Corporate Finance Midterm

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Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?

The reason is that, ultimately, sales are the driving force behind a business. A firm's assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm's future need for things like capital assets, employees, inventory, and financing are determined by its future sales level.

Would long-range financial planing be more important for a capital intensive company, such as a heavy equipment manufacturer, or an import-export business? Why?

Two assumptions of the sustainable growth formula are that the company does not want to sell new equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt-equity ratio it can grow at a higher rate than the sustainable growth rate. Of course the company could also grow faster than its profit margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover increases.

Testaburger Ltd. uses no external financing and maintains a positive retention ratio. When sales grow by 15 percent, the firm has a negative projected EFN. What does this tell you about the firm's internal growth rate? How about the sustainable growth rate? At this same level of sales growth, what will happen to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What happens to the projected EFN if the firm pays out all of its earnings in the form of dividends?

The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates that there is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable growth rate is certainly greater than 15%, because there is additional debt financing used in that case (assuming the firm is not 100% equity-financed). As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets.

Broslofski Co. maintains a positive retention ratio and keeps its debt-equity ratio constant every year. When sales grow by 20 %, the firm has a negative projected EFN. What does this tell you about the firm's sustainable growth rate? Do you know, with certainty, if the internal growth rate is grater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What if the retention ration is decreased? What if the retention ratio is zero?

The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN indicates that there is excess financing still available. If the firm is 100% equity financed, then the sustainable and internal growth rates are equal and the internal growth rate would be greater than 20%. However, when the firm has some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether the internal growth rate would be greater than or less than 20%. If the retention ratio is increased, the firm will have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets.

Do you think a company would experience negative growth if its product was less popular? Why or why not?

Presumably not, but, of course, if the product had been much less popular, then a similar fate would have awaited due to lack of sales.

The Grandmother Calendar Company has a cash flow problem. In the context of cash flow analysis, what was the impact of customers not paying until orders were shipped?

Since customers did not pay until shipment, receivables rose. The firm's NWC, but not its cash, increased. At the same time, costs were rising faster than cash revenues, so operating cash flow declined. The firm's capital spending was also rising. Thus, all three components of cash flow from assets were negatively impacted.

A firm priced its product about 20% less than competitors, even though their product was more detailed. The company later went out of business. Was this pricing a wise choice?

Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the extra demand from the lower price

If a firm is very successful at selling, why wouldn't a bank or some other lender step in and provide it with the cash needed to continue?

Financing possibly could have been arranged if the company had taken quick enough action. Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the need for planning.

What is the biggest culprit in a firm failure: too many orders, too little cash, or too little production capacity?

All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure

What are some of the actions a small company like The Grandmother Calendar Company can take if it finds itself in a situation in which growth in sales outstrips production capacity and available financial resources? What other options (beside expansion of capacity) are available to a company when orders exceed capacity?

Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may be especially beneficial.

Given that Nortel was up by more than 300% in the 12 months ending in July 2000, why didn't all investors hold Nortel?

They all wish they had! Since they didn't, it must have been the case that the stellar performance was not foreseeable, at least not by most.

Given that Hayes was down by 98% for 1998, why did some investors hold the stock? Why didn't they sell out before the price declined so shortly?

As in the previous question, it's easy to see after the fact that the investment was terrible, but it probably wasn't so easy ahead of time.

We have seen that, over long periods of time, stock investments have tended to substantially outperform bond investments. However it is not at all uncommon to observe investors with long horizons holding entirely bonds. Are such investors irrational?

No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn't attract them relative to the extra risk.

Explain why a characteristic of an efficient market is that investments in that market have zero NPVs.

On average, the only return that is earned is the required return—investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus the causing the return to rise to the required return (zero NPV).

A stock market analyst is able to identify misplaced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?

The market is not weak form efficient.

If a market is semi strong form efficient, is it also weak form efficient? Explain.

Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.

What are the implications of the efficient markets hypothesis for investors who buy and sell stock in an attempt to "beat the market"?

Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

Critically evaluate the following statement: Playing the stock market is like gambling. Such speculative investing has no social value, other than the pleasure people get from this form of gambling.

Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency.

There are several celebrated investors and stock pickers frequently mentioned in the financial press who have recorded huge returns on their investments over the past two decades. Is the success of these particular investors an invalidation of the EMH? Explain.

The EMH only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention from the financial press.

The stock price has risen steadily on each day for the past 30 days. Do profit opportunities exist from trading stock of the firm under the conditions (1) the market is not weak form efficient (2) the market is weak form but not semistrong efficient (3) the market is semistrong firm but not strong form efficient (4) the market is strong firm efficient.

