Solution Manual for Corporate Finance , 4th Edition

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SOLUTIONS MANUALForJonathan BerkPeter DeMarzoStanford UniversityStanford UniversityAccuracy EditorSukarnen Suwanto

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iiiContentsChapter 1The Corporation1Chapter 2Introduction to Financial Statement Analysis4Chapter 3Financial Decision Makingand the Law of One Price20Chapter 4The Time Value of Money30Chapter 5Interest Rates56Chapter 6Valuing Bonds75Chapter 7Investment Decision Rules92Chapter 8Fundamentals of Capital Budgeting112Chapter 9Valuing Stocks130Chapter 10Capital Markets and the Pricing of Risk142Chapter 11Optimal Portfolio Choice and the Capital Asset Pricing Model157Chapter 12Estimating the Cost of Capital177Chapter 13Investor Behavior and Capital Market Efficiency186Chapter 14Capital Structure in a Perfect Market196Chapter 15Debt and Taxes206Chapter 16Financial Distress, Managerial Incentives, and Information215Chapter 17Payout Policy231Chapter 18Capital Budgeting and Valuation with Leverage242Chapter 19Valuation and Financial Modeling: A Case Study262Chapter 20Financial Options271Chapter 21Option Valuation283Chapter 22Real Options295Chapter 23Raising Equity Capital321Chapter 24Debt Financing329Chapter 25Leasing333Chapter 26Working Capital Management341Chapter 27Short-Term Financial Planning348Chapter 28Mergers and Acquisitions354Chapter 29Corporate Governance359Chapter 30Risk Management362Chapter 31International Corporate Finance374

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1Chapter 1The Corporation1-1.What is the most important difference between a corporation andallother organizationalforms?A corporation is a legal entity separate from its owners.1-2.What does the phraselimited liabilitymean in a corporate context?Owners’liability is limited to the amount they invested in the firm.Stockholders are not responsiblefor any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurredby the firm.1-3.Which organizational forms give their owners limited liability?Corporations and limited liability companiesgive owners limited liability. Limited partnershipsprovide limited liability for the limited partners, but not for the general partners.1-4.What are the main advantages and disadvantages of organizing a firm as a corporation?Advantages: Limited liability, liquidity, infinite lifeDisadvantages: Double taxation, separation of ownership and control1-5.Explain the difference between an S corporation and a C corporation.C corporations mustpay corporate income taxes; S corporations do not pay corporate taxes,but mustpass through the income to shareholders to whom it is taxable.S corporations are also limited to 75shareholders and cannot have corporate or foreign stockholders.1-6.You are a shareholder in a C corporation. The corporation earns $2 per share before taxes. Onceit has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate taxrate is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. Howmuch is left for you after all taxes are paid?First,the corporation pays the taxes. After taxes,$2(10.4)$1.20´-=is left to pay dividends. Oncethe dividend is paid, personal tax must be paid, which leaves$1.20(10.3)$0.84´-=.So,after all thetaxes are paid, you are left with 84¢.1-7.Repeat Problem 6 assuming the corporation is an S corporation.An S corporation does not pay corporate income tax.So it distributes $2 to its stockholders. Thesestockholdersmustthenpaypersonalincometaxonthedistribution.Sotheyareleftwith$2(10.3)$1.40´-=.

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2Berk/DeMarzo,Corporate Finance,FourthEdition, Global Edition1-8.You have decided to form a new start-up company developing applications for the iPhone. Giveexamples of the three distinct types of financial decisions you will need to make.As the manager of an iPhone applications developer,you will make three types of financial decisions.i.You will make investment decisions such as determining which type of iPhone applicationprojects will offer your company a positive NPV andthatyour company,therefore,shoulddevelop.ii.You will make the decision on how to fund your iPhone application investments and what mix ofdebt and equity your company will have.iii.You will be responsible for the cash management of your company, ensuring that your companyhas the necessary funds to make investments, pay interest on loans, and pay your employees.1-9.When a pharmaceutical company develops a new drug, it often receives patent protection forthat medication, allowing it to charge a higher price. Explain how this public policy of providingpatent protection might help align the corporation’s interests with society’s interests.Without patent protection, the developer of the drug would be forced to lower prices to compete withgeneric manufacturers.Because this price competition would lower expected future profits, thedeveloper would be willing to spend much less in R&D to develop the drug initially, and druginnovation would be curtailed.Alternatively, by allowing the drug’s developer to earn higher profits that are commensurate with thevalue of the drug to society, drug developers will find it in their best interests to spend more on R&D,and drug innovation is enhanced.Thus,patent protection can align the corporation’s and society’sinterests and provide for more efficient spending on drug R&D.1-10.Corporate managers work for the owners of the corporation. Consequently, they should makedecisions that are in the interests of the owners, rather than their own. What strategies areavailable to shareholders to help ensure that managers are motivated to act this way?Shareholders cando the following.i.Ensure that employees are paid with company stock and/or stock options.ii.Ensure that underperforming managers are fired.iii.Write contracts that ensure that the interests of the managers and shareholders are closely aligned.iv.Mount hostile takeovers.1-11.Suppose you are considering renting an apartment. You, the renter, can be viewed as an agentwhile the company that owns the apartment can be viewed as the principal. What principal-agent conflicts do you anticipate? Suppose instead that you work for the apartment company.What features would you put into the lease agreement that would give the renter incentives totake good care of the apartment?The agent (renter) will not take the same care of the apartment as the principal (owner), because therenter does not share in the costs ofrepairingdamage to the apartment. To mitigate this problem,having the renter pay a depositshould motivate the renter to keep damages to a minimum. The depositforces the renter to share in the costs ofrepairingany problems thattheycause.1-12.You are the CEO of a company and you are considering entering into an agreement to have yourcompany buy another company. You think the price might be too high, but you will be the CEOof the combined, much larger,company. You know that when the company gets bigger, your payand prestige will increase. What is the nature of the agency conflict here and how is it related toethical considerations?There is an ethical dilemma when the CEO of a firm hastheopposite incentives to those of theshareholders. In this case, you (as the CEO) have an incentive to potentially overpay for anothercompany (which would be damaging to your shareholders) because your pay and prestige willimprove.1-13.Are hostile takeovers necessarily bad for firms or their investors? Explain.No.They are a way to discipline managers who are not working in the interests of shareholders.

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Chapter 1/The Corporation31-14.What is the difference between a public and private corporation?The shares of a public corporation are traded on an exchange (or“over the counter”in an electronictrading system) while the shares of a private corporation are not traded on a public exchange.1-15.Describe the important changes that have occurred in stock markets over the last decade.Markets have become more fragmented, stocks no longer predominantly trade on the markets on whichthey are listed, off exchange transactions in dark pools are now much more common,andofficialmarket makers have largely disappeared, replaced now by the limit order book.1-16.Explain why the bid-ask spread is a transaction cost.Investors always buy at the ask and sell at the bid.Since ask prices always exceed bid prices, investors“lose”this difference. It is one of the costs of transacting.Since the market makers take the other sideof the trade, they make this difference.1-17.Explain how the bid-ask spread is determined today.The bid-ask spread of a stock is determined by the outstanding limit orders. The limit sell order withthe lowest price is the ask price. The limit buy order with the highest price is the bid price.1-18.The following quote on Yahoo! Stock appeared onJuly 23, 2015, on Yahoo! Finance:If you wanted to buy Yahoo!, what price would you pay? How much would you receive if youwanted to sell Yahoo!?You would buy at $39.66 and sell for $39.65.1-19.Suppose the following orders are received by an exchange for Cisco stock:•Limit Order:Buy 200 shares at $25•Limit Order:Sell 200 shares at $26•Limit Order:Sell 100 shares at $25.50•Limit Order:Buy 100 shares at $25.25a)What are the best bid and ask prices for Cisco stock?Best bid = $25.25, Best ask = $25.50b)What is the current bid-ask spread for Cisco stock?Bid-Ask spread = $25.50–25.25 = $0.25c)Suppose a market order arrives to buy 200 shares of Cisco.What average price will thebuyer pay?Buy 100 shares at $25.50 and 100 shares at $26, for an average price of $25.75d)After the market order in (c)clears, what are the new best bid and ask prices, and what isthe new bid-ask spread for Cisco?Best bid = $25.75, Best ask = $26, Bid-Ask spread = $0.25

