Chapter 2:
the objective function in corporate finance

Answer to First Concept Check on Page 12: Maximizing firm value is the broadest of the objective functions. Maximizing stockholder wealth and maximizing firm value become equivalent objectives when bondholders are fully protected from expropriation. Maximizing stock prices becomes an equivalent objective to maximizing stockholder wealth when financial markets are efficient. Maximizing stockholder wealth might not lead to maximizing firm value if it is accomplished by stealing from bondholders. Maximizing stock prices might not lead to maximizing stockholder wealth if markets are not efficient.

Answer to Second Concept Check on Page 12: While there are certainly scenarios and circumstances where firms that focus on maximizing stockholder wealth might have to compromise on what is best for customers, employees or society, it is also true that in general firms that take care of their employees, customers and are viewed as good corporate citizens are much more likely to do well for their stockholders.

Answer to Concept Check on Page 13: It depends upon which side costs one is talking about. The owners of private firms may have an even stronger incentive than managers of publicly traded firms to maximize their wealth at the expense of bondholders and society. At the same time, the reputation effect of doing so may way more heavily on the owner of a private firm.

Answer to Concept Check on Page 17: As a stockholder in a company, I would not vote for an anti-takeover amendment because it transfers power from me to the incumbent management. This may, however, be rooted in my deep distrust of incumbent managers. An investor with greater trust in the good will of incumbent managers may be more likely to vote for such an amendment.

Answer to Concept Check on Page 18: An acquisition can never be forced on an acquiring firm. The fact that other firms in the sector are doing acquisitions in completely irrelevant, if such acquisitions cannot be accomplished without paying large premiums over the "true" value (which includes any potential gains from synergy etc.)

Answer to Concept Check on Page 20: The owner of a convertible bond can convert his bond stake into equity. Thus, if equity investors expropriate wealth from bondholders, the convertible bondholder is less affected for two reasons. One is that he can convert his stake into equity and thus no longer be the target of expropriation. The other is that the value of the equity component of the convertible bond will increase, partially or completely offsetting any losses on the bond portion.

Answer to Concept Check on Page 23: Companies that need to access capital markets repeatedly are less inclined to mislead the financial markets because they will pay a much larger price, in terms of reputation lost and future costs, from doing so.

Answer to Concept Check on Page 25: If financial markets are not efficient, then we may not be able to justify the objective function of maximizing stock prices. However, we can still focus on maximization of stockholder wealth or firm value.

Answer to Concept Check on Page 26: The problem of social costs still exists even if there is comprehensive legislation because legislation can almost never perfectly cover "anti-social" acts and adequately penalize offenders. The other problem, however, is that this is based upon the assumption that there is always a consensus in society on which acts create social costs and how much these costs are. In reality, there is a great deal of debate and division on these issues.

Answer to First Concept Check on Page 27: The best candidates for leveraged buyouts would be those large, inefficient, and unprofitable firms that have a high degree of separation of ownership and management, and low debt (relative to what they can afford).

Answer to Second Concept Check on Page 27: Institutional investors may have more information than individual investors, and their tax status can be very different. These differences may cause conflicts of interests between these two groups of investors. Consider the scenario, where pension funds and individual investors both hold stock in a firm, which is considering returning the cash in the form of dividends. Pension funds, which are tax exempt, may want the dividends paid, and individual investors might not.

Answer to Concept Check on Page 28: The typical target firm in a hostile takeover is poorly managed and poorly run. When there is legislation against hostile takeovers, it is the manages of these firms who benefit the most from the protection.

Answer to Concept Check on Page 30: Emerging markets that are not very efficient still justify the objective function of value maximization, though stock prices may not be accurate measurement of the value to be maximized.

Answer to Concept Check on Page 32: Customer satisfaction is a means to an end. You want satisfied customers because you want them to keep buying your products, which, in turn, increases your revenues and potentially your value.

Answer to Concept Check on Page 33: A not-for-profit organization needs an objective function. The choice of objective function depends on the nature of this organization. Thus, a not-for-profit hospital's objective may be to deliver a specified level of health care to a target population at the lowest cost possible.

Chapter 3:
Present Value

Answer to Concept Check on Page 40: A low savings rate in conjunction with a higher investment rate generally translates into a higher required real rate of return. This, in turn, translates into a higher discount rate.

Answer to Concept Check on Page 43: Investing in stocks gives higher long-term returns which are associated with higher risk. The risk is buffered by the fact that I have a long time horizon, when I am young, leading to higher investments in stocks. As I age, my time horizon shrinks, leading to a greater allocation to lower risk investments such as money market funds.

Answer to Concept Check on Page 46: No. It is not, for the simple reason that you do not own the car at the end of the lease period, whereas you do, in the case of a purchase. You will have to estimate the expected salvage value of the car at the end of the lease period, and reduce your purchase price by this amount to make the two options comparable.

Answer to First Concept Check on Page 47: You can try to pay him less in the first two years and more in the last year. For example, you might want to pay $1 million in the first year, $1 million in the second year, and $3 million in the last year.

Answer to Second Concept Check on Page 47: The present value of the payments over the next 30 years has to be equal $20 million (50% of $ 40 million). There are a number of possible combinations that will provide this present value. For instance, paying $ 1 million a year for the next 14 years, and $ 1.625 million a year for the following 16 years, will yield a nominal value of $ 40 million and a present value of $ 20 million.

Answer to Concept Check on Page 50: Suppose that the first installment of $690,295 is paid at the end of the first year, it would grow to $1,269,079 nine years later at the interest rate of 7% as a part of principal payment. The new annual installment of the sinking fund would be $728,914 for the next nine years at the interest rate of 7%. (Take the difference between $10 million and $ 1,269,079, and look for the annuity over 9 years at an interest rate of 7%)

Answer to Concept Check on Page 53: The present value of the gold to be extracted from the mine would increase to $16,229,046. The present value effect (of a higher discount rate) is dominated by the growth effect ( of a higher growth rate), but only because r<g. If r were greater than g, the present value effect would have dominated. (Try it out and think of the implications of higher inflation for the stock prices of high growth versus low growth companies.)

Chapter 4:
understanding financial statements

Answer to Concept Check on Page 67: If a firm has all cash sales, pays for all its material and labor in cash at the time of production and production is instantaneous (there is no inventory), then accrual and cash accounting will provide the same values. In the far more likely scenario where sales may be on credit, there is inventory and some material may be bought on credit, then switching from accrual to cash accounting will affect income. Whether it will increase or decrease income depends upon whether the effect of credit sales dominates the effect of inventory and accounts payable.

Answer to Concept Check on Page 70: The market value of an asset in the secondary market is determined by the interaction of supply and demand, while the book value of an asset is determined by its purchase price and depreciation method used. I would view the market value as a more reliable indicator, since it reflects any new information that has come out about the value of the asset. Accountants tend to use book value for fixed assets, because it is much more easily obtained and less subject to volatility.


Answer to Concept Check on Page 76: Companies with high growth in earnings often have to make significant investments in capital expenditures and working capital needs. This, in turn, creates cash deficits. These investments are really what create growth in earnings in the future. Thus, I would not find the presence of high earnings growth and negative cash flows in the same firm to be inconsistent.

Answer to Concept Check on Page 77: If the measure of return on assets is defined as the net income divided by total assets, then firms with high interest payments would have low return, not because they have taken bad projects, but because of the limitations of the return measure.

Answer to Concept Check on Page 80: The choice of divisions for investment purposes should not be based on the divisional ROA alone because ROA does not take into consideration the financing mix and riskiness for each division.

Answer to Concept Check on Page 81: The firm with higher ROA is better and has a higher quality ROE because it gets to the same level of return with lower level of risk.

Answer to Concept Check on Page 86: If a firm’s market value of equity is much larger than its book value (this firm is probably called a growth company), then its book valued-based debt ratio would overstate its debt relative to equity, resulting in underutilization of debt. In other words, companies with higher price to book ratios than average will underutilize debt, whereas companies with lower price to book ratios will overutilize debt.


Chapter 5:
risk and return -- theory

Answer to First Concept Check on Page 96: In CAPM, the variance as the measure of risk should be the variance for the future return. Only if we assume that the variance does not change, could the historical variance be used as the measure as risk.

Answer to Second Concept Check on Page 96: Risk is of course the "downside" potential. If the returns are symmetrical, then the "upside" potential is assumed to be the same as the "downside" potential. If returns are not symmetrical, we should probably start defining risk in terms of downside potential (with semi-variance, for instance, where we look at only those returns below the mean in computing variance).

Answer to Concept Check on Page 98: This statement might be true from the perspective of total risk, but not from the perspective of market risk. The quality of management is a "firm-specific" component of risk and is thus diversifiable. (Note that firms with high quality managers will tend to have higher stock prices. It is only the deviation of actual management quality from expected management quality that is risk).