If the market is not weak form efficient, then this information could be acted on and a profit earned from following the price trend. Under 2, 3, and 4, this information is fully impounded in the current price and no abnormal profit opportunity exists.

The financial statements for a company were released 3 days ago, and you believe you uncovered some anomalies in the company's inventory and cost control reporting techniques that are causing the firm's true liquidity strength to be understated. Do profit opportunities exist from trading stock of the firm under the conditions (1) the market is not weak form efficient (2) the market is weak form but not semistrong efficient (3) the market is semistrong firm but not strong form efficient (4) the market is strong firm efficient.

Under 2, if the market is not semi-strong form efficient, then this information could be used to buy the stock "cheap" before the rest of the market discovers the financial statement anomaly. Since 2 is stronger than 1, both imply that a profit opportunity exists; under 3 and 4, this information is fully impounded in the current price and no profit opportunity exists.

You observe that the senior management of a company has been buying a lot of the company's stock on the open market over the past week. Do profit opportunities exist from trading stock of the firm under the conditions (1) the market is not weak form efficient (2) the market is weak form but not semistrong efficient (3) the market is semistrong firm but not strong form efficient (4) the market is strong firm efficient.

Under 3, if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since 1 and 2 are weaker than 3, all three imply that a profit opportunity exists. Under 4, this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully reflected in the current share price.

In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns.

Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2% in the coming year, as compared to 5% for the year just completed. Will security prices increase, decrease, or stay the same following this announcement? Doe it make any difference whether or not the 2% figure was anticipated by the market? Explain?

If the market expected the growth rate in the coming year to be 2 percent, then there would be no change in security prices if this expectation had been fully anticipated and priced. However, if the market had been expecting a growth rate different than 2 percent and the expectation was incorporated into security prices, then the government's announcement would most likely cause security prices in general to change; prices would drop if the anticipated growth rate had been more than 2 percent, and prices would rise if the anticipated growth rate had been less than 2 percent.

Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case?
a. Short-term interest rates increase unexpectedly.
b. The interest rate a company pays on its short-term debt borrowing is increased by its bank.
c. Oil prices unexpectedly decline.
d. An oil tanker ruptures, creating a large oil spill.
e. A manufacture loses a multimillion-dollar product liability suit.
f. A Supreme Court of Canada decision substantially broadens producer liability for injuries suffered by product users.

a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic

Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.'s stock to change price.
a. The gov't announces that inflation unexpectedly jumped by 2% last month.
b. Big Widget's quarterly earnings report, just issued, generally fell in line with analysts' expectations
c. The government reports that economic growth last year was at 3%, which generally agreed with most economists' forecasts.
d. The directors of Big Widget die in a plane crash.
e. The Gov't of Canada approves changes to the tax code that will increase the top marginal corporate tax rate. The legislation has been debated for the previous six months.

a. a change in systematic risk has occurred; market prices in general will most likely decline.
b. no change in unsystematic risk; company price will most likely stay constant.
c. no change in systematic risk; market prices in general will most likely stay constant.
d. a change in unsystematic risk has occurred; company price will most likely decline.
e. no change in systematic risk; market prices in general will most likely stay constant.

If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer.

No to both questions. The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return.

True or false: The most important characteristic in determine the expected return of a well-diversified portfolio is the variances of the individual assets in the portfolio. Explain.

False. The variance of the individual assets is a measure of the total risk. The variance on a well-diversified portfolio is a function of systematic risk only.

If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?

Yes, the standard deviation can be less than that of every asset in the portfolio. However, βp cannot be less than the smallest beta because βp is a weighted average of the individual asset betas.

Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?

Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument.

In recent years, it has been common for companies to experience significant stock price changes in reaction to announcements of massive layoffs. Critics charge that such events encourage companies to fire long-term employees and that Bay Street is cheering them on. Do you agree or disagree?

Such layoffs generally occur in the context of corporate restructurings. To the extent that the market views a restructuring as value-creating, stock prices will rise. So, it's not layoffs per se that are being cheered on. Nonetheless, Bay Street does encourage corporations to takes actions to create value, even if such actions involve layoffs.

As indicated by a number of examples in this chapter, earnings announcements by companies are closely followed by, and frequently result in, share price revisions. Two issues should come to mind. First, earings announcements concern past periods. if the market values stocks based on expectations of the future, why are numbers summarizing past performance relevant? Second, these announcements concern accounting earnings. Going back to Ch 2, such earnings may have little to do with cash flow, so, again, why are they relevant?

Earnings contain information about recent sales and costs. This information is useful for projecting future growth rates and cash flows. Thus, unexpectedly low earnings often lead market participants to reduce estimates of future growth rates and cash flows; price drops are the result. The reverse is often true for unexpectedly high earnings.

On the most basic level, if a firm's WACC is 12%, what does this mean?