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4Chapter 2Introduction to Financial StatementAnalysis2-1.What four financial statements can be found in a firm’s 10-K filing? What checks are there onthe accuracy of these statements?In a firm’s 10-K filing, four financialstatements can be found: the balance sheet, income statement,statement of cash flows, and statement of stockholders’ equity.Financial statements in form 10-K arerequired to be audited by a neutral third party, who checks and ensures that the financial statements areprepared according to GAAP and that the information contained is reliable.2-2.Who reads financial statements? List at least three different categories of people. For eachcategory, provide an example of the type of information they might be interested in and discusswhy.Users of financial statements include present and potential investors, financial analysts, and otherinterested outside parties (such as lenders, suppliers and other trade creditors, and customers).Financial managers within the firm also use the financial statements when making financial decisions.Investors. Investors are concerned with the risk inherent in,and return provided by,their investments.Bondholders use the firm’s financial statements to assess the ability of the company to make its debtpayments.Stockholders use the statements to assess the firm’s profitability and ability to make futuredividend payments.Financialanalysts.Financialanalystsgatherfinancialinformation,analyzeit,andmakerecommendations. They read financial statements to determine a firm’s value and project futureearnings, so that they can provide guidance to businesses and individuals to help them with theirinvestment decisions.Managers. Managers use financial statementsto look at trends in their own business, and to comparetheir own results with that of competitors.2-3.Find the most recent financial statements for Starbucks’ corporation (SBUX) using the followingsources:a.From the company’s Websitewww.starbucks.com (Hint:Search for “investor relations.”)b.From the SEC Web site www.sec.gov.(Hint:Search for company filings in the EDGARdatabase.)c.From the Yahoo! Finance Web site http://finance.yahoo.com.d.From at least one other source. (Hint:Enter “SBUX 10K” at www.google.com.)Each method will help find the same SEC filings. Yahoo! Finance also provides some analysis such ascharts and key statistics.

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Chapter 2/Introduction to Financial Statement Analysis52-4.Consider the following potential events that might havetaken place atGlobal Conglomerate onDecember 30, 2015. For each one, indicate which line items in Global’s balance sheet would beaffected and by how much. Also indicate the change to Global’s book value of equity. (In allcases, ignore any tax consequences for simplicity.)a.Global used $20 million of its available cash to repay $20 million of its long-term debt.b.A warehouse fire destroyed $5 million worth of uninsured inventory.c.Global used $5 million in cash and $5 million in new long-term debt to purchase a $10million building.d.A large customer owing $3 million for products it already received declared bankruptcy,leaving no possibility that Global would ever receive payment.e.Global’s engineers discover a new manufacturing process that will cut the cost of its flagshipproduct by over 50%.f.A key competitor announces a radical new pricing policy that will drastically undercutGlobal’s prices.a.Long-term liabilities would decrease by $20 million, and cash would decrease by the sameamount.The book value of equity would be unchanged.b.Inventory would decrease by $5 million, as would the book value of equity.c.Long-term assets would increase by $10 million, cash woulddecrease by $5 million, and long-term liabilities would increase by $5 million.There would be no change to the book value ofequity.d.Accounts receivable would decrease by $3 million, as would the book value of equity.e.This event would not affect the balance sheet.f.This event would not affect the balance sheet.2-5.What was the change in Global Conglomerate’s book value of equity from 2014to 2015according to Table 2.1? Does this imply that the market price of Global’s shares increased in2015? Explain.Global Conglomerate’s book value of equity increased by $1 million from2014to2015. An increasein book value does not necessarily indicate an increase in Global’s share price. The market value of astock does not depend on the historical cost of the firm’s assets, but on investors’ expectation of thefirm’s future performance. There are many events that may affect Global’s future profitability, andhence its share price, that do not show up on the balance sheet.2-6.Use EDGAR to find Qualcomm’s 10-K filing for 2015. From the balance sheet, answer thefollowing questions:a.How much did Qualcomm have in cash and short-term investments?b.What were Qualcomm’s total accounts receivable?c.What were Qualcomm’s total assets?d.What were Qualcomm’s total liabilities? How much of this was long-term debt?e.What was the book value of Qualcomm’s equity?a.$7,560million (cash) and $9,761million (short-term investments/marketable securities) for atotalof $17,321millionb.$1,964millionc.$50,796million

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6Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editiond.$19,382million,$9,969 million.e.$31,414million.2-7.Find onlinethe annual 10-K report forCostco Wholesale Corporation(COST)forfiscal year2015 (filed in October 2015).Answer the following questions from their balance sheet:a.How much cash didCostcohave at the end of the fiscal year?b.What wereCostco’s total assets?c.What wereCostco’s total liabilities? How much debt didCostcohave?d.What was the book value ofCostco’s equity?a.At the end of the fiscal year,Costcohad cash andcash equivalents of $4,801million.b.Costco’stotal assets were $33,440million.c.Costco’stotal liabilities were $22,597million,and ithad$6,157million indebt.d.Thebook value ofCostco’s equity was $10,843million.2-8.In early 2012, General Electric (GE) had a book value of equity of $109 billion, 10.3 billionshares outstanding, and a market price of $9.66 per share. GE also had cash of $40 billion, andtotal debt of $530 billion. Three years later, in early 2015, GE had abook value of equity of$112billion, 10.9 billion shares outstanding with a market price of $16.59 per share, cash of$85billion, and total debt of $417 billion. Over this period, what was the change in GE’sa.market capitalization?b.market-to-book ratio?c.enterprise value?a.2012Market Capitalization:10.3 billion shares$9.66/share =$99.5billion.2015 MarketCapitalization: 10.9 billion shares$16.59/share = $180.8.The change over the period is $180.8–$99.5 =$81.3billion.b.2012Market-to-Book= 99.5/109 = 0.91.2015Market-to-Book= 180.8/112 = 1.61. Thechangeover the period is: 1.61–0.91 = 0.70.e.2012Enterprise Value = $109–40+ 530 = $599billion.2015 Enterprise Value = $112–85 +417= $444billion. The change over the period is:$599–$444 =–$155billion.2-9.In early-2015, Abercrombie & Fitch (ANF) had a book equity of $1390million, a price per shareof $25.52, and 69.35million shares outstanding. At the same time, The Gap(GPS) had a bookequity of $2983million, a share price of $41.19, and421million shares outstanding.a.What is the market-to-book ratio of each of these clothing retailers?b.What conclusions can you draw by comparing the two ratios?a.ANF’smarket-to-book ratio = (25.52 x 69.35)/1,390 = 1.27.GPS’smarket-to-book ratio = (41.19 x 421)/2,983 = 5.81.b.For the market, the outlook of Abercrombie and Fitchisless favorablethanthat ofThe Gap.Forevery dollar of equity invested in ANF,the market values that dollar today at $1.27versus $5.81for a dollar invested in the GPS. Equity investors are willing to pay relativelylesstoday for sharesof ANF than for GPS because they expectGPSto produce superior performance in the future.2-10.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.What is Mydeco’s market capitalization at the end of each year?b.What is Mydeco’s market-to-book ratio at the end of each year?c.What is Mydeco’s enterprise value at the end of each year?2012–2016Financial Statement Data and Stock Price Data for Mydeco Corp.

