Firms have different corporate governance requirements based on their sizes, forms, cultures, and complexities. Imposing the same governance structures on all firms would hinder growth and the risk-taking opportunities that determine the return to the shareholders. 9. In a sole proprietorship there is no real need for formal governance structures since all business activities are concentrated on one individual. That is, the stakeholders, the shareholders, and the managers are all one individual. In a partnership semi- formal corporate governance structures are present, such as a Partnership Agreement or Partnership Deed. These are designed to ensure that each partner carries out his or her duties as expected. A limited corporation is a separate legal entity that is different from a sole proprietorship and partnership. Corporate governance structures are required. 10. While a corporation’s goal remains the same (maximization of share value), different institutional, economic, legal, financial, and cultural characteristics means that the corporate governance environment will vary across countries. Similarly, corporate governance codes for emerging market firms should consider the real issues in each country such as poor quality of law enforcement and limited ability to obtain independent directors. Thus, corporate governance structures that are borrowed from developed markets such as the US, UK, Japan, Germany and others must be adjusted in a manner that suits the environment in emerging markets. 11. Supervisory boards, like the Sharia board, can be of use when the objectives of a firm are tied to social, environmental or ethical issues. The purpose of such a board is to guide executives in making the correct decisions with respect to the company’s remit. An example of a supervisory board that may work in a separate area is that of football teams. In this situation, the supervisory board would consist of fan representatives and they would guide the executive board on football decisions. Other areas include firms where public oversight is required, such as the banking sector. 12. In a general partnership all partners agree to provide some fraction of the work and cash and to share the profits and losses. Each partner is liable for all of the debts of the partnership. A partnership agreement specifies the nature of the arrangement. Limited partnerships permit some of the partners to have limited liability and who are legally liable only to the amount of cash each has contributed to the partnership. Limited partnerships usually require that (1) at least one partner be a general partner and (2) the limited partners do not participate in managing the business. Firms choose to be partnerships instead of limited liability corporations because it is inexpensive and easy to set up a partnership rather setting up a limited liability corporation. 13. Although a sole proprietorship is the cheapest to set up, it has disadvantages such as a limited ability to raise funds, a limited life, and unlimited liability. The sole proprietor may reduce these problems by forming a partnership. Other partners are expected to bring in extra cash to finance business activities, and the scope of the firm can be widened. However, a partnership does not resolve all the problems such as transferability of ownership, unlimited liability and the ability to raise money from the public. In order to remove these hurdles a partnership may convert to a limited corporation. 14. All the governance principles are important. However, clearly your role in a company would make you feel one principle is more important than any other. For example, if you are a minority shareholder, Principle 3 (2004 OECD Principles of Corporate Governance) would be important. If you are an international investor, then Principle I (2004 OECD Principles of Corporate Governance) would be more important. 15. Yes, it is possible to improve one governance principle and weaken another. For example, Principle II (2004 OECD Principles of Corporate Governance) encourages firms to ensure that the rights of shareholders are maintained and promoted. However, that may weaken the rights of other stakeholders (Principle IV-2004 OECD Principles of Corporate Governance) such as employees and communities. Many examples can be given here and lecturers should encourage students to come up with their own solutions. 16. Corporate governance is the trust entrusted into those running the corporation whether directly or indirectly that they will treat all stakeholders fairly. This is an extremely important function in business as if not properly followed the corporate goal to maximize shareholders’ wealth cannot be achieved. Yes, corporate governance reduces conflicting interests that are costly to shareholders and other stakeholders. It also encourages improvement in corporate performance and enterprise within firms. Although Starbucks appears to be serious with corporate governance within the organisation, it does not place the same emphasise on one of its key stakeholders, the farmers from poor countries. The farmers are indeed not receiving a fair return for their contribution to the success of the company. Therefore, a ‘good’ corporate governance system should address other stakeholders’ interests. 17. Students should take most of their answer from section 2.4, which goes into the OECD principles in a lot of detail. They should also be encouraged to develop their own ideas as to the most important principle and come up with their own examples. 18. Students should consider the different principles of corporate governance that are discussed in Section 2.4 and reflect on the main issues pertaining to a poor country. In these environments, governance at the government level is just as (and even more) important as governance in corporations. As such, Principle I is likely to be of most importance in the first instance. 