Legs Diamond owns shares in a Vanguard Index 500 mutual fund worth $1 million on July 15. (This is an index fund that tracks the Standard and Poor’s 500 Index.) He wants to cash in now, but his accountant advises him to wait six months so as to defer a large capital gains tax. Explain to Legs how he can use stock index futures to hedge out his exposure to market movements over the next six months. Could Legs “cash in” without actually selling his shares?
> We noted that, when calculating EVA, you should calculate income as the sum of the after-tax interest payment and net income. Why do you need to deduct the tax shield? Would an alternative be to use a different measure of the cost of capital? Or would yo
> Suppose that you wish to use financial ratios to estimate the risk of a company’s stock. Which of those that we have described in this chapter are likely to be helpful? Can you think of other accounting measures of risk?
> How would rapid inflation affect the accuracy and relevance of a manufacturing company’s balance sheet and income statement? Does your answer depend on how much debt the firm has issued?
> If you buy a nine-month T-bill future, you undertake to buy a $1 million three-month bill in nine months’ time. Suppose that Treasury bills and notes currently offer the following yields: Months to Maturity.....................Annual Yield 3...
> Here are some data for five companies in the same industry: You have been asked to calculate a measure of times-interest-earned for the industry. Discuss the possible ways that you might calculate such a measure. Does changing the method of calculation m
> As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad (Table 28.11). Can you use the following information to work out the missing entries? (Note: For this problem,
> Sara Togas sells all its output to Federal Stores. The following table shows selected financial data, in millions, for the two firms: Calculate the sales-to-assets ratio, the operating profit margin, and the return on assets for the two firms. Now assum
> The following table shows interest rates and exchange rates for the U.S. dollar and the Lilliputian nano. The spot exchange rate is 15 nanos = $1. Complete the missing entries: 1 Month 3 Months 1 Year Dollar intere
> How would the following actions affect a firm’s current ratio? a. Inventory is sold. b. The firm takes out a bank loan to pay its suppliers. c. The firm arranges a line of credit with a bank that allows it to borrow at any time to pay its suppliers. d
> Suppose that a firm has both fixed-rate and floating-rate debt outstanding. What effect will a decline in interest rates have on the firm’s times-interest-earned ratio? What about the ratio of the market value of debt to that of equity? Would you judge t
> Discuss alternative measures of financial leverage. Should the market value of equity be used or the book value? Is it better to use the market value of debt or the book value? How should you treat off-balance-sheet obligations such as pension liabilitie
> Describe some alternative measures of a firm’s overall performance. What are their advantages and disadvantages? In each case discuss what benchmarks you might use to judge whether performance is satisfactory.
> True or false? a. A company’s debt–equity ratio is always less than 1. b. The quick ratio is always less than the current ratio. c. The return on equity is always less than the return on assets.
> On average, it takes Microlimp’s customers 60 days to pay their bills. If Microlimp has annual sales of $500 million, what is the average value of unpaid bills?
> Do Japanese investors play an important role in corporate financial policy and governance? If not, could they?
> Airlux Antarctica has current assets of $300 million, current liabilities of $200 million and a crash—sorry—cash ratio of .05. How much cash and marketable securities does it hold?
> A firm in the United States is due to receive payment of €1 million in eight years’ time. It would like to protect itself against a decline in the value of the euro, but finds it difficult to get forward cover for such a long period. Is there any other w
> A U.S. company has committed to pay 10 million kronor to a Swedish company in one year. What is the cost (in present value) of covering this liability by buying kronor forward? The Swedish interest rate is .6%, and exchange rates are shown in TableÂ
> In March 1997, the exchange rate for the Indonesian rupiah was R2,419 = $1. Inflation in the year to March 1998 was about 30% in Indonesia and 2% in the United States. a. If purchasing power parity held, what should have been the nominal exchange rate i
> “Northern Refineries does not avoid risk by selling oil futures. If prices stay above $2.40 a gallon, then it will actually have lost by selling oil futures at that price.” Is this a fair comment?
