# Financial Markets and Corporate Strategy

Assignment 4b: Financial Markets and Corporate Strategy (assignment template) – 1 of 2 Insights/Instructions: Use this template to complete the assignment. Please do not delete these insights/instructions or inquiries provided herein; rather, save the template, type your response below then, after saving your work, upload the document to the assignment’s drop-box provided in Moodle. 1. Time Value of Money. Access the online Corporate Finance resource and read the section on Time Value of Money (pages 33 thru 69). (File is located in your Moodle Shell) 1. The “Time Value of Money” chapter offered several concepts and practical examples. Which concept and example did you find most interesting? Explain/elaborate. Response: 2. Manhattan Island (an example offered within the chapter): a. Explain how $24 invested in a savings account offering a compound interest rate, r, of 8% in 1626, would have been worth $75.979 trillion in the year 2000 (374 years). Response: b. Explain how $24 invested in a savings account offering a compound interest rate, r, of 3.5% in 1626, would have been worth $9,287,569 (or approximately 9.3 million) in the year 2000. Response: c. What accounts for the significant difference in the value of the account in the year 2000? Response: 3. * Present Values. Compute the present value of a $100 cash flow for the following combinations of discount rates and times. Include the formula used to make the calculations. Note: See page 50 and 51 of the online resource; the general formula is: Present Value = Future Value after t periods / (1 + r)t Show your work: a. r = 12%; t = 10 years b. r = 12%; t = 20 years c. r = 7 percent; t = 10 years d. r = 7 percent; t = 20 years 4. * Present Values. Would you rather receive $1,000 a year for 10 years or $800 a year for 15 years if: Show your work: a. The interest rate is 7 percent? Response and rationale: b. The interest rate is 22 percent? Response and rationale: c. Provide a rational as to why do your answers to “(a)” and “(b”) differ? Response: 5. * Future Values. Compute the future value of a $100 cash flow for the following combinations of discount rates and times. Include the formula used to make the calculations. The general formula is: Future Value = Present Value * (1 + r)t Show your work: a. r = 12%; t = 10 years b. r = 12%; t = 20 years c. r = 7 percent; t = 10 years d. r = 7 percent; t = 20 years 6. * Calculating Interest Rate. Showing/explaining all of your work, find the interest rate implied by the following combinations of present and future values: Scenario A B C Years 10 3 6 Present Value $400 $187 $260 Future Value $684 $249 $300 Show your work: A. For scenario A, the interest rate is: Re: show/explain your work B. For scenario B, the interest rate is: Re: show/explain your work C. For scenario C, the interest rate is: Re: show/explain your work Selected material from Fundamentals of Corporate Finance Third Edition Richard A. Brealey Bank of England and London Business School Stewart C. Myers Sloan School of Management Massachusetts Institute of Technology Alan J. Marcus Wallace E. Carroll School of Management Boston College with additional material from Fundamentals of Corporate Finance, Alternate Fifth Edition Essentials of Corporate Finance, Second Edition Stephen A. Ross, Massachusetts Institute of Technology Randolph W. Westerfield, University of Southern California Bradford D. Jordan, University of Kentucky UNIVERSITY OF PHOENIX Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Lisbon London Madrid Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto Selected material from FUNDAMENTALS OF CORPORATE FINANCE, Third Edition with additional material from FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition ESSENTIALS OF CORPORATE FINANCE, Second