Answers to Review and Concept Check Questions Fundamentals of Corporate Finance, Canadian Edition, 4 by StudyGuide

Answers to Review and Concept Check Questions Fundamentals of Corporate Finance, Canadian Edition, 4th edition Jonathan Berk, Peter DeMarzo, David A. Stangeland, Andras Marosi, Jarrad Harford Chapter 1-25

Chapter 1 Corporate Finance and the Financial Manager 

Answers to Chapter 1 Concept Check Questions

1. What are the advantages and disadvantages of organizing a business as a corporation? Advantages Disadvantages Corporation responsible for obligations More expensive to set up Not responsible for obligations of owners Double taxation More borrowing power/funding Articles of incorporation 2. What is a limited liability partnership (LLP)? How does it differ from a limited partnership? An LLP is similar to a general partnership in that the partners can be active in the management of the firm, and they do have a degree of unlimited liability. The limitation on a partner‘s liability is only in cases related to actions of negligence of other partners or those supervised by other partners. In all other respects, including a particular partner‘s own negligence or the negligence of those supervised by the particular partner, that partner has unlimited personal liability. Limited partners, however, have limited liability—that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firm‘s outstanding debts. 3. What is an income trust? Which type of trust still gets preferential tax treatment after 2011? Canada Revenue Agency allows an exemption from double taxation for certain flow-through entities where all income produced by the business flows to the investors and virtually no earnings are retained within the business. This type of entities are called income trusts and they come in three forms, such as a business income trust, an energy trust, and a real estate investment trust (REIT). Income trusts formed before November 2006 are not taxed at the business level until 2011. REITs will continue to have no tax at the business level beyond 2011, but the other forms of income trusts are now taxed. 4. What are the main types of decisions that a financial manager makes? The financial manager has three main tasks which are described below: 1. Make investment decisions – capital budgeting investment opportunities 2. Make financial decisions – balance between debt and equity and the capital structure 3. Management of the short-term cash needs – cash planning for the firm.

5. What is the goal of the financial manager? Although there are many potential goals for the financial manager, the financial manager is the caretaker of the money (capital) the stockholders have invested in the company and the bottom line is the long-term maximization of the shareholders' wealth. 6. How do shareholders control a corporation? Shareholders control the corporation through their voting rights; however directors and executive are rarely replaced though a grassroots shareholder uprising. If shareholders are unhappy with a CEO‘s performance, they could, in principle, pressure the board to oust the CEO. Instead, dissatisfied investors often choose to sell their shares. Of course, somebody must be willing to buy the shares from the dissatisfied shareholders. If enough shareholders are dissatisfied, the only way to entice investors to buy (or hold) the shares is to offer them a low price. Similarly, investors who see a wellmanaged corporation will want to purchase shares, which drives the stock price up. Thus, the stock price of the corporation is a barometer for corporate leaders that continuously gives them feedback on the shareholders‘ opinion of their performance. 7. What types of jobs would a financial manager have in a corporation? There are various positions within a corporation that a financial manage may hold. The financial manager could hold the position of chief financial officer (CFO), controller, treasurer, budgeting, risk management or credit management. 8. What ethical issues could confront a financial manager? Managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders (also called the principals). Managers face the ethical dilemma of whether to do what is in their own best interests or adhere to their responsibility to put the interests of shareholders first, For example, managers‘ compensation contracts are designed to ensure that most decisions in the shareholders‘ interests are also in the managers‘ interests; shareholders often tie the compensation of top managers to the corporation‘s profits or perhaps to its stock price. For example, biotech firms take big risks on drugs that fight cancer, AIDS, and other widespread diseases. The market for a successful drug is huge, but the risk of failure is high. Investors who put only some of their money in biotech may be comfortable with this risk, but a manager who has all of his or her compensation tied to the success of such a drug might opt to develop a less risky drug that has a smaller market. 9. What advantages does a stock market provide to corporate investors? Markets provide liquidity for a company‘s shares and determine the market price for those shares. An investor in a public company values the ability to turn his investment into cash easily and quickly by simply selling his shares on one of these markets. The analysis and trading by participants in these markets provide an evaluation of financial managers‘ decisions that not only determine the stock price, but also provide feedback to the managers on their decisions. 10. What is the importance of a stock market to a financial manager? The analysis and trading by participants in these markets provide an evaluation of financial managers‘ decisions that not only determine the stock price, but also provide feedback to the managers on their decisions.

11. What is the basic financial cycle? In the financial cycle, (1) people invest and save their money; (2) that money, through loans and stock, flows to companies that use it to fund growth through new products, generating profits and wages; and (3) the money then flows back to the savers and investors. All financial institutions play a role at some point in this cycle of connecting money with ideas and returning the profits back to the investors. 12. What are the three main roles financial institutions play? Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funds (borrowers and firms); they also move funds through time.

Chapter 2 Introduction to Financial Statement Analysis 

Answers to Chapter 2 Review Questions

1. Why do firms disclose financial information? Firms disclose financial statements to communicate financial information to the investment community. 2. Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why. Anyone interested in a firm can look to the financial statements for information. This includes:  Shareholders: Checking the profitability and performance of the firm.  Lenders: Looking for information about the credit-worthiness of the firm.

 Suppliers: Will this firm be a dependable customer?  Competitors: Seeking sales and profitability of the competition.  Management: How well are we running the firm? 3. 4. What is the purpose of the statement of financial position? The purpose of the statement of financial position is to show the financial position of the firm at a specific point in time. 5. How can you use the statement of financial position to assess the health of the firm? The statement of financial position can show how well the firm is managing the assets and financing the operations of the firm. 6. What is the purpose of the income statement? The purpose of the income statement is to report the firm‘s revenues, expenses, and earnings. It shows the profitability of the firm over a specific period of time. 7. How are the statement of financial position and the income statement related? The statement of financial position shows the financial situation of a firm at a given point in time, while the income statement shows the financial performance of the firm during the period leading up to the balance sheet date. The statements are linked through the retained earnings account on the balance sheet, which shows the cumulative profits of the firm during its existence. 8. What is the DuPont Identity and how can a financial manager use it? The DuPont Identity takes the return on equity (ROE) and breaks it into three components: net profit margin, asset turnover, and asset multiplier. The DuPont Identity equation is as shown below:

Return on Equity  Net Profit Margin  Asset Turnover  Equity Multiplier i.e., Net Income Net Income Sales Assets    Shareholder Equity Sales Assets Shareholder Equity The DuPont Identity is useful to managers, as it identifies three drivers that the manager can use to affect ROE. 9. How does the statement of cash flows differ from the income statement? The income statement measures the profits of the firm, while the statement of cash flows measures how cash moves in and out of the firm. These are not necessarily the same, as many non-cash flow transactions are included in the income statement (such as depreciation), while other cash flow transactions are not included in the income statement (such as investment in working capital and property, plant, and equipment). 10. Can a firm with positive net income run out of cash? Explain. Yes, a firm with positive net income can run out of cash. A rapidly growing firm, which is investing heavily in working capital and property, plant, and equipment, can have positive net income on the income statement but show negative cash flows from operating and investing activities. 11. What can you learn from management‘s discussion or notes to the financial statements? Management‘s discussion contains their analysis of the performance of the firm and identifies the risks that the business faces. The notes to the financial statements often clarify and augment the information used and reported in the financial statements.

12. How did accounting fraud contribute to the collapse of Enron? Enron utilized off-balance sheet transactions to inflate profits and hide liabilities.

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Answers to Chapter 2 Concept Check Questions

1. What is the role of an auditor? Investors also need some assurance that the financial statements are prepared accurately. Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, ensure they are prepared according to GAAP, and provide evidence to support the reliability of the information. 2. What are the four financial statements that all public companies must produce? Every public company is required to produce four financial statements: the statement of financial position or balance sheet, the statement of comprehensive income (which includes the income statement), the statement of cash flows, and the statement of changes in equity. 3. What is depreciation designed to capture? Because equipment tends to wear out or become obsolete over time, companies will reduce the value recorded for this equipment through a yearly deduction called depreciation according to a depreciation schedule that depends on an asset‘s life span. Depreciation is not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get. 4. The book value of a company‘s assets usually does not equal the market value of those assets. What are some reasons for this difference? Many of the assets listed on the balance sheet are valued based on their historical cost rather than their true value today. An office building is listed on the balance sheet according to its historical cost less its accumulated depreciation. But the actual value of the office building today may be very different than this amount; in fact, it may be much more valuable. A second, and probably more important, problem is that many of the firm’s valuable assets are not captured on the balance sheet. Consider, for example, the expertise of the firm‘s employees, the firm‘s reputation in the marketplace, the relationships with customers and suppliers, and the quality of the management team. All these assets add to the value of the firm but do not appear on the balance sheet. For these reasons, the book value of equity is an inaccurate assessment of the actual value of the firm‘s equity. 5. What do a firm‘s earnings measure? The income statement shows the flow of revenues and expenses generated by those assets and liabilities between two dates. 6. What is meant by dilution? In the cases of stock options and convertible bonds, because there will be more total shares to divide the same earnings, this growth in the number of shares is referred to as dilution. Firms disclose the potential for dilution from options they have awarded by reporting diluted EPS, which shows the earnings per share the company would have if the stock options were exercised. 7. Why does a firm‘s net income not correspond to cash earned?

There are two reasons that net income does not correspond to cash earned. First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses, such as the purchase of a building or expenditures on inventory, and sources of cash, such as the collection of accounts receivable, are not reported on the income statement. 8. What are the components of the statement of cash flows? The components roughly correspond to the three major jobs of the financial manager as given below: 1. Operating activity starts with net income from the income statement. It then adjusts this number by adding back all non-cash entries related to the firm‘s operating activities. 2. Investment activity lists the cash used for investment. 3. Financing activity shows the flow of cash between the firm and its investors. 9. Where do off-balance sheet transactions appear in a firm‘s financial statements? Management must also discuss any important risks that the firm faces or issues that may affect the firm‘s liquidity or resources. Management is also required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm‘s future performance yet do not appear on the balance sheet. 10. What information do the notes to financial statements provide? In addition to the four financial statements, companies provide extensive notes with additional details on the information provided in the statements. For example, the notes document important accounting assumptions that were used in preparing the statements. They often provide information specific to a firm‘s subsidiaries or its separate product lines. They show the details of the firm‘s stock-based compensation plans for employees and the different types of debt the firm has outstanding. Details of acquisitions, spinoffs, leases, taxes, and risk management activities are also given. The information provided in the notes is often very important to a full interpretation of the firm‘s financial statements.

11. What does a high debt-equity ratio tell you? The debt-equity ratio is a common ratio used to assess a firm‘s leverage. Because of the difficulty of interpreting the book value of equity, the book debt-equity ratio is not especially useful. We will see later in the text, a firm‘s market debt-to-equity ratio has important consequences for the risk and return of its stock. 12. What is a firm‘s enterprise value? The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities. We compute it as follows: Enterprise Value = Market Value of Equity + Debt – Cash. 13. How can a financial manager use the DuPont Identity to assess the firm‘s ROE? A financial manager looking for ways to increase ROE could turn to the DuPont Identity to assess the drivers behind its current ROE. 14. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm? Analysts and investors use a number of ratios to gauge the market value of the firm The P/ E ratio is a simple measure that is used to assess whether a stock is over- or under-valued, based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. 15. Describe the transactions Enron used to increase its reported earnings. Enron sold assets at inflated prices to other firms (or, in many cases, business entities that Enron‘s CFO Andrew Fastow had created), together with a promise to buy back those assets at an even higher future price. Thus, Enron was effectively borrowing money, receiving cash today in exchange for a promise to pay more cash in the future. But Enron recorded the incoming cash as revenue and then, in a variety of ways, hid the promises to buy the assets back. In the end, much of Enron‘s revenue growth and profits in the late 1990s were the result of this type of manipulation. 16. What is the Sarbanes-Oxley Act? In 2002, the United States Congress passed the Sarbanes-Oxley Act (SOX) that requires, among other things, that CEOs and CFOs certify the accuracy and appropriateness of their firm‘s financial statements and increases the penalties against them if the financial statements later prove to be fraudulent. While SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in three ways: (1) by overhauling incentives and independence in the auditing process, (2) by stiffening penalties for providing false information, and (3) by forcing companies to validate their internal financial control processes.

Chapter 3 The Valuation Principle: The Foundation of Financial Decision Making

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Answers to Chapter 3 Critical Thinking Questions

1. What makes an investment decision a good one? A decision is a good one when the present value of the benefits is greater than the present value of the costs. 2. How important are our personal preferences in valuing an investment decision? When markets are competitive, personal preferences are irrelevant in determining the value of an investment. It is the market price that determines the cash value of a good. 3. Why are market prices useful to a financial manager? Market prices are useful to a manager because it is the market price that determines the value of a good. When market prices are not available, it becomes more difficult to value an investment. 4. What is the relation between the Law of One Price and the Principle of No Arbitrage? If the Law of One Price is violated that is the same goods are priced differently on different markets, then an arbitrage opportunity exists. The supply and demand forces will cause the price difference to disappear as astute investors try to take an advantage of the profitable opportunity. In a normal competitive market, arbitrage opportunities quickly disappear. Hence, in a normal competitive market, the supply and demand forces cause prices to equalize so that arbitrage opportunities are eliminated. This is the Principle of No Arbitrage. The actions that lead to the Principle of No Arbitrage are the same that resulted in the Law of One Price. 5. How does the Valuation Principle help a financial manager make decisions? The Valuation Principle helps a financial manager to evaluate the costs and benefits of a decision using market prices. It then guides the financial manager by showing him or her that only decisions where the value of the benefits outweighs the value of the costs will be good ones in the sense of increasing the value of the firm. 6. Can we directly compare dollar amounts received at different points in time? No, we cannot directly compare cash flows at different points in time. Doing so ignores the time value of money—that a dollar sooner is worth more than a dollar later.

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Answers to Chapter 3 Concept Check Questions

1. When costs and benefits are in different units or goods, how can we compare them? Determine a common denominator such as today‘s cash value or present value. 2. If canola trades in a competitive market, would a canola oil producer that has a use for the canola value it differently than another investor would? An individual may value it for more or less depending on his or her preferences for the good. 3. How do investors‘ profit motives keep competitive market prices correct? If arbitrage opportunities exist, investors will race to take advantage of it. Supply and demand forces, influenced by their trades, will cause prices to equalize across competitive markets and eliminate the arbitrage opportunity. 4. How do we determine whether a decision increases the value of the firm? Any decision in which the value of the benefits exceeds the costs will increase the value of the firm. 5. How is an interest rate like a price? Interest rate tells us the market price today of money in the future. It is the price for exchanging money today for money in a year. 6. Is the value today of money to be received in one year higher when interest rates are high or when interest rates are low? When interest rates are high, the value today is lower. You would need to invest a lower sum today to receive the same value in the future had the interest rates been lower. If the interest rates are lower, the value today is higher. An investor would need to invest more today to have the same value in the future and the interest had been higher. 7. How do you compare costs at different points in time? In general, a dollar today is worth more than a dollar in one year. To compare costs at different points in time, we either need to find the future value (compounding) of all the cash flows at the same point in time in the future or find the present value (discounting) of all the future cash flows today. 8. What do you need to know to compute a cash flow‘s present or future value? To compute a cash flow's present or future value we must know the number of periods, the discounting rate for present value (PV), compounding rate for future value (FV) and cash flows.

Chapter 4 The Time Value of Money

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Answers to Chapter 4 Review Questions

1. What is the intuition behind the fact that the present value of a stream of cash flows is just the sum of the present values of each individual cash flow? Each cash flow in the future has a value today. The sum of value of the individual cash flows today represents the total value today of the investment for the investor. 2. What must be true about a cash flow stream in order for us to be able to use the shortcut formulas? In order to use the shortcut formulas, the cash flows have to be constant (or in the case of the growing perpetuities and growing annuities, growing at a constant rate), the cash flows must be paid every period, and the same discount rate must be used on each cash flow. 3. What is the difference between an annuity and a perpetuity? An annuity is a stream of constant cash flows paid in regular intervals for a finite period of time, while a perpetuity is a stream of constant cash flows paid every period, forever. 4. What are some examples of perpetuities? The perpetual bonds: The British government bond–the Consol, The Dutch water board bond– Hoogheemraadschap Lekdijk Bovendams. 5. How can a perpetuity have a finite value? The sum of an infinite number of positive terms could be finite. Cash flows in the future are discounted for an ever increasing number of periods, so their contribution to the sum eventually becomes negligible. 

C n n 1 (1  r )

PV  

6. What are some examples of annuities? Some examples of annuities are: car loans, mortgages, and bonds. 7. What must be true about the growth rate in order for a growing perpetuity to have a finite value? For a growing perpetuity to have a finite value, the growth rate must be less than the interest rate. So that each of the successive terms in the sum is less than the previous term and the overall sum is finite. C1 (1  g)n 1 (1  r )n n 1 

PV  

8. In what types of situations would it be useful to solve for the number of periods or the rate of return? Solve for n, the number of periods: You are planning to buy your first home and need $25,000 as the down payment. You have $15,000 in an investment account that is producing a rate of return of 10%. Solving for the number of periods will determine how long it will take for your investment to grow to $25,000. Solve for r, the rate of return: You have evaluated two investment options to determine which one will yield the highest return on investment. (a) Invest $1,000 in XYZ and they will repay $2,000 in six years time; or (b) Put your $1,000 in an investment account with an annual rate of return of 12.5%. You will need to calculate the rate of return on the first investment option to effectively evaluate these two investment options.

