Case 1: Insider Trading

Ethics: Insider Trading over the Internet

You don't have to be a member of the Board of Directors to engage in illegal insider trading. John J.
Freeman, a part-time temporary word processor at two investment houses, learned all he needed to
know from the desks of co-workers, garbage cans, and from making copies of documents that
discussed impending mergers and acquisitions. Even though the documents referred to the companies
involved by code, Freeman was able to learn their true identity by piecing together their industry,
historical stock prices, names of officers, and geographic location.

Once Freeman knew who and when, he disseminated the information to friends, family, and anyone
who would listen via an Internet chat room under the name "TheBren." What Freeman did not know is
that among his many listeners were members of the Securities and Exchange Commission (SEC), the
FBI, and federal prosecutors. In fact, at any given time, 100 specially trained SEC employees are
surfing the Net, visiting chat rooms, and reading message boards looking for illegal inside traders.
When they identify a red flag, they forward the information to the Office of Internet Enforcement, a
special division of the SEC who helps build cases to pursue criminal charges and/or civil lawsuits.

The SEC is not the only surveillance group out in cyberspace. The exchanges monitor trading activity
as well. In fact, the American Stock Exchange was the organization who originally identified a problem
when they noticed unusual trading patterns prior to the public announcement of these mergers and
acquisitions. Once the SEC was notified, it was only a matter of time.

Freeman directly told at least 10 people, but as with any valuable secret, the information spread like
wildfire. A friend of Freeman's, a waiter at a New York restaurant, made over $285,000. He told a
patron who profited by at least $445,000, which was certainly more than he earned in his former
career as a school teacher.

While his friends made millions of dollars, Freeman was more conservative and profited by only
$70,000-$110,000, plus various non-pecuniary benefits such as cases of wine. This seems to be a
small gain given the hefty fines and prison time that is certain to follow.

It seems the Internet is affecting the stock market in all sorts of ways, both good and bad. It remains
to be seen if the perceived anonymity of the Internet acts as a breeding ground for the conveying of
private corporate information. One thing is for certain, however, the SEC is readying themselves by
continual efforts and manpower devoted to policing cyberspace.

Questions

1. What is the definition of non-public, or private, information?

2. Who can come into contact with private, or inside, information?
3. When does private corporate information turn into illegal insider trading?
4. Why is the Internet such a high potential breeding ground for inside information?
5. What should you do if you learn of inside information?
Case 2: The Tobacco Industry
Special Management Topics: Ethics

Cigarettes have long been known to cause cancer, lung diseases, and other related illnesses, but until
recently, only minor steps have been taken to prevent this pernicious habit from reaching those who
do not smoke. The government is strongly considering a ban on smoking in the work place. Offices,
restaurants, sporting events, casinos, bars, and even construction sites are included in this definition
of "work place."

It has been argued that placing a ban on smoking in the work place will result in millions of dollars in
savings by businesses through a lower rate of absenteeism, higher productivity, and an overall
healthier work force. For those businesses that insist on providing on-site smoking facilities, smoking
rooms would have to be established with ventilation systems separate from the rest of the building.

Small firms have already complained that this would be detrimental to them due to the costs involved
with installing such systems. Smokers argue that the necessity for smoking rooms would be so costly
to businesses that they would find it too expensive to hire smokers. Thus, discrimination is also a key
issue.

The Food and Drug Administration (FDA) has also voiced complaints against the tobacco industry.
Specifically, they accused the tobacco industry of increasing the amount of nicotine, a highly addictive
narcotic, in its cigarettes. By increasing nicotine levels, tobacco firms are able to keep existing
smokers addicted, while increasing their chances of hooking first time smokers.

The tobacco industry has retaliated by stating they have not altered natural nicotine levels. Further,
although the removal of nicotine is scientifically possible, just as caffeine can be removed from coffee,
the industry refuses to reduce levels because nicotine gives cigarettes its flavor and feel.

The FDA refuses to believe that tobacco companies do not boost nicotine levels. They cite three
disturbing facts that support this contention. First, the tobacco industry has known through research
conducted by its own scientists that nicotine causes cancer. This fact provides the tobacco industry's
motive. Second, the tobacco industry holds several U.S. patents on technology that controls the
amount of nicotine in cigarettes. Why would the tobacco industry spend millions of research and
development dollars to develop technology that it did not intend to use? Finally, even the cigarettes
that the industry claims are low in nicotine are still at levels that can induce addiction in the majority
of smokers.

It's only a matter of time before we find out which party is telling the truth. Meanwhile, the smoking
ban becomes more and more realistic and within the next few years many experts feel that it will be in
effect across the entire country.

Questions

1. The Surgeon General has long since declared that cigarettes are hazardous to people's health.
Since this is common knowledge, is it unethical for the tobacco industry to increase the level
of nicotine in their cigarettes without informing consumers?
2. Is it unethical for the tobacco industry to increase the level of nicotine in their cigarettes if
they do inform consumers?
3. If the tobacco industry decided voluntarily or otherwise to convey to consumers that nicotine
levels are higher in a particular brand of cigarette, how should the message be conveyed?
That is, is a fine print warning on the side of a pack of cigarettes ample warning?
4. Do you feel that the ban on smoking in all work places, such as those listed in the case,
violates the civil rights of smokers? Does smoking in the work place violate the civil rights of
non-smokers?
5. What can the government do to protect or help defray the costs of establishing smoke rooms
in the work place for small businesses that cannot afford to install ventilation systems?
6. It can be argued that if the ban is implemented, businesses will find the costs associated with
hiring smokers (due to having to establish smoke rooms) outweigh the benefits. What can the
government do to prevent or mitigate the discrimination law suits that might result from a
firm's hesitation to hire a smoker after the ban is implemented?
Case 3: Connect Cable Contractors
Entrepreneurial Decision Making

Caldwell Cable Company is responsible for providing and maintaining cable services to Lexington
County in South Carolina. To reduce expenses and remove the burden of providing insurance and
company vehicles, Caldwell Cable hires outside contractors to perform installations and initial
connection of cable service. Every three years the cable contract expires and anyone can submit a
closed-bid in an attempt to get the contract.

Until recently, P&R Cable, owned by Bob Martin, held the contract. Five years ago, Bob promoted an
installer from within the company, named Steve Seiler, to run the business. Since then, Steve has
taken on full responsibilities at P&R. On March 15, the contract came up for bid again. Over-burdened
by the additional responsibilities and displeased with Bob's unwillingness to share in the profits of P&R,
Steve decided to submit a closed bid under the company name "Connect Cable Contractors." Connect
Cable underbid P&R by 2% (This figure was discovered later when all the bids became public record
after the contract was awarded). This, coupled with Caldwell Cable's preference for working with
Steve, caused Caldwell to award the contract to Connect Cable.

Steve now faced several new obstacles. In the course of complying with industry regulations, Steve
found that Bob's treatment of worker's compensation was not in compliance with IRS regulations.
Under the previous contract, Bob had passed on worker's compensation premiums to his three sub-
contractors by deducting 12% from their gross weekly paycheck. By law, Bob should have paid a fixed
amount of approximately $6,000 a year. This amount is the responsibility of P&R, not of each sub-
contractor.

Steve now has to pay the $6,000 at the beginning of the year and cannot pass on the charges to his
sub-contractors. Each sub-contractor is paid on a per job basis and Steve is given an override on each
job. Exhibit 1 lists the various jobs that can be performed and the amount both Steve and his sub-
contractors earned under the previous contract.

Exhibit 1
Various jobs that can be performed and the price Bob paid for each
under the previous contract
Type of job Bob's price
Overhead Install $14.50
Underground Install $14.50
A/O(unwired-w/) $5.50
A/O( wired-w/) $5.50
VCR (w/ install) $1.50
Long Drop $10.00
Replace Drop $14.50
Relocate; A/O Only:
Wired $10.00
Unwired $10.00
Reconnect $10.50
VCR (w/ reconnect) $1.50
VCR Hook-Up Only $6.50
Upgrades $6.50
 Trip Charge $5.00

With the removal of the 12% charge, the current amounts that are paid to sub-contractors per job are
too high. Therefore, Steve must decide on a new level of prices to pay each person per job. His goal is
to pay the sub-contractors more, in real terms, but less in nominal terms. For example, if Steve
reduces the pay on a job by exactly 12%, this would be a decrease of 12% in nominal terms, but no
change in pay in real terms because the 12% decrease is offset by the sub-contractors not having to
pay 12% for worker's compensation. Steve would prefer to give them a raise of between 7%-8%,
in real terms.

Furthermore, Bob's old prices are not commensurate with the level of difficulty each job entails. For
example, "replacing a drop" is much easier than completely installing cable in a house for the first
time, yet both jobs pay the same amount. This disparity in prices relative to the amount of time
required to complete a job causes low morale and overall dissatisfaction. Steve, therefore, must
revamp the pricing structure to reflect the level of time each job requires and include an increase
in real pay of approximately 7%-8%.

The previous prices are consistent relative to each other with the following exceptions. First, overhead
and underground installations are priced the same as replacing a drop. Because understanding the
differences between the three requires a great familiarity with the cable industry, the analysis will be
simplified by informing the reader that overhead installations require the most time, followed by
underground installations, then finally replacing the drop. For this reason, Steve would like to pay a
higher price for overhead installations, a lower price for underground installations, and an even lower
price for replacing a drop. These prices should be altered only slightly as all three are still more time
consuming than a basic reconnect.

Second, the previous price structure paid the same amount for installing an additional cable outlet
whether or not the outlet was already wired (Exhibit 1, lines 3 and 4. Also lines 8a and 8b.). From a
sub-contractor's standpoint, installing cable wire for an additional outlet is not worth the small amount
of revenue received, whereas activating an existing line is very quick and easy. Since both jobs paid
the same amount, many sub-contractors avoided installing unwired outlets. This caused Bob to lose
revenue. Steve knew that something had to be done to entice sub-contractors to promote the
installation of additional outlets. After deciding on the new prices, Steve wishes to demonstrate to his
employees that in real terms, they will be better off.

To show the resulting increases in real income, Steve asked each sub-contractor for a copy of their
invoices since the "time window" system was initiated in January of this year. Steve felt that using
records prior to January would be misleading since the time windows have caused a permanent
decrease in everyone's income. Due to constraints, such as incompletely kept records and Bob's
unwillingness to provide official records, Steve was able to gather only five weeks of records for one
sub-contractor named Burt. A second sub-contractor, Chris, provided Steve with nineteen weeks of
financial records; Steve kept all twenty weeks worth of records on himself. From this data, Steve
calculated a weekly average of the number of each job performed by each sub-contractor, including
himself. These weekly averages are shown in Exhibit 2.

Exhibit 2
Weekly averages of the number and type of job performed by each
sub-contractor from January 1995 to the first week in March 1995
Steve's average number of Burt's average number of Chris' average number of
Type of job
each job per week each job per week each job per week
Overhead Install 5.5 11.8 8.1
Underground Install 6.9 1.6 7.6
A/O(unwired-w/) 17.8 17.6 18.5
A/O( wired-w/) 20.3 11.6 9.9
VCR (w/ install) 9.2 11.6 11.9
Long Drop 2.1 4.6 3.7
Replace Drop 3.0 2.8 0.9
Relocate; A/O Only:
Wired 2.0 0.4 0.8
Unwired 7.8 3.4 8.4
Reconnect 9.9 6.8 7.2
VCR (w/ reconnect) 9.9 2.8 3.8
VCR Hook-Up Only 0.0 0.0 0.0
Upgrades 1.0 1.0 1.0
Trip Charge 0.5 1.2 2.4

Put yourself in Steve's position. What are the new prices you will pay to make the amount of time that
each job requires commensurate with the amount of money the sub-contractors receive, and at the
same time provide the sub-contractors with an increase in real income of approximately 7%-8%? As
you perform the analysis and answer the following questions, remember that Steve's employees will
surely ask you to explain the assumptions you have made and where the calculations came from.
Keep in mind that the purpose of the new pricing structure is to benefit the employees as well as
Steve and to allow for a smooth transition in the transfer of the contract from Bob to Steve.

Questions

1. Complete the following table. Be sure to reflect both adjustments for the time required to do
different jobs and a 7%-8% increase in REAL pay for each sub-contractor.

Table 1
Calculations Worksheet for New Prices
(1) (2) (3) = {[(2-1)(1-.12)]/ (1)(1-.12)}*100
Type of job Bob's price Steve's price Percentage increase in pay
Overhead Install
Underground Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O Only:
Wired
Unwired
Reconnect
VCR (w/ reconnect)
VCR Hook-Up Only
 Upgrades
Trip Charge
2. How much did Chris and Burt earn under Bob's old pricing per week?
3. How much more will they earn per week under Steve's new system?

Table 2
Calculations Worksheet for Increases in Weekly Earnings
Under the New Pricing System for Chris
Average number of each job Dollar increase in pay Total dollar increase in pay per
Type of job per week per job type of job
Overhead Install
Underground
Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O
Only:
Wired
Unwired
Reconnect
VCR (w/
reconnect)
VCR Hook-Up
Only
Upgrades
Trip Charge
Table 3
Calculations Worksheet for Increases in Weekly Earnings
Under the New Pricing System for Burt
Average number of each job Dollar increase in pay Total dollar increase in pay per
Type of job per week per job type of job
Overhead Install
Underground
Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O
Only:
Wired
Unwired
Reconnect
VCR (w/
reconnect)
VCR Hook-Up
Only
Upgrades
Trip Charge
4. How much MORE will EACH sub-contractor earn under the new pricing structure per year?
5. In question 3, you assumed that they will work the same number of each job in each of the 52
weeks throughout the year. How valid of an assumption is this? Is the assumption just as valid
for each sub-contractor? Explain.
6. Based on your results from Question 2, can Steve hire another sub-contractor to help cope
with the new time windows without cutting into the existing contractor's income too much?
Explain.
7. The entire analysis is based on using data that dates back only to January of this year. What
are the advantages and disadvantages of using such a period in the case?
8. In addition to the steps suggested in the case, what else can Steve do to increase his chances
of renewing the contract three years from now? This may be the most important question in
the case!