> Define each of the following theories in a sentence or simple equation: a. Interest rate parity. b. Expectations theory of forward rates. c. Purchasing power parity. d. International capital market equilibrium (relationship of real and nominal intere
> Look at Table 27.1. a. How many Japanese yen do you get for your dollar? b. What is the one-month forward rate for yen? c. Is the yen at a forward discount or premium on the dollar? d. Use the one-year forward rate to calculate the annual
> Alpha and Omega are U.S. corporations. Alpha has a plant in Hamburg that imports components from the United States, assembles them, and then sells the finished product in Germany. Omega is at the opposite extreme. It also has a plant in Hamburg, but it b
> Carpet Baggers, Inc., is proposing to construct a new bagging plant in a country in Europe. The two prime candidates are Germany and Switzerland. The forecasted cash flows from the proposed plants are as follows: The spot exchange rate for euros is $1.3/
> “Last year we had a substantial income in sterling, which we hedged by selling sterling forward. In the event sterling appreciated. So our decision to sell forward cost us a lot of money. I think that in the future we should either stop hedging our curre
> What is a keiretsu? Give a brief description.
> Table 27.5 shows the annual interest rate (annually compounded) and exchange rates against the dollar for different currencies. Are there any arbitrage opportunities? If so, how would you secure a positive cash flow today, while zeroing out a
> In November 2014, an American investor buys 1,000 shares in a Mexican company at a price of 500 pesos each. The share does not pay any dividend. A year later she sells the shares for 550 pesos each. The exchange rates when she buys the stock are shown in
> You have bid for a possible export order that would provide a cash inflow of €1 million in six months. The spot exchange rate is $1.3549 = €1 and the six-month forward rate is $1.3620 = €1. There are two sources of uncertainty: (1) the euro could apprec
> A Ford dealer in the United States may be exposed to a devaluation of the yen if this leads to a cut in the price of Japanese cars. Suppose that the dealer estimates that a 1% decline in the value of the yen would result in a permanent decline of 5% in t
> Companies may be affected by changes in the nominal exchange rate or in the real exchange rate. Explain how this can occur. Which changes are easiest to hedge against?
> Exacta, s.a. Exacta, s.a., is a major French producer, based in Lyons, of precision machine tools. About two thirds of its output is exported. The majority of these sales is within the European Union. However, the company also has a thriving business in
> Suppose you are the treasurer of Lufthansa, the German international airline. How is company value likely to be affected by exchange rate changes? What policies would you adopt to reduce exchange rate risk?
> Penny Farthing, the treasurer of International Bicycles, Inc., has noticed that the interest rate in Japan is below the rates in most other countries. She is, therefore, suggesting that the company should make an issue of Japanese yen bonds. Does this ma
> Look at Table 27.1. If the three-month interest rate on dollars is 0.2%, what do you think is the three-month interest rate on the Brazilian real? Explain what would happen if the rate were substantially above your figure. Table 2
> Table 27.1 shows the 90-day forward rate on the South African rand. a. Is the dollar at a forward discount or premium on the rand? b. What is the annual percentage discount or premium? c. If you have no other information about the two curr
> Why are pyramids common in many countries but not in the United States or United Kingdom?
> It is the year 2021 and Pork Barrels Inc. is considering construction of a new barrel plant in Spain. The forecasted cash flows in millions of euros are as follows: The spot exchange rate is $1.2 = €1. The interes
> Suppose that in 2023 one- and two-year interest rates are 5.2% in the United States and 1.0% in Japan. The spot exchange rate is ¥120.22/$. Suppose that one year later interest rates are 3% in both countries, while the value of the yen has appreciated to
> An importer in the United States is due to take delivery of clothing from Mexico in six months. The price is fixed in Mexican pesos. Which of the following transactions could eliminate the importer’s exchange risk? a. Sell six-month call options on peso
> Phillip’s Screwdriver Company has borrowed $20 million from a bank at a floating interest rate of 2 percentage points above three-month Treasury bills, which now yield 5%. Assume that interest payments are made quarterly and that the entire principal of
> Your investment bank has an investment of $100 million in the stock of the Swiss Roll Corporation and a short position in the stock of the Frankfurter Sausage Company. Here is the recent price history of the two stocks: On the evidence of these six mo
> “Speculators want futures contracts to be incorrectly priced; hedgers want them to be correctly priced.” Why?
> Yesterday you sold six-month futures on the German DAX stock market index at a price of 9,120. Today the DAX closed at 9,100 and DAX futures closed at 9,140. You get a call from your broker, who reminds you that your futures position is marked to market
> Is a total return swap on a bond the same as a credit default swap? Why or why not?