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Answers to Chapter 4 Concept Check Questions

1. How do you calculate the present value of a cash flow stream? To calculate the present value of a cash flow stream you must discount the cash flows. 2. How do you calculate the future value of a cash flow stream? To calculate the future value of a cash flow stream you must use compounding of the cash flows. 3. How do you calculate the present value of a. a perpetuity? To calculate the present value of a perpetual cash flow, we divide the cash flow by the interest rate. Or using the formula: C PV0  r b. an annuity? To calculate the present value of the annuity, we discount each of the cash flows by (1 + r)n or using the formula: 1 1  PV0  C   1   r  (1  r )n 

4. How do you calculate the future value of an annuity? If we want to know the value n years in the future, we move the present value n periods forward on the timeline. FVn  PV0  (1  r )n 5. How do you calculate the cash flow of an annuity? Think of the value of the annuity as the present value of the cash flows. If the cash flows are an annuity, we can solve for the cash flow by inverting the annuity formula. Writing the equation for the annuity formally with principal P, which needs n periodic payments of C and interest rate r, we

1 r

have PV0  C  1 

1   (1  r ) n 

By isolating C, we can determine the cash flow of an annuity, i.e., C 

PV0 1 1  1  r  (1  r )n 

6. What is the rate of return on an investment or the interest rate on a loan, and how do you calculate the rate? The rate of return is defined as the interest rate that sets the net present value of the cash flows equal to zero–the rate of return an investment earns internally as a stand-alone investment. The rate of return can be solved using trial and error, interpolation, financial calculator or Excel spread sheet. 7. How do you solve for the number of periods for an investment or loan? The number of periods like the internal rate of return can be solved using trial and error, interpolation, financial calculator or Excel spread sheet. Additionally, the number of periods may be solved using the rule of 72 or the use of logarithms. 8. What is the reasoning behind the fact that an infinite stream of cash flows has a finite present value? The cash flows in the future are discounted for an ever increasing number of periods, so their contribution to the sum eventually becomes negligible. The Valuation Principle tells us that the value of a perpetuity must be the same as the cost we incurred to create our own identical perpetuity; thus, the sum of an infinite number of positive terms could be finite. 9. How do you calculate the present value of a: a. growing perpetuity? To calculate the present value of a perpetual growing cash flow, we divide the first cash flow by the interest rate less the growth rate. Or using the following formula: C PV0  rg b. growing annuity? To calculate the present value of the growing annuity, we discount each of the growing cash flows by (1+r)n. Or using the following formula:

PV0  C 

n 1  1 g   1    r  g   1  r  

10. How do you calculate the future value of a growing annuity? Finding a simple formula for the future value of a growing annuity, just as we saw for regular annuities. If we want to know the value n years in the future, we move the present value n periods forward on the timeline; that is, we compound the present value for n periods at interest rate r: So, the future value of a growing annuity is n 1   1 g   PV0  C1  1     r  g   1  r  

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Answers to Chapter 5 Review Questions

1. Explain how an interest rate is just a price. An interest rate is the price of using money today rather than in the future. For example, if you want to spend $100 today, you are foregoing interest that could be earned on that $100 if you left it in an interest-bearing account. This interest rate is the price of spending the money now. 2. Why is the EAR for 6% APR, with semi-annual compounding, higher than 6%? The EAR increases when discounting is more frequent because of compound interest. For a given APR, the EAR increases as compounding increases. 3. Why is it so important to match the frequency of the interest rate to the frequency of the cash flows? The formulas for valuing cash flows require that the interest rate match the length of time between cash flows. Thus, you must match the frequency of the interest rate with the frequency of the cash flows. 4. Why aren‘t the payments for a 15-year mortgage twice the payments for a 30-year mortgage at the same rate? The total sum of payments on a mortgage must repay the principal and all of the interest that accrues during the mortgage period. Due to the time value of money (and compound interest), the amount of total interest on a 30-year mortgage is more than double that of a 15-year mortgage. Thus, the mortgage payment on a 15-year mortgage is not quite double that of the 30-year mortgage. 5. What mistake do you make when you discount real cash flows with nominal discount rates? When you discount real cash flows with nominal interest rates, you are accounting for inflation twice. Real cash flows are stripped of any inflation components, but nominal interest rates include an inflation component. Thus, you end up double-discounting for inflation. 6. How do changes in inflation expectations affect interest rates? An interest rate is the price of using money today rather than in the future. Alternatively, an interest rate is the reward for saving money for the future. However, if inflation is expected to increase, the purchasing power of the money in the future is less. This makes the reward of saving less attractive. Normally, when inflation expectations increase, so do interest rates, as borrowers offer greater incentives to lenders to counteract the additional burden of higher inflation. 7. Can the nominal interest rate available to an investor be negative? (Hint: Consider the interest rate earned from saving cash ―under the mattress.‖) Can the real interest rate be negative? Nominal interest rates cannot be negative. An investor would rather save money ―under the mattress‖ at home than pay a bank to hold it. But real interest rates can be negative if inflation is higher than nominal interest rates. This was the case in Japan during the 1990s. 8. In the early 1980s, inflation was in the double digits and the yield curve sloped sharply downward. What did the yield curve say about investors‘ expectations about future inflation rates? The yield curve indicated that investors saw the high interest rates as temporary, with lower interest rates in the future. 9. What do we mean when we refer to the ―opportunity cost‖ of capital?

The opportunity cost of capital is the best available alternative to the investment that you are looking at, given the same level of risk and investment horizon.

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Answers to Chapter 5 Concept Check Questions

1. What is the difference between an EAR and an APR quote? An effective annual rate (EAR) indicates the total amount of interest that will be earned at the end of one year. The most common way to quote interest rates is in terms of an annual percentage rate (APR) indicates the amount of simple interest earned in one year, that is, the amount of interest earned without the effect of compounding even though compounding may occur. 2. Why can‘t the APR be used as a discount rate? Because it does not include the effect of compounding, the APR quote is typically less than the actual amount of interest that you will earn. To compute the actual amount that you will earn in one year, you must first convert the APR to an effective annual rate. It is important to remember that because the APR does not reflect the true amount you will earn over one year, the APR itself cannot be used as a discount rate. Instead, the APR is an indirect way of quoting the actual interest earned each compounding period. 3. How is the principal repaid in an amortizing loan? Your loan payment each month includes interest and repayment of part of the principal. The amount of the principle in each payment repays the principle over the amortization period. 4. Why does the part of your loan payment covering interest change over time? Your loan payment each month includes interest and repayment of part of the principal, reducing the amount you still owe. Because the loan balance (amount you still owe) is decreasing each month, the interest that accrues on that balance is decreasing. As a result, even though your payment stays the same over the entire 60-month life of the loan, the part of that payment needed to cover interest each month is constantly decreasing and the part left over to reduce the principal further is constantly increasing. 5. What is the difference between a nominal and real interest rate? Inflation affects how we evaluate the interest rates being quoted by banks and other financial institutions. Those interest rates, and the ones we have used for discounting cash flows in this book, are nominal interest rates, which indicate the rate at which your money will grow if invested for a certain period.

6. How are interest rates and the level of investment made by businesses related? The discount rates for risk-free cash flows that occur at different horizons, the yield curve provides information about future interest rate expectations and is also a potential leading indicator of future economic growth. Due to these qualities, the yield curve provides extremely important information for a business manager. 7. What is the opportunity cost of capital? The opportunity cost of capital is the best available alternative to the investment that you are looking at, given the same level of risk and investment horizon. 8. Can you ignore the cost of capital if you already have the funds inside the firm? The term (opportunity) cost of capital comes from—investors in your firm are giving up the opportunity to invest their funds elsewhere. This is an opportunity cost to them, and to overcome it you must offer them a return equal to or better than their opportunity cost of capital. Even if you already have the funds internally in the firm to invest, the logic still applies. You could either return the funds to your shareholders to invest elsewhere or reinvest the funds in a new project; however, you should reinvest them only if doing so provides a better return than the shareholders‘ other opportunities. The opportunity cost of capital is the return the investor forgoes when the investor takes on a new investment. For a risk-free project, the opportunity cost of capital will typically correspond to the interest rate on Government of Canada securities with a similar term. But the opportunity cost of capital is a much more general concept that can be applied to risky investments as well.

Chapter 6 Bonds

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Answers to Chapter 6 Review Questions

1. How is a bond like a loan? A bond is like a loan because of the structure of the payments. The bond pays a regular coupon payment, which closely resembles an interest payment on a loan. At the maturity of the bond, the par value is paid, which is like repaying the principal of the loan. Any missed payment on a bond is considered a default on the loan, similar to defaulting on a loan. 2. How does an investor receive a return from buying a bond? Like any investment, a bond requires an initial cost (the price of the bond) and results in future cash flows (coupon payments and par value) to the investor. An investor will discount the future cash flows to ensure that the initial investment earns an adequate rate of return. The return is in the form of future coupon payments and par value payment that have a present value at least as great as the price of the bond. Copyright © 2023 Pearson Toronto, Ontario

3. How is yield to maturity related to the concept of rate of return? The rate of return is the single discount rate that implies that the PV of the benefits of an investment is equal to the PV of the costs of the investment. The yield to maturity is the rate of return for a bond. The yield to maturity is the single discount rate that implies that the PV of the bond‘s cash flows is equal to its price. 4. Does a bond‘s yield to maturity determine its price, or does the price determine the yield to maturity? The price of the bond determines the yield to maturity. The price of the bond is determined by the interest rate yield curve for the bond. The yield to maturity is just the single discount rate that implies the observed market price of the bond. 5. Explain why the yield of a bond that trades at a discount exceeds the bond‘s coupon rate. When the coupon rate is equal to the yield of maturity, the price of the bond equals the par value. Thus, when the yield increases (while holding the coupon rate constant), the price of the bond must decrease and therefore is priced below the par value (at a discount). 6. Explain the relationship between interest rates and bond prices. Bond prices and interest rates are inversely related. As interest rates rise, the PV of the bond‘s cash flows decreases causing a decrease in the price of the bond. As interest rates fall, the PV of the bond‘s future cash flows increases resulting in an increase in the price of the bond. 7. Why are longer-term bonds more sensitive to changes in interest rates than shorter-term bonds? Longer-term bonds are more sensitive to interest rate changes because the compounding of interest. Compounding effects increase as time periods get longer, thus longer-term cash flows are affected more than shorter-term cash flows. 8. Explain why the expected return of a corporate bond does not equal its yield to maturity. The yield to maturity on a corporate bond reflects the single discount rate that implies the price given the promised cash flows of the bond. However, corporate bonds have the potential to default, thus the expected cash flows from the bond are lower than the promised cash flows. (To the extent that the probability of default can be determined, the expected cash flows reflect the probability of default.) Thus, the expected return is lower than the yield to maturity for corporate bonds.

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Answers to Chapter 6 Concept Check Questions

1. What types of cash flows does a bond buyer receive? Bonds typically make two types of payments to their holders. The principal or face value (also known as par value) of a bond is the notional amount we use to compute the interest payments. In addition to the face value, some bonds also promise additional payments called coupons. 2. How are the periodic coupon payments on a bond determined? The amount of each coupon payment is determined by the coupon rate of the bond. This coupon rate is set by the issuer and stated on the bond indenture. By convention, the coupon rate indicates the percent of face value paid out as coupons each year. 3. Why would you want to know the yield to maturity of a bond?

The yield to maturity for a coupon bond is the return you will earn as an investor by buying the bond at its current market price, holding the bond to maturity, and receiving the promised face value payment. 4. What is the relationship between a bond‘s price and its yield to maturity? Bond prices and yield to maturity are inversely related. As the yield to maturity rises, the PV of the bond‘s cash flows decreases causing a decrease in the price of the bond. As the yield to maturity falls, the PV of the bond‘s future cash flows increases resulting in an increase in the price of the bond. 5. What cash flows does a company pay to investors holding its coupon bonds? Bonds typically make two types of cash flows to their holders. The principal or face value (also known as par value) of a bond and in addition to the face value, coupon bonds also promise to make additional period cash payments called coupon interest payments. 6. What do we need in order to value a coupon bond? In order to value a coupon bond we will need the following information: face or maturity value; coupon interest payments; frequency of the coupon payments; maturity date; and yield to maturity or market rate of return.

7. Why do interest rates and bond prices move in opposite directions? Most issuers of coupon bonds choose a coupon rate so that the bonds will initially trade at, or very close to, par (that is, at the bond‘s face value). A higher yield to maturity means that investors demand a higher return for investing. They apply a higher discount rate for a bond‘s remaining cash flows, reducing their present value and hence the bond‘s price. The reverse holds when interest rates fall. Investors then demand a lower yield to maturity, reducing the discount rate applied to the bond‘s cash flows and raising the price. Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa, so that interest rates and bond prices always move in the opposite direction. 8. If a bond‘s yield to maturity does not change, how does its cash price change between coupon payments? As the next payment from a bond grows nearer, the price of the bond will increase to reflect the increasing present value of the next cash flow. This pattern—the price slowly rising as a coupon payment nears and then dropping abruptly after the payment is made—continues for the life of the bond. 9. What is a junk bond? Bonds in the bottom five categories are often called speculative bonds, junk bonds, or high-yield bonds because the likelihood of their default is high and so they promise higher yields. The rating depends on the risk of bankruptcy, as well as the bondholders‘ ability to lay claim to the firm‘s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high priority in bankruptcy or that are backed by a specific asset, such as a building or a plant. 10. How will the yield to maturity of a bond vary with the bond‘s risk of default? This risk of default, which is known as the credit risk of the bond, means that the bond‘s cash flows are not known with certainty. To compensate for the risk that the firm may default, investors demand a higher interest rate. Because the yield to maturity for a bond is calculated using the promised cash flows instead of the expected cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds

Answer to Practitioner Interview Questions 1.

In what ways might you as a financial manager make use of the information in interest rate changes and the yield curve? Interest rate changes affect bond prices and bond portfolio values. Changes in interest rate determine the yields investors demand in order to invest in bonds. The sensitivity of bond prices to changes in interest depends on the timing of cash flows. Depending on the shape of the yield curve (upward sloping, flat or downward sloping), managers can determine the cost of borrowing as various maturities that is short, medium or long term. The yield curve is used to determine the yield to maturity which is used to price bond with different maturities.

How do you think financial managers will prepare the companies for future credit market crises? It is likely that financial managers will help companies to deal with credit market crises or to adapt to crises. Preparation for crises is difficult since we do not know when they will occur and what form they will take.

Chapter 7 Valuing Stocks

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Answers to Chapter 7 Review Questions

1. What rights come with a share of stock? A share of stock gives its owner the right to elect board members, vote on certain transactions of the firm (such as mergers), and receive periodic dividend payments as a partial return on the investment in the stock. 2. Which two components make up the total return to an investor in a share of stock? The two components of the total return of the stock are the dividend payments and the capital appreciation (price change) of the stock. 3. What does the dividend discount model (DDM) say about valuing shares of stock? The dividend-discount model states that the value of a share of stock should equal the present value of all future payments to be received from the stock. It is a direct application of the Valuation Principle. 4. What is the relationship between the NPV of reinvesting cash flows and the change in the price of the stock? In general, if the return is greater than the firm‘s cost of capital, then reinvesting cash flows will increase with the increase of stock prices. If the return is less than the firm‘s cost of capital, the stock price will fall. 5. How can the DDM be used with changing growth rates in future dividends? The dividend-discount model is easily adaptable to multiple growth rates in dividends. Just forecast the dividends until the growth rate stays constant into perpetuity, then, take the present value of the dividends. This is very simple with the use of Excel. 6. What are some of the drawbacks of the DDM? The dividend-discount model (DDM) relies on forecasting dividends, which can be very uncertain. It also does not apply to non-dividend paying stocks. 7. What are share repurchase and how can they be incorporated into the valuation of a stock? Share repurchases are the investment of a firm‘s cash flow in its own stock. This reduces the number of shares outstanding. To incorporate share repurchases in the valuation of a stock, it is best to use the total payout model instead of the dividend-discount model.

8. What are the advantages of valuing a stock based on discounted free cash flows? The advantage of the discounted free cash flow model is that it allows us to value a firm without explicitly forecasting its dividends, share repurchases, or use of debt. 9. Explain the connection between the FCF valuation model and capital budgeting. We can interpret the firm‘s enterprise value as the total NPV that the firm will earn from continuing its existing projects and initiating new ones. The NPV of any individual project represents its contribution to the firm‘s enterprise value and the total value of the enterprise is equal to the sum of the free cash flows from the firm‘s current and future investments. 10. What is the reasoning behind valuation by multiples and what are the major assumptions? We can adjust for differences in scale between firms by expressing their value in terms of a valuation multiple, which is a ratio of the value to some measure of the firm‘s scale. 11. What are the limitations of valuation by multiples? Firms are not identical, so the usefulness of a valuation multiple will inevitably depend on the nature of the differences between firms and the sensitivity of the multiples to these differences. 12. What is an efficient market? The idea that competition among investors works to eliminate all positive NPV trading opportunities is referred to as the efficient markets hypothesis. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors. 13. How do interactions in a market lead to information being incorporated into stock prices? Competition among investors works to eliminate all positive NPV trading opportunities is referred to as the efficient markets hypothesis. Depending on the degree of competition, that is, on the number of investors who have access to this new information, the information will be incorporated into the stock prices. 14. Why does market efficiency lead a manager to focus on NPV and free cash flow? If stocks are fairly valued according to the models we have described, then the value of a firm is determined by the cash flows that it can pay to its investors. A manager seeking to boost the price of her firm‘s stock should make investments that increase the present value of the firm‘s free cash flow. Thus the capital budgeting methods outlined in Chapter 7 are fully consistent with the objective of maximizing the firm‘s share price. 15. Why don‘t investors always trade rationally? Investors are people and as such are subject to a range of the behavioural biases that affect their investing behaviour. 16. What are some of the major behavioural trading biases? Excessive Trading and Over Confidence. Active investors tend to have a higher turnover rate on average and we call investors‘ presumption of their ability to beat the market by overtrading the overconfidence hypothesis. Disposition Effect. We call this tendency to keep losers and sell winners the disposition effect.

Investor Attention. Investors have limited time and attention to spend on their investment decisions and may be influenced by attention-grabbing news stories or other events. Investor Moods. Investment behaviour also seems to be affected by investors‘ moods. Investor Experience. Investors appear to put too much weight on their own experience rather than considering all the historical evidence.

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Answers to Chapter 7 Concept Check Questions

1. What is a share of stock and what are dividends? The ownership of a corporation is divided into shares of stock. As an ownership claim, common stock carries the right to share in the profits of the corporation through dividend payments. Recall from Chapter 1 that dividends are periodic payments, usually in the form of cash, which firms make to shareholders as a partial return on their investment in the corporation. 2. What are some key differences between preferred and common stock? Economically, a preferred share is like a perpetual bond. It has a promised cash flow to holders, and there are consequences if these cash flows are not paid. However, preferred shareholders cannot force the firm into bankruptcy. Preferred shareholders stand in line in front of common shareholders for annual dividends but behind regular bondholders, whose interest payments come first. If the firm is bankrupt, the same priority is followed in settling claims: bondholders, preferred shareholders, and then common shareholders. Finally, as long as the firm is meeting its preferred dividend obligations, the preferred shareholders have none of the control rights of owners, such as voting on directors or other important matters. 3. How do you calculate the total return of a stock? The sum of the dividend yield and the capital gain rate is called the total return of the stock where the dividend yield is the value of the dividend that is received divided by the original purchase price plus the capital gain (current price less the original purchase price all divided by the original purchase price). 4. What discount rate do you use to discount the future cash flows of a stock? Because the future cash flows are risky, we cannot discount them using the risk-free interest rate, but instead must use the cost of capital for the firm‘s equity. 5. What are three ways that a firm can increase the amount of its future dividends per share? The firm can, therefore, increase its dividend in three ways: 1. It can increase its earnings (net income). 2. It can increase its dividend payout rate. 3. It can decrease its number of shares outstanding. 6. Under what circumstances can a firm increase its share price by cutting its dividend and investing more? A firm can increase its growth rate by retaining more of its earnings. However, if the firm retains more earnings, it will be able to pay out less of those earnings and then firm will then have to reduce its dividend. If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut its investments and increase its dividend? Not surprisingly, the answer to this question will depend on the profitability of the firm‘s investments.

7. What are the main limitations of the dividend-discount model? The dividend-discount model values a stock based on a forecast of the future dividends paid to shareholders. However; there is a tremendous amount of uncertainty associated with any forecast of a firm‘s future dividends. Even small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price. 8. What pieces of information are needed to forecast dividends? The forecasting of dividends requires forecasting the firm‘s earnings, dividend payout rate and the future share count. Because borrowing and repurchase decisions are at management‘s discretion, they can be more difficult to forecast reliably than other more fundamental aspects of the firm‘s cash flows. 9. What is the relation between capital budgeting and the discounted free cash flow model? There is an important connection between the discounted free cash flow model and the NPV rule for capital budgeting. Because the firm‘s free cash flow is equal to the sum of the free cash flows from the firm‘s current and future investments, we can interpret t he firm‘s enterprise value as the total NPV that the firm will earn from continuing its existing projects and initiating new ones. Hence, the NPV of any individual project represents its contribution to the firm‘s enterprise value. To maximize the firm‘s share price, we should accept those projects that have a positive NPV. 10. Why do we ignore interest payments on the firm‘s debt in the discounted free cash flow model? The present value of the firm‘s free cash flow, which is the amount of cash the firm has available to make payments to equity or debt holders, determines the firm‘s enterprise value. The effect of the interest payments are incorporated in the discount rate or opportunity cost of capital that is used to discount the future cash flows. 11. What are some common valuation multiples? The common valuation multiples are the price-earnings ratio (P/E); the enterprise value as a multiple of sales can be useful if it is reasonable to assume that the firm will maintain a similar margin in the future; for firms with substantial tangible assets, the ratio of price to book value of equity per share is sometimes used as a valuation multiple and some multiples are specific to an industry. In the cable TV industry, for example, it is natural to consider enterprise value per subscriber. 12. What implicit assumptions are made when valuing a firm using multiples based on comparable firms? The following assumptions are made when using comparables. Comparables were identical to those of the firms being valued and the firms‘ multiples would match precisely. The assumption that the comparable firm has the same expected future growth rates, risk (and therefore costs of capital), uses the same accounting conventions and that there are many comparable companies (that match based on industry and size). 13. State the efficient markets hypothesis. The idea that competition among investors works to eliminate all positive NPV trading opportunities is referred to as the efficient markets hypothesis. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors. There are three forms of market efficiency—weak, semi-strong, and strong form market efficiency.