Case 4: Tyson Foods, Inc.

Financial Statement Construction: The Balance Sheet

Tyson is a worldwide provider of various food products such as chicken, beef, pork, and prepared
foods. The company felt that recent positive performance was due primarily to their focus on the
"home-meal replacement" market segment. For years the traditional family unit has undergone
tremendous change. The "typical" American household no longer consists of a working father and a
stay-at-home housewife mother who prepares four course meals for the family (which includes 2.4
children).

Today, there is no one definition of a "family" or "household." Phrases used to describe life today
include, duel family incomes, fast-food takeout, microwave cooking, etc. People just don't seem to
have the time or are not willing to make the time to cook at home the way they used
to. Forbes Magazine reports that a decade ago 70% of all purchases from the grocery store were for
ingredients used to make meals in the home. Today, only 47 cents out of every dollar are spent on
ingredients. What then are people spending their money on at the grocery store? They're buying
meals that are prepared someplace else and only need to be heated up. The food industry refers to
this as ready-to-cook or ready-to-eat meals. Examples include frozen pizzas, deli sandwiches, canned
soup, frozen dinners, chicken pot pies, frozen sausage biscuits, and the list goes on and on. Industry
experts predict this trend will continue for the foreseeable future. In fact, they say that within the next
ten years, this market segment will represent over two-thirds of all grocery store purchases.

Even in these exciting times of high earnings, Tyson must be sure to keep track of their accounting.
Below is a list of all the items found on their Balance Sheet. Reconstruct Tyson's Balance Sheet by
arranging the items in their correct order.

Tyson's Balance Sheet items in Alphabetical Dollar amount in millions (except per share
Order data)
Accounts receivable 1,240
Accumulated other comprehensive loss (12)
Assets
Capital in excess of par value 1,849
Cash and cash equivalents 33
Current assets
Current debt 338
Current liabilities:
Deferred income taxes 695
Goodwill 2,558
Intangible assets 149
Inventories 2,063
Less treasury stock 264
Less unamortized deferred compensation 46
Liabilities and Shareholder's Equity
Long-term debt 3,024
Net property, plant and equipment 3,964
Other assets 261
Other current assets 196
 Other current liabilities 1,010
Other liabilities 160
Retained earnings 2,728
Shareholder's equity:
Class-A common stock 27
Class-B common stock 10
Total assets 10,464
Total current assets 3,532
Total current liabilities 2,293
Total liabilities and shareholder's equity 10,464
Total shareholder's equity 4,292
Trade accounts payable 945

Case 5: Chrysler
Ratio Analysis

Before Chysler merged to become DaimlerChrysler AG, they were presented with a takeover bid of
$55 per share by MGM billionaire Kirk Kerkorian and former Chrysler chairman Lee Iacocca. Kirk
Kerkorian was a stockholder in Chrysler and an experienced takeover financier who apparently found
Chrysler to be a good buy. Chrysler rejected the offer, however, stating that the firm was not for sale.
Further, many Wall Street experts felt that Kerkorian could not come up with the $20 billion necessary
to complete the deal.

After Chrysler rejected Kirk Kerkorian's bid of $55 per share, Kerkorian decided to have his people
repeat the analysis of the firm's financial performance over the two most recent years to determine if
he should increase his bid in this friendly takeover attempt. To measure the financial performance of
Chrysler over the past two years, key financial ratios will have to be computed and compared with
industry averages. To help in this endeavor, Chrysler's financial statements are found on the following
pages.

Chrysler Corporation's Balance Sheet

for the year ending December 31 (in millions)
This Last
year year
Assets
Current Assets
Cash and cash equivalents $ 5,543 $ 5,145
Marketable securities $ 2,582 $ 3,226
Accounts receivable $ 2,003 $ 1,695
Inventories $ 4,448 $ 3,356
Prepaid taxes $ 985 $ 1,330
Finance receivables $13,623 $12,433
Total Current Assets $29,184 $27,185
Property & equipment $20,468 $18,281
Less: Accumulated Depreciation $ 7,873 $ 7,208
Net Plant & Equipment $12,595 $11,073
Other Assets
Special tools $ 3,566 $ 3,643
Intangible assets $ 2,082 $ 2,162
Deferred tax assets $ 490 $ 395
Other assets $ 5,839 $ 5,081
Total Assets $53,756 $49,539

Liabilities
Current Liabilities
Accounts payable $ 8,290 $ 7,826
Short-term debt $ 2,674 $ 4,645
Accrued liabilities $ 7,032 $ 5,582
Other payments $ 1,661 $ 811
Total Current Liabilities $19,657 $18,864
Long-term Liabilities
Long-term debt $ 9,858 $ 7,650
Accrued employee benefits $ 9,217 $ 8,595
 Other non-current liabilities $ 4,065 $ 3,736
Total Long-term Liabilities $23,140 $19,981
Total Liabilities $42,797 $38,845

Stockholder's Equity
Preferred stock $ 0 $ 2
Common stock (at $1 par) $ 408 $ 364
Additional paid-in capital $ 5,506 $ 5,536
Retained earnings $ 6,280 $ 5,006
Treasury stock ($1,235) ($ 214)
Total Shareholder's Equity $10,959 $10,694

Total Liabilities and Share. Equity $53,756 $49,539

Chrysler Corporation's Income Statement
for the year ending December 31, (in millions)
This Last
year year
Sales revenue $53,195 $52,235
Less: Cost of goods sold $41,304 $38,032
Gross profits $11,891 $14,203
Less: Operating expenses
Selling & admin. $4,064 $3,933
Pension $ 405 $ 714
Nonpension post ret. $ 758 $ 834
Depreciation $1,100 $ 994
Amort. of tools $1,120 $ 961
Total operating expenses $ 7,447 $ 7,436
Operating profits $ 4,444 $ 6,767
Less: Interest expenses $ 995 $ 937
Net profit before taxes $ 3,449 $ 5,830
Less: Taxes (40%) $ 1,380 $ 2,332
Net profit after taxes $ 2,069 $ 3,498
Industry Average Financial ratios this year and last year
This Last
year year
Liquidity
Net Working Capital $5,056 $4,892
Current Ratio 1.78 1.69
Quick Ratio (Acid Test) 1.55 1.51

Activity
Inventory Turnover 7.41 7.58
Average Age of Inventory .021 .021
Average Collection Period 22.8 23.4
Fixed Asset Turnover 1.54 1.62
Total Asset Turnover .89 .91
Debt
Debt 75% 77%
Times Interest Earned 6.4 7.0

Profitability
Gross Profit Margin 24% 28%
Net Profit Margin 4.7% 4.9%
Return on Total Assets 4.6% 4.7%
Return on Equity 20.7% 33.8%

Questions

1. Compute Chrysler's financial ratios for the past two years.

2. Compare these ratios to the industry's average. Comment on Chrysler's strengths and
weaknesses by ratio category.
3. Should Kerkorian have pursued the purchase of Chrysler?
4. If Kerkorian did not want to takeover Chrysler, what other reasons might he have had for
trying to convince other people that Chrysler was a takeover candidate?
Case 6: Moog
Financial Statement Construction: Consolidated Statement of Earnings

The future of military warfare is being defined by innovations and advancements in technology. For
example, Moog, Inc., has recently seen their flight control device installed in the V-22 Osprey, a wing-
folding aircraft that is effectively both a helicopter and a fighter plane.

But this is just the tip of the iceberg. Moog is in the process of creating technology that will allow
unmanned vehicles and airplanes to be operated by remote control. Sound like futuristic science
fiction? It really is not that far away. Think about the advantages of flying from a remote location.
Today, it costs millions of dollars to train a single fighter pilot. When the pilot is lost in a war, a new
pilot must be trained in his place. However, if the pilot is flying the plane from a remote, safe location,
even when the plane is lost in a battle, the pilot will survive to flying again.

Advancements are taking place in artillery as well. You may have heard of the expression, "I've got a
bullet with your name on it." Well, this may be more true than you realize. Smart bullets are being
developed that use the same technology as a guided missile. Instead of locking on a stationary target
many miles away, this bullet will receive continually updated target location information that will
enable it to follow a moving target even if that target goes around corners.

No matter how good Moog's technology, they still need to construct their Consolidated Statement of
Earnings to continue to be a successful company. Below is an alphabetical list of the items that appear
on their Consolidated Statement of Earnings. Using these items, reconstruct the statement by putting
all of the items in the correct order. Double check your answer to make sure the numbers add up.

Items on the Consolidated Statement of Earnings

Cost of Sales $652,447
Earnings Before Income Taxes $83,469
Income Taxes $26,182
Interest $11,080
Gross Profit $286,405
Net Earnings $57,287
Net Earnings Per Share
Basic $2.21
Diluted $2.17
Net Sales $938,852
Other $750
Research and Development $29,729
Selling, general and administrative $161,377
Case 7: Kate Myers
Basic Concepts: The Time Value of Money

After graduating from Ohio State University with a degree in Finance, Kate Myers took a position as a
stock broker with Merrill Lynch in Cleveland. Although she had several college loans to make
payments on, her goal was to set aside funds for the next eight years in order to make a down
payment on a house. After considering the various suburbs of Cleveland, Kate chose Lakewood as her
desired future residency. Based on median house price data, she learned that a three-bedroom, two-
bath house currently costs $98,000. To avoid paying Private Mortgage Insurance (PMI), Kate wanted
to make a down payment of 20%.

Because it will be eight years before Kate buys a house, the $98,000 price will surely not be the same
in the future. To estimate the rate at which the median house price will increase, she considered the
historical price appreciation in Lakewood. In the past, homes appreciated by nearly 4% per annum.
Kate was satisfied with this estimation.

Merrill Lynch provides several opportunities for Kate to invest the funds that will be devoted to the
purchase of her future home. She feels that a balanced account containing stocks, bonds, and
government securities would realistically achieve an annual rate of return of 8%.

Questions

1. Taking into consideration the fact that the $98,000 home price will grow at 4% per year, what
will be the future median home selling price in Lakewood in eight years? What amount will
Kate Myers have to accumulate as a down payment if she does decide to buy a house in
Lakewood?
2. Based on your answer from number 1, how much will have to be deposited into the Merrill
Lynch account (which earns 8% per year) at the end of each month to accumulate the
required down payment?
3. If Kate decides to make end-of-the-year deposits into the Merrill Lynch account, how much
would these deposits be? Why is this amount greater than twelve times the monthly payment
amount?
4. If homes in Lakewood appreciate by 6% per annum over the next eight years instead of the
assumed 4%, how much would Kate have to deposit at the end of each month to make the
down payment? What if the appreciation is only 2% per year?
5. If Kate decided to deposit her down payment funds in less risky certificates of deposit (CDs)
earning only 4%, how much would she have to deposit at the end of each month to make the
down payment? What if she pursued a more risky investment of growth stocks that have an
expected return of 12%?
Case 8: Quilici Family
Basic Concepts: The Time Value of Money

Greg and Debra Quilici own a four bedroom home in an affluent neighborhood just north of San
Francisco, California. Greg is a partner in the family owned commercial painting business. Debra now
stays home with their child, Brady, who is age 5. Until recently, the Quilicis have felt very comfortable
with their financial position.

After visiting Lawrence Krause, a family financial planner, the couple became concerned that they
were spending too much and not putting enough funds aside for both their child's future education
needs and their own retirement. Greg earns $85,000 per year, but with the rising costs of education,
their past contribution efforts have left them short of their financial goals.

To estimate the amount of money the Quilicis need to begin putting away for future security some
general information was obtained by their financial planner. The couple felt that the amount of money
they currently contribute to their Koegh plan would be sufficient for their retirement needs. What they
had not accounted for was Brady's education.

Greg is an alumni of Stanford University, a private school with an extremely high tuition of
approximately $20,000 per year. Debra graduated from the University of North Carolina at Chapel Hill.
The tuition expense there is only $2,500 per year. When Brady turns 18, the couple wishes to send
him to either of these exceptional universities. They have a slight preference for the much more local
Stanford University. The problem, however, is that with the rate at which tuition is increasing the
Quilicis are not sure they can raise enough money.

To assist in the calculations, assume the tuition at both universities will increase at an annual rate of
5%. Living expenses are currently estimated at $6,000 per year at both schools. This expense is
expected to grow at only 3% per year. Further assume the Quilicis can deposit their money into a
growth oriented mutual fund at Neuberger & Berman Management, Inc., which has historically earned
a 12% return per annum (1% per month).

The couple wishes to have a pre-determined monthly amount automatically drafted from their
checking account. When Brady starts college they will slowly liquidate the account by making an
annual payment to Brady to cover tuition and living expenses at the beginning of each year for the
four years he will be in college.

Questions

1. How much will be the tuition and living expenses per year when Brady is ready to attend? Give
an answer for each university.
2. Once Brady starts college what will his total expenses be in each of his four years? Again, give
an answer for each university.
3. How much money will Greg and Debra have to deposit per month to allow Brady to attend
Stanford University? How much money will have to be deposited per month to allow Brady to
attend the University of North Carolina? (HINT: To answer this question you need to consider
the costs of ALL four years.)
4. What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10%. How much
will have to be deposited per month in order for Brady to attend each college?
5. What is the relationship between the amount that must be deposited monthly by the parents
and the future increases in both tuition and living expenses?
Case 9: WalMart
Basic Concepts: Risk and Return Analysis

Marvin Brown is a savvy investor who is always looking for a sound company to include in his portfolio
of stocks and bonds. Being somewhat risk-averse, his main objective is to buy stock in firms that are
mature and well-established in their respective industries. WalMart is one of the stocks Marv is
currently considering for inclusion in his portfolio.

WalMart has five major areas of business: traditional WalMart discount stores, Supercenters, Sam's
Clubs, neighborhood markets, and international operations. Although WalMart was established over 50
years ago, it continues to achieve growth through expansion.

