This Document Contains Chapters 21 to 24 Brealey 5CE Solutions to Chapter 21 1. Ledger balance = starting balance – payments + deposits Ledger balance = $250,000 – 20,000 – 60,000 + 45,000 Ledger balance = $215,000 The payment float is the outstanding total of not-yet-cleared cheques written by the firm, which equals $60,000 in this case. The net float is: $60,000 – $45,000 = $15,000 2. a. Payment float = $625,000 – $600,000 = $25,000. Availability float = $625,000 – $550,000 = $75,000. b. It can earn interest on these funds. c. Payment float increases. The bank’s ledger balance and available balance increase by the same amount. 3. a. Payment float = $20,000 × 6 = $120,000 Availability float = $22,000 × 3 = 6 6,000 Net float = $54,000 b. Interest could be earned on $22,000 if availability float were reduced by 1 day. Annual interest earnings would be .06 × $22,000 = $1,320. The present value of the earnings, if the reduction in float were permanent, would be $22,000. 4. a. The lock-box reduces collection float by 300 payments per day × $1500 per payment × 2 days = $900,000. Daily interest saved is .00015 × $900,000 = $135. The bank charge each day is: 300 payments per day × $.40 per payment = $120. The lock-box is worthwhile; interest earnings exceed the bank charges. b. Break-even occurs when interest earned equals the bank fees: .00015 × [300 × 1500 × Days saved] = $120 Days saved = 1.78 20-1 This Document Contains Chapters 21 to 24 5. Payment float; availability float; net float; lock-box banking. 6. a. Collection float decreases by $10,000 per day × 2 days saved = $20,000. b. Daily interest saving = .0002 × 20,000 = $4 c. Monthly savings = 30 × $4 = $120. This is the maximum fee Sherman’s should pay. Please note that we should always consider using time value of money concepts. 7. a. The lock box will collect an average of $10,000 per day [$300,000/30], and the money will be available three days earlier; this will increase the cash available to JAC by $30,000. Thus, JAC will be better off accepting the compensating balance offer: $20,000 is tied up in the compensating balance, but the lock-box frees up $30,000. b. Let x equal the average cheque size for break-even. Then the number of cheques written per month is (300,000/x) and the monthly cost of the lockbox is (300,000/x) (.10) The alternative is the compensating balance of $20,000; its monthly cost is the lost interest, which is equal to (20,000) (.06/12) These costs are equal if (300,000/x) (.10) = (20,000) (.06/12) which implies that x equals $300. If the average cheque size is greater than $300, paying per cheque is less costly; if the average size is less than $300, the compensating balance arrangement is less costly. c. In part (a) we were comparing balances with balances: how many dollars are made available to JAC compared to the number of dollars required to be kept in the bank. In part (b) one cost is compared to another. The interest forgone by holding the compensating balances is compared to the cost of processing cheques, and so here we needed to know the interest rate. 20-2 8. Total compensating balances increase by US$100,000. However, collection float decreases by US$1 million. Opening the new account increases funds on which the firm can earn interest by US$900,000. The firm should open the account. 9. a. Optimal initial cash balance, from the Baumol model, equals Q = 2 × 200,000 × 20 .02 = $20,000 So the firm should sell securities for cash 200,000/20,000 = 10 times per year. b. The average cash balance is $20,000/2 = $10,000. 10. Sales = 200 per month Carrying cost = $1 per month per gem Order cost = $20 Q* = 2 × 200 × 20 1 = 89.4 The economic order quantity is only about 90 gems, which is less than one-half of a month’s sales. The firm should place smaller but more frequent orders. 11. Order cost = $20 Sales = 200 pounds per week Carrying cost = .05 per pound per week Q* = 2 × 200 × 20 .05 = 400 Patty should restock less frequently. The optimal order size is 400 pounds, meaning that she should reorder every other week. 12. a. Order Size 100 200 250 500 Orders per month 10 5 4 2 Total order cost 300 150 120.0 60 Average inventory 50 100 125.0 250 Total carrying costs 75 150 187.5 375 Total inventory cost 375 300 307.5 435 20-3 b. EOQ = 2 × purchases × order cost carrying cost = 2 × 1000 × 30 1.50 = 200 The order size of 200 does in fact minimize total costs. 13. a. Economic order quantity = 2 × order cost × purchases carrying cost = 2 × 250 × 7200 .20 × 50 = 600 b. Total costs = order costs + carrying costs = 250 × 7200 600 + .20 × 50 × 600 2 = $6000 14. If the firm takes the discount, it gets the goods at a lower price, but it is obligated to place larger orders than the optimal order size derived in the previous problem. Total inventory-related costs will increase, possibly by more than the price discount. If the firm places an order of 1800 units, its total costs are as follows. (We continue to assume carrying costs are 20% of the purchase price, which has fallen by 1% to .99 × $50.) Total costs = order costs + carrying costs = 250 × 7200 1800 + .20 × 50 × .99 × 1800 2 = $9910 Therefore, inventory costs have increased by $9910 − $6000 = $3910 compared to the value in the previous problem. The reduction in the purchase cost is .01 × 50 × 7200 = $3600. Therefore, the firm saves less from the purchase price than the increase in its inventory costs. The firm should reject the discount. 15. Q* = 2 × sales × order cost carrying cost 20-4 If order cost falls by a factor of 100, then Q* falls by a factor of 10. So you should order one-tenth as many goods, but 10 times as often. 16. This problem is a straightforward application of the Baumol model. The optimal initial cash balance is: Q = 2 × 100,000 × 10 .01 Q = $14,142 This implies that the average number of transfers per month is: 100,000/14,142 = 7.07 or approximately one transfer every three business days. 17. a. While the firm pays less for its payment to clear through the ACH system, the system also speeds up the clearing process. In the process, the firm loses payment float, and the interest it could be earning on that float. If the payment is large enough, it might be better to pay more for the clearing service, but continue to earn interest for an extra day or so. b. We saw in the chapter that, under Canada’s payments system, depositors usually receive immediate credit for cheques deposited even if they do so at another branch on the other side of the country. In this respect, float time could be less than in the United States, where a deposited cheque may be placed on hold till it is verified that the person who wrote it has the funds in his or her account. However, Canadians would still encounter mail float and processing float. 18. There is no solution to this internet activity. This activity is mainly to illustrate how businesses have embraced the internet to allow customers to pay bills electronically. For a business, the number of bounced cheques will decrease when customers pay bills by transferring money from their bank account to the business. 19. When accessed on September 28, 2011, the interest rates (yields) on the 1, 2 and 3 month corporate papers were 1.06%, 1.09% and 1.15%, respectively. The corresponding rates for the 1, 2 and 3 month Treasury Bills were .82%, .82% and .83%. The higher rates on corporate commercial paper reflects the higher default risk of corporations, relative to the Government of Canada. 20-5 20. a. The interest rate, the cost of each transaction, and the variability of cash flows. b. It should restore it to the lower limit plus one-third of the distance from the lower to the upper limit. c. The firm would minimize the expected number of times its cash balance hits either of the limit points by restoring the cash balance to the halfway point between the limits. The forgone interest earnings that result from holding cash balances, however, is another (opportunity) cost that the firm would like to control. This consideration reduces the optimal level to which cash should be restored. The return point that best trades off these costs turns out to be one- third of the distance from the lower to the upper limit. By holding a cash balance below the halfway point between the upper and lower limits, the firm increases the transaction frequency but earns more interest. This minimizes the sum of transaction costs and costs of forgone interest. 21. Annual cash disbursements = $80 × 52 = $4160 Cost per transaction = $.15 Interest rate = .03 Q = 2 × 4160 × .15 .03 = 204 a. You should go to the bank about once every 2 1/2 weeks (204/80 = 2.55). b. You should withdraw $204 at a time c. Your average cash on hand will be $204/2 = $102. 22. With an increase in the rate of interest, the opportunity cost of holding cash increases. This should decrease cash balances relative to sales. 23. The economic order quantity is proportional to the square root of sales. Since the average inventory level equals order quantity divided by 2, inventory level is also proportional to the square root of sales. Similarly, the average cash balance is proportional to the square root of disbursements, which in turn ought to be about proportional to production. Therefore, both cash and inventories should increase by the square root of 2. A percentage of sales model would predict that both would double. The percentage of sales models do not capture the nonlinear relationships in these two components of current assets. 24. Canadian banks assist corporations to manage their cash in a variety of ways. For example, some of the cash management services provided by Scotiabank to 20-6 corporations include cash concentration, balance management, balance consolidation and electronic cheque services. On the TD website click on Collections and then either Wholesale or Retail Lockbox to read about TD’s lock box services to help companies collect cheques faster. 