19. The Audit committee is one of the sub-committees of the Board of Directors and will normally report to it. It is responsible for oversight of financial reporting disclosure, regulatory compliance, and risk management. Members of the committee are drawn from members of the company's board of directors. The chairperson of the committee is also elected from among the members. a. The duties of an audit committee include: b. Oversee and promote risk management c. Ensure appropriate audit work is undertaken and of high quality d. Review internal and external audit reports e. Review corporate governance statements f. Report to the governing body. Students are expected to come up with their own examples of flawed audit processes. Recent years have provided many good examples! 20. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. 21. We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of equity in the United Kingdom and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.K. corporations and a more efficient market for corporate control. 22. Governments have different objectives to shareholders. Whereas shareholders wish to maximise the value of their own investment, governments are more concerned with maximising social welfare. This can sometimes contradict that of shareholders. For example, several governments purchased the shares of financially stricken banks in 2008. Shortly afterwards, they put pressure on the banks to lend to smaller companies and give mortgages, even though the banks themselves felt that the lending decisions were not value maximising. 23. A stakeholder is any party which has an interest in the operations of the company, either directly or indirectly. Examples include shareholders, employees, creditors, customers, suppliers, normal citizens, etc. In a two tier board system, the board structure is divided into two parts consisting of the supervisory and executive board. The supervisory board is composed of outside shareholders and other stakeholders, such as employee groups (trade unions) and banks (capital providers). A good example of a supervisory board is DaimlerChrysler AG, which was comprised of 20 members - half of which were elected by shareholders at the Annual Meeting. The other half comprises members elected by the company’s employees who work in Germany (Annual report, 2008). The supervisory board can hire or fire any member of the executive board. The latter is composed of executive directors who direct the day to day operations of the firm. In a unitary board, the executive and non-executive directors sit on the same board and it is very rare for stakeholders such as employees to be represented. 24. Institutional shareholders are increasingly becoming instrumental in demanding good corporate governance in companies in which they invest, (e.g. NAPF in UK and CalPERS in US). The main reason why institutions are important in corporate governance is because they are normally the largest shareholders in the firm. As representatives of their investee base, they should take the role of owners in monitoring firms. With respect to country specific regulations, the student should review their own countries corporate governance code and take a view on the effectiveness of the code. 25. In agency theory, the underlying contract between the principal (shareholders) and agent (management) is based in maximising the principal’s wealth. One aspect of corporate governance is to align the interests of managers and shareholders. Given that bondholders’ interests may not be fully convergent with shareholder interests, bondholders protect their interests through bond indentures that restrict the activities of management. We would expect managers to pursue the objectives of shareholders only if their interests are the same as that of the shareholders. This can be done through appropriate executive compensation contracts. In most situations, the shareholder and bondholder objectives will be the same. However, when a firm is in financial distress, these may differ and then shareholder objectives will naturally take precedence. This is why we have bond indentures. 26. The student would be expected to carry out this research themselves. 27. The board is a supreme body that represents shareholders’ interest within the company. It sets strategies and the direction of the company. An effective board is more likely to influence major decisions which enhance shareholders value. In evaluating board performance, the following issues should be taken into account; board attendance, independence of board members, contribution of each member, ability of members to work as a team etc. Boards provide long term strategic direction of the company which can influence its long term well being. Hiring an independent and objective consultant can give confidence to the shareholders that the board is performing efficiently and making the right decisions. 28. As managers build up their shareholdings, they become more like equity holders. This effect will grow in strength as managers’ shareholdings get larger. At moderate levels of shareholdings, managers will have a significant stake in the company but can also make more money or power out of extracting wealth from the company through the purchase of executive jets, company cars, excessive administrative support and other wealth destroying behaviour. When this happens, we say that managers are entrenched. Examples are in abundance for managerial entrenchment in corporations and it is up to the student to find these in their own research activities. 29. How much is too much? Who is worth more, Cristiano Ronaldo or Lionel Messi? The simplest answer is that there is a market for executives just as there is for all types of labour. Executive compensation is the price that clears the market. The same is true for athletes and performers. 