It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.

In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?

Book values for debt are likely to be much closer to market values than are equity book values.

If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?

No. The cost of capital depends on the risk of the project, not the source of the money.

Why do we use an after-tax figure for cost of debt but not for cost of equity?

Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.

What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages? What specific piece of information do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?

The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1) the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (3) the estimated cost of equity from this method is very sensitive to changes in g, which is a very uncertain parameter; and (4) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the stock into its market price. While the share price and most recent dividend can be observed in the market, the dividend growth rate must be estimated. Two common methods of estimating g are to use analysts' earnings and payout forecasts or to determine some appropriate average historical g from the firm's available data.

What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What are the specific pieces of information needed to use this method? Are all of these variables observable, or do they need to be estimated? What are some of the ways you could get these estimates?

Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the dividend discount model model, since the SML doesn't make any assumptions about the firm's dividends. The primary disadvantages of the SML method are (1) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (2) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market's return data, or by using beta estimates provided by analysts and investment firms.

How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?

The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately-placed, the firm could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the firm's private debt is rated), or (3) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication is when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous.

Suppose Tom O'Bedlam, president of Bedlam Products Inc. has hired you to determine the firm's cost of debt and cost of equity capital.
a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, "It will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10% ($5/50)." What's wrong with his conclusion?
b. Based on the most recent financial statements, Bedlam Products' total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, "We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million = 12.5%." What's wrong with this conclusion?
c. Based on his own analysis, Tom is recommending that the company increase its use of equity financing, because "debt costs 12.5%, but equity only costs 10%; thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less that the cost of debt?

a. This only considers the dividend yield component of the required return on equity.
b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes.
c. Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm's assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.

Both Enbridge Inc., a large natural gas user, and Canadian Natural Resources Ltd., a major natural gas producer, are thinking of investing in natural gas wells near Edmonton. Both are all-equity-financed companies. Enbridge Inc. and Canadian Natural Resources Ltd. are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their project would have a net present value of $1 million at an 18% discount rate and a -$1.1 million NPV at a 22% discount rate. Enbridge Inc. has a beta of 1.25, whereas Canadian Natural Resources Ltd. has a beta of .75. The expected risk premium on the market is 8%, and risk-free bonds are yielding 12%. Should either company proceed? Should both? Explain.

) RSup = .12 + .75(.08) = .1800 or 18.00%
Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takes it.

Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital of different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each divisions cost of capital?

If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.

Explain what is meant by business and financial risk. Suppose firm A has greater risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.

Business risk is the equity risk arising from the nature of the firm's operating activity, and is directly related to the systematic risk of the firm's assets. Financial risk is the equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage.

How would you answer in the following debate?
Q. Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing?
A. Yes, that's the essence of M&M Proposition II.
Q. And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increase, thereby increasing the risk of the firm's debt?
A. Yes.
Q. In other words, increased borrowing increase the risk of the equity and the debt?
A. That's right.
Q. Well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it now follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?
A. ??

) No, it doesn't follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.

Is there an easily identifiable debt-equity ratio that will maximize that the value of a firm? Why or why not?

Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it's practically impossible to determine the precise debt/equity ratio that maximizes the value of the firm. However, if the firm's cost of new debt suddenly becomes much more expensive, it's probably true that the firm is too highly leveraged.

What do you notice about the types of industries with respect to their average debt-equity ratio? Are certain types of industries more likely to be highly leveraged than others? What are some possible reasons for this observed segmentation? Do the operating results and tax history of the firms play a role? How about the future earnings prospects? Explain.

The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter.

Why is the use of debt financing referred to as financial "leverage"?

It's called leverage (or "gearing" in the UK) because it magnifies gains or losses.

What is homemade leverage?

Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level.

As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation -related losses. Is this a proper use of the bankruptcy process?

One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders' best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents "a race to the courthouse steps," it would seem to be a reasonable use of the process.

Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases, the firms is using bankruptcy laws "as a sword rather than shield." Is this an ethical tactic?

As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it.

In the context of the extended pie model, what is the basic goal of financial management with regard to capital structure?

The basic goal is to minimize the value of non-marketed claims.

What basic options does a firm have if it cannot (or chooses not to) make a contractually required payment such an interest? Describe them.

The two most basic options are liquidation or reorganization, though creative alternatives may exist.

Absolue Priority Rule. In the event of corporate liquidation proceedings, rank the following claimants of the firm from highest to lowest in order of their priority for being paid:
a. Preferred shareholders
b. CRA
c. Unsecured debt holders
d. The company pension plan
e. Common shareholders
f. Employee wages
g. The law firm representing the company in the bankruptcy proceedings.

g, f, d, b, c, a, e.

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