Solution Manual For Fundamentals of Financial Management, 15th Edition

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ContentsiiiSolution ManualContentsPrefaceAlternative Formats for the Introductory CoursevContents of the Instructor’s ManualvIntegrated CasesvPowerPointSlide ShowviComprehensive/SpreadsheetProblemsviiChapterSpreadsheet ModelsviiTextbook Companion WebsiteviiTest BankviiiMindTapviiiOrdering Ancillary MaterialsviiiConclusionixSampleCourse SyllabusxCourse SchedulexivAnswers to End-of-Chapter ProblemsxviChapter 1An Overviewof Financial Management1Chapter 2Financial Markets and Institutions7Chapter 3Financial Statements, Cash Flow, and Taxes23Chapter 4Analysis of Financial Statements49Chapter 5Time Value of Money81Chapter 6Interest Rates125Chapter 7Bonds and Their Valuation151Chapter 8Risk and Rates of Return189Chapter 9Stocks and Their Valuation225Chapter 10The Cost of Capital257Chapter 11The Basics of Capital Budgeting279Chapter 12Cash Flow Estimation and Risk Analysis319

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ivContentsChapter 13Real Options and Other Topics in Capital Budgeting367Chapter 14Capital Structure and Leverage385Chapter 15Distributions to Shareholders: Dividends andShare Repurchases421Chapter 16Working Capital Management447Chapter 17Financial Planning and Forecasting475Chapter 18Derivatives and Risk Management499Chapter 19Multinational Financial Management525Chapter20Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles553Chapter 21Mergers and Acquisitions583

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Chapter1:An Overview of Financial ManagementLearning Objectives1Chapter 1An Overview of Financial ManagementLearning ObjectivesAfter reading this chapter, students should be able todo the following:◆Explainthe role of finance and the different types of jobs in finance.◆Identifythe advantages and disadvantages of different forms of business organization.◆Explainthe links between stock price, intrinsic value,and executive compensation.◆Identifythe potential conflicts that arise within the firm between stockholders and managers andbetween stockholders and bondholders,and discussthe techniques that firms can use to mitigate thesepotential conflicts.◆Discussthe importance of business ethics and the consequences of unethical behavior.

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2Lecture SuggestionsChapter 1:An Overview of Financial ManagementLecture SuggestionsChapter 1 covers some important concepts, and discussing them in class can be interesting. However,students can read the chapter on their own, so it can be assigned but not covered in class.We spend the first day going over the syllabus and discussing grading and other mechanics relatingto the course. To the extent that time permits, we talk about the topics that will be covered in the courseand the structure of the book. We also discuss briefly the fact that it is assumed that managers try tomaximize stock prices, but that they may have other goals, hence that it is useful to tie executivecompensation to stockholder-oriented performance measures. If time permits, we think it’s worthwhile tospend at least a full day on the chapter. If not, we ask students to read it on their own, and to keep themhonest, we ask one or two questions about the material on the first exam.One point we emphasize in the first class is that students shouldprint a copy of thePowerPointslides for each chapter coveredandpurchasea financial calculator immediately, and bring both to classregularly. We also put copies of the various versions of our“Brief Calculator Manual,”which in about 12pages explains how to use the most popular calculators, in the copy center.Students will need to learnhow to use their calculatorsbeforetime value of money concepts are covered in Chapter 5. It is importantfor students to grasp these concepts early as many of the remaining chapters build on the TVM concepts.We are often asked what calculator students should buy. If they already have a financial calculatorthat can find IRRs, we tell them that it will do, but if they do not have one, we recommend either theHP-10BII+or 17BII+. Please see the“Lecture Suggestions”for Chapter5for more on calculators.DAYS ON CHAPTER: 1 OF 56DAYS (50-minute periods)