14. What are the implications of the efficient markets hypothesis for corporate managers? If stocks are fairly valued according to the models we have described, then the value of a firm is determined by the cash flows that it can pay to its investors. This result has several key implications for corporate managers:  Focus on NPV and free cash flow. A manager seeking to boost the price of her firm’s stock should make investments that increase the present value of the firm’s free cash flow. Thus the capital budgeting methods outlined in Chapter 8 are fully consistent with the objective of maximizing the firm’s share price.  Avoid accounting illusions. Many managers make the mistake of focusing on accounting earnings as opposed to free cash flows. According to the efficient markets hypothesis, the accounting consequences of a decision do not directly affect the value of the firm and should not drive decision making.  Use financial transactions to support investment. With efficient markets, a firm can sell its shares at a fair price to new investors. As a consequence, the firm should not be constrained from raising capital to fund positive-NPV investment opportunities. 15. What are several systematic behavioural biases that individual investors fall prey to? Studying of trading behaviour of individual investors found that individual investors tend to trade very actively, with high average turnover rates. Psychologists have known since the 1960s that uninformed individuals tend to overestimate the precision of their knowledge called the overconfidence hypothesis and as a result will tend to over-purchase shares. This will also result in the tendency to keep losers and sell winners the disposition effect disposition effect in many studies. A study in the Taiwanese stock market from 1995 to 1999, investors in aggregate were twice as likely to realize gains as they were to realize losses. 16. Why would excessive trading lead to lower realized return? Excessive trading would result in an increase of seller or supply in the market. This increase in supply will result in lower prices in the market that resulting a lower rate of return.

Chapter 8 Investment Decision Rules

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Answers to Chapter 8 Review Questions

1. How is the NPV rule related to the goal of maximizing shareholder wealth? When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. The NPV of an investment gives the value created by the investment. This is the increase in shareholder wealth by investing in the project. 2. What is the intuition behind the payback rule? What are some of its drawbacks? The payback period is the amount of time it takes for a project to pay back the initial investment. The drawbacks of the payback period are:  It does not adjust cash flows for time value of money  It ignores all cash flows beyond the payback period  The choice of the payback time period is not grounded in economic theory 3. What is the intuition behind the IRR rule? What are some of its drawbacks? The IRR decision rule is to accept a project when the IRR is greater than the cost of capital. This gives the same decision as NPV most of the time, but does not necessarily work under any of the following conditions:  You are deciding between mutually exclusive investments and the required rate of return is less than the crossover rate.  The investment has an initial inflow of cash, followed by cash outflows.  There are multiple IRRs  There is no IRR 4. Under what conditions will the IRR rule and NPV rule give the same accept/reject decision? The following conditions will lead to the same accept/reject decision by both NPV and IRR  There are initial cash outflows, then followed only by cash inflows  The investment under consideration is not mutually exclusive of any other potential investments  The opportunity cost of capital is greater than the crossover point.

5. When is it possible to have no IRR or multiple IRRs? Multiple sign changes in the stream of cash flows from an investment can lead to multiple IRRs for that investment.

6. Why is it generally a bad idea to use IRR to choose between mutually exclusive projects? If the opportunity cost of capital of a project is greater than the crossover rate, the NPV and the IRR rule will select the same project. However, if the opportunity cost of capital is less than the crossover rate, the IRR and the NPV decision rule will result in different decisions. If the project is mutually exclusive, the IRR rule might select the project that adds less value for the shareholder rather than selecting the project that adds more value for the shareholder. 7. When should you use the equivalent annual annuity? The equivalent annual annuity should be used when you are deciding between two mutually exclusive investments with different lives where you plan to reinvest in the chosen investment. 8. What is the intuition behind the profitability index? The profitability index measures the value created per dollar of investment, or ―bang per buck.‖

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Answers to Chapter 8 Concept Check Questions

1. What is the NPV decision rule? How is it related to the Valuation Principle? The NPV decision rule states that when choosing among investment alternatives, take the alternative with the highest positive NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. The NPV decision rule is related to the Valuation Principle because undertaking projects with positive NPV increases wealth. The NPV decision rule is a simple way to apply the Valuation Principle. 2. Why doesn‘t the NPV decision rule depend on the investor‘s preferences? We do not need to know anything about the investor‘s preferences to reach a decision. As long as we have correctly captured all the cash flows of a project and applied that appropriate discount rate, we can determine whether the project makes us wealthier. Being wealthier increases our options and makes us better off, whatever our preferences are. 3. Explain the NPV decision rule for stand-alone projects. When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. The NPV rule is a direct application of the Valuation Principle and, as such, will always lead to the correct decision. In the case of a standalone project, the alternatives we are considering are to accept or reject a project. The NPV rule then implies that we should compare the project‘s NPV to zero (the NPV of rejecting the project and doing nothing). Thus, we should accept the project if its NPV is positive. 4. How can you interpret the difference between the cost of capital and the IRR? In general, what the difference between the cost of capital and the IRR tells us is the amount of estimation error in the cost of capital estimate that can exist without altering the original decision. 5. How do you apply the payback rule? The payback investment rule states that you should accept a project only if its cash flows pay back its initial investment within a pre-specified period. The rule is based on the notion that an opportunity that pays back its initial investment quickly is a good idea.

6. Under what conditions will the IRR rule lead to the same decision as the NPV rule? IRR Investment Rule: Take any investment opportunity where IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital. The IRR and the NPV decision rule with select the same investment opportunities as long as the opportunity cost of capital is greater than the crossover rate. 7. What is the most reliable way to choose between mutually exclusive projects? When projects are mutually exclusive, it is not enough to determine which projects have positive NPVs. With mutually exclusive projects, the manager‘s goal is to rank the projects and choose only the best one. In this situation, the NPV rule provides a straightforward answer: pick the project with the highest NPV. 8. For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes. Because the IRR is a measure of the expected return of investing in the project, you might be tempted to extend the IRR investment rule to the case of mutually exclusive projects by picking the project with the highest IRR. Unfortunately, picking one project over another simply because it has a larger IRR can lead to mistakes because you may accept a project that provides less value of the investor. 9. Explain why choosing the option with the highest NPV is not always correct when the options have different lives. Projects that have a longer life will have more cash inflow periods than the shorter period project. These present value additional cash flow periods may be sufficiently high enough for the longer term project to be the most valuable project that is under consideration. The shorter life project does not include the present value of the benefits of the additional periods and the company may choose a project that adds less value to the firm for the long run. 10. What issues should you keep in mind when choosing among projects with different lives? A company must consider the required life and the replacement cost of the asset. Assets that are constantly changing due to technological improvements may need to be replaced quite often. Secondly, as assets are in the market for a period of time, the replacement cost of the asset may be less expensive and more valuable for the firm at a later date. 11. Explain why picking the project with the highest NPV might not be optimal when you evaluate projects with different resource requirements. Different investment opportunities may demand different amounts of a particular resource. If there is a fixed supply of the resource so that you cannot undertake all possible opportunities, simply picking the highest NPV opportunity might not lead to the best decision. We usually assume that you will be able to finance all positive-NPV projects that you have. In reality, managers work within the constraint of a budget that restricts the amount of capital they may invest in a given period. Such a constraint would force a manager to choose among positive-NPV projects to maximize the total NPV while staying within their budget. 12. What does the profitability index tell you?

The profitability index measures the value created per dollar of investment, or ―bang per buck.‖

Chapter 9 Fundamentals of Capital Budgeting

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Answers to Chapter 9 Review Questions

1. What are pro forma incremental earnings? The incremental earnings of a project comprise the amount by which the project is expected to change the firm‘s earnings. Pro forma indicates that these earnings are estimated. 2. What is the difference between pro forma incremental earnings and pro forma free cash flows? Pro forma incremental earnings comprise the amount by which the investment is expected to change the firm‘s earnings, while pro forma free cash flows indicate the amount by which the investment is expected to change the firm‘s free cash flows. 3. Why do we convert from incremental earnings to free cash flows when performing capital budgeting? Incremental earnings do not correctly capture the timing of when cash is put to work in the project. For example, capital expenditures do not directly affect earnings and depreciation is not a cash outflow. In order to apply the NPV decision rule, we need to know when the incremental cash flows of the project occur. 4. What is the role of NWC in projects? Net working capital is the net amount of current assets required to operate the investment. Net working capital is defined as Cash + Receivables + Inventory – Payables. 5. How does NWC affect the cash flows of a project? A project may expand the size of the firm, which may require increase in current assets. This increase in current assets requires the investment of cash to purchase these assets, which affects the cash flows of the firm. Because we are concerned about the incremental cash flows of the project, changes in net working capital are important in the analysis. 6. Why is it important to adjust the project sales and costs for externalities? The financial manager‘s goal is to maximize the wealth of shareholders. Shareholders own the entire firm, thus managers must be aware of an investment‘s effects on cash flows of the entire firm. Thus, if an investment in one division of the firm will affect another division‘s cash flows, this externality must be considered in order to make the correct investment decision.

7. How is sensitivity analysis performed and what is its purpose? Sensitivity analysis is performed by measuring the NPV of an investment as you alter one of the assumptions of the NPV analysis (this could be the growth rate of sales, the discount rate, the expected tax rate, etc.). This allows you to observe the sensitivity of NPV to each assumption and identify the most ―influential‖ assumptions in your NPV analysis.

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Answers to Chapter 9 Concept Check Questions

1. What is capital budgeting, and what is its goal? A capital budget lists the projects and investments that a company plans to undertake during future years. To create this list, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. Our ultimate goal is to determine the effect of the decision to accept or reject a project on the firm‘s cash flows, and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm‘s value. 2. Why is computing a project‘s effect on the firm‘s earnings insufficient for capital budgeting? One common starting point is first to consider the consequences of the project for the firm‘s earnings. We begin our analysis by determining the incremental earnings of a project—that is, the amount by which the firm‘s earnings are expected to change as a result of the investment decision. The incremental earnings forecast tell us how the decision will affect the firm‘s reported profits from an accounting perspective. However, as we emphasized in Chapter 2, earnings are not actual cash flows. We need to estimate the project‘s cash flows to determine its NPV and decide whether it is a good project for the firm. 3. How are operating expenses and capital expenditures treated differently when calculating incremental earnings? While investments in plant, property, and equipment are a cash expense, they are not directly listed as expenses when calculating earnings. The benefits of the investment in assets will benefit the company over a period of years and the expense will be recognized over the life of the investment. Expenses, on the other hand are incurred every period. 4. Why do we focus only on incremental revenues and costs, rather than all revenues and costs of the firm? All our revenue and cost estimates should be incremental, meaning that we account only for additional sales and costs generated by the project. For example, if we are evaluating the purchase of a faster manufacturing machine, we are concerned only with how many additional units of the product we will be able to sell (and at what price) and any additional costs created by the new machine. We do not forecast total sales and costs, because those include our production using the old machine. Remember, we are evaluating how the project will change the cash flows of the firm. That is why we focus on incremental revenues and costs. 5. If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it? Investments in plant, property, and equipment are a cash expense. They are not directly listed as expenses when calculating earnings. Instead, the firm deducts a fraction of the cost of these items each year for tax purposes as capital cost allowance or CCA—the Canada Revenue Agency (CRA) version of depreciation. Since the capital expenditures do not show up as a cash outflow in the earnings calculation and the non-cash CCA deduction does, we can see why earnings are not an accurate representation of cash flows and the non-cash deduction must be added back for the calculation of the cash flows.

6. Why does an increase in NWC represent a cash outflow? A project may expand the size of the firm, which may require increase in current assets. This increase in current assets requires the investment of cash to purchase these assets which represents a cash flow for the firm. 7. Should we include sunk costs in the cash flows of a project? Why or why not? A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs have been or will be paid regardless of whether or not the decision is made to proceed with the project. Therefore, they are not incremental with respect to the current decision and should not be included in its analysis. 8. Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes. The most accelerated depreciation schedule will result in the quickest write off of the capital asset investments. The quicker the write off, the more tax savings will result earlier in the assets life and the earlier the cash flows the more valuable for the company. 9. What is sensitivity analysis? Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV estimates for a project. 10. How does scenario analysis differ from sensitivity analysis? By conducting a sensitivity analysis, we learn which assumptions are the most important; we can then invest further resources and effort to refine these assumptions. Such an analysis also reveals which aspects of a project are most critical when we are actually managing the project. In reality, certain factors may affect more than one parameter. Scenario analysis considers the effect on NPV of changing multiple project parameters. 11. What are real options? We assumed that our forecast of a project‘s expected future cash flows already incorporated the effect of future decisions that would be made. In truth, most projects contain real options. A real option is the right, but not the obligation, to make a particular business decision. Because you are not obligated to take the action, you will do so only if it increases the NPV of the project. In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity. 12. Why do real options increase the NPV of the project? The option to delay commitment (the option to time the investment) is almost always present. The option to expand which is the option to start with limited production and expand production later only if the product is successful. The option to abandon an investment at a later date which means a firm can drop a project if it turns out to be unsuccessful or even sell the investment to another investor. These are all examples of options that are available for the firm as more or different information becomes available.

Chapter 10 Risk and Return in Capital Markets

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Answers to Chapter 10 Review Questions

1. What does the historical relationship between volatility and return tell us about investor‘s attitude toward risk? The historical relation between volatility and return tells us that investors are risk-averse. 2. What are the components of a stock‘s realized return? The components of a stock‘s realized return are dividend yield and capital gain. 3. What is the reasoning behind using the average annual return as a measure of expected return? If we believe that the distribution of possible returns for a stock does not change over time, then the historical average return is a good estimate of what to expect in the future. 4. How does the standard deviation relate to the general concept of risk? The risk of an investment is the potential for an investment‘s return to be different than expected. Standard deviation of returns is the measure of how volatile returns have been over a period of time. Thus, standard deviation is a good measure for how much a stock‘s return may differ from its expected return. 5. How does the relationship between the average return and the historical volatility of individual stocks differ from the relationship between the average return and the historical volatility of large, well-diversified, portfolios? There is a strong relationship between the average returns and historical volatility of portfolios, but this relationship breaks down when looking at average returns and historical volatility of individual stocks. 6. What is meant by diversification, and how does it relate to common versus independent risk? Diversification is the elimination of risk by combining multiple assets into a portfolio. The risk that is eliminated through diversification is the independent risk. This is the risk that is unique to a particular stock. The common risk, or risk that is shared by all stocks, cannot be diversified away.

7 Which of the following risks of a stock are likely to be unsystematic, diversifiable risks and which are likely to be systematic risks? Which risks will affect the risk premium that investors will demand? a. The risk that the founder and CEO retires. Diversifiable b. The risk that oil prices rise, increasing production costs. Systematic c. The risk that a product design is faulty and the product must be recalled. Diversifiable d. The risk that the economy slows, reducing demand for the firm’s products. Systematic e. The risk that your best employees will be hired away. Diversifiable f. The risk that the new product you expect your R&D division to produce will not materialize. Diversifiable The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk. 8. What is the difference between systematic and unsystematic risk? Systematic risk is the risk that cannot be diversified away, while unsystematic risk is the risk that is diversifiable. 9. There are three companies working on a new approach to customer-tracking software. You work for a software company that thinks this could be a good addition to its software line. If you invest in one of them versus all three of them, a. Is your systematic risk likely to be very different? The systematic risk of investing in one company is not likely to be different than the systematic risk of investing in all three. The systematic risk of developing the software will be roughly the same for each of the three firms. So, each company is as risky (in terms of systematic risk) as the others. The systematic risk of a portfolio is simply the weighted average of the systematic risk of each asset in the portfolio. Since each company has approximately the same systematic risk, the weighted average of the betas of each company will result in the same beta for the portfolio. b. Is your unsystematic risk likely to be very different? The unsystematic risk of investing in just one company will be higher than investing in all three companies. The unsystematic risk of each company can be reduced in a portfolio by combining the companies together. Thus, the risk that one company will not succeed in the development of the new software is offset by the likely success of one of the other firms. Therefore, the unsystematic risk of the portfolio will be less than the unsystematic risk of each company by itself. 10. If you randomly select 10 stocks for a portfolio and 20 other stocks for a different portfolio, which portfolio is likely to have the lower standard deviation? Why? The portfolio with 20 randomly selected stocks will likely have a lower standard deviation of returns than the portfolio with 10 randomly selected stocks. The additional 10 stocks should decrease the standard deviation of returns by increasing the diversification of unsystematic risk. 11. Why doesn‘t the risk premium of a stock depend on its diversifiable risk? The diversifiable risk is the risk that investors can eliminate by combining stocks into a portfolio. Because investors can eliminate this risk on their own, investors are not compensated for holding onto diversifiable risk. Only systematic risk is priced.

12. Your spouse works for Southwest Airlines and you work for a grocery store. Is your company or your spouse‘s company likely to be more exposed to systematic risk? Southwest Airlines is more exposed to systematic risk. Systematic risk describes the movement of the stock relative to the market. Grocery stores will perform about the same in a recession and a boom, as consumers do not alter their purchases of groceries much. But air travel is more sensitive to market swings, so an airline will be exposed to more systematic risk.

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Answers to Chapter 10 Concept Check Questions

1. Historically, which types of investments have had the highest average returns, and which have been the most volatile from year to year? Is there a relation? Treasury bills have the smallest fluctuations in value, but their growth over the period was also the least while the S&P/TSX Composite Index performed the best in the long run, its value also experienced the largest fluctuations or volatility. Yes, more volatile investments tend to have higher average returns. 2. Why do investors demand a higher return when investing in riskier securities? We have established the general principle that investors do not like risk and therefore demand a risk premium to bear risk. 3. For what purpose do we use the average and standard deviation of historical stock returns? The average annual return of an investment during some historical period is simply the average of the realized returns for each year. If we assume that the distribution of possible returns is the same over time, the average return provides an estimate of the return we should expect in any given year the expected return. The standard deviation is the square root of the variance of the distribution of realized returns. 4. How does the standard deviation of historical returns affect our confidence in predicting the next period‘s return? Variance measures the variability in returns by the standard deviation simply indicating the tendency of the historical returns to be different from their average and how far from the average they tend to be. Standard deviation therefore captures our intuition of risk: how often will we miss the mark and how far off will we be? 5. What is the relationship between risk and return for large portfolios? How are individual stocks different? When we plot the average return versus the volatility of each type of investment, we can observe that the investments with higher volatility, measured by the standard deviation, have rewarded investors with higher average returns. While volatility (standard deviation) seems to be a reasonable measure of risk when evaluating a large portfolio, the volatility of an individual security doesn‘t explain the size of the individual stock‘s average return. 6. Do portfolios or the stocks in the portfolios tend to have the lower volatility? Individual stocks, each contain unsystematic risk and volatility in their returns, which is eliminated when we combine them into a large portfolio. Thus, the portfolio can have lower volatility than each of the stocks within it.

7. What is the difference between common and independent risk? We call risk factors that are linked to the factor as common risk. Independent risk factors, such as the risk of theft, are not linked across all companies. When risks are independent, some companies are unlucky and are affected by the risk factor while others are lucky and not affected by the risk; but, overall the risk factor remains similar. 8. How does diversification help with independent risk? The averaging out of risks in a large portfolio is called diversification. Diversification is used to reduce the overall independent risk because the risk factor will affect some securities and not other. 9. Why is the risk of a portfolio usually less than the average risk of the stocks in the portfolio? The individual stocks each contain unsystematic risk, which is eliminated when we combine them into a large portfolio. Thus, the portfolio can have lower volatility than each of the stocks within it. 10. Is systematic or unsystematic risk priced? Why? If the market compensated you with an additional risk premium for choosing to bear diversifiable risk, then other investors could buy the same stocks and earn the additional premium, while putting them in a portfolio so that they could diversify and eliminate the unsystematic risk. As more and more investors take advantage of this situation and purchase shares that pay a risk premium for diversifiable, unsystematic risk, the current share price of those firms would rise, lowering their expected return. This trading would stop only when the risk premium for diversifiable risk dropped to zero. Competition among investors ensures that no additional return can be earned for diversifiable risk. The result: The risk premium of a stock is not affected by its diversifiable, unsystematic risk. This line of reasoning suggests the following more general principle: The risk premium for diversifiable risk is zero. Thus, investors are not compensated for holding unsystematic risk.