25. Currently, to get bigger range of treasury bill rates at the Bank of Canada website (http://www.bankofcanada.ca/rates/daily-digest) you will see Money Market [ + more ] and click on + more. From the websites, in February 2012, the 3-month T- bill rate in Canada was 0.89%, whereas in the U.S. the 3-month T-bill rate was only 0.08%. Investors considering the two investment options must also consider currency exchange rates and associated risks. Hence, investors may not necessarily choose to not to invest in the lower T-bill (U.S.) rate. Also on the Bank of Canada website the 3-month prime corporate paper rate was 1.16%, higher than the Government of Canada rate but riskier. The US website had a variety of commercial paper, some issue by nonfinancial corporations and some issued by financial corporations. Generally the rate for the nonfinancial corporate commercial paper is higher than the financial corporation commercial paper, due to the higher risk of the nonfinancial corporations. The February rates for the 3 month nonfinancial commercial paper was .16% and for the financial commercial paper was .13% 26. a). L= lower limit, C*= target cash balance, R = daily rate, andσ 2= variance F = fixed cost Daily rate = (1.06)1/365 – 1 = 0.00016 or 0.016 % C* = L + [ × (F )× 4 3 (σ 2)/R] 1/3 =40,000 + [ × 4 3 (50) (300,000)/0.00016] 1/3 =$44,127.41 Upper limit U = 3 × C* – (2 ×L) = 3 x 44,127.41 – (2 x 40,000) = $52,382.23 b). We used the Miller – Orr model in part (a) above. 27. a. In the 28-month period encompassing September 1976 through December 1978, there are 852 days (365 + 365 + 30 + 31 + 30 + 31). Thus, Merrill Lynch disbursed, per day, $1.25 billion/852 = $1,467,000 (approximately; the amount has been rounded-off). b. Remote disbursement delayed the payment of 20-7 1.5 days × 1,467,000 per day = $2,200,500 from day 0 to day 852 (i.e., remote disbursing shifted the stream of daily payments back by 1 1/2 days). At an annual interest rate of 8%, a 28-month delay in the payment of $2,200,500 is worth PV = 2.2005 – 2.2005 1.0828/12 = .362 million or $362,000 (rounded-off) c. If the benefits are permanent, the net benefit is the immediate cash inflow, or $2,200,500. d. Merrill Lynch disbursed $1,467,000 each day. The 1.5 day delay is worth $1,467,000 × 1.5 × .08/365 = $482.30. Also, Merrill Lynch writes 428.4 cheques per day [365,000/852]. Therefore, Merrill Lynch would have been justified in incurring additional costs of $482.30/428.4 = $1.126 per cheque. 20-8 Brealey 5CE Solutions to Chapter 22 1. a. The discount is 1% of $1000 = $10. b. The customer gains an extra 40 days of credit. c. With the discount the customer pays $990. Without it, the customer pays $1000. The difference is 10/990 = 1.01%. 1.01% per 40 days of extra credit is equivalent to an annual rate of (1.0101)365/40 – 1 = .0960 = 9.60%. 2. open account promissory note commercial draft trade acceptance the customer’s bankers’ acceptance 3. a. Perishable goods (bread) call for a shorter credit period. b. Rapid turnover (higher turnover ratio) calls for a shorter credit period. c. The firm selling to customers with the more tangible and saleable assets will grant a longer credit period. This is the firm selling to electric utilities. 4. a. The service charge has no impact on the terms lag but will discourage late payment. The due lag falls and, therefore, pay lag falls. b. Companies might be forced to stretch payables. Due lag and, therefore, pay lag increase. The terms lag is not changed. c. Terms lag increases and, therefore, pay lag increases. Assume that customer doesn’t change the due lag. 5. The current terms allow a 3% discount if the customer gives up an extra 40 – 20 = 20 days of credit. The effective annual rate is (1 + 3/97)365/20 – 1 = (1.0309)365/20 – 1 = .743 = 74.3% a. The implicit rate increases because the discount is higher: 4/20, net 40: (1 + 4/96)365/20 – 1 = 1.106 = 110.6% 21-1 b. The implicit rate increases because the extra days of credit “bought” by forfeiting the discount fall to 40 – 30 = 10 days. 3/30, net 40: (1 + 3/97)365/10 – 1 = 2.040 = 204.0% c. The implicit rate increases because the extra days of credit “bought” by forfeiting the discount fall to 30 – 20 = 10 days. 3/20, net 30: (1 + 3/97)365/10 – 1 = 2.040 = 204.0% 6. a. Two-thirds of customers will pay by 15 days. The other 1/3 will pay by 30 days. Therefore, the average days in receivables will be 2/3 × 15 days + 1/3 × 30 days = 20 days b. Investment in A/R = days in receivables × daily sales = 20 × $20 million 365 = $1.096 million c. With greater incentive to pay early, more customers will pay at 15 days instead of 30. Therefore, one would expect average days in receivables to fall. 7. a. PV of a cash-on-delivery sale = $50 – $40 = $10 per carton. Under the present C.O.D. policy, sales are 1000 cartons per month. $10 per carton × 1000 cartons = $10,000. If credit is extended, sales increase, but PV per carton falls to: PV of revenue – Cost = $50 1.01 − $40 = $9.505 per carton $9.505 per carton × 1060 cartons = $10,075 Thus, the higher sales more than make up for the time value cost of the credit extended. b. If the interest rate is 1.5%, PV per carton falls to: PV of revenue – Cost = $50 1.015 − $40 = $9.261 per carton $9.261 per carton × 1060 cartons = $9,817 At the higher carrying cost, the higher sales no longer are enough to make up for the cost of the credit extended. 21-2 c. The PV of the old customers remains unaffected. The PV of the new customers clearly is positive: The additional sales gained by extending credit is 60 cartons. The profit margin (in present value terms) is 50/1.015 – 40 = $9.261. 8. PV(COST) = 95 PV(REV) = 101/1.01 = 100 a. The expected profit from a sale is: .93(100 – 95) – .07(95) = –$2 The firm should not extend credit. b. At the break-even probability, expected profit equals zero: p(100 – 95) – (1 – p)(95) = 0 which implies that p = .95. So if the firm is to break even, 95% of its customers must pay their bills. c. A paying customer now represents a perpetuity of profits of 100 – 95 = $5 per month. The present value is $5/.01 = $500. So the present value of a sale, given a 7% default rate, is .93(500) – .07(95) = $458.35 It clearly pays to extend credit. d. p(500) – (1 – p)95 = 0 595p – 95 = 0 p = .16 = 16%. So the probability of payment needs to be greater than only 16% to justify extending credit. 21-3 9. a. The expected profit of a sale is .90(1200 – 1050) – .10(1050) = $30 Cast Iron should grant the credit. b. The break-even probability of collection is found by solving p(1200 – 1050) – (1 – p)1050 = 0 1200p – 1050 = 0 p = 1050/1200 = .875 10. From the discussion in the text regarding financial ratios (see Chapter 4, especially Table 4.6) the important ratios to consider are measures of leverage and liquidity! Leverage measures: (1) Long-term debt ratio = long-term debt/(Long-term debt + equity) (2) Total debt/Total assets = total liabilities/total assets (3) Times interest earned = EBIT/interest expense (4) Cash coverage ratio = (EBIT + depreciation and amortization)/interest expense Liquidity measures: (1) Net working capital to assets = Net Working capital / Total assets (2) Current ratio = Current assets / Current liabilities (3) Quick ratio = (cash + marketable securities + trade receivables)/current liabilities (4) Cash ratio = (cash + marketable securities)/current liabilities You might also want to examine profitability ratios such as ROE and ROA 11. The production cost is $40. The PV of revenues is $50 (1.10)1/2 = $47.67 The expected profit of the order is therefore .75(47.67 – 40) – .25(40) = –$4.25 per iron. You should reject the order. 21-4 12. The more stringent policy should be adopted because profit will increase. For every $100 of current sales: Current Policy More Stringent Policy Sales 100 95.0 Less bad debts* 6 3.8 Less cost of goods** 80 76.0 Profits 14 15.2 *6% of sales under current policy; 4% under proposed policy. **80% of sales. 13. a. The present value of a sale under current credit terms, and allowing for the possibility of default is .75 × ( 15 1.01 − 10) – .25 × 10 = 1.14 Under a cash-on-delivery policy, sales would be 40% lower, but defaults and the time value cost of extended credit would be eliminated. Present value (assuming sales volume of 60% of current levels) would be: .6 × (15 – 10) = 3 The switch to a COD policy seems to make sense. b. If customers who pay bills on time generate six additional repeat sales, then each successful sale is repeated an additional six times; in contrast, a defaulting sale occurs only once. The PV of a credit sale becomes (note that the 6-month annuity factor for 1% per month is 5.7955): × −10 1.01 0.75 15 × + × −10 1.01 0.75 15 annuity factor(1%, 6 months) − (0.25 × 10) = $22.23 The present value of a cash-on-delivery policy given the lower sales volume is: 0.60 × [(15 – 10) + (15 – 10) × Annuity factor(1%, 6 months)] = $20.39 In this case, repeat sales make the extension of credit a preferable strategy. 14. Cost = $80. The profits from cash sales are currently 200($101 – $80) = $4,200. a. If 1 month (30 days) free credit is granted, the PV of revenue per unit falls to $101/1.01 = $100. Assuming that both old and new customers take advantage of the free credit, the present value of profits will increase to 220($100 – $80) = $4,400. Allowing trade credit therefore is beneficial. 21-5 b. Now assume that 5% of all customers will default on their bills. The expected value of (discounted) profits becomes Units sold × [p × PV(REV – COST) – (1 – p) × PV(COST)] = 220 × [.95 × (100 – 80) – .05 × 80)] = $3,300. This is less than the original value, which means that trade credit should not be allowed. c. If only new customers pose default risk, you need to look at the incremental profit from the new customers you will attract by relaxing credit policy minus the value of the free credit that you extend to your current customers. The free credit costs the firm $1 per current customer, since the present value of a sale falls from $101 to $100. Value of new customers = 20[.95(100 − 80) – .05(80)] = $300 Value of free credit to current customers = 200 × $1 = $200 Net benefit from advancing credit = $300 – $200 = $100 Now it appears worthwhile to allow trade credit. d. Now that it is allowing customers to 30 days to pay for their purchases it must establish a collection policy. It must keep track of customers’ payments. If a customer is in arrears, the company must contact the customer to tell them that they must pay their bills. 