Answer to Concept Check on Page 100: The minimum variance portfolio is not the best portfolio to hold for all investors, since risk aversion varies across investors. For an investor who is extremely risk averse, it may be the best portfolio.


Answer to Concept Check on Page 102: The less random the process for picking stocks, the more stocks you would need to become diversified. Each selection criteria added on runs the risk of biasing the search towards some sectors at the expense of others. Thus, a strategy of picking low PE ratio stocks will require more stocks to become fully diversified than a random diversification strategy.

Answer to Concept Check on Page 106: Combining the riskless asset with the market portfolio allows invstors to take on more risk without compromising on diversification. Any other strategy that involves buying subsets of the market portfolio will involve some degree of compromise on diversification and thus lead to higher risk for any given level of return.

Answer to First Concept Check on Page 107: If a new asset is a significant proportion of the market portfolio, the risk of that asset will now become a factor over and above the covariance of the asset with the market portfolio. In other words, a portion of the firm specific risk of this asset will now become part of the overall market risk.

Answer to Second Concept Check on Page 107: Sure. An investment with a negative beta is an investment which reduces the risk of your overall portfolio. It operates as insurance against some component of market risk. A commonly given example is gold, which provides insurance against hyper inflation. Thus, it goes up when the rest of your financial assets are battered by inflation. A negative beta investment will have an expected return less than the riskfree rate. (Insurance has a price)

Answer to Concept Check on Page 111: The number of factors and the factors themselves that determine returns can change over time if there are structural changes in the economy and financial markets. Each factor is measuring some component of overall market risk, and there is nothing in the process that binds market risk to stay stagnant over time.

Answer to Concept Check on Page 112: The APM would work better to explain past returns on stocks because it uses more independent variables than CAPM. However, it is not clear whether the APM will work better than the CAPM in forecasting expected returns for the future. What is gained by having more independent factors may well be lost in estimation noise when these factors and their loadings are predicted for the future.

Answer to Concept Check on Page 113: It is very much possible that a factor is significant in some periods but not so significant in some other periods. Economies go through structural changes, resulting in different factors determining the expected returns of assets in different periods. This fact may imply that multi-factor models that work well at explaining past returns may not necessarily work well at predicting future returns.

Answer to Concept Check on Page 117: If markets have already incorporated in bond prices all the public information that is the basis for bond rating, then bond prices should not react significantly to changes in bond rating.


Chapter 6:
risk and return In practice: estimation of discount rates

Answer to Concept Check on Page 128: The assumption is that the historical risk premium is also the future risk premium on stocks and bonds. If investors risk aversion has changed over time, and/or there has been a change in the risk in the market, this assumption may not hold up.

Answer to Concept Check on Page 129: While the long term bond rate is usually higher than the T.Bill rate (The term structure in the United States has been upward sloping for much of the last century), the risk premium used for T.Bonds is generally lower than the risk premium used for T.Bills. Thus, the cost of equity using T.Bonds may higher than that estimated using T.Bills for some stocks (usually high beta stocks) and lower for others (usually low beta stocks). It can also change over time, depending upon how upward sloping the term structure is at that point.

Answer to First Concept Check on Page 132: To get a reasonable range for the beta, consider the standard error of the beta estimate. (With about 67% confidence, the true beta should lie within one standard error of the coefficient estimated).

Answer to Second Concept Check on Page 132: Not really. The fact that a stock has a low R-squared just indicates a significant portion of firm specific risk in that stock. If an investor is well diversified, this should be eliminated in the portfolio anyway. If you are not well diversified, a stock with a high R-squared is a better investment, since its has less firm-specific risk.

Answer to Concept Check on Page 133: Stocks listed on overseas markets will generally have lower betas if the NYSE index is used to make the estimation instead of the local index. More of the risk in this stock is diversifiable if the marginal investor is a US investor. If I were an investor with most or all of my wealth invested in US stocks, the beta relative to the US index is more relevant. If I were an investor invested primarily in the local market, the beta relative to the local index has more meaning.

Answer to Concept Check on Page 135: The cost structure of European firms should have more fixed costs, because of restrictions on lay offs. This would imply that European firms would have higher betas due to higher operating leverage.

Answer to Concept Check on Page 137: As an investor, I would care about why my beta was high, since changes in beta will track the changes in the underlying fundamentals. Thus, if I were invested in a firm with a high beta due to high financial leverage, any action that the firm takes that would reduce its debt will reduce their risk.

Answer to First Concept Check on Page 139: If the acquisition were financed entirely with equity, then the total debt = $615 + 3,186 = $3,801 million, and total equity = $18,500 + 31,100 = $49,600 million. D/E = 0.07663. Then new beta = 1.026 (1 + 0.64 (0.07663)) = 1.076.

Answer to Second Concept Check on Page 139: If all divisions with different risk characteristics use the same cost of equity, then the divisions with higher risk will overinvest while the divisions with lower risk will underinvest.

Answer to First Concept Check on Page 140: The weighted average of the divisional beta will generally not be equal to the beta from the regression for two reasons - the first is estimation risk and the second is that the firm itself may have gone through significant restructuring over the period of the regression. The bottom-up beta is a much more reliable estimate of the true beta because it reflects the current structure of the firm and it has less estimation error (since the standard error of the average beta is significantly lower than the standard error on one regression beta).

Answer to Second Concept Check on Page 140: Ultimately, the definition of comparable firms lies in the fact that these firms should be exposed to the same market risks and in the same proportion as the firm being analyzed. Thus, entertainment firms may have been the right comparable firms to use when looking at the Boston Celtics, since overall revenues in professional sports tend to be correlated with overall revenues in entertainment.

Answer to First Concept Check on Page 143: As interest rates in the economy go up, the cost of debt, cost of equity, and cost of capital will all go up.

Answer to Second Concept Check on Page 143: Both the pre-tax and after-tax cost of debt should be always smaller than the firm’s cost of equity because debt is always less risky than equity to investors and there are no tax advantages associated with equity. (Equity investors always stand behind bondholders & banks in the line when it comes to cash flows each period and on liquidation. Thus, why would they ever accept a return lower than the one demanded by bondholders)

Answer to Concept Check on Page 144: It is a mystery to me. One possible reason may be that ratings agencies and regulatory authorities treat preferred stock as equity. Thus, firms which are constrained by these authorities may feel that the additional cost of preferred stock is worth the flexibility it offers them. (Banks and insurance companies tend to be big users of preferred stock.)

Answer to Concept Check on Page 145: If the convertible bond increases as stock price increases, the proportion of the value that is debt should decrease

Chapter 7:
capital budgeting decision rules

Answer to Concept Check on Page 162: When a project is a pre-requisit for another project, the two projects should be considered together in investment analysis. As an example, consider market testing as a pre-requisit for taking on a new product. The market testing and the product analysis have to be bound together and considered as a whole.

Answer to Concept Check on Page 163: Whether different projects should use different hurdle rates depend on whether these projects have different risk characteristics. It would be appropriate to use the same hurdle rate only if all the projects under consideration have equal exposure to risk.

Answer to Concept Check on Page 164: The fact that some businesses have succeeded without formal investment rules is no argument against the use of decision rules. A more relevant test might be in terms of the number of businesses that have failed without formal decision rules, which might well have survived with them.

Answer to Concept Check on Page 168: The major problem with equal weights given to returns on capital each year is that it does not consider the time value of money. One way around this problem is to time weight the returns, with returns in earlier years weighted more than returns in later years in computing the average return.

Answer to Concept Check on Page 171: It may be greater than or less than the operating income depending up whether capital expenditures exceed or are less than depreciation and on whether working capital increased or decreased. In general, though, you would expect the cash flows to be lower than operating income for firms with growth in operating income (since this growth has to be created with new investment)

Answer to Concept Check on Page 172: The cash flow to equity may be greater than the cash flow to the firm if the firm has a positive net borrowing. (In other words, a substantial amount of new debt in a period may make the FCFE in that period higher than FCFF). In most cases, however, FCFE will be less than FCFF.

Answer to Concept Check on Page 175: Many firms, when thinking about risk on projects, consider the likelihood that they will lose some or much of what they have invested in the projects to be a source of risk. To the degree that this fear is set to rest at the point of payback, lower payback projects are less riskly than higher payback projects.

Answer to Concept Check on Page 179: It is true that a firm that takes on a positive net present value project should see its value go up because the total market value of a firm is the sum of the present value of projects in place and the net present value of expected future project. This does not imply, however, that the stock price will go up, since the stock price reflects market expectations about the net present value of new projects. Thus, if markets expect a firm to take on a stream of high net present value projects, taking on a positive net present value project may lead to lower price if the net present value turns out to be less than expected.