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Chapter 1: An Overview of Financial ManagementAnswers and Solutions3Answers to End-of-Chapter Questions1-1A firm’s intrinsic value is an estimate of a stock’s“true”value based on accurate risk and returndata. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor.From these definitions, you can see that a stock’s“true”long-run value is more closely related to itsintrinsic value rather than its current price.1-2Equilibrium is the situation where the actual market price equals the intrinsic value, so investors areindifferent between buyingandselling a stock. If a stock is in equilibrium then there is nofundamental imbalance, hence no pressure for a change in the stock’s price. At any given time,most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium.However, at times stock prices and equilibrium values are different, so stocks can be temporarilyundervalued or overvalued.Investor optimism and pessimism, along with imperfect knowledgeabout the true intrinsic value, leads to deviations between the actual prices and intrinsic values.1-3If the three intrinsic value estimates for Stock X were different,youwould have the mostconfidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and differentanalysts with different data and different views of the future will form different estimates of theintrinsic value for any given stock. However, a firm’s managers have the best information aboutthe company’s future prospects, so managers’estimates of intrinsic value are generally better thanthe estimates of outside investors.1-4If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there isno pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the twobe equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximizethe firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize theaverage price over the long run but not necessarily the current price at each point in time. So,stockholders in general would probably expect the firm’s market price to be under the intrinsicvalue—realizing that if management is doing its job that current price at any point in time wouldnot necessarily be maximized.However, the CEO would prefer that the market price be high—since it is the current price that he will receive when exercising his stock options. In addition, hewill be retiring after exercising those options, so there will be no repercussions to him (with respectto his job) if the market price drops—unless he did something illegal during his tenure as CEO.1-5The board of directors should set CEO compensation dependent on how well the firm performs.The compensation package should be sufficient to attract and retain the CEO but not go beyondwhat is needed. Compensation should be structured so that the CEO is rewarded on the basis ofthe stock’s performance over the long run, not the stock’s price on an option exercise date. Thismeans that options (or direct stock awards) should be phased in over a number of years so theCEO will have an incentive to keep the stock price high over time. If the intrinsic value could bemeasured in an objective and verifiable manner, then performance pay could be based on changesin intrinsic value. However, it is easier to measure the growth rate in reported profits than theintrinsic value, although reported profits can be manipulated through aggressive accountingprocedures and intrinsic value cannot be manipulated.Since intrinsic value is not observable,compensation must be based on the stock’s market price—but the price used should be an averageover time rather than on a specificdate.

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4Answers and SolutionsChapter 1:An Overview of Financial Management1-6Thedifferentforms of business organization are proprietorships, partnerships, corporations, andlimited liability corporations and partnerships. The advantages of the first two include the ease andlow cost of formation. The advantages of corporationsinclude limited liability, indefinite life, easeof ownership transfer, and access to capital markets.Limited liability companies and partnershipshave limited liability like corporations.The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital; (2)unlimited personal liability for business debts; and (3) limited life. The disadvantages of apartnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4)difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) doubletaxation of earnings and (2) setting up a corporation and filing required state and federal reports,which are complex and time-consuming.Among the disadvantagesof limited liability corporationsand partnershipsaredifficulty in raising capital andthecomplexity ofsettingthemup.1-7Stockholder wealth maximization is a long-run goal. Companies, and consequently thestockholders, prosper by management making decisions that will produce long-term earningsincreases. Actions that are continually shortsighted often“catch up”with a firm and, as a result, itmay find itself unable to compete effectively against its competitors. There has been much criticismin recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. autoindustry, which has been accused of continuing to build large“gas guzzler”automobiles becausethey had higher profit margins rather than retooling for smaller, more fuel-efficient models.1-8Useful motivational tools that will aid in aligning stockholders’and management’s interests include:(1) reasonable compensation packages, (2) direct intervention by shareholders, including firingmanagers who don’t perform well, and (3) the threat of takeover.The compensation package should be sufficient to attract and retain able managers but not gobeyond what is needed. Also, compensation packages should be structured so that managers arerewarded on the basis of the stock’s performance over the long run, not the stock’s price on anoption exercise date. This means that options (or direct stock awards) should be phased in over anumber of years so managers will have an incentive to keep the stock price high over time. Sinceintrinsic value is not observable, compensation must be based on the stock’s market price—but theprice used should be an average over time rather than on a specificdate.Stockholders can intervene directly with managers. Today, the majority of stock is owned byinstitutional investors and these institutional money managers have the clout to exerciseconsiderable influence over firms’operations. First, they can talk with managers and makesuggestions about how the business should be run. In effect, these institutional investors act aslobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of acompany’s stock for one year can sponsor a proposal that must be voted on at the annualstockholders’meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are clearly heard by topmanagement.If a firm’s stock is undervalued, then corporate raiders will see it to be a bargain and willattempt to capture the firm in a hostile takeover. If the raid is successful, the target’s executiveswill almost certainly be fired. This situation gives managers a strong incentive to take actions tomaximize their stock’s price.1-9a.Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping tocreate a more attractive community that will make it easier to hire a productive work force.This corporate philanthropy could be received by stockholders negatively, especially thosestockholders not living in its headquarters city. Stockholders are interested in actions thatmaximize share price, and if competing firms are not making similar contributions, the“cost”ofthis philanthropy has to be borne by someone—the stockholders. Thus, stock price coulddecrease.