30. State shareholders have different objectives to private companies. Whereas private firms have an overriding objective to earn profits for their shareholders, the government tends to have political objectives such as maximizing social welfare. These can conflict when the government wishes to develop infrastructure that is not necessarily consistent with maximizing shareholder value. In the YPF case, the Argentinian government surprised the shareholders by nationalizing the firm suddenly. Only time will tell how this affects the shareholders of the firm. Chapter 3 Financial Statement Analysis and Long Term Planning 1. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 2. Market values can never be negative. Imagine a share of equity selling for –£20. This would mean that if you placed an order for 100 shares, you would get the shares along with a cheque for £2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 3. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. 4. Time trend analysis gives a picture of changes in the company’s financial situation over time. Comparing a firm to itself over time allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities have changed. Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. Both allow an investigation into what is different about a company from a financial perspective, but neither method gives an indication of whether the difference is positive or negative. For example, suppose a company’s current ratio is increasing over time. It could mean that the company had been facing liquidity problems in the past and is rectifying those problems, or it could mean the company has become less efficient in managing its current accounts. Similar arguments could be made for a peer group comparison. A company with a current ratio lower than its peers could be more efficient at managing its current accounts, or it could be facing liquidity problems. Neither analysis method tells us whether a ratio is good or bad, both simply show that something is different, and tells us where to look. 5. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 6. ROE is a better measure of the company’s performance. ROE shows the percentage return for the year earned on shareholder investment. Since the goal of a company is to maximize shareholder wealth, this ratio shows the company’s performance in achieving this goal over the period. 7. Building Statement of Financial Position BAE Systems plc Statement of Financial Position 01-Jun-11 Assets Liabilities & Owners' Equity £ in billion £ in billion Current assets 6.642 Current liabilities 11.283 Non-current assets 16.521 Non-current liabilities 6.589 Owners' equity x 23.163 23.163 Owners' equity £5.291 billion £ in billion Current assets 6.642 Current liabilities 11.283 Net working capital -4.641 8. Legal & General plc Income Statement 31-Dec-10 £ in million Sales 38,440 Total operating costs -37,133 Gross Profit 1,307 Tax -487 Net Income 820 Legal & General plc Statement of Retained Earnings 31-Dec-10 £ in million Net income 820 Dividend -238 Addition to retained earnings 582 9. P/E = 6.35; Share Price = Skr71.70; EPS = 71.70/6.35 = Skr11.29 10. Market Values and Book Values Statement of Financial Position Before Sale After Sale Non-Current Assets 4 0.8 Net Working Capital 0.9 4.1 Total Assets 4.9 4.9 Non-current liabilities 2.2 2.2 Equity 2.7 2.7 4.9 4.9 If the firm is following IFRS, the accounting value of the building should be the same as the market value. This is because buildings should be revalued on an annual basis. 11. Calculating taxes Ferrera NV, Dutch firm Marginal tax rate Taxable income 0.20 0.235 0.255 273,000 25,000 35,000 213,000 5,000 8,225 54,315 Total tax 67,540 Company’s average tax rate = Total tax amount/taxable income = (67,540.00/273,000.00)x100 = 24.74% If Herrera NV made an additional euro, the tax on that euro would be 25.5 cents, so marginal tax rate is 25.5%. 12. Net Cash Flow Statement of Cash Flow £million £million Net Revenues 6,065 Net Non-Cash Expenses 2,380 Cash Flow From Operating Activities 8,445 Cash Flow From Investing Activities -3,270 Dividends -1,380 Interest -3,410 Cash Flow From Financing Activities -4,790 Net Cash Flow 385 13. Calculating net capital spending Net capital spending = NCAend – NCAbeg + Depreciation 14. The long-term debt account will increase by €16 million, the amount of the new long-term debt issue. Since the company sold 20 million new shares of equity with a €1 par value, Ordinary Share account will increase by €20 million. The capital surplus account will increase by €32 million, the value of the new shares sold above its par value. Since the company had a net income of €14 million, and paid €8 million in dividends, the addition to retained earnings was €6 million, which will increase the accumulated retained earnings Morena's Driving School Year £ million Non-current assets 2011 4.2 Non-current assets 2012 4.7 Net non-current assets 0.5 Add: Depreciation 0.925 Net capital spending 1.425 account. So, the new long-term debt and shareholders’ equity portion of the balance sheet will be: Last Year Changes Current Year Long-term debt 60,000,000 16,000,000 76,000,000 Preference shares 18,000,000 18,000,000 Ordinary shares (€1 par value) 25,000,000 20,000,000 45,000,000 Capital surplus 49,000,000 32,000,000 81,000,000 Accumulated retained earnings 89,000,000 6,000,000 95,000,000 241,000,000 315,000,000 15. This question requires that students undertake their own study. Given that the year of available accounts for Experian and First Group will change as the book ages, we have not provided a solution for this question. This is because the solution will change depending on the financial year of accounts the student is able to source. The equation that students should use is given below: 16. Since we have the ratio, D/TA, it is easy to calculate the ratio, E/TA (= 1 – D/TA). Since ROA is Net Income/TA, we calculate ROE as ROA/(E/TA) A B D/TA 0.7 0.3 ROA 0.2 0.3 E/TA 0.3 0.7 Return on Equity 0.666666667 0.428571429 Firm A has the biggest Return on Equity 17. Ratios and foreign companies Net Loss = £2,305 million Revenues= £14,437 million Profit margin = Net income/ sales Net income Sales Assets ROE = × × Sales Assets Total equity Return on