Chapter 11 Systematic Risk and the Equity Risk Premium

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Answers to Chapter 11 Review Questions

1. What information do you need to compute the expected return of a portfolio? To compute the expected return of a portfolio, one needs the expected returns of each asset in the portfolio and the weight of each asset in the portfolio. 2. What does correlation tell us? Correlation tells us how the returns of two assets move relative to one another. A correlation of +1 tells us that when Stock A goes up, Stock B always goes up. A correlation of 1 tells us that when Stock A goes up, Stock B always goes down. 3. Why isn‘t the total risk of a portfolio simply equal to the weighted average of the risks of the securities in the portfolio? The risk of the portfolio is not simply the weighted average of the risks of the securities in the portfolio, because diversification eliminates the independent risks of the securities in the portfolio. Thus, the risk of the portfolio is actually less than the weighted average of the risks of the securities in the portfolio. 4. What does beta measure? How do we use beta? Beta measures the sensitivity of the returns of a portfolio or security to the fluctuations of the market portfolio. We use beta to measure the systematic risk of an asset or portfolio. 5. What, intuitively, does CAPM say drives expected return? The CAPM says that systematic risk drives the expected returns of an asset. 6. What relationship is described by the security market line? The security market line describes the relation between systematic risk and expected return.

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Answers to Chapter 11 Concept Check Questions

1. What do the weights in a portfolio tell us? We can describe a portfolio by its portfolio weights, which are the fractions of the total investment in the portfolio held in each individual investment in the portfolio. 2. How is the expected return of a portfolio related to the expected returns of the stocks in the portfolio? The return on a portfolio is the weighted average of the returns on the investments in the portfolio, where the weights correspond to portfolio weights. 3. What determines how much risk will be eliminated by combining stocks in a portfolio? To find the risk of a portfolio, we need to know more than just the risk of the component stocks: we need to know the degree to which the stocks‘ returns move together. Correlation is a barometer of the degree to which the returns share common risk. 4. When do stocks have more or less correlation? The closer the correlation is to +1, the more the returns tend to move together as a result of common risk. When the correlation equals 0, the returns are uncorrelated; that is, they have no tendency to move together or in opposite directions. Independent risks are uncorrelated. Finally, the closer the correlation is to 1, the more the returns tend to move in opposite directions. 5. What is the market portfolio? The market portfolio will consist of all risky securities in the market, with portfolio weights proportional to their market capitalization. Because the market portfolio contains only systematic risk, we can use it to measure the amount of systematic risk of other securities in the market. In particular, any risk that is correlated with the market portfolio must be systematic risk. 6. What does beta (ß) tell us? We can use the relationship between an individual stock‘s returns and the market portfolio‘s returns to measure the amount of systematic risk present in that stock. The reasoning is that if a stock‘s returns are highly sensitive to the market portfolio‘s returns, then that stock is highly sensitive to systematic risk. Stocks whose returns are volatile and are highly correlated with the market‘s returns are the riskiest in the sense that they have the most systematic risk. We can measure a stock‘s systematic risk by estimating the stock‘s sensitivity to the market portfolio, which we refer to as its beta. Beta (ß) is the expected percent change in the return of a security for a 1% change in the return of the market portfolio. 7. What does the CAPM say about the required return of a security? The CAPM simply says that the return we should expect on any investment is equal to the risk-free rate of return plus a risk premium proportional to the amount of systematic risk in the investment. 8. What is the security market line? The security market line describes the relationship between systematic risk and expected return.

Chapter 12 Determining the Cost of Capital

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Answers to Chapter 12 Review Questions

1. What does the WACC measure? The WACC measures the average return required on the assets of the firm to satisfy the investor base of the firm. It shows how much managers must earn on the assets of the firm in order for investors to earn their required rates of return on their investment. 2. Why are market-based weights important? Market weights are used because market values are forward-looking while book values are historical and backward-looking. Since investors use market values to make investment decisions, managers should use market weights in order to accurately estimate the return on asset required to satisfy investors. 3. Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital? The coupon rate sets the level of coupon payments over the life of the bond. This rate is locked in when the bond is issued; thus, this is a historical rate of return. Market conditions change, and for the cost of debt the firm should use the rate of return that bond investors currently demand on the debt. This is the yield to maturity. 4. Why is it easier to determine the cost of preferred stock and of debt than it is to determine the cost of common equity? It is easier to estimate the costs of preferred stock and debt than the cost of equity because the cash flows from preferred stock and debt are much easier to forecast. 5. Describe the steps involved in the CAPM approach to estimating the cost of equity. To use the CAPM, first estimate the equity beta for the firm by regression, 60 months of the firm‘s stock returns against 60 months of the returns for a market portfolio proxy (such as the S&P 500). Then, determine the risk-free rate and estimate the market risk premium. Once you have these inputs, use the CAPM equation to calculate a cost of equity for the firm. 6. Why would the CDGM and CAPM produce different estimates of the cost of equity capital? Each is based on different assumptions and different inputs. The CDGM also makes a very strong assumption that dividends will follow a pattern of constant growth. Because the inputs and assumptions underlying them are different, there is no reason to believe that the approaches would produce similar estimates of the cost of equity. 7. Under what assumptions can the WACC be used to value a project? The WACC method can be used under the following assumptions: a. The market risk of the project is equal to the average risk of the firm. b. The market debt-to-equity ratio of the firm will not fluctuate over the life of the project.

c. The main effect of leverage on valuation is the tax effect. Other effects of leverage (such as financial distress) are not significant at the level of leverage chosen by the firm. 8. What are some possible problems that might be associated with the assumption used in applying the WACC method? One problem with the assumptions is that the risk of the project is rarely the same as an average risk investment by the firm. Also, firms are usually increasing leverage as firm size increases, so the market debt-to-equity ratio is unlikely to stay constant over the life of the project. Also, the non-tax effects of leverage can play an important role in the cost of capital when leverage is high. 9. How should you value a project in a line of business with risk that is different from the average risk of the firm‘s projects? If the project has a different level of risk than the average risk investment of the firm, you should use the WACC of a firm that operates within the business of the project and has a similar capital structure to your firm. 10. What is the right way to adjust for the costs of raising external financing? The correct way to adjust for the costs of raising external capital is to subtract the present value of these costs from the NPV of the project.

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Answers to Chapter 12 Concept Check Questions

1. Why does a firm‘s capital have a cost? When investors buy the stock or bonds of a company, they forgo the opportunity to invest that money elsewhere. The expected return from those alternative investments constitutes an opportunity cost to them. Thus, to attract their investments as capital to the firm, the firm must offer potential investors an expected return equal to that they could expect to earn elsewhere for assuming the same level of risk. Providing this return is the cost a company bears in exchange for obtaining capital from investors. 2. Why do we use market-value weights in the weighted average cost of capital? You must use the market values of the debt and equity to determine the proportions, not the accounting-based book values listed on the balance sheet. Book values reflect historical costs, but market values are forward looking, based on what the assets are expected to produce in the future. Holders of the firm‘s financial claims—equity and, if the firm has it, debt—assess the firm based on the market value of its assets, not the book value. 3. How can you measure a firm‘s cost of debt? The market price of the firm‘s existing debt implies a yield to maturity, which is the return that current purchasers of the debt would earn if they held the debt to maturity and received all of the payments as promised. So, we can use the yield to maturity to estimate the firm‘s current cost of debt: it is the yield that investors demand to hold the firm‘s debt. 4. What are the major trade-offs in using the CAPM versus the CDGM to estimate the cost of equity? CAPM is a forward estimate of the assumptions used to calculate the rate of return of the equity while CDGM is an estimate of the future values using the company past to calculate the required rate of return. 5. Why do different companies have different WACCs? The WACC is driven by the risk of a company‘s line of business and, because of the tax effect of interest, its leverage. As a result, WACCs vary widely across industries and companies.

6. What are the trade-offs in estimating the market risk premium? Using the CAPM also requires an estimate of the market risk premium. We are interested in the future market risk premium. We face a trade off in terms of the amount of data we use. As noted in Chapter 10, it takes many years of data to produce even moderately accurate estimates of expected returns—yet data that are very old may have little relevance for investors‘ expectations of the market risk premium today. 7. What are the main assumptions you make when you use the WACC method? The main assumptions:  Average risk  Constant debt to equity ratio  Limited leverage effects 8. What inputs do you need to be ready to apply the WACC method? The key steps in the WACC valuation method are as follows: 1. Determine the incremental free cash flow of the investment. 2. Compute the weighted average cost of capital using Equation 12.6. 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the incremental free cash flow of the investment using the WACC. 9. When evaluating a project in a new line of business, which assumptions about the WACC method are most likely to be violated? We have assumed that both the risk and the leverage of the project under consideration matched those characteristics for the firm as a whole. In reality, specific projects often differ from the average investment made by the firm. 10. How can you estimate the WACC to be used in a new line of business? Multidivisional firms benchmark their own divisions on the basis of companies that compete with their division and are focused in that single line of business. By performing the same analysis as we did in Figure 12.3, the multidivisional firm can estimate the WACCs of its divisions‘ competitors— adjusting for different financing if necessary—to estimate the cost of capital for each division. 11. What types of additional costs does a firm incur when accessing external capital? Issuing new equity or bonds carries a number of costs. These costs include the costs of filing and registering with a provincial regulator (e.g., the Ontario Securities Commission) and the fees charged by investment bankers to place the securities. 12. What is the best way to incorporate these additional costs into capital budgeting? One approach would be to adjust the costs of equity and debt capital in the WACC to incorporate the issuing costs. A better and far more direct route is to simply treat the issuing costs as what they are— a negative cash outflow that are necessary to the project. We can then incorporate this additional cost as a negative cash flow in the NPV analysis.

Chapter 13 Risk and the Pricing of Options

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Answers to Chapter 13 Review Questions

1. Explain what the following financial terms mean: a. Option: An option is a contract that gives one party the right, but not the obligation, to buy or sell an asset at some point in the future. b. Expiration date: The last date on which the holder still has the right to exercise the option. If the option is American, the right can be exercised until the exercise date; if it is European, the option can be exercised only on the exercise date. c. Strike price: The price at which the holder of the option has the right to buy or sell the asset. d. Call: An option that gives its holder the right to buy an asset. e. Put: An option that gives its holder the right to sell an asset. 2. What is the difference between a European option and an American option. European options can be exercised only on the exercise date, while American options can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America. 3. Explain the difference between a long position in a put and short position in a call. When a party has a long position in a put, it has the right to sell the underlying asset at the strike price; when it has a short position in a call, it has the obligation to sell the underlying asset at the strike price if exercised. These are clearly different positions. 4. What position has more downside exposure: a short position in a call or a short position in a put? That is, in the worst case, in which of these two positions would your losses be the greater? Downside exposure is larger with a short call (the downside is unlimited) than with a short put (the downside cannot be larger than the strike price). 5. If you own a call option at expiration and the stock price equals the strike price, is you profit zero? When the stock price equals the strike price at maturity, the profit is negative. This is because you purchased the option for some positive value prior to expiration. The profit is the negative price of the option.

6. Is an increase in the stock‘s volatility good for the holder of a call option? Is it good for the holder of a put option? An increase in a stock‘s volatility is good for the holders of both call and put options. Volatility increases the probability of large swings in the stock price. Large increases (decreases) will increase the profits of call (put) options, but the opposite swings do not affect the profits of the options, as the holders will choose not to exercise them. 7. Why are the prices of puts and calls on the same stock related? They are related because one can form identical portfolios using call options and bonds or put options and the underlying stock. Because of this, the prices of the call and put options are related. 8. Explain why an option can be thought of as an insurance contract. An option can be thought of as an insurance contract, because you pay a premium for it and in exchange you are protected against bad outcomes. For example, you can protect yourself against a fall in the price of a stock by buying a put option. In that case, if the price of the stock falls, you are guaranteed to obtain at least the strike price for it. 9. Explain why equity can be viewed as a call option on a firm. Equity can be viewed as a call option on the firm because the payoffs that investors obtain—given limited liability—replicate a call option. On the maturity date of the debt, if the value of the firm is larger than the value of the debt, investors will pay back the debt and keep the difference for themselves. If the value of the firm is lower than the value of the debt, investors will be forced to hand over the assets to lenders, and end up with zero payoffs.

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Answers to Chapter 13 Concept Check Questions

1. Does the holder of an option have to exercise it? A financial option contract gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date. 2. What is the difference between an American option and a European option? American options, the most common kind, allow their holders to exercise the option on any date up to and including a final date called the expiration date. European options allow their holders to exercise the option only on the expiration date—that is, holders cannot exercise the option before the expiration date. 3. How are the profits from buying an option different from the payoff to the option at expiration? Because a short position in an option is the other side of a long position, the profits from a short position in an option are the negative of the profits of a long position. 4. How are the payoffs to buying a call option related to the payoffs from writing a call option? The profits from taking the long position (buying the call) will be exactly the opposite of the writer (seller) of the call option.

5. Can a European option with a later expiration date be worth less than an identical European option with an earlier expiration date? An American option with a later exercise date cannot be worth less than an otherwise identical American option with an earlier exercise date. The same argument will not work for European options, because a one-year European option cannot be exercised early at six months. As a consequence, a European option with a later exercise date may potentially trade for less than an otherwise identical option with an earlier exercise date. 6. Why are options more valuable when there is increased uncertainty about the value of the stock? The value of an option generally increases with the volatility of the stock. The reasoning behind this result is that an increase in volatility increases the likelihood of very high and very low returns for the stock. 7. What is the key assumption of the Binomial Option Pricing Model? This model prices options by making the simplifying assumption that at the end of the next period, the stock price has only two possible values.

8. Why don’t we need to know the probabilities of the states in the binominal tree in order to solve for the price of the option? By using the Law of One Price, we are able to solve for the price of the option without knowing the probabilities of the states in the Binominal tree. That is, we did not need to specify the likelihood that the stock would go up or down. Using a replicating portfolio of stock and bonds to match the value of the option and by the Law of One Price, the price of an option today must equal the current market value of the replicating portfolio. 9. What is a replicating portfolio? A portfolio of other securities that has exactly the same value in one period as the option. 10. What factors are used in the Black-Scholes formula to price a call option? The present value is calculated using the risk-free rate, and N(d1) and N(d2) are probabilities. However, we note here that they contain only the stock price, strike price, risk-free rate, time to expiration of the option, and volatility of the stock. 11.

How can the Black-Scholes formula not include the expected return on the stock? The expected return of the stock is already incorporated into the current stock price, and the value of the option today depends on the stock price today.

12. Explain put-call parity. The expected payoffs determine the prices of the options, so the prices of puts and calls depend partly on the price of the underlying stock. Because the prices of both a put and a call on a given stock are influenced by the price of that same stock, their prices are related to each other. 13. If a put option trades at a higher price from the value indicated by the put-call parity equation, what action should you take? An investor should take the short position in the overvalued option and then close their position by taking a long position in the same option when the price adjusts to the correct price. Or take the long position in the undervalued option and then close their position by taking a short position in the same option when the price adjusts to the correct price.

14. Explain how equity can be viewed as a call option on the firm. A share of stock can be thought of as a call option on the assets of the firm with a strike price equal to the value of debt outstanding. To illustrate, consider a single-period world in which at the end of the period the firm is liquidated. If the firm‘s asset value does not exceed the value of debt outstanding at the end of the period, the firm must declare bankruptcy and the equity holders receive nothing. Conversely, if the asset value exceeds the value of debt outstanding, the equity holders get whatever is left once the debt has been repaid. This payoff to equity looks exactly the same as the payoff of a call option. 15. Under what circumstances would equity holders have a possible incentive to take on negative-NPV investments? The option price is more sensitive to changes in volatility for at-the-money options than it is for inthe-money options. In the context of corporate finance, equity is at-the money when a firm is close to bankruptcy. In this case, the loss in equity value that results from taking on a negative-NPV investment might be outweighed by the gain in equity value from the increase in volatility. Hence, equity holders have an incentive to take on negative-NPV, high-volatility investments.

Chapter 14 Raising Equity Capital

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Answers to Chapter 13 Review Questions

1. What are some of the alternate sources from which private companies can raise equity capital? Private companies can raise equity capital from angel investors, venture capital firms, institutional investors, and corporate investors. 2. What are the advantages and the disadvantages to a private company raising money from a corporate investor? An advantage of raising money from a corporate investor is that corporate investors are not always looking at financial returns when making investments. A disadvantage is that, in return for giving up financial returns, corporate investors usually have strategic objectives that may result in pressure to make changes to business strategy. 3. What are the main advantages and disadvantages of going public? Main advantages of IPOs include greater liquidity for investors and better access to capital for the firm. Disadvantages include a more dispersed base of investors (which makes monitoring more difficult) and complying with all the regulations and requirements of public firms, which can be costly. 4. What are the main differences between a firm commitment IPO and an auction IPO?

A firm commitment IPO results in the firm selling all of the shares to the underwriter for a set price that is slightly below the offer price with the underwriter then selling the shares at the offer price on the IPO day. An auction IPO will result in the market setting the offer price for the stock given the number of shares that the issuing firm is selling. 5. Do underwriters face the most risk from a best-efforts IPO, a firm commitment IPO or an auction IPO? Underwriters face the most risk in a firm commitment IPO because it is guaranteeing the issuing firm that it will sell the IPO shares at a fixed price. If the underwriter is unable to unload the shares at the offer price, it must incur the losses. 6. How is the price set in an auction IPO? In an auction IPO, investors bid for the number of shares and price per share that they are willing to buy. The offer price in an auction IPO is the highest price at which the total number of issued shares can be sold to investors given the bids for the IPO.

7. Why should a financial manager be concerned about underpricing? Underpricing means that the market values the stock more on the issuing day than the offer price set by the firm. The firm could have raised additional money (or sold a smaller percentage of the firm) if it had raised the offer price. 8. IPOs are very cyclical. In some years, there are large numbers of IPOs; in other years, there are very few. Why is this cyclicality a puzzle? This cyclicality is a puzzle because the demand for capital should not vary so widely from year to year. 9. What are the advantages of a rights offer? The rights offer has lower costs and protects existing shareholders from underpricing of the new issue in the market. 10. What are the advantages to a company of selling a stock in a SEO using a cash offer? The cash offer involves an underwriter which can credibly attest to the issue's quality. 11. Why does the stock price typically decrease when a firm announces an SEO? It is due to something called adverse selection (or the ―lemons problem‖). Because managers concerned about protecting their existing shareholders will tend to sell only at a price that correctly values or overvalues the firm, investors infer from the decision to sell that the company is likely to be overvalued. As a result, the price drops with the announcement of the SEO.

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Answers to Chapter 14 Concept Check Questions

1. What are the main sources of funding for private companies to raise outside equity capital? When a private company decides to raise outside equity capital, it can seek funding from several potential sources: angel investors, venture capital firms, institutional investors, sovereign wealth funds, and corporate investors. 2. What is a venture capital firm? A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms. 3. What services does the underwriter provide in a traditional IPO? The lead underwriter is the primary investment banking firm responsible for managing the security issuance. The lead underwriter provides most of the advice on the sale and arranges for a group of other underwriters, called the syndicate, to help market and sell the issue. Table 14.3 shows 2016‘s Top 10 Canadian Equity and Equity-Related Issuers. Underwriters market the IPO and help the company with all the necessary filings. Underwriters actively participate in determining the offer price. In many cases, the underwriter will also commit to making a market in the stock by matching buyers and sellers after the issue, thereby guaranteeing that the stock will be liquid. 4. Explain the mechanics of an auction IPO. Potential buyers submit bids at various prices for the number of shares the investor is willing to purchase. This total represents the number of shares that can be sold at each price. The firm will select the bid price that will ensure the total issue to be sold. Because investors are willing to buy at prices lower than the amount they bid, all the shares will be sold at the same specific price. The number of shares each investor to be offered will be prorated by the number of shares the investor is willing to purchase.

