SOLUTION FOR MANAGERIAL FINANCE

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PART A:

Question 1:

a) Within the financial markets, there are three principal sets of players that interact.

Discuss.

Answer: Within the financial markets there are three principal sets of players that interact:

1. Borrowers: Those who need money to finance their purchases. This includes businesses

that need money to finance their investments or to expand their inventories as well as

individuals who borrow money to purchase a new automobile or a new home.

2. Savers (Investors): Those who have money to invest. These are principally individuals

who save money for a variety of reasons, such as accumulating a down payment for a home

or saving for a return to graduate school. Firms also save when they have excess cash.

3. Financial Institutions (Intermediaries): The financial institutions and markets that help

bring borrowers and savers together. The financial institution you are probably most familiar

with is the commercial bank, a financial institution that accepts deposits and makes loans,

such as Bank of America or Citibank, where you might have a checking account. However,

as we discuss in the next section, there are many other types of financial institutions that bring

together borrowers and savers.

The three basic principles of financial marketing are savers, borrowers, and intermediaries.

The one thing that is wellknown, without borrowers, savers and financial institutions what we

refer to as banks the financial market could not work. Savers or investors are people that

always put a little moneyaside for rainy days. Borrowers are like most people or companies

that need money for buying anew home or business or making improvements to one or the

other. Intermediaries better known as a commercial bank for example Wells Fargo, Bank Of

America, and Fifth/third Bank just toname a few. These financial institutes try to match the

right investor with the right borrower. Theway that these institutes do this is by using the

money that you have deposited in to an account. All in all “The financial markets facilitate

the movement of money from savers, who tend to beindividuals, to borrowers, who tend to

be businesses. In return for the use of the savers’ money, borrowers provide the savers with a

return on their investment” (Titman, Martin, & Keown,2011).

b) The role of securities markets is to bring investors together with businesses looking

for financing. Explain the four-step process of raising money in the securities market.

Answer: We can think of the process of raising money in the securities markets in terms of

the four step process:

Step 1. The firm sells securities to investors. Corporations raise money in the securities

markets by selling either debt or equity. When the firm initially sells the securities to the

public it is considered to take place in the primary markets. This is the only time the firm

receives money in return for its securities.

Step 2. The firm invests the funds it raises in its business. The corporation invests the cash

raised in the security market in hopes that it will generate cash flows - for example, it may

invest in a new restaurant, a new hotel, a factory expansion, or a new product line.

Step 3. The firm distributes the cash earned from its investments. The cash flow from the

firm’s investments is reinvested in the corporation, paid to the government in taxes, or

distributed to the investors who own the securities issued in Step 1. In the latter case, the cash

is distributed to the investors that loaned the firm money (that is, bought the firm’s debt

securities) through the payment of interest and principal. Cash is paid to the investors that

bought equity (stock) through the payment of cash dividends or the repurchase of the shares

of the firm’s previously issued stock.

Step 4. Securities trading in the secondary market. Immediately after the securities are sold

to the public, the investors who purchased them are free to resell them to other investors.

These subsequent transactions take place in the secondary market.

Question 2:

a) Answer: This problem can be solved by calculating the PV of each coupon interest

payment, plus the PV of the face value. However, an easier approach is to first calculate the PV

of the bond under the assumption that all the coupon interest is paid; then deduct the PV of the

payments that are skipped and add the PV of the payments made at maturity. The bond's value,

ignoring skipped and repaid coupons, is $817.43.

The PV of skipped coupons is:

PV = $70/(1.09)8 + $70/(1.09)9 + $70/(1.09)10 = $96.93.

At maturity, an extra (3 × $70) = $210 will be paid. The PV of this $210 is $37.47. Thus the

value of the bond is ($817.43 - $96.93 + $37.47) = $757.97.

b) Answer:

Bond Value = Coupon payment [l-l/(l+i)n] / i + Par value / (l+i)n

980=100*(1-(1/(1+i)^7))/i+1000/(1+i)^7

YTM = i = 10.42%

PART B:

Question 1:

a) Common stock does not offer its owners a promised interest payments, maturity

payment or dividend. Explain the three-step procedure to value common stock.