Answer to Concept Check on Page 180: Using an average discount rate across the four years to calculate the net present value does not yield the same result in the example. Actually, using the average discount rate of 11.5% would give a NPV of $339.70. There is some discount rate, however, that will yield the net present value of $354.23. This discount rate is a weighted average of the year-specific discount rates, with weights dependings upon the magnitude and the timing of the cash flows.

Answer to Concept Check on Page 182: The NPV may increase as the discount rates are increased if there are significant cash outflows in the future.


Chapter 8:
estimating cash flows

Answer to Concept Check on Page 199: No. As tax rates increase, the after-tax income from the project will decrease. This effect will probably dominate the depreciation effect.

Answer to First Concept Check on Page 204: With a tax rate of 20%, the capital gains taxes in year 10 would have been only $ 4 million, a saving of $ 3.2 million. The net present value of $3.2 million at 12% over 10 years is about $1.5 million.

Answer to Second Concept Check on Page 204: The present value of tax savings from expensing the initial investment of $100 million would be equal to $36 million / 1.12 = $32.14 million.

Answer to Concept Check on Page 205: If the research could be sold to a competitor, then the price its competitor is willing to pay needs to be considered as a cash outflow for the project because it reflects an opportunity cost from taking the project.

Answer to Concept Check on Page 208: The net present value of a project will decrease if the salvage value of working capital is ignored because the salvage creates a positive cash flow in the project's final year.

Answer to Concept Check on Page 215: The accounting approach to dealing with excess capacity is to assign a portion of the book value of the capacity as a cost. This approach will not always lead to a higher cost than using the cash-flow based approach, since the book value might be a very small number (especially if the capacity is old) and the lost cash flows can be a very large number.

Answer to Concept Check on Page 217: Building new capacity will become relatively more attractive if the project life for Cinnamon Bran were increased because the present value of the lost sales would be greater.

Answer to Concept Check on Page 219: If all G&A costs are fixed and do not depend upon the number of stores that the Home Depot has, I would ignore allocated G&A costs.

Chapter 9:
issues in capital budgeting

Answer to Concept Check on Page 237: It is not always true that small, high-growth firms face capital rationing constraints. If a small firm is believed by the financial markets to have excellent investment opportunities, then investors are willing to provide the capital to the firm. This phenomenon has been repeated over and over with new technology industries.

Answer to Concept Check on Page 238: There is a difference between an internally imposed capital rationing constraint and an externally imposed capital rationing constraint. An externally imposed constraint is much more severe, leaving no flexibility for investment policy. An internally imposed constraint can be relaxed if the management can identify new and lucrative investment opportunities.

Answer to Concept Check on Page 239: The projects picked using the profitability index are usually not the same as the projects that would have been picked based on an IRR ranking. It is because the IRR is based on the reinvestment assumption that the future cash flows can be invested at the IRR. The PI assumes that the reinvestment rate would be the cost of capital, or the hurdle rate.

Answer to Concept Check on Page 240: If Project B’s initial investment is $40 million, then its PI would be 0.75. There are three options now:

Projects Total Initial Capital Total NPV

B, C, and G 80 55

A, B, C, and G 105 65

A, B, and G 100 60

Answer to Concept Check on Page 241: If capital rationing constraint is reduced, then the hurdle rate should be adjusted down. If the capital rationing constraint becomes more severe, the hurdle rate should go up as well. If the capital rationing constraint is gone, then use the cost of capital as the hurdle rate.

Answer to Concept Check on Page 244: The average discount rate would have no financial meaning, and therefore, cannot be used for computing the NPV of projects with different risk levels. The IRR can still be computed for the differential cash flows, but there would be no relevant comparison (since the hurdle rates for each project will be different).

Answer to Concept Check on Page 245: If the differential cash flows had been computed using the less expensive system as the index projects, the net present value would be negative $8,954 and the internal rate of return would remain the same: 41.04%.

Answer to Concept Check on Page 246: When there is inflation in the economy, both the discount rate and the cash flows would have to reflect the inflation rate. Thus, there would be replication but the costs with each replication would be higher because of the inflation factor. The discount rate would also be higher reflecting the inflation rate.

Answer to Concept Check on Page 249: If the cost of the third-party storage option increases 3% a year, then the NPV of the costs = 2*1.03/(.125 - 0.03) = $21.68 million and the equivalent annuity = 21.68 * .125 = $2.71 million.

Answer to Concept Check on Page 251: Solving the following equation for X: NPV = 0, e.g., -$135,000 + (4,000 + X*0.6) * 5.6502 = 0, then we get X = $33,155. This is the minimum pre-tax savings on operating expenses that will make replacement economical.

Chapter 10:
uncertainty and risk in capital budgeting: Part i

Answer to Concept Check on Page 265: My decision on the project would not change from the base case since the sensitivity analysis suggests that the net present value would be negative only if the parameters are significantly different from that which were used in the base case analysis. This is a subjective judgment, though. Your decision, which reflects your risk aversion, may be different.

Answer to Concept Check on Page 267: Forcing a fixed life for all projects under consideration does not affect the projects equally since the expected life of each project may be different. Longer term projects are much more negatively affected by fixing a life than shorter term projects.

Answer to Concept Check on Page 270: It is possible that the accounting breakeven may be higher than the financial breakeven if accounting income is much lower than cash flows and if this effect dominates the discounting effect.

Answer to Concept Check on Page 272: The results from breakeven analysis will indicate which variables have lower margins for error. Those variables need more through examination from direct research and market research.

Answer to Concept Check on Page 273: Boeing may be able to protect itself against that eventuality by buying a long term put on the collective value of airline stocks. While no such put might exist in the market, it may be able to find a financial service firm that will create this put on the airline industry for it. Thus, if the airline business worsens, these puts will generate the positive cash flows to cushion Boeing against project losses.

Answer to Concept Check on Page 282: Information from past experience with similar projects provides a better understanding of project stages and better estimates of probabilities of outcomes at each stage. In addition, information from past experience also helps estimating the cash flows at each stage.

Chapter 11:
uncertainty and risk in capital budgeting: part ii

Answer to Concept Check on Page 289: One of the major benefits that accrue from this acquisition is that the total market value of the assets in place and future projects of this private firm would be much higher after being acquired. The reason is that the private firm has firm-specific risks which imply a higher discount rate for the owners of this private firm, while the larger, publicly traded firm treats these risks as diversifiable risks and can thus get away with a much lower discount rate

Answer to Concept Check on Page 292: If these firms are indeed comparable, there should be a correlation between revenues/profits at these firms collectively and the revenues/profits of the firm being analyzed over time.

Answer to Concept Check on Page 293: One exception may be that the division has its own debt financing with its assets as collateral. Thus, GE Capital, GMAC and Ford Capital will have their own debt/equity ratios within the parent companies because they carry their own ratings and issue their own debt.

Answer to Concept Check on Page 294: Accounting betas calculated with net income have automatically adjusted for financial leverages, and thus measure equity beta. Using operating income which a pre-debt income would yield unlevered betas, which could then have been levered up to get equity betas.

Answer to Concept Check on Page 295: If the regression has low explanatory power, I would be reluctant to consider the estimate of beta for the division or project obtained from this approach accurate. It would suggest either that betas are not related to financial fundamentals, or that the fundamentals that I chosen were not the ones that explained differences in betas.

Answer to First Concept Check on Page 297: If the potential acquirer is a publicly traded firm, I woud use the cost of equity from the perspective of a publicly traded firm to do my valuation. Whether I would add a currency risk premium would depend upon whether the stockholders in the publicly traded firm were internationally diversified (or the capacity to do so).

Answer to Second Concept Check on Page 297: As the owner of a private firm, facing a higher cost of equity and capital than an otherwise similar publicly traded firm, I would have to generate higher cash flows to compensate. One reason I might be able to do this is that there is separation of ownership and management at large public firms, which might impede these firms when it comes to cutting costs and maximizing cash flows.

Answer to Concept Check on Page 300: If certainty equivalent cash flows are discounted at a risk-adjusted discount rate, the risk is adjusted twice and the net present value would be underestimated. Being too conservative in investment analysis would exclude many profitable projects and results in lower value for the company.

Chapter 12:
organizing and following up on investment analysis

Answer to Concept Check on Page 306: In a perfectly competitive market, firms would expect to have projects that have zero or negative net present value. The returns from these projects would be equal to or smaller than the hurdle rate.

Answer to First Concept Check on Page 309: New development in shopping on line means more competition for the retailing industry. New competition will result in lower return to traditional retailers. To succeed in the this environment, retailers have to provide services to customers that are unavailable when shopping on line.