15. PV(REV) = $1200 PV(COST) = $1000 Slow payers have a 70% probability of paying their bills. The expected profit of a sale to a slow payer is therefore .70(1200 –1000) – .30(1000) = –$160 The expected savings from doing the credit check equals the probability of uncovering a slow payer times the expected loss saved by denying credit to the slow payer: .10 × $160 = $16 The credit check costs $5, so it is cost effective. 16. The possibility of collecting a portion of the amount owed to the firm reduces the expected loss from advancing credit to slow payers and reduces the incentive to pay for a credit check. Even with a relatively high probability of default, the prospect of collecting a portion of the bad debt may mean that you would choose to advance credit to these customers. 21-6 17. For every $100 in sales, PV(REV) = 100 (1.15)n/365 where n is the average collection period, in days. Costs are 85 percent of $100, or $85. Classification Collection Period PV(REV) 1 45 100/(1.15)45/365 = 98.29 2 42 100/(1.15)42/365 = 98.40 3 50 100/(1.15)50/365 = 98.10 4 80 100/(1.15)80/365 = 96.98 Classifi- Probability cation of Payment p × PV(REV − COST) – (1 − p) COST 1 1.00 1.00 × (98.29 − 85) = $13.29 2 .98 .98 × (98.40 – 85) – .02(85) = $11.44 3 .90 .90 × (98.10 – 85) – .10(85) = $3.29 4 .80 .80 × (96.98 – 85) – .20(85) = –$7.42 If customers can be classified without cost, then Velcro should sell only to groups 1, 2, and 3. The exception would be if nondefaulting group 4 accounts subsequently became regular and reliable customers (i.e., become members of group 1, 2, or 3). In that case, extending credit to new group 4 customers would be profitable. 18. a. For every $100 in current sales, Galenic has $5.00 profit (ignoring bad debts); this implies costs of $95.00. If the bad debt ratio is 1%, then, per $100 sales, the bad debts will be $1 and actual profit will be $4.00, a net profit margin of 4%. b. Sales will fall to 91.6% of their previous level (9,160/10,000), or to $91.60 per $100 of original sales. With a cost-to-revenue ratio of 95%, total costs will be .95 × $91.60 = $87.02; bad debts will be (60/9160) × $91.60 = $.60. Under the new scoring system, profit per $100 of original sales will be $91.60 – 87.02 – .60 = $3.98. Profit will be very slightly less than under the current policy. Although the profit margin is higher, sales are lower and total profit decreases slightly. Therefore, the new scoring system reduces Galenic’s profit by denying credit to this group. Another way to see this is to compute the expected profit on the “worse than 80” group. Probability of default = 40/840 = 1/21 21-7 Therefore, the expected profit for $100 in sales is p × PV(REV – COST) – (1 – p) × PV(COST) = 20 21 (100 − 95) − 1 21 (95) = .24, which is small, but positive. Therefore, denying credit to this group would reduce expected profit by a small amount. c. There are many reasons why the predicted and actual default rates may differ. For example, the credit scoring system is based on historical data and does not allow for changing customer behavior; also, the estimation process ignores data from loan applications that have been rejected, which may lead to biases in the credit scoring system. d. If one of the variables is whether the customer has an existing account with Galenic, the credit scoring system is likely to be biased because it will ignore the potential profit from new customers who might generate repeat orders. 19. Data to compute Z scores was retrieved from the US Yahoo finance site, finance.yahoo.com, in September 2011 for Exxon Mobil Corp (XOM) and AMR Corp.(the holding company for American Airlines). In both cases, the data is for the year ending December 2010. AMR Corp., appears to be in financial trouble with a Z score of .5955, well below the minimum 2.99 for good shape. Exxon however, seems to be in good shape financially with a Z score of 5.6590. The z- scores were arrived at by inputting information regarding variables (don’t input commas!). Here are some details regarding the variables used: List of Variables: Exxon ($000) AMR Corp.($000) Earnings before interest and taxes 53,218,000 286,000 Total assets 302,510,000 25,088,000 Net Sales 383,211,000 22,170,000 Market Value of equity 364,110,000 1,050,000 Total Liabilities 155,671,000 29,033,000 Working capital = total current assets – total current liabilities -3,649,000 -1,942,000 Retained earnings 298,899,000 -5,607,000 Here’s what the website says are the key z-scores: Z-SCORE ABOVE 2.99--YOU'RE IN GOOD SHAPE Z-SCORE BETWEEN 2.99 and 1.81--WARNING SIGNS Z-SCORE BELOW 1.81--BIG TROUBLE--COULD BE HEADING TOWARD BANKRUPTCY 21-8 20. Rather than click “see example’, now you click on “View Sample Report.” A sample report and the indicated rating will give an idea about the likelihood of a company receiving credit. Based on the report, you will get an idea of whether the company is likely to experience financial difficulties in the foreseeable future; say, over the next 12 months. In addition, the company will receive a rating on the likelihood of paying bills on time over the next 12 months. For the Sample Report, the firm looks like it’s in rough shape. Dunn and Bradstreet are predicting high probability of financial distress (score of 4 out of 5) in the next 12 months and very high that it will fail to pay bills on time in the next 12 months (score of 5 out 5) 21. The finance.yahoo.com website was accessed in September 2011. Winn-Dixie operates grocery stores. Dean Foods and Lifeway Foods are food manufacturers. Winn-Dixie Dean Foods Lifeway Foods June 2011 June2010 Dec10 Dec09 Dec10 Dec09 Sales 6,880,776 6,980,118 12,122887 11,113,782 58,500 53,918 Net Receivables 71,082 63,356 1,104,009 1,046,194 8,133 7,610 AR turnover 96.8 110.2 10.98 10.62 7.19 7.08 ACP 3.77 days 3.31 days 33.23 days 34.36 days 50.74 days 51.52 days The type of business operations will account for some of the difference in investment in accounts receivable. Winn-Dixie is in retail business. In the retail business, many of its sales are for cash and create no receivables. The main reason for ACP is letting customers pay with cheques or credit cards. Both Dean Foods and Lifeway Foods sell products to the other businesses, which is why their average collection period is longer. However, it is not obvious why the average collection period for Lifeway Foods is longer. It could be because more of Lifeway Products, such as seasonings and cheese, have a longer shelf life than those of Dean Foods. Winn-Dixie Winn-Dixie Stores, Inc. operates as a food retailing company primarily under the Winn-Dixie banner. The company’s stores offer grocery, dairy, frozen food, meat, seafood, produce, deli, bakery, floral, health and beauty, and other general merchandise items. Its stores also provide pharmacies, distilled spirits, and fuel products. The company offers national brands, as well as its own private-label products in its stores. As of June 29, 2011, it operated 484 retail grocery stores with 4 fuel centers and 75 liquor stores at the retail stores, as well as 379 in-store pharmacies in Florida, Alabama, Louisiana, Georgia, and Mississippi. Winn-Dixie Stores, Inc. was founded in 1925 and is headquartered in Jacksonville, Florida. 21-9 Dean Foods Dean Foods Company, together with its subsidiaries, operates as a food and beverage company in the United States. It operates in two segments, Fresh Dairy Direct-Morningstar and WhiteWave-Alpro. The Fresh Dairy Direct-Morningstar segment manufactures, markets, and distributes various branded and private label dairy case products, including cream, ice cream mix, and ice cream novelties; creamers and other extended shelf life fluids; yogurt, cottage cheeses, sour creams, and dairy-based dips; fruit juices, fruit-flavored drinks, iced teas, and water; half-and-half and whipping creams; and items for resale, such as butter, cheese, eggs, and milk shakes. This segment sells its dairy case products to retailers, distributors, foodservice outlets, educational institutions, and governmental entities. The WhiteWave-Alpro segment manufactures, develops, markets, and sells various branded dairy and dairy-related products, such as milk and other dairy products; organic dairy products; plant-based beverages, such as soy, almond, and coconut milks; and soy food products, coffee creamers, and creamers and fluid dairy products. It also provides branded soy-based beverages and food products in Europe under the Alpro and Provamel brands. This segment sells its products to various customers, including grocery stores, club stores, natural foods stores, mass merchandisers, convenience stores, drug stores, and foodservice outlets. The company was formerly known as Suiza Foods Corporation and changed its name to Dean Foods Company on December 21, 2001 as a result of merger between the former Dean Foods Company and Suiza Foods Corporation. Dean Foods Company was founded in 1995 and is headquartered in Dallas, Texas. Lifeway Foods Lifeway Foods, Inc., together with its subsidiaries, manufactures dairy and non-dairy health food products. It offers Kefir, a drinkable product under the Lifeway’s Kefir, ProBugs, and Helios Nutrition Organic Kefir brand names; a plain farmer’s cheese under the Lifeway’s Farmer’s Cheese brand name; a fruit sugar-flavored product under the Sweet Kiss brand name; and a dairy beverage under the Basics Plus brand name. The company also provides soy-based products under the Soy Treat brand name; a vegetable-based seasoning under the Golden Zesta brand name; Lifeway’s organic kefir, a product sweetened with organic cane juice; Lifeway’s Slim6, a line of low-fat kefir beverages with no added sugar; La Fruta drinkable yogurt; and La Fruta cheese, a cheese product. In addition, it offers Tuscan brand drinkable yogurt, a cultured dairy beverage; Elita and Bambino cheeses, which are kefir based cheese spreads; Krestyanski Tworog, a European-style kefir-based soft style cheese; Kefir Starter, a powdered form of kefir that is sold in envelope packets; Lassi, a cultured drink; and It’s Pudding!, an organic pudding. The company sells its products to supermarkets, grocery stores, gourmet shops, delicatessens, and convenience stores in the United States, Canada, and eastern Europe through distributors. Lifeway Foods, Inc. was founded in 1986 and is headquartered in Morton Grove, Illinois. 