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Free Download Chapter 30 Solution Manual Financial Management by Brigham

Chapter 30

Financial Management in Not-for-Profit BusinessesANSWERS TO END-OF-CHAPTER QUESTIONS

 

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 Summary
This chapter focuses on financial management within not-for-profit businesses.
The key concepts covered are listed below:
• Although most finance graduates will go to work for investor-owned firms,
many financial management professionals work for or closely with not-for-profit organizations, which range from government agencies such as school districts and colleges to charities such as the United Way and the American Heart
Association.
• If an organization meets a set of stringent requirements, it can qualify for tax-exempt status. Such organizations, which must be incorporated, are called not-for-profit corporations. One type of not-for-profit organization is the not-for-profit business,which sells goods and/or services to the public but which has
not-for-profit status.
• The goal of a not-for-profit business is typically stated in terms of some mission
rather than shareholder wealth maximization.
• Not-for-profit businesses raise the equivalent of equity capital, which is called
fund capital,in three ways: (1) by earning profits, which by law are retained
within the business, (2) by receiving grants from governmental entities, and
(3) by receiving contributions from individuals and companies.
• In not-for-profit businesses, the weighted average cost of capital is developed in the same way as in investor-owned firms. Although there is no direct tax benefit to the issuer associated with debt financing, there is a benefit to investors because interest received is often tax exempt; thus, the net cost of debt is similar for investor-owned and not-for-profit businesses.
• For cost of capital purposes, fund capital has an opportunity cost that is roughly equal to the cost of equity of similar investor owned firms.
• The trade-off theory of capital structure generally applies to not-for-profit firms, but such firms do not have as much financial flexibility as investor-owned firms because not for profit firms cannot issue new common stock.
• The social value version of the net present value model recognizes that not-for-profit businesses should value social contributions as well as cash flows.

30-20 Chapter 30 Financial Management in Not-for-Profit Businesses

Self-Test Questions
• In general, the relevant capital budgeting risk for not-for-profit businesses is
corporate risk rather than market risk. Corporate risk is measured by a proect’s corporate beta.
• Many not-for-profit organizations can raise funds in the municipal bond market.
• Credit enhancement upgrades the rating of a municipal bond issue to that of the insurer. However, issuers must pay a fee to obtain credit enhancement.
• With minor exceptions, the financial statement formats of investor-owned and
not-for-profit businesses are the same.
• Short-term financial management is generally unaffected by the ownership type.
Questions
(30-1) What is the major difference in ownership structure between investor-owned and