Answer to Second Concept Check on Page 309: The future returns for the firm will drop towards the hurdle rate (cost of equity and capital) unless the firm can develop and market new patented products very quickly. Competitors will jump in as soon as the patents expire, resulting in much lower prices for the products.

Answer to Concept Check on Page 311: To earn excess returns in trading, you have to be able to create a differential advantage in terms of information or costs over other trading firms. Since most of the large trading firms share the same characteristics and often compete for the services of the same traders, it is very difficult to sustain a differential advantage in trading. I would expect banks to essentially find trading to be a zero net-present value business, if they compete well, and a negative net-present value business, if they do not.

Answer to Concept Check on Page 312: Acquiring a private firm would have higher odds of success than acquiring a publicly traded firm for two reasons. First, private firms are much more likely to have capital rationing and other constraints, which could be released by your acquistion, thus creating value. Second, you do not have to pay a premium over a market price when acquiring a private firm. The acquisition strategy should be to identify those private firms that have difficulty obtaining financing, but have great products or technology.

Answer to Concept Check on Page 315: The manufacturing company that make only two or three large investments each year should worry more about estimation errors because it is less likely that these estimation errors will average out across projects

Answer to Concept Check on Page 316: I disagree with the statement that a pessimistic bias is beneficial. A pessimistic bias often results in underinvestment, which in turn implies that good projects, which could have increased the firm value, are being turned away.

Answer to Concept Check on Page 317: The most common constraints imposed by corporate headquarters to investment analysis relate to total capital investment during a period and hurdle rates. The rationale is to keep control over the investment process and prevent divisional managers from over reaching. However, internally imposed capital rationing constraint can end up forcing the divisions with great projects to under invest, while creating over investment at divisions without very many projects.

Answer to Concept Check on Page 320: I disagree with this argument that firms should always divest or terminate underperforming divisions. An underperforming division’s returns may be below the expected return or even the cost of capital when the projects were undertaken. However, much of the cash flows may be sunk costs today and we need to recalculate whether returns going forward exceed the hurdle rate. As far as divestiture goes, it is always an issue of price. If a third party is willing to pay more than what a division is worth to the firm (in terms of present value of expected future cash flows), the division should be sold. There is no reason, ex-ante, why this would occur only with divisions that are not performing well.

Answer to Concept Check on Page 325: When actual returns on equity and capital are used to judge a firm’s performance at picking projects, we have to keep in mind the following considerations - the returns on equity and capital are based upon accounting income which may not reflect true cash flow returns from these projects; the book value used to compute returns might not measure the amount invested in these projects; the returns in any particular year or years may reflect, besides the quality of project selection, other factors including chance factors outside the control of the firm.

Chapter 13:
the leasing decision

Answer to Concept Check on Page 332: The IRS is mainly concerned that some leases are designed to reduce taxes. The FASB is concerned that some leases are used as off-balance sheet financing. Because the objectives are different, it is not surprising that the definitions of capital lease by the IRS and FASB are different.

Answer to Concept Check on Page 334: Since capital leases lead to more deductions earlier than operating leases, it would result in lower net income but higher cash flows in earlier years.

Answer to Concept Check on Page 336: If the firm used an accelerated depreciation method, the cumulative tax deductions would have been higher and net income would have been lower in the earlier years, and the reverse would have occurred in later years.

Answer to First Concept Check on Page 337: From the financial point view, there is no difference between debt created by borrowing and the liability created by operating lease payments, if the operating lease agreement cannot be terminated without penalty by the lessee before the final lease payment is made. The only differences are really on the priority of the claims (operating leases might come after interest payments on secured debt, and thus might be slightly riskier).

Answer to Second Concept Check on Page 337: When all leases are treated as operating leases in Japan while the American firm capitalizes the leases, we would find that the American firm has higher debt ratios and lower profitability ratios. To correct for these biases during comparison, we should convert operating leases to debt at French and Japanse firms, and then compare the debt and profitability ratios.

Answer to Concept Check on Page 343: If the value of the asset had been depreciated to zero instead of the salvage value, then the annual depreciation would be $3,333,333, which results in tax deduction of $1,200,000 a year. The increase in tax savings from depreciation would be in the amount of $360,000 a year for 15 years. However, the capital gains for selling the project in year 15 would result in a tax liability of $3.0 million (= $15 million * 20% of capital gains tax). So the net cash flow in year 15 would be reduced by the equal amount to $6,668,786.

Answer to Concept Check on Page 344: Since the net advantage to leasing is $2,509,412, the price discount for purchase has to be in the same amount so that you will be indifferent between buying and leasing the distribution system.

Answer to Concept Check on Page 346: For the "riskier" lease payments, we can use the discount rate for the debt of the same firm that has similar priority in claims. For the salvage value, we may use the cost of capital as a proxy for the discount rate. (If the lease is a real-estate lease, I would have used the beta of comparable real estate firms to arrive at a cost of equity and then a cost of capital)

Answer to Concept Check on Page 347: If there is significant renewal risk for the lease option, the firm may decide to buy instead of leasing the asset. Conversely, if the buy decision looks better than the lease decision, based on the present value of the cash flows, I might override if a substantial portion of the present value comes from the estimated salvage value at the end of the estimation period. It is also possible that I might be able to get better servicing of the product and quicker replacement with leasing rather than buying.

Answer to Concept Check on Page 350: The NPV of $101,143 is equivalent to an annual cash inflow of $9,033.42 (= $101,143 / 11.1965) for 15 years. So the breakeven lease payment would be $5,482,628.04 (= $5,500,000 - 9,033.42 / (1-0.48) ).

Chapter 14:
working capital: investment decisions and financing

Answer to Concept Check on Page 356: It would be a quite difficult task to estimate the effect of changing working capital investment on growth rates and discount rates. One approach would be to look at firms in the sector, with different working capital policies, and see the effec on revenue and earnings growth. Another is to test out changes in working capital on a small scale and record the changes in revenues and earnings. In the above example, if the changing working capital did not affect the discount rate, then the value of the firm would be $1,176.47 and $1,196.75, respectively, when the working capital is 10% and 20% of the revenue. So the conclusion that the firm value is maximized would not change.

Answer to Concept Check on Page 358: The pharmaceuticals, and mining industries have the highest average working capital ratios relative to revenues. (The real estate industry looks strange. It might be worth examining how they define working capital) These industries tend to have higher inventory needs than other businesses. The restaurants and eating places, telephone utilities, and electrical and gas utilities have the lowest average working capital ratios. These industries tend to have little or no credit sales and small or no inventory.

Answer to Concept Check on Page 360: Any unanticipated (and random) factors that affect revenues and the overall business of a firm are also likely to create similar changes in current assets over time.

Answer to Concept Check on Page 362: The matching strategy depicted in Figure 14.3 would minimize the interest costs paid because it uses less long-term debt. The conservative strategy depicted in Figure 14.4 would minimize risk because it has more cash available to deal with random needs for current assets.

Answer to Concept Check on Page 365: Technological advances will on average reduce both payment and processing float. To the degree that firms are able to reduce their processing float, while keeping payment float high, the net float will decrease. This is likely when payments are made by large businesses, which can take advantage of technologicial advances much better, to individuals or smaller businesses. However, it is possible that technological advances will decrease the payment float at some smaller firms which make payments to larger firms, and thus increase the net float.

Answer to Concept Check on Page 367: As it becomes easier to preserve liquidity and still earn interest, optimal cash balances would decline because the transaction costs for selling the marketable securities become lower.

Answer to Concept Check on Page 368: The spread between upper and lower cash balance limits = 216.337 *(Variance in Operating Cash Flows)^(1/3). Obviously, the higher the variance in operating cash flows is, the higher the spread between upper and lower cash balance limits is.

Answer to Concept Check on Page 369: One simple approach to control for differences across industries in cash balances is to use the difference between cash balance ratios for individual firms and the average ratio for the industry.

Answer to Concept Check on Page 370: The decision by the retailer to reduce the number of brand names it carries in its stores would reduce inventories at this firm because each brand name needs a minimum inventory and the total inventory is a function of the number of brand names the firm carries.

Answer to Concept Check on Page 373:
The average inventory = 80 + 24.5 * Sqrt[Ordering Cost per Order / Carrying Cost per Car]. As interest rates increase, the carrying cost per unit would rise, and the optimal average inventory should decline.

Answer to Concept Check on Page 376: It is possible that the firm value declines with credit sales even if the interest rate on credit sales is higher than the cost of capital. Customers may default on credit sales and it costs money to convert accounts receivable into cash. The firm value would be reduced by default and collection costs.