> Consider the commodities and financial assets listed in Table 26.5. The risk-free interest rate is 6% a year, and the term structure is flat. a. Calculate the six-month futures price for each case. b. Explain how a magnoosium producer would use a futures
> Petrochemical Parfum (PP) is concerned about a possible increase in the price of heavy fuel oil, which is one of its major inputs. Show how PP can use either options or futures contracts to protect itself against a rise in the price of crude oil. Show ho
> What kind of industries do you think should thrive in a market-based financial system? In a bank-based system?
> Price changes of two gold-mining stocks have shown strong positive correlation. Their historical relationship is Average percentage change in A = .001 + .75 (percentage change in B) Changes in B explain 60% of the variation of the changes in A (R2 = .6).
> A gold-mining firm is concerned about short-term volatility in its revenues. Gold currently sells for $1,300 an ounce, but the price is extremely volatile and could fall as low as $1,220 or rise as high as $1,380 in the next month. The company will bring
> What is meant by “delta” (δ) in the context of hedging? Give examples of how delta can be estimated or calculated.
> Securities A, B, and C have the following cash flows: a. Calculate their durations if the interest rate is 8%. b. Suppose that you have an investment of $10 million in A. What combination of B and C would hedge this investment against interest rate c
> In September 2020 swap dealers were quoting a rate for five-year euro interest rate swaps of 4.5% against Euribor (the short-term interest rate for euro loans). Euribor at the time was 4.1%. Suppose that A arranges with a dealer to swap a €10 million fiv
> The following table shows 2014 gold futures prices for varying contract lengths. Gold is predominantly an investment good, not an industrial commodity. Investors hold gold because it diversifies their portfolios and because they hope its price will rise.
> Why is transparency important in a market-based financial system? Why is it less important in a bank-based system?
> Banks are not the only financial intermediary from which corporations can obtain financing. What are the other intermediaries? How much financing do they supply, relative to banks, in the United Kingdom, Germany, and Japan?
> Agency problems are inevitable. That is, we can never expect managers to give 100% weight to shareholders’ interests and none to their own. a. Why not? b. List the mechanisms that are used around the world to keep agency problems under control.
> What is tunneling? Why does the threat of tunneling impede the development of financial markets?
> What is meant by the German system of codetermination?
> In December 2014, 6-month futures on the Australian S&P/ASX 200 Index traded at 5,376. Spot was 5,442. The interest rate was 2.5%, and the dividend yield was about 4.7%. Were the futures fairly priced?
> Which countries have a. The largest stock markets? b. The largest bond markets? c. The smallest direct holdings of shares by individual investors? d. The largest holdings of bank deposits by individual investors? e. The largest holdings of shares by
> What are some of the advantages and disadvantages of Japanese keiretsu’s?
> “Privatization appears to bring efficiency gains because public companies are better able to reduce agency costs.” Why do you think this may (or may not) be true?
> True or false? a. Hedging transactions in an active futures market have zero or slightly negative NPVs. b. When you buy a futures contract, you pay now for delivery at a future date. c. The holder of a financial futures contract misses out on any dividen
> We described carried interest as an option. What kind of option? How does this option change incentives in a private-equity partnership? Can you think of circumstances where these incentive changes would be perverse, that is, potentially value-destroying
> Explain the structure of a private-equity partnership. Pay particular attention to incentives and compensation. What types of investment were such partnerships designed to make?
> Read Barbarians at the Gate (Further Reading). What agency costs can you identify? Do you think the LBO was well-designed to reduce these costs?
> The Sealed Air leveraged restructuring is described in the Chapter 18 Beyond the Page feature. Outline the similarities and differences between the RJR Nabisco LBO and the Sealed Air restructuring. Were the economic motives the same? Were the results the
> True, false, or “It depends on. . .”? a. Carve-out or spin-off of a division improves incentives for the division’s managers. b. Private-equity partnerships have limited lives. The main purpose is to force the general partners to seek out quick payback
> True or false? a. When a company becomes bankrupt, it is usually in the interests of stockholders to seek a liquidation rather than a reorganization. b. In Chapter 11 a reorganization plan must be presented for approval by each class of creditor. c. In
> Private-equity partnerships have a limited term. What are the advantages of this arrangement?
> Phoenix Motors wants to lock in the cost of 10,000 ounces of platinum to be used in next quarter’s production of catalytic converters. It buys three-month futures contracts for 10,000 ounces at a price of $1,300 per ounce. a. Suppose the spot price of pl
> What advantages have been claimed for public conglomerates?