Edition Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base retrieval system, without prior written permission of the publisher. This book contains select material from: Fundamentals of Corporate Finance, Third Edition by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus. Copyright © 2001, 1999, 1995, by The McGraw-Hill Companies, Inc. Fundamentals of Corporate Finance, Alternate Fifth Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 2000, 1998, 1995, 1993, 1991 by The McGraw-Hill Companies, Inc. Essentials of Corporate Finance, Second Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 1999 by The McGraw-Hill Companies, Inc. Previous edition © 1996 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All reprinted with permission of the publisher. ISBN 0-07-553109-7 Sponsoring Editor: Christian Perlee Production Editor: Nina Meyer Contents 1 SECTION 1 How to Value Perpetuities 50 How to Value Annuities 51 Annuities Due 54 Future Value of an Annuity 57 The Firm and the Financial Manager 3 Organizing a Business 4 Sole Proprietorships 4 Partnerships 5 Corporations 5 Hybrid Forms of Business Organization 6 The Role of the Financial Manager 7 The Capital Budgeting Decision The Financing Decision 9 Inflation and the Time Value of Money 8 Effective Annual Interest Rates Financial Institutions and Markets Summary 10 Careers in Finance 13 15 Goals of the Corporation Financial Planning 17 Shareholders Want Managers to Maximize Market Value 17 Ethics and Management Objectives 19 Do Managers Really Maximize Firm Value? Snippets of History 25 Summary 21 Financial Planning Models Planners Beware 87 93 Pitfalls in Model Design 93 The Assumption in Percentage of Sales Models The Role of Financial Planning Models 95 33 34 External Financing and Growth 38 Multiple Cash Flows 86 Components of a Financial Planning Model An Example of a Planning Model 88 An Improved Model 89 Future Values and Compound Interest Finding the Interest Rate 82 Financial Planning Focuses on the Big Picture 83 Financial Planning Is Not Just Forecasting 84 Three Requirements for Effective Planning 84 Related Web Links 28 Key Terms 28 Quiz 28 Practice Problems 29 Solutions to Self-Test Questions 31 Present Values 77 81 What Is Financial Planning? 25 The Time Value of Money 67 69 Related Web Links 69 Key Terms 70 Quiz 70 Practice Problems 72 Challenge Problems 75 Solutions to Self-Test Questions Minicase 79 Financial Institutions 10 Financial Markets 11 Other Functions of Financial Markets and Institutions 12 Who Is the Financial Manager? 61 Real versus Nominal Cash Flows 61 Inflation and Interest Rates 63 Valuing Real Cash Payments 65 Real or Nominal? 67 Summary 44 46 Future Value of Multiple Cash Flows 46 Present Value of Multiple Cash Flows 49 Level Cash Flows: Perpetuities and Annuities 50 94 96 100 Related Web Links 101 Key Terms 101 Quiz 101 Practice Problems 102 Challenge Problems 106 Solutions to Self-Test Questions 106 iii IV CONTENTS 109 APPENDIX A Accounting and Finance The Balance Sheet Financial Ratios The Income Statement 117 Profits versus Cash Flow 118 115 The Statement of Cash Flows Accounting for Differences 119 121 134 The Du Pont System 145 Other Financial Ratios 146 Using Financial Ratios 147 Choosing a Benchmark 147 123 Corporate Tax 123 Personal Tax 125 Summary 133 Leverage Ratios 138 Liquidity Ratios 139 Efficiency Ratios 141 Profitability Ratios 143 112 Book Values and Market Values Taxes Financial Statement Analysis 111 Measuring Company Performance The Role of Financial Ratios 126 Related Web Links 127 Key Terms 127 Quiz 127 Practice Problems 128 Challenge Problem 131 Solutions to Self-Test Questions Summary Bank Loans 185 Commercial Paper 186 Secured Loans 186 Working Capital Management and Short-Term Planning 165 167 The Components of Working Capital 167 Working