21-10 Solution to Minicase for Chapter 22 1. Relevant credit information: i. Earnings record is only fair. Negative net income in 2011 but it was positive in 2012. ii. Expectation that SS will pay its bills slowly. This is based on the telephone calls with SS suppliers who suggested that SS was 30 days late paying its bills. iii. The firm has a $5 million line of credit, but it is facing a pending renegotiation of its $15 million bank loan that is due for repayment at the end of the year. iv. Some of SS’s financial ratios are as follows: All numbers in the ratios are millions of dollars Leverage Ratios: Long-term debt ratio = long-term debt/(Long-term debt + equity) = 40.840.8+65.1 = .385 Total debt/Total assets = total liabilities/total assets = (41.8+40.8)/147.7 =.56 Times interest earned = EBIT/interest expense = 9/5.1 = 1.76 Cash coverage ratio = (EBIT + depreciation and amortization)/interest expense = (9+8.1)/5.1 = 3.35 Liquidity measures: Net working capital to assets = Net Working capital / Total assets = Net working capital total assets = 48.7 - 41.8 147.7 = .047 Current ratio = Current assets / Current liabilities = 48.7 41.8 = 1.165 Quick ratio = (cash + marketable securities + trade receivables)/current liabilities = 5 + 16.2 41.8 = .507 Cash ratio = (cash + marketable securities)/current liabilities = 5 41.8 =.12 Some ratios used to evaluate operating efficiency and profitability: Asset turnover = Sales average total assets = 149.8 (147.7 + 160.9)/2 = .971 Inventory turnover = Cost of goods sold average inventories = 131 (27.5 + 32.5)/2 = 4.367 21-11 NOPAT = Net income +after-tax interest expense After-tax interest expense = (1-tax rate) interest expense Estimated tax rate = Taxes/taxable income = taxes/(EBIT – interest expense) = 1.4/(9.0 – 5.1) = .359 so assume it is 36% So: NOPAT = Net income +after-tax interest expense = 2.5 + (1-.36)5.1 = 5.76 ROA = NOPAT initial total assets = 5.76 160.9 = .0358 = 3.58% Operating profit margin = NOPATSales = 5.76 149.8 = .0385 = 3.85% ROE = Return on equity = Net Income initial equity = 2.5 65.1 = .0384 = 3.84% These ratios are generally worse than those presented in Table 4.7. The most relevant industry is food products. In particular, the liquidity ratios for the firm are low. Also, both asset turnover and profit margin are below average. This lends some support to the decision to refuse credit. The Z-score for SS calculated using the US Z-Score from footnote 7: Z = 3.3 × EBIT total assets + 1.0 × sales total assets + .6 × market equity book debt + 1.4 × retained earnings total assets + 1.2 × working capital total assets The ratios used in this calculation are: 0.0583 5.83% (147.7 160.9) / 2 9 Average total assets EBIT = = = + Asset turnover 0.971 (147.7 160.9) / 2 149.8 total assets sales = = = + Market equity = stock price x number of shares = $5.80 x 10 million = $58 million 0.912 40.8 22.8 58 Total book debt Market equity = = + 0.373 147.7 55.1 Total assets Retained earnings = = 0.047 147.7 48.7 41.8 Total assets Net working capital = − = Z = (3.3 × .0583) + (1.0 × .971) + (.6 × .912) + (1.4 ×.373) + (1.2 × .047) = 2.289 21-12 This Z-score is worse than the cut-off (2.7), indicating significant bankruptcy risk, and also would argue against extending credit. The Z-score for SS calculated using that Canadian Z-score: = .972 net profit after tax + .234 sales .531 total debt total debt total assets total assets + 1.002 current assets + .612 (rate of growth of equity rate of growth of assets) current liabilities ZC − × − Additional ratios needed for ZC. Net profit after tax is NOPAT and total debt = total liabilities NOPAT average total debt = 5.76 (82.6 + 86.5)/2 =.0681 Rate of growth of equity = 2012 Equity 2011 Equity - 1 = 65.1 74.4 -1 = -0.125 Rate of growth of assets = 2012 Total Assets 2011 Total Assets - 1 = 147.7 160.9 -1 = -0.082 Zc = (.972 × .0681) + (.234 × .971) – (.531 × .56) + (1.002 × 1.165) + .612 ×(-.125 - .082) = 1.1358372 This Z-score is worse that the cut-off (1.626), indicating significant bankruptcy risk, and would also argue against extending credit. 2. Breakeven probability of default At a purchase price of $10,000 the sale of each encapsulator will bring in $500 in profit, assuming that SS forgoes the discount. If it takes the discount, which seems unlikely, the net price would fall to $9,800 and the profit would fall to $300. Assume first that, if SS pays, it does so on the due date, exactly 60 days after the sale. Then, at an 8% interest rate, the net present value of profit per unit is: NPV per unit = PV(sales price) – cost of goods NPV per unit = $10,000 (1.08)60/365 − $9,500 = $9,874 – $9,500 = $374 Therefore, the break-even probability is determined as follows: p × 374 – (1 – p) × 9,500 = 0 p = .96 The sale has a positive NPV if the probability of collection exceeds 96 percent. If SS pays 30 days slow (i.e., in 90 days), then the present value of the sale is less than $9,874 and, consequently, the break-even probability is even higher. 21-13 3. Repeat orders Given SS’s marginal, at best, credit rating and the break-even probability near 1.0, SS would not be given credit if this is a one-time sale. However, MEC believes that this sale will in all probability lead to more profitable sales in the future. Therefore, MEC will be willing to grant credit even when the probability of collection is considerably below 96 percent. 21-14 Brealey 5CE Solutions for Chapter 23 1. a. Economies of scale are a valid reason for a merger. Reduce overall costs. b. Diversification is not a valid reason. Shareholders can diversify for themselves. c. This may make sense, but note that there are other ways to redeploy excess cash besides using it to purchase another firm. Why not payout a higher dividend? d. The bootstrap strategy is not a valid reason for a merger. Playing games with the accounting numbers does not generate real value. 2. The firms can benefit from operational efficiencies. Heating will be busier in the winter; Air Conditioning in the summer. By merging, the firms can even out the work load over the year and use their resources at full capacity. 3. a. True. b. False. c. True. d. True. e. Largely false. While there are some gains from mergers, they do not seem to be “substantial.” f. False. In a tender offer, the acquirer “goes over the heads” of management directly to the shareholders. g. False. This is not true when the acquired firm is paid for with stock. 4. A. LBO: 6. Company of business bought out by private investors, largely debt financed. B. Poison pill: 4. Shareholders are issued rights to buy shares if bidder acquires large stake in the firm. C. Takeover bid: 5. Offer to buy shares directly from shareholders. 23-1 D. Shark repellent: 2. Changes in corporate charter designed to deter an unwelcome takeover. E. Proxy contest: 1. Attempt to gain control of a firm by winning the votes of its shareholders. F. White knight: 3. Friendly potential acquirer sought by a threatened target firm. 5. a. True b. False c. True 6. Premerger data: Acquiring: value = 10,000,000 × $40 = $400,000,000 Target: value = 5,000,000 × $20 = $100,000,000 Gain from merger = $20,000,000 The merger gain per share of Target is $20 million/5 million shares = $4 per share. Thus, Acquiring can pay up to $24 per share for Target, $4 above the current price. If it pays this amount, the NPV of the merger to Acquiring will be zero, NPV = -$24 per share × 5 million shares + 100 million + 20 million = 0 7. Acquiring: value = $400 million P/E = 12 Earnings = $400 million/12 = $33.33 million Target: value = $100 million P/E = 8 Earnings = $100 million/8 = $12.5 million Merged: value = $400 + $100 + $20 = $520 million Current earnings = 33.33 + 12.5 = $45.83 million P/E = $520/$45.83 = 11.35 The P/E of the merged firm is less than that of Acquiring. 23-2 8. a. The present value of the $500,000 annual saving is $500,000/.08 = $6,250,000 = $6.25 million. This is the gain from the merger. b. The cost of the offer is the cash offer to Pogo shareholders minus the original value of Pogo's shares = $14 million – $10 million = $4 million. c. NPV = gain - cost = $6.25 million – $4 million = $2.25 million. 9. a. From question 8 a. the gain from the merger is $6.25million, and is from cost reduction. So this this gain is called the cost savings from the merger.The merged firm will have a total value of $36.25 million ($20 million + $10 million + $6.25 million from cost savings). Since the Pogo shareholders own half of the firm, their stock is now worth $18.125 million. (= $36.25 million x 50%) b. The cost of the stock alternative is the value of the Velcro shareholders issued to Pogo's shareholders minus the original value of Pogo's shares = $18.125 million - $10 million = $8.125 million. This is the increase in the value of the stock held by Pogo shareholders. c. NPV = gain - cost = $6.25 million - $8.125 million = –$1.875 million. This equals the decrease in the value of the stock held by Velcro's original shareholders. Note: Another way to measure the NPV is the difference between the investment and the present value of the future cash flows received. The investment is the total amount paid to Pogo's shareholders, $18.125 million. The present value of the future cash flows from the investment equal the sum of the original value of Pogo's shares ($10 million) plus the gain from the merger ($6.25 million): NPV = -$18.125 million + ($10 million + $6.25 million) = –$1.875 million. 