Chapter 15:
Capital structure: an overview of financial choices

Answer to Concept Check on Page 393: When a venture capitalist makes investments in a large number of private companies in a variety of businesses, he or she gets a diversified portfolio of private businesses. The assessment of risk in an investment by such a venure capitalist will be to look at the risk added on by this investment to a well diversified portfolio (or beta, if he or she is using the CAPM)

Answer to Concept Check on Page 394: Some firms may be perceived to have great growth potential and therefore can issue warrants to obtain equity funds now. Other firms may believe that their stocks are underpriced, and issuing contingent value rights becomes a low-cost way of providing a signal to the market and to provide insurance to investors. Both firms use the variance in their stock prices to increase the values of their option issues.

Answer to Concept Check on Page 395: If the firm needs to have flexibility on the terms of borrowing, needs to convey confidental information to the lender or is not willing to submit itself to the scrutiny of bond rating agencies, bank debt will be a better choice than bond issues.

Answer to Concept Check on Page 401: The debt ratio will decline over time, because the equity portion of the convertible debt will become more valuable, while the debt portion should be relatively unaffected.

Answer to Concept Check on Page 402: It is possible that preferred stock has a lower cost than straight debt to a company. The tax exemption on 70% of the preferred dividends can be shared between the firm that issues a preferred stock and the firm that invests in the preferred stock, resulting in lower cost for the preferred stock than for bonds.

Answer to Concept Check on Page 406: Many factors might cause differences in terms of financing mix used by firms between U.S. and Japan. Let us consider just two. The first is differences in the tax benefit of debt, arising from different tax rates in the two countries. The second is differences in expected bankruptcy cost. To the extent that both the Japanese corporate governance system (with its keiretsus) and the Japanese government are less willing to let firms go bankrupt will push down the expected bankrupty cost and increase leverage.

Answer to Concept Check on Page 408: When dividend models are used to find the cost of equity, the impact of flotation costs on stock issues can be counted by using a net price that is the difference between market price and flotation costs. When risk-return models are used, the expected return needs to be adjusted for flotation costs. Note, though, that the effect has to be annualized and the long life of equity implies that the added cost per year will be very small.

Answer to Concept Check on Page 415: The arbitrage can be done in the following fashion: (1) purchasing five rights for a total price of $9.0; (2) using five rights and additional $12.5 to purchase 1 share of common stock; and (3) selling the share in the market. The arbitrage profit would be $1.42 (= $22.92-$12.5-$9.0)

Answer to Concept Check on Page 416: In the text example of a rights offering by Tech Temp, Inc., suppose that an investor owns 1,000 shares before the rights offering and exercises all the rights received. Since there is one right for every share owned, he or she receives 1,000 rights, which entitle the purchase of additional 200 shares from the company. The total number of shares after exercising the rights is now 1,200. The proportional ownership in the company remains the same (1,000 relative to 10 million = 1,200 relative to 12 million). Therefore, the rights offering does not dilute the ownership of current shareholders if they exercise the rights distributed to them. The fact that the share price has gone down is irrelevant, since each stockholder has been exactly compensated with more shares.


Chapter 16:
market efficiency lessons for corporate finance

Answer to Concept Check on Page 421: The market with lower transaction costs should be likely to be more efficient than the market with higher transaction costs because prices can adjust more quickly to any new information.


Chapter 17:
Capital structure: tradeoffs and theory

Answer to Concept Check on Page 448: When a firm has large accumulated net losses, there are no tax benefits associated with interest payments. Consequently, the after-tax cost of debt is the same as the pre-tax cost of debt for the period when the net operating losses shelter the firm from taxe. The tax advantage to debt will be reinstated in future periods, once the net losses have been used up.

Answer to First Concept Check on Page 449: A nonprofit organization should follow a low-debt policy since there is no tax advantage of paying interest due to its non-tax paying status.

Answer to Second Concept Check on Page 449: The firm with low returns would probably benefit more from the discipline of debt because there is more room to improve efficiency.

Answer to Concept Check on Page 450: Those firms acquired through hostile acquisitions may be acquired precisely because they are poorly run and under levered (one might follow from the other). Substantial increases in debt ratios after acquisitions may be designed to improve efficiency by imposing discipline on new management.

Answer to First Concept Check on Page 451: The firm will be exposed to higher probability of bankruptcy because it is no longer in a protected business. This is turn should lead to lower leverage, at least in the unregulated businesses.

Answer to Second Concept Check on Page 451: The loss in value of stock associated with companies going bankrupty is really not a cost of bankruptcy, since the equity has already lost its value by the time the firm goes bankrupt.

Answer to Concept Check on Page 453: The cross-holding system in Japan and Germany could make firms take on more debt since the system provides protection against bankruptcy.

Answer to Concept Check on Page 454: This argument is wrong since bondholders may not be able to collect their interest payments and principal payments when the firm increases its default risk. That is precisely the reason why the bond price declines to reflect the higher default risk.

Answer to Concept Check on Page 456: As a bondholder, I would view the latter much more negatively than the former. When firms increase dividends because they foresee higher earnings in the future, these higher earnings could work to my benefit as a bondholder in future periods. When the dividends are paid out of cash accumulated over time, there is really no good news for me as a bondholder.

Answer to Concept Check on Page 457: Both the arguments either for preserving flexibility or for reducing free cash flows have basis, but it boils down to an issue of trust. In firms where I trust management (based upon its past track record), I would be inclined to weight the flexibility argument more. In firms where management has not done a good job of picking projects, I would weight the discipline argument more.

Answer to Concept Check on Page 461: If the tax rate is 28% on all income for all investors, the tax rate on debt income would still be lower than the tax rate on equity income, and thus firm value would increase with leverage. To the extent that some investors are still tax exempt, and that this is the highest marginal tax rate, this conclusion might not hold.


Chapter 18:
Capital structure:
models and applications

Answer to Concept Check on Page 474: The factors that determine the maximum acceptable probability of default for the management of a firm would include: (1) the risk preference or tolerance of the management; (2) the accessibility to financial markets for funds; and (3) the magnitude of potential bankruptcy costs. I would expect a closely held company, where managers are not diversified and often have the bulk of their wealth invested in the company, to be much more reluctant to take on debt, because default would have a much greater consequence to them than it would to owners in a large, widely held public firm.

Answer to Concept Check on Page 487: The higher agency costs as a result of the higher leverage can be incorporated into analysis by building in an extra component into the cost of debt, reflecting this agency cost. In other words, we can assume that lenders who are concerned about agency costs will charge a higher interest rate on debt. To the extent that the flexibility lost as firms take on debt refers to the effect of convenants on the capacity to take future projects, it can be reflected in the expected growth rate.


Answer to Concept Check on Page 489: I would expect a high-growth, high-technology firm to have a low optimal debt ratio because the operating income as a percentage of firm value is usually low for high growth firms (operating income drives the capacity to make interest payments and carry debt) and there is usually high variance in operating income.

Answer to Concept Check on Page 491: I would expect insurance companies to have operating income which is sensitive to their ratings, since it is likely that their customers will switch to other companies if they feel that there is a risk that the firm will default. The same argument can be made for any firm whose assets have long lives and where these assets require service and parts (a good example would be the automobile business). I would expect these firms to maintain low debt ratios, relative to their operating income.

Chapter 19:
Capital structure—
The financing details

Answer to Concept Check on Page 512: While every input to the optimal capital structure has noise associated with it, the key input for the analysis is the operating income. To the extent that we would really like to estimate the operating income for the future, and borrow on that basis, the greater the variability in operating income, the more noise there will be in the estimate of the optimal debt ratio..

Answer to Concept Check on Page 513: An overlevered firm whose operating income is being affected adversely by its perceived default risk, has a much greater incentive to lower debt and default risk quickly.

Answer to Concept Check on Page 515: Closely held firms are seldom the targets of hostile takeovers, precisely because they are closely held. Since most of the leveraged recaps listed in table 19.1 were triggered by hostile takeoovers, this may explain why closely held firms seldom do recaps. It is also worth noting that closely held firms are also likely to be much more cautious about increasing leverage, since the effects of default on the undiversified owners of these firms would be catastrophic.

Answer to Concept Check on Page 516: Optimally, the firm should keep its best performing divisions and sell off the worst performing divisions. However, the worst performing divisions may not get a good price in the market. The rule is that you want to sell those assets where you can get at least the fair market value, or even better, in excess of fair market value.

Answer to Concept Check on Page 518: The Home Depot is short by roughly 5% at the end of year 5 of the 20% desired debt ratio. If the firm bought back about 1% of the outstanding stock each year, it will be able to reach its optimal debt ratio by the end of year 5.

Answer to Concept Check on Page 520: If Time Warner doubles its capital expenditure from the levels shown on Table 19.5, it has to reduce the repayment of debt each year which will mean that the leverage will not decrease as much over the period.