Capital and the Cash Conversion Cycle The Working Capital Trade-Off 171 The Cost of Bank Loans 168 Links between Long-Term and Short-Term Financing 172 Tracing Changes in Cash and Working Capital 175 Cash Budgeting 159 163 SECTION 2 Working Capital 151 153 Related Web Links 155 Key Terms 155 Quiz 155 Practice Problems 157 Challenge Problem 158 Solutions to Self-Test Questions Minicase 160 131 150 177 Forecast Sources of Cash 177 Forecast Uses of Cash 179 The Cash Balance 179 A Short-Term Financing Plan 180 Options for Short-Term Financing Evaluating the Plan 184 180 Sources of Short-Term Financing 187 Simple Interest 187 Discount Interest 188 Interest with Compensating Balances Summary 189 190 Related Web Links 191 Key Terms 191 Quiz 191 Practice Problems 192 Challenge Problem 194 Solutions to Self-Test Questions Minicase 197 195 Cash and Inventory Management Cash Collection, Disbursement, and Float 185 Float 203 Valuing Float 204 201 202 CONTENTS Managing Float 205 Credit Analysis Speeding Up Collections 206 Controlling Disbursements 209 Electronic Funds Transfer 210 Inventories and Cash Balances 211 Managing Inventories 212 Managing Inventories of Cash 215 Uncertain Cash Flows 216 Cash Management in the Largest Corporations Investing Idle Cash: The Money Market 218 Summary The Credit Decision 217 Bankruptcy 224 231 SECTION 3 Valuing Bonds 240 227 244 Related Web Links 245 Key Terms 245 Quiz 245 Practice Problems 246 Challenge Problems 248 Solutions to Self-Test Questions 249 Minicase 250 Book Values, Liquidation Values, and Market Values 283 256 Reading the Financial Pages Valuing Common Stocks 257 Bond Prices and Yields 259 How Bond Prices Vary with Interest Rates 260 Yield to Maturity versus Current Yield 261 Rate of Return 265 Interest Rate Risk 267 The Yield Curve 268 Nominal and Real Rates of Interest 268 Default Risk 270 Valuations in Corporate Bonds 273 Summary 273 Related Web Links 274 Key Terms 274 Quiz 274 Practice Problems 275 Challenge Problems 277 Solutions to Self-Test Questions Valuing Stocks 239 253 255 Bond Characteristics Collection Policy Summary 229 Credit Agreements 236 Bankruptcy Procedures 241 The Choice between Liquidation and Reorganization 242 Credit Management and Collection Terms of Sale 234 Credit Decisions with Repeat Orders 237 Some General Principles 238 219 Related Web Links 220 Key Terms 220 Quiz 220 Practice Problems 221 Challenge Problem 224 Solutions to Self-Test Questions 232 Financial Ratio Analysis 233 Numerical Credit Scoring 233 When to Stop Looking for Clues Simplifying the Dividend Discount Model 279 Stocks and the Stock Market Reading the Stock Market Listings 280 281 291 The Dividend Discount Model with No Growth 291 The Constant-Growth Dividend Discount Model 292 Estimating Expected Rates of Return 293 Nonconstant Growth 295 Growth Stocks and Income Stocks The Price-Earnings Ratio 298 What Do Earnings Mean? 298 Valuing Entire Businesses 301 Summary 277 287 Today’s Price and Tomorrow’s Price 287 The Dividend Discount Model 288 301 Related Web Links 302 Key Terms 302 Quiz 302 Practice Problems 303 Challenge Problems 306 Solutions to Self-Test Questions 307 296 V VI CONTENTS Introduction to Risk, Return, and the Opportunity Cost of Capital 311 Rates of Return: A Review 312 Market Indexes 314 The Historical Record 314 Using Historical Evidence to Estimate Today’s Cost of Capital 317 318 Variance and Standard Deviation 318 A Note on Calculating Variance 322 Measuring the Variation in Stock Returns 322 Net Present Value and Other Investment Criteria 341 343 A Comment on Risk and Present Value Valuing Long-Lived Projects 345 Other Investment Criteria 344 349 Internal Rate of Return 349 A Closer Look at the Rate of Return Rule 350 Calculating the Rate of Return for Long-Lived Projects 351 A Word of Caution 352 Payback 352 Book