10. a. At a price of $25 per share, Immense will have to pay Sleepy $25 million. The current value of Sleepy is $20 million and Immense believes it can increase the value by $5 million. So Immense would have to pay the full value of the target firm under the improved management; therefore, the deal would be a zero-NPV proposition for Immense. The deal is just barely acceptable for shareholders of Immense, and clearly attractive for Sleepy's shareholders. Therefore, it can be accomplished on a friendly basis. b. If Sleepy tries to get $28 a share, the deal will have negative NPV to Immense shareholders: NPV to Immense = economic gain of merger ($5 million) minus cost of acquiring Sleepy ($28 million - $20 million = $8 million) = $5 23-3 million - $8 million = -3 million. There could not be a friendly takeover on this basis. 23-4 11. P/E Shares Price EPS* Earnings** Castles in the Sand (CS) 10 2m 40 4.00 $8.0m Firm Foundation (FF) 8 1m 20 2.50 $2.5m * EPS = Price divided by P/E ratio ** Earnings = EPS × Shares a. New Castle shares issued = .5 million (1 million FF shares become .5×1 million = .5 million CS shares) Total Castle shares = 2.0 + 0.5 = 2.5 million Total earnings = $8 + $2.5 = $10.5 million EPS = $10.5/2.5 = $4.20 b. Value of merged companies = (2 million sh × $40/sh) + (1 million sh × $20/sh) = $100 million Shares = 2.5 million NEW Price = $100/2.5 = $40 per share Thus Castle shareholders’ wealth is unchanged. Firm Foundation shareholders have stock worth $40 × .5 million = $20 million which is also unchanged. P/E of merged firm = $100 million / $10.5 million = 9.524 which is between the P/Es of the two original firms. c. If the P/E of Castles remains at 10, the merged firm will sell for: New EPS × 10 = $4.20 × 10 = $42 Notice that the firm is thus worth $42 × 2.5 = $105 million, yet the combined market value of the old firms was only $100 million. Why would shareholders fall for this??? d. Gain to Castle: Increase in share price = $42 – 40, $2/share × 2 million shares = $4 million gain Gain to FF: Value of new shares – Original value of firm = .5 million × $42/share – $20 million = $1 million The total gain is thus $5 million, which is the increase in the combined market value of the firms. 23-5 12. SCC value = 3,000 shares × $50/share = $150,000 SDP value = 2,000 shares × $17.50/share = $ 35,000 Merger gain = $ 10,000 a. Cost of merger to SCC = ($20/sh – $17.50/sh) × 2,000 shares = $5,000 NPV = gain – cost = $10,000 – $5,000 = $5,000 b. SCC will sell for its original price plus the per share NPV of the merger: $50 + $5,000 3,000 = $51.67 which represents a 3.34% gain in share price: (51.67 – 50)/50 = .0334 As a group, the SCC shareholders' fraction of the economic gain is $5,000/$10,000, or 50%. SDP share price will increase from $17.50 to the tender offer price of $20, a percentage gain of $2.50/ $17.50 = .1429 = 14.29%. The per share economic gain to the SDP shareholders is $20 - $17.5 or $2.5 per share. As group, the SDP shareholders' fraction of the economic gain created by the merger is $2.5/share × 2,000 shares or $5,000. Thus the SDP shareholders also receive 50% of the total economic gain. c. SCC shares issued to acquire SDP = .40 × 2,000 = 800 shares Value of merged firm: $150,000 (SCC) + 35,000 (SDP) + 10,000 (Merger gain) $195,000 Shares outstanding = 3,000 + 800 = 3,800 Price = $195,000 / 3,800 = $51.31579 Notice that SCC sells for a lower post-merger price than in part (b), despite the fact that the terms of the merger seemed equivalent. d. NPV to SCC = Price gain per share × original shares outstanding. = (51.31579 – 50) × 3,000 = 1.31579 × 3,000 = $3,947.37 which is lower than the $5,000 NPV from part (a). Another way to calculate the NPV = gain - cost Gain = $10,000 23-6 Cost of acquiring SDP shares = Value of SCC shares exchanged - SDP original share value = 800 shares × $51.31579/share - $35,000 = $41,052.63 - $35,000 = $6,052.63 NPV = gain - cost = $10,000 - $6,052.63 = $3,947.37 Because SDP shareholders receive stock in SCC, and the price of SCC shares rises to reflect the NPV of the merger, SDP shareholders capture an extra part of the merger gains from SCC shareholders. The total synergy is $10,000. In the cash offer in (a), SCC’s shareholders get 5,000/10,000 or 50% of the gain. In the share exchange in (c), SCC’s shareholders receive 3,947.37/10,000 or 39.47% of the gain. To make the two deals equivalent, SDP shareholders would receive fewer shares of SCC, accounting for the increase in the SCC share price. SDP's shareholders need to receive SCC shares worth $20 × 2,000 or $40,000. The correct SCC price to use in determining the merger terms is $51.67, from part (b). This price includes SCC's share of the merger gains. Thus, SDP shareholders need $40,000/$51.67 per share, or 774.1436 shares of SCC. The terms of share exchange should be: 2,000 old SDP shares = 774.1436 SCC shares, or 1 old SDP share = 774.1436/2,000 SCC shares = .3871 shares 13. Internet: Looking at merger data Tips: Students will need Adobe Acrobat reader to access the press releases. As we write this, Crosbie is also providing access to its Quarterly M&A Report, on the same webpage as its quarterly press releases. The Quarterly M&A Report contains more statistics and charts. If these are still available when you are using this question, point the students to the Quarterly M&A Reports. Expected results: This is a very straightforward exercise. Students will read the press releases to find the merger statistics. Example: From the press releases accessed in September 2010 The oldest report, 1st quarter of 2003: In the 1st quarter of 2003, 200 merger announcements were made and total transaction value was $14.4 billion, down from previous quarters. However, special attention was given to the fact that the number of transactions under $1 billion had increased 6% from the previous quarter. The reduction in the number of “mega” deals (over $1 billion) and the increase in the smaller deal was taken as an indicator of expected growth. The market for smaller deals was reported to be far more stable and robust than the mega deal market. 23-7 In 1st quarter 2003, from an industry prospective, Industrial Products, Oil & Gas, Financial Services and Communications & Media were the four sectors driving the market, accounting for 50% of the activity and 66% of the value. Cross border activity (91 deals) accounted for 46% of announcements and 69% of the value. Canadian firms acquired 65 businesses ($6.8 billion) and foreign owned firm acquired 26 Canadian owned firms ($3.0 billion). Thus Canadian acquirers outspent foreigners 2.3:1, consistent with the long-term trends. The newest report, 2nd quarter of 2011: They reported 280 transaction in the 2nd quarter of 2011, a 19% increase from the 1st quarter of 2011. Total transaction value was $51.2 billion, up 74% from the 1st quarter of 2011. The biggest number of deals were in consumable fuels (oil and gas) and real estate industries. In the 2nd quarter 121 deals involved a foreign buyer, but in the 1st quarter 98 deals had a foreign buyer. The number of Canadian-led cross-border acquisitions exceeded foreign-led acquisitions by 2.5:1. While this is consistent with the recent trend of Canadian acquirers outnumbering their foreign counterparts, the value of foreign-led acquisitions exceeded that of Canadian-led acquisitions by 1.2:1. This was contrary to the trend seen in 2009-2010 when the value of Canadian led acquisitions exceeded those led by foreign firms. 14. a. First note that, because there are no real gains from the merger, earnings and market value are just the respective sums of the values for each firm independently: Total market value = $4,000,000 + $5,000,000 = $9,000,000 Total earnings = $ 200,000 + $ 500,000 = $ 700,000 Because total earnings are $700,000 and earnings per share is $2.67, shares outstanding must be 700,000/2.67 = 262,172. Price per share = $9,000,000/262,172 = $34.33 Price-earnings ratio = 34.33/2.67 = 12.9 b. World Enterprises originally had 100,000 shares outstanding. It must have issued 262,172 – 100,000 = 162,172 new shares to take over Wheelrim and Axle. Because Wheelrim had 200,000 shares outstanding, we conclude that 162,172 World Enterprise shares were exchanged for 200,000 Wheelrim shares. Thus,the share-exchange ratio is .81 shares( = 162,172/200,000). So .81 share of World Enterprises was exchanged for each share of Wheelrim and 23-8 Axle. c. The cost of the merger is the difference between the value of the World Enterprises shares given to the Wheelrim shareholders and the value of Wheelrim. World Enterprise gave stock worth $34.33 × 162,172 = $5,567,365 for a company worth $5,000,000. The cost is thus $567,365. d. The World Enterprise shares outstanding before the merger decline in value by the cost of the merger (since there were no economic gains to offset the cost). The shares fall in value by $567,365. The price of the original 100,000 shares falls to $34.33 per share from an original value of $40. 