assets = Profit margin × Total asset turnover × Equity multiplier =-£2,305/£14,437 = -15.97% Therefore, profit margin of Lloyds Banking Group is -15.97% The quotation in euros does not make any difference to a British investor. This is because if euros are converted (translated) into pounds at the prevailing exchange rate, the profit margin ratio remains the same. Calculation of exchange rate £/€ = £14,437/€16,603 = £0.86954/€ -£2,305/£0.86954/€= -€2,650.82 Net Loss is equal to -€2,650.82 million 18. The Cash Coverage Ratio is (EBIT + Depreciation)/Interest £million Revenues 1,027 Costs 817 EBIT 210 Depreciation 12 EBIT+Depreciation 222 Interest Expense £29 Cash Coverage Ratio 7.66 19. Days’ Sales in Receivable This is a multi-step problem involving several ratios. It is often easier to look backward to determine where to start. We need receivables turnover to find days’ sales in receivables. To calculate receivables turnover, we need credit sales, and to find credit sales, we need total sales. Since we are given the profit margin and net income, we can use these to calculate total sales as: PM = 0.086 = NI / Sales = €173,000 / Sales; Sales = €2,011,628 Credit sales are 75 percent of total sales, so: Credit sales = €2,011,628(0.75) = €1,508,721 Now we can find receivables turnover by: Receivables turnover = Sales / Accounts receivable = €1,508,721 / €143,200 = 10.54 times Days’ sales in receivables = 365 days / Receivables turnover = 365 / 10.54 = 34.63 days 20. Ratios and Fixed Assets The solution to this problem requires a number of steps. First, remember that CA + NCA = TA. So, if we find the CA and the TA, we can solve for NCA. Using the numbers given for the current ratio and the current liabilities, we solve for CA: CR = CA / CL CA = CR(CL) = 1.20(€€850) = €1,020 To find the total assets, we must first find the total debt and equity from the information given. So, we find the net income using the profit margin: PM = NI / Sales NI = Profit margin × Sales = .095(€4,310) = €409.45 We now use the net income figure as an input into ROE to find the total equity: ROE = NI / TE TE = NI / ROE = €409.45 / .215 = €1,904.419 Next, we need to find the long-term debt. The long-term debt ratio is: Long-term debt to total assets = 0.70 = LTD / (LTD + CL+TE) Inverting both sides gives: 1 / 0.70 = (LTD + CL+TE) / LTD = 1 + (TE / LTD)+(CL /LTD) Substituting the total equity and CL into the equation and solving for long-term debt gives the following: 1 + (€1,904. 419 / LTD) +(€850/LTD) = 1.429 LTD = (€1,904. 419 + €850) / .429 = €6,426.977 Now, we can find the total debt of the company: TD = CL + LTD = €850 + €6,426.977 = €7,276.977 And, with the total debt, we can find the TD and TE, which is equal to TA: TA = TD + TE = €7,276.977 + €1,904.42 = €9,181.395 And finally, we are ready to find NCA using the following equation: NCA = TA – CA = €9,181.395 – €1,020 = €8,161.395 21. Calculating the cash coverage ratio This problem requires you to work backward through the income statement. First, recognize that Net income = (1 – tC)EBT. Plugging in the numbers given and solving for EBT, we get: EBT = €7,850 / (1-0.3725) = €12,509.96 Now, we can add interest to EBT to get EBIT as follows: EBIT = EBT + Interest paid = €12,509.96 + 2,108 = €14,617.96 To get EBITD (earnings before interest, taxes, and depreciation), the numerator in the cash coverage ratio, add depreciation to EBIT: EBITD = EBIT + Depreciation = €14,617.96 + 1,687 = €16,304.96 Now, simply plug the numbers into the cash coverage ratio and calculate: Cash coverage ratio = EBITD / Interest = €16,304.96 / €2,108 = 7.73 times 22. Cost of goods sold The only ratio given which includes cost of goods sold is the inventory turnover ratio, so it is the last ratio used. Since current liabilities are given, we start with the current ratio: Current ratio = 3.3 = CA / CL = CA / £340,000 CA = £1,122,000 Using the quick ratio, we solve for inventory: Quick ratio = 1.8 = (CA – Inventory) / CL = (£1,122,000 – Inventory) / £340,000 Inventory = CA – (Quick ratio × CL) Inventory = £1,122,000 – (1.8 × £340,000) Inventory = £510,000 Inventory turnover = 4.2 = COGS / Inventory = COGS / £510,000 COGS = £2,142,000 23. Financial Ratios Short-Term Solvency or Liquidity Measures Current Ratio Current Assets 43,242 1.02 times Current Liabilities 42,451 Quick ratio Current Assets - Inventory 28,733 0.68 times Current Liabilities 42,451 Cash ratio Cash 6,893 0.16 times Current Liabilities 42,451 Long-Term Solvency Total debt ratio Total Assets -Total Equity 94,463 - 27,380 0.71 times Total Assets 94,463 Debt-Equity ratio Total debt 67,083 2.45 times Total equity 27,380 Equity Multiplier Total Assets 94,463 3.45 times Total Equity 27,380 Asset Management or Turnover Measures Inventory Turnover Cost of Goods 56,284 3.88 times Inventory 14,509 Days Sales in Inventory 365 365 94.09 days Inventory Turnover 3.88 Receivable Turnover Sales 77,327 4.90 times Account Receivable 15,785 Days' Sales in Receivables 365 days 365 days 74.51 days Receivable Turnover 4.90 Total asset turnover Sales 77,327 0.82 times Total Assets 94,463 Capital Intensity Total Assets 94,463 1.22 times Sales 77,327 Profitability Measures Profit Margin Net profit 5,886 7.61% Sales 77,327 Return on Asset Net Income 5,886 6.23% Total Assets 94,463 Return on Equity Net Income 5,886 21.5% Total Equity 27,380 24. Financial Statement Analysis The main weakness of the financial statement analysis is that you have nothing to compare the ratios to. One could consider past ratios for the same company. Alternatively, a peer group analysis could be carried out. 25. This question is for more advanced readers. Students may take either side of the argument and course leaders should encourage one half of the class to argue against the statement and the other half to argue for the statement. 