Rate of Return 355 Investment Criteria When Projects Interact Mutually Exclusive Projects 356 Investment Timing 357 Long- versus Short-Lived Equipment 359 Replacing an Old Machine 361 Mutually Exclusive Projects and the IRR Rule Other Pitfalls of the IRR Rule 363 Capital Rationing 365 Soft Rationing 365 Hard Rationing 366 Pitfalls of the Profitability Index Summary 331 Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable 331 Message 2: Market Risks Are Macro Risks 332 Message 3: Risk Can Be Measured 333 Summary 334 Related Web Links 334 Key Terms 334 Quiz 335 Practice Problems 336 Solutions to Self-Test Questions 338 Challenge Problems 373 Solutions to Self-Test Questions 373 339 SECTION 4 Net Present Value 324 Diversification 324 Asset versus Portfolio Risk 325 Market Risk versus Unique Risk 330 Thinking about Risk Seventy-Three Years of Capital Market History 313 Measuring Risk Risk and Diversification 367 Related Web Links 368 Key Terms 368 Quiz 368 Practice Problems 369 3667 Using Discounted Cash-Flow Analysis to Make Investment Decisions 377 Discount Cash Flows, Not Profits 379 Discount Incremental Cash Flows 381 Include All Indirect Effects 381 Forget Sunk Costs 382 Include Opportunity Costs 382 Recognize the Investment in Working Capital Beware of Allocated Overhead Costs 384 356 383 Discount Nominal Cash Flows by the Nominal Cost of Capital 385 Separate Investment and Financing Decisions Calculating Cash Flow 387 361 Capital Investment 387 Investment in Working Capital 387 Cash Flow from Operations 388 Example: Blooper Industries 390 Calculating Blooper’s Project Cash Flows 391 Calculating the NPV of Blooper’s Project 392 Further Notes and Wrinkles Arising from Blooper’s Project 393 Summary 397 Related Web Links Key Terms 398 Quiz 398 398 386 CONTENTS Practice Problems 200 Challenge Problems 402 Solutions to Spreadsheet Model Questions Solutions to Self-Test Questions 404 Minicase 405 403 Risk, Return, and Capital Budgeting Measuring Market Risk 408 Measuring Beta 409 Betas for MCI WorldCom and Exxon Portfolio Betas 412 Risk and Return Big Oil’s Weighted-Average Cost of Capital 420 The Cost of Capital 435 Geothermal’s Cost of Capital 436 450 When You Can and Can’t Use WACC 451 Some Common Mistakes 452 How Changing Capital Structure Affects Expected Returns 452 What Happens When the Corporate Tax Rate Is Not Zero 453 424 Flotation Costs and the Cost of Capital Summary 454 Related Web Links 455 Key Terms 455 Quiz 455 Practice Problems 456 Challenge Problems 458 Solutions to Self-Test Questions Minicase 459 Calculating the Weighted-Average Cost of Capital 438 458 463 SECTION 5 Project Analysis Real Oil Company WACCs 465 How Firms Organize the Investment Process Stage 1: The Capital Budget 467 Stage 2: Project Authorizations 467 Problems and Some Solutions 468 Some “What-If ” Questions 469 Sensitivity Analysis 469 Scenario Analysis 472 Break-Even Analysis 473 Accounting Break-Even Analysis 474 450 Interpreting the Weighted-Average Cost of Capital 451 425 432 447 The Expected Return on Bonds 448 The Expected Return on Common Stock 448 The Expected Return on Preferred Stock 449 422 Company versus Project Risk 422 Determinants of Project Risk 423 Don’t Add Fudge Factors to Discount Rates Related Web Links 426 Key Terms 426 Quiz 426 Practice Problems 427 Challenge Problem 432 Solutions to Self-Test Questions 446 Calculating Required Rates of Return 414 Capital Budgeting and Project Risk Calculating Company Cost of Capital as a Weighted Average 440 Market versus Book Weights 441 Taxes and the Weighted-Average Cost of Capital 442 What If There Are Three (or More) Sources of Financing? 