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Chapter 2/Introduction to Financial Statement Analysis7

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8Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editiona.Year20122013201420152016Shares Outstanding (millions)56.856.856.856.856.8StockPrice$7.02$3.55$5.86$8.33$11.57Market capitalization (millions)$398.7$201.6$332.8$473.1$657.2b.Year20122013201420152016Market capitalization (millions)$398.7$201.6$332.8$473.1$657.2Stockholders' Equity(millions)$255.0$255.6$257.8$270.8$279.8Market-to-book1.560.791.291.752.35c.Year20122013201420152016Market capitalization (millions)$398.7$201.6$332.8$473.1$657.2Cash (millions)$49.4$68.0$91.7$80.4$83.6Long-term Debt (millions)$498.9$498.9$572.2$597.5$597.5Enterprise value (millions)$848.2$632.5$813.3$990.2$1,171.12-11.Suppose that in 2016, Global launches an aggressive marketing campaign that boosts sales by15%.However, their operating margin falls from 5.57% to 4.50%. Suppose that they have noother income, interest expenses are unchanged, and taxes are the same percentage of pretaxincome as in 2015.a.What is Global’s EBIT in 2016?b.What is Global’snetincome in 2016?c.If Global’s P/E ratio and number of shares outstanding remains unchanged, whatis Global’sshare price in 2016?a.Revenues in 2016= 1.15 × 186.7 = $214.705 million.EBIT = 4.50% × 214.705 = $9.66 million (there is no other income).b.Net Income = EBIT–Interest Expenses–Taxes = (9.66–7.7) × (1–26%) = $1.45 million.c.Share price = (P/E Ratio in 20015) x (EPS in 2016) = 25.2 x (1.45/3.6) = $10.15.Note: Differences from spreadsheet solutions due to rounding.2-12.Findonline the annual 10-K report for Costco Wholesale Corporation (COST) for fiscal year2015 (filed in October 2015).Answer the following questions from their income statement:a.What wereCostco'srevenues for fiscal year 2015? By what percentage did revenues growfrom the prior year?b.What wasCostco'soperating income for the fiscal year?c.What wasCostco'saverage tax rate for the year?d.What wereCostco'sdiluted earnings per share in fiscal year 2015? What number of sharesis this EPS based on?a.Revenues = $116,199million. Revenue growth= (116,199/112,640)–1 = 3.16%.b.Operating Income = $3,624million.c.Average tax rate=1,195/3,604 = 33.16%.d.The diluted earnings per share in 2015was $5.37. The number of shares used in this calculation ofdiluted EPS was442.72million.

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Chapter 2/Introduction to Financial Statement Analysis92-13.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.By what percentage did Mydeco’s revenues grow each year from 2013 to 2016?b.By what percentage did net income grow each year?c.Why might the growth rates of revenues and net income differ?a.Year20122013201420152016Revenue (millions)$401.9$361.6$429.6$513.6$602.6Revenue growth–10.0%18.8%19.6%17.3%b.Year20122013201420152016NetIncome (millions)$15.0$4.3$9.6$11.8$16.2Net income growth–71.3%123.3%22.9%37.3%c.Net Income growth rate differs from revenue growth rate because cost of goods sold and otherexpenses can move at different rates than revenues. Forexample, revenues declined in 2013 by10%, however, cost of goods sold only declined by 9%.2-14.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. SupposeMydeco repurchases 2.3 million shares each year from 2013 to 2016. What would its earningsper share be in years 2013–2016? (Assume Mydeco pays for the shares using its available cashand that Mydeco earns no interest on its cash balances.)A repurchase does not impact earnings directly, so any change to EPS will come from a reduction inshares outstanding.Year20122013201420152016Shares Outstanding (millions)56.854.552.249.947.6Net Income (millions)$15.0$4.3$9.6$11.8$16.2EPS$0.26$0.08$0.18$0.24$0.342-15.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. SupposeMydeco had purchased additional equipment for $12.3 million at the end of 2013, and thisequipment was depreciated by $4.1 million per year in 2014, 2015, and 2016. Given Mydeco’staxrate of 35%, what impact would this additional purchase have had on Mydeco’s net incomeinyears 2013–2016? (Assume the equipment is paid for out of cash and that Mydeco earns nointerest on its cash balances.)The equipment purchase does not impact net income directly, however the increased depreciationexpense and tax savings changes net income.Year20122013201420152016Net Income$15.0$4.3$9.6$11.8$16.2Additional Depreciation–$4.1–$4.1–$4.1Tax savings$1.4$1.4$1.4New Net Income (millions)$15.0$4.3$6.9$9.1$13.52-16.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. SupposeMydeco’scosts and expenses had been the same fraction of revenues in 2013–2016 as they werein 2012. What would Mydeco’s EPS have been each year in this case?If Mydeco’s costs and expenses had been the same fraction of revenues in 2013–2016 as they were in2012, then their net profit margins would have been equal.

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10Berk/DeMarzo,Corporate Finance,FourthEdition, Global Edition2012 net profit margin = 15/401.9 = 3.73%.Year20122013201420152016Revenue$401.9$361.6$429.6$513.6$602.6Net Profit Margin3.7%3.7%3.7%3.7%3.7%New Net Income$15.0$13.5$16.0$19.2$22.5Shares Outstanding56.856.856.856.856.8New EPS$0.26$0.24$0.28$0.34$0.402-17.Suppose a firm’s tax rate is 30%.a.What effect would a $10 million operating expense have on this years earnings? What effectwould it have on next year’s earnings?b.What effect would a $10 million capital expense have on this years earnings if the capitalexpenditure isdepreciated at a rate of $2 million per year for five years? What effect wouldit have on next year’s earnings?a.A $10 million operating expense would be immediately expensed, increasing operating expensesby $10 million. This would lead to a reduction in taxes of 30% × $10 million = $3 million. Thus,earnings would decline by 10–3 = $7 million. There would be no effect on next year’s earnings.b.Capital expenses do not affect earnings directly. However, the depreciation of $2 million wouldappear each year as an operating expense. With a reduction in taxes of 2 × 30% = $0.6 million,earnings would be lower by 2–0.6 = $1.4 million for each of the next 5 years.2-18.Quisco Systems has 6.17 billion shares outstanding and a share price of $18.96. Quisco isconsideringdevelopinganewnetworkingproductin-houseatacostof$509million.Alternatively,Quisco can acquire a firm that already has the technology for $893 million worth(at the currentprice) of Quisco stock. Suppose that absent the expense of the new technology,Quisco willhave EPS of $0.83.a.Suppose Quisco develops the product in-house. What impact would the development costhave on Quisco’s EPS? Assume all costs are incurred this year and are treated as an R&Dexpense, Quisco’s tax rate is 35%, and the number of shares outstanding is unchanged.b.Suppose Quisco does not develop the product in-house but instead acquires the technology.What effect would the acquisition have on Quisco’s EPS this year? (Note that acquisitionexpenses do not appear directly on the income statement. Assume the firm was acquired atthe start of the year and has no revenues or expenses of its own, so that the only effect onEPS is due to the change in the number of shares outstanding.)c.Which method of acquiring the technology has a smaller impact on earnings? Is this methodcheaper? Explain.a.If Quisco develops the product in-house, its earnings would fall by $509 × (1–35%) = $330.85million. With no change to the number of shares outstanding, its EPS would decrease by($330.9/6,170) = $0.054 to $0.776. (Assume the new product would not change this year’srevenues.)b.If Quisco acquires the technology for $893 million worth of its stock, it will issue $893/18.96 =47.10 million new shares. Since earnings without this transaction are $0.83 × 6.17 billion = $5.12billion, its EPS with the purchase is 5,121/(6,170 + 47.10) = $0.82.c.Acquiring the technology would have a smaller impact on earnings, but this method is notcheaper. Developing it in-house is less costly and provides an immediate tax benefit. The earningsimpact is not a good measure of the expense. In addition, note that because the acquisitionpermanently increases the number of shares outstanding, it will reduce Quisco’s earnings per sharein future years as well.

