Corporate Finance pppimg

Chapter 1

The Corporation

1-1. What is the most important difference between a corporation and all other organization forms?

A corporation is a legal entity separate from its owners.

1-2. What does the phrase limited liability mean in a corporate context?

Owners’ liability is limited to the amount they invested in the firm. Stockholders are not responsible

for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred

by the firm.

1-3. Which organization forms give their owners limited liability?

Corporations and limited liability companies give owners limited liability. Limited partnerships

provide 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 life

Disadvantages: Double taxation, separation of ownership and control

1-5. Explain the difference between an S corporation and a C corporation.

C corporations much pay corporate income taxes; S corporations do not pay corporate taxes but must

pass through the income to shareholders to whom it is taxable. S corporations are also limited to 75

shareholders 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. Once

it has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate tax

rate is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. How

much is left for you after all taxes are paid?

First the corporation pays the taxes. After taxes,

$2 (1 0.4) $1.20

× − =

is left to pay dividends. Once the

dividend is paid, personal tax on this must be paid, which leaves

$1.20 (1 0.3) $0.84

× − =

. So after all

the taxes 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. These

stockholders must then pay personal income tax on the distribution. So they are left with

$2 (1 0.3) $1.40

× − =

.

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1-8. You have decided to form a new start-up company developing applications for the iPhone. Give

examples 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 application

projects will offer your company a positive NPV and therefore your company should develop.

ii. You will make the decision on how to fund your iPhone application investments and what mix of

debt and equity your company will have.

iii. You will be responsible for the cash management of your company, ensuring that your company

has the necessary funds to make investments, pay interest on loans, and pay your employees.

1-9. Corporate managers work for the owners of the corporation. Consequently, they should make

decisions that are in the interests of the owners, rather than their own. What strategies are

available to shareholders to help ensure that managers are motivated to act this way?

Shareholders can do 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.

1-10. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent

while 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 to

take good care of the apartment?

The agent (renter) will not take the same care of the apartment as the principal (owner), because the

renter does not share in the costs of fixing damage to the apartment. To mitigate this problem, having

the renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces

the renter to share in the costs of fixing any problems that are caused by the renter.

1-11. You are the CEO of a company and you are considering entering into an agreement to have your

company buy another company. You think the price might be too high, but you will be the CEO

of the combined, much larger company. You know that when the company gets bigger, your pay

and prestige will increase. What is the nature of the agency conflict here and how is it related to

ethical considerations?

There is an ethical dilemma when the CEO of a firm has opposite incentives to those of the

shareholders. In this case, you (as the CEO) have an incentive to potentially overpay for another

company (which would be damaging to your shareholders) because your pay and prestige will

improve.

1-12. 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.

1-13. 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 electronic

trading system) while the shares of a private corporation are not traded on a public exchange.

1-14. 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 side

of the trade, they make this difference.

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1-15. The following quote on Yahoo! Stock appeared on February 11, 2009, on Yahoo! Finance:

If you wanted to buy Yahoo!, what price would you pay? How much would you receive if you

wanted to sell Yahoo!?

You would buy at $12.54 and sell for $12.53.

Chapter 2

Introduction to Financial Statement

Analysis

2-1. What four financial statements can be found in a firm’s 10-K filing? What checks are there on

the accuracy of these statements?

In a firm’s 10-K filing, four financial statements can be found: the balance sheet, the income statement,

the statement of cash flows, and the statement of stockholders’ equity. Financial statements in form 10-

K are required to be audited by a neutral third party, who checks and ensures that the financial

statements are prepared 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 each

category, provide an example of the type of information they might be interested in and discuss

why.

Users of financial statements include present and potential investors, financial analysts, and other

interested 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 debt

payments. Stockholders use the statements to assess the firm’s profitability and ability to make future

dividend payments.

Financial analysts. Financial analysts gather financial information, analyze it, and make

recommendations. They read financial statements to determine a firm’s value and project future

earnings, so that they can provide guidance to businesses and individuals to help them with their

investment decisions.

Managers. Managers use financial statement to look at trends in their own business, and to compare

their own results with that of competitors.

2-3. Find the most recent financial statements for Starbucks’ corporation (SBUX) using the following

sources:

a. From the company’s Web site www.starbucks.com (Hint : Search for “investor relations.”)

b. From the SEC Web site www.sec.gov. (Hint : Search for company filings in the EDGAR

database.)

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 as

charts and key statistics.

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2-4. Consider the following potential events that might have occurred to Global Conglomerate on

December 30, 2009. For each one, indicate which line items in Global’s balance sheet would be

affected and by how much. Also indicate the change to Global’s book value of equity.

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 $10

million 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 flagship

product by over 50%.

f. A key competitor announces a radical new pricing policy that will drastically undercut

Global’s prices.

a. Long-term liabilities would decrease by $20 million, and cash would decrease by the same

amount. 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 would decrease by $5 million, and long-

term liabilities would increase by $5 million. There would be no change to the book value of

equity.

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 2008 to 2009

according to Table 2.1? Does this imply that the market price of Global’s shares increased in

2009? Explain.

Global Conglomerate’s book value of equity increased by $1 million from 2008 to 2009. An increase

in book value does not necessarily indicate an increase in Global’s share price. The market value of a

stock does not depend on the historical cost of the firm’s assets, but on investors’ expectation of the

firm’s future performance. There are many events that may affect Global’s future profitability, and

hence its share price, that do not show up on the balance sheet.