15. a. We can use the stock valuation formula from Chapter 6 to value the stream of dividends. The first step is to obtain the discount rate for the common stock of Plastitoys (Company B, the acquired company). Use the current stock price, forecasted dividend, and forecasted growth rate to solve for r from the following equation: DIV1 r − g = P0 If we take the dividend entry from the table in the problem as a forecast of year-end dividends, DIV1, then r $.80 − .06 = $20 Þ r = .10 Under new management, the growth rate would increase to 8 percent, and a share of Plastitioys (Company B) would be worth .10$.80−.08 = $40 The economic gain = New value of Plastitoy - Old value = $40/share × 600,000 shares - $20/share × 600,000 shares = $12,000,000 An alternative way to calculate the economic gain: The value of the combined firm (Company AB) is the sum of the value of the acquiring firm, Leisure Products (Company A), and the post-merger value of Plastitoys, or, PVAB = 1,000,000 × $90 + 600,000 × $40 = $114,000,000 We now calculate the gain from the acquisition as 23-9 GAIN = PVAB – (PVA + PVB) = $114,000,000 – (90,000,000 + 12,000,000) = $12,000,000 b. Because this is a cash acquisition: COST = Cash paid – PVB = $25 × 600,000 – $12,000,000 = $3,000,000 NPV = GAIN - COST = 12,000,000 - 3,000,000 = $9 million c. Because this merger is financed with stock, the cost depends on the value of the stock given to the shareholders of Plastitoys. Leisure Products will have to offer 600,000/3.96 = 151,515 shares to acquire Plastitoys. Therefore, after the merger, there will be 1,151,515 shares outstanding, and the value of the merged firm will be $114,000,000 (see part a). Price per share = $114,000,000/1,151,515 = $99 Therefore, COST = Value of shares offered to firm B – PVB = $99 × 151,515 – $12,000,000 = $2,999,985 NPV = - COST + GAIN = -2,999,985+ 12,000,000 = $9,000,015 With these terms of the share exchange, the NPV is the same as the cash offer. d. If the acquisition is for cash, the cost of the merger is unaffected by the change in the forecasted growth rate. The price paid for Plastitoys is still $15,000,000 and its current value is still $12,000,000. The cost remains at $3,000,000. However, the gain is zero, making the NPV to Leisure Products -$3,000,000. If the acquisition is for stock, however, the value of the stock given to the shareholders of Plastitoys will be lower than under the original growth forecast. Therefore, the cost to Leisure Products will be lower. If the value of Plastitoys is unaffected by the merger, then PVAB = $90 × 1,000,000 + $20 × 600,000 = $102,000,000 and the new share price will be $102,000,000/1,151,515 = $88.58 23-10 Therefore, the cost of the merger is COST = $88.58 × 151,515 – $20 × 600,000 = $1,421,199 which is $1,578,801 million less than the original estimate, $3,000,000 - $1,421,199. The NPV of the share exchange for Leisure Products is -$1,421,053. 16. a. Currently, both Teachers' pension fund and OMERS mention their fund sizes on their main webpages. When accessed in September 2011, Teachers reported assets of $107.5 billion and OMERS reported $53 billion of assets. b. To access Teacher’s corporate governance guidelines point on “Responsible Investments” and then click on “Corporate Governance” and “Proxy Voting Guidelines”. Teachers defines corporate governance as: Corporate Governance Defined “We define corporate governance as “the system by which companies are directed, controlled and evaluated.” Responsibility for corporate governance lies primarily with the board of directors. The role of shareholders and other investors is to appoint directors and to ensure that a proper governance structure is in place. However, good governance is about good practice and not merely about good structure. We must be diligent in evaluating the performance of the directors of the companies whose shares we own to ensure that the governance system is working. We have developed our Corporate Governance Policies and Proxy Voting Guidelines keeping in mind our rights and our responsibilities as fiduciaries acting on behalf of our pension plan’s beneficiaries. It would be inconsistent with our fiduciary responsibility to vote for any management or shareholder-sponsored initiative that we believe is likely to diminish shareholder value over the long term. Our guidelines are guidelines only. They are not regulations and will evolve as circumstances change. We commit to remain open-minded and pragmatic. We will apply these policies and guidelines with thought and with consideration to the individual circumstances of companies. Actions taken under these guidelines are reviewed by the investment committee of Teachers' board at least once a year.” Source: http://www.otpp.com/wps/wcm/connect/otpp_en/Home/Responsible+Investing/Governance/Guidelines/Guidelines_Corporate+Governance+ Defined The issues that Teachers identify as of concern include (1) the structure and the election of the board of directors (issues such as who can be on the board, how many board members), (2) the compensation of board members and management, (3) protecting shareholders in takeovers, and (4) shareholder rights issues (eg. whether certain share structures are permitted) For OMERS, select “Investments”, “Corporate Governance” then "About Corporate Governance. From there, the Proxy Voting Guidelines outline the governance rules by which OMERS operates. Quoting from this document: “OMERS beneficially owns shares in over 2,000 publicly traded companies around the world and prefers to invest in companies governed by directors who understand that their primary duty is to represent the best interests of the shareholders by ensuring management has a well thought out strategy for growing the business, running it efficiently and achieving long term 23-11 profitability. OMERS believes that companies that have strong corporate governance are generally more capable of creating growing value for shareholders.” The areas of concern identified in the OMERS document are the same as those listed by Teachers: board of directors, executive and director compensation, takeover protection, and shareholders rights. They also list social responsibility. Quoting from the document, they state, Many Canadians believe that there is more to share ownership than supporting profit-making to improve short-term share price. OMERS believes that the effective management of the risks associated with social, environmental and ethical matters can lead to long-term financial benefits for the companies concerned and that shareholders have a right to know about the activities of their companies. We support reasonable shareholder resolutions that ask companies to make full disclosure of all reasonable information on social, environmental and ethical matters that significantly affect the company’s short- and long-term value. c. Teacher’s lists the upcoming board meeting of Canon Inc. on March 27, 2009. Teacher’s is voting agains the appointment of Fujio Mitarai as a Director. The reason given is: All of the nominees for director are company insiders. Teachers' believes that a board of directors should have a majority of independent directors to ensure that the board and its committees are truly independent of management. In addition, the nominees include 25 incumbents. A board of this size dilutes the voting power of individual members and can also reduce the effectiveness of the board. To register our dissatisfaction with these two matters, we vote against Mr. Mitarai, the Chairman of the Board. d. OMERS proxy voting report for January 2009 shows mostly votes for corporate proposals. They voted against increasing the number of authorized shares of CenturyTel Inc., voted against amendments to omnibus (general) stock plans for a number of companies 17. The glossary of terms is accessible at www.cicbv.ca/?page=Glossary, also found by clicking on “About Us”. There is no solution to this question. 23-12 Solution to Minicase for Chapter 23 The market values of the two firms in March, before McPhee’s price increased in response to a possible takeover were: McPhee: £4.90 × 5 million = £ 24.5 million Fenton: £8.00 × 10 million = £ 80.0 million Combined value: £104.5 million We are told that the London stock market as a whole has been largely unchanged during this period, so we can assume that changes in the prices of McPhee and Fenton shares between March and June 11 are due to news about the potential merger. After the takeover bid was announced, the combined market value of the two firms becomes: McPhee: £6.32 × 5 million = £ 31.6 million Fenton: £7.90 × 10 million = £ 79.0 million Combined value: £110.6 million Thus, the market agrees with Fenton that there are gains to be had from a merger and new management. Still, the market is not as optimistic as Fenton. The combined value of the shares increases by £6.1 million, which is less than Fenton’s estimate of cost savings worth £10 million. The gain of the merger based on the market’s assessment is therefore £6.1 million. However, in light of the drop in the market value of Fenton stock, the cost must be greater than this amount. In fact, the cost to Fenton is the increase in the value of McPhee shares resulting from the announcement of the takeover bid – this is the premium paid to the McPhee shareholders. McPhee shares increase in value by £7.1 million, so the NPV of the merger to Fenton is Economic gain − costs = £6.1 − £7.1 = −£1 million which is the amount by which the stock value declines. It would not be wise for Fenton to sweeten its offer. The verdict of the market is that it already is paying more for McPhee than the company will be worth. Any increase in the offer would most likely further reduce the value of Fenton shares. 23-13 Brealey 5CE Solutions to Chapter 24 1. a. You can buy 100 /1.388512 = 72.02 euros for $100. You can buy 100 x 1.388512 = 138.85 dollars for 100 euros. b. You can buy 100/1.080513 = 92.55 Swiss francs for $100. You can buy 100 x 1.080513 = 108.05 dollars for 100 Swiss francs. c. If the euro depreciates, then $1 will buy more euros, so the direct exchange rate ($/€) will decrease and the indirect exchange rate (€/$) will increase. d. One Australian dollar can buy 1.011736 U.S. dollars. Therefore, one U.S. dollar is worth less than one Australian dollar. 2. a. ¥82.912/$; that is, ¥82.912 is equal to 1 dollar. b. ¥81.673 = 1 dollar c. Premium. You get fewer yen for each dollar in the forward market. d. 0.0152 81.673 82.912 − 81.673 = , or 1.52% e. ¥ / $ ¥ / $ $ ¥ 1 1 S F r r = + + 82.912 81.673 1.016 1+ r¥ = r¥ = 0.0008 = 0.08% [In fact, the short-term interest rate in Japan at the end of March 2011 was around 0.1%]. f. ¥81.673 = 1 dollar g. 82.912 .9851 81.673 (1 ) (1 ) ¥ / $ ¥ / $ $ ¥ = = = + + S F E i E i That is, the inflation rate in Japan is expected to be 1 – .9851 = .0149, or 1.49 percentage points lower than the inflation rate in Canada. 