In order to determine if WalMart is a "good buy," Marv has to perform several analyses. First, he must
calculate the returns on WalMart's common stock over the past eight quarters as an indicator of how
the stock might perform over the next year. He must then calculate the standard deviation of the
stock as a proxy for its risk. To aid in his calculation, Marv has gathered the following stock price and
dividend data.

Quarterly Stock Prices and Dividend Payments

Quarter Closing Stock Price Dividend Payment During This Quarter
December (this year) $52.82 $0.13
September (this year) $53.07 $0.13
June (this year) $52.25 $0.13
March (this year) $59.26 $0.13
December (last year) $52.55 $0.09
September (last year) $55.14 $0.09
June (last year) $52.99 $0.09
March (last year) $51.29 $0.09

Questions

1. Calculate the returns for each of the seven quarters.

2. Calculate the standard deviation of the returns from question 1.
3. Assume that WalMart has a Beta of 1.2, the risk-free rate of interest (i.e. as proxied by the
return on a 3-month treasury bill) is 5.25%, and the return on the market is 12.2% annually
(as proxied by the expected return on the Standard & Poor's 500). Based on CAPM, what is
the required rate of return on WalMart's stock?
4. Using your answer from question 3, if WalMart had an expected return of 14%, would Marv be
well advised to purchase the stock? At what minimum expected rate of return would Marv be
encouraged to buy the stock?
5. Marv has based his buy decision on quarterly data from the past two years. If the same
analysis was performed five years ago or five years from now, do you think Marv might have
come to a different conclusion? Discuss the effect that choosing this particular time period
might have on Marv's results.
Case 10: Intel
Basic Concepts: Portfolio Risk and Return Analysis

Michael Frank is an individual investor who is currently considering the purchase of $4,000 worth of
Intel's common stock. Mike already has a significant amount invested in the computer industry, but he
feels Intel will be one of the leading companies in the future. One of the reasons for this perceived
future success is the Research and Development being done in the area of parallel supercomputers.

Justin Rattner, Intel's former scientist of the year, is a leading researcher in parallel supercomputing.
Parallel supercomputing breaks down a complex problem into many, easier to manage components.
Further, all of these components can be manipulated simultaneously. It is analogous to Tom Sawyer
getting all his friends to paint the fence.

The speed of parallel computers is much faster than their larger and supposedly faster computers
competitors. Computer chip manufacturers are concerned primarily with speed and the size of the
components necessary to generate the speed. With Intel leading the way in this emerging area, Mike
feels he should own their stock.

One concern Mike has is how the inclusion of Intel's common stock will affect the overall return and
risk of the computer stocks he currently owns. Presently, Mike holds $2,000 worth of IBM, $3,500 in
Compaq, and $4,500 in Apple.

To determine the impact of the purchase of $4,000 worth of Intel, Mike has calculated the expected
annual returns over the next eight years for each of the four stocks. The expected returns for each are
shown in the table below.

Years into Expected Return for each Company (%)

the future IBM Compaq Apple Intel
1 6.2 0.1 -4.2 4.8
2 7.8 2.8 6.6 10.2
3 6.9 -1.9 12.2 11.3
4 -4.1 2.9 7.8 18.1
5 8.9 7.7 4.3 6.6
6 10.2 15.1 -2.1 -1.8
7 15.3 19.3 8.4 2.7
8 9.2 14.2 10.2 10.9

The beta of Intel is projected to be 1.1 over the next eight years. The betas of IBM, Compaq, and
Apple assumed to be 0.7, 1.6, and 1.0, respectively. Mike wants to see what affect the purchase of
Intel will have on the beta of his overall portfolio. He is assuming the beta of each firm will remain
constant over the eight year period.

Questions

1. Calculate the expected return for each of the next eight years without the inclusion of Intel.
2. Calculate the expected return for each of the next eight years with the inclusion of Intel.
3. Calculate the standard deviation for each of the next eight years without the inclusion of Intel.
4. Calculate the standard deviation for each of the next eight years with the inclusion of Intel.
5. Calculate the beta of the portfolio both with and without Intel.
6. We have assumed that beta will be constant over the next eight years. How realistic is this
assumption. That is, does beta tend to remain constant over time?
7. Which measure of risk is more appropriate when considering Intel's inclusion into Mike Frank's
portfolio, standard deviation or beta?
Case 11: Amber Plank
Term Structure of Interest Rates

Amber Plank is a high school senior who plans to attend college next year and major in Astronomy.
Her first choice is to attend the University of Charleston, which is highly regarded in her intended field.
However, to do so she will have to take out a substantial amount of loans as this is a private
university with high tuition costs. While loan rates today are not high by historical standards, Amber
will be charged the one-year rate that exists at the time she takes out the loans. That is, each year
when she borrows to pay for her tuition, she will be assessed interest at a rate consistent with the
short-term rate that exists in the future.

Amber's second collegiate choice is to attend the University of Florida. The benefit of doing so is that
she will receive a full scholarship and thus will not have to borrow in order to attend this institution.
The drawback is that while this is a fine university, it does not specialize in her major.

Selecting which university to attend is an extremely important decision to make. In order to perform a
complete cost comparison between the two universities, Amber must determine the future one-year
interest rates that are likely to exist. Since they are the rates at which she will have to borrow in the
future, accuracy is extremely important as these interest costs will eventually be used in a cost-benefit
analysis.

Table 1 lists today's rates that exist for U.S. Treasury securities of various maturities.

Table 1
Time to Maturity Yield to Maturity
1 year 7.0%
2 years 7.5%
3 years 8.0%
4 years 8.5%
5 years 8.6%

Questions

1. What are the four most important variables that determine a bond's yield to maturity?
2. Define a Yield Curve.
3. Explain the Expectations Hypothesis and use the theory to try to predict what the one-year
interest rates will be over the next five years.
4. Explain the Liquidity Preference Hypothesis and use the theory to try to predict what the one-
year interest rates will be over the next five years.
5. Explain the Market Segmentation Hypothesis and use the theory to try to predict what the
one-year interest rates will be over the next five years.
Case 12: Fruit of the Loom
Bond Ratings

The Standard & Poor's CreditWire recently reported that Fruit of the Loom's 8.875% senior notes,
which mature in 2006, were downgraded from BB- to B. This downgrade came after the company
recently amended its credit agreement on all other outstanding issues which effectively made the
8.875% notes subordinate to existing claims.

Since this represented a mere shuffling of priority claims, Fruit of the Loom's overall corporate credit
rating remained at BB- as did the rating of all but one other claim (an $850 million senior unsecured
debt shelf filing was downgraded to B as well). The corporate BB- rating was justified by Standard &
Poor's because while Fruit of the Loom still has strong brand name recognition and holds significant
market share in underwear, imprinted T-shirt and fleece markets, they are having performance and
operational difficulties.

Below is a qualitative description of each of Standard & Poor's bond rating categories.

Standard & Poor's Bond Rating Scale

AAA–An obligor rated 'AAA' has EXTREMELY STRONG capacity to meet its financial commitments.

AA–An obligor rated 'AA' has VERY STRONG capacity to meet its financial commitments. It differs from
the highest rated obligors only in small degree.

A–An obligor rated 'A' has STRONG capacity to meet its financial commitments but is somewhat more
susceptible to the adverse effects of changes in circumstances and economic conditions than obligors
in higher-rated categories.

BBB–An obligor rated 'BBB' has ADEQUATE capacity to meet its financial commitments. However,
adverse economic conditions or changing circumstances are more likely to lead to a weakened
capacity of the obligor to meet its financial commitments.

BB–An obligor rated 'BB' is LESS VULNERABLE in the near term than other lower rated obligors.
However, it faces major ongoing uncertainties and exposure to adverse business, financial, or
economic conditions which could lead to the obligor's inadequate capacity to meet its financial
commitments.

B–An obligor rated 'B' is MORE VULNERABLE than the obligors rated 'BB', but the obligor currently has
the capacity to meet its financial commitments. Adverse business, financial, or economic conditions
will likely impair the obligor's capacity or willingness to meet its financial commitments.

CCC–An obligor rated 'CCC' is CURRENTLY VULNERABLE, and is dependent upon favorable business,
financial, and economic conditions to meet its financial commitments.

CC–An obligor rated 'CC' is CURRENTLY HIGHLY VULNERABLE.

R–An obligor rated 'R' is under regulatory supervision owing to its financial condition. During the
pendency of the regulatory supervision the regulators may have the power to favor one class of
obligations over others or pay some obligations and not others. Please see Standard & Poor's issue
credit ratings for a more detailed description of the effects of regulatory supervision on specific issues
or classes of obligations.
SD and D–An obligor rated 'SD' (Selective Default) or 'D' has failed to pay one or more of its financial
obligations (rated or unrated) when it came due. A 'D' rating is assigned when Standard & Poor's
believes that the default will be a general default and that the obligor will fail to pay all or substantially
all of its obligations as they come due. An 'SD' rating is assigned when Standard & Poor's believes that
the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to
meet its payment obligations on other issues or classes of obligations in a timely manner. Please see
Standard & Poor's issue credit ratings for a more detailed description of the effects of a default on
specific issues or classes of obligations.

***

Note: Obligors rated 'BB', 'B', 'CCC', and 'CC' are regarded as having significant speculative
characteristics. 'BB' indicates the least degree of speculation and 'CC' the highest. While such obligors
will likely have some quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.

Plus (+) or minus (-): Ratings from 'AA' to 'CCC' may be modified by the addition of a plus or minus
sign to show relative standing within the major rating categories.

Source: Standard & Poors

Questions

1. Define what is meant by "a Pecking Order."

2. Why is it, specifically, that the 8.875% bond received a downgrading from BB- to B?
3. Should the stock price react to this bond's down rating? Why or why not?
4. Why is it that firms in different industries can have the same capital structure and the same
Earnings Per Share (EPS), but still have a different bond rating?
Case 13: Nations Bank
Valuation: Stock Valuation - the Gordon Growth model

Before Nations Bank was bought by Bank of America, Tina Brown was considering the purchase of
Nations Bank's common stock. Given Nations Bank's recent merger with the Southeastern
powerhouse, Bank South, and talks of penetration into the Florida market via a takeover of Barnett
Bank, Tina felt Nations Bank would be a solid "buy and hold" as it continued to increase its market
share through aggressive growth by acquisition.

While Tina was convinced she wanted to own Nations Bank, with all the price volatility surrounding the
recent speculations, she was not sure if the price was above or below the stock's intrinsic value. She
decided to derive the price of Nations Bank's common stock by using the Gordon Growth Model
(Constant Growth Model).

To use the Gordon Growth Model, Tina had to first calculate Nations Bank's required rate of return on
their common stock. The risk free rate, as proxied by the yield on a three month Treasury Bill, was
6%. The return on the market, as proxied by the return on the Standard and Poor's 500 (S&P 500),
was 10%. Nations Bank had a beta of 1.75.

Past dividend payments also had to be known. Tina was not sure how far back into the future she
should go to retrieve the dividend payment information, so she arbitrarily stopped in 1987. Between
1987 and 1990, Nations Bank seemed to have very different payout amounts. Not fully understanding
the reasons behind these differences, Tina decided to consider two periods for analysis: from 1987-
1995 and from 1990-1995. The dividend information that Tina recovered is shown below in Table 1.

Table 1
Year Dividends
1995 $2.00 ($1.00 through June 1995)
1994 $1.88
1993 $1.64
1992 $1.51
1991 $1.48
1990 $1.42
1989 $1.10
1988 $0.94
1987 $0.86

Questions

1. Using the Capital Asset Pricing Model (CAPM), what was Nations Bank's required rate of return
on common stock?
2. Consider the first time period from 1987-1995. Use the Gordon Growth Model to determine
the price of Nations Bank's common stock.
3. Consider the second time period from 1990-1995. Use the Gordon Growth Model to determine
the price of Nations Bank's common stock.
4. The answers for questions 2 and 3 are very different. What does this indicate, in general,
about the Gordon Growth Model? (Hint–The observed market price of Nations Bank's common
stock is $70.25.)
5. What effect does the stock's required rate of return have on the calculation of its stock price
when using the Gordon Growth Model?
6. If you felt that Nations Bank's last year dividend of $2.00 was going to be paid in that
constant amount throughout the remainder of the company's life (i.e. zero growth), what
would be the value of the stock today?
7. Based on your response to question 6, what is the relationship between the present value of a
dividend paid one year from now, a dividend paid ten years from now and a dividend paid one
hundred years from now?
Case 14: AMR - American Airlines
Valuation: Valuing a Corporate Bond Issue

AMR is the parent company of American Airlines. In addition to its primary subsidiary, AMR also
operates several airline support companies such as the SABRE group (reservations), the Management
Services Group, and American Eagle (a regional carrier).

American Airlines is currently considering the issuance of a series of $1,000 par bonds. The coupon
rate offered, based on current market interest rates and the Standard & Poor's based AMR bond
rating, will be 10%. The current interest rate is coincidentally 10% as well. Interest on the bonds will
be paid semi-annually. However, American cannot decide on the maturity of the new issue. The life of
the bonds will be 10, 20, or 30 years.

Questions

1. Ignoring floatation costs, what will the bonds sell for today if American decides to issue the
bonds with a maturity of 10 years? What will the price be if the bonds have a maturity of 20
years? 30 years?
2. If the bonds are issued with 10 years to maturity and the day after they are issued, the
market interest rates increase to 12%, what will be the price of American Airline's bonds?
What if interest rates drop to 8%?
3. If the bonds are issued with 20 years to maturity and the day after they are issued, the
market interest rates increase to 12%, what will be the price of American Airline's bonds?
What if interest rates drop to 8%?
4. If the bonds are issued with 30 years to maturity and the day after they are issued, the
market interest rates increase to 12%, what will be the price of American Airline's bonds?
What if interest rates drop to 8%?
5. Based on your answers to questions 2 through 4, what is the relationship between time to
maturity and the price of the bond?
6. Based on your answer to question 1, what is the relationship between current interest rates,
the coupon rate, and time to maturity?
Case 15: Mirage Resorts
Refunding a Bond Issue

Las Vegas is one of the fastest growing and arguably the most exciting city in the United States. In
fact, Las Vegas now has more visitors than Orlando or the entire state of Hawaii. The difference is,
when people visit Orlando and Hawaii, they come to see theme parks and beaches and coincidentally
stay in hotels. But, when people come to Las Vegas, they come to see its hotels.