Answer to Concept Check on Page 525: The salvage value of a project is different from the face value of a bond since the salvage value is the estimated terminal value at the end of a specified period. The face value of a bond is a fixed amount. In addition, the terminal value is really not a cash flow that you will get at the end of the project life, but the present value of cash flows beyond that point.

Answer to Concept Check on Page 526: When the total assets held by a firm is viewed as a portfolio, then the portfolio theory would argue that some of the project-specific risks of individual projects can be diversified away. Matching up the characteristics of the financing to those of the overall project portfolio may be a more cost efficient way of risk matching than matching up financing with each individual project's risk characteristics.

Answer to Concept Check on Page 527: The tremendous growth of floating rate loans and bonds in 1970s was caused by the unstable and high inflation rates. Since inflation has been stable since late 1980s, there should be a decline in the demand for floating rate bonds. Companies may still want to issue floating rate bonds if there is uncertainty about future projects.

Answer to Concept Check on Page 530: Preferred stock is treated as equity by accountants and ratings agencies. This may be a reason for the use of preferred stock by firms which are sensitive about how the ratings agencies perceive their default risk.

Answer to Concept Check on Page 536: When the R-squared of the regression is only 13% and the t-statistic is only marginally significant, the regression lacks explanatory power. In other word, the relationship between change in firm value and change in interest rates is very weak, and the duration estimate obtained from the regression has considerable noise associated with. Looking at the average across a number of firms in the same sector may yield a better estimate of true duration.

Chapter 20:
the determinants
of dividend policy

Answer to First Concept Check on Page 546: Uncertainty about future operating cash flows and the need for new financing are two factors that determine the extent of the lag between earnings and dividends at a firm.

Answer to Second Concept Check on Page 546: We should not expect to see many cyclical firms to cut their dividends during recessions, if they base their dividend policy on normalized income (over economic booms and recessions). At the same time, we should expect them to not increase dividends as much as earnings go up during economic booms.

Answer to Concept Check on Page 548: When the growth rates have begun to ease off and the firm does not start paying dividends, the cash reserves will build up rapidly.

Answer to Concept Check on Page 550: The stock price would not go up on the ex-dividend day because the information about the dividend changereaches the market on the declaration day which occurs well before the ex-dividend day. If the dividend change is a surprise, the market reaction will be on or around the declaration date.

Answer to Concept Check on Page 552: Firms can pay out more than 100% of their earnings as dividends for a short period of time using either borrowed money or accumulated cash reserves from prior periods.

Answer to Concept Check on Page 553: While investing in T.Bills earns a low return, it is also riskless. In fact, on a risk-adjusted basis, investing in T.Bills is a neutral investment (with a zero net present value).

Answer to Concept Check on Page 558: We can argue that the market movements on the ex-dividend days are random and not correlated across firms across different ex-dividend days. Hence, the average movement would be zero and would have no significant impact on the dividend effect.

Answer to Concept Check on Page 559: For companies, capital gains are taxed more heavily than dividends if tcg > 0.15 to. If the marginal investor in a firm is another corporation, dividends may have a tax advantage over capital gains.

Answer to Concept Check on Page 563: Since pension funds pay no taxes either on dividends or on capital gains, they should be more likely to hold dividend paying stocks. Other investors, who are taxed on dividends, will push the prices of stocks that pay dividends down making them attractive to tax-exempt entities, like pension funds.

Answer to Concept Check on Page 564: Given that pension funds are tax exempt and that debate about whether dividends are bad rests on a tax argment, this would provide support for the notion that the value of a firm should not be affected by its dividend policy.

Chapter 21:
a framework for analyzing dividend policy

Answer to Concept Check on Page 578: The portion of free cash flow to equity that does not get returned to stockholders as a dividend or in the form of equity repurchase will add to the cash balance of the firm.

Answer to Concept Check on Page 582: One year’s data contains too much noise on investment returns and free cash flows to equity tend to jump around on a year-to-year basis - earnings, net cap ex and working capial all tend to be volatile.

Answer to Concept Check on Page 584: When incumbent managers are protected, they are less likely to pay out FCFE as dividends and more likely to accumulate cash, since they face little or no pressure from stockholders to return the cash.

Answer to Concept Check on Page 585: I would begin to reassess my willingness to allow the management to retain a lot of cash if the firm’s investment returns show signs of decline or if the firm begins to acquire other companies at significant premiums.

Answer to Concept Check on Page 586: My primary questions would relate to why I would expect the future (in terms of investment returns) to be any different than the past. If I do not expect future projects to be any different from current projects, I would rather see this firm liquidate itself over time by paying out dividends well in exces of its FCFE.

Answer to Concept Check on Page 587: I would disagree for two reasons. First, for every investor the firm will gain by paying dividends, it will probably lose one who does not want to own any stock that pays a dividend. Second, an more importantly, firms which cannot pay dividends should not try to attract investors who like dividends. They will find themselves under pressure to pay out more and more in dividends.

Answer to Concept Check on Page 590: If this firm is paying out less in dividends than its peer group, it can be argued that (1) this firm has more good projects than other firms in the industry; (2) this firm has more volatile earnings than other firms in the industry; and (3) this firm has less access to capital markets than other firms in the industry, and thus needs to retain cash. If this firm is paying out more in dividends that its peer group, the arguments will have to be reversed.

Chapter 22:
returning cash to stockholders

Answer to Concept Check on Page 600: Firms have to pay a lower price in a privately negotiated transaction than in an open market repurchase for two reasons. First, there is no liquidity effect created in the market by a stock repurchase. Second, privately negotiated repurchases are usually mutually beneficial, with both the seller and the buying wanting to go through with the transaction.

Answer to Concept Check on Page 603: As long as the return on market capital (EBIT (1-t)/Market Values of Equity and Debt) exceeds the after-tax cost of debt, the earnings per share will go up after the stock buyback.

Answer to Concept Check on Page 604: Not all equity repurchases are good news for stockholders. If a firm with significant investment needs and limited access to capital buys back stock, stockholders are right to be wary about the effect on market value. Furthermore, an equity repurchase by a high-growth company can be viewed as a signal that good projects are drying up.

Answer to Concept Check on Page 605: A forward contract is a delayed purchase of the stock while a put is an option to sell the stock back to the issuing firm at the discretion of the buyer. Puts will be exercised only if the stock price drops below the exercise price. From the firm's perspective, puts carry much more risk than forward contracts.

Answer to Concept Check on Page 607: Since stock prices are not continuous, there is a minimum level of bid-ask spread, say, 1/8. When the price is lower, the ratio of bid-ask spread relative to the price would be higher.

Answer to Concept Check on Page 609: There would be no increase in value because the source of undervaluation, the incumbent management, is still with the spun off business. The spin off process itself does not increase the value of the businesses.

Answer to Concept Check on Page 612: It is possible that the divisions that have been spun off have been weighed down by their association to the parent firm. Thus, the spin off might make them even more profitable than they are currently, and could be viewed as good news.



Chapter 23:
basics of valuation

Answer to Concept Check on Page 620: This is not true. The cost of capital, which is used to discount these cash flows, will be affected by leverage and thus affect value.

Answer to Concept Check on Page 622: It is absurd to believe that any company including Microsoft can grow at 15% a year forever when the economy is not assumed to have a sustainable growth rate of more than 5% (in nominal terms). With this growth rate, it would not be long before Microsoft is larger than the U.S. economy.

Answer to Concept Check on Page 623: It is possible for a firm to go from 15% growth in earnings to less than 5% growth in a short period, especially if the source of the high growth has disappeared (a patent or protection against competition, for instance).

Answer to Concept Check on Page 624: Both high beta and low beta companies will find their betas move toward one as they approach stable growth because the risk level of these companies will move close to the average risk of the market

Answer to Concept Check on Page 625: I would weigh the fundamental growth rate the most, because the inputs can reflect my understanding and expectations of the firm's investment prospects, financing and dividend policy. Historical growth rates look at the past, and analyst projections are too general.

Answer to Concept Check on Page 627: No. No economist that I know of has been able to predict recoveries and recessions with any degree of accuracy. It is far better to smooth out earnings estimates to reflect the expectation of growth over recoveries and recessions.

Answer to Concept Check on Page 628: If the payout ratio is not adjusted upward when the firm is expected to arrive at the stable growth period, the estimate for the value of equity would be low since the level of dividends would be low in the stable period as well.

Answer to Concept Check on Page 629: The assumptions made about the high-growth period still matters since the magnitude of the terminal value is a function of assumptions about how high the growth during the high-growth period will be, and how long it will last.

Answer to Concept Check on Page 630: Solving for g in the following equation:
$26.75 = $2.00 * (1+g)/(.1163 - g), we find that g = 3.864%.