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Chapter 2/Introduction to Financial Statement Analysis112-19.Find online the annual 10-K report for Costco Wholesale Corporation (COST) for fiscal year2015 (filed in October 2015).Answer the following questions from their cash flow statement:a.How much cash didCostcogenerate from operating activities infiscal year 2015?b.What wasCostcodepreciationand amortization expense?c.How much cash was invested innew property and equipment(net of any sales)?d.How much didCostcoraise from the sale of shares of its stock (net of any purchases)?a.Net cash provided by operating activities was $4,285million infiscal year 2015.b.Depreciation and amortization expenses were $1,127million.c.Net cash used incapital expenditures forproperty and equipmentwas $2,393million.d.Costcoraised nothingfromthesale of shares of its stock, while it spent $481million on thepurchase of common stock.Costcoraised–$481million from the sale of its shares of stock (net ofany purchases).2-20.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.From 2012 to 2016, what was the total cash flow fromoperations that Mydeco generated?b.What fraction of the total in (a) was spent on capital expenditures?c.What fraction of the total in (a) was spent paying dividends to shareholders?d.What was Mydeco’s total retained earnings for this period?a.Total cash flow from operations = 45.2 + 47.6 + 53.1 + 44 + 48.8 = $238.7 million.b.Total fraction spent on capital expenditures = (26.6 + 23.8 + 97.5 + 75.4 + 40)/238.7 = 110.3%.c.Total fraction spent on dividends = (5.2 × 4 + 5.6)/238.7 = 11.06%.d.Retained earnings = Net Income–Dividends = (15 + 4.3 + 9.6 + 11.8 + 16.2)–(5.2 × 4 + 5.6) =$30.5 million.2-21.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.In what year was Mydeco’s net income the lowest?b.In what year did Mydeco need to reduce its cash reserves?c.Why did Mydeco need to reduce its cash reserves in ayear when net income was reasonablyhigh?a.In 2013 (net income was $4.3 million).b.2015 (cash was reduced from 91.7 to 80.4).c.Mydeco needed to reduce cash (it also issued debt) to pay for large capital expenditures in 2014and 2015. In addition, even though net income was reasonably high, cash from operations was atthelowest amountinthe five-year period duetoanincreaseinaccounts receivableandinventories.2-22.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. Use thedata from the balance sheetand cash flow statement in 2012to determine the following:a.How much cash did Mydecohave at the end of 2011?b.What were Mydeco’s accounts receivableand inventory at the end of 2011?c.What were Mydeco’s total liabilities at the end of 2011?d.Assuming goodwill and intangibles were equal in 2011 and 2012, what was Mydeco’s netproperty, plant,and equipment at the end of 2011?a.20011 Cash = 2012 Cash–2012 Change in Cash = 49.4–13.4 = $36 million.

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12Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editionb.2011 Accounts Receivable = 87.6–3.9 = $83.7 million; 2011 inventory = 33.5–(-2.9) = $36.4millionc.2011 TotalLiabilities = 525.3–1.7 = $523.6 million.d.2011 net property, plant, and equipment = 2012 net property, plant, and equipment–2012 capitalexpenditures + 2012 depreciation = 244.3–26.6 + 27.5 = $245.2 million2-23.Can a firm with positive net income run out of cash? Explain.A firm can have positive net income but still run out of cash. For example, to expand its currentproduction, a profitable company may spend more on investment activities than it generates fromoperating activities and financing activities. Net cash flow for that period would be negative, althoughits net income is positive. It could also run out of cashifit spends a lot on financing activities, perhapsby paying off other maturing long-term debt, repurchasing shares, or paying dividends.2-24.Suppose your firm receives a $4.1million order on the last day of the year. You fill the orderwith $2.9million worth of inventory. The customer picks up the entire order the same day andpays $1.5million upfront in cash; you also issue a bill for the customer to pay the remainingbalance of $2.6million in 30 days. Suppose your firm’s tax rate is 0% (i.e., ignore taxes).Determine the consequences of this transaction for each of the following:a.Revenuesb.Earningsc.Receivablesd.Inventorye.Casha.Revenues: increase by $4.1 millionb.Earnings: increase by 4.1–2.9 = $1.2 millionc.Receivables: increase by $2.6 milliond.Inventory: decrease by $2.9 millione.Cash: increase by $1.2 million (earnings)–$2.6 million (receivables) + $2.9 million (inventory) =$1.5 million (cash).2-25.NokelaIndustriespurchasesa$38.5millioncyclo-converter.Thecyclo-converterwillbedepreciated by $7.7million per year over four years, starting this year. Suppose Nokela’s taxrate is 40%.a.What impact will the cost of the purchase have on earnings for each of the next fiveyears?b.What impact will the cost of the purchase have on the firm’s cash flow for the next fiveyears?a.To calculate the impact on earnings for the next fiveyears, we would have to deduct thedepreciation expense. After taxes, this would lead to a decline of 7.7 × (1–40%) = $4.62 millioneach year for the next five years.b.Cash flow for the next five years: less $35.42 million (–4.62 + 7.7–38.5) this year, and add $3.08million (–4.62 + 7.7) for the four following years.2-26.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.What were Mydeco’s retained earnings each year?b.Using the data from2012, what was Mydeco’s total stockholders’ equity in 2011?a.Retained earnings = Net Income–Dividends Paid

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Chapter 2/Introduction to Financial Statement Analysis13Year20122013201420152016Net Income$15.0$4.3$9.6$11.8$16.2Dividends Paid–$5.2–$5.2–$5.2–$5.2–$5.6Retained Earnings (millions)$9.8–$0.9$4.4$6.6$10.6b.2011 stockholders’ equity = 2012 stockholders’ equity–2012 retained earnings = 255–9.8 =$245.2 million.2-27.Find online the annual 10-K report for Costco Wholesale Corporation (COST) for fiscal year2015 (filed in October2015).Answer the following questions from the notes to their financialstatements:a.How many stores did Costco open outside of the U.S. in 2015?b.What property doesCostcolease? What are the minimum lease payments due in 2016?c.What wasCostco’sworldwide member renewal rate for 2015?What proportion ofCostcocardholders had Gold Star memberships in 2015?d.What fraction ofCostco’s 2015sales came fromgas stations, pharmacy, food court, andoptical? What fraction came fromapparel andsmall appliances?a.Costcoopened 11 stores outside of the U.S. in 2015.b.Costcoleasesland and/or buildings at warehouses and certain other office and distributionfacilities.The minimum lease payments due in 2016are $211million.c.Costco had a worldwide member renewal rate of 88% for 2015.34,000/81,300 = 42% of Costcocardholders had Gold Star memberships in 2015.d.16%ofCostco’s 2015sales came fromgas stations, pharmacy, food court, and optical.11% ofCostco’s 2015sales came fromapparel and small appliances.2-28.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.What were Mydeco’s gross margins each year?b.Comparing Mydeco’s gross margin, EBIT margin, and net profit margin in 2012 and 2016,which margins improved?a.Year20122013201420152016Revenue$401.9$361.6$429.6$513.6$602.6Gross Profit$209.8$186.2$222.5$265.3$306.8Gross Margin52.2%51.5%51.8%51.7%50.9%b.None of the margins improved from 2012 to 2016Year20122013201420152016Revenue$401.9$361.6$429.6$513.6$602.6Gross Profit$209.8$186.2$222.5$265.3$306.8EBIT$55.5$38.4$46.7$55.2$65.8Net Income$15.0$4.3$9.6$11.8$16.2Gross Margin52.2%51.5%51.8%51.7%50.9%EBIT Margin13.8%10.6%10.9%10.7%10.9%Net Profit Margin3.7%1.2%2.2%2.3%2.7%2-29.Forfiscal yearend2015,Walmart Stores, Inc. (WMT)had revenue of $485.65billion, grossprofit of $120.57billion, and net income of $16.36billion.Costco Wholesale Corporation (COST)had revenue of $116.20billion, gross profit of $15.13billion,and net income of $2.38billion.a.Compare the gross margins forWalmartandCostco.