Mirage Resorts owns several hotels along the Las Vegas strip: The Mirage, MGM Grand, Bellagio, New
York-New York, and Treasure Island. When the Mirage hotel was first built, Mirage Resorts financed
the project with 11% notes from the GNS Finance Corporation. These 20-year, $1,000 par, callable
bonds had a face value of $40,000,000 and were issued in March of 1988. When they actually sold,
they went at a discount at $970 each. The call price of each bond is $1,110. Further, when the bonds
were originally issued, the floatation costs totaled $200,000. The unamortized debt discount is
$39,065,000.

Today, interest rates have dropped substantially. Mirage Resorts is considering the possibility that it
might be able to refund the old bond issue and replace it with a new issue that has a much lower
coupon rate. After meeting with several investment bankers, Mirage learned they could get new bonds
at a much lower coupon rate.

The new bonds are expected to sell at their par value of $1,000, have only an 8.5% coupon rate, and
a 13-year maturity. Mirage estimates that there will be a two month overlapping period while it retires
the old bond issue.

Goldman Sachs was chosen to underwrite the issue because of their reputation and relatively low
floatation costs. The deal held that Goldman Sachs would receive a fixed amount of $120,000 to cover
administration expenses plus a variable amount equal to .4% of the par value of the offering. The
selling group would receive another .3% of the par value upon the offering.

Mirage Resorts has an after-tax cost of debt equal to 6% and their corporate tax rate is 35%.

Questions

1. Calculate the total floatation costs associated with the new bond issue.
2. What is the initial investment required to issue the new debt?
3. What is the annual cash flow from the old bond issue?
4. What is the annual cash flow from the new bond issue?
5. Calculate the annual cash flow savings associated with the new bond issue.
6. What is the present value of the annual cash flow savings associated with the new bond issue?
(Hint: these saving will occur every year until the bond issue matures.)
7. Should Mirage refund the bond issue?
8. Mirage issued the debt only seven years ago. Why is it that they are able to get such a lower
interest rate today? Do you think Mirage Resorts should have waited until interest rates had
decreased in the first place before building the Mirage hotel?
9. What factor(s) do you think were most responsible for the decision you made? That is, of all
the factors that affect the refunding decision, which ones do you feel tend to have the greatest
impact?
Case 16: eBay
Stock Market Efficiency

Everyone knows eBay, Inc. as the world's largest on-line auction based trading system created for
individuals. eBay provides a trading place for millions of items on almost everything imaginable. If you
want to buy, sell or trade it, chances are eBay knows someone else just like you.

The creation of this new market had been an overwhelming success for this high-flying internet stock
until June 10, 1999. On that date, eBay had an unexpected all day outage of their site that resulted in
a plummeting stock price and a need for answers. eBay's CEO promptly refunded customers a total of
$4 million in user fees and assured traders that the company would take steps to be sure this type of
failure would never happen again.

Just before 8:00 A.M. Eastern Standard Time, on August 6, 1999, eBay's Web site crashed again
following scheduled maintenance that was supposed to occur overnight. Surprisingly, the news of the
crash did not make its way to Wall Street as the stock rose early after the opening bell (The stock
market opens at 9:30 A.M.). There was some unrelated profit-taking which ended around 10:30 A.M.
This dropped the price back down to around $92 where it remained relatively stable until the Dow
Jones NewsWire publicly reported the crash at 12:01 P.M. Immediately, eBay's stock took a nosedive
amid high volume selling. By the close of trading at 4:00 P.M., the stock had lost $9.625 per share
which represents 10.36%, or nearly $1 billion, in market capitalization. Most of the stock price drop
had occurred within the first 15 minutes after the news release.

Questions

1. At 12:01 P.M., when the Dow Jones NewsWire publicly reported the crash of eBay's Web site,
the stock price dropped precipitously right away then remained relatively stable (exhibited
normal levels of volatility) for the rest of the day. Is this consistent with the notion of efficient
markets? Explain.
2. Since eBay's Web site crashed an hour and a half before the stock market opened, why didn't
eBay's stock open lower as opposed to higher the way it did?
3. Could people who were aware of the site's crash right before 8 A.M. have made money by
taking certain actions in the stock market? If so, what could they have done?
Case 17: Aether Systems
Common Stock Valuation: The Variable Growth Model

It seems the whole world is going wireless. On the shuttle bus from SFO airport to my hotel
downtown, I couldn't help but overhear an attorney discuss his legal strategy. First he called his office
on his cell phone to see if a settlement offer had been reached. Then he pulled out his Palm Pilot to
log the next sequence of motions to be filed.

Not wanting to seem nosey, I busied myself by tracking the latest stock performance within my
portfolio via PocketBroker, a hand-held wireless investment service through Charles Schwab. With my
RIM (Research in Motion) 950, I can access my account, download the latest quotes and even execute
trades all while being driven on Highway 101. With my TradeStation 2000 technical analysis based
automated software package, I was able to identify several sell signals and lock in a hefty profit all
before arriving at my hotel. The shuttle driver used his antenna to obtain my credit card approval and
I was off to my meeting.

If you think only business people use wireless technology to this extent, think again. On board the
USS McFaul, Naval crew members are now able to move freely throughout the ship while sending vital
information back and forth over their wireless Palm handheld devices. Note only does the mobility
directly translate into greater efficiency, but the need to keep extensive paper records and hold
clipboards is a way of the past.

The Wake Forest University School of Medicine uses wireless handheld devices not only to track
patient records, but update them as well. Updated records are automatically sent back to the central
computer via the system's intranet. Aether Systems, Inc., is the firm responsible for many of these
advancements. Their commitment to increasing mobility, productivity, and efficiency has allowed them
to grow at an exponential rate.

Your task is to determine, using the discounted cash flow method, whether or not Aether is fairly,
over-, or under-valued. To complicate matters, since the firm only came into existence in 1998 and
because they are growth oriented, they have yet to pay a dividend and do not plan to do so in the
short to intermediate run.

Instead, Aether will only begin to pay a dividend 10 years from now. The expected annualized
dividend at the end of year 10 will be $2.50 per share. This dividend is expected to grow at a rate of
9% over the next 5 years and will then taper off to a steady 4%, a rate at which it is assumed to grow
forever. Answer the following questions using a discount rate of 13%.

Questions

1. Calculate the dividends over the first growth stage.

2. Using the Gordon Growth Model, calculate the value of all remaining dividends at time 15.
3. Calculate the present value (at time 0) of ALL future dividends.
4. Assuming Aether was currently trading at $10 per share, what would be your long-term
recommendation for this stock: buy, sell, or hold?
Case 18: NetJ.com
The Behavioral Component of Pricing Common Stocks

A few years ago when the stock market was reaching new highs every day, investors were pouring
more and more money into the capital markets. This free flow of funds encouraged small firms to go
public before they were ready. More directly, many of these firms had limited track records, and in
several cases, no track record at all. Still, with such a hot IPO market, these premature public
offerings had been extremely successful; the majority of these firms had no problem fully subscribing
their shares.

The market capitalization of NetJ.com was over $22.9 million. Yet in their SEC statement it read, "The
company is not currently engaged in any substantial business activity and has no plans to engage in
any such activity in the foreseeable future." How is it that a firm with no business operations had
come to command such a market capitalization? NetJ.com began under the name NetBanx.com. The
mission of this firm was to perform bad debt collections for doctors. Finding this to be a not so
profitable venture, the firm shifted gears. Recognizing that the IPO process is a lengthy and expensive
one, they saw value in the fact that they were already a publicly held corporation. As such, they could
identify private companies who wished to go public, but didn't want to put the necessary time and
effort into the process. The game plan was to merge with the other firm and have that be their line of
business.

This practice of making it up as you go along seemed not only to be a necessary course of action, but
an attractive one as well. The trick appears to be keeping yourself "new." NetJ.com is certainly
keeping itself open to possibilities. As stated in their SEC statement, "The company does not intend to
restrict its search (for a partner) to any particular business or industry…high tech, natural resources,
manufacturing, R&D, communications, transportations, insurance, brokerage, finance, and all medical
related industries." That pretty much covers it.

With "extremely limited assets" and "no source of revenue," one wonders how long NetJ.com can
continue to command a stock price above zero before investors stop believing in possibilities and start
demanding performance.

Questions

1. How is it that a company with little to no track record can successfully go public?
2. How can a firm with no revenue have a positive stock price?
3. Why would a privately held firm generating significant profits consider merging with a publicly
held firm who seems to be without direction and who is operating at a loss?
4. How long can a corporation with no revenue and no immediate plans to generate revenue
expect to have their stock price supported by the market?
Case 19: OTCBB
The Trading of Stocks in the OTCBB Market

Having just made senior partner in his Hawaii based architectural firm, Matt Gilbertson sought to
invest a substantial portion of his new, much higher salary in speculative grade stock. Normally in the
habit of deleting mass e-mail, Matt's attention was drawn to the subject line: "Bulletin Board Trading
Now Available," that was sent by TD Waterhouse. TD Waterhouse is a brokerage firm that allows
investors to trade for only $9.95 per transaction up to 2,500 shares of a single stock. This emerging
trend of do-it-yourself investing (at a much lower commission cost) was attractive to Matt. However,
since Matt did not know what a Bulletin Board Stock was, he carefully read the e-mail to learn more
about them.

Bulletin Board stocks are recommended for investors at the high end of the risk-return spectrum.
There are several sources of risk associated with these securities. OTCBB stocks are not required to
meet minimum listing and reporting requirements as are stocks listed on organized exchanges, such
as the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE or AMEX). This means
that investors will find it more difficult to find publicly available information and news that affects the
value of the firm. Moreover, since national exchanges have stringent listing requirements, OTCBB
stocks tend to be less stable companies with short track records, possibly facing regulatory actions or
maybe even bankruptcy.

Another concern with OTCBB stocks is that because of low volume or liquidity, they have dramatically
higher bid-ask spreads and are subject to partial order executions and in some cases unfilled orders.
Finally, automation, which so many investors have become accustomed to in recent years, is not
available in the OTCBB. For all these reasons, OTCBB stock investing opportunities are being
presented by TD Waterhouse with a warning label that investors should do their homework, not only
about the firm itself, but on this risky marketplace as well.

Questions

1. With the added risk associated with OTCBB stocks, why are investors so attracted to them?
2. If we assume the added risk of the OTCBB stocks is not sufficiently compensated for by higher
rates of return, should TD Waterhouse continue to offer these stocks for sale to their
customers?
3. Should stocks be allowed to be available for sale if they do not have to disclose information
and have no reporting requirements?
4. Should an investor in Matt's position decide to invest in OTCBB stocks?
Case 20: Pittston
Tracking Stocks

With the Initial Public Offering (IPO) market doing so well a few years ago, tracking stocks were
popping up everywhere. A tracking stock is a separately traded common stock that only reflects the
well being of a particular division. The parent company still completely owns and operates the division.
But, the parent has its own stock price that trades independent of the tracking stock's division.
Tapping into the then hot IPO market, tracking stocks, particularly those in the technology sector,
were able to generate significant proceeds when offered as a separate trading opportunity. With the
overall market performing so well for so long, there seemed to be no drawback to this relatively new
way to raise extra capital.

The question many investors started to ask was, "What will happen if tracking stocks start to act more
as an anchor rather than a sail?" Pittston Co., announced it would revert back to its non-tracking stock
structure because its coal division was dragging down its other, more healthy divisions. This brings up
many interesting conflict of interest concerns for investors.

While the two stocks are managed by the same Board of Directors, the stockholders are not
necessarily the same. In fact, they will likely be quite different. For which set of shareholders should
the board seek to maximize value? Both the tracking stock and the parent stock are tapping into the
same pool of resources. If the tracking division begins to flag or seems to be an unsuccessful venture,
the natural managerial decision might be to divest or at least cut back on investment. However, this
would cause the tracking stockholders to complain because their stock would go down in value. The
question then becomes, is the job of management to maximize the value of the two stocks
concurrently?

Executive compensation becomes an issue as well. Consider what might happen if the board owned a
different amount or percentage of shares in the parent company when compared to the tracking stock.
Might there be an incentive to place the interests of one set of stockholders above those of the other?

The stock market cannot remain bullish forever. And when it corrects, there is likely to be a
tremendous backlash surrounding tracking stocks. Are tracking stocks the wave of the future or are
they a law suit waiting to happen?

Questions

1. Why would the price of a firm before tracking stocks are introduced be different from the
combined price of the parent and the tracking stock once the new structure is in place?
2. Why are there so many tracking stocks in the technology sector as opposed to other sectors?
3. Why is it necessary for the market to become bearish before the potential problems associated
with tracking stocks get noticed?
4. For which set of shareholders should the board seek to maximize value?
5. How could executive compensation be structured to discourage favoritism of either the parent
stock or the tracking stock?
Case 21: Vanguard
Mutual Funds and Taxes

Most everyone is aware that mutual funds are an ideal investment vehicle for the small investor.
Mutual funds allow for the benefits of a diversified portfolio yet require only a small amount of funds to
be invested. Moreover, for those who wish to avoid market timing strategies and the time consuming
process of analyzing individual stocks, index investing in broad market indexes is a favorable
alternative. What most people do not know, however, is that even a buy and hold objective pursued
through an index mutual fund is not without serious potential tax consequences.

Billy and Sherri Simpson invest regularly in Vanguard's Extended Market Fund, a mid-cap, buy and
hold index mutual fund roughly tracking the Wilshire 4500. To date, Billy and Sherri have never
withdrawn money from the fund. Instead, they periodically make deposits whenever they have enough
to do so. Even though the Simpsons have never sold their mutual fund shares, they noticed on their
FORM 1099-DIV, that they were listed as earning $1,266.90 in capital gains (Box 2a).