Answer to Concept Check on Page 636: A firm cannot growth with reinvesting. If the net cap ex is zero (and working capital needs are small), the firm cannot grow over time. The net capital expenditures in stable growth can be estimated from the expected growth rate and the return that the firm earns on its projects: Reinvestment Rate = Growth Rate / Return on Capital

Answer to Concept Check on Page 638: You could value each part of AT&T separately, using reasonable assumptions about risk and growth. If these values are added up and the sum is larger than the traded market value of AT&T as a combined firm, it can be argued that the sum of the parts exceeds the whole.

Answer to Concept Check on Page 640: If the net capital expenditures is assumed to be growing at the same rate as the earnings, the expected FCFE at year 6 would be smaller, resulting in a lower terminal value and a smaller value today.

Answer to First Concept Check on Page 641: The assumption is that net capital expenditures are zero and that there are no working capital requirements. Under this assumption FCFF = EBIT (1 - tax rate) and it is appropriate to use the cost of capital as the discount rate on EBIT (1 - tax rate). For a high-growth firm this assumption is not very proper since the net capital expenditures are high and the firm will have working capital needs over time.

Answer to Second Concept Check on Page 641: The growth in earnings per shre will almost always be greater than the growth in operating income. Leverage can push up growth in earnings per share but it cannot affect operating income.

Answer to Concept Check on Page 643: This equity value will be the same as the value obtained by valuing equity directly if all the following three conditions are satisfied: (1) consistent assumptions are made about the growth in the two approaches; (2) outstanding debt means the market value of the debt, not the par value of the debt; and (3) bonds are priced correctly.

Answer to Concept Check on Page 647: If interest income is part of the cash flows in the discounted cash flow valuation, and cash is added back to this value, it is being counted twice.

Answer to Concept Check on Page 649: When she uses multiples, she is already making implicit assumptions about growth, risk, and payout. For instance, if she is comparing the multiple to the average multiple for the sector, she is assuming that her firm has similar growth potential, risk characteristics and payout as the typicla firm in the sector.

Answer to Concept Check on Page 650: The assumption is that all the comparable firms have the same level of risk.

Answer to Concept Check on Page 651: An investment banker would probably value the IPO based on comparables, since he has to sell the IPO in the market as it is priced today. The approach used by an individual investor should depend upon her time horizon. If she has a short time horizon, she should also use relative valuation. If she has a long time horizon, the argument for using a discounted cash flow model increases.


Chapter 24:
management decisions, corporate strategy, and firm value

Answer to Concept Check on Page 659: Any division that can get a higher market price than its value to the firm should be divested. This is much more likely to happen if the source of the problem is poor management. The acquirer then will be willing to pay a premium over current value to reflect the expected improvement from putting in a new management team.

Answer to Concept Check on Page 660: Higher risk implies a higher discount rate that, in turn, results in a lower PE ratio. In the example, if the cost of equity of the new project is 18% and the return on equity is 25%, then PE ratio would be 7.53. What matters is the difference between the ROE and the cost of equity.

Answer to Concept Check on Page 661: If the firm has a poor record of investment performance in the past, its announcement of new capital investment may result in a negative price reaction. This observation would be consistent with the evidence in these studies because they are statistical average reactions.

Answer to Concept Check on Page 664: Based on the evidence in Table 24.4, we could expect, on average, that the stock price would go down since issuing stocks and paying down debt decreases leverage. The price reaction would still be negative, although milder, if the cash reserves are used to pay down debt.

Answer to Concept Check on Page 666: If the discount rate is increased due to higher riskiness of its assets even more than the return on assets, the value of the firm would still go down.

Answer to Concept Check on Page 668: The NPV of investments in existing assets calculates the present value of all future cash flows associated with these projects, while the EVA calculates the excess dollar value created in a period. The present value of EVA over time is equal to the net present value.

Answer to Concept Check on Page 670: The major value of a high-growth company comes from the future investment projects while the EVA focuses on the existing projects. The risk of using the EVA approach is that the increased return on capital may be obtained by sacrificing future growth opportunities. In order to prevent abuses, the firm will have to judge management based not just on EVA but also on risk and expected growth potential.


Chapter 25:
acquisitions and takeovers

Answer to Concept Check on Page 677: If the management believes that stockholders do not have as much information as it does about the target firm’s finances and its fit with the bidding firm, then it is the responsibility of the management to convey the information in a credible way. Looking at the empirical evidence, stockholders seem to have good reason to be skeptical about management claims on synergy and value created in mergers.

Answer to Concept Check on Page 678: If it cannot be valued, then how do you decide how much to pay for it?.

Answer to Concept Check on Page 680: A simple way to do it is to take the present value of the synergy estimated in the problem to be $12,514 and discount it back five years at the cost of capital of 9.50%. This yields value of $7,949.

Answer to Concept Check on Page 681: I would think that the procedure to estimate the value of synergy would be the same whether the merger occurs between firms of equal sizes or of unequal sizes. However, the values of synergy tend to be large, relative to the value of the target firm, when a large firm takes over a small firm, since even small changes in the large firm (due to synergy) will create large changes in value.

Answer to Concept Check on Page 683: If either Lube & Auto or Dalton Motors had been a private firm, the diversification may reduce the risk at the firm level, since private firms care about total risk and not just about market risk.

Answer to Concept Check on Page 684: It depends upon which is in short supply in the overall economy. If it far more difficult to find great projects, the firm with great projects/cash shortages will get the larger share of the synergy benefits. If it is more difficult to find excess cash, the firm with the excess cash will get the larger share of benefits.

Answer to Concept Check on Page 686: If the merger goes through and the combined firm’s debt is kept at pre-merger levels, then the bond prices would go up and stockholders would find a portion of their wealth has been transferred to the bondholders.

Answer to Concept Check on Page 687: This argument has two flaws. First, most managers at the time of the merger claim that synergy is just around the corner and will occur right after the merger. Second, the present value of the synergy benefits will decrease substantially if the benefits will not show up for 5 or 10 years, reducing its effectiveness as an argument for paying large premiums.

Answer to Concept Check on Page 690: If a firm is optimally run, and managers seem to be doing stockholder bidding, there is really no value to control, and thus there should be no premium for voting over non-voting shares.

Answer to Concept Check on Page 691: Well-managed firms (those firms that have been generating good returns on investment projects) are most likely to be successful in getting anti-takeover amendments approved by shareholders. Consequently, it should not be surprising that there are no significant negative stock price reactions to the news that anti-takeover amendments have been approved, since the approvals are mostly at these well managed firms. The negative price reaction is more likely when poorly managed firms manage to get anti-takeover amendments through.

Answer to Concept Check on Page 693: Going private will probably give rise to higher agency costs associated with the conflict of interests between stockholders and bondholders because the managers of the private firm now have a much more immediate stake in maximizing their (and stockholder) wealth, often at the expense of bondholders.

Answer to Concept Check on Page 694: Yes, it is possible for a deal to make sense from the perspective of equity investors, but not from the perspective of all investors. This is likely to occur when the deal is financed with debt borrowed at rates which are lower than they should be (given the default risk). This cheap debt makes the deal attractive from the perspective of equity investors.

Answer to Concept Check on Page 698: The biggest problem with this argument is that the sub-group that you are looking at (other acquisitions) is likely to be biased. Acquisitions require premiums and acquirers often overpay. Thus, basing the price on the prices paid for other acquisitions will result in you overpaying as well.



Chapter 26:
international finance

Answer to Concept Check on Page 706: The inflation rates have been much higher in Mexico, Brazil, and Russia than in the United States in the last few years. Inflation rate differentials will ultimately show up in exchange rates.

Answer to Concept Check on Page 707: Three major obstacles would prevent the international Fisher effect from being fully realized: (1) government regulations and restrictions; (2) transaction costs of moving capital across country borders; and (3) market frictions that might prevent investors from investing in other currencies or markets.

Answer to Concept Check on Page 709: If the lending rate is different from the borrowing rate, there will be no arbitrage feasible as long as the price stays within a band around the equlibrium price. If prices move outside this bound, arbitrage will again become feasible. Put another way the difference between the lending and the borrowing rate is a transactions cost which has to be compared to the deviations from interest rate parity.

Answer to Concept Check on Page 711: Not necessarily. The drop in exchange rates was public information and investors may already have built in its effect on earnings, cash flows and value. To the extent that the actual earnings announcement matches up to expectations, there should be no price reaction on the announcement.

Answer to Concept Check on Page 712: I think that the real choice is between continuous political risk (which is what you have in a democracy) and discontinuous political risk (which is what you have in a dictatorship). Over long periods, dictatorships can look like they have no risk, until the explosion occurs (a coup or the death of the dictator) and the country changes a lot quickly. I would rather deal with continuous risk (irritating though it might be) than discontinuous risk.

