CHAPTER 2

1. There is a conflict of interest between stockholders and managers. In theory, stockholders are
expected to exercise control over managers through the annual meeting or the board of
directors. In practice, why might these disciplinary mechanisms not work?

2. Stockholders can transfer wealth from bondholders through a variety of actions. How would
the following actions by stockholders transfer wealth from bondholders?
An increase in dividends
A leveraged buyout
Acquiring a risky business
How would bondholders protect themselves against these actions?

3. Stock prices are much too volatile for financial markets to be efficient. Comment.

4. Maximizing stock prices does not make sense because investors focus on short-term results
and not on the long-term consequences. Comment.

5. There are some corporate strategists who have suggested that firms focus on maximizing
market share rather than market prices. When might this strategy work, and when might it fail?

6. Antitakeover amendments can be in the best interests of stockholders. Under what

conditions is this likely to be true?

7. Companies outside the United States often have two classes of stock outstanding. One class
of shares is voting and is held by the incumbent managers of the firm. The other class is
nonvoting and represents the bulk of traded shares. What are the consequences for corporate
governance?

8. In recent years, top managers have been given large packages of options, giving them the
right to buy stock in the firm at a fixed price. Will these compensation schemes make managers
more responsive to stockholders? Why or why not? Are lenders to the firm affected by these
compensation schemes?

11. It is often argued that managers, when asked to maximize stock price, have to choose
between being socially responsible and carrying out their fiduciary duty. Do you agree? Can you
provide an example where social responsibility and firm value maximization go hand in hand?

12. Assume that you are advising a Turkish firm on corporate financial questions and that you
do not believe that the Turkish stock market is efficient. Would you recommend stock price
maximization as the objective? If not, what would you recommend?

13. It has been argued by some that convertible bonds (i.e., bonds that are convertible into
stock at the option of the bondholders) provide one form of protection against expropriation by
stockholders. On what is this argument based?

14. Societies attempt to keep private interests in line by legislating against behavior that might
create social costs (such as polluting the water). If the legislation is comprehensive enough,
does the problem of social costs cease to exist? Why or why not?

CHAPTER 3

1. The following table lists the stock prices for Microsoft from 1989 to 1998. The company did
not pay any dividends during the period
Estimate the average annual return you would have made on your investment.
Estimate the standard deviation and variance in annual returns.
If you were investing in Microsoft today, would you expect the historical standard deviations
and variances to continue to hold? Why or why not?

2. Unicom is a regulated utility serving Northern Illinois. The following table lists the stock prices
and dividends on Unicom from 1989 to 1998.

Estimate the average annual return you would have made on your investment.
Estimate the standard deviation and variance in annual returns.
If you were investing in Unicom today, would you expect the historical standard deviations and
variances to continue to hold? Why or why not?

3. The following table summarizes the annual returns you would have made on two
companies—Scientific Atlanta, a satellite and data equipment manufacturer, and AT&T, the
telecomm giant, from 1988 to 1998.

Estimate the average and standard deviation in annual returns in each company.
Estimate the covariance and correlation in returns between the two companies
Estimate the variance of a portfolio composed, in equal parts, of the two investments.

4. You are in a world where there are only two assets, gold and stocks. You are interested in
investing your money in one, the other, or both assets. Consequently, you collect the following
data on the returns on the two assets over the last six years.

If you were constrained to pick just one, which one would you choose?
A friend argues that this is wrong. He says that you are ignoring the big payoffs that you can get
on gold. How would you go about alleviating his concern?
How would a portfolio composed of equal proportions in gold and stocks do in terms of mean
and variance?
You now learn that GPEC (a cartel of gold-producing countries) is going to vary the amount of
gold it produces with stock prices in the United States. (GPEC will produce less gold when stock
markets are up and more when it is down.) What effect will this have on your portfolios?
Explain.

12. The following table lists returns on the market portfolio and on Microsoft, each year from
1989 to 1998.

Estimate the covariance in returns between Microsoft and the market portfolio.
Estimate the variances in returns on both investments.
Estimate the beta for Microsoft.

13. United Airlines has a beta of 1.50. The standard deviation in the market portfolio is 22% and
United Airlines has a standard deviation of 66%.
Estimate the correlation between United Airlines and the market portfolio.
What proportion of United Airlines' risk is market risk?