5. List and discuss four characteristics about IPOs that are puzzling. Four characteristics of IPOs puzzle financial economists, and all are relevant to the financial manager: 1. On average, IPOs appear to be underpriced: the price at the end of trading on the first day is often substantially higher than the IPO price. 2. The number of IPOs is highly cyclical. When times are good, the market is flooded with IPOs; when times are bad, the number of IPOs dries up. 3. The transaction costs of the IPO are very high, and it is unclear why firms willingly incur such high costs. 4. The long-run performance of a newly public company (three to five years from the date of issue) is poor. That is, on average, a three- to five-year buy-and-hold strategy appears to be a bad investment. 6. For each characteristic, identify its relevance to financial managers. Underpricing of the IPO. Generally, underwriters set the issue price of an IPO so that the average first-day return is positive. Who benefits from the offer price being set below the market price at the end of the first day of trading (underpricing)? We have already explained how the underwriters benefit by controlling their risk—it is much easier to sell the firm‘s shares if the price is set low. Of course, investors who are able to buy stock from underwriters at the IPO price also gain from the first-day underpricing. Who bears the cost? The pre-IPO shareholders of the issuing firms do. In effect, these owners are selling stock in their firm for less than they could get in the aftermarket. The number of IPOs is highly cyclical. An even more important feature of the data is that the trends related to the number of issues are cyclical. Sometimes, as in 1996, the volume of IPOs is unprecedented by historical standards, yet within a year or two the volume of IPOs may decrease significantly. This cyclicality by itself is not particularly surprising. We would expect there to be a greater need for capital in times with more growth opportunities than in times with fewer growth opportunities. What is surprising is the magnitude of the swings. For example, it is difficult to explain the almost seven-fold increase in IPOs from the early to mid-1990s, and the nearly 75% drop from 2000 to 2001and a 45% drop from 2014 to 2015. It appears that the number of IPOs is not solely driven by the demand for capital. Sometimes firms and investors seem to favour IPOs; at other times firms appear to rely on alternative sources of capital. The Transaction Costs of the IPO. In the United States, a typical spread—that is, the discount below the issue price at which the underwriter purchases the shares from the issuing firm—is about 7% of the issue price. For an issue size of $50 million, this amounts to $3.5 million. This fee covers the cost to the underwriter of managing the syndicate and helping the company prepare for the IPO, as well as providing it with a return on the capital employed to purchase and market the issue. By most standards, however, this fee is large, especially considering the additional cost to the firm associated with underpricing. Internationally, spreads are generally about half this amount. Even more puzzling is the seeming lack of sensitivity of fees to issue size. Although a large issue requires some additional effort, one would not expect the increased effort to be rewarded as lucratively. The Long-run Performance. Shares of IPOs generally perform very well immediately following the public offering. It‘s perhaps surprising, then, that Jay Ritter found that newly listed firms subsequently appear to perform relatively poorly over the three to five years. Recently, researchers have begun to explore the possibility that underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place.

7. What is the difference between a cash offer and a rights offer for an SEO? When issuing stock using an SEO (seasoned equity offering), a firm follows many of the same steps as for an IPO. The main difference is that a market price for the stock already exists, so the price setting process is not necessary. Two types of SEOs exist: a cash offer and a rights offer. In a cash offer, the firm offers the new shares to investors at large. In a rights offer, the firm offers the new shares only to existing shareholders. In Canada and the United States, most offers are cash offers, but the same is not true elsewhere. For example, in the United Kingdom most seasoned offerings of new shares are rights offers. 8. What is the typical stock price reaction to an SEO? Researchers have found that, on average, the market greets the news of an SEO with a price decline. Often, the value lost due to the price decline can be a significant fraction of the new money raised. The lemons problem is very real for financial managers contemplating selling new equity. Because managers concerned about protecting their existing shareholders will tend to sell only at a price that correctly values or overvalues the firm, investors infer from the decision to sell that the company is likely to be overvalued. As a result, the price drops with the announcement of the SEO.

Chapter 15 Debt Financing

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Answers to Chapter 15 Review Questions

1. What are the different types of corporate debt and how do they differ? The different types of debt are notes, debentures, mortgage bonds, and asset-backed bonds. Mortgage bonds and asset-backed bonds are secured, while notes and debentures are unsecured. 2. Explain some of the differences between a public debt offering and a private debt offering. A public debt offering is publicly traded, while a private debt offering is not. Because of this, private debt offerings do not incur the costs and delays of registration with the SEC. 3. Explain the difference between a secured corporate bond and an unsecured corporate bond. Bonds with lower seniority have higher yields than equivalent bonds with higher seniority because lower seniority bonds have higher risks. If a bond issuer defaults on a bond, higher seniority claims get access to the firm‘s assets before lower seniority claims. This results in lower seniority bonds being more risky. 4. Why do bonds with lower seniority have higher yields than equivalent bonds with higher seniority? A secured corporate bond is backed by collateral, while an unsecured corporate bond has no collateral.

5. What is the difference between a foreign bond and a Eurobond? Foreign bonds are bonds issued by foreign companies in a local market and are denominated in the local currency, while Eurobonds are international bonds that are not denominated by the local currency of the country in which they are issued. 6. Why would companies voluntarily choose to put restrictive covenants into a new bond issue? Covenants reduce the risk of a bond, and the lower risk results in lower borrowing costs to the issuer. Thus, issuers will voluntarily include restrictive covenants in their bonds to reduce the borrowing costs of the bonds. 7. Why would a call feature be valuable to a company issuing bonds? A call feature allows a company to call a bond when the market price of the bond exceeds the call price of the bond. The company benefits by the difference between the market price and the call price. 8. What is the effect of including a standard call feature on the price a company can receive for its bonds? By including a call option in the bond, the bond becomes less valuable to bondholders (because the company can call the bonds if the market price exceeds the call price). Thus, the price the issuer can obtain for the callable bond decreases relative to the otherwise identical non-callable bond. 9. When will the yield to maturity be higher than the yield to call for a bond with a standard call feature? The yield to call is less than the yield to maturity for a callable bond when the bond trades at a premium, and is greater when the bond trades at a discount. 10. Why might a company‘s management want to issue a bond with the Canada call provision?

Many companies have adopted the ―Canada call‖ or ―make-whole call‖ provision instead. This call provision sets the call price as the present value of the remaining coupons, which is calculated using a rate that adjusts with changes in prevailing interest rates in the economy. Thus, if interest rates fall, the call price rises, and the incentive to call the bond in order to refinance at lower rates is eliminated due to the higher call price that would need to be paid. 11. How does a sinking fund provision affect the cash flows associated with a bond issue from the company‘s perspective? From a single bondholder’s perspective? A sinking fund increases the cash outflows associated with the bond issuance from the company‘s perspective, as the company must make regular payments into the sinking fund. It also reduces the final cash outflow associated with the maturity of the bond, as the company has a much smaller principal to repay at maturity. From the individual bondholder‘s perspective, the cash flows of the bond do not change unless the bondholder sells the bond back to the firm through the sinking fund. 12. Why is the yield on a convertible bond lower than the yield on an otherwise identical bond without a conversion feature? The yield on a convertible bond is lower than that of an otherwise identical nonconvertible bond because the option to convert is valuable to bondholders. They are willing to pay for this option, which increases the value of the bond and decreases the yield.

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Answers to Chapter 15 Concept Check Questions

1. List the four types of corporate public debt that are typically issued. Four types of corporate debt are typically issued: notes, debentures, mortgage bonds, and asset-backed bonds. These types of debt fall into two categories: unsecured and secured debt. 2. What are the four categories of international bonds? International bonds are classified into four broadly defined categories as follows: 1. Domestic bonds are bonds issued by a local entity and traded in a local market, but purchased by foreigners. They are denominated in the local currency of the country in which they are issued. 2. Foreign bonds are bonds issued by a foreign company in a local market and are intended for local investors. They are also denominated in the local currency. Foreign bonds in Canada are known as Maple bonds; in the United States, foreign bonds are known as Yankee bonds. In other countries, foreign bonds also have special names; for example, in Japan they are called Samurai bonds; in the United Kingdom, they are known as Bulldogs. 3. Eurobonds are international bonds that are not denominated in the local currency of the country in which they are issued. Consequently, there is no connection between the physical location of the market on which they trade and the location of the issuing entity. Eurobonds can be denominated in any number of currencies that might or might not be connected to the location of the issuer. The trading of these bonds is not subject to any particular nation‘s regulations. 4. Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously. Unlike Eurobonds, global bonds can be offered for sale in the same currency as the country of issuance. The Hertz junk bond issue is an example of a global bond issue: it was simultaneously offered for sale in the United States and Europe. 3.

What are the seven kinds of securities issued by the Canadian government? They are: Cash Management Bills, Treasury Bills, Fixed-Coupon Marketable Bonds, Real Return Bonds, Canada Bills, Canada Notes and Euro Medium-Term Notes.

4. What is an asset-backed security? Asset-backed securities are instruments in which specific assets are pledged as collateral, such as a portfolio of loans or mortgages. Agency Securities are a kind of asset-backed security but are distinguished by the fact they are created by a government agency rather than financial institution. 5. What is the major difference between U.S. municipal bonds and Canadian municipal bonds? In the United States ―munis‖ are not taxable at the federal level and some are also exempt from state and local taxes. Not so in Canada. 6. What happens if an issuer fails to live up to a bond covenant? If the firm fails to live up to any covenant, the bond goes into technical default and the bondholder can demand immediate repayment or force the company to renegotiate the terms of the bond. 7.

Why can bond covenants reduce a firm‘s borrowing costs? The stronger the covenants in the bond contract, the less likely the firm will be to default on the bond, and thus the lower the interest rate will be that investors will require to buy the bond. That is, by including more covenants, firms can reduce their costs of borrowing. The reduction in the firm‘s borrowing costs can more than outweigh the cost of the loss of flexibility associated with covenants.

Do bonds with a standard call feature have a higher or lower yield than otherwise identical bonds without a call feature? Why? A firm raising capital by issuing callable bonds instead of non-callable bonds will have to either pay a higher coupon rate or accept lower proceeds. A firm will choose to issue callable bonds despite their higher yield if it finds the option to refinance the debt in the future particularly valuable.

Will a drop in interest rates make it advantageous for a company to call a bond with a Canada call feature? This call provision sets the call price as the present value of the remaining coupons, which is calculated using a rate that adjusts with changes in prevailing interest rates in the economy. Thus, if interest rates fall, the call price rises, and the incentive to call the bond in order to refinance at lower rates is eliminated due to the higher call price that would need to be paid.

10. What is a sinking fund? A sinking fund, a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal balance on the maturity date. These payments are then used to repurchase bonds, usually at par. 11. Why does a convertible bond have a lower yield than an otherwise identical bond without the option to convert? The option (which is not an obligation) to convert the bonds into equity is worth something to a bondholder. Thus, prior to the bond maturity date, a convertible bond is worth more than an otherwise identical straight bond, a non-callable, non-convertible bond (also called a plain-vanilla bond). Consequently, if both bonds are issued at par, the straight bond must offer a higher interest rate.

Chapter 16 Capital Structure

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Answers to Chapter 16 Review Questions

1. Absent tax effects, why can‘t we change the cost of capital of the firm by using more debt financing and less equity financing? When you shift financing from equity financing to debt financing (absent tax effects), the cost of equity increases (due to the increased riskiness of the equity cash flows). This increase in the cost of equity capital offsets any reduction in the cost of capital due to using debt financing. 2. Explain what is wrong with the following argument: ―If a firm issues debt that is risk free because there is no possibility of default, the risk of the firm‘s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity.‖ The fact that the debt is risk-free does not mean that the risk of the equity does not increase. The volatility of the equity cash flows will increase because debt payments are made first (due to the seniority of debt claims). Therefore, even though the debt is risk-free, equity is more risky. 3. What are the channels through which financing choices can affect firm value? Financing choices affect firm value through the following channels:  Taxes  Transaction/Issuance costs  Investment policy  Imperfect information

4. How do taxes affect the choice of debt versus equity? Taxes make debt a more attractive financing option than equity. Interest expense on debt capital can be used to shield operating income from taxes, which increases the value of the firm. 5. What is meant by ―indirect costs of financial distress‖? Indirect costs of financial distress are the costs that the firm incurs from having high debt levels but without going into bankruptcy. These costs come from loss of customers, suppliers, employees, or from fire sales of assets.

6. Which type of firm is more likely to experience a loss of customers in the event of financial distress: a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)? b. Allstate Corporation (an insurance company) or Reebok International (a footwear and clothing firm)? a. Intuit is more likely to experience the loss of customers in the event of financial distress, as their product requires more customer service and training to use than soup. b. Allstate will lose more customers because switching insurance firms is more costly than switching the shoes one wears. 7. According to the trade-off theory, how is capital structure determined? According to the trade-off theory, capital structure is determined by balancing the costs of additional debt financing with the benefit of additional financing. When these are equal, the firm has reached its optimal capital structure. 8. For each pair below, which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress: a. An office building or a brand name? b. Product inventory or raw materials? c. Patent rights or engineering ―know-how‖? a. An office building is more tangible than a brand name, so it is more likely to be sold for its full market value. b. Raw materials have more alternative uses than product inventory, so they are more likely to be sold for their full market value. c. Patent rights have a more certain cash flow stream, so these are more likely to be sold for their full market value. 9. Which of the following industries have low optimal debt levels according to the trade-off theory? Which have high optimal levels of debt? a. Tobacco firms b. Accounting firms c. Established restaurant chains d. Lumber companies e. Cell phone manufacturers a. b. c. d. e.

High (steady cash flows and high asset tangibility) Low (low asset tangibility) Low (high sensitivity to economic swings) High (high asset tangibility) Low (high sensitivity to economic swings)

10. How can leverage alter the incentives of managers? Leverage increases the incentives for managers, as they have less cash available to potentially waste on projects that are self-serving. Also, the threat of financial distress (and potential loss of a job) motivates managers to work harder when dealing with higher leverage.

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Answers to Chapter 16 Concept Check Questions

1. What constitutes a firm‘s capital structure? The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. 2. What are some factors a manager must consider when making a financing decision? First and foremost, various financing choices will promise different future amounts to each security holder in exchange for the cash that is raised today. But beyond that, the firm may also need to consider whether the securities it issues will receive a fair price in the market, have tax consequences, entail transactions costs, or even change its future investment opportunities. 3. How does leverage affect the risk and cost of equity for the firm? Leverage will increase the risk of the firm‘s equity and raise its equity cost of capital. 4. In a perfect capital market, can you alter the firm‘s value or WACC by relying more on debt capital? Modigliani and Miller‘s conclusion went against the common view that even with perfect capital markets leverage would affect a firm‘s value. With no debt, the WACC is equal to the unlevered equity cost of capital. As a firm borrows at the lower cost of capital using debt, its equity cost of capital rise will rise. The net effect is that the firm‘s WACC is unchanged. Of course, as the amount of debt increases, the debt becomes riskier because there is an increased chance the firm will default; as a result, the debt cost of capital also rises. With close to 100% debt, the debt would be almost as risky as the assets themselves (similar to unlevered equity). Even though the debt and equity costs of capital both rise when leverage is high because more of the firm is financed with debt (which has lower cost), the WACC remains constant. 5. How does the interest tax deduction affect firm value? Corporations can deduct interest expenses from their taxable income. The deduction reduces the taxes they pay and thereby increases the amount available to pay investors. In doing so, the interest tax deduction increases the value of the corporation. 6. How does the firm‘s WACC change with leverage? The reduction in the WACC increases with the amount of debt financing. The higher the firm‘s leverage, the more the firm exploits the tax advantage of debt and the lower its WACC. 7. What are the direct costs of bankruptcy? When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are generally hired. Investment bankers may also assist with a potential financial restructuring. I n addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. In the case of reorganization, creditors must often wait several years for a reorganization plan to be approved and to receive payment. To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice.

8. Why are the indirect costs of financial distress likely to be more important than the direct costs of bankruptcy? Studies typically report that the average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets. The indirect costs of financial distress may be substantial. A study of highly levered firms by Gregor Andrade and Steven Kaplan estimated a potential loss due to financial distress of 10% to 20% of firm value. Importantly, many of these indirect costs may be incurred even if the firm is not yet in financial distress, but simply faces a significant possibility that it may occur in the future. 9. According to the trade-off theory, how should a financial manager determine the right capital structure for a firm? The trade-off theory weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage. According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress cost. Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs. 10. Why would managers in one industry choose different capital structures than those in another industry? The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default. This probability increases with the amount of a firm‘s liabilities (relative to its assets). It also increases with the volatility of a firm‘s cash flows and asset values. Thus, firms with steady, reliable cash flows, such as power companies, are able to use high levels of debt and still have a very low probability of default. Firms whose value and cash flows are very volatile (for example, telecom firms) must have much lower levels of debt to avoid a significant risk of default. 11. How can too much debt lead to excessive risk-taking? When a firm has leverage, a conflict of interest exists if investment decisions have different consequences or the value of equity and the value of debt. Such a conflict is most likely to occur when the risk of financial distress is high. Even if the project fails, you are no worse off because you were headed for default anyway. If it succeeds, then you avoid default and retain ownership of the firm. This incentive leads to excessive risk-taking, a situation that occurs when a company is near distress and shareholders have an incentive to invest in risky negative-NPV projects that will destroy value for debt holders and the firm overall. 12. What is the pecking order hypothesis? Managers do not want to sell equity if they have to discount it to find buyers. Therefore, managers may seek alternative forms of financing. Debt issues may also suffer from adverse selection. Because the value of low-risk debt is not very sensitive to managers‘ private information about the firm (but is instead determined mainly by interest rates), the discount needed to attract buyers will be smaller for debt than for equity. Of course, a firm can avoid under-pricing altogether by financing investment using its cash (retained earnings) when possible. The pecking order hypothesis states what managers will have a preference to fund investment using retained earnings, followed by debt, and will choose to issue equity only as a last resort.

Chapter 17 Payout Policy

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Answers to Chapter 17 Review Questions

1. What are the ways in which a corporation can distribute cash to its shareholders? A firm can distribute cash to its shareholders through dividends and share repurchases. 2. Describe the different mechanisms available to a firm for the repurchase of shares. Firms can repurchase shares through different mechanisms. An open market share repurchase results in the firm buying shares in the open market like any other investor. A tender offer repurchase involves the firm offering to buy a certain number of shares at a price set by the firm. A Dutch auction share repurchase enables shareholders to bid how many shares they are willing to sell at a particular price; while a targeted repurchase is the negotiated repurchase of shares from a selected group or groups of existing shareholders. 3. Without taxes or any other imperfections, why doesn‘t it matter how the firm distributes cash? In perfect markets, it does not matter how the firm distributes cash because investors can without cost replicate any method of payout on their own. 4. What kind of payout preference do tax codes typically create? Tax codes usually lead to tax advantages for share repurchases over dividend payouts. 5. What are the advantages and disadvantages of retaining excess cash? The advantages of retaining cash are the ability to avoid the costs of raising new capital in the future and the ability to avoid financial distress costs. The disadvantages of retaining cash are the additional tax effects of cash retention and the agency costs of retaining excess cash. 6. How can dividends and repurchases be used to signal managers‘ information about their firms‘ prospects? The payment of dividends tends to be a more permanent payout decision than share repurchases. Thus, the choice of dividends signals that management is confident enough about future prospects to start a permanent payout of cash to shareholders. Also, repurchases are most beneficial to shareholders if the stock is undervalued, so a share repurchase program may signal management‘s belief that the stock is undervalued.

7. Explain under which conditions an increase in the dividend payment can be interpreted as a signal of good news or bad news. a. Dividends can signal management‘s optimism about future cash flows. Also, a dividend reduces the cash available for management to use for self-serving investments, thus reducing agency costs at the firm. b. Dividends can signal that investment opportunities for the firm have dried up, leaving the firm fewer growth opportunities for which to save cash. 8. Why is an announcement of a share repurchase considered a positive signal? The announcement of a share repurchase is considered a positive signal because management is more inclined to repurchase shares when the stock is undervalued. So a share repurchase is a signal that management believes that the stock is undervalued. 9. Why do managers split their firms‘ stock? Managers split their stock to keep it affordable to small investors.