Answer to Concept Check on Page 713: This firm should hedge its exchange rate risk because the owner-managers are not diversified. Thus, the argument that exchange rate risk is diversifiable does not apply.

Answer to Concept Check on Page 716: The put option is preferred to the forward contract since Boeing can reap the profits from a stronger Singapore dollar if the forecast that the Singapore dollar will strengthen indeed happens.

Answer to Concept Check on Page 719: Since investing in government securities and earning risk-free rate is a zero-NPV project, the restrictions should not affect the net present value of the project negatively. This assumes, however, that the government security rate is set by a market mechanism and not by the government itself (arbitrarily).

Answer to Concept Check on Page 722: Without the remittance restrictions, the total present value for the cash flows from year 1 to year 6 would be equal to $100.79 million. With the remittance restrictions, there is no cash flow until year 6 and the present value for the cash flows in year 6 would be $151.39 million / (1 + 14%)^6 = $68.97 million. There is a loss of $31.82 million in the NPV of this project due to the remittance restrictions. The loss occurs because the cash flows from year 1 to year 5 are invested to earn a below-market rate of 25% (when the fair market rate was 35%).

Answer to Concept Check on Page 723: There may be many conditions which make issuing foreign bonds more favorable than issuing domestic bonds. For example, if the tax rate in foreign country is higher than in the home country, the after-tax cost of debt could be lower with foreign bonds. In addition, some firms may have better reputations in foreign markets than domestic markets. Compaanies which have better reputations in the domestic market (than in foreign markets) will generally get better terms on domestic borrowing than foreign borrowing.



Chapter 27:
Option pricing theory

Answer to Concept Check on Page 731: There is a difference between announcements of dividend changes and the actual dividends themselves. Stock prices tend to go up on the announcement of dividend increases because they provide a positive signal about the future. The actual dividend itself results in a drop in the stock price (on the ex-dividend day).



Chapter 28:
application of Option pricing theory in corporate finance

Answer to First Concept Check on Page 749: In a case of a project option, this will generally not be true, since the option cannot be exercised on the very last date of the option. The project loses value as you wait, creating the equivalent of a large dividend yield.

Answer to Second Concept Check on Page 749: Since the call value equals to $51.02 million, this would be the maximum price the pharmaceutical company is willing to pay for the rights to the drug. If I were the pharmaceutical company, I would want to pay a lower price. If I were the entrepreneur, I would push for the higher price, but it is unlikely that I will get it.

Answer to Concept Check on Page 750: If the firm did not have the exclusive right to the project, then it cannot use the option pricing approach to valuing the option to delay because the project may be undertaken by other firms.

Answer to Concept Check on Page 754: While the oil price itself has not changed, the perceived volatility in oil prices will increase after this event. This, in turn, will make the undeveloped reserves more valuable, since option values increase with variance..

Answer to Concept Check on Page 755: If the value of growth option is added to the net present value of the initial ventures in new markets, the adjusted net present value may change from negative to positive. If, however, these initial ventures are analysed using tradition capital budgeting techniques and no option value is calculated, these ventures are much less likely t be initiated.

Answer to Concept Check on Page 756: Basic research often leads to commercial products.. Technically, basic reasearch projects can be viewed as call options, though it is extremely difficult to estimate the input for valuing these options.

Answer to Concept Check on Page 766: When a firm issues puts, it increases its downside when the stock price goes down, since the puts will get exercised as the stock price drops. This, in turn, will increase the beta of the stock. An investor can still hold both the stock and the put and reduce the beta of her overall investment in the company.

Answer to Concept Check on Page 767: I disagree with the statement that convertible bonds are cheaper than straight bonds because the conversion options that are attached to these bonds are valuable. When the convertible bonds are eventually converted into stocks, there is a value transferred from stockholders to the holders of the convertible bonds. The convertible bonds will be cheaper than straight bonds only when the conversion options are over priced.

Answer to Concept Check on Page 769: Indeed, the call feature provides the firm with additional flexibility. However, potential bond buyers recognize this fact and would pay a lower price for callable bonds than otherwise similar issues of bonds that are not callable.


Chapter 29:
risk management

Answer to Concept Check on Page 777: Much of the risks considered as firm-specific risks by diversified investors would be viewed as market risks by the CEO. The CEO would take measures to reduce or hedge these kinds of risks and these measures would be considered unnecessary and costly by other diversified investors.

Answer to Concept Check on Page 778: The duration of the firm is the weighted average of the duration of the equity and the duration of the debt. When a firm’s assets have long duration (as is evidenced when cash flows move negatively with interest rates), and a firm uses floating rate debt (which has a short duration), the duration of equity will be much higher than the duration of the firm’s assets.

Answer to Concept Check on Page 781: I would expect the duration of firm value to be greater than the conventional estimate of duration, which keeps cash flows constant. The reason is intuitive: Cash flows on projects generally are negatively affected by higher interest rates. Thus, a duration measure that allows cash flows to change as interest rates change will lead to a higher estimate for duration than one that does not.

Answer to Concept Check on Page 782: The regression estimates made from the firm contain random noise while the average obtained across many such estimates should be much less noisy. This is similar to the argument used for bottom-up betas being better than regression betas.

Answer to Concept Check on Page 786: Since the risk management results in a net tax saving of $4.56 million in today’s terms, the firm should be willing to pay up to this amount to smooth the income.

Answer to First Concept Check on Page 787: Managers lose their jobs when firms go bankrupt and bondholders lose a significant portion of what they have lent to the firm. Managers cannot diversify away the human capital risk, and bondholders can do so only to a limited extent.

Answer to Second Concept Check on Page 787: It is worth costing out self-imposed constraints and presenting these costs to management, which can then choose to relax these constraints. External constraints are more difficult to get around, since the bondholders or lenders have little or no incentive to relax them. If the opportunities last are valuable enough, the firm could consider refinancing this debt to reduce or eliminate these constraints.

Answer to Concept Check on Page 789: Whether a small, privately run firm should or should not use risk management products depends the tradeoff between the benefits and the costs. Even if the hedging cost is very high, it might still be good practice to hedge the risk, especially since the owners of these firms tend not to be diversified and would pay a much larger price if these firms ever went bankrupt.

Chapter 30:
corporate finance for privately held firms

Answer to Concept Check on Page 800: This statement is correct only if all of the net income is paid out as dividends entirely. If a portion of the net income is retained, as in the most cases, then investors do not need to pay taxes on these retained earnings. Furthermore, it will also depend upon the tax status of the investors in the publicly traded

Answer to Concept Check on Page 803: If the cost of owner’s time had been ignored, the after-tax cash flows would be overstated and consequently, the NPV of the project would be overstated. The private firm may accept projects with negative NPV.

Answer to Concept Check on Page 805: We are assuming that the historical premiums earned by venture capital firms are indeed the premiums which should be earned by the private firm from the projects under consideration. To the extent that there will be variations even among private firms in different sectors in terms of riskiness and expected returns, this may not be an appropriate assumption.

Answer to Concept Check on Page 806: The 5% return on their savings in the bank is a riskless return while the internal rate of return on the expansion is from a risky project. We cannot compare the two returns without making adjustment for the risks.

Answer to Concept Check on Page 807: There are a number of factors that will determine who gets the bulk of the synergy benefit. Ultimately, it will depend upon which side has the resource that is more in demand. In an economy where good projects are plentiful and capital is limited, the publicly traded firm will get the bulk of the benefit. In an economy where projects are few and capital is plentiful, I would expect the private firm to win out.

Answer to Concept Check on Page 808: Unlimited liability increases the expected bankruptcy costs from borrowing. To that extent, it should result in firms with unlimited liability taking on less deb debt than firms with limited liability.

Answer to Concept Check on Page 809: The empirical findings that closely held or family-run publicly traded firms are less levered than other publicly traded firms are consistent with the arguments laid down in this section — the owners are less diversified and thus feel bankruptcy costs much more directly, agency costs are accentuated and future flexibility is highly valued at these firms.

Answer to Concept Check on Page 810: It is still possible to estimate the value of a private firm even though the estimate is likely to be less accurate than that for publicly traded firms. All historical data including that for publicly traded firms contains noise.

Answer to Concept Check on Page 811: The value of a private firm would be lower when the discount rate contains a diversifiable risk premium. The synergy gains obtained when the private firm is purchased at this price by a diversified investor will end up with the diversified investor.

Answer to Concept Check on Page 814: I agree with the statement that all investments trade at a liquidity discount. It always incurs transaction costs to buy and sell securities, whether they are issued by publicly traded firms, or just the private businesses.