CHAPTER 4
1. In December 1995, Boise Cascade's stock had a beta of 0.95. The Treasury bill rate at the time
was 5.8%, and the Treasury bond rate was 6.4%. The firm had debt outstanding of $1.7 billion
and a market value of equity of $1.5 billion; the corporate marginal tax rate was 36%.
Estimate the expected return on the stock for a short-term investor in the company. (The
arithmetic average risk premium for stocks over T.Bills was 8.76% at the time of this
assessment)
Estimate the expected return on the stock for a long-term investor in the company.
Estimate the cost of equity for the company.

2. Boise Cascade also had debt outstanding of $1.7 billion and a market value of equity of $1.5
billion; the corporate marginal tax rate was 36%.
Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the unlevered
beta for the company.
How much of the risk in the company can be attributed to business risk and how much to
financial leverage risk?

3. Biogen, a biotechnology firm, had a beta of 1.70 in 1995. It had no debt outstanding at the
end of that year.
Estimate the cost of equity for Biogen, if the Treasury bond rate is 6.4%.
What effect will an increase in long-term bond rates to 7.5% have on Biogen's cost of equity?
How much of Biogen's risk can be attributed to business risk?

4. Genting Berhad is a Malaysian conglomerate with holdings in plantations and tourist resorts.
The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and the
long-term local currency risk free rate in Malaysia is 11.5%.
Estimate the expected return on the stock in the local currency.
If you were an international investor, what concerns (if any) would you have about using the
beta estimated relative to the Malaysian index? If you do, how would you modify the beta?

8. You are analyzing the beta for Hewlett Packard and have broken down the company into four
broad business groups, with market values and betas for each group.
Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the beta
estimated by regressing past returns on their stock against a market index. Why or why not?
If the Treasury bond rate is 7.5%, estimate the cost of equity for Hewlett Packard. Estimate the
cost of equity for each division. Which cost of equity would you use to value the printer
division?
Assume that HP divests itself of the mainframe business and pays the cash out as a dividend.
Estimate the beta for HP after the divestiture. (HP had $1 billion in debt outstanding.)

CHAPTER 5
1. You have been given the following information on a project:

It has a five-year lifetime

The initial investment in the project will be $25 million, and the investment will be depreciated
straight line, down to a salvage value of $10 million at the end of the fifth year.
The revenues are expected to be $20 million next year and to grow 10% a year after that for the
remaining four years.
The cost of goods sold, excluding depreciation, is expected to be 50% of revenues.
The tax rate is 40%.
Estimate the pretax return on capital, by year and on average, for the project.
Estimate the after-tax return on capital, by year and on average, for the project.
If the firm faced a cost of capital of 12%, should it take this project?

6. You are provided with the projected income statements for a project:
The tax rate is 40%.
The project required an initial investment of $15,000 and an additional investment of $2,000 at
the end of year 2.
The working capital is anticipated to be 10% of revenues, and the working capital investment
has to be made at the beginning of each period.
Estimate the free cash flow to the firm for each of the four years.
Estimate the payback period for investors in the firm.
Estimate the NPV to investors in the firm, if the cost of capital is 12%. Would you accept the
project?
Estimate the IRR to investors in the firm. Would you accept the project?

8. You are provided with the following cash flows on a project:

Year Operating (pre-debt) cash flows ($)

0 −10,000,000
1   4,000,000
2   5,000,000
3   6,000,000
Plot the net present value (NPV) profile for this project. What is the IRR? If this firm had a cost
of capital of 10% and a cost of equity of 15%, would you accept this project?
11. You are analyzing two mutually exclusive projects with the following cash flows:

Year A B
0 −$4,000,000 −$4,000,000
1  $2,000,000  $1,000,000
2  $1,500,000  $1,500,000
3  $1,250,000  $1,700,000
4  $1,000,000  $2,400,000
Estimate the NPV of each project, assuming a cost of capital of 10%. Which is the better
project?
Estimate the IRR for each project. Which is the better project?
What reinvestment rate assumptions are made by each of these rules? Can you show the effect
on future cash flows of these assumptions?
What is the MIRR on each of these projects?

12. You have a project that does not require an initial investment but has its expenses spread
over the life of the project. Can the IRR be estimated for this project? Why or why not?