> True or false? a. One of the first tasks of an LBO’s financial manager is to pay down debt. b. Once an LBO or MBO goes private, it almost always stays private. c. Targets for LBOs in the 1980s tended to be profitable companies in mature industries. d
> Table 26.4 contains spot and six-month futures prices for several commodities and financial instruments. There may be some money-making opportunities. See if you can find them, and explain how you would trade to take advantage of them. The interest rate
> Define the following terms: a. LBO b. MBO c. Spin-off d. Carve-out e. Asset sale f. Privatization g. Leveraged restructuring
> We described several problems with Chapter 11 bankruptcy. Which of these problems could be mitigated by negotiating a prepackaged bankruptcy?
> For what kinds of firm would an LBO or MBO transaction not be productive?
> Explain why equity can sometimes have a positive value even when companies file for bankruptcy.
> What is the difference between Chapter 7 and Chapter 11 bankruptcies?
> List the disadvantages of traditional U.S. conglomerates.
> What are the government’s motives in a privatization?
> Which of the following transactions are not likely to be classed as tax-free? a. A cash acquisition of assets. b. A merger in which payment is entirely in the form of voting stock.
> List some of the commodity futures contracts that are traded on exchanges. Who do you think could usefully reduce risk by buying each of these contracts? Who do you think might wish to sell each contract?
> Are the following hypothetical mergers horizontal, vertical, or conglomerate? a. IBM acquires Dell Computer. b. Dell Computer acquires Walmart. c. Walmart acquires Tyson Foods. d. Tyson Foods acquires IBM.
> Why may market-based financial systems be better in supporting innovation and in releasing capital from declining industries?
> What is meant by dual-class equity? Do you think it should be allowed or outlawed?
> Explain the distinction between a tax-free and a taxable merger. Are there circumstances in which you would expect buyer and seller to agree to a taxable merger?
> The Muck and Slurry merger has fallen through (see Section 31-2). But World Enterprises is determined to report earnings per share of $2.67. It therefore acquires the Wheelrim and Axle Company. You are given the following facts: Once again there are n
> As treasurer of Leisure Products, Inc., you are investigating the possible acquisition of Plastitoys. You have the following basic data: You estimate that investors currently expect a steady growth of about 6% in Plastitoys’ earnings and dividends. Un
> Suppose you obtain special information—information unavailable to investors—indicating that Backwoods Chemical’s stock price is 40% undervalued. Is that a reason to launch a takeover bid for Backwoods? Explain carefully.
> Sometimes the stock price of a possible target company rises in anticipation of a merger bid. Explain how this complicates the bidder’s evaluation of the target company.
> Respond to the following comments. a. “Our cost of debt is too darn high, but our banks won’t reduce interest rates as long as we’re stuck in this volatile widget-trading business. We’ve got to acquire other companies with safer income streams.” b. “Merg
> Briefly define the following terms: a. Purchase accounting b. Tender offer c. Poison pill d. Golden parachute e. Synergy
> True or false? a. Sellers almost always gain in mergers. b. Buyers usually gain more than sellers in acquisitions. c. Firms that do unusually well tend to be acquisition targets. d. Merger activity in the United States varies dramatically from year to ye
> Velcro Saddles is contemplating the acquisition of Pogo Ski Sticks, Inc. The values of the two companies as separate entities are $20 million and $10 million, respectively. Velcro Saddles estimates that by combining the two companies, it will reduce mark
> On some catastrophe bonds, payments are reduced if the claims against the issuer exceed a specified sum. In other cases payments are reduced only if claims against the entire industry exceed some sum. What are the advantages and disadvantages of the two
> Which of the following motives for mergers make economic sense? a. Merging to achieve economies of scale. b. Merging to reduce risk by diversification. c. Merging to redeploy cash generated by a firm with ample profits but limited growth opportunities. d
> Look again at Table 31.3. Suppose that B Corporation’s fixed assets are reexamined and found to be worth $12 million instead of $9 million. How would this affect the AB Corporation’s balance sheet under purchase accounting? How would the value of AB Corp
> Until recently, Augean Cleaning Products sold its products on terms of net 60, with an average collection period of 75 days. In an attempt to induce customers to pay more promptly, it has changed its terms to 2/10, EOM, net 60. The initial effect of the