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Answers to Chapter 17 Concept Check Questions

1. How is a stock‘s ex-dividend date determined, and what is its significance? Because it takes three business days for shares to be registered, only shareholders who purchase the stock at least three days prior to the record date receive the dividend. As a result, the two trading days prior to the record date is known as the ex-dividend date. 2. What is an open market share repurchase? The most common way that firms repurchase shares, a firm announces its intention to buy its own shares on the open market and then proceeds to do so over time, just as any other investor. 3. Explain the misconception that when a firm repurchases its own shares, the price rises due to the decrease in the supply of shares outstanding. The market value of assets falls when the company pays out cash, and the number of shares outstanding also falls. The two changes offset each other, so the share price remains the same. 4. In a perfect capital market, how important is the firm‘s decision to pay dividends versus repurchase shares? In a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter. I n perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead. 5. Under what conditions will investors have a tax preference for share repurchases rather than dividends? When a firm pays a dividend, shareholders are taxed according to the dividend tax rate. If the firm repurchases shares instead, and shareholders sell shares to create a homemade dividend, the homemade dividend will be taxed according to the capital gains tax rate. If dividends are taxed at a higher rate than capital gains, shareholders will prefer share repurchases to dividends. 6. What is the dividend puzzle? While this evidence is indicative of the growing importance of share repurchases as a part of firms‘ payout policies, it also shows that dividends remain a key form of payouts to shareholders. The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the dividend puzzle.

7. Is there an advantage for a firm to retain its cash instead of paying it out to shareholders in perfect capital markets? Ultimately, firms should choose to retain cash for the same reasons they would use low leverage—to preserve financial slack for future growth opportunities and to avoid financial distress costs. These needs must be balanced against the tax disadvantage of holding cash and the agency cost of wasteful investment. 8. How do corporate taxes affect the decision of a firm to retain excess cash? The cost of retaining cash therefore depends on the combined effect of the corporate and capital gains taxes, compared to the single tax on interest income. Under most tax regimes there remains a substantial tax disadvantage for the firm to retaining excess cash even after adjusting for investor taxes. 9. What possible signals does a firm give when it cuts its dividend? When managers cut the dividend, it may signal that they have given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash. 10. Would managers be more likely to repurchase shares if they believe the stock is under- or overvalued? The cost of a share repurchase depends on the market price of the stock. If managers believe the stock is currently overvalued, a share repurchase will be costly to the firm. That is, buying the stock at its current (overvalued) price is a negative-NPV investment. By contrast, repurchasing shares when managers perceive the stock to be undervalued is a positive-NPV investment. Managers will clearly be more likely to repurchase shares if they believe the stock to be undervalued. 11. What is the difference between a stock dividend and a stock split? In a stock dividend, or stock split, the company issues additional shares rather than cash to its shareholders. If a company declares a 10% stock dividend, each shareholder will receive one new share of stock for every 10 shares already owned. With a stock split, the firm will issue a multiple of the number of shares the shareholder owns and the price in the market will adjust accordingly. 12. What are some advantages of a spinoff as opposed to selling the division and distributing the cash? A spinoff offer has two advantages over a cash dividend: (1) it avoids the transaction costs associated with such a sale, and (2) the special dividend is not taxed as a cash distribution.

Chapter 18 Financial Modelling and Pro Forma Analysis

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Answers to Chapter 18 Review Questions

1. What is the purpose of long-term forecasting? The purpose of long-term forecasting is to identify and plan for financing requirements in the near and long-term. 2. What are the advantages and disadvantages of the percent of sales method? The percent of sales is a useful method for forecasting income statements and balance sheets, but it assumes constant, steady growth. Thus, it is less appropriate for firms with fast growth requiring ―lumpy‖ investments in capacity and expansion. 3. What is gained by forecasting capital expenditures and external financing specifically? Capacity expansion often requires large, infrequent investments, which dictate large, infrequent financing rounds. By forecasting capital expenditures and external financing separately from a percent of sales method, one can more accurately capture these realities in the forecasted financial statements. 4. How can the financial manager use the long-term forecast to decide on adopting a new business plan? Managers can use long-term forecasts to decide on new business plans by estimating the change in free cash flows that result from the new business plan. Once a long-term forecast of free cash flows is estimated, the manager can calculate an NPV and decide whether the new business plan increases or decreases the value of the firm. 5. What can the sustainable growth rate tell a financial manager and what can it not tell? The sustainable growth rate gives managers a target of growth that does not require increasing the leverage of the firm. Repeated growth above (below) the sustainable growth rate will dictate that the firm increases (decreases) profitability, operating efficiency, and/or leverage. However, the sustainable growth rate does not say whether planned growth will increase or decrease firm value.

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Answers to Chapter 18 Concept Check Questions

1. How does long-term financial planning fit into the goal of the financial manager? The goal of the financial manager is to maximize the value of the stockholders‘ stake in the firm. By building a long-term model of your firm‘s financials, you can examine exactly how such business plans will affect the firm‘s free cash flows and hence value. 2. What are the three main things that the financial manager can accomplish by building a long-term financial model of the firm? A well-designed spreadsheet model will allow you to examine how a change in your cost structure will affect your future free cash flows, financing needs, and will allow for the analysis of the impact of a firm-wide expansion plan, including necessary capital investment, debt financing, and how the changes in free cash flows will affect the changes in value for the shareholder. 3. What is the basic idea behind the percent of sales method for forecasting? The percent of sales method assumes that as sales grow, many income statement and balance sheet items will grow, maintaining the same percentage of sales. 4. How does the pro forma balance sheet help the financial manager forecast net new financing? The projected difference assets and liabilities in the pro forma balance sheet provide a preliminary estimate of the need to obtain new financing from its investors. 5. What is the advantage of forecasting capital expenditures, working capital, and financing events directly? We can address these realities in our long-term forecasting by modelling our capacity needs and capital expenditures directly. In this section, we consider a planned expansion by KXS and generate pro forma statements that allow us to decide whether the expansion will increase the value of KXS. First, we identify capacity needs and how to finance that capacity. Next, we construct pro forma income statements and forecast future free cash flows. Finally, we use those forecasted free cash flows to assess the impact of the expansion on firm value. 6. What role does minimum required cash play in working capital? The minimum required cash represents the minimum level of cash needed to keep the business running smoothly, allowing for the daily variations in the timing of income and expenses. 7. What is the difference between internal growth rate and sustainable growth rate? A firm‘s internal growth rate—the maximum growth rate a firm can achieve without resorting to external financing. Intuitively, this is the growth the firm can support by reinvesting its earnings. A closely related and more commonly used measure is the firm‘s sustainable growth rate—the maximum growth rate the firm can sustain without issuing new equity or increasing its debt-toequity ratio. 8. If a firm grows faster than its sustainable growth rate, is that growth value-decreasing? While the internal and sustainable growth rates are useful in alerting you to the need to plan for external financing, they cannot tell you whether your planned growth increases or decreases the firm‘s value. There is nothing inherently bad or unsustainable about growth greater than the sustainable growth rate as long as that growth is value-increasing. The firm will simply need to raise additional capital to finance the growth.

9. What is the multiples approach to continuation value? Practitioners generally estimate a firm‘s continuation value (also called the terminal value) at the end of the forecast horizon using a valuation multiple. Explicitly forecasting cash flows is useful in capturing those specific aspects of a company that distinguish the firm from its competitors in the short run. However, because of competition between firms, the long-term expected growth rates, profitability, and risk of firms in the same industry should move toward one another. As a consequence, long-term expectations of multiples are likely to be relatively homogeneous across firms in a given sector. Thus, a realistic assumption is that a firm‘s multiple will eventually move toward the industry average. Because distant cash flows are difficult to forecast accurately, estimating the firm‘s continuation, or terminal, value based on a long-term estimate of the valuation multiple for the industry is a common (and, generally, reasonably reliable) approach. 10. How does forecasting help the financial manager decide whether to implement a new business plan? We use forecasts to provide our best estimate of whether the expansion plan is a good idea—does it increase the value of the firm? There are two ways of doing this: (1) value the whole company with and without the expansion and compare the values or (2) value only the incremental changes to the company caused by the expansion, as we did in capital budgeting exercises in Chapter 8.

Chapter 19 Working Capital Management

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Answers to Chapter 19 Review Questions

1. What does a firm‘s cash cycle tell us? A firm‘s cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. 2. Answer the following: a. What is the difference between a firm‘s cash cycle and its operating cycle? The cash cycle is the time it takes between the payment of cash for inventory and the receipt of cash for the finished goods from that inventory. The operating cycle is the amount of time between the purchase of the inventory and the receipt of cash from that inventory. b. How will a firm‘s cash cycle be affected if a firm increases its inventory, all else being equal? A firm‘s cash cycle will increase when it increases its inventory, as its inventory days will increase. c. How will a firm‘s cash cycle be affected if the firm begins to take the discounts offered by its suppliers, all else being equal? A firm‘s cash cycle will increase when it accepts the discounts given by suppliers because the payables days will decrease.

3. Does an increase in a firm‘s cash cycle necessarily mean that the firm is managing its cash poorly? No, a high cash cycle does not necessarily mean that the firm is poorly managing the cash. Economic conditions may influence the cash cycle for a firm. However, the cash cycle is one way for managers to monitor the flow of cash in and out of the firm 4. Why is trade credit important? Trade credit is an attractive source of funds. It is simple and convenient to use, it has lower transactions costs than alternative sources of funds, and it is flexible. 5. What are the ways that receivables management can affect a firm‘s value? Managing receivables is important, as a strict collection policy will shorten the time to the receipt of cash flows but may cause customers to go to other competitors for better collection terms. The collection policies will attract customers but will lengthen the time to the receipt of cash flows.

6. What are the three steps involved in establishing a credit policy? The three steps involved in establishing a credit policy are establishing credit standards, establishing credit terms, and establishing a collection policy. 7. What factors determine how a firm should manage its payables? Factors that determine the management of payables include the discount percentage offered, the length of the loan period, and the strictness of the collection policy of the suppliers. 8. What is meant by ―stretching the accounts payable‖? ―Stretching the accounts payable‖ is when the firm ignores the payment due date and pays later. 9. What are the trade-offs involved in reducing inventory? Inventory represents an investment of capital, and a reduction of inventory frees up capital for other uses. However, the cost of reduced inventory is the potential for stock-outs. 10. What are the different ways you can invest your firm‘s cash? Cash can be invested in Treasury Bills, CDs, Repurchase Agreements, Banker‘s Acceptances, Commercial Paper, and Short-Term Tax Exempts. 11. Which of the following short-term securities would you expect to offer the highest before-tax return: treasury bills, certificates of deposit, short-term tax exempts, or commercial paper? Why? Commercial paper should have the highest before-tax return. Treasury bills offer the least default risk. CDs are insured by the CDIC for up to $100,000. Short-term tax receipts are exempted from federal taxation, so their pre-tax returns are lower than other similar risk investments. Commercial paper presents the highest risk of the four options, and as such will require the highest before-tax return.

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Answers to Chapter 19 Concept Check Questions

1. What is the difference between a firm‘s cash cycle and operating cycle? A firm‘s operating cycle is the average length of time between when the firm originally purchases its inventory and when it receives the cash back from selling its product. A firm‘s cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. 2. How does working capital affect a firm‘s value? Managing working capital efficiently will increase those free cash flows, allowing a manager to maximize firm value. 3. What does the term ―2/ 10, net 30‖ mean? The terms ―2/ 10, net 30‖ mean that the buying firm will receive a 2% discount if it pays for the goods within 10 days; otherwise, the full amount is due in 30 days.

4. List three factors that determine collection float. Mail float: How long it takes the firm to receive a payment cheque after the customer has mailed it. Processing float: How long it takes the firm to process a customer‘s payment cheque and deposit it in the bank. Availability float: How long it takes a bank to post the funds from customer payments the firm has deposited in the bank. 5. Describe three steps in establishing a credit policy. Establishing a credit policy involves three steps that we will discuss in turn: 1. Establishing credit standards 2. Establishing credit terms 3. Establishing a collection policy 6. What is the difference between accounts receivable days and an aging schedule? The accounts receivable days is the average number of days that it takes a firm to collect on its sales. An aging schedule categorizes accounts by the number of days they have been on the firm‘s books. 7. What is the optimal time for a firm to pay its accounts payable? A firm should always pay on the latest day allowed. A firm should strive to keep its money working for it as long as possible without developing a bad relationship with its suppliers or engaging in unethical practices. 8. What do the terms ―COD‖ and ―CBD‖ mean? Suppliers may react to a firm whose payments are always late by imposing terms of cash on delivery (COD) or cash before delivery (CBD). 9. What are the direct costs of holding inventory? Tying up capital in inventory is costly for a firm. We can classify the direct costs associated with inventory into three categories:  Acquisition costs are the costs of the inventory itself over the period being analyzed (usually one year).  Order costs are the total costs of placing an order over the period being analyzed.  Carrying costs include storage costs, insurance, taxes, spoilage, obsolescence, and the opportunity cost of the funds tied up in the inventory. 10. Describe ―just-in-time‖ inventory management. With ―just-in-time‖ (JIT) inventory management, a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it. This technique requires exceptional coordination with suppliers, as well as a predictable demand for the firm‘s products. 10. List three reasons why a firm holds cash. A firm holds cash for three reasons:  to meet its day-to-day needs.  to compensate for the uncertainty associated with its cash flows.  to satisfy bank requirements.

11. What trade-off does a firm face when choosing how to invest its cash? The greater the risk associated with an investment, the higher the expected return on that investment. A financial manager who wants to invest the firm‘s funds in the least risky security will choose to invest in treasury bills. However, if the financial manager wishes to earn a higher return on the firm‘s short-term investments, she may opt to invest some or all of the firm‘s excess cash in a riskier alternative, such as commercial paper.

Chapter 20 Short-Term Financial Planning

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Answers to Chapter 20 Review Questions

1. What are the objectives of short-term financial planning? The objectives of short-term financial planning are to forecast the cash surpluses or deficits that are temporary. 2. What are seasonalities and what role do they play in short term financial planning? Seasonalities are differences in cash flows due to changes in demand. Firms with high fixed costs and highly seasonal demand for goods will see surpluses and deficits of cash flows as demand ebbs and flows. These firms will have higher short-term financing needs relative to non-seasonal firms. 3. Which of the following companies are likely to have high short term financing needs? Why? a. A clothing retailer: Clothing retailers have very seasonal business and therefore would have high short-term financing needs. b. A professional sports team: A professional sports team is seasonal by nature and would have high short-term financing needs. c. An electric utility: An electric utility has some seasonal variation in demand, but this variation is small. The utility does not likely have high short-term financing needs. d. A company that operates toll roads: A company that operates toll roads does not have seasonal demand for its services, so short-term financing needs will be small. e. A restaurant chain: A restaurant chain has very steady demand, thus small short-term financing needs. 4. Why is it important to distinguish between permanent and temporary shortfalls? It is important to determine whether shortfalls are temporary or permanent in nature because you want to finance the shortfall with financing of a similar time frame. This is the matching principle. 5. What is the difference between permanent working capital and temporary working capital?

Permanent working capital is the investment in working capital required to maintain operations, while temporary working capital is the portion of working capital investment that varies from seasonal fluctuations or cash flow shocks.

6. Describe the different approaches a firm could take in preparing for cash flow shortfalls? Firms can be aggressive or conservative in financing short-term needs. Aggressive financing involves financing part or all of permanent working capital with short-term financing, while conservative financing involves financing short-term needs with long-term debt. 7. What are the different bank financing options and what are their relative advantages? The different bank financing options are single end-of-period loans, lines of credit, and bridge loans. Single end-of-period loans are very straightforward. Lines of credit are convenient for firms with seasonal financing requirements but a cost is required to keep the line of credit open. Bridge loans are useful when the firm requires an amount of financing for a short period of time until another type of financing is available. 8. What is the difference between evergreen credit and a revolving line of credit? Evergreen credit is a revolving line of credit with no maturity. 9. What is the difference between direct paper and dealer paper? When the firm sells the commercial paper directly to investors, it is direct paper, whereas dealer paper involves selling the commercial paper through a dealer. 10. What is the difference between pledging account receivable to secure a loan and factoring accounts receivable? What types of short-term secured financing can a firm use to cover short-falls? In a pledging of accounts receivable agreement, the lender reviews the invoices that represent the credit sales of the borrowing firm and decides which credit accounts it will accept as collateral for the loan, based on its own credit standards. In a factoring of accounts receivable arrangement, the firm sells receivables to the lender (i.e., the factor), and the lender agrees to pay the firm the amount due from its customers at the end of the firm‘s payment period. The main types of secured short-term financing are to use either receivables or inventory as collateral or to sell receivables. 11. What will a short-term financial plan enable a financial manager to do? By creating a short-term financial plan, the managers can anticipate upcoming shortfalls, allowing them enough time to investigate the least costly way to finance those shortfalls.

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Answers to Chapter 20 Concept Check Questions

1. How do we forecast the firm‘s future cash requirements? The first step in short-term financial planning is to forecast the company‘s future cash flows. This exercise has two distinct objectives. First, a company forecasts its cash flows to determine whether it will have surplus cash or a cash deficit for each period. Second, management needs to decide whether that surplus or deficit is temporary or permanent. 2. What is the effect of seasonalities on short-term cash flows? For many firms, sales are seasonal. When sales are concentrated during a few months, sources and uses of cash are also likely to be seasonal. Firms in this position may find themselves with a surplus of cash during some months that is sufficient to compensate for a shortfall during other months. However, because of timing differences, such firms often have short-term financing needs.

3. What is the matching principle? The matching principle states that short-term cash needs should be financed with short term debt and long-term cash needs should be financed with long-term sources of funds. 4. What is the difference between temporary and permanent working capital? Permanent working capital is the investment in working capital required to maintain operations, while temporary working capital is the portion of working capital investment that varies from seasonal fluctuations or cash flow shocks. 5. What is the difference between an uncommitted line of credit and a committed line of credit? An uncommitted line of credit is an informal agreement that does not legally bind the bank to provide the funds. As long as the borrower‘s financial condition remains good, the bank is happy to advance additional funds. A committed line of credit consists of a legally binding written agreement that obligates the bank to provide funds to a firm (up to a stated credit limit) regardless of the financial condition of the firm (unless the firm is bankrupt) as long as the firm satisfies any restrictions in the agreement. 6. Describe common loan stipulations and fees. Common loan stipulations and fees affect the effective interest rate on a loan. Specifically, we look at loan commitment fees, loan origination fees, and compensating balance requirements. The commitment fee associated with a committed line of credit increases the effective cost of the loan to the firm. The ―fee‖ can really be considered an interest charge under another name. A loan origination fee is a charge that a bank makes to cover credit checks and legal fees. The firm pays the fee when the loan is initiated. The bank may include a compensating balance requirement in the loan agreement that reduces the usable loan proceeds. A compensating balance requirement means that the firm must hold a certain percentage of the principal of the loan in an account at the bank. 7. What is commercial paper? Commercial paper is short-term, unsecured debt used by large corporations that is usually a cheaper source of funds than a short-term bank loan. 8. What is the maximum maturity of commercial paper? The average maturity of commercial paper is 30 days, and the maximum maturity is one year. 9. What is factoring of accounts receivable? A factoring of accounts receivable arrangement, the firm sells receivables to the lender (i.e., the factor), and the lender agrees to pay the firm the amount due from its customers at the end of the firm‘s payment period. 10. What is the difference between a floating lien and a trust receipt? In a floating lien (general lien, or blanket lien) arrangement, the firm‘s entire inventory is used to secure the loan. With a trust receipts loan, or floor planning, distinguishable inventory items are held in a trust as security for the loan. As these items are sold, the firm remits the proceeds from their sale to the lender in repayment of the loan.