24-1 3. a. The interest rate differential equals the forward premium or discount, i.e., for currency x, E A= A E(sx/$) Esx/$ E c. Prices of goods in different countries are equal when measured in terms of the same currency. It follows that the expected inflation differential equals the expected change in the spot rate, i.e., A E(1 + ix) EE(1 + i$) E =A A E(sx/$) Esx/$ E d. Expected real interest rates in different countries are equal, i.e., A 1 + rx 1 + r$ E =A A E(1 + ix) EE(1 + i$) E 4. a. Forecasts of future exchange rates to convert cash flows into domestic currency b. Forecasts of the foreign inflation rate to produce cash-flow forecasts e. Domestic interest rates to discount domestic currency cash flows 5. If international capital markets are competitive, the real cost of funds in Switzerland must be the same as the real cost of funds elsewhere. That is, the low Swiss franc interest rate is likely to reflect the relatively low expected rate of inflation in Switzerland and the expected appreciation of the Swiss franc. Note that the parity relationships imply that the difference in interest rates is equal to the expected change in the spot exchange rate and also equal to the expected difference in inflation rates. If the funds are to be used outside Switzerland, Ms. Stone should consider whether to hedge against changes in the exchange rate, and how much this hedging will cost. 6. (a) This locks in the dollar value of the euros that the importer will pay in 6 months. 1 + rx 1 + r$ = b. The forward premium or discount equals the expected change in the spot rate, i.e., fx/$ sx/$ fx/$ sx/$ 24-2 7. If the dollar does depreciate, then to maintain a fixed yen price, Sanyo will need to raise the dollar price. This action can cause Sanyo to lose business in the U.S. It can hedge this exchange rate risk by selling dollars forward, so that any loss in U.S. profits due to dollar depreciation will be offset by gains on the forward sale of the dollar. Alternatively, Sanyo can fix the dollar price of its products. This means that its U.S. sales are independent of the exchange rate. But then the yen value of the dollar revenues that it realizes in the U.S. will fall if the dollar depreciates. To reduce this exchange rate risk, Sanyo can sell dollars forward, meaning that its future dollar revenues can be exchanged for yen at the forward exchange rate. 8. The firm can borrow the present value of 1 million Australian dollars, sell those Australian dollars for U.S. dollars in the spot market, and invest the proceeds in an 8- year U.S. dollar loan. In 8 years, it can repay the Australian loan with the anticipated Australian dollar payment. 9. U1 MonthU U12 Months Dollar interest rate (annually compounded) 5.5% 7.0% A Peso interest rate (annually compounded)E A 20.0% 26.1%b Forward pesos 9.603c 11.2 per dollara Notes: a. Spot pesos per dollar = 9.5 b. To find this value we use the interest rate parity relationship. Denote the annual peso interest rate as rx. Then A 1 + rx 1 + r$ E =A A fx/$ sx/$ E Aimplies that rx = A fx/$ sx/$ E ×A (1 + r$) – 1 rx = A11.2 9.5 E ×A 1.07 – 1 = .261 = 26.1% 24-3 c. Again, we can use interest rate parity, this time for a one-month horizon. Parity implies that fx/$ = sx/$ × A 1 + rx 1 + r$ E fx/$ = 9.5 × A 1.20 1.055 E A 1/12 = 9.603 We need to take the 1/12 power in the above equation because the interest rates are expressed in the table as effective annual (compounded) interest rates. We need to put the interest rates on a monthly basis to compute the one-month forward exchange rate from the parity relationship. 10. Call s£ the spot rate ($/£) in one year. The rate of return to a U.S. investor is given by 1+ r$ = (1 + r£) × s£/1.60. If the pound appreciates (meaning that s£ > 1.60), the dollar- denominated return is higher. Because 1 + r£ = 1.04: 1 + r$ = 1.04 × s£/1.60 s£ r$ ———————————— a. 1.60 4.0% b. 1.70 10.5% c. 1.50 − 2.5% 11. We can utilize the interest rate parity theorem: $ £ 1 1 r r + + = £ / $ £ / $ S F The indirect exchange rates are SR£/$R = 1/1.60101 = 0.624606 and FR£/$R = 1/1.602329 = 0.624092 Remembering that we are using the 3-month interest rates expressed at an annual rate, we have: ( ) ( + ) = ⇒ = + 1/ 4 £ 1/ 4 £ 0.624606 0.624092 1 .06 1 r r 0.0565, or 5.65% 24-4 If the sterling interest rate is higher than this, you could earn an immediate arbitrage profit by buying sterling, investing in the 3-month sterling deposit and selling the proceeds forward, ignoring any associated transaction costs. 12. a. The U.S. dollar is at a forward premuim. It takes less U.S. dollars to buy one Canadian dollar in the forward market than in the spot market. b. 0.0100 1.013377 1.023541−1.013377 = , or 1% premium. c. Using the expectations theory of exchange rates, the forecast is Cdn $1 = 1.013377 U.S. dollars. d. $100,000 x 0.9868 = Cdn $98,680 13. The interest rate in the U.S. is 5%. Borrowing or lending in the U.K. and covering interest rate risk with futures or forwards offers a rate of return of: (1 + rUK) × (forward rate/spot rate) – 1 = 1.06(1.54/1.55) – 1 = .0532 = 5.32% It appears to be advantageous to borrow in the U.S. where the rates are lower, and to lend in the U.K. where rates are higher. In other words, the interest rate parity relationship is violated. An arbitrage strategy to take advantage of this violation involves simultaneous lending and borrowing with the covering of any exchange rate risk: UAction NowU UCF in $U UAction at period-endU UCF in $ Lend 1 pound –$1.55 Be repaid; exchange 1.06 × E1 in U.K. proceeds for dollars Borrow in U.S. $1.55 Repay loan –1.55(1.05) Sell forward 1.06 pounds for $1.54 each. (i.e., sell forward $0 Unwind 1.06 × (1.54 – E1) proceeds from the U.K. loan.) TOTAL $0 TOTAL $.0049 24-5 This strategy thus provides a riskless payoff of $.0049 (for every pound loaned in the U.K.) with an initial cash outflow of zero. It is a pure arbitrage opportunity. With no money down, you can earn riskless profits; clearly, you (and other investors) would pursue this strategy to the fullest extent possible. As a result, we would expect the price pressure from this arbitrage activity to restore the interest-rate parity relationship. 14. According to purchasing power parity, the Canadian dollar should be depreciating relative to the U.S. dollar. The purchasing power of Canadian dollars is falling faster than that of U.S. dollars. Therefore, the number of U.S. dollars that can be obtained for one Canadian dollar should be falling. 15. 1.080513 Canadian dollars per Swiss franc, or 0.925486 Swiss francs per dollar. 0.012061 Canadian dollar per yen, or 82.912 yen per dollar. Since 82.912 yen have the same value as 0.925486 Swiss francs, each franc should be worth 82.912/0.925486 = 89.588 yen. So the bank would quote an exchange rate of ¥89.588/Swiss franc. If it did not, you could earn risk-free profits. Suppose that the exchange rate was ¥70/franc. Then an investor could convert $1 into ¥82.912, convert the ¥82.912 into 82.912/70 = 1.184457 Swiss francs, and convert the Swiss francs into 1.184457/0.925486 = $1.28. Therefore, you immediately and risklessly convert $1 into $1.28. 16. The forecasted leos cash flows are converted into dollars at the spot rate that is forecast for each date. The current spot rate is 2 leos per dollar, but the leo is expected to depreciate at 2% per year. UYearU 0 1 2 3 4 5 Leo cash flow, millions -7.6 2.0 2.5 3.0 3.5 4.0 Forecast exchange rate 2.0 2.040 2.081 2.122 2.165 2.208 $ cash flow, millions -3.8 0.980 1.201 1.414 1.617 1.812 At a discount rate of 15%, the net present value of the dollar cash flows is $.72 million. [NOTE: As we point out in the text, we think it is poor practice to mix up the profits from the Narnian operation with the profits that are expected from guessing the direction of currency movements. The exchange rate forecasts used in the problem are inconsistent with the interest rate and inflation rate forecasts. It makes more sense to think first whether the project is worthwhile, and then to look at whether the firm should hedge against, or bet on, exchange rate changes.] 24-6 17. Revenue in Euros (million) Dollar value of euro revenue given exchange rate Additional income from forward contract given exchange rate Total profit (or loss) given exchange rate 0.74 0.65 0.74 0.65 0.74 0.65 1 (receive order) 1.3514 1.5385 +0.0958 - 0.0913 1.4472 1.4472 0 (lose order) 0 0 +0.0958 - 0.0913 +0.0958 - 0.0913 Note: profit on the forward contract = 1/forward rate – 1/ultimate spot exchange rate = 1/0.691 – 1/spot rate Selling the euros forward results in a hedged position only if the export order is received and the firm receives euro-denominated cash flows. The profits on the forward sale offset the fluctuation in the dollar value of the euro revenue. However, if the order is not received, euro revenue will be zero and the forward sale of euros introduces foreign exchange exposure. 18. a. Revenue will be in Trinidadian dollars, whereas the Canadian firm is concerned with the Canadian dollar value of revenue. Therefore, the value of the revenues in Canadian dollars will depend on the exchange rate at the time the goods are sold. b. If the Canadian firm borrows in Trinidad and converts the borrowed funds to dollars, the future revenue in Trinidadian dollars can be used to pay off the Trinidadian debt. Therefore, the loan offsets the exposure created by foreign- currency denominated cash inflows. c. Now costs as well as revenue are foreign currency denominated. The firm’s foreign exchange exposure is based on its net profits rather than its gross revenue. Therefore, its exposure is mitigated. 19. a. Most revenues are in dollars while a large fraction of costs are in Swiss francs. If the Swiss franc appreciates, then net cash flow will decline when expressed in a common currency (either dollars or Swiss francs). The stock price will fall. b. Nestle's net cash flow as measured in a non-Swiss currency, such as U.S. dollars, will be largely unaffected by the appreciation of the Swiss franc since neither costs nor revenues are denominated in Swiss francs. However, the value of the cash flow stream (which is in non-Swiss currencies) will fall as measured 24-7 in Swiss francs. Therefore, the dollar value of Nestle stock might be unaffected, but the Swiss franc value of the stock might fall. c. Costs are in Swiss francs. The Swiss franc value of revenues is hedged. So the Swiss franc value of Union Bank should be unaffected by the appreciation. 