Thinking there had been a mistake, Billy called Vanguard's 1-800 number and asked for clarification.
The Vanguard representative explained that when common stock is owned directly, there are two
ways to realize returns: (1) payment of dividends by the company, and (2) capital gains (or losses)
when the individual sells their shares. However, with mutual funds, there are three ways to realize a
return. The first two are the same as if the stock was owned directly. The third is a capital gain that
occurs when the fund itself sells shares in the portfolio. It was this third reason that had caused the
Simpsons to realize the capital gain even though they themselves had never redeemed any mutual
fund shares.

The next year when the Simpsons received their FORM 1099-Div, they noticed that the capital gains
number in Box 2a had jumped up to $4,208.71 even though they did not contribute any more money
that year. Knowing that the index fund had a buy and hold strategy, the Simpsons were very
surprised that so much turnover could have been caused within a single year's time.

After again calling Vanguard, they learned that due to the stock market's run up in that year, the mid-
cap stocks that the fund held were now large cap stocks. To keep to the objective of holding mid-cap
stocks, Vanguard said they sold off the firms that had become large cap stocks and used the proceeds
to buy smaller firms. This turnover generated realized capital gains that had to be spread out over the
mutual fund investment base on a pro rata basis.

The next year, the stock market bottomed out. Vanguard's Extended Market fund lost over 40% of its
value. Sherri joked that the good news was that at least they didn't have to pay high capital gains this
year. However, at the end of January when they received their FORM 1099-DIV, they saw the highest
number yet in Box 2a. The Total Capital Gain Distributions were reported to $7,444.72, even though
the Simpsons had never withdrawn money from the account.

Not surprisingly, Sherri called Vanguard for an answer. The Vanguard representative explained that
investors panicked when the stock market dropped. They sold off so many shares that the cash the
fund keeps on hand to handle "normal" transactions had run out. In order to meet investor demand to
withdraw funds, Vanguard had to sell off shares to raise the necessary funds. Many of the shares sold
were originally purchased many decades ago. As such, they had a very low cost basis for tax
accounting purposes.

Extremely upset by the turn about of events that had transpired, Billy and Sherri Simpson seriously
contemplated the way they would invest in the future.

Questions
1. Do you think Vanguard's objective to maintain a mid-cap index is more important than the tax
burden it causes their clients?
2. Explain how investor behavior can be extremely detrimental to a mutual fund owner who will
truly follow a buy and hold strategy through good times and bad.
3. Will there be certain economic conditions/times when this investor behavior will be worse than
others?
4. Why should current mutual fund shareholders pay for the taxes caused by stocks that were
purchased many decades before they became an investor? That is, why not recalculate the
cost basis of a stock to more fairly assign tax liabilities to investors?
5. How might you change the way you would invest if you were the Simpsons?
Case 22: Florida Power & Light
Capital Budgeting: Renewal versus Replacement

Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group, representing
84% of their earnings. FP&L is a utility company that supplies electric service throughout most of
Florida's eastern seaboard. Their service area contains 27,605 square miles which translates into
approximately 4 million customers. Of these 4 million customers, as a percentage of operating
income, roughly 55% comes from residential customers, 35% from commercial, 4% from industrial,
and the remaining 6% from other sources.

Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant in Florida City,
Florida, is debating on whether to renew or replace the commercial nuclear reactor's reactimeter. A
reactimeter is a vital component of the nuclear power generating process.

The core of a nuclear reactor must be maintained at a certain temperature and must possess a
particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-
optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with
accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant
System (RCS) and make minor adjustments as needed.

Alternative 1:

In order to determine whether the reactimeter should be renewed or replaced, Paul had to gather
some financial information. If the current computer system is upgraded and new software is
purchased, the cost will be $80,000. An additional $5,000 will be required to have the system installed
and calibrated for accuracy. The renewed computer system will have a useful life of just five years and
will be depreciated in compliance with the MACRS five year recovery system. Depreciation rates for
years one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of $80,000
will be depreciable, not the installation cost.

At the end of the five year period, the renewed machine can be sold for $5,000 before taxes. The
renewed machine would also result in an increase in net working capital of $20,000. Net profits
resulting from an increase in operational efficiency for each year will be as follows:

Table 1
Year Net increase in profits
1 $650,000
2 $425,000
3 $317,000
4 $220,000
5 $129,000

Alternative 2:

The new system will also have a five year life and will be depreciated in compliance with the MACRS
five year recovery system. The fully depreciable cost of the new system will be $100,000. Installation
costs will be an additional $5,000. At the end of the five year period, the renewed machine can be sold
for $10,000 before taxes. Implementing the new machine would result in an increase in net working
capital of $15,000. If FP&L decides to replace the old system with a new reactimeter, the resulting net
profits will be:
 Table 2
Year Net increase in profits
1 $350,000
2 $350,000
3 $350,000
4 $350,000
5 $350,000

If a new system is purchased, the old system can be salvaged for $10,000. Finally, FP&L has a 40%
corporate tax rate.

Questions

1. What is the initial investment associated with both alternatives?

2. Calculate the net after-tax operating cash inflows associated with both alternatives.
3. Calculate the year 5 cash flow associated with the sale of the computer for both alternatives.
That is, remember to consider that both computer systems can be sold at the end of the fifth
year.
4. Using a discount rate of 10%, calculate the present value of both alternatives. Which
alternative should Paul choose?
5. What are some of the qualitative factors to consider when making a decision between the two
alternatives?
6. Based on your answers from questions 4 and 5, has your decision changed concerning which
alternative is preferred?
Case 23: Southwest Airlines
Capital Budgeting: One Project - Accept/Reject Decision

The airline industry is extremely cyclical. That is, when the economy does well, so too do airlines. In
recent years, the airline industry has found itself with too many seats and too few passengers. Some
experts point to the past deregulation of the industry while others argue that technological advances
such as teleconferencing are responsible. Several airlines such as Continental, America West, Eastern,
and Trans World Airlines, have filed for Chapter 11 Bankruptcy. Some have fully recovered, while
others have been forced to liquidate (Chapter 7). Narrowing profit margins have prompted airlines to
develop creative survival tactics.

Southwest Airlines has successfully found its niche in the industry by providing direct flight service to
less traveled routes such as those to and from smaller cities. Since these routes do not generate
nearly as much revenue as major city routes, Southwest has found ways to reduce its costs. Costs are
reduced by following a no frills policy that the travelers refer to as "peanut flights." This means that
instead of serving costly meals (the quality of which passengers have historically complained about
anyway), Southwest serves just a bag of peanuts and a soft drink. With the recent success of short,
direct flights, Southwest is considering the purchase of one such additional route.

Before an airline applies to the federal government for a new route, a lengthy analysis is performed to
determine the feasibility of the route. Expenses to consider include airport costs such as gate and
landing fees and labor costs such as local baggage handlers and maintenance workers. Many times the
airline will provide its own employees to load and unload luggage or to provide upkeep for their
planes, but in the case of Southwest, they have so many small cities to service that the outsourcing of
these jobs is not uncommon.

Table 1 provides a summary of the after-tax cash flows associated with the acquiring of an additional
small route. All costs and revenues are reflected by the following numbers.

Table 1
Projected Net Cash flows (in Millions of Dollars)
Year Net Cash Flow
0 -$20.8
1 $4.5
2 $6.3
3 $5.2
4 $3.9
5 $2.1
6 $1.3
7 $0.5

The initial costs of the venture (i.e. year 0) reflect the expenses involved with moving employees, FAA
filing fees, the initial offering of low fares in order to gain customers, and the high advertising costs
necessary to make the public aware of the new route offering.

Questions

1. What is the project's NPV assuming Southwest has a discount rate of 10%? How do we
interpret the NPV?
2. What is the project's IRR? How is this measure different from the NPV? What is the
interpretation of this number?
3. Calculate the project's Payback Period.
4. Assuming that Southwest has a required payback period of 5 years and a hurdle rate of 10%,
should Southwest accept the additional route? Based on the project's NPV, should it be
accepted? If conflicting conclusions occur, which criteria would you follow?
5. When will conflicts likely occur among the three criteria?
6. Calculate the project's Modified Internal Rate of Return (MIRR). What critical assumption does
the MIRR make that differentiates it from the IRR?
7. Where does the value of MIRR fall relative to the discount rate and IRR?
Case 24: Tecmo
Capital Budgeting: Multiple Projects with unequal lives

The video gaming industry began modestly with the debut of Pac-Man, Asteroids, and Donkey Kong.
These games appeared in arcades where teens gathered to drop quarter after quarter for high score
bragging rights. In the home video game market, Atari reigned supreme. Technology has made vast
improvements since then. As a result, the level of reality experienced in each successive generation of
video games has increased exponentially. One of the players in this highly evolving and competitive
market is Tecmo.

Not only is the interactive entertainment industry characterized by rapid technological change, no one
particular hardware system has achieved long-term dominance. Accordingly, Tecmo focuses its
production efforts on the development of software for the hardware systems that dominate the
interactive entertainment market at a given point in time or in the very near future. Presently, Tecmo
has licensing agreements with three industry leaders: XBox, Nintendo, and Sony.

Tecmo is currently in the design/production stage of a new version of Dead or Alive. Since the
previous versions of the game were extremely successful, Tecmo is not greatly concerned with the
acceptance of the game by the general public. It is concerned, however, with the hardware platform
that should be chosen to distribute the game.

Since licensing agreements are extremely short term, Tecmo wonders which of the three hardware
companies should carry Dead or Alive. For example, the licensing agreement with XBox expires in
December two years from now. The Nintendo agreement expires in December of this year and the
Sony contract expires in December of next year. While these contracts expire and have traditionally
been renewed every few years, there is no guarantee they will be successfully renewed or extended in
the future.

A further consideration involves the costs charged by each company. XBox, Nintendo, and Sony
charge their licensees a fixed amount per unit based on chip configuration, memory capacity, and
market price. This charge covers manufacturing, printing and packaging of the unit, as well as a
royalty for the use of their respective names, proprietary information and technology. Furthermore,
these charges are subject to adjustment at the discretion of XBox, Nintendo, and Sony.

To offset the expenses of licensing fees, Tecmo must speculate on the ability of the three hardware
platforms to access enough end-users to make their games profitable. Nintendo and Sony hold a
grater share of the market, but XBox charges lower licensing fees.

In general, the product life cycle in the interactive software business is from one month up to eighteen
months with the majority of sales occurring within the first three months after introduction. Although
titles older than eighteen months may still be available for sale, Tecmo generally actively markets only
its ten to fifteen most recently released titles. Mortal Combat represents somewhat of an exception to
the rule. Being one of the most successful products, Dead or Alive's most feared competitor will be the
prospect of the next version of Dead or Alive. There has currently been no discussion of the number of
games that will be produced in the series.

Tecmo's management has assembled the following projected net cash flows associated with the
distribution of Dead or Alive. These net cash flows reflect all licensing fees, productions costs,
advertising expenditures, revenues, etc.

Table 1
Net cash flow (in millions)
 Time XBox Nintendo Sony
(end of year)
0 -$40 -$40 -$40
1 $34 $44 $41
2 $10 $16 $18
3 $5 $4
4 $1

Questions

1. What is the Payback Period for Dead or Alive when marketed under the three different
hardware companies? Assuming a required payback period of 1 year, which company would
you allow to carry the new product?
2. Assuming a discount rate of 10%, what is the Net Present Value (NPV) under each system?
Under which system, if any, would you be willing produce Dead or Alive?
3. What are the Internal Rates of Return (IRR) under each marketer? Which marketer(s)
has/have acceptable IRRs?
4. Thus far we have assumed that Dead or Alive will be marketed through only one hardware
system. Under this assumption, the projects are mutually exclusive. If we explore the
possibility of allowing more than one company to market Dead or Alive, which company(ies)
would you allow to market the product? Base your answer on the three criteria from the above
questions.
5. Dead or Alive will have a different life span depending on the hardware system Tecmo
chooses. Since the lives of the three projects are not equal, can a comparison truly be made
based on conventional NPV measures? Calculate the Annualized Net Present Value (ANPV) for
each of the three alternatives. Based on ANPV, which marketer would you choose to sell the
product through if the projects were mutually exclusive? What if they were independent?
Case 25: Philip Morris
Capital Budgeting: Projects with Dissimilar Risks

When most people hear the name Philip Morris, they think of tobacco, or more specifically, Marlboro
cigarettes. What most people do not realized is that the food products Philip Morris markets generate
more sales revenue for the firm. Recognizable brand names include Kraft, Post, Maxwell House, and
Entenmann's. Philip Morris is considering the introduction of two new products. The first product is a
new breakfast cereal called Post Blueberry Morning. Post is an established name in the cereal market
with a market share of 16.7%. Getting shelf space is extremely difficult and costly for most new
products because grocery stores traditionally charge slotting fees. Slotting fees are fixed amounts that
companies must pay to gain ideal shelf locations for their products. Post, however, feels less pressure
from grocery stores because of the consumer demand for their products. With the consumer
preference for Post brand cereal, Philip Morris feels that introducing Post Blueberry Morning will be a
low risk venture.

The second new product Philip Morris is considering the introduction of is a Gourmet Hazel Nut coffee
that will be sold under the Maxwell House family of products. Maxwell House is also established in its
market, but the coffee industry itself is more risky than the high profit margin breakfast cereal
market. Coffee profits are strongly affected by the general swings in the commodity's price due to
uncontrollable factors such as weather. From month to month the price of coffee fluctuates making
profits from coffee sales fluctuate as well.

In performing a capital budgeting analysis, Philip Morris recognizes that these two products should not
be considered to be of equal risk. Therefore, traditional net present value analysis should not be used
to decide which product, if any, to produce. To help the company decide how to handle the
perspective investments, their finance department forecasted the projects' expected net cash flows.
Both projects have an expected life of seven years. Table 1 shows the projected net cash flows
associated with both projects.