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14Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editionb.Compare the net profit margins forWalmartandCostco.c.Whichfirm was more profitable in 2015?a.Walmart’sgross margin=120.57/485.65=24.83%;Costco’sgross margin =15.13/116.20 =13.02%.b.Walmart’snet margin= 16.36/485.65=3.37%;Costco’s net margin =2.38/116.20 = 2.05%.c.Walmartwas more profitable in 2015.2-30.At the end of 2015, Apple had cash and short-term investments of$41.60billion, accountsreceivable of $35.89billion, current assets of $89.38billion, and currentliabilities of $80.61billion.a.What was Apple’s current ratio?b.What was Apple’s quick ratio?c.What is Apple’s cash ratio?d.At the end of 2015, HPQ had a cash ratio of 0.35, a quick ratio of 0.73 and a current ratio of1.15. What can you say about the asset liquidity of Apple relative to HPQ?a.Apple’s current ratio= 89.38/80.61 = 1.11.b.Apple’s quick ratio= (41.60 + 35.89)/80.61 = 0.96.c.Apple’s cash ratio= 41.60/80.61 = 0.52.d.Applegenerally has more liquid assets than HPQrelative to current liabilities, with the exceptionof a slightly lower current ratiodue to a lower proportion of inventory.2-31.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.How did Mydeco’s accounts receivable days change over this period?b.How did Mydeco’s inventory days change over this period?c.Based on your analysis, has Mydeco improved its management of its working capital duringthis time period?a.2012 accounts receivable days = 365 × 87.6 /401.9 = 79.56.2016 accounts receivable days = 365 × 84.2 / 602.6 = 51.00.b.2012 inventory days = 365 × 33.5 / 192.1 = 63.65.2016 inventory days = 365 × 35.8 / 295.8 = 44.18.c.Between 2012 and 2016, Mydeco improved its working capital management by reducing bothaccounts receivable days and inventory days.2-32See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.Compare accounts payable days in 2012 and 2016.b.Did this change in accounts payable days improve or worsen Mydeco’s cash position in2016?a.2012 accounts payable days = 365 × 18.8 / 192.1 = 35.72.2016 accounts payable days = 365 × 30.3 / 295.8 = 37.39.b.Accounts payable days increased from 2012 to 2016, which improved the cash position of Mydeco

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Chapter 2/Introduction to Financial Statement Analysis152-33.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.By how much did Mydeco increase its debt from 2012 to 2016?b.What was Mydeco’s EBITDA/Interest coverage ratio in 2012 and 2016? Did its coverageratio ever fall below 2?c.Overall, did Mydeco’s ability to meet its interest payments improve or decline over thisperiod?a.Mydeco increased its debt from $498.9 million in 2012 to $595.5 million in 2016 (by $98.6million).b.Interest coverage ratio = (EBIT +Depreciation) / Interest expenseYear20122013201420152016EBIT$55.5$38.4$46.7$55.2$65.8Depreciation & Amortization$27.5$26.3$32.5$38.3$40.1Interest Expense$32.4$31.8$32.0$37.0$40.9Interest Coverage ratio2.562.032.482.532.59Mydeco’s coverage ratio did not fall below 2 between 2012 and 2016c.Overall, Mydeco’sability to meet its interest payments remained relatively constant, although itexperienced a slight dip in 2013.2-34.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.How did Mydeco’s book debt-equity ratio change from 2012 to 2016?b.How did Mydeco’s market debt-equity ratio change from 2012 to 2016?c.Compute Mydeco’s debt-to-enterprise value ratio to assess how the fraction of its businessthat is debt financed has changed over the period.a.Year20122013201420152016Long-term Debt$498.9$498.9$572.2$597.5$597.5Stockholders' Equity$255.0$255.6$257.8$270.8$279.8Book debt-equity ratio1.961.952.222.212.14b.Year20122013201420152016Long-term Debt$498.9$498.9$572.2$597.5$597.5Market capitalization (millions)$398.7$201.6$332.8$473.1$657.2Market debt-equity ratio1.252.471.721.260.91c.Year20122013201420152016Long-term Debt$498.9$498.9$572.2$597.5$597.5Enterprise value$848.2$632.5$813.3$990.2$1,171.1Debt-to-enterprise value ratio0.590.790.700.600.512-35.Use the data in Problem 8 todetermine the change, from 2012 to 2015, in GE’sa.book debt-equity ratio?b.marketdebt-equity ratio?a.2012book debt-equity ratio= 410/116 = 3.53.2015book debt-equity ratio= 302/128 = 2.36b.2012market debt-equity ratio= 410/(17 x 10.6) = 2.28.2015market debt-equity ratio= 302/(25 x 10) = 1.21.

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16Berk/DeMarzo,Corporate Finance,FourthEdition, Global Edition2-36.You areanalyzing the leverage of two firms and you note the following (all values in millions ofdollars):a.What is the market debt-to-equity ratio of each firm?b.What is the book debt-to-equity ratio of each firm?c.What is the interest coverageratio of each firm?d.Which firm may have more difficulty meeting its debt obligations? Explain.a.Firm A:Market debt-equity ratio = 495.8/401.1 = 1.24Firm B:Market debt-equity ratio = 83.8/35.9 = 2.33b.Firm A:Book debt-equity ratio = 495.8/297.9 = 1.66Firm B:Book debt-equity ratio = 83.8/38.3 = 2.19c.Firm A:Interest coverage ratio = 106.8/45.2 = 2.36Firm B:Interest coverage ratio = 8.4/7.5 = 1.12d.Firm B has a lower coverage ratio and will have more difficulty meeting its debtobligations thanFirm A.2-37.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.Compute Mydeco’s PE ratio each year from 2012 to 2016. Inwhich year was it the highest?b.What was Mydeco’s Enterprise Value to EBITDA ratio each year? In which year was it thehighest?c.What might explain the differing time pattern of the two valuation ratios?a.Year20122013201420152016Stock Price$7.02$3.55$5.86$8.33$11.57EPS$0.26$0.08$0.17$0.21$0.29PE ratio27.044.434.539.739.9The PE ratio was highest in 2013.b.Year20122013201420152016Enterprise value$848.2$632.5$813.3$990.2$1,171.1EBIT$55.5$38.4$46.7$55.2$65.8Depreciation & Amortization$27.5$26.3$32.5$38.3$40.1Enterprise value-to-EBITDA ratio10.29.810.310.611.1The enterprise value/EBITDA ratio was the highest in 2016.c.The different time patterns are caused by a change in the leverage ratio (increasing debt) thatoccurred in 2014 and 2015 and reduced the earnings per share due to increased interest expense.The PE ratio is sensitive to changes in leverage, while the enterprise value/EBITDA ratio is not.2-38.In early-2015, United Airlines (UAL) hada market capitalization of $24.8 billion, debt of $12.8billion, and cash of $5.5billion. United also had annual revenues of $38.9billion. SouthwestAirlines (LUV) hada market capitalization of $28.8billion, debt of $2.7 billion, cash of $2.9billion, and annual revenues of $18.6billion.

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Chapter 2/Introduction to Financial Statement Analysis17a.Compare the market capitalization-to-revenue ratio (also called the price-to-sales ratio) forUnited Airlines and Southwest Airlines.b.Compare the enterprise value-to-revenue ratio forUnited Airlines and Southwest Airlines.c.Which of these comparisons is more meaningful? Explain.a.Market capitalization-to-revenue ratio:= 24.8/38.9 = 0.64forUnitedAirlines.= 28.8/18.6 = 1.55forSouthwest Airlines.b.Enterprise value-to-revenue ratio:= (24.8–5.5 + 12.8)/38.9 = 0.83forUnitedAirlines.= (28.8–2.9 + 2.7)/18.6 = 1.54forSouthwest Airlines.c.The market capitalization to revenue ratio cannot be meaningfully compared when the firms havedifferent amounts of leverage, as market capitalization measures only the value of the firm’sequity. The enterprise value to revenue ratio is therefore more useful when firm’s leverage is quitedifferent, as it is here.2-39.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.a.Compute Mydeco’sROEeach year from 2012 to 2016.b.Compute Mydeco’sROAeach year from 2012 to 2016.c.Which return is more volatile? Why?a.Year20122013201420152016Net Income$15.0$4.3$9.6$11.8$16.2Stockholders' Equity$255.0$255.6$257.8$270.8$279.8ROE5.9%1.7%3.7%4.4%5.8%b.Year20122013201420152016Net Income$15.0$4.3$9.6$11.8$16.2Interest Expense$32.4$31.8$32.0$37.0$40.9Total Assets$780.3$779.6$859.9$903.1$917.0Enterprise value-to-EBITDA ratio6.1%4.6%4.8%5.4%6.2%c.ROE is more volatile. Mydeco’sdebt level causes a large portion of EBIT to go to interestexpense (which is relatively constant). This magnifies the volatility of earnings left over forshareholders through net income. ROA adjusts net income by including interest expense, and thusis less sensitive to leverage.2-40.See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. WasMydecoable to improve its ROIC in 2016 relative to what it was in 2012?55.5(10.35)2012 ROIC5.12%.255.0498.949.4−==+−65.8(10.35)2016 ROIC5.39%.279.8597.583.6−==+−Mydeco was able to improve its ROIC in 2016 relative to 2012.2-41.For fiscal year 2015,Costco Wholesale Corporationhad a net profit margin of2.05%, assetturnover of3.48, anda book equity multiplier of3.15.