Answer: Three Step Procedure for Valuing Common Stock:

1. Estimate the amount and timing of future cash flows the common stock is expected to

provide.

2. Evaluate the riskiness of the future dividends, and determine the rate of return an investor

might expect to receive from a comparable risky investment, which becomes the investor’s

required rate of return.

3. Calculate the present value of the expected dividends by discounting them back to the

present at the investor’s required rate of return.

Let's take a look at these three steps. Each of these three steps relies on one of our basic

principles: Step 1 relies on Principle 3: Cash Flows Are the Source of Value, Step 2 relies on

Principle 2: There Is a Risk-Return Tradeoff, and Step 3 relies on Principle 1: Money Has a

Time Value. In Step 1, we estimate the amount and timing of future cash flows. If you bought

a share of common stock and never sold it, the only cash flow you would ever receive would

be the dividends that the firm paid. Step 2 involves an estimate of the required rate of return,

whereas Step 3 involves calculating the present value of the future cash flows, discounted at

the required rate of return. What this all means is that the value of a common stock is equal

to the present value of all future dividends.

b) The growth rate in dividends and the investor’s required rate of return to go up and

down caused by determinants. Discuss the real determinants of the P/E ratio.

Answer: The simplest model for valuing a stock is to assume that the value of the stock is

the present value of the expected future dividends. Since equity in publicly traded firms could

potentially last forever, this present value can be computed fairly simply if you assume that

the dividends paid by a firm will grow at a constant rate forever. In this model, which is called

the Gordon Growth Model, the value of equity can be written as:

The cost of equity is the rate of return that investors in the stock require, given its risk. As a

simple example, consider investing in stock in Consolidated Edison, the utility that serves

much of New York city. The stock is expected to pay a dividend of $2.20 per share next year

(out of expected earnings per share of $3.30), the cost of equity for the firm is 8%, and the

expected growth rate in perpetuity is 3%. The value per share can be written as:

Generations of students in valuation classes have looked at this model and some of them have

thrown up their hands in despair. How, they wonder, can you value firms like Microsoft that

do not pay dividends? And what you do when the expected growth rate is higher than the cost

of equity, rendering the value negative? There are simple answers to both questions. The first

is that a growth rate that can be maintained forever cannot be greater than the growth rate of

the economy. Thus, an expected growth rate that is 15% would be incompatible with this

model; in fact, the expected growth rate has to be less than the 4%–5% that even the most

optimistic forecasters believe that the economy (U.S. or global) can grow at in the long

term.[2] The second is that firms that are growing at these stable growth rates should have

cash available to return to their stockholders; most firms that pay no dividends do so because

they have to reinvest in their businesses to generate high growth.

To get from this model for value to one for the price-earnings ratio, you will divide both sides

of the equation by the expected earnings per share next year. When you do, you obtain the

discounted cash flow equation specifying the forward PE ratio for a stable growth firm.

To illustrate with Con Ed, using the numbers from the previous paragraph, you get the

following:

Forward PE for Con Ed = ($2.20 / $3.30) / (.08 − .04) = 16.67

The PE ratio will increase as the expected growth rate increases; higher growth firms should

have higher PE ratios, which makes intuitive sense. ThePE ratio will be lower if the firm is a

high-risk firm and has a high cost of equity. Finally, the PE ratio will increase as the payout

ratio increases, for any given growth rate. In other words, firms that are more efficient about

generating growth (by earning a higher return on equity) will trade at higher multiples of

earnings.