Table 1
Year Net cash flow Net cash flow
Gourmet Hazel Nut Post Blueberry Morning
0 -$4,000,000 -$2,500,000
1 $1,000,000 $803,000
2 $1,200,000 $521,000
3 $750,000 $235,000
4 $950,000 $400,000
5 $880,000 $498,000
6 $500,000 $612,000
7 $206,000 $519,000

Since the two projects have dissimilar risks, the finance department felt it would be appropriate to
indicate how certain they were about their estimates of the net cash flows associated with each
project. These certainty equivalents are shown in Table 2.

Table 2
Year C.E. C.E.
Gourmet Hazel Nut Post Blueberry Morning
 0 1.00 1.00
1 .80 .95
2 .70 .90
3 .60 .85
4 .50 .80
5 .40 .75
6 .30 .70
7 .20 .65

The appropriate discount rate for an average risk project for Philip Morris is 10%. They feel that
because the Gourmet Hazel Nut project is more risky than average, a risk-adjusted discount rate of
12% should be used. Finally, the risk-free rate of return is currently 5%.

Questions

1. If you assume the two projects are of equal risk, what is the net present value (NPV) of each
project? Because the projects are independent, which project(s) would you accept?
2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV using the Risk-
Adjusted Discount Rate (RADR).
3. Using the certainty equivalents method, calculate the projects' NPV. Does your accept/reject
decision change?
4. Explain the concept of certainty equivalents. Start with a definition and then explain fully.
5. How do certainty equivalents adjust cash flows for risk and time. How does this adjustment
compare to the way RADRs treat risk and time?
Case 26: Computerized Business Systems
Capital Budgeting: Weighted Average Cost of Capital

Computerized Business Systems (CBS) transforms manual accounting and inventory systems into
computerized, more efficient, systems. Many of their customers describe the transition as an overnight
evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with
respects to both time and inventory control.

CBS's computerized inventory systems, for example, allow every item in inventory, no matter how
small, to be tracked at all points throughout the production process. Replenishing stock becomes an
automatic process because the CBS system alerts the manager when supplies reach a pre-
programmed level.

Vicky Pagel has been a financial analyst with CBS for over five years. Although she normally does not
get involved with sales, her most recent assignment was to assist Jack Ingram, a new sales
representative. Jack is in the process of trying to sell a CBS system to Corbin Mills, a firm that does
not know how to determine accurately its weighted average cost of capital (WACC). Corbin Mills,
therefore, cannot determine whether the net present value (NPV) of the CBS system is positive or
negative.

To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's cost of raising
funds from various sources. As she proceeded with the analysis, she learned that Corbin Mills could
issue 20-year corporate bonds at a coupon rate of 9%. As a result of current interest rates, the bonds
could be sold for $1,005 each. These bonds have floatation costs of $35 per bond, pay interest semi-
annually, and have a par value of $1,000. A corporate tax rate of 40% applies.

Corbin Mills can raise additional funds through either retained earnings or new issues of common
stock. Their common stock is currently selling for $68.25 per share. The most recent dividend paid
was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 4%, but this growth
rate is expected to jump to 10% the year after and continue at this rate to infinity. If the firm wanted
to sell new shares of common stock, after underpricing and floatation costs, they could do so for
$62.75 per share.

A final source from which funds could be raised is via preferred stock. $100-par preferred stock can be
issued at an 11% annual dividend rate. After floatation costs, the preferred stock would sell for $95.50
per share.

The final set of information needed to calculate the WACC is the proportion of total funds that each
asset class represents. This information is given in Table 1. In performing the NPV calculation, net
after-tax cash flows must be known. These cash flows are given in Table 2. All variables such as
improvements in efficiency, employee training costs, and salvage value are already incorporated in the
cash flows.

Put yourself in Vicky Pagel's position, and develop the WACC calculation that will be used in evaluating
projects for Corbin Mills. Next, demonstrate whether the NPV for the proposed CBS system is positive
or negative. The following questions will lead you step-by-step to complete the analysis.

To perform this type of analysis you are implicitly making several assumptions. Since Jack will be the
only one involved in communicating with Corbin Mills, he must completely understand all of the
assumptions and calculations that will be made throughout the analysis. For this reason, the analysis
must be clear as well as technically correct.

Questions
Table 1 contains the market and book values of each asset class. Table 2 shows the after-tax cash
flows associated with the CBS system. Use these tables to answer the questions which follow.

Table 1
Asset Class Book Value Market Value Target Ratio
Long-term Debt $35,000,000 $33,400,000 35%
Preferred Stock $5,000,000 $7,000,000 5%
Common Stock $40,000,000 $42,000,000 40%
Retained Earnings $10,000,000 $10,000,000 20%
Table 2
Year After-tax net cash flow
0 -$480,000
1-10 $80,000
11 $10,000
1. What is the firm's cost of preferred stock? Is this the same as the after-tax cost of preferred
stock?
2. What is the firm's cost of long-term debt? Is this the same as the after-tax cost of long-term
debt?
3. What is the firm's cost of retained earnings? Is this the same as the after-tax cost of retained
earnings?
4. What is the firm's cost of new common stock? Is this the same as the after-tax cost of new
common stock?
5. Using market values, what is Corbin Mill's WACC?
6. Using book values, what is Corbin Mill's WACC?
7. Using target ratios, what is Corbin Mill's WACC? Explain why the target ratio will not always be
maintained by a firm.
8. Which weights, market, book, or target, should be used in this analysis? Explain.
9. Would Corbin Mills be better off with the new CBS system (i.e. What is the NPV of the
proposed system?)? Does the answer to this question depend upon which weight is used to
calculate the WACC? Explain.

Case 27: McLeodUSA

Long-Term Investment Decision: Optimal Capital Structure

The recent growth of McLeodUSA prompted the firm once again to go into the financial markets and
file a registration statement for another $400 million in 10-year senior notes. This move represents
the fifth time in the last 27 months that McLeod has borrowed in the private debt market raising over
$1.125 billion.

The reason for the offering was given as a need to raise capital to fund continued expansion in the
area of intracity fiber optic networks. Acquisitions, joint ventures, and other strategic alliances have
been the source of capital usage in the past and McLeod will certainly keep these types of options
open in the future.

With such a great need for outside capital, McLeod has decided to fully investigate their optimal capital
structure. As such, they have decided to gather data to help analysts with the necessary calculations.
Table 1 provides expected levels of earnings per share (EPS), standard deviation in EPS, and
estimated required rates of return associated with each capital structure scenario.

Table 1
Debt Expected Standard Deviation Estimated Required Rate
Ratio EPS of EPS of Return
0% $0.38 $0.21 10.3%
10% $0.43 $0.26 10.6%
20% $0.49 $0.33 11.4%
30% $0.55 $0.45 12.2%
40% $0.60 $0.62 13.4%
50% $0.52 $0.84 16.7%
60% $0.41 $1.08 20.6%

Questions

1. Calculate the coefficient of variation in EPS for each of the seven debt scenarios using the data
in Table 1.
2. Using the zero-growth valuation model, calculate the estimated stock price of McLeod under
each of the seven debt scenarios.
3. What are the two simplifying assumptions that the zero-growth valuation model makes?
4. Based on the zero-growth valuation model, what is McLeod's optimal level of debt?
5. Note from Table 1 that expected EPS are maximized at a debt level of 40%. Does this
optimum agree with the optimal capital structure derived from the zero-growth valuation
model? Which of the two should McLeod be more concerned with maximizing? Explain.

Case 28: Lancaster Colony

Dividend Policy

Lancaster Colony, a diversified manufacturer and marketer, has increased its dividend payment to
stockholders each year for the past 42 years. This impressive track record provides stockholders with
a steady and predictable stream of income on which they can rely.

Since sales and earnings have reached new highs, and because Lancaster sees several investment
opportunities in their Specialty Foods division, they are considering cutting their dividend next year
and using the funds to invest more heavily in the lucrative Specialty Foods Group. The Board of
Directors feel the rate of return Lancaster could earn by investing the funds internally is greater than
the rate of return their stockholders could get if they invested the dividend payments in an equally
risky venture outside the firm.

To the Board, it seemed silly to pay out a dividend when they had a good use for the money
internally. Still they recognized that cutting the dividend would stop their impressive 42 year streak
and more importantly surprise investors in a negative way.

Table 1 shows the earnings per share (EPS), dividends per share (DPS), and corresponding dividend
payout ratio for Lancaster over the past 11 years.

Table 1
Year DPS EPS Dividend Payout Ratio
1994 $0.29 $1.32 22.3%
1995 $0.37 $1.57 23.4%
1996 $0.44 $1.71 25.7%
1997 $0.48 $2.01 23.8%
1998 $0.54 $2.22 24.3%
1999 $0.59 $2.28 25.9%
2000 $0.63 $2.51 25.1%
2001 $0.67 $2.37 28.3%
2002 $0.71 $2.49 28.5%
2003 $0.78 $3.11 25.1%
2004 $0.89 $2.24 39.7%

Questions

1. Define the Residual Theory of Dividends. Does Lancaster appear to be employing this dividend
policy alternative?
2. Define the Constant Payout Ratio policy. Does Lancaster appear to be employing this dividend
policy alternative?
3. Define the Fixed-Dollar or "Regular" dividend policy. Does Lancaster appear to be employing
this dividend policy alternative?
4. Define the Low-Regular-and-Extra Dividend policy. Does Lancaster appear to be employing
this dividend policy alternative?
5. How would stockholders likely react if Lancaster decided to cut their dividend next year? (i.e.
What would happen to the stock price and what would happen to investor composition?)
6. What could Lancaster's Board of Directors do to mitigate the reaction of its stockholders?

Case 29: Anheuser-Busch

Short-term Asset Management: The Baumol Model

Brewing beer has always been the core business of Anheuser-Busch Companies, Inc. The industry
leader since 1957, Anheuser-Busch currently owns nearly half of the domestic beer market. Market
share has grown so much that Anheuser-Busch now has a larger portion of the market than their next
four largest competitors combined. International sales are no different. Anheuser-Busch International
remains the leading exporter of beer from the United States with sales in more than 65 countries.

Microbreweries, or microbrews for short, have been gaining attention in recent years. Microbrews are
defined as breweries that produce less than 15,000 barrels a year. The strength of microbrews is their
philosophy that beer should be of the highest quality. Microbrews are only made with malted barley,
hops, water, and yeast, the only four ingredients found in the purist German beers. Mass bottled beers
usually add rice and corn to minimize costs. The drawback of microbrews is their cost. The more
expensive ingredients make microbrews cost an average of 60% more than mass bottled beers.

Beer is not like wine which gets better with age. Instead, it is a food that should be consumed as soon
after production as possible. As such, beer pubs or microbrews that produce beer on the premises, are
the hottest new trend with an average of four new pubs popping up every week. Sales have grown an
average of 40% per year. This figure is extremely impressive when one considers that the beer
market as a whole is shrinking. Even with this success, microbrew sales represent only around two
percent of the total beer market.

In their relentless pursuit to continue to dominate all sectors of the beer market, Anheuser-Busch has
tapped into the microbrewing trend. They have recently bought a stake in the Seattle based Red Hook
Ale micro-brewery. The new products introduced into the regional and mainstream specialty beer
segment include Red Wolf, Elk Mountain Red, Elk Mountain Amber Ale, and Elephant Red.

Since microbrews are typically produced regionally, Anheuser-Busch is developing regional

manufacturers and distributors. As such, they must decide on the best way to handle their short-term
cash needs for purchasing inventory in these small plants. Anheuser-Busch has decided to use the
Baumol model to determine the level of cash to keep on hand versus the amount to keep in
marketable securities.

Anheuser-Busch can earn 7% if they keep their funds in marketable securities. Every time they
convert their marketable securities to cash, it costs them $25. Finally, they anticipate their total cash
outlays over the next year to be $2,000,000.

Questions

1. Using the Baumol Model, what is the economic conversion quantity (ECQ) that will maximize
the firm's value given their short-term cash needs? Why is it important for a business to
correctly determine their ECQ?
2. Based on your answer from question 1, how many times will Anheuser-Busch convert
marketable securities into cash per year?
3. What is the average cash balance the firm will hold throughout the year, assuming the cash
outflows will occur on a consistent or smooth basis?
4. What is the total cost associated with managing these short-term funds? How can you be sure
this is the optimal ECQ?
5. In the above analysis, we have not considered a level of safety stock. Why is safety stock so
important? What primary factor will determine the amount of safety stock for each specific
firm?

Case 30: Pepsi

Short-term Cash Management: Managing the Cash Conversion Cycle
Pepsi is a multinational company who operates within three primary industry segments: beverages,
snack foods, and restaurants. The primary products sold in the beverage segment include Pepsi, Diet
Pepsi, 7UP, and Mountain Dew. Frito-Lay represents the domestic snack food business, while PepsiCo's
restaurant segment consists primarily of Taco Bell, Pizza Hut, and KFC. Pepsi also engages in several
joint ventures around the world, each within one of the three industry segments.

Because Pepsi is such a large manufacturer and distributor, they spend millions of dollars each year on
salaries trying to keep track of orders, payments, and receipts for each of their three lines of business.

Todd Rovelstad, a manager in Financial Services at Pepsi's Phoenix plant, has discovered a way to
reduce the time required to log orders, payments, and receipts. His idea is simple, yet innovative.
Todd uses bar codes to sort paperwork.

Just as bar codes are used in a grocery store to identify each item and its price, Todd can use bar
codes to identify where orders are sent to and from, the product that is being referred to, and the
amount of the product to be bought, sold, or shipped.

This idea has several positive attributes. First, the Pepsi employees will be able to do their logging up
to four times faster than they are able to under the current system. Today, receipts for payment are
left stacked until a processor can get to them. This also allows employees to concentrate more on
other ways in which the company can save money. Second, the accuracy rate under the bar code
system is 99.99%. While keying in codes is relatively accurate also, Pepsi has been experiencing
problems because their workers are putting in too much over time and fatigue has increased the error
rate.