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Chapter 1: An Overview of Financial ManagementAnswers and Solutions5b.Companies must make investments in the current period in order to generate future cash flows.Stockholders should be aware of this, and assuming a correct analysis has been performed,they should react positively to the decision. TheChineseplant is in this category.Capitalbudgeting is covered in depth inPart 4of the text. Assuming that the correct capital budgetinganalysis has been made, the stock price should increase in the future.c.U.S.Treasury bonds are considered safe investments, while common stocksare far more risky.If the company were to switch the emergency funds from Treasury bonds to stocks,stockholders should see this as increasing the firm’s risk because stock returns are notguaranteed—sometimes theyincreaseand sometimes theydecline. The firm might need thefunds when the prices of their investments were low and not have the needed emergencyfunds. Consequently, the firm’s stock price would probably fall.1-10a.No, TIAA-CREF is not an ordinary shareholder. Because it is one of the largest institutionalshareholders in the United States and it controlsmore than900billion in pension funds, itsvoice carries a lot of weight. This“shareholder”in effect consists of many individualshareholders whose pensions are invested with this group.b.For TIAA-CREF to be effective in wielding its weight, it must act as a coordinated unit. In orderto do this, the fund’s managers should solicit from the individual shareholders their“votes”onthe fund’s practices, and from those“votes”act on the majority’s wishes. In so doing, theindividual teachers whose pensions are invested in the fund have,in effect,determined thefund’s voting practices.1-11Earnings per share in the current year will decline due to the cost of the investment made in thecurrent year and no significant performance impact in the short run. However, the company’s stockprice should increase due to the significant cost savings expected in the future.1-12The board of directors should set CEO compensation dependent on how well the firm performs.The compensation package should be sufficient to attract and retain the CEO but not go beyondwhat is needed. Compensation should be structured so that the CEO is rewarded on the basis ofthe stock’s performance over the long run, not the stock’s price on an option exercise date. Thismeans that options (or direct stock awards) should be phased in over a number of years so theCEO will have an incentive to keep the stock price high over time. If the intrinsic value could bemeasured in an objective and verifiable manner, then performance pay could be based on changesin intrinsic value. Since intrinsic value is not observable, compensation must be based on thestock’s market price—but the price used should be an average over time rather than on a specificdate. The board should probably set the CEO’s compensation as a mix between a fixed salary andstock options. Theactions of thevice president of Company X would be different than if he wereCEO of some other company.1-13Setting the compensation policy for threedivision managers would be different than setting thecompensation policy for a CEO because performance of each of these managers could be moreeasily observed. For a CEO an award based on stock price performance makes sense, whilebasingthe compensation for division managers on stock price performancedoesn’t make sense. Each ofthe managers could still be given stock awards; however, rather than the award being based onstock price it could be determined from some observable measure like increasedgas output, oiloutput, etc.1-14a.The expected payoff to debtholders is $77 million. The expected payoff to stockholders is (0.5× $13 million + 0.5× $53 million) = $33 million. If management selects Project L, then the