Chapter 21 Risk Management

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Answers to Chapter 21 Review Questions

1. Why is it possible for a firm to pay an actuarially fair price for insurance and still have the insurance purchase be a positive-NPV investment? In a perfect market without other frictions, insurance companies should compete until they are just earning a fair return and the NPV from selling insurance is zero. The NPV is zero if the price of insurance equals the present value of the expected payment; in that case, we say the price is actuarially fair. However, in the event a disaster does strike, the insurance covers the value of the disaster and the investment has a positive outcome. 2. How can an insurance company mitigate adverse selection and moral hazard? A firm‘s desire to buy insurance may signal that it has above average risk. If firms have private information about how risky they are, insurance companies must be compensated for this adverse selection with higher premiums. Agency costs are another factor that contributes to the price of insurance. Insurance reduces the firm‘s incentive to avoid risk. This change in behaviour that results from the presence of insurance is referred to as moral hazard. Insurance companies also structure their policies to reduce these costs. For example, most policies include both a deductible, which is the initial amount of the loss that is not covered by insurance and must be paid by the insured, and policy limits, provisions that limit the amount of the loss that is covered regardless of the extent of the damage. These provisions mean that the firm continues to bear some of the risk of the loss even after it is insured. In this way, the firm retains an incentive to avoid the loss, reducing moral hazard. A risky firm will prefer lower deductibles and higher limits (because it is more likely to experience a loss), insurers can use the firm‘s policy choice to help identify its risk and reduce adverse selection. 3. What are some common approaches to hedging commodity price risk? Firms use insurance to protect against the unlikely event that their real assets are damaged or destroyed by hazards such as fire, hurricane, accident, or other catastrophes that are outside their normal course of business. For many firms, changes in the market prices of the raw materials they use and the goods they produce may be the most important source of risk to their profitability. Vertical Integration. The merger of a firm and its supplier (or a firm and its customer) is referred to as vertical integration. Because an increase in the price of the commodity raises the firm‘s costs and the supplier‘s revenues, these firms can offset their risks by merging. Hedging with Storage. Using long-term storage of inventory to avoid price hikes. Hedging with Long-term Contracts. An alternative to vertical integration or storage is a long-term supply contract. Default Risk Prevention. Futures exchanges use two mechanisms to prevent buyers or sellers from defaulting. First, investors (both the long and short parties to the futures contract) are required to post collateral, called margin, when using futures contracts. This collateral serves as a guarantee that traders will meet their obligations. In addition, cash flows are exchanged on a daily basis, rather than

waiting until the end of the contract, through a procedure called marking to market. That is, gains and losses are computed each day based on the change in the market price of the futures contract. Forward Contracts. A forward contract is a customized agreement between two parties who are known to each other whereby they agree to trade a certain quantity of an asset on some future date at a price that is fixed today. Forward contracts and many other types of long-term supply contracts are bilateral contracts negotiated by a buyer and a seller to suit their particular needs. 4. Can hedging lead to losses? Similar to insurance, commodity hedging does not always boost a firm‘s profits. Like insurance, hedging involves contracts or transactions at a cost that is expensed that provide the firm with cash flows that offset its losses from un-favourable price changes. Buy hedging commodity price risk can benefit the firm by reducing the costs of other frictions. Just as with insurance, the potential benefits include reduced financial distress and issuance costs, tax savings, increased debt capacity, and improved managerial incentives and risk assessment. 5. How can a firm become exposed to interest rate risk? Firms that borrow must pay interest on their debt. An increase in interest rates raises firms‘ borrowing costs and can reduce their profitability. In addition, many firms have fixed long-term future liabilities, such as capital leases or pension fund liabilities. A decrease in interest rates raises the present value of these liabilities and can lower the value of the firm. 6. How can a firm use a swap to manage its interest rate risk? Interest rate swaps are an alternative means of modifying the firms‘ interest rate risk exposure without buying or selling assets. An interest rate swap is a contract a firm enters into with a bank in which the firm and the bank agree to exchange the coupons from two different types of loans. Corporations routinely use interest rate swaps to alter their exposure to interest rate fluctuations. The interest rate a firm pays on its loans can fluctuate for two reasons. First, the risk-free interest rate in the market may change. Second, the firm‘s credit quality, which determines the spread the firm must pay over the risk-free interest rate, can vary over time. By combining swaps with loans, firms can choose which of these sources of interest rate risk they will tolerate and which they will eliminate.

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Answers to Chapter 21 Concept Check Questions

1. How can insurance add value to a firm? The value of insurance must come from reducing the cost of market imperfections to the firm. 2. Identify the costs of insurance that arise due to market imperfections. When insurance premiums are actuarially fair; using insurance to manage the firm‘s risk can reduce costs and improve investment decisions. But in reality, market imperfections exist that can raise the cost of insurance above the actuarially fair price and offset some of these benefits. Three main frictions may arise between the firm and its insurer. First, transferring the risk to an insurance company. A second factor that raises the cost of insurance is adverse selection. Agency costs are a third factor that contributes to the price of insurance. Insurance reduces the firm‘s incentive to avoid risk. This change in behaviour that results from the presence of insurance is referred to as moral hazard. 3. Discuss risk-management strategies that firms use to hedge commodity price risk. Firms use insurance to protect against the unlikely event that their real assets are damaged or destroyed by hazards such as fire, hurricane, accident, or other catastrophes that are outside their

normal course of business. For many firms, changes in the market prices of the raw materials they use and the goods they produce may be the most important source of risk to their profitability. Vertical Integration. The merger of a firm and its supplier (or a firm and its customer) is referred to as vertical integration. Because an increase in the price of the commodity raises the firm‘s costs and the supplier‘s revenues, these firms can offset their risks by merging.

Hedging with Storage. Using long-term storage of inventory to avoid price hikes. Hedging with Long-term Contracts. An alternative to vertical integration or storage is a long-term supply contract. Default Risk Prevention. Futures exchanges use two mechanisms to prevent buyers or sellers from defaulting. First, investors (both the long and short parties to the futures contract) are required to post collateral, called margin, when using futures contracts. This collateral serves as a guarantee that traders will meet their obligations. In addition, cash flows are exchanged on a daily basis, rather than waiting until the end of the contract, through a procedure called marking to market. That is, gains and losses are computed each day based on the change in the market price of the futures contract. Forward Contracts. A forward contract is a customized agreement between two parties who are known to each other whereby they agree to trade a certain quantity of an asset on some future date at a price that is fixed today. Forward contracts and many other types of long-term supply contracts are bilateral contracts negotiated by a buyer and a seller to suit their particular needs. 4. What are the potential risks associated with hedging using futures contracts? With a futures hedging strategy, there is no cost to enter into the contract. In effect, the party who takes the long futures position does not have to pay the party who takes the short futures position at the time the contract is entered, because both parties are simply signing a contract at a fair market price for a future transaction. With a futures contract, the final price is fixed regardless of whether the market price rises or falls. 5. What is the intuition behind the calculation of duration? Duration measures the sensitivity to interest rate changes of their assets and liabilities. The farther away the cash flow is, the larger the effect of interest rate changes on its present value. 6. How do firms manage interest rate risk? Interest rate swaps are an alternative means of modifying the firms‘ interest rate risk exposure without buying or selling assets. An interest rate swap is a contract a firm enters into with a bank in which the firm and the bank agree to exchange the coupons from two different types of loans. Corporations routinely use interest rate swaps to alter their exposure to interest rate fluctuations. The interest rate a firm pays on its loans can fluctuate for two reasons. First, the risk-free interest rate in the market may change. Second, the firm‘s credit quality, which determines the spread the firm must pay over the risk-free interest rate, can vary over time. By combining swaps with loans, firms can choose which of these sources of interest rate risk they will tolerate and which they will eliminate.

Chapter 22 International Corporate Finance

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Answers to Chapter 22 Review Questions

1. How is an exchange rate used? Exchange rates are used to determine the cost of a currency in terms of another currency. 2. What are some reasons a financial manager would need to access the foreign exchange market? Firms with suppliers and outlets in foreign countries have costs and revenues that are denominated in other currencies. To the extent that the revenues and costs of each foreign currency do not equate, financial managers may need to buy or sell foreign currencies in foreign exchange markets. 3. What are the differences between hedging exchange rate risk with options versus forwards? The use of forward contracts allows firms to lock in an exchange rate today for some future point in time, thus eliminating the risk of exchange rate fluctuations. Option contracts allow firms to benefit from interest rate fluctuations in their favor, while protecting against interest rate fluctuations that move against them. 4. What does it mean to say that international capital markets are integrated? Internationally integrated capital markets are the conditions in which the value of an investment does not depend on the currency used in the analysis. 5. What assumptions are necessary to value foreign cash flows using the domestic WACC method? We must assume that the risk of the foreign cash flows is the same as the riskiness of the cash flows of the domestic firm as a whole. 6. How are Canadian firms taxed on their foreign earnings? Canadian firms are taxed only on their repatriated profits. If the foreign tax rate is greater than the Canadian tax rate, the firm‘s tax rate is the foreign tax rate, and all the taxes are paid to the foreign country (with no taxes paid to the Canadian Government). If the foreign tax rate is less than the Canadian tax rate, the firm‘s tax rate is the Canadian tax rate. The firm pays its foreign taxes and an additional amount to the Canadian government up to the Canadian tax rate. 7. If international markets are segmented, how does that change the way the financial manager approaches valuation problems? If international capital markets are segmented, financial managers can exploit the differences between the two markets to create value for shareholders. 8. How does exchange rate risk affect our approach to valuation? As exchange rates become correlated with the free cash flows of the project, we must account for the effects of exchange rate risk on the value of the project.

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Answers to Chapter 22 Concept Check Questions

1. What is an exchange rate? The price of one country‘s currency in terms of another country‘s currency is called a currency exchange rate. 2. Why would multinational companies need to exchange currencies? A multinational company‘s revenues may come in many different currencies. In addition to revenues, a firm has costs may incurred in many currencies. Other currencies may be used when a multinational purchases equipment from suppliers in countries where the multinational does not have operations. Because of its multinational operations, the multinational must regularly transact in the FX market. Eventually may want to exchange their profits in the various currencies back into multinational‘s domestic currency. However, the FX market is not just important for large multinational enterprises. Many businesses import or export some of their products from abroad, and the companies will need to participate in the FX markets. 3. How can firms hedge exchange rate risk? The most common method firms use to reduce the risk that results from changes in exchange rates is to hedge the transaction using currency forward contracts. 4. Why might a firm prefer to hedge exchange rate risk with options rather than forward contracts? Currency options give the holder the right—but not the obligation—to exchange currency at a given exchange rate. Currency forward contracts allow firms to lock in a future exchange rate; currency options allow firms to insure themselves against the exchange rate moving beyond a certain level. A forward contract could commit them to making an exchange at an unfavourable rate for currency they do not need, whereas an option allows them to walk away from the exchange. 5. What assumptions are needed to have internationally integrated capital markets? The development of a conceptual benchmark based on the assumptions that any investor can exchange either currency in any amount at the spot rate or forward rates, and is free to purchase or sell any security in any amount in either country at their current market prices. 6. What implication do internationally integrated capital markets have for the value of the same asset in different countries? Under internationally integrated capital markets, the value of an investment does not depend on the currency we use in the analysis. By the Law of One Price, this value must be equal to what the Canadian investor paid for the security.

7. Explain two methods we use to calculate the NPV of a foreign project. In an internationally integrated capital market, two equivalent methods are available for calculating the NPV of a foreign project:  Calculate the NPV in the foreign country and convert it to the home currency at the spot rate. This method is essentially what we have done throughout this book (calculating the NPV of a project in a single currency) with the added step at the end of converting the NPV into the home currency using spot rates  Convert the cash flows of the foreign project into the home currency and then calculate the NPV of these cash flows. This valuation method requires converting to the expected CAD value of the foreign currency cash flows and then proceeding to value the project as if it were a domestic project. 8. When do these two methods give the same NPV of the foreign project? For the two methods to provide the same answer the estimate for the foreign cost of capital must satisfy the Law of One Price 9. What tax rate should we use to value a foreign project? If the foreign tax rate exceeds the Canadian tax rate, companies must pay this higher rate on foreign earnings. Because the Canadian tax credit exceeds the amount of Canadian taxes owed, no tax is owed in Canada. 10. How can a Canadian firm lower its taxes on foreign projects? When the foreign tax rate is less than the Canadian tax rate, deferral can provide significant benefits. Deferring repatriation of earnings lowers the overall tax burden in much the same way as deferring capital gains lowers the tax burden imposed by the capital gains tax. Other benefits from deferral arise because the firm effectively gains a real option to repatriate income at times when repatriation might be cheaper. For example, we have already noted that by pooling foreign income, the firm effectively pays the combined tax rate on all foreign income. Because the income generated across countries changes, this combined tax rate will vary from year to year. In years in which it exceeds the Canadian tax rate, the repatriation of additional income does not incur an additional Canadian tax liability, so the earnings can be repatriated tax free. 11. What are the reasons for segmentation of capital markets? In some countries, especially in the developing world, all investors do not have equal access to financial securities. As a result, countries‘ capital markets might not be integrated but be segmented capital markets. Markets for a specific firm‘s securities and markets for risk-free instruments may be segmented. Important macroeconomic reasons for segmented capital markets include capital controls and foreign exchange controls that create barriers to international capital flows and thus segment national markets.

12. What is the main implication for international corporate finance of a segmented financial market? Many countries regulate or limit capital inflows or outflows, and many do not allow their currencies to be freely converted into dollars, thereby creating capital market segmentation. Similarly, some countries restrict who can hold financial securities. Political, legal, social, and cultural characteristics that differ across countries may require compensation in the form of a country risk premium. A segmented financial market has an important implication for international corporate finance: one country or currency has a higher rate of return than another country or currency, when the two rates are compared in the same currency. If the return difference results from a market friction such as capital controls that corporations can exploit companies will set up projects in the high-return country/currency and raising capital in the low-return country/currency. 13. What conditions cause the cash flows of a foreign project to be affected by exchange rate risk? The risk is that the cash flows generated by the project will depend on the future level of the exchange rate. 14. How do we make adjustments when a project has inputs and outputs in different currencies? Often, an assumption that makes sense if the firm operates as a local firm in the foreign market—it purchases its inputs and sells its outputs in that market, and price changes of the inputs and outputs are uncorrelated with exchange rates.

Chapter 23 Leasing

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Answers to Chapter 23 Review Questions

1. Why would a firm enter into a sale and leaseback transaction? If a firm already owns an asset that it would prefer to lease, it can arrange a sale and leaseback transaction. In this type of lease, the lessee receives cash from the sale of the asset and then makes lease payments to retain the use of the asset. 2. What are the main differences between fair market value, $1 out, fixed-price, and fair market value cap leases? A fair market value (FMV) lease gives the lessee the option to purchase the asset at its fair market value at the termination of the lease. In a $1.00 out lease (also known as a finance lease), ownership of the asset transfers to the lessee at the end of the lease for a nominal cost of $1.00. In a fixed price lease, the lessee has the option to purchase the asset at the end of the lease for a fixed price that is set upfront in the lease contract. In a fair market value cap lease, the lessee can purchase the asset at the minimum of its fair market value and a fixed price (the ―cap‖). 3. How are operating leases different from capital leases? Finance leases increase the apparent leverage on the firm‘s balance sheet, firms sometimes prefer to have a lease categorized as an operating lease to keep it off the balance sheet. IFRS [under International Accounting Standard (IAS) 17] does not provide separate guidance for lessees and lessors when determining the classification of a lease. Instead, examples are provided of situations that individually or in combination would normally lead to a lease being classified as a finance lease. These are as follows: 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. 3. The lease term is for the major part of the economic life of the asset, even if title is not transferred. 4. At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. 5. The leased assets are of such a specialized nature that only the lessee can use them without major modifications.

Other indicators that individually, or in combination, could also lead to a lease being classified as a finance lease are as follows: 1. If the lessee can cancel the lease, the lessor‘s losses associated with the cancellation are borne by the lessee 2. Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (e.g., in the form of a rent rebate equaling most of the sales proceeds at the end of the lease). 3. The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. 4. Which classification of a lease is more important for cash flows and valuation: that of the IFRS or Canada Revenue Agency? The categories used to report leases on the financial statements affect the values of assets on the balance sheet, but they have no direct effect on the cash flows that result from a leasing transaction. 5. What is the advantage of a synthetic lease? Synthetic leases are designed to obtain specific accounting and tax treatment. Synthetic leases are designed to be treated as an operating lease for accounting purposes and as a non-tax lease for tax purposes. With a synthetic lease, the lessee is able to deduct depreciation and interest expenses for tax purposes, just as if it had borrowed to purchase the asset, but does not need to report the asset or the debt on its balance sheet. 6. Why does it matter whether the lease is classified as a security interest or as a true lease? If the lease is deemed to be a security interest, the firm is assumed to have effective ownership of the asset and the asset is protected against seizure. The lessor is then treated as any other secured creditor and must await the firm‘s reorganization or ultimate liquidation. If the lease is classified as a true lease in bankruptcy, then the lessor retains ownership rights over the asset. 7. Why is comparing leasing versus buying an unfair comparison? Because leasing is a form of financing, we should compare it to other financing options that the firm may have. Rather than buy the asset outright, the firm could borrow funds (or reduce its planned cash balances, and thereby increase its net debt) to finance the purchase of the equipment, thus matching the leverage of the lease. If the firm does borrow, it will also benefit from the interest tax shield provided by leverage. This tax advantage may make borrowing to buy the equipment more attractive than leasing. Thus, to evaluate a lease correctly, we should compare it to purchasing the asset using an equivalent amount of leverage. In other words, the appropriate comparison is not lease versus buy, but rather lease versus borrow. 8. What are the main steps in evaluating a true tax lease? When evaluating a true tax lease, we should compare leasing to a purchase that is financed with equivalent leverage. We suggest the following approach: 1. Compute the incremental cash flows for leasing versus buying, as we did in Table 23.2. Include the CCA tax shield (if buying) and the tax deductibility of the lease payments (if leasing). 2. Compute the NPV of leasing versus buying using equivalent leverage by discounting the incremental cash flows at the after-tax borrowing rate. If the NPV is negative, then leasing is unattractive compared to traditional debt financing. In this case, the firm should not lease, but rather should acquire the asset using an optimal amount of leverage (based on the trade-offs and techniques discussed in Part 6).

If the NPV is positive, then leasing does provide an advantage over traditional debt financing and should be considered. Management should recognize, however, that while it may not be listed on the balance sheet, the lease increases the firm‘s effective leverage by the amount of the lease-equivalent loan. 9. Explain why preserving capital and reducing leverage are suspect reasons for leasing. A common argument made in favor of leasing is that it provides ―100% financing‖ because no down payment is required, so the lessee can save cash to use for other needs. Of course, the firm can also borrow to purchase an asset (possibly using the asset as collateral). Because a lease is equivalent to a loan, the firm can increase its actual leverage without increasing the debt-to-equity ratio on its balance sheet. But whether they appear on the balance sheet or not, l ease commitments are liabilities for the firm. As a result, they will have the same effect on the risk and return characteristics of the firm as other forms of leverage do. Most financial analysts and sophisticated investors understand this fact and consider operating leases (which must be listed in the footnotes of the financial statements) to be additional sources of leverage.

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Answers to Chapter 23 Concept Check Questions

1. In a perfect capital market, how is the amount of a lease payment determined? In a perfect market, the cost of leasing is equivalent to the cost of purchasing and reselling the asset. In effect, this is just another example of the application of the Law of One Price. 2. What types of lease options would raise the amount of the lease payment? The lease payments will increase the most depending on the end on the lease cash flows. The higher the residual value of the asset the lower the lease payments. In a $1.00 out lease (also known as a finance lease), ownership of the asset transfers to the lessee at the end of the lease for a nominal cost of $1.00 and would have the highest lease payments. This will follow by a fair market value cap lease, the lessee can purchase the asset at the minimum of its fair market value and a fixed price (the ―cap‖). 3. How is a $1.00 out lease characterized for accounting and tax purposes? A lease is classified as a finance lease if it meets any of the following conditions: 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. 3. The lease term is for the major part of the economic life of the asset, even if title is not transferred. 4. At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. 5. The leased assets are of such a specialized nature that only the lessee can use them without major modifications. A lease with a $1.00 out will meet both conditions 1 and 2.