26. This question is similar to Question 25 in that students are expected to take the material in the book and extend it beyond the scope of this chapter. The exercise gets the student to think on ratios as measures to suit a purpose rather than being theoretically set in stone. The remaining questions in this chapter draw from the financial statements of William Hill, the bookmakers. This company is an interesting one because they deal only in cash, with almost no inventory. Course facilitators may decide to choose another, more relevant firm, for students to carry out their financial analysis using the same structure as for questions 27-37. In the answers below, only one year is chosen for the ratio analysis. Students should use their own initiative in their interpretation of the financial results. 27. Earnings per Share is Net Income/Number of Shares: 2010 2009 2008 2007 Profit (Loss) after Tax 201 170 141 183 Number of Shares 14.686 14.686 14.686 14.686 Earnings per Share 13.69 11.58 9.60 12.46 28. The Effective Tax Rate is Taxation/Net Income 2010 2009 2008 2007 Profit (Loss) after Tax 201 170 141 183 Taxation -53 -46 -49 -18 Effective Tax Rate 26.37% 27.06% 34.75% 9.84% 29. Net Working Capital is: 2010 2009 2008 2007 Current Assets 711 97 72 61 Current Liabilities -2,035 -1,413 -1,376 -1,374 Net Working Capital -1,324 -1,316 -1,304 -1,313 30. Total Assets for each year are as follows: (£millions) 2010 2009 2008 2007 Total Assets 2,228 1,617 1,593 1,599 Divide each item in the balance sheet by these amounts. The common size statement is thus: Fixed Assets (£millions) 2010 2009 2008 2007 Tangible Assets 7.36% 10.33% 11.30% 11.76% Land & Buildings 3.19% 4.33% 4.27% 4.13% Freehold Land 3.19% 4.33% 0.00% 0.00% Fixtures & Fittings 3.50% 5.01% 5.84% 6.44% Plant & Vehicles 0.67% 0.93% 1.19% 1.19% Plant 0.67% 0.93% 0.00% 0.00% Intangible Assets 37.34% 51.45% 52.23% 52.03% Investments 23.34% 32.22% 31.95% 32.40% Fixed Assets 68.09% 94.00% 95.48% 96.19% Current Assets Stock & W.I.P. 0.00% 0.00% 0.00% 0.06% Stock 0.00% 0.00% 0.00% 0.06% W.I.P. 0.00% 0.00% 0.00% 0.00% Finished Goods 0.00% 0.00% 0.00% 0.00% Trade Debtors 0.09% 0.25% 0.00% 0.06% Bank & Deposits 2.11% 3.59% 2.70% 2.13% Other Current Assets 29.71% 2.16% 1.76% 1.63% Group Loans (asset) 27.74% 0.00% 0.00% 0.00% Directors Loans (asset) 0.00% 0.00% 0.00% 0.00% Other Debtors 0.54% 0.31% 1.76% 1.63% Prepayments 1.44% 1.86% 0.00% 0.00% Current Assets 31.91% 6.00% 4.52% 3.81% Current Liabilities Trade Creditors -0.31% -0.62% -0.88% -1.13% Short Term Loans & Overdrafts -86.36% -81.94% -79.10% -78.49% Bank Overdrafts 0.00% 0.00% 0.00% 0.00% Group Loans (short t.) -86.31% -81.88% -79.03% -78.49% Director Loans (short t.) 0.00% 0.00% 0.00% 0.00% Hire Purch. & Leas. (short t.) 0.00% -0.06% -0.06% 0.00% Hire Purchase (short t.) 0.00% 0.00% 0.00% 0.00% Leasing (short t.) 0.00% 0.00% -0.06% 0.00% Other Short Term Loans 0.00% 0.00% 0.00% 0.00% Total Other Current Liabilities -4.71% -4.82% -6.40% -6.38% Corporation Tax -1.30% -1.73% -2.26% -1.81% Dividends 0.00% 0.00% 0.00% 0.00% Accruals & Def. Inc. (sh. t.) -1.48% -1.30% -2.57% -2.31% Social Securities & V.A.T. -0.85% -1.11% -1.26% -1.31% Other Current Liabilities -1.12% -0.68% -0.31% -0.94% Current Liabilities -91.34% -87.38% -86.38% -85.93% Net Current Assets (Liab.) -59.43% -81.39% -81.86% -82.11% Net Tangible Assets (Liab.) -28.68% -38.84% -38.61% -37.96% Working Capital -59.43% -81.39% -81.86% -82.11% Total Assets 100.00% 100.00% 100.00% 100.00% Total Assets less Cur. Liab. 8.66% 12.62% 13.62% 14.07% Long Term Liabilities Provisions for Other Liab. -0.54% -0.80% -1.95% -0.88% Deferred Tax -0.54% -0.80% -0.82% -0.75% Other Provisions 0.00% 0.00% -1.19% -0.13% Pension Liabilities -1.03% -1.92% 0.00% 0.00% Long Term Liabilities -1.57% -2.72% -1.95% -0.88% 0.00% 0.00% 0.00% 0.00% Total Assets less Liabilities 7.09% 9.89% 11.68% 13.13% Shareholders Funds Issued Capital 0.04% 0.06% 0.06% 0.06% Ordinary Shares 0.04% 0.06% 0.00% 0.00% Preference Shares 0.00% 0.00% 0.00% 0.00% Other Shares 0.00% 0.00% 0.00% 0.00% Total Reserves 7.05% 9.77% 11.55% 13.07% Share Premium Account 0.13% 0.19% 0.19% 0.19% Profit (Loss) Account 7.14% 10.02% 11.30% 12.82% Other Reserves -0.22% -0.37% 0.06% 0.06% Shareholders Funds 7.09% 9.89% 11.68% 13.13% For the Income Statement, you divide each item by the revenues for the year: Income Statement (£millions) 2010 2009 2008 2007 Turnover 100.00% 100.00% 100.00% 100.00% Cost of Sales -95.63% -95.47% -95.28% -95.41% Gross Profit 4.37% 4.53% 4.72% 4.59% Administration Expenses 0.00% -2.88% -2.77% -7.04% Other Operating Income pre OP -2.59% 0.00% 0.00% 0.00% Exceptional Items pre OP 0.00% -0.10% 0.00% 0.00% Operating Profit 1.78% 1.56% 1.95% -2.46% Other Income 0.07% 0.24% 0.22% 6.82% Total Other Income & Int. Received 0.15% 0.32% 0.22% 6.82% Exceptional Items 0.00% 0.00% -0.12% -0.25% Profit (Loss) before Interest paid 1.94% 1.88% 2.05% 4.11% Interest Received 0.08% 0.07% 0.00% 0.00% Interest Paid -0.19% -0.27% -0.63% -1.29% Other Interest Paid -0.19% -0.27% 0.00% 0.00% Net Interest -0.11% -0.20% -0.63% -1.29% Profit (Loss) before Tax 1.74% 1.60% 1.42% 2.82% Taxation -0.36% -0.34% -0.37% -0.25% Profit (Loss) after Tax 1.38% 1.26% 1.06% 2.57% Dividends -1.44% -1.30% -1.12% -0.28% Retained Profit(Loss) -0.06% -0.04% -0.07% 2.29% Depreciation 0.18% 0.20% 0.22% 0.36% 31. Liquidity Ratios: Short-Term Solvency or Liquidity Measures Current Ratio Current Assets 711 0.35 Current Liabilities 2,035 Quick ratio Current Assets - Inventory 711 0.35 Current Liabilities 2,035 Cash ratio Cash 47 0.02 Current Liabilities 2,035 32. Long Term Solvency Total debt ratio Total Assets -Total Equity 2,070 0.93 Total Assets 2,228 Debt-Equity ratio Total debt 2070.00 13.10126582 Total equity 158 Equity Multiplier Total Assets 2,228 14.10 Total Equity 158 33. Efficiency Ratios Inventory Turnover Cost of Goods 13,932 N/A Inventory 0 Days Sales in Inventory 365 365 N/A Inventory Turnover N/A Receivable Turnover Sales 14,569 7284.50 Account Receivable 2 Days' Sales in Receivables 365 days 365 days 0.05 Receivable Turnover 7284.50 Total asset turnover Sales 14,569 6.54 Total Assets 2,228 Capital Intensity Total Assets 2,228 