Todd did not stop at bar codes for processing accounts receivables. He also saw the usefulness of bar
codes for mail. The post office now sorts mail electronically by bar codes for those letters that have
them. Pepsi can use coded envelopes to speed up the return time when its customers pay for
shipments. These funds can then be deposited into PepsiCo's account much sooner than they currently
can be. Even though interest is earned on only one to two additional days, when considering the size
of Pepsi, this will translates into big savings.

Pepsi wants to determine just how much these new programs will save the company. To determine
the amount, they have disclosed the following information concerning the operating cycle. Pepsi's
average payment period is 29 days. Their average age of inventory is 42 days. And the average
collection period is 39 days.

Pepsi feels that with the new system in place, it can speed up the average collection period by 12
days. This figure reflects the fact that the employees will not only receive the payments earlier, but
more importantly, they will be able to start processing the receipts much sooner than they are
currently able to do. The average age of the inventory and average payment period are assumed to
remain unchanged.

Pepsi currently spends $28,000,000 per year on its operating cycle investments. Funds used for
financing the operating cycle cost 12% per annum. Todd feels the additional annual cost of $50,000
will be sufficient to pay for the added hardware necessary to use bar codes. This expense does not
take into consideration the additional salary expenses that will be avoided due to a reduction in
overtime costs.

Questions

1. Calculate Pepsi's current operating cycle, cash conversion cycle, and need for short-term
financing of the cash conversion cycle (i.e. What is Pepsi's negotiated financing need?).
 2. Calculate the operating cycle, cash conversion cycle, and need for short-term financing of the
cash conversion cycle if Pepsi decides to implement the use of bar codes.
3. If the bar codes are used in the future, what will be the annual savings stemming specifically
from the cash conversion cycle financing reduction?
4. Considering the annual costs associated with implementing the bar code system, should Pepsi
change their logging systems?
5. Assume the cost of implementing the bar code system exceeds the savings in reduction of
short-term financing needs. Should Pepsi decide not to change systems? Discuss.
6. Define the cash conversion cycle and explain why it is so important. Do you think cash
conversion cycles should be different for different industries (HINT - consider a manufacturer
versus a retailer).
7. What are the three ways to speed up the cash conversion cycle?

Case 31: Inn-Room Safe

Managing Accounts Receivable

Mass media news programs have made travelers aware, via hidden video cameras, of how common it
is for hotel employees and outsiders posing as hotel guests to gain access to your room and steal your
valuables right off the night stand. Of course, by the time you find out something is missing there is
no way to figure out who did it. And housekeeping never seems to keep track of who cleaned your
room. To combat this problem, most hospitality establishments provide, at a nominal fee, an in-room
safe that can only be accessed by the guest and the top manager of the hotel.

Inn-Room Safe is a manufacturer and wholesaler of the most popular and secure in-room safes on the
market, the "Interchangeable Lock Block." Inn-Room specializes by manufacturing and distributing
only this one product which comes in four different sizes to fit almost all hotel spaces.

Currently, Inn-Room provides shipping credit terms of net 30 days to top qualifying customers and
those paying by bank wire transfer. For other, less credit worthy customers, net terms of 10 and 15
days are required. Inn-Room does not allow for a discount for early accounts receivable collections.
Recognizing that sales volume should increase and that bad debt expenses should decrease, Inn-
Room is considering offering a 2% discount to those hotels who pay for shipments within 10 days.

Today, Inn-Room's average collection period is 23 days. With the proposed discount offering, this
number is expected to reduce to 14 days. Bad debt expense is expected to decrease from 0.8% to
0.5%. Inn-Room now sells 1,700 safes on credit at an average price of $234 and a variable cost of
$157 per unit. After the discount, Inn-Room forecasts that sales will increase by 7% and that 70% of
all credit sales will be by hotels that take the 2% discount. Finally, Inn-Room's required rate of return
on a similar risk investment is 12% under both account receivable options.

Questions

1. If Inn-Room decides to implement the newly proposed discount, what will be the additional
profit contribution from an increase in sales?
2. If Inn-Room decides to implement the newly proposed discount, what will be the cost of the
marginal investment in accounts receivable?
3. If Inn-Room decides to implement the newly proposed discount, what will be the marginal
benefit of reducing the bad debt expense?
4. If Inn-Room decides to implement the newly proposed discount, what will be the marginal cost
of paying the cash discount to early paying customers?
5. If Inn-Room decides to implement the newly proposed discount, what will be the net profit
from implementing the proposed plan?
6. What additional factors should Inn-Room consider when making such an important decision?

Case 32: Home Depot

Working Capital and Short-Term Management: The Cost of Taking a Cash Discount on
Accounts Payable

Home Depot, the largest home improvement retailer in the world, is on the cutting edge of retail
innovations. Much of their quick and steady rise to success is attributed to their approach to creating
new customers and cultivating future customers. Through an idea called Home Depot University,
adults take a four week comprehensive course in home improvement techniques which, of course,
illustrate how the products sold by Home Depot can be used to enhance and modernize homes. The
potential of kids as customers has not slipped their attention either. A program, known as "Our Kids
Workshops," teaches children not only safety and creativity, but also plants a loyalty seed for the
future.

Another means by which Home Depot has differentiated themselves from their competition is by
marketing what are called proprietary brands. This simply means that the product lines are only
offered at Home Depot. Once customers adopt the product, they cannot buy it elsewhere. This is a
way for Home Depot to protect their customer base from discount retailers who compete purely on
price and drive down profit margins. One of Home Depot's proprietary brands is RIDGID who produce
everything from power tools to wet/dry vacuums and air filtration systems.

When Home Depot buys products from RIDGID, they use credit and have 45 days to make full
payment on these accounts payable. However, if Home Depot wants to take advantage of RIDGID's
2% cash discount offer, they must pay within 15 days. To simplify record keeping, RIDGID uses the
end-of-month (EOM) method when determining the beginning of the credit period. This simply means
that any sales made throughout the month will have a starting credit period beginning on the first day
of the next month.

For example, Home Depot recently purchased a shipment of stationary bench-top power tools from
RIDGID on December 23. Since RIDGID follows the EOM method, Home Depot's credit period does not
start until January 1. If Home Depot wishes to take the 2% cash discount offered, they must make full
payment by January 15. If not, they must pay the entire amount by February 14.

Questions

1. Calculate the exact cost of giving up the discount.

2. Home Depot's risk-free required rate of return is currently 7%. The firm's Weighted Average
Cost of Capital (WACC) is 13.4%. Finally, the rate at which the company can borrow from a
bank is 9.7%. Should Home Depot take the cash discount or should they wait until the full
credit period is up? On which of the above three figures did you base your comparison?
Explain.
3. Calculate the approximate cost of giving up the discount.
4. Perform a sensitivity analysis using both the actual and the approximation formulas with cash
discounts of 1%, 2%, and 3% and credit periods of 30 days, 45 days, and 60 days. What is
the relationship between these two variables and the error yielded by the approximation
formula?

Case 33: Hasbro

Leasing versus Buying

Hasbro, Inc., is a multinational parent company who is in the primary business of designing,
manufacturing, and marketing toys, games, puzzles, etc. Their subsidiary companies include such
household names as Parker Brothers, Milton Bradely, Tonka, and Playskool. These companies produce
some of the most easily recognized products in the world: Monopoly, Mr. Potato Head, G.I. Joe,
Scrabble, East Bake Ovens, Play Doh, and Transformers, to name a few.

Hasbro is currently trying to pick-up ground in the doll market by directly competing with Mattel's
Barbie, a front runner in the doll market segment for decades. To do so, Hasbro has proposed the sale
of their own teenage doll, Maxie. To produce Maxie, Hasbro must acquire several new pieces of
equipment.

As part of the production process, Hasbro currently occupies certain manufacturing facilities and sales
offices and uses certain equipment under various operating leases. Now that they need to acquire
more machinery, they must decide whether to buy or lease the new equipment.

Hasbro can purchase the machinery for $30,000 by financing over a five year period at 8% interest. The
corresponding annual payment would be $7,514. Buying the machinery has an advantage in that the
machine can be depreciated using the MACRS five year recovery system. Depreciation rates are given
below.

Year Percent that can

be Depreciated
1 20
2 32
3 19
4 12
5 12

The drawback to purchasing the machinery, however, is that the maintenance duties are borne by the
owner. To maintain the machinery will cost Hasbro $1,000 each year for five years.

If Hasbro decides to lease the machinery, they will have to pay the lessor $7,000 per year for the next
five years. As with most operating leases, the lessor will pay for all maintenance necessary. At the end
of the five year period, Hasbro will have the option to buy the machinery at a cost of $6,000. The tax
rate for Hasbro is 40%.

Questions

1. Find the after-tax cash flows associated with the lease payments. Assume Hasbro will agree to
purchase the machinery at the end of the five year period for the agreed upon $6,000.
2. If the machinery is purchased, the interest paid from financing it is tax deductible. Since this is
the case, find the amount of interest paid each year.
3. Depreciation is also tax deductible if the machinery is purchased. Calculate the depreciation
expenses over the five year period.
4. Knowing that depreciation, interest expenses, and maintenance costs are tax deductible,
calculate the total tax shield associated with purchasing the machinery.
5. What are the total net after-tax cash outflows associated with purchasing the machinery?
6. Using your answers from questions 1 and 5, should Hasbro lease or buy the machinery? (i.e.
What is the present value of the costs associated with both options?)
 7. In general, what are the advantages and disadvantages to leasing?

In question 1, we assumed Hasbro would purchase the machinery for $6,000 at the end of the five
year lease period. In practice, Hasbro will want to wait the full five years before they make that
decision. What will their decision be based on at that time? That is, if Hasbro decides to lease the
machinery, what factors will determine their decision of whether or not to buy the machinery at the
end of the lease?
Case 34: Microsoft
Special Topics: Options

Chris Jubran is an avid follower of technology stocks. He currently owns 500 shares of Microsoft's
common stock. Today the price of each share is $89. Tomorrow, Microsoft will announce whether a
much anticipated business deal with long-distance phone service giant, AT&T, will go through. If the
deal is made, the stock price of both firms should increase substantially. While most of the investment
community believes the agreement will occur, Chris feels otherwise.

Chris is very concerned that the value of his holdings, $44,500($89 x 500 shares), will greatly
decrease if the Microsoft/AT&T deal does not pan out. One way out of this predicament is to sell off his
Microsoft holdings, wait for the announcement and the corresponding decrease in the stock price, then
repurchase the shares at a lower rate. Although this would not result in a profit, Chris would avoid the
loss associated with holding the shares.

After calling his discount broker at Charles Schwab to determine the transaction costs associated with
selling off the 500 shares, Chris found that the round trip transaction costs would be far too
expensive. Instead, his broker recommended the use of put options.

The following information is a reprint from a recent edition of the Wall Street Journal on December 15:

Table 1

MicroSoft Strike Expiration Call Put

(MSFT) Price Date Vol. Last Vol. Last
Stock Price
89 75 Jan 11 17 7/8 118 1/2
89 75 Apr 17 17 1/2 62 2 1/4
89 80 Jan ----- ----- 1475 1 1/4
89 85 Dec 813 3 7/8 253 1 1/4
89 85 Jan 147 7 430 2 5/8
89 85 Apr 75 11 1/8 28 4 7/8
89 90 Dec 2221 3/8 1684 1 1/2
89 90 Jan 1373 4 641 4 3/4
89 90 Apr 71 7 5/8 16 7
89 90 Jul 50 10 1/2 27 8
89 95 Dec 1758 1/16 292 6 1/2
89 95 Jan 836 2 1/4 849 7 7/8
89 95 Apr 89 6 13 10 1/4
89 100 Jan 1068 1 3/16 58 11 3/4
89 100 Apr 324 4 1/4 2 13 1/4
89 105 Jan 186 1/2 ----- -----
89 110 Jan 92 1/4 5 18 3/8
89 110 Apr 125 2 ----- -----
Questions

1. How can Chris use put options to hedge himself against the possibility that Microsoft and AT&T
will not come to an agreement? Be sure to indicate which specific contract should be used.
2. If Chris buys 5 put contracts (i.e. on 500 underlying shares) with an exercise price of $90 and
an expiration in December for $1.50 per option, how will his overall wealth position change if
the stock price jumps up to $93 after the announcement? What if the stock price falls to $85?
For simplicity, ignore transaction costs and margin requirements.
3. Microsoft's options trade on a January, April, July, October cycle. Why then do we see that
options are offered with a maturity month in December as well?
4. Consider the four call options with a strike price of $90. What appears to be the relationship
between time to maturity and volume? What appears to be the relationship between the price
of the call and the time to maturity? Do these relationships hold for the corresponding put
options as well? Explain why or why not.
5. Most trading volume in calls occurs in contracts where the exercise price is above the current
stock price. Why does this make sense?
6. In a call option, when the strike price is far below the current stock price, the call option price
tends to be extremely high (in of the money) and when the strike price is far above the
current stock price, the call option price tends to be extremely low (out of the money). Why
does this relationship make perfect sense?
Case 35: REITs
Real Estate Investment Trusts

REITs have been in existence since 1960. However, it wasn't until around 1992 that they became
popular. A REIT is a securitized form of owning real estate. Before REITs, the only way to experience
the risk and return associated with commercial real estate was to own it directly through property
pools, commingled real estate funds (CREFs), syndications, or separate accounts. Today, you can buy
a REIT, which represents ownership in a company that holds real estate as their primary assets. REITs
are real estate stocks and are traded on the NASDAQ, AMEX, and NYSE. As such, they are exposed to
market noise like any other stocks, but are also similar to their underlying assets, real estate. This
makes the capital gains component of their returns very attractive as a hedge against inflation, a
characteristic much desired by investors.

Moreover, since a minimum of 95% of a REIT's taxable income must be paid out in the form of a
dividend, investors liken the income stream to utility stocks that also pay a high percentage in
dividends. Finally, REITs have a low correlation with other stocks, bonds, etc. and therefore have been
found to warrant inclusion in mixed-asset portfolios. But, even with their steady returns and low
volatility, REITs have received little attention from the investment community.