4. Is it possible for a lease to be treated as an operating lease for accounting purposes and as a non-tax lease for tax purposes? Finance leases increase the apparent leverage on the firm‘s balance sheet and firms sometimes prefer to have a lease categorized as an operating lease to keep it off the balance sheet. IFRS [under International Accounting Standard (IAS) 17] does not provide separate guidance for lessees and lessors when determining the classification of a lease. Under the Specialized Leasing Property Rules, certain assets held under financial (i.e. finance) leases could be fully treated as a lease for tax purposes. 5. What discount rate should be used for the incremental lease cash flows to compare a true tax lease to borrowing? Compute the NPV of leasing versus buying using equivalent leverage by discounting the incremental cash flows at the after-tax borrowing rate. 6. How can we compare a non-tax lease to borrowing? In terms of cash flows, a non-tax lease is directly comparable to a traditional loan. Therefore, it is attractive if it offers a better interest rate than would be available with a loan. To determine whether it does offer a better rate, we can discount the lease payments at the firm‘s pre-tax borrowing rate and compare it to the purchase price of the asset. 7. What are some of the potential gains from leasing if the lessee plans to hold the asset for only a small fraction of its useful life? If a firm needs to use the asset for only a short time, leasing it is probably less costly than buying and later reselling the asset. In this case, the lessor is responsible for finding a new user for the asset. 8. If a lease is not listed as a liability on the firm‘s balance sheet, does it mean that a firm that leases rather than borrows is less risky? Whether a lease appears on the balance sheet or not, lease commitments are liabilities for the firm. As a result, they will have the same effect on the risk and return characteristics of the firm as other forms of leverage do. Most financial analysts and sophisticated investors understand this fact and consider operating leases (which must be listed in the footnotes of the financial statements) to be additional sources of leverage.

Chapter 24 Mergers and Acquisitions

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Answers to Chapter 24 Review Questions

1. What are the two primary mechanisms under which ownership and control of a public corporation can change? Either another corporation or group of individuals can acquire the target firm, or the target firm can merge with another firm. 2. Why do you think mergers cluster in time, causing merger waves? There are many competing theories as to why this is so. They generally fall into two camps: either stock market valuations drive merger activity or industry shocks accompanying economic expansions drive merger activity. It is clear that merger activity is much greater during economic expansions than during contractions and that merger activity strongly correlates with bull markets. Thus, there must be something about economic expansions in general and higher stock market valuations in particular that grease the wheels of the merger process. However, unless you are willing to believe that the majority of managers simply buy other companies because they can, without regard to economic reasoning, this cannot be the whole story. There must be real economic impetus to the activity. Many of the same technological and economic conditions that lead to bull markets also motivate managers to reshuffle assets through merger and acquisitions. Thus, it takes a combination of forces usually only present during strong economic expansions to drive peaks in merger activity. 3. What are some reasons why a horizontal merger might create value for shareholders? Horizontal mergers are more likely to create value for acquiring shareholders. Horizontal mergers combine two firms in the same industry. This provides for greater potential synergies in eliminating redundant functions within the two firms and potentially increased pricing power with both vendors and customers. 4. Why do you think shareholders from target companies enjoy an average gain when acquired, while acquiring shareholders on average often do not gain anything? The acquiring firm has to compete against other firms, thus reducing the gains it can obtain from the transaction. Target shareholders benefit from this competition, as they obtain higher bids for the company.

5. If you are planning an acquisition that is motivated by trying to acquire expertise, you are basically seeking to gain intellectual capital. What concerns would you have in structuring the deal and the post-merger integration that would be different from the concerns you would have when buying physical capital? In cases where you are buying a lot of intangible assets, especially human capital, you have to be particularly worried about how you are going to create incentives for the target‘s employees to stay on. Retention bonuses are common for key employees in these types of acquisitions. It is also hard to be successful with a hostile acquisition when retention of target employees is critical. Keeping uncertainty low and moving quickly during the integration phase are both critical to acquisitions of expertise. 6. Do you agree that the European Union should be able to block mergers between two U.S.-based firms? Why or why not? The argument can go either way on this. Some of the critical factors to consider are: What is the social good created by antitrust regulation? Do European regulators have a right to regulate firms doing business in Europe, regardless of where those firms are headquartered? What would be the alternatives? 7. How do the carry forward and carry back provisions of the Canadian or U.S. tax codes affect the benefits of merging to capture operating losses? Carry forward and carry back provisions generally reduce the attractiveness of tax losses as a motivation to merger. Since the tax loss motivation is based on the ability of a larger firm to capture the tax deduction from the losses of the target, it requires that the target not be able to capture the value of that deduction itself. Carry forward and carry back provisions give the target more opportunities to capture the deduction either through recapture of previously paid taxes or by applying the deduction in the future when the company returns to profitability. 8. Diversification is good for shareholders, so why shouldn‘t managers acquire firms in different industries to diversify a company? Yes, diversification is good for shareholders, and they can do it efficiently themselves by purchasing shares in different companies. There is no need for managers to do this for them by creating a conglomerate through purchasing other companies at a premium over market prices. Given the premium paid in an acquisition and the differing preferences of shareholders, it cannot be efficient for managers to diversify the company rather than leaving it to shareholders to diversify their portfolio. 9. How does a toehold help overcome the free rider problem? Since the acquirer gains the full amount of the value improvement on the shares acquired as a toehold, a toehold provides an incentive to undertake the acquisition, even if the acquirer must pay a price equal to the with-improvement value for the rest of the shares.

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Answers to Chapter 24 Concept Check Questions

1. What are merger waves? The takeover market is also characterized by merger waves —peaks of heavy activity followed by quiet troughs of few transactions.

2. What is the difference between a horizontal and a vertical merger? If the target and acquirer are in the same industry, the merger is typically called a horizontal merger, whereas if the target‘s industry buys or sells to the acquirer‘s industry, it is called a vertical merger. 3. On average, what happens to the target share price on the announcement of a takeover? When a bid is announced, the target shareholders enjoy a gain on average in their stock price. 4. On average, what happens to the acquirer share price on the announcement of a takeover? Although acquirer shareholders see an average gain of 1%, in half of the transactions the bidder price decreases (in effect the median gain is not significantly different from 0%). 5. What are the reasons most often cited for a takeover? The answer is that an acquirer might be able to add economic value, as a result of the acquisition, that an individual investor cannot add. The basis of the assumption that the value of the combined companies will be worth more than the sum of the two companies‘ individual values is the assumption that they will create synergies. 6. Explain why risk-diversification benefits and earnings growth are not good justifications for a takeover intended to increase shareholder wealth. Like a large portfolio, large firms bear less idiosyncratic risk, so often mergers are justified on the basis that the combined firm is less risky. The problem with this argument is that it ignores the fact that investors can achieve the benefits of diversification themselves by purchasing shares in the two separate firms. Because most stockholders will already be holding a well-diversified portfolio, they get no further benefit from the firm diversifying through acquisition. When a firm acquires a company with low growth potential (and thus a low P/E multiple) a company with high growth potential (and high P/E multiple) can raise its earnings per share. In the past, people have cited this increase as a reason to merge. Of course, a savvy investor will see that the merger adds no economic value. All that has happened is that the high-growth company, by combining with a lowgrowth company, has lowered its overall growth rate. As a result, its P/E multiple should fall, which results from its earnings per share rising. Thus, we can draw no conclusion regarding whether a merger was beneficial solely by looking at its impact on the acquirer‘s earnings per share. 7. What are the steps in the takeover process? The takeover process undertakes the following steps: 1. Valuation — direct comparison to others and incorporating multiples — prepare a valuation of the projections of the incremental cash flows including any synergistic gains 2. The Offer — cash offer for the outstanding stock — stock offer including the exchange ratio 3. Merger Arbitrage 4. Tax and Accounting Issues 5. Board and Shareholder Approval

8. What do risk arbitrageurs do? Because of this uncertainty about whether a takeover will succeed, the market price generally does not rise by the amount of the premium when the takeover is announced. This uncertainty creates an opportunity for investors to speculate on the outcome of the deal. Traders known as risk arbitrageurs, who believe that they can predict the outcome of a deal, take positions based on their beliefs. While the strategies these traders use are sometimes referred to as arbitrage, they are actually quite risky, so they do not represent a true arbitrage opportunity in the sense we have defined in this book. 9. What defensive strategies are available to help target companies resist an unwanted takeover? A poison pill is a rights offering that gives existing target shareholders the right to buy shares in the target or the acquirer at a deeply discounted price once certain conditions are met. A staggered (or classified) board is less typical in Canada. In a typical staggered board, every director serves a three-year term and the terms are staggered so that only one-third of the directors are up for election each year. Thus, even if the bidder‘s candidates win board seats, the bidder will control only a minority of the target board. A target company will sometimes look for another, friendlier company to acquire it. This company that comes charging to the target‘s rescue is known as a white knight. The white knight will make a more lucrative offer for the target than the hostile bidder did. A golden parachute is an extremely lucrative severance package that is guaranteed to a firm‘s senior managers in the event that the firm is taken over and the managers are let go. The recapitalization defense against a takeover is when a company changes its capital structure to make itself less attractive as a target A supermajority can be included in the corporation‘s charter can requires a supermajority (sometimes as much as 80%) of votes to approve a merger. Vote restrictions can restrict the voting rights of very large shareholders Government approvals In Canada, the Competition Bureau monitors potential monopoly combinations. In the U.S., under the HSR Act all mergers above a certain size (the formula for determining whether a transaction qualifies is complicated, but it comes out to approximately $60 million) must be approved by the government before the proposed takeovers occur. 10. How can a hostile acquirer get around a poison pill? For a hostile takeover to succeed, the acquirer must go around the target board and appeal directly to the target shareholders. The acquirer can do this by making an unsolicited offer to buy target stock directly from the shareholders (a tender offer). The acquirer will usually couple this with a proxy fight: the acquirer attempts to convince target shareholders to unseat the target board by using their proxy votes to support the acquirers‘ candidates for election to the target board. 11. What mechanisms allow corporate raiders to get around the free rider problem in takeovers? The ‗free rider‘ problem stems from the benefit that can be realized by the shareholders that do not tender their shares in the event of a takeover and are expecting share prices to increase. The Toehold. One way to get around the problem of shareholders‘ reluctance to tender their shares is to buy the shares in the market anonymously. However, Canadian securities laws and the SEC in the U.S. make it difficult for investors to buy much more than 10% of a firm in secret. The acquiring company acquires an initial stake in the target, called a toehold.

Leveraged Buyout. A lower-cost mechanism allows an acquiring to take over companies and fire underperforming managers. This mechanism is called the leveraged buyout (LBO). Instead of using his own cash to pay for these shares, the acquiring firm borrows the money through a shell corporation (one that is created for the sole purpose of making the acquisition) by pledging the shares themselves as collateral on the loan. Freezeout Merger. The laws on tender offers allows the acquiring company to freeze existing shareholders out of the gains from merging by forcing non-tendering shareholders to sell their shares for the tender offer price. In Canada, it is a requirement that 90% of the target‘s shares be acquired by the bidder before a freeze out can be implemented. 12. Based on the empirical evidence, who gets the value added from a takeover? What is the most likely explanation of this fact? The empirical evidence suggests that, despite the availability of both the freeze out merger and the leveraged buyout as acquisition strategies, most of the value added still appears to accrue to the target shareholders. Once an acquirer starts bidding on a target company and it becomes clear that a significant gain exists, other potential acquirers may submit their own bids. The result is effectively an auction in which the target is sold to the highest bidder. Even when a bidding war does not result, most likely it is because, rather than participate in a bidding war, an acquirer offered a large enough initial premium to forestall the process. In essence, it must give up most of the value added to the target shareholders.

Chapter 25 Corporate Governance

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Answers to Chapter 25 Review Questions

1. Why is governance important in a corporation? Corporate governance is the system of controls, regulations, and incentives designed to prevent fraud in the corporation. It is a story of conflicts of interest and attempts to minimize the conflicts. Different stakeholders in a firm all have their own interests. When those interests diverge, we may have agency conflicts. The role of the corporate governance system is to mitigate the conflict of interest that results from the separation of ownership and control without unduly burdening managers with the risk of the firm. The system attempts to align the interests of management and shareholders by providing incentives for taking the right action and punishments for taking the wrong action in the corporation 2. Why would a grey director be compromised as a monitor? Grey directors are people who are not as directly connected to the firm as insiders are but have existing or potential business relationships with the firm. For example, bankers, lawyers, and

consultants who are already retained by the firm, or who would be interested in being retained, may sit on a board. Thus, their judgment could be compromised by their desire to keep the CEO happy. 3. Why can we not simply rely on regulators to monitor managers? From time to time government has added to existing requirements by passing laws that force minimum standards of governance. The overall intent of SOX was to improve the accuracy of information given to both boards and shareholders. SOX had three main components: (1) it overhauled incentives and independence in the auditing process, (2) stiffened penalties for providing false information, and (3) required companies to validate their internal financial control processes. The difficulty lies in the fact that government regulation is a reaction to massive failures of large public companies and corporate fraud scandals rather than being proactive in its requirements. 4. How can compensation design help mitigate principal-agent problems? In the absence of monitoring, the conflict of interest between managers and owners can be mitigated by closely aligning their interests through the managers‘ compensation policy. That is, by tying compensation to performance, the shareholders effectively give the manager an ownership stake in the firm. Many companies adopted compensation policies that more directly gave managers an ownership stake by including grants of stock or stock options to executives. These grants give managers a direct incentive to increase the stock price to make their stock or options as valuable as possible.

5. Why is managerial ownership not always value improving? Besides increasing managers‘ risk exposure, increasing the sensitivity of managerial pay and wealth to firm performance has some other negative effects. For example, often options are granted ―at the money,‖ meaning that the exercise price is equal to the current stock price. Therefore, managers have an incentive to manipulate the release of financial forecasts so that bad news comes out before options are granted (to drive the exercise price down) and good news comes out after options are granted. Studies have found evidence that the practice of timing the release of information to maximize the value of CEO stock options is widespread. Evidence suggesting that many executives have engaged in a more direct form of manipulating their stock option compensation: backdating their option grants. Backdating refers to the practice of choosing the grant date of a stock option retroactively, so that the date of the grant would coincide with a date when the stock price was at its low for the quarter or for the year. By backdating the option in this way, the executive receives a stock option that is already in-the-money, with a strike price equal to the lower price on the supposed grant date. The use of backdating suggests that some executive stock option compensation may not truly have been earned as the result of good future performance of the firm. 6. What are shareholders‘ options to confront managers who they believe are damaging shareholder value? Shareholders will use all of the tools at their disposal to mitigate the agency conflicts. When shareholders are angry about the management of the company and frustrated by a board unwilling to take action, however, they have at their disposal a variety of options for expressing that displeasure. Shareholder Voice. Any shareholder can submit a resolution that is put to a vote at the annual meeting. Shareholder Approval. In addition to electing the directors of the company, shareholders must approve many major actions taken by the board. Proxy Contests. The most extreme form of direct action that disgruntled shareholders can take is to hold a proxy contest and introduce a rival slate of directors for election to the board. 7. Should insider trading be illegal? Insider trading occurs when a person makes a trade based on privileged information. Managers have access to information that outside investors do not have. By using this information, managers can exploit profitable trading opportunities that are not available to outside investors. If they were allowed to trade on their information, their profits would come at the expense of outside investors and, as a result, outside investors would be less willing to invest in corporations. 8. How is it possible for an entity with low cash flow interest in a company to exercise control? A minority shareholder can control a corporation without owning 50% of the equity by creating a pyramid structure. In a pyramid structure, an investor first creates a company in which they own more than 50% of the shares and therefore has a controlling interest. This company then owns a controlling interest - that is, at least 50% of the shares - in another company. Notice that the investor controls both companies, but owns only 25% of the second company. Indeed, if the second company purchased 50% of the shares of a third company, then the investor would control all three companies, even though it would own only 12.5% of the third company. The farther you move down the pyramid the less ownership the investor has, but it still remains in complete control of all the companies.

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Solutions to Chapter 25 Concept Check Questions

1. What is corporate governance? Corporate governance—the system of controls, regulations, and incentives designed to prevent fraud—is a story of conflicts of interest and attempts to minimize them. 2. What agency conflict do corporate governance structures address? The separation of ownership and control is perhaps the most important reason for the success of the corporate organizational form. Once control and ownership are separated, however, a conflict of interest arises between the owners and the people in control of a corporation managers‘ desire to manage a larger firm, gaining them more prestige and greater pay, even if that might not be in the best interests of shareholders. The role of the corporate governance system is to mitigate the conflict of interest that results from the separation of ownership and control without unduly burdening managers with the risk of the firm. The system attempts to align these interests by providing incentives for taking the right action and punishments for taking the wrong action. 3. What is the difference between grey directors and outside directors? Grey directors are people who are not as directly connected to the firm as insiders are but have existing or potential business relationships with the firm. Other directors are considered outside (or independent) directors and are the most likely to make decisions solely in the interests of the shareholders. 4. What does it mean for a board to be captured? A board is said to be a captured board when its monitoring duties have been compromised by connections or perceived loyalties to management. 5. What is the main reason for tying managers‘ compensation to firm performance? The other way the conflict of interest between managers and owners can be mitigated is by closely aligning their interests through the managers‘ compensation policy. That is, by tying compensation to performance, the shareholders effectively give the manager an ownership stake in the firm. 6. What is the negative effect of increasing the sensitivity of managerial pay to firm performance? Managers have an incentive to manipulate the release of financial forecasts so that bad news comes out before options are granted (to drive the exercise price down) and good news comes out after options are granted. Studies have found evidence that the practice of timing the release of information to maximize the value of CEO stock options is widespread. 7. Describe and explain a proxy contest. The most extreme form of direct action that disgruntled shareholders can take is to hold a proxy contest and introduce a rival slate of directors for election to the board (see Figure 25.2). This action gives shareholders an actual choice between the nominees put forth by management and the current board and a completely different slate of nominees put forth by dissident shareholders 8. What is the role of takeovers in corporate governance? When internal governance systems such as ownership, compensation, board oversight, and shareholder activism fail, the one remaining way to remove poorly performing managers is by mounting a hostile takeover. Thus, the effectiveness of the corporate governance structure of a firm depends on how well protected its managers are from removal in a hostile takeover. An active takeover market is part of the system through which the threat of dismissal is maintained. In fact, some research has suggested that an active takeover market complements a board‘s own vigilance in dismissing incompetent managers.

9. Describe the main requirements of the Sarbanes-Oxley Act of 2002. One of the most critical inputs to the monitoring process is accurate information. If a board of directors has inaccurate information, it cannot do its job. The overall intent of SOX was to improve the accuracy of information given to both boards and shareholders. SOX had three main components: (1) it overhauled incentives and independence in the auditing process, (2) stiffened penalties for providing false information, and (3) required companies to validate their internal financial control processes. More specifically,  to reduce incentive conflicts in auditing, SOX put strict limits on the amount of non-audit fees (consulting or otherwise) that an accounting firm can earn from the same firm that it audits.  required that audit partners rotate every five years.  called on the SEC to force companies to have audit committees that are dominated by outside directors and required that at least one outside director have a financial background. 10. What is insider trading, and how can it harm investors? Insider trading occurs when a person makes a trade based on privileged information. Managers have access to information that outside investors do not have. By using this information, managers can exploit profitable trading opportunities that are not available to outside investors. If they were allowed to trade on their information, their profits would come at the expense of outside investors and, as a result, outside investors would be less willing to invest in corporations. 11. How does shareholder protection vary across countries? The degree of investor protection was largely determined by the legal origin of the country specifically, whether its legal system was based on British common law (more protection) or French, German, or Scandinavian civil law (less protection). 12. How can a minority owner in a business gain a controlling interest? A minority shareholder can control a corporation without owning 50% of the equity by creating a pyramid structure. In a pyramid structure, an investor first creates a company in which they own more than 50% of the shares and therefore has a controlling interest. This company then owns a controlling interest - that is, at least 50% of the shares - in another company. Notice that the investor controls both companies, but owns only 25% of the second company. Indeed, if the second company purchased 50% of the shares of a third company, then the investor would control all three companies, even though it would own only 12.5% of the third company. The farther you move down the pyramid the less ownership the investor has, but it still remains in complete control of all the companies.