0.15 Sales 14,569 34. Profitability Ratios Profit Margin Net profit 201 1.38% Sales 14,569 Return on Asset Net Income 201 9.02% Total Assets 2,228 Return on Equity Net Income 201 127.22% Total Equity 158 35. Market to Book Equity: Share Price 2.78 Number of Shares 14,687,856 Market Cap 40,832,239 Total Equity 158,000,000 Market to Book Equity 0.25 36. The Du Pont Identity is: Net Income 1.38% ROE 127.22% Sales Sales 6.54 Assets Assets 14 Equity Sales Net income Assets ROE = × × Sales Assets Total equity 37. Students should be given every encouragement to be creative in their analysis. The purpose of this question is to give the students experience in analysing financial statements. Chapter 4 Discounted Cash Flow Valuation 1. Your friend is not correct because the present day purchasing power of Nkr10,000 received one year from now is less than Nkr10,000 received today. This is because of a concept called the Time Value of Money. 2. There are several ways to answer this question but we will go for the most intuitive. The payment should be more than £55 because you have not given any compensation to the lender who is going without the £220 cash for the next four years. Your loan will also be risky because the lender does not know if you will pay the money back in part or full. As a result, you should pay more than just £55 per year. 3. Assuming positive cash flows and interest rates, the future value increases and the present value decreases. 4. The simplified formulae make simplifying assumptions such as cash flows being made at the exact same point in time every year. These will obviously be unrealistic and therefore the formulae cannot hope to capture every eventuality. For example, a business earns profit throughout the year. However, cash flows are generally assumed to occur at the end of the year, which is unrealistic. 5. The techniques can be used to value firms although care should be taken when doing so. As in any investment analysis, you will have to estimate future cash flows from the company and the risk of the firm. This can be exceptionally difficult, especially for smaller firms with little access to information or price history. Cash flows from a firm come from dividends and changes in share price. In addition, an analyst needs to consider the value and risk of a firm’s debt. 6. FV = PV (1+r)T Given FV = R£104,000 PV = £ 110,000 T= 6 months (1/2 year) r=? Mr. Noel Ms. Biggs £116,000 = £100,000 (1+r)2 1.16 = (1+r)2, 1.077 = 1+r r = 7.7% You should go for Mr. Noel £104,000 = £100,000(1+ r)12 (1+ r)1/2 =1.04 r =1.04 2 =1.0816 -1 = 0.0816 = 8.16% 7. PV = €250; t = 18 years; r = 3.5% The future value is PV(1+r)t = €250(1.035)18 = €464.37 8. PV = €1,000; r = 4%; FV = 3 x PV = €3,000; t = ? Solve for t. 9. FV = PV (1+r)T PV = 330million (1.056)30 PV= £331.54 million 10. To calculate the annual return, first sum the cash flows over the three years. €3,244 + €6,532 + €5,059 = €14,835 The return over the three year project is (€14,835-17,000)/17,000) = -0.127 This means that the annual return is -0.127/3 = -0.0425 = 4.25% 11. FV = PV (1+r)T 13,300,000= 5,000,000 (1+r)5 2.66 = (1+r)5 1.216 = 1+r, therefore r = 21.6% 12. PV of perpetuity = 𝐶 𝑟 = £4 0.03 PV = £133.33 13. FV = PVerT €1,000 = €442.41erT 2.367 = ert, apply natural logarithm both sides 1n2.367 = 1n (erT) PV = FV(1+ r)t 1000 = 3000(1.04)t 1.04t = 0.33333 t ln(1.04) = ln0.33333 t = ln0.33333 / ln(1.04) = 28.01 years £1.7 billion (1.056)30 0.862 = 10r r = 8.62 14. In order to break the player’s contract the purchasing club have to pay: 4 x Player’s annual salary (weekly salary x 52 weeks) x number of years left on the contract a) the player has to pay 10% of the amount the purchasing club must pay, therefore amount paid when: i) 4 years remaining on the contract = 10 % x [4 x €6,240,000 x 4] = €9,984,000 ii) 3 years remaining on the contract = 10 % x [4 x €6,240,000 x 3] = €7,488,000 iii) 2 years remaining on the contract = 10 % x [4 x €6,240,000 x 2] = €4,992,000 iv) 1 year remaining on the contract = 10 % x [4 x €6,240,000 x 1] = €2,496,000 b) i) PV of 4 years remaining on the contract The PV is equivalent to today’s amount that the player would pay, which is €9,984,000 ii) PV of 3 years remaining on the contract PV = = €6,933,333.33 iii) PV of 2 years remaining on the contract PV = = €4,279,835.4 iv) PV of 1 year remaining on the contract PV = = €1,981,405.3 v) PV of 0 years remaining on the contract will be equivalent to zero as he would pay nothing hence leaving for free. This is the time when his contract expires. c) The player’s agent will have to incur the same cost (outflow) as the player if they are to break the contract. However, if successful he will earn €5 million for getting him to sign pre-contract agreement. Therefore his NPV = PV of inflow –PV of Cash outflow i) NPV when 4 years remaining on the contract = €5,000,000 - €9,984,000 €7,488,000 1.08 2 €4,992,000 (1.08) 3 €2,496,000 (1.08) = -€4,984,000 ii) NPV when 3 years remaining on the contract = €5,000,000 - €6,933,333.33 = -€1,933,333 iii) NPV when 2 years remaining on the contract = €5,000,000 - €4,279,835.4 = €720,164.6 iv) NPV when 1 year remaining on the contract =€5,000,000 - €1,981,405.3 = €3,018,594.7 The agent will be better off if he makes the player sign a pre-contract agreement with 2 years and 1 year remaining on the contract. 