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6Answers and SolutionsChapter 1:An Overview of Financial Managementfirm will have enough cash flow to fully pay debtholders the promised $77 million, regardless ofthe state of the economy.The stockholders receive the cash flows that are available after thedebtholders have been paid.b.The expected payoff to debtholders is (0.5 × $50 million + 0.5 × $77 million) = $63.5 million.The expected payoff to stockholders is (0.5 × 0 + 0.5 × $93) = $46.5 million. If managementselects Project H and the economy is weak, then the company will not have enough cash tofully pay off its debts. In this case, the debtholders would receive all of the available cash ($50million) and there will be nothing left over for the stockholders.If the economy is strong,there will be enough cash to fully payoff the debtholders and the stockholders will receive allthe remaining cash ($170 million–$77 million = $93 million).c.Thebondholderswould clearly prefer that the company select Project L, since it would givethem a higher cash flow and less risk.d.Even though Project L and Project Hhavethe same overall expected payoff, Project H shiftsthe distribution ofthefirm’s cash flow payoffs from debtholders to stockholders. So, in manyinstances, despite the higher risk, stockholders may prefer Project H because it provides themwith a significantly higher expected payoff.e.Bondholders attempt to protect themselves by including covenants in the bond agreementsthat limit firms’use of additional debt and constraining managers’actions (such as taking onrisky projects to the detriment of bondholders) in other ways.

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Chapter2: FinancialMarkets and InstitutionsLearning Objectives7Chapter 2FinancialMarkets and InstitutionsLearning ObjectivesAfter reading this chapter, students should be able todo the following:◆Identifythe different types of financial markets and financial institutions,andexplainhow thesemarkets and institutions enhance capital allocation.◆Explainhow the stock market operates,andlistthe distinctions between the different types of stockmarkets.◆Explainhow the stock market has performed in recent years.◆Discussthe importance of market efficiency,andexplainwhy some markets are more efficient thanothers.◆Develop a simple understanding of behavioral finance.

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8Lecture SuggestionsChapter2: FinancialMarkets and InstitutionsLecture SuggestionsChapter 2presents an overview of financial markets and institutions.Studentsdefinitelyhave an interest infinancial markets and institutions.We base our lecture on the integrated case. The case goessystematically through the key points in the chapter, and within a context that helps students see the realworld relevance of the material in the chapter.We ask the students to read the chapter, and also to “lookover” the case before class. However, our class consists of about 1,000 students, many of whom view thelecture on TV, so we cannot count on them to prepare for class. For this reason, we designed our lecturesto be useful to both prepared and unprepared students.Since we have easy access to computer projection equipment, we generally use thePowerPointslidesas the core of our lectures. Wemake theseslides available to our students, and westronglysuggestto our students that they print a copy of thePowerPointslides for the chapter and bring it to class. This willprovide them with a hard copy of our lecture, and they can take notes in the space provided. Students canthen concentrate on the lecture rather than on taking notes.We do not stick strictly to the slide show—we go to the board frequently to present somewhatdifferent examples, to help answer questions, and the like. We like the spontaneity and change of pacetrips to the board provide, and, of course, use of the board provides needed flexibility. Also, if we feel thatwe have covered a topic adequately at the board, we then click quickly through one or more slides.The lecture notes we take to class consist of our own marked-up copy of thePowerPointslides,with notes on the comments we want to say about each slide. If we want to bring up some current event,provide an additional example, or the like, we use post-it notes attached at the proper spot. Theadvantages of this system are (1) that we have a carefully structured lecture that is easy for us to prepare(now that we have it done) and for students to follow, and (2) that both we and the students always knowexactly where we are. The students also appreciate the fact that our lectures are closely coordinated withboth the text and our exams.The slides contain the essence of the solution to each part of the integrated case, but we alsoprovide more in-depth solutions in thisInstructor’s Manual. It is not essential, but you might find it usefulto read through the detailed solution. Also, we put a copy of the solution on reserve in the library forinterested students, but most find that they do not need it.Finally, we remind students again, at the startof the lecture on Chapter 2, that they should bring a printout of thePowerPointslides to class;otherwise,they will find it difficult to take notes.DAYS ON CHAPTER:2OF 56DAYS (50-minute periods)