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18Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editiona.Use this data to computeCostco's ROEusing the DuPont Identity.b.IfCostco'smanagers wanted to increase its ROE by one percentage point, how much higherwould their asset turnover need to be?c.IfCostco'snet profit margin fell by one percentage point, by how much would their assetturnover need to increase to maintain their ROE?a.Costco’s ROE (DuPont) = 2.05% × 3.48 × 3.15 = 22.47%.b.Costco's new asset turnover=23.47%/(2.05% ×3.15) =3.63 or an increase of 3.63–3.48 = 0.15.c.Costco's new asset turnover= 22.47%/(1.05% × 3.15) =6.79or an increase of6.79–3.48 = 3.31.2-42.For fiscal year 2015,Walmart Stores Inc. (WMT) had total revenues of $484.65 billion, netincome of $16.36billion, total assets of $203.49billion, and total shareholder’s equity of $81.39billion.a.CalculateWal-Mart’sROE directly, and using the DuPont Identity.b.Comparing with the data forCostcoin problem 41, use the DuPont Identity to understandthe difference between the two firms’ ROEs.a.Walmart’sROE= 16.36/81.39=20.10%.Walmart’snet profit margin=16.36/484.65=3.38%.Walmart’sasset turnover=484.65/203.49=2.38.Walmart’sequity multiplier=203.49/81.39 = 2.50.Walmart’s ROE (DuPont) =3.38% × 2.38 × 2.50=20.11%(difference due to rounding).b.Walmarthas a superior profit margin,but a lower asset turnoverand alowerequity multiplier(which could representlessleverage).Despite the higher profit margin, it has a smaller ROE thatis driven by it’s lower asset turnover and leverage.2-43.Consider a retailing firm with a net profit margin of 3.1%, a total asset turnover of 1.85, totalassets of $44.4million, and a book value of equity of $18.2million.a.What is the firm’s current ROE?b.If the firm increased its net profit margin to3.6%, what would be its ROE?c.If, in addition, the firm increased its revenues by 23% (while maintaining this higher profitmargin and without changing its assets or liabilities), what would be its ROE?a.3.1% × 1.85 × 44.4/18.2 = 14.0%.b.3.6% × 1.85 × 44.4/18.2 = 16.2%.c.3.6% × (1.85 × 1.23) × 44.4/18.2 = 20.0%.2-44.Find online the annual 10-K report for Costco Wholesale Corporation (COST) for fiscal year2015 (filed in October 2015).a.Which auditing firmcertified these financial statements?b.Which officers ofCostco’s certified the financial statements?a.KPMGLLPcertifiedCostco’s financial statements.b.W. Craig Jelinek, President and CEO and Richard A. Galanti, Executive Vice President and CFOcertifiedCostco’s financial statements.2-45.WorldCom reclassified $3.85 billion of operating expenses as capital expenditures. Explain theeffect this reclassification would have on WorldCom’s cash flows. (Hint:Consider taxes.)

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Chapter 2/Introduction to Financial Statement Analysis19WorldCom’s actions were illegal and clearly designed to deceive investors. But if a firm couldlegitimately choose how to classify an expense for tax purposes, which choice is truly better forthe firm’s investors?By reclassifying $3.85 billion operating expenses as capital expenditures, WorldCom increased its netincome but lowered its cash flow for that period. If a firm could legitimately choose how to classify anexpense, expensing as much as possible in a profitable period rather than capitalizing them will savemore on taxes, which results in higher cash flows, and thus is better for the firm’s investors.

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20Chapter 3Financial Decision Making and the Law ofOne Price3-1.Honda Motor Company is considering offering a $2500 rebate on its minivan, lowering thevehicle’s price from $21,000 to $18,000. The marketing group estimates that this rebate willincrease sales over the next year from31,000 to 51,000 vehicles. Suppose Honda’s profit marginwith the rebate is $6000 per vehicle. If the change in sales is the only consequence of this decision,what are its costs and benefits? Is it a good idea?The benefit of the rebate is that Honda will sell more vehicles and earn a profit on each additionalvehicle sold:Benefit = Profit of $6,000 per vehicle × 20,000 additional vehicles sold = $120 million.The cost of the rebate is that Honda will make less on the vehicles it would have sold:Cost = Loss of $2,500 per vehicle × 31,000 vehicles that would have sold without rebate = $77.5million.Thus, Benefit–Cost = $120 million–$77.5 million = $42.5 million, and offering the rebate looksattractive.(Alternatively, we could view it in terms of total, rather than incremental, profits. The benefit as$6000/vehicle × 51,000 sold = $306 million, and the cost is $8,500/vehicle × 31,000 sold = $263.5million.)3-2.You are an international shrimp trader. A food producer in the Czech Republic offers to pay you2.2million Czech koruna today in exchange for a year’s supply of frozen shrimp. Your Thaisupplier will provide you with the same supply for 3.6million Thai baht today. If the currentcompetitive market exchange rates are 24.60 koruna per dollar and34.99baht per dollar, whatis the value of this deal?Czech buyer’s offer = 2,200,000 CZK / (24.60 CZK/USD) = 89,430.89 USD.Thai supplier’s offer = 3,600,000 THB / (34.99 THB/USD) = 102,886.54 USD.The value of the deal is $89,430.89–102,886.54 =–$13,455.64 today (i.e. it is a bad deal and shouldbe rejected).3-3.Suppose the current market price of corn is $4.23per bushel. Your firm has a technology thatcan convert 1 bushel of corn to 3 gallons of ethanol. If the cost of conversion is $1.47per bushel,at what market price of ethanol does conversion become attractive?The price in which ethanol becomes attractive is ($4.23 + $1.47 / bushel of corn) / (3 gallons of ethanol/ bushel of corn) = $1.90 per gallon of ethanol.

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Chapter 3/Financial Decision Making and the Law of One Price213-4.Suppose your employer offers you a choice between a $5700 bonus and 120 shares of thecompany stock. Whichever one you choose will be awarded today. The stock is currently tradingfor $58per share.a.Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonusshould you choose? What is its value?b.Suppose that if you receive the stock bonus, you are required to hold it for at least one year.What can you say about the value of the stock bonus now? What will your decision dependon?a.Stock bonus = 120 × $58 = $6,960Cash bonus = $5,700Since you can sell the stock for $6,960 in cash today, its value is $6,960 which is better than thecash bonus.b.Because you could buy the stock today for $6,960 if you wanted to, the value of the stock bonuscannot be more than $6,960. But if you are not allowed to sell the company’s stock for the nextyear, its value to you could be less than $6,960. Its value will depend on what you expect the stockto be worth in one year, as well as how you feel about the risk involved. You might decide that itis better to take the $5,700 in cash than wait for the uncertain value of the stock in one year.3-5.You have decided to take your daughter skiing in Utah. The best price you have been able to findfor a roundtrip air ticket is $364. You notice that you have 20,000 frequent flier miles that areabout to expire, but you need 25,000 miles to get her a free ticket. The airline offers to sell you5000 additional miles for $0.04per mile.a.Suppose that if you don’t use the miles for your daughter’s ticket they will becomeworthless. What should you do?b.What additional information would your decision depend on if the miles were not expiring?Why?a.The price of the ticket if you purchase it is $364. The price if you purchase the miles is $0.04 ×5000 = $200. Thus, you should purchase the miles.b.In part a, the existing miles are worthless if you don’t use them. They are not worthless now, soyou must add in the cost of using them. Because there is no competitive market price for thesemiles (you can purchase at 4¢ but not sell for that price), the decision will depend on how muchyou value the existing miles (which will depend on your likelihood of using them in the future, thecost of the equivalent ticket, the cost of additional miles you may have to buy in the future, etc.).3-6.Suppose the risk-free interest rate is3.9%.a.Having $500 today is equivalent to having what amount in one year?b.Having $500 in one year is equivalent to having what amount today?c.Which would you prefer, $500 today or $500 in one year? Does your answer depend on whenyou need the money? Why or why not?a.Having $500 today is equivalent to having $500 × 1.039 = $519.5 in one year.b.Having $500 in one year is equivalent to having $500 / 1.039 = $481.23 today.c.Because money today is worth more than money in the future, $500 today is preferred to $500 inone year. This answer is correct even if you don’t need the money today, because by investing the$500 you receive today at the current interest rate, you will have more than $500 in one year.