One of the reasons why REITs are given little attention is because there are only around 200 in
existence today. While this is three times greater than the number just ten years ago, the total
market capitalization of all REITs is still less than that of Microsoft. As such, analysts have not
considered them worth the time to monitor and evaluate.

That being said, REITs are being used by several real estate portfolio managers as a way to rebalance
their portfolios over time. Why? Unsecuritized real estate, such as a $50 million dollar office building in
downtown Chicago, is an illiquid and lumpy asset. That is, if you want to sell $1 million dollars of it, it
would not be possible. You would have to be able to sell off just one or two floors of the building.
Since this is not possible, institutional investors might instead sell off $1 million worth of an office
REIT.

Whether or not REITs gain widespread acceptance and continue to perform well remains to be seen.
Still, at present, REITs do offer an attractive risk-return tradeoff.

Questions

1. Why would you suspect real estate is a good hedge against inflation?
2. Which types of investors are more likely to own REITs?
3. REITs have had a lower correlation recently than in the past. Explain why and justify whether
or not you think this trend will continue.
4. Does the fact that the total market capitalization of all REITs sums to less than that of
MicroSoft present a problem for real estate portfolio investors who are trying to use REITs to
rebalance their large portfolios? Explain why or why not.
Case 36: HOLDRs
New Security Offerings: HOLDRs versus UITs

A type of security, known as a HOLDR, is now available to investors. The first HOLDR was introduced
by Merrill Lynch in September of 1999. Since then several more have been offered, and given their
early success, this trend is likely to continue.

A HOLDR is similar to a Unit Investment Trust (UIT) in that both are unmanaged baskets of securities
that can be redeemed for their underlying assets. The primary differences involve pricing and trading.
UITs are like mutual funds in that their price is calculated once a day, at the end of each trading
session. HOLDRs, on the other hand, trade like stocks in that their price changes continuously during
trading hours. This is an added attraction in today's environment of so many day traders.

The second major difference is that it is not difficult to find the price of a HOLDR. HOLDRs have a
ticker symbol which means it is very easy to track their prices - say from various Internet sites. UITs
do not have ticker symbols. Investors are often forced to call brokers or the trust sponsor to get
pricing information. In response to the new, much more convenient HOLDR security, a UIT industry
representative states, "It's being discussed among the major broker/dealers and sponsors, and we
want to implement them (ticker symbols) as soon as possible."

Other differences between the two types of secureties include changes in the composition of portfolios
(HOLDRs are completely fixed, whereas UITs can add securities - particularly ones that track indexes),
sales charges (HOLDRs are very similar to common stocks, whereas UITs are quite complex and vary
from UIT to UIT), and time to maturity (HOLDRs, like common stocks, have no expiration, but UITs
have a finite life).

While it is difficult to draw definite conclusions as to which type of investment vehicle is better for
investors, HOLDRs do seem to have caught the attention of UIT sponsors. What we do know is that
Merrill Lynch plans to offer more of these stock bundles in the future. Whether HOLDRs will cut into
the volume of UIT trading, simply attract more capital into the markets as a whole, or at least provide
a financial incentive for the UIT industry to improve upon the transparency and availability of price
data for their products remains to be seen.

Questions

1. What causes firms, like Merrill Lynch, to offer new variations of existing securities?
2. When compared to UITs, why would HOLDRs attract more day traders?
3. Do you think it is a coincidence that the UIT industry is starting to offer better price availability
now that HOLDRs have emerged? Explain.
4. The HOLDRs introduced thus far by Merrill Lynch have been industry specific (Internet - HHH,
Biotech - BBH, Telecom - TTH, and Pharmaceutical - PPH). Considering diversification, is it
enough to hold just one type of HOLDR? Explain.
Case 37: Reynolds
Mergers and Takeovers

Strap your seatbelts on, keep your hands inside the vehicle and hold on for dear life. The merger
mania roller coaster that has been so prevalent in today's market is going for another ride. Just hours
after a three-way $17.6 billion mega-merger was announced between Canada's Alcan, Pechiney of
France, and Switzerland's Algroup, U.S. based Alcoa, the world leader in the aluminum industry,
announced plans to buy Reynolds Metal for $5.6 billion. If the merger between Alcoa and Reynolds,
the third largest aluminum firm, were to happen it would make the resulting Alcoa by far the market
dominator.

There are two things standing in the way of the Alcoa-Reynolds merger. Since the union of the two
giants would result in a market leader akin to Microsoft in the computer industry, and because
competition would be drastically reduced, there are several regulatory anti-trust concerns. The second
potential hold up involves the degree of willingness on the part of Reynolds' management to be
purchased by Alcoa. Since mergers also mean layoffs, managers are always cautious about merger
deals.

But mergers also mean large stock price increases for the firms who are the target of merger and
takeover attempts. Therefore, most stockholders prefer their company to be the topic of bidding
speculation. In fact, Highfields Capital Management LP, Reynolds' single largest stockholder, has taken
the initiative to foster further merger consideration. They are pressuring Reynolds' management to
arrange an auction to the highest bidder.

Highfields Capital's managing director, Richard Grubman, wrote a letter to Reynolds' CEO, Jeremiah
Sheehan stating, "Your shareholders deserve nothing less and will hold you accountable if you fail to
take this action now." Fearing derivative shareholder action and accepting what seems to be the
inevitable, Reynolds appears to be open to listen to deals from anyone and everyone.

So where do the smaller firms in the aluminum industry fit into all this? Industry analysts report that
these firms are scrambling in an attempt to be a part of deals while the market is in a state of frenzy.
The fear of being left out could be a rational one as many feel bidding wars result in over paying for
firms.

Just when things could not be more unpredictable, an outside player has announced intentions to
challenge the bid of Alcoa for Reynolds Metal. Michigan Avenue Partners (MAP), a firm who got their
start in commercial real estate, has come out of the woodwork to announce interest in Reynolds. MAP
is not exactly a stranger to the aluminum industry, however. A few years ago they bought Reynolds'
McCook division and are now the second largest producer of aluminum plating (behind Alcoa). They
also own Metro Metals which is a steel processing firm. Still, analysts did not even see MAP on the
bidding radar screen.

The next few months will prove telling for this capricious environment. Said John Martin, aluminum
industry analyst at the CRU consultancy in London, "Nothing would surprise me."

Questions

1. Why is it that firms like Alcoa desire to merger or buy other large firms in the same industry
like Reynolds?
2. Why might regulators have a problem with firms like Alcoa buying firms like Reynolds?
3. What are the general reasons why firms merge?
4. What can firms do to prevent a takeover attempt from an unwanted suitor?
5. How are funds raised to complete a merger between two such large firms?
6. In the case it stated that several of the smaller firms in the industry wanted to be considered
as bidding candidates because bidders tend to pay over fair market value for the smaller firm's
shares. Why does this happen?
Case 38: Adaptec
Corporate Spin-offs

Brian Reeves opened his mailbox to find a letter from Adaptec, Inc., a global leader in data storage
access solutions, which had cost him a lot of heartache in the recent 6 months. After being enticed to
purchase shares in high-tech companies after they enjoyed a significant run-up in value, Brian jumped
on the band wagon only to see the value of the stock get cut in half.

The letter read, "Adaptec, Inc.,… announced that the Form 10 Registration Statement for the spin-off
of Roxio, Inc., a wholly owned subsidiary of Adaptec, has been declared effective by the Securities and
Exchange Commission. Included in the Form 10 is an Information Statement, which will be mailed to
Adaptec stockholders later this week…" Skipping over a few sentences, Brian continued.

"On April 12, 2001, the Adaptec board declared a dividend to Adaptec stockholders of record on April
30, 2001, of shares of Roxio common stock. The dividend will be paid after the close of business on
May 11, 2001, in the amount of 0.1646 shares of Roxio common stock for each share of Adaptec
common stock. Adaptec stockholders will not be required to pay any cash or other consideration for
the shares of Roxio common stock distribution to them or to surrender or exchange their shares of
Adaptec common stock to receive the dividend of Roxio common stock."

After reading through all the documents, Brian learned that there are two ways to trade the Adaptec
shares between the date of record, April 30, and the distribution date of May 11. He could either trade
the "regular way," which meant when he sold a share of Adaptec, he would also be selling the right to
the shares of Roxio (Ticker symbol = ADPT), or he could sell "when issued," which meant that he is
only parting with shares of Adaptec (Ticker symbol = ADPTV). That is, he would retain the rights of
owning shares in Roxio when they became available for sale.

Questions

1. Brian wondered why he did not have to do anything in order to be awarded shares of this new
company, Roxio. Explain why it makes sense that he did not have to do anything.
2. Assume Brian owned 100 shares of Adaptec. Based on the ratio of exchange of 1 share of
Adaptec = 0.1646 shares of Roxio, how many shares of Roxio will Brian receive assuming he
retains his Adaptec shares?
3. To follow up from question 2, what will happen to the rights to FRACTIONAL shares? That is,
after calculating the number of shares Brian is to receive, what happens to the extra fraction
of a share given that with common stock, fractional shares ownership is disallowed?
4. Continuing with the fractional share discussion, what are the tax ramifications of these
fractional shares?
Case 39: Roxio
Corporate Spin-offs

Roxio, a wholly-owned subsidiary of Adaptec, recently finalized its decision to become a completely
separately traded corporation. In their own words, Roxio describes themselves as "... a leading
provider of digital media software solutions that enable individuals to create, manage and move
music, photos, video and data onto recordable compact discs, or CDs. Our principal products are our
East CD Creator and Toast families of CD recording software and our GoBack system recovery
software. Our software was bundled with approximately 70% of the CD recorders shipped in 2000.

We sell our products to a wide range of customers, including leading personal computer, or PC, and
CD recordable drive manufacturers and integrators such as Dell, Hewlett-Packard, Philips and Yamaha.
Sales to PC and CD recordable drive manufacturers and integrators generate 64% of our net revenues
for the nine months ended December 31, 2000. We also sell our products to retailers through our
distributors, such as Computer 2000, Ingram Micro, Softbank and Tech Data, and directly to end
users. Sales to retailers through our distributors and directly to our end users generated 36% of our
net revenues for the nine months ended December 31, 2000."

Concerning the independence of Roxio from Adaptec, "... we will enter into a Master Separation and
Distribution Agreement and several ancillary agreements for the purpose of accomplishing the
contribution of substantially all of the business and assets of Adaptec's software products group to us
and the distribution of our common stock to Adaptec's stockholders (at a ratio of 1 Adaptec share =
0.1646 shares of Roxio)."

Questions

1. Although the benefits can vary from firm to firm, what do you imagine are the common benefits to
a firm when they spin-off from a larger corporation?

2. What are the key risk factors associated with any spin-off?

3. Will Adaptec, Inc. keep any of the shares in Roxio? If so, why?

4. Do you imagine Roxio will pay a dividend in the near future?

Case 40: Tyco
Special Topics: Multi-National Financial Management

$17 billion worth of toys are sold each year with 2/3 of the sales occurring during the last quarter.
Every year as Christmas nears, parents are bombarded with pressures to fulfill their children's every
toy related desire. From increased advertisements on Saturday mornings (cartoon day) to sitting on
Santa's lap at the mall, toy companies see the last three months of the year as their make or break
time.

Tyco Toys, Inc. is one of the largest toy company in the United States. They produce and sell radio
control toys, dolls, electric racing sets, view-master 3-D viewers, playschool toys, and much, much
more. Their most recent success is a product called Doctor Dreadful. Tyco had noticed a recent trend
in toys that are designed to push the outer limits on grossing kids out. From candy that turns your
tongue different colors to edible candy snot that is dispensed from a toy nose, kids were ready to push
the (disgusting) envelope.

Doctor Dreadful is a small-scale scientist's laboratory that kids use to create candy warts, brains, and
other vile corporal creations. The product is mainly geared towards boys, but none the less, it sold
over $50 million in its first quarter.

Tyco is not only a domestic seller, but it has several foreign operations as well. Many of its products
are sold in the United Kingdom, Canada, Mexico, Australia, Thailand, the People’s Republic of China,
Belgium, France, Spain, Austria, Switzerland, and Germany. Since Tyco has been able to penetrate the
western European market it has been contemplating an entrance into the Netherlands. With the
success of Doctor Dreadful, Tyco feels this is the ideal time.

Cees Van Der Lelij, Senior Vice President of Tyco International in Europe, is responsible for
determining the feasibility of establishing a factory in the Netherlands. Cees noticed that the current
exchange rate between the United States and the Netherlands is $1 = 1.6 Guilders. Based on this
rate, it will cost approximately $13,000,000 (20.8 million guilders) to build the factory.

In order to raise funds for the foreign direct investment, Tyco felt that raising funds domestically
would be much less risky than listing securities in a foreign stock market. Tyco decided the funds
should be raised with 50% debt and 50% equity. Additionally, working capital would also have to be
dedicated to the project in the amount of $1.5 million. To fulfill the need for the net working capital,
Tyco could either raise the entire amount in dollars in London’s Eurodollar market at a 6% annual rate
or the entire amount could be borrowed in the Netherlands at 9% locally. Tyco’s domestic cost of
equity is 11.4% and its after-tax cost of debt is 5.6%.

Initially, Tyco will ship major toy components from the United States. Accordingly, roughly half of the
costs will be in dollars and half will be in guilders. All of the revenues, however, will be in guilders. If
exchange rates remain constant, Tyco feels profits from the Netherlands market will be 17% of sales.

Questions

1. Calculate the cost of capital for Tyco's proposed foreign direct investment.
2. If sales are generated in the amount of $35,000,000 over the next four years and exchange
rates do not change, what is the present value of profits from the Netherlands?
3. If the dollar were to appreciate relative to the guilder over the next four years, how would this
affect the profits of Tyco?
4. What steps can Tyco take to reduce their exposure to foreign exchange rate risk from a
financing standpoint?
5. What steps can Tyco take to reduce their exposure to foreign exchange rate risk from a
production standpoint?