The price-earnings ratio for a high growth firm can also be related to fundamentals. When

you work through the algebra, which is more tedious than difficult, the variables that

determine the price-earnings ratio remain the same: the risk of the company, the expected

growth rate and the payout ratio, with the only difference being that these variables have to

be estimated separately for each growth phase.[3] In the special case in which you expect a

stock to grow at a high rate for the next few years and grow at a stable rate after that, you

would estimate the payout ratio, cost of equity and expected growth rate in the high growth

period and the stable growth period. This approach is general enough to be applied to any

firm, even one that is not paying dividends right now

Looking at the determinants of price-earnings ratios, you can clearly see that a low price-

earnings ratio, by itself, signifies little. If you expect low growth in earnings (or even negative

growth) and there is high risk in a firm's earnings, you should pay a low multiple of earnings

for the firm. For a firm to be undervalued, you need to get a mismatch: a low price-earnings

ratio without the stigma of high risk or poor growth. Later in this chapter, you will examine

a portfolio of low PE stocks to see if you can separate the firms that have low PE ratios and

are fairly valued or even overvalued from firms that have low PE ratios that may be attractive

investments.

Question 4:

a) Answer:

Factor

Market Weights Book Weights Costs Market Book

Debt 42,830 0.359 40,000 0.488 8.5% 3.05 4.15

Preferred Stock 10,650 0.090 10,000 0.122 10.6% 0.95 1.29

Common Equity 65,740 0.551 32,000 0.390 25.3% 13.94 9.87

119,220 1.000 82,000 1.000 17.94 15.31

Use WACCs 17.9% 15.3%

b) Answer:

Cost from retained earnings: ks = D0 (1 + g) / P0 + g = 6.50 (1 + 9%) / 60 + 9% = 20.81%

Cost of equity from new stock: ke = D0 (1 + g) / [(1 – F) P0] + g = 6.50 (1 + 9%) / [(1-

12%)60] + 9% = 22.42%

Question 5:

a) Answer:

First thought: gaming industry should be a much more predictable and ongoing activity,

thereby making debt financing less risky.

So, one would expect to see heavier weighting in debt for the gaming industry. Many times

we think of Venture capital (mostly equity)when thinking of IT Companies, especially start-

ups or new ventures.

So, if we're trying to minimize weighted average cost of capital, we may just be comparing

apples and oranges here (underlying assets).

In a nutshell, (if that's possible) in the ideal world for an economist the total market value of

everything (all the securities issued) by a firm would have to be governed by the (1) earning

power and (2) risk of its underlying real assets and (or hence) would be independent of capital

structure (the mix of debt and equity).

Some financial managers might think that they can increase total value by increasing the

proportion of debt, but under real-world conditions (all other variables remaining

unchanged)the added risk to the shareholders will raise the required yields on equity just

enough to offset the seeming gains from using lower cost debt.

Bottom line, debt will be more accessible to the gaming industry. And those willing to take

more risk will be more willing to finance (typically through equity) the potential breakout

gains from a new IT companies.

Optimal capital structure will always be elusive when we get past the mathematics of Finance

101, and when trying to incorporate (or accommodate) current economic conditions and risk

tolerance it gets even more nebulous.

Further, when we add comparing two fundamentally different industries, the question itself

becomes suspect.

b) Answer:

A firm is considering two alternative capital structures, and has calculated its profitability at

various EBIT levels under each structure. What should the firm do if its projected EBIT is:

- Below the indifference point? In this case, choose the capital structure with the lower

degree of financial leverage. If EBIT is below (to the left of) the financing indifference point,

higher financial leverage would decrease EPS (lower return) as it increases the volatility of

the EPS stream (higher risk). However, lower financial leverage would increase EPS (higher

return) and decrease the volatility of the EPS stream (lower risk), the combination preferred

by risk-averse investors.

- Above the indifference point? In this case, the choice of capital structure is not obvious,

since there is a tradeoff between the effects of financial leverage on risk and return. If EBIT

is above (to the right of) the indifference point, higher financial leverage would increase EPS

(higher return) but also increase the volatility of the EPS stream (higher risk). Lower financial

leverage would decrease EPS (lower return) and decrease the volatility of the EPS stream

(lower risk). Further analysis is required to identify which capital structure provides investors

with the best risk-return combination.