15. PV = C x ATr The value if the payments occurred for 10 years PV = C x A100.09 = €4000 x 6.42 PV = €25,670.63 The value if the payments occurred for 20 years PV = C x A200.09 = €4000 x 9.1285 PV = €36,514.18 The value if the payments occurred for 50 years PV = C x A500.09 = €4000 x 10.9617 PV = €43,846.73 The value if the payments occurred for forever PV = PV = PV = €44,444.44 16. Interest charged per year = £1,050 (7% of £15,000) Total interest payment over 5 years = £5,250 The regular monthly installment = (£15,000 + £5,250)/60 = £337.5 Solving for APR: £15,000 = £250 + 337.5 (1+APR) 1 12 + 337.5 (1+APR) 2 12 + ⋯ + 337.5 (1+APR) 60 12 APR = 14.085% 1 1 PV (1 ) C r r = − +    T  c r €4,000 0.09 17. PV = C x ATr r= 0.0614/12 = 0.005117 T= 25x12 = 300 PV = C x A3000.005117 =€717 x 153.1602 Mortgage loan= €109,815.89 Purchase Price = Mortgage loan + Deposit (20% of mortgage loan) = €109,815.89 + [€109,815.89 x 20%] = €131,779.07 18. FV = PV (1+r)T a) Compounded annually FV = €1000 (1+0.1)4 FV = €1,464.1 b) Compounded semiannually FV = €1000 (1+0.1/2)4x2 FV = €1,477.46 c) Compounded monthly FV = €1000 (1+0.1/12)4x12 FV = €1,489.354 d) Compounded continuously FV = PVerT FV = €1000e0.1X4 FV = €1,491.82 e) The future value increases when the compounding period is shorter because interest is earned on previously accrued interest. The shorter the compounding period, the more frequently interest is earned, and the greater the future value, assuming the same stated interest rate. 19. Step 1: Find monthly rate of return on share investment: Find monthly rate of return on bond investment: Step 2: Calculate future value in 30 years of share investment T=30 x 12 = 360 C = £500 r = 0.5654% FV=£584,706.30 Calculate future value in 30 years of bond investment T=30 x 12 = 360 C = £500 r = (1+0.07)1/12 −1=0.5654% r = (1+0.04)1/12 −1=0.3274% (1 ) 1 (1 ) 1 FV =  + −  =  + −      r T r T C C r r r (1 ) 1 (1 ) 1 FV =  + −  =  + −      r T r T C C r r r r = 0.3274% FV=£342,654.30 Total Value of investment in 30 years is £584,706.30 + £342,654.30 = £927,360.60 Step 3: Calculate monthly rate on retirement investment Step 4: Calculate monthly payment T = 25 x 12 = 300 months PV = £927,360.60 r = 0.4868% C = £5,885.53 20. i) (1 + r 365 ) (1 + r 365 ) 1.1236 = 1+ r/365 = 1.000319, r = 0.00319 x 365 r= 11.6556% ii) (1 + r 365 ) e0.12 = 1.127497 (1 + r 365 ) = (1.127497)1/365 1+ r/365 = 1.000329, r = 0.00329 x 365 r= 12.002% 21. PV = 𝐶 𝑟−𝑔 , however Oasis Technology receive two years from today therefore PV = 𝐶 𝑟−𝑔 x 1 (1+𝑟) = 200,000 0.1−0.05 x 1 (1+0.1) = €3,636,363.64 22. You will receive £1,000 every two years forever. To find the present value of this payment stream we must calculate the two-year interest rate. This is: (1.08)2 – 1 = 0.1664 = 16.64% Now we discount the £1,000 perpetuity using the two year rate PV = £1,000/.1664 = £6,009.62 r = (1+0.06)1/12 −1=0.4868% 1 1 PV (1 ) = − +   C r r r T  365 0.12 2 1 1 365 2  + r  =  +          365 1 365  + r  =     1 365  + r      (1.1236)1/365 365 1 365  + r  =     1 365  + r      23. The amount borrowed is the value of the restaurant times one minus the down payment, or: Amount borrowed = €500,000(1 – .25) = €375,000 The monthly payments with a balloon payment loan are calculated assuming a longer amortization schedule, in this case, 30 years. The monthly return rate is: r = 1.091/12 – 1 = 0.0072 The payments based on a 30-year repayment schedule would be: PVA = €375,000 = C({1 – [1 / (1 + .0072)]360} / .0072) C = €2,923.06 Now, at time = 8, we need to find the PV of the payments which have not been made. The balloon payment will be: PVA = €2,923.06 ({1 – [1 / (1 + .0072)]22(12)} / .0072) PVA = €344,659.22 24. Here, we need to find the FV of a lump sum, with a changing interest rate. We must do this problem in two parts. After the first six months, the balance will be: FV = £4,000 [1 + (.019/12)]6 = £4,038.15 This is the balance in six months. The FV in another six months will be: FV = £4,038.15 [1 + (.16/12)]6 = £4,372.16 The problem asks for the interest accrued, so, to find the interest, we subtract the beginning balance from the FV. The interest accrued is: Interest = £4,372.16 – £4,000.00 = £372.16 25. Step 1: Determine the total contribution 2% of annual salary = £100,000 x 0.02 = £2,000 Company contribution (£2 for every £1) = 2 x £2000 = £4,000 Total contribution = £6,000 The salary increases by 4% per year the total contribution one year hence = £6,000 x 1.04 = £6,240 Step 2: Determine the PV of Growing Annuity, PV = C x [ 1 r−g − 1 r−g x (1+g 1+r ) T ] PV = £6,240 x = £6,240 X 19.2626 PV = £120,198.735 Step 3: Determine the amount on retirement 40 years from today FV = £120,198(1+0.08)40 = £2,611,260.01 26. €20,000 = 1,900 (1+APR)1/12 1,900 (1+APR)2/12 APR = 27.959% This is the rate that would legally have to be reported 27. 1 1 1 0.04 40 0.08 0.04 0.08 0.04 1 0.08  −  +        − −  +   The cash flows in this problem are semiannual, so we need the effective semiannual rate. The interest rate given is the stated rate, so the monthly interest rate is: Monthly rate = .10 / 12 = .008333 To get the semiannual interest rate, we can use the EAR equation, but instead of using 12 months as the exponent, we will use 6 months. The effective semiannual rate is: Semiannual rate = (1.008333)6 – 1 = 5.11% We can now use this rate to find the PV of the annuity. The PV of the annuity is: PVA @ t = 10: Note, that this is the value one period (six months) before the first payment, so it is the value at t = 10. So, the value at the various times the questions asked for uses this value 10 years from now. PV @ t = 5: £25,289.43 / 1.051110 = £15,363.80 Note, that you can also calculate this present value (as well as the remaining present values) using the number of years. To do this, you need the EAR. The EAR is: The value of the annuity at the other times in the problem is: PV @ t = 3: £25,289 / 1.051114 = £12,587.01 PV @ t = 0: £25,289 / 1.051120 = £9.333.80 28. Step 1: Determine the monthly interest rate 0.12/12 = 0.01 Step 2: Determine the monthly lease payment using PV of annuity due formula, PV = £3,000 £3,000 = C + C x A230.01 £3,000 = C (1+ A230.01) C = £3,000/ (1 + A230.01) C = £3,000/20.46= £146.63 29. Step 1: Calculate the present value of primary schooling, secondary schooling and university tuition the year before the activity starts. a. Primary schooling (7 years) PV = C x A70.045 = £8,000 x A70.045 = £47,141.61 b. Secondary schooling (6 years) PV = C x A60.045 = £9,000 x A60.045 = £46,420.85 c. University (4 years) 1 1 £5, 000 £25, 289.43 0.0511 0.0511(1.05116) 1 1 PV (1 ) C r r r   =  −  =   = − +    T  PV = C x A40.065 = £15,000 x A40.045 = £53,812.89 