20. The chronology of a few selected major events leading to the creation of the euro is provided below (you can visit the Financial Times website at http://specials.ft.com/euro/ and the European Commission’s website at http://ec.europa.eu/economy_finance/euro/index_en.htm for additional details): December 1991: Members of the European Union conclude the Maastricht Treaty, in the Netherlands. The treaty provides a plan and timeline for replacing national currencies with a single common currency, called the euro. September 1992: France narrowly votes to adopt the Maastricht treaty. January 1995: Austria, Finland and Sweden join the European Union. June 1998: The European Central Bank is established. January 1999: Launch of the euro. September 2000: Following a referendum, Denmark decides not to adopt the single currency. January 2001: Greece becomes the 12th member of the eurozone. January 2002: Euro notes and coins begin circulation. In 2007 Slovenia becomes the 13th member of the eurozone. Cyprus and Malta become members in 2008 and Slovakia becomes a eurozone member in 2009. As of January 2009, there are 16 eurozone member countries. 21. The euro was launched on January 1, 1999. The permanent conversion rates of the euro against the national currencies of the eurozone currencies are provided below. 24-8 Fixed euro conversion rates Euro-area Member State Old national currency Conversion rate to €1 Austria Austrian schilling (ATS) 13.7603 Belgium/Luxembourg Belgian franc (BEF)/ Luxembourg franc (LUF) 40.3399 Cyprus Cyprus pound 0.585274 Finland Finnish markka (FIM) 5.94573 France French franc (FRF) 6.55957 Germany German mark (DEM) 1.95583 Greece Greek drachma (GRD) 340.750 Ireland Irish pound (punt) (IEP) 0.787564 Italy Italian lira (ITL) 1936.27 Malta Maltese lira (MTL) 0.429300 The Netherlands Dutch guilder (NLG) 2.20371 Portugal Portugese escudo (PTE) 200.482 Slovakia Slovak koruna (SKK) 30.1260 Slovenia Slovenian tolar (SIT) 239.640 Spain Spanish peseta (ESP) 166.386 Source: The information has been compiled from the European Commission’s website at http://ec.europa.eu/economy_finance/euro/adoption/conversion/index_en.htm 24-9 22. At the website of OECD, as of March 2011, the most recent PPP rates are for 2010. The PPP rates can be retrieved by clicking on “PPPs and exchange rates”. For example, the PPP for the Japanese Yen in 2010 was ¥111.447/U.S$. 23. Foreign exchange quotes around noon time (Eastern) on Monday, March 07, 2011 from Pacific Exchange Rate Service website (http://fx.sauder.ubc.ca/CAD/forward.html). Using the interest parity relationship, and assuming the U.S. to be the domestic country, we can deduce which interest rate is higher. F = forward rate, S = spot rate, rd=domestic interest rate, rf = foreign interest rate F = S + + rd rf 1 1 , This formula assumes indirect quotes for the “domestic” country. For example, the Canadian Dollar 6 month forward = US$1.0231 while the spot quote for the CAD = US$1.0279. Applying the formula above and using the interest parity relationship we can deduce which interest rate is higher. 1.0231 = 1.0279 + + rd rf 1 1 , notice that the forward US$ is at a discount relative to the Canadian Dollar. 24. From the OECD website,www.oecd.org, as of March 2011, we note that for the most part the U.S dollar was appreciating against other major currencies from 1991 to 2000. However, from 2001 to 2010, the U.S dollar has been depreciating. At the same time most major currencies such as, the Canadian dollar, Great Britain pound, the Australian dollar has been appreciating in real terms over the same period. A depreciating U.S dollar is a good news for U.S exporters since U.S goods becomes cheaper in the eyes for foreign consumers. As a result, U.S exports should increase. A country that experienced a big decline in the real value of its currency is Mexico. The Mexican Peso has experienced a sharp decline over the period of 2002- 2004 and in 2009. 25. Return = Ending value of shares + dividend – initial investment Initial investment From the Bank of Canada website: The average monthly exchange rate for February 2010 = ¥85.251 The average monthly exchange rate for February 2011 = ¥83.612 From Yahoo Finance website: Ending share price for Magna: closing price for February 2011 = $47.85 From Yahoo Finance website: Total Dividends per Share (From May 2010 to February 2011) = $0.852 24-10 Initial cost: 2,000 x $60 = $120,000 (in Yen, this is $120,000 x 85.251 = ¥10,230,120), Ending value (February 2011) = 2,000 x $47.85 =$95,700 (in Yen, this is $95,700 x 83.612 = ¥8,001,668.4) Dividend = 2,000 x $0.852 = $1,704 (2,000 x ¥70.847 = ¥141,694). Note: Dividend in Yen was calculated using quarterly dividends ($0.186 for May 2010, $0.305 for August 2010, and $0.361 for November 2010) and the average exchange rates for the corresponding months. (¥88.417 for May 2010, ¥81.900 for August 2010, and ¥81.500 for November 2010) Return in Cdn.$ = ($95,700 + $1,704 – $120,000)/$120,000 = -0.1883 or -18.83% Return in ¥ = (¥8,001,668.4 + ¥141,694 – ¥10,230,120)/ ¥10,230,120 = -0.2040 or -20.40% Percentage change Yen/Cdn. Exchange rate from February 2010 to February 2011: = − ¥83.612 ¥85.251 ¥83.612 1.96% During the investment period, the share price has decreased and at the same time, Canadian Dollar also has depreciated by 1.96% against Yen, thus the impact on the return in Yen is more pronounced than in Canadian Dollars. 26. Period: 1 2 3 Real cash flow (millions of rupiah) 250,000 250,000 250,000 Nominal CF (millions of rupiah) 280,000 313,600 351,232 Forecast exchange rate* 9,778.99 10,710.42 11,730.56 Nominal CF ($ million) 28.63 29.28 29.94 PV of CF** 25.25 22.77 20.53 * The real interest rate in Indonesia is (1 + nominal interest rate) / (1 + inflation rate) – 1 = 1.15/1.12 – 1 = .02679 = 2.679%. If real rates in Indonesia and Canada are equal, the real rate in Canada also must be 2.679%. Therefore, the Canadian inflation rate is (1 + nominal Canadian interest rate) / (1 + real rate) – 1 = 1.05/1.02679 – 1 = .02260 or 2.26%. The present spot exchange rate is $0.000112/Rupiah, or Rupiah8,928.571/$. 24-11 Therefore, from purchasing power parity, Forecast spot exchange rate = spot x T ¸ T ¹ ¨ · © ¸¸ u§ ¹ · ©¨§¨ 1.0226 1.12 8,928.571 1 inflation 1 inflation Canada IN The project cost in dollars = 500 billion/8,928.571 = $56 million. NPV = –56 + 25.25 + 22.77 + 20.53 = $12.55 million 27. Possible alternatives for hedging foreign exchange risk: Forward Hedge: Enter into a 3-month forward contract today to buy US$ @ $0.9790/US$. In three months, buy US$200,000 paying $200,000 x 0.9790 = $195,800. Funds needed today = $193,382.72 1.0125 $195,800 4 1 .05 $195,800 ¸ ¹ ¨ · © § Money Market Hedge: Buy US$ spot and invest for 3 months @ 3% p.a. (or 0.75% for 3 months) to yield a future sum of US $200,000. US$ amount needed today = US$198,511.16 1.0075 US$ 200,000 Canadian dollar amount needed today = 198,511.16 x 0.9770 = $193,945.40 Therefore, pay using forward hedge, as it is the lowest cost alternative. 24-12 **Discount rate = (1 + risk premium) × (1 + interest rate) – 1 = 1.08 × 1.05 – 1 = .134 = 13.4% 28. a) For Affiliate Years (in Zp.) 0 1 2 3 Sales revenue 13,000 14,300 15,730 Less: Fixed Cost (1,000) (1,000) (1,000) Variable cost (3,900) (4,290) (4,719) Less: Depreciation (2,333) (2,333) (2,334) EBIT 5,767 6,677 7,677 Less: Taxes (1,730) (2,003) (2,303) Net Income 4,037 4,674 5,374 Add Depreciation 2,333 2,333 2,334 Liquidation Value 5,000 6,370 7,007 12,708 Less: ½ of addition of working capital (1,050) (130) (143) Less: Project cost (7,500) Net Cash flow (7,500) 5,320 6,877 12,565 18% PV factor 1.000 0.8475 0.7182 0.6086 PV of each year (7,500) 4,509 4,939 7,647 Cumulative PV (7,500) (2,991) 1,948 9,595 NPV = Zp. 9,595.00 For Parent Year 0 1 2 3 Cash dividend(1/2 of NI) 2,019 2,337 2,687 Add back tax (0.5 of Affiliate taxes) 865 1,002 1,152 Grossed Up Dividend 2,884 3,339 3,839 Exchange rate 2.0 2.2 2.42 2.66 Grossed up dividend ($) 1,311 1,380 1,443 Parent taxes (393) (414) (433) Credit for Zamboana tax 393 414 433 Additional taxes due - - - Dividend Recd. 918 966 1,010 Project cost (3,500) Liquidation Value 1,880 Net Cash flow (3,500) 918 966 2,890 18 % PV factor 1.0000 0.8475 0.7182 0.6086 PV of each year (3,500) 778 694 1,759 Cumulative PV (3,500) (2,722) (2,028) (269) 24-13 NPV = ($269.00) Note: Working Capital calculation: 1 2 3 Total Sales 13,000 14,300 15,730 Working Capital (20 % of sales) 2,600 2,860 3,146 Less: beginning working capital 500 2,600 2,860 2,100 260 286 Less: w/cap. finance by accrual & A/C payable 1,050 130 143 Net new investment in working capital 1,050 130 143 b). The project in acceptable in Zamboana, however it is not acceptable in Canada due to the negative NPV. Notice the importance of the exchange rate in the capital budgeting decision. Solution to Minicase for Chapter 24 The points you should make are: a. When judging the cost of forward cover, the relevant comparison is between the forward rate and the expected spot rate. Since the forward rate is on average close to the subsequent spot rate, the cost of insurance is low. b. The firm could buy spot yen today but would then receive the low yen rate of interest for 1 year rather than the higher dollar rate. Interest rate parity states that the two methods of hedging (buying yen forward or buying spot and investing in yen deposits) have similar cost. c. The yen interest rate is likely to be low because investors expect the yen to appreciate against the dollar. The firm can expect the benefit of borrowing at the low interest rate to be offset by the extra cost of buying yen to pay the interest and principal. Also, borrowing yen would add currency risk and it would be odd to do this at the same time as buying yen and putting them on deposit. 24-14 Solution Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011
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