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Chapter2: FinancialMarkets and InstitutionsAnswers and Solutions9Answers to End-of-Chapter Questions2-1The prices of goods and services must cover their costs. Costs include labor, materials, and capital.Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up(called a “spread”) for the financial intermediary that brings the saver and the borrower together.The more efficient the financial system, the lower the costs of intermediation, the lower the costs tothe borrower, and, hence, the lower the prices of goods and services to consumers.2-2In a well-functioning economy, capital will flow efficiently from those who supply capital to thosewho demand it.Thistransfer of capital can take place in three different ways:1.Direct transfers of moneyand securities occur when a business sells its stocks or bonds directlyto savers, without going through any type of financial institution. The business delivers itssecurities to savers, who,in turn,give the firm the money it needs.2.Transfers may also go through an investment bankthatunderwrites the issue. An underwriterserves as a middleman and facilitates the issuance of securities. The company sells its stocksor bonds to the investment bank, whichthensells these same securities to savers.Thebusinesses’ securities and the savers’ money merely “pass through” the investment bank.3.Transfers can also be made througha financial intermediary. Here the intermediary obtainsfunds from savers in exchange for its own securities. The intermediary uses this money to buyand hold businesses’ securities, while the savers hold the intermediary’s securities.Intermediaries literally create new forms of capital. The existence of intermediaries greatlyincreases the efficiency of money and capital markets.2-3A primary market is the market in which corporations raise capital by issuing new securities. Aninitial public offering(IPO)is a stock issue in which privately held firms go public. Therefore, anIPO would be an example of a primary market transaction.2-4A money market transaction occurs in the financial market in which funds are borrowed or loanedfor short periods (less than oneyear).A capital market transaction occurs in the financial market inwhich stocks and intermediate—or long-term debt (one year or longer)—are issued.a.A U.S. Treasury bill is an example of a money marketsecurity.b.Long-term corporate bonds are examples of capital marketsecurities.c.Common stocks are examples of capital marketsecurities.d.Preferred stocks are examples of capital marketsecurities.e.Dealer commercial paper is an example of a money marketsecurity.2-5If people lost faith in the safety of financial institutions, it would be difficult for firms to raise capital.Thus, capital investment would slow down, unemployment would rise, the output of goods andservices would fall, and, in general, our standard of living would decline.

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10Answers and SolutionsChapter2: FinancialMarkets and Institutions2-6Financial markets have experienced many changes during the last two decades. Technologicaladvances in computers and telecommunications, along with the globalization of banking andcommerce, have led to deregulation,whichhas increased competition throughout the world.As aresult, there aremore efficient, internationally linked markets,which arefar more complex thanwhatexisted a few years ago. While these developments have been largely positive, they havealso created problems for policy makers.With these concerns in mind, Congress and regulatorshave moved to reregulate parts of the financial sector following the recent financial crisis.Globalization has exposed the need for greater cooperation among regulators at theinternational level. Factors that complicate coordination include (1) the differentstructuresinnations’ banking and securities industries;(2) the trend toward financial services conglomerates,which obscures developments in various market segments;and (3)thereluctance of individualcountries to give up control over their national monetary policies.Still, regulators are unanimousabout the need to close the gaps in the supervision of worldwide markets.Another important trend in recent years has beentheincreased use of derivatives.The marketfor derivatives has grown faster than any other market in recent years, providinginvestorswithnew opportunities but also exposing them to new risks. Derivatives can be used either to reducerisks or to speculate.Derivatives should allow companies to better manage risk but it’s not clearwhether recent innovations have “increased or decreased the inherent stability of the financialsystem.”2-7The physical location exchanges are tangible entities.Each of the larger ones occupies its ownbuilding,allowsa limited number ofpeople to trade on its floor, and has an elected governingbody. A dealer market includesall facilities that are needed to conduct security transactions notconductedon the physical location exchanges.The dealer market system consists of(1) therelatively few dealers who hold inventories of these securities and who are said to “make a market”in these securities; (2) the thousands of brokers who act as agents in bringing the dealers togetherwith investors; and (3) the computers, terminals, and electronic networks that provide acommunication link between dealers and brokers.2-8The two leading stock markets today are the New York Stock Exchange(NYSE)and the Nasdaqstock market.The NYSE is a physical location exchange, while the Nasdaq is an electronic dealer-based market.2-9There is an “efficiency continuum,” with the market for some companies’ stocks being highlyefficient and the market for other stocks being highly inefficient. The key factor is the size of thecompany—the larger the firm, the more analysts tend to follow it and thus the faster newinformation is likely to be reflected in the stock’s price.Also, different companies communicatebetter with analysts and investors; and the better the communications, the more efficient themarket for the stock.Highly InefficientHighly EfficientSmall companies notfollowed by many analysts.Not much contact withinvestors.Large companies followedby many analysts. Goodcommunications withinvestors.

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Chapter2: FinancialMarkets and InstitutionsAnswers and Solutions112-10a.False; derivatives can be used either to reduce risks or to speculate.b.True; hedge fundshave large minimum investments and are marketed to institutions andindividuals with high net worths. Hedge funds take on risks that are considerably higher thanthat of an average individual stock or mutual fund.c.False; hedge funds are largelyunregulated because hedge funds target sophisticated investors.d.True; the NYSE is a physical location exchange with a tangible physical location that conductsauction markets in designated securities.e.False; a larger bid-ask spread means the dealer will realize a higher profit.

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12Integrated CaseChapter2: FinancialMarkets and InstitutionsIntegrated Case2-1Smyth Barry & CompanyFinancial Markets andInstitutionsAssume that you recently graduated with a degree in finance and have justreported to work as an investmentadviserat the brokerage firm of SmythBarry&Co. Your first assignment is to explain the nature of theU.S. financial marketstoMichelleVarga, a professional tennis player whorecently cameto theUnitedStates fromMexico. Varga is a highlyranked tennis player who expects to investsubstantial amounts of money through SmythBarry. She is very bright;therefore, she would like to understand in general terms what will happen to hermoney. Your boss has developed the following questions that you mustusetoexplain theU.S. financial system toVarga.A.What arethe three primary ways in which capital is transferredbetween savers and borrowers? Describe each one.Answer:[Show S2-1 throughS2-4here.] Transfers of capital can be made (1)by direct transfer of money and securities, (2) through an investmentbank, or (3) through a financial intermediary. In adirect transfer, abusiness sells its stocks or bonds directly to investors (savers),without going through any type of institution. The business borrowerreceives dollars from the savers, and the savers receive securities(bonds or stock) in return.If the transfer is made through aninvestment bank, theinvestment bank serves as a middleman. The business sells itssecurities to the investment bank, which in turn sells them to the

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Chapter2: FinancialMarkets and InstitutionsIntegrated Case13savers. Although the securities are sold twice, the two salesconstitute one complete transaction in the primary market.If the transfer is made through afinancial intermediary, saversinvest funds with the intermediary, which then issues its ownsecurities in exchange. Banks are one type of intermediary, receivingdollars from many small savers and then lending these dollars toborrowers to purchase homes, automobiles, vacations, and so on, andalso to businesses and government units. The savers receive acertificate of deposit or some other instrument in exchange for thefunds deposited with the bank. Mutual funds, insurance companies,and pension funds are other types of intermediaries.B.What is a market? Differentiate between the following types ofmarkets:physical assetmarketsversusfinancialassetmarkets, spotmarketsversusfutures markets, moneymarketsversuscapitalmarkets, primarymarketsversussecondary markets, and publicmarketsversusprivate markets.Answer:[ShowS2-5andS2-6here.] A market isa venue whereassetsarebought and sold. There are many different types of financial markets,each one dealing with a different type of financial asset, serving adifferent set of customers, or operating in a different part of thecountry. Financial markets differ from physical asset markets in thatreal, or tangible, assets such as machinery, real estate, andagricultural products are traded in the physical asset markets, butfinancial securities representingclaims on assetsare traded in thefinancial markets. Spot markets are markets in which assets arebought or sold for “on-the-spot” delivery, while futures markets aremarkets in which participants agree today to buy or sell an asset atsome future date.

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