Step 2: Calculate the present value of primary schooling, secondary schooling and university tuition a. Primary schooling PV = £47,141.61/ (1.045)4 = £39,531.13 b. Secondary schooling PV = £46,420.85/ (1.045)11 = £28,604.47 c. University PV = £53,812.89/ (1.045)17 = £25,462.99 Present Value of all payments = £39,531.13 + £28,604.47 + £25,462.99 = £93,598.59 Since you already have £3,000 invested, the amount you need to invest is £93,598.59 - £3,000 = £90,598.59 Step 3: Calculate annual deposits 30. Since she put £1,000 down, the amount borrowed will be: Amount borrowed = £15,000 – £1,000 = £14,000 So, the monthly payments will be: PVA = C({1 – [1/(1 + r)]t } / r ) £14,000 = C[{1 – [1/(1 + .096/12)]60 } / (.096/12)] C = £294.71 The amount remaining on the loan is the present value of the remaining payments. Since the first payment was made on October 1, 2012, and she made a payment on October 1, 2014, there are 35 payments remaining, with the first payment due immediately. So, we can find the present value of the remaining 34 payments after November 1, 2014, and add the payment made on this date. So the remaining principal owed on the loan is: PV = C({1 – [1/(1 + r)]t } / r ) + C0 PV = £294.71[{1 – [1/(1 + .096/12)]34 } / (.096/12)] + £294.71 C = £9,037.33 She must also pay a one percent prepayment penalty, so the total amount of the payment is: Total payment = Amount due(1 + Prepayment penalty) Total payment = £9,037.33(1 + .01) Total payment = £9,127.71 31. Here, we have cash flows that would have occurred in the past and cash flows that would occur in the future. We need to bring both cash flows to today. Before we calculate the value of the cash flows today, we must adjust the interest rate, so we have the effective monthly interest rate. r = (1 + 0.04)(1/12) – 1 = .327% We must now discount the monthly payments relating to €25,000 to: t -2. Monthly payments are €25,000/12 = €2,083.33 This should be compounded forward two years to: t = 0. PV @ t=0: €24,476.64(1.04)2 = €26,473.93 We must do the same for the salary of €28,000 in year: t -1. Monthly payments are €28,000/12 = €2,333.33 This should be compounded forward one year to t = 0. PV @ t=0: €27,413.83(1.04) = €28,510.38 Calculate the present value of the €28,000 salary for five years. Monthly payments are €28,000/12 = €2,333.33 The total settlement figure is €26,473.93 + €28,510.38 + €126,934.08 + €120,000 = €301,918.39 The plaintiff would prefer a lower interest rate. In this problem, we are calculating both the PV and FV of annuities. A lower interest rate will decrease the FVA, but increase the PVA. So, by a lower interest rate, we are lowering the value of the back pay. But, we are also increasing the PV of the future salary. Since the future salary is larger and has a longer time, this is the more important cash flow to the plaintiff. 32. There are several ways to solve this problem. First, find the present value of £1,000,000 received in 43 years at an interest rate of 11.8% per annum. 1 1 €2083.33 0.00327 0.00327(1.00327)12 PV €24, 476.64 1 1 PV (1 ) C r r r   =  −    = = − +    T  1 1 €2333.33 0.00327 0.00327(1.00327)12 C €27, 413.83 1 1 PV (1 ) C r r r   =  −    = = − +    T  1 1 €2333.33 0.00327 0.00327(1.00327)60 C €126, 934.08 1 1 PV (1 ) C r r r   =  −    = = − +    T  PV = £1,000,000/(1.11843) = £8,260.43 Now find the annual payment that delivers a present value of £8,260.43 over 43 years at an interest rate of 11.8% per annum. If you wish to just invest today, you would invest £8,260.43. 33. To solve for the PVA due: PVA = PVAdue = PVAdue = PVAdue = (1 + r) PVA And the FVA due is: FVA = C + C(1 + r) + C(1 + r)2 + …. + C(1 + r)t – 1 FVAdue = C(1 + r) + C(1 + r)2 + …. + C(1 + r)t FVAdue = (1 + r)[C + C(1 + r) + …. + C(1 + r)t – 1] FVAdue = (1 + r)FVA 34. To answer this, we can diagram the perpetuity cash flows, which are: (Note, the subscripts are only to differentiate when the cash flows begin. The cash flows are all the same amount.) ….. C3 C2 C2 C1 C1 C1 Thus, each of the increased cash flows is a perpetuity in itself. So, we can write the cash flows stream as: C1/R C2/R C3/R C4/R …. 1 1 £8, 260.43 C 0.118 0.118(1.118)43 C £982.85 1 1 PV (1 ) C r r r   = =  −    = = − +    T  (1 ) .... (1 ) (1 )2 r t C r C r C + + + + + + (1 ) .... (1 ) r t - 1 C r C C + + + + + (1 ) .... (1 ) (1 ) (1 ) 2    + + + + + + + r t C r C r C r So, we can write the cash flows as the present value of a perpetuity with a perpetuity payment of: C2/R C3/R C4/R …. The present value of this perpetuity is: PV = (C/R) / R = C/R2 So, the present value equation of a perpetuity that increases by C each period is: PV = C/R + C/R2 35. Since it is only an approximation, we know the Rule of 72 is exact for only one interest rate. Using the basic future value equation for an amount that doubles in value and solving for t, we find: FV = PV(1 + R)t £2 = £1(1 + R)t ln(2) = t ln(1 + R) t = ln(2) / ln(1 + R) We also know the Rule of 72 approximation is: t = 72 / (R x 100) [We need to multiply R with 100 because the Rule of 72 uses interest rate expressed in percentage, not in decimal] Dividing both numerator and denominator in the R.H.S of the equation by 100, we get: t= .72/R We can set these two equations equal to each other and solve for R. .72 / R = ln(2) / ln(1 + R) 1 = (.72 / R) / [ ln(2) / ln(1 + R)] It is not possible to solve this equation directly for R, but using Solver, we find the interest rate for which the Rule of 72 is exact is 7.846894 percent. Rule of 69.3 We are only concerned with the time it takes money to double, so the monetary amounts are irrelevant. So, we can write the future value of a lump sum with continuously compounded interest as: £2 = £1eRt 2 = eRt Rt = ln(2) Rt = .693147 t = .693147 / R Since we are using percentage interest rates while the equation uses decimal form, to make the equation correct with percentages, we can multiply by 100: t = 69.3147 / R Solution Manual for Corporate Finance David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan 9780077139148