443 Wrapping Up Geothermal 444 Checking Our Logic 445 Measuring Capital Structure 411 Why the CAPM Works 416 The Security Market Line 417 How Well Does the CAPM Work? 419 Using the CAPM to Estimate Expected Returns Summary 407 VII 466 NPV Break-Even Analysis 475 Operating Leverage 478 Flexibility in Capital Budgeting Decision Trees 481 The Option to Expand 482 Abandonment Options 483 Flexible Production Facilities 484 Investment Timing Options 484 Summary 485 Related Web Links Key Terms 485 485 481 454 VIII CONTENTS Quiz 512 Practice Problems 513 Solutions to Self-Test Questions Quiz 485 Practice Problems 486 Challenge Problems 489 Solutions to Self-Test Questions Minicase 491 489 How Corporations Issue Securities Venture Capital An Overview of Corporate Financing 493 Common Stock Arranging a Public Issue The Underwriters Book Value versus Market Value 496 Dividends 497 Stockholders’ Rights 497 Voting Procedures 497 Classes of Stock 498 Corporate Governance in the United States and Elsewhere 498 499 Corporate Debt 500 General Cash Offers and Shelf Registration Costs of the General Cash Offer 529 Market Reaction to Stock Issues 530 507 Patterns of Corporate Financing 508 Do Firms Rely Too Heavily on Internal Funds? External Sources of Capital 510 526 General Cash Offers by Public Companies Debt Comes in Many Forms 501 Innovation in the Debt Market 504 Summary 526 The Private Placement Convertible Securities 508 Related Web Links Key Terms 512 532 Related Web Links 533 Key Terms 533 Quiz 534 Practice Problems 534 Challenge Problem 536 Solutions to Self-Test Questions Minicase 537 537 512 545 APPENDIX B Leasing 547 Lease or Buy? Leasing versus Buying A Preliminary Analysis 555 555 548 555 Operating Leases 548 Three Potential Pitfalls Financial Leases 549 NPV Analysis Tax-Oriented Leases Leveraged Leases 550 Sale and Leaseback Agreements Accounting and Leasing 552 The Cash Flows from Leasing The Incremental Cash Flows 554 550 556 Leverage and Capital Structure 559 The Capital Structure Question 560 550 Taxes, the IRS, and Leases 556 A Misconception 549 553 553 528 528 531 Appendix: Hotch Pot’s New Issue Prospectus 511 A Note on Taxes 520 521 Who Are the Underwriters? Summary 517 519 The Initial Public Offering 494 Preferred Stock 514 The Effect of Financial Leverage 560 The Impact of Financial Leverage 560 Financial Leverage, EPS, and ROE: An Example 561 EPS versus EBIT 561 539 CONTENTS 565 SECTION 6 Mergers, Acquisitions, and Corporate Control 567 22.1 The Market for Corporate Control 569 Method 1: Proxy Contests 569 Method 2: Mergers and Acquisitions 570 Method 3: Leveraged Buyouts 571 Method 4: Divestitures and Spin-offs 571 22.2 Sensible Motives for Mergers 572 Economies of Scale 573 Economies of Vertical Integration 573 Combining Complementary Resources 574 Mergers as a Use for Surplus Funds 574 22.3 Dubious Reasons for Mergers 575 Diversification 575 The Bootstrap Game 575 22.4 Evaluating Mergers 577 22.6 Leveraged Buyouts 587 588 Merger Waves 588 Do Mergers Generate Net Benefits? 22.8 Summary Glossary 589 590 APPENDIX C 635 23.2 Some Basic Relationships 598 602 Exchange Rates and Inflation 602 Inflation and Interest Rates 606 Interest Rates and Exchange Rates 608 The Forward Rate and the Expected Spot Rate Some Implications 610 23.5 Summary 585 22.7 Mergers and the Economy 23.1 Foreign Exchange Markets 625 617 Related Web Links 618 Key Terms 618 Quiz 618 Practice Problems 619 Challenge Problem 621 Solutions to Self-Test Questions Minicase 623 609 612 613 Net Present Value Analysis 613 The Cost of Capital for Foreign Investment Avoiding Fudge Factors 616 584 Barbarians at the Gate? International Financial Management 597 23.4 International Capital Budgeting 582 Who Gets the Gains? 595 23.3 Hedging Exchange Rate Risk Mergers Financed by Cash 577 Mergers Financed by Stock 579 A Warning 580 Another Warning 580 22.5 Merger Tactics Related Web Links 592 Key Terms 592 Quiz 592 Practice Problems 5…

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