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22Berk/DeMarzo,Corporate Finance,FourthEdition, Global Edition3-7.You have an investment opportunity in Japan. It requires an investment of $1.06million todayand will produce a cash flow of ¥ 106million in one year with no risk. Suppose the risk-freeinterest rate in the United States is 4.7%, the risk-free interest rate in Japan is 2.9%, and thecurrent competitive exchange rate is ¥ 110 perdollar. What is the NPV of this investment? Is it agood opportunity?Cost = $1.06 million todayBenefit = (¥1106) / (1.029 ¥1/¥0) / (110 ¥0/$0) = $00.936 million[Note: for easy reading, I use a currency’s subscript to denote the period.]NPV = 0.936–1.06 =–$0.124 million.The NPV is negative, so it is not a good investment opportunity.3-8.Your firm has a risk-free investment opportunity where it can invest $161,000 today and receive$178,000 in one year. For what level of interest rates is this project attractive?You are indifferent if r = 178,000/161,000–1 = 10.559%Thus, the project is attractive if r < 10.559% (indifferent if =)3-9.You run a construction firm. You have just won a contract to constructa government officebuilding. Constructingit will take one year and require an investment of $9.78million today and$5million in oneyear.Thegovernmentwill payyou $22.5million upon thebuilding’scompletion. Suppose the cash flows and their times of payment are certain, and the risk-freeinterest rate is 11%.a.What is the NPV of this opportunity?b.How can your firm turn this NPV into cash today?a.BenefitsCostsNPVPVPV=−Benefits$1.10 in one yearPV= $20 million in one year ÷$ today= $18.18 millionThis year's costPV= $10 million todayNext year's cost$1.10 in one yearPV= $5 million in one year ÷$ today= $4.55 million todayNPV18.18104.55$3.63 million today=−−=b.The firm can borrow $18.18 million today, and pay it back with 10% interest using the $20 millionit will receive from the government (18.18 × 1.10 = 20). The firm can use $10 million of the 18.18million to cover its costs todayand save $4.55 million in the banktoearn 10% interest to cover itscost of 4.55 × 1.10 = $5 million next year.This leaves 18.18–10–4.55 = $3.63 million in cash for the firm today.3-10.Your firm has identified three potential investment projects. The projects and their cash flowsare shown here:

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Chapter 3/Financial Decision Making and the Law of One Price23Suppose all cash flows are certain and the risk-free interest rate is 10%.a.What is the NPV of each project?b.If the firm can choose only one of these projects, which should it choose?c.If the firm can choose any two of these projects, which should it choose?a.A20NPV10$8.181.1= −+=B5NPV5$9.551.1=+=C10NPV20$10.911.1=−=b.If only one of the projects can be chosen, project C is the best choice because it has the highestNPV.c.If two of the projects can be chosen, projects B and C are the best choice because they offer ahigher total NPV than any other combinations.3-11.Your computer manufacturing firm must purchase 12,000 keyboards from a supplier. Onesupplier demands a payment of $144,000 today plus $12per keyboard payable in one year.Another supplier will charge $25per keyboard, also payable in one year. The risk-free interestrate is9%.a.What is the difference in their offers in terms of dollars today? Which offer should your firmtake?b.Suppose your firm does not want to spend cash today. How can it take the first offer and notspend $144,000 of its own cash today?a.1212, 000Supplier 1: PV144,000$276,1101.09= −−= −2512, 000Supplier 2: PV$275, 2291.09= −= −Costs are lower under the second supplier’s offer, so it is the better choice.b.The firm can borrow $144,000 at 9% from a bank for one year to make the initial payment to thefirst supplier. One year later, the firm will pay back the bank $156,960 (= 144,000 × 1.09) and thefirst supplier $144,000 (= 12 × 12,000), for a total of $300,960 (the PV does not change).3-12.Suppose Bank One offers a risk-free interest rate of10.0% on both savings and loans, and BankEnn offers a risk-free interest rate of10.5% on both savings and loans.a.What arbitrage opportunity is available?b.Which bank would experience a surge in the demand for loans? Which bank would receive asurge in deposits?c.What would you expect to happen to the interest rates the two banks are offering?

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24Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editiona.Take a loan from Bank One at 10% and save the money in Bank Enn at 10.5%.b.Bank One would experience a surge in the demand for loans, while Bank Enn would receive asurge in deposits.c.Bank One would increase the interest rate, and/or Bank Enn would decrease its rate, such thatneither bank offers a savings rate that is higher than either bank’s loan rates.3-13.Throughout the 1990s, interest rates in Japan were lower than interest rates in the United States.As a result, many Japanese investors were tempted to borrow in Japan and invest the proceedsin the United States. Explain why this strategy does not represent an arbitrage opportunity.There is exchange rate risk. Engaging in such transactions may incur a loss if the value of the dollarfalls relative to the yen. Because a profit is not guaranteed, this strategy is not an arbitrage opportunity.3-14.An American Depositary Receipt (ADR) is security issued by a U.S. bank and traded on a U.S.stock exchange that represents a specific number of shares of a foreign stock. For example,Nokia Corporation trades as an ADR with symbol NOK on the NYSE. Each ADRrepresents oneshare of Nokia Corporation stock, which trades with symbol NOK1V on the Helsinki stockexchange. If the U.S. ADR for Nokia is trading for $5.76per share, and Nokia stock is trading onthe Helsinki exchange for €5.25per share, use the Law of One Price to determine the current $/€exchange rate.We can trade one share of Nokia stock for $5.76 per share in the U.S. and €5.24 per share in Helsinki.By the Law of One Price, these two competitive prices must be the same at the current exchange rate.Therefore, the exchange rate must be:$5.76/share = $1.0992/5.24/share€€3-15.The promised cash flows of three securities are listed here. If the cash flows are risk-free, and therisk-free interest rate is4%, determine the no-arbitrage price of each security before the firstcash flow is paid.A600PV= 600 += $1,176.921.04B1,200PV== $1,153.851.04CPV= $1,200While the total cash flows paid by each security are the same ($1200), securities A and B are worthless than $1200 because some or all of the money is received in the future.3-16.An Exchange-Traded Fund (ETF) is a security that represents a portfolio of individual stocks.Consider an ETF for which each share represents a portfolio of two shares of Hewlett-Packard(HPQ), one share of Sears (SHLD), and three shares of General Electric (GE). Suppose thecurrent stock prices of each individual stock are as shown here:

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Chapter 3/Financial Decision Making and the Law of One Price25a.What is the price per share of the ETF in a normal market?b.If the ETF currently trades for $164, what arbitrage opportunity is available? What tradeswould you make?c.If the ETF currently trades for $194, what arbitrage opportunity is available? What tradeswould you make?a.We can value the portfolio by summing the value of the securities in it:Price per share of ETF = 1 × $34 + 2 × $42 + 4 × $16 = $182b.If the ETF currently trades for $164, an arbitrage opportunity is available. To take advantage of it,one should buy the ETF for $164, sell one share of HPQ for $34, sell two shares of SHLD for $42each, and sell four shares of GE for $16 each. Total profit for such transaction is $182–$164 =$18.c.If the ETF trades for $194, an arbitrage opportunity is also available. To take advantage of it, oneshould sell the ETF for $194, buy one share of HPQ for $34, buy two shares of SHLD for $42each, and buy four shares of GE for $16 each. Total profit for such transaction is $194–$182 =$12.3-17.Consider two securities that pay risk-free cash flows over the next two years and that have thecurrent market prices shown here:a.What is the no-arbitrage price of a security that pays cash flows of $200 in one year and$200 in two years?b.What is the no-arbitrage price of a security that pays cash flows of $200 in one year and$1600 in two years?c.Suppose a security with cash flows of $100 in one year and $200 in two years is trading for aprice of $260. What arbitrage opportunity is available?a.This security has the same cash flows as a portfolio of one share of B1 and one share of B2.Therefore, its no-arbitrage price is 192 + 176 = $368.b.This security has the same cash flows as a portfolio of one share of B1 and eight shares of B2.Therefore, its no-arbitrage price is 192 + 8 × 176 = $1,600c.There is an arbitrage opportunity because the no-arbitrage price should be $272 (= 192 / 2 + 176).One should buy two shares of the security at $260/share and sell one share of B1 and two shares ofB2. Total profit would be $24 (–260 × 2 + 192 + 176 × 2).3-18.Suppose a security with a risk-free cash flow of $154in one year trades for $137today. If thereare no arbitrage opportunities, what is the current risk-free interest rate?The PV of the security’s cash flow is ($154 in one year)/(1 +r), whereris the one-year risk-freeinterest rate. If there are no arbitrage opportunities, this PV equals the security’s price of $137 today.Therefore,$137 today = ($154 in one year) / (1 +r)

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26Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editionr= 154 / 137–1 = 12.41%3-19.Xia Corporation is a company whose sole assets are $100,000 in cash and three projects that itwill undertake. The projects are riskfree and have the following cash flows:Xia plans to invest any unused cash today at the risk-free interest rate of9.2%. In one year, allcash will be paid to investors and the company will be shut down.a.What is the NPV of each project? Which projects should Xia undertake and how much cashshould it retain?b.What is the total value of Xia’s assets (projects and cash) today?c.What cash flows will the investors in Xia receive? Based on these cash flows, what is thevalue of Xia today?d.Suppose Xia pays any unused cash to investors today, rather than investing it. What are thecash flows to the investors in this case? What is the value of Xia now?e.Explain the relationship in your answers to parts (b), (c), and (d).a.A28, 000NPV20, 000$5, 641.031.092= −+=B29, 000NPV13, 000$13, 556.781.092= −+=C75, 000NPV56, 000$12, 681.321.092= −+=All projects have positive NPV, and Xia has enough cash ($11,000 left over), so Xia should takeall of them.b.Total value today = Cash + NPV(projects) = 100,000 + 5,641.03 + 13,556.78 + 12,681.32 =$131,879.12c.After taking the projects, Xia will have 100,000–20,000–13,000–56,000 = $11,000 in cash leftto invest at 9.2%. Thus, Xia’s cash flows in one year = 28,000 + 29,000 + 75,000 + 11,000 ×1.092 = $144,012.Value of Xia today = $144,012 / 1.092 = $131,879.12, the same as calculated in b.d.Unused cash = $11,000Cash flows today = $11,000Cash flows in one year = 28,000 + 29,000 + 75,000 = $132,000Value of Xia today = 11,000 + 132,012 / 1.092 = $131,879.12, the same as calculated in b.e.Results from b, c, and d are the same because all methods value Xia’s assets today. Whether Xiapays out cash now or invests it at the risk-free rate, investors get the same value today. The pointis that a firm cannot increase its value by doing what investors can do by themselves (and is theessence of the separation principle).3-A.1.The table here shows the no-arbitrage prices of securities A and B that we calculated.

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Chapter 3/Financial Decision Making and the Law of One Price27a.What are the payoffs of a portfolio of one share of security A and one share of security B?b.What is the market price of this portfolio? What expected return will you earn from holdingthis portfolio?a.A + B pays $600 in both states of the economy (i.e., it its risk free).b.Market price= 231 + 346 = 577. Expected return is (600–577) / 577 = 3.99%, which must equalthe risk-free interest rate for there to be no arbitrage.3-A.2.Suppose security C has a payoff of $600 when the economy is weak and $1800 when the economyis strong. The risk-free interest rate is 4%.a.Security C has the same payoffs as whichportfolio of the securities A and B in problem A-1?b.What is the no-arbitrage price of security C?c.What is the expected return of security C if both states are equally likely? What is its riskpremium?d.What is the difference between the return of security C when the economy is strong andwhen it is weak?e.If security C had a risk premium of 10%, what arbitrage opportunity would be available?a.C3AB=+b.Price ofC32313461039=+=c.Expected payoff is6001, 8001, 20022+=;Expected return1, 2001, 03915.5%1, 039−==Risk premium15.5411.5%=−=d.Return when strong1, 8001, 03973%1, 039−==;return when weak600103942%1039−== −Difference()7342115%=−−=e.Price of C given 10% risk premium1, 200$1, 0531.14==Buy3AB+for 1039, sell C for 1053, and earn a profit of1, 0531, 039$14−=.3-A.3.You work for Innovation Partners and are considering creating a new security. This securitywould pay out $2000 in one year if the last digit in the closing value of the Dow Jones Industrialindex in one year is an even number and zero if it is odd. The one-year risk-free interest rate is5.3%. Assume that all investors are averse to risk.a.What can you say about the price of this security if it were traded today?b.Say the security paid out $2000 if the last digit of the Dow is odd and zero otherwise. Wouldyour answer to part (a) change?c.Assume both securities (the one that paid out on even digits and the one that paid out on odddigits) trade in the market today. Would that affect your answers?

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28Berk/DeMarzo,Corporate Finance,FourthEdition, Global Editiona.Whether the last digit in the Dow is odd or even has no correlation with the Dow index itself oranything else in the economy. Hence the payout of this security does not vary with anything elsein the economy, so it will not have a risk premium. So the price of the security will be112000022$949.671.053P+==b.No: the analysis is exactly the same and thus the price is the same.c.The answers would remain the same; however, in this case if the actual prices departed from949.67, an arbitrage opportunity would result because by purchasing both securities you can createa riskless investment. The investment will only have a 5.3% return if the price of the basket ofboth securities is $949.67 × 2 = $1899.34.3-A.4.Suppose a risky security pays an expected cash flow of $83in one year. The risk-free rate is3.5%, and the expected return on the market index is 10.5%.a.If the returns of this security are high when the economy is strong and low when theeconomy is weak, but the returns vary by only half as much as the market index, what riskpremium is appropriate for this security?b.What is the security’s market price?a.If the security is half as variable, it should only earn half the risk premium of the market. The riskpremium of the market isMarket risk premium= 10.5%–3.5% = 7%.Thus, the security’s risk premium must equal 3.5%b.8383$77.571risk premium13.5%3.5%Prf===++++3-A.5.Suppose Hewlett-Packard (HPQ) stock is currently trading on the NYSE with a bid price of$28.12and an ask price of $28.24. At the same time, a NASDAQ dealer posts a bid price for HPQof $27.98and an ask price of $28.10.a.Is there an arbitrage opportunity in this case? If so, how would you exploit it?b.Suppose the NASDAQ dealer revises his quotes to a bid price of $28.10and an ask price of$28.22. Is there an arbitrage opportunity now? If so, how would you exploit it?c.What must be true of the highest bid price and the lowest ask price for no arbitrageopportunity to exist?a.There is an arbitrage opportunity. One would buy from the NASDAQ dealer at $27.95 and sell toNYSE dealer at $28.00, making profit of $0.05 per share.b.There is no arbitrage opportunity.c.To eliminate any arbitrage opportunity, the highest bid price should be lower then the lowest askprice.3-A.6.Consider a portfolio of two securities: one share of Johnson and Johnson (JNJ) stock and a bondthat pays $100 in one year. Suppose this portfolio is currently trading with a bid price of $141.71and an ask price of $142.26, and the bond is trading with a bid price of $91.67and an ask priceof $91.88. In this case, what is the no-arbitrage price range for JNJ stock?According to theLawofOne Price,the price that portfolio of securities is tradingatis equal to the sumof the price of securities within the portfolio. If the portfolio, composed of a bond and JNJ stock iscurrently trading with a bid price of $141.65 and an ask price of $142.25, and the bond is trading at a

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