2-6. Use EDGAR to find Qualcomm’s 10K filing for 2009. From the balance sheet, answer the

following 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. $2,717 million (cash) and $8,352 million (short-term investments/marketable securities) for a total

of $11,069 million

b. $700 million

c. $27,445 million

d. 7,129 million, nothing

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e. $20,316 million

2-7. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the

following questions from their balance sheet:

a. How much cash did Peet’s have at the end of 2008?

b. What were Peet’s total assets?

c. What were Peet’s total liabilities? How much debt did Peet’s have?

d. What was the book value of Peet’s equity?

a. At the end of 2008, Peet’s had cash and cash equivalents of $4.719 million.

b. Peet’s total assets were $176.352 million.

c. Peet’s total liabilities were $32.445 million, and it had no debt.

d. The book value of Peet’s equity was $143.907 million.

2-8. In March 2005, General Electric (GE) had a book value of equity of $113 billion, 10.6 billion

shares outstanding, and a market price of $36 per share. GE also had cash of $13 billion, and

total debt of $370 billion. Four years later, in early 2009, GE had a book value of equity of $105

billion, 10.5 billion shares outstanding with a market price of $10.80 per share, cash of $48

billion, and total debt of $524 billion. Over this period, what was the change in GE’s

a. market capitalization?

b. market-to-book ratio?

c. book debt-equity ratio?

d. market debt-equity ratio?

e. enterprise value?

a. 2005 Market Capitalization: 10.6 billion shares x $36.00/share = $381.6 billion. 2009 Market

Capitalization: 10.5 billion shares x $10.80/share = $113.4. The change over the period is $113.4 –

$381.6 = -$268.2 billion.

b. 2005 Market-to-Book 381.6 3.38

113

==

. 2009 Market-to-Book 113.4 1.08

105

==

. The change over the

period is: 1.08 – 3.38 = -2.3.

c. 2005 Book Debt-to-Equity 370 3.27

113

==. 2009 Book Debt-to-Equity 524 4.99

105

==. The change

over the period is: 4.99 – 3.27 = 1.72.

d. 2005 Market Debt-to-Equity 370 0.97

381.6

==

. 2009 Market Debt-to-Equity 524 4.62

113.4

==

. The

change over the period is: 4.62 – 0.97 = 3.65.

e. 2005 Enterprise Value = $381.6 – 13 + 370 = $738.6 billion. 2009 Enterprise Value = $113.4 – 48

+ 524 = $589.4 billion. The change over the period is: $589.4 – 738.6 = – $149.2 billion.

2-9. In July 2007, Apple had cash of $7.12 billion, current assets of $18.75 billion, current liabilities of

$6.99 billion, and inventories of $0.25 billion.

a. What was Apple’s current ratio?

b. What was Apple’s quick ratio?

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c. In July 2007, Dell had a quick ratio of 1.25 and a current ratio of 1.30. What can you say

about the asset liquidity of Apple relative to Dell?

a. Apple’s current ratio 18.75 2.68

6.99

==

b. Apple’s quick ratio 18.75 0.25 2.65

6.99

−

==

c. Apple has significantly more liquid assets than Dell relative to current liabilities.

2-10. In November 2007, Abercrombie and Fitch (ANF) had a book equity of $1458 million, a price

per share of $75.01, and 86.67 million shares outstanding. At the same time, The Gap (GPS) had

a book equity of $5194 million, a share price of $20.09, and 798.22 million 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’s 75.01 86.67

market-to-book ratio 4.59

1,458

×

==

GPS’s 20.09 798.22

market-to-book ratio 3.09

5,194

×

==

b. The market values, in a relative sense, the outlook of Abercrombie and Fitch more favorably than

it does The Gap. For every dollar of equity invested in ANF, the market values that dollar today at

$4.59 versus $3.09 for a dollar invested in the GPS. Equity investors are willing to pay relatively

more today for shares of ANF than for GPS because they expect ANF to produce superior

performance in the future.

2-11. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the

following questions from the income statement:

a. What were Peet’s revenues for 2008? By what percentage did revenues grow from 2007?

b. What were Peet’s operating and net profit margin in 2008? How do they compare with its

margins in 2007?

c. What were Peet’s diluted earnings per share in 2008? What number of shares is this EPS

based on?

a. 284,822

Increase in revenues 1 14.23%

249,349

=−=

b. 11,606

Operating margin (2007) 4.66%

249,349

==

17,001

Operating margin (2008) 5.97%

284,822

==

8,377

Net profit margin (2007) 3.36%

249,349

==

11,165

N

et profit margin (2008) 3.92%

284,822

==

Both margins increased compared with the year before.

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c. The diluted earnings per share in 2008 was $0.80. The number of shares used in this calculation of

diluted EPS was 13.997 million.

2-12. Suppose that in 2010, Global launches an aggressive marketing campaign that boosts sales by

15%. However, their operating margin falls from 5.57% to 4.50%. Suppose that they have no

other income, interest expenses are unchanged, and taxes are the same percentage of pretax

income as in 2009.

a. What is Global’s EBIT in 2010?

b. What is Global’s income in 2010?

c. If Global’s P/E ratio and number of shares outstanding remains unchanged, what is Global’s

share price in 2010?

a. Revenues in 2009 = 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. 1.45

Share price = (P/E Ratio in 2005) × (EPS in 2006) = 25.2 × = $10.15

3.6

⎛⎞

⎜⎟

⎝⎠

2-13. Suppose a firm’s tax rate is 35%.

a. What effect would a $10 million operating expense have on this year’s earnings? What effect

would it have on next year’s earnings?

b. What effect would a $10 million capital expense have on this year’s earnings if the capital is

depreciated at a rate of $2 million per year for five years? What effect would it have on next

year’s earnings?

a. A $10 million operating expense would be immediately expensed, increasing operating expenses

by $10 million. This would lead to a reduction in taxes of 35% × $10 million = $3.5 million. Thus,