13. Businesses with severe capital rationing constraints should use IRR more than NPV. Do you
agree? Explain.

14. You have to pick between three mutually exclusive projects with the following cash flows to
the firm:

Year Project A Project B Project C

0 −$10,000  $5,000 −$15,000
1    $8,000  $5,000   $10,000
2    $7,000 −$8,000   $10,000
The cost of capital is 12%.

Which project would you pick using the NPV rule?

Which project would you pick using the IRR rule?
How would you explain the differences between the two rules? Which one would you rely on to
make your choice?
15. You are analyzing an investment decision, in which you will have to make an initial
investment of $10 million and you will be generating annual cash flows to the firm of $2 million
every year, growing at 5% a year, forever.

Estimate the NPV of this project, if the cost of capital is 10%.

Estimate the IRR of this project.

16. You are analyzing a project with a thirty-year lifetime, with the following characteristics:

The project will require an initial investment of $20 million and additional investments of $5
million in year 10 and $5 million in year 20.
The project will generate earnings before interest and taxes of $3 million each year. (The tax rate
is 40%.)
The depreciation will amount to $500,000 each year, and the salvage value of the equipment
will be equal to the remaining book value at the end of year 30.
The cost of capital is 12.5%.
Estimate the NPV of this project.
Estimate the IRR on this project. What might be some of the problems in estimating the IRR for
this project?

18. Barring the case of multiple IRRs, is it possible for the NPV of a project to be positive while
the IRR is less than the discount rate? Explain.

19. You are helping a manufacturing firm decide whether it should invest in a new plant. The
initial investment is expected to be $50 million, and the plant is expected to generate after-tax
cash flows of $5 million a year for the next twenty years. There will be an additional investment
of $20 million needed to upgrade the plant in ten years. If the discount rate is 10%,

Estimate the NPV of the project.

Prepare an NPV Profile for this project.
Estimate the IRR for this project. Is there any aspect of the cash flows that may prove to be a
problem for calculating IRR?

CHAPTER 6
1. A small manufacturing firm, which has limited access to capital, has a capital rationing
constraint of $150 million and is faced with the following investment projects (numbers in
millions):

Which of these projects would you accept? Why?

What is the cost of the capital rationing constraint?

3. You own a rental building in the city and are interested in replacing the heating system. You
are faced with the following alternatives:

A solar heating system, which will cost $12,000 to install and $500 a year to run and will last
forever (assume that your building will, too).
A gas heating system, which will cost $5,000 to install and 1,000 a year to run and will last 20
years.
An oil heating system, which will cost $3,500 to install and $1,200 a year to run and will last 15
years.
If your opportunity cost is 10%, which of these three options is best for you?

4. You are trying to choose a new siding for your house. A salesman offers you two choices:

Wood siding, which will last 10 years and cost $5,000 to install and $1,000/year to maintain.
Aluminum siding, which will last forever, cost $15,000 to install, and will have a lower
maintenance cost per year.
If your discount rate is 10%, how low would your maintenance costs on the aluminium siding
have to be for you to choose the aluminum siding?

5. You have just been approached by a magazine with an offer for renewing your subscription.
You can renew for one year at $20, two years for $36, or three years at $45. Assuming that you
have an opportunity cost of 20% and the cost of a subscription will not change over time, which
of these three options should you choose?

8. You are helping a bookstore decide whether it should open a coffee shop on the premises.
The details of the investment are as follows:

The coffee shop will cost $50,000 to open; it will have a five-year life and be depreciated
straight line over the period to a salvage value of $10,000.
The sales at the shop are expected to be $15,000 in the first year and grow 5% a year for the
following four years.
The operating expenses will be 50% of revenues.
The tax rate is 40%.
The coffee shop is expected to generate additional sales of $20,000 next year for the book shop,
and the pretax operating margin on book sales is 40%. These sales will grow 10% a year for the
following four years.
Estimate the NPV of the coffee shop without the additional book sales.
Estimate the present value of the cash flows accruing from the additional book sales.
Would you open the coffee shop?
10. You are a small business owner considering two alternatives for your phone system.

12. You are the manager of a pharmaceutical company and are considering what type of laptop
computers to buy for your salespeople to take with them on their calls.

You can buy fairly inexpensive (and less powerful) older machines for about $2,000 each. These
machines will be obsolete in three years and are expected to have an annual maintenance cost
of $150.
You can buy newer and more powerful laptops for about $4,000 each. These machines will last
five years and are expected to have an annual maintenance cost of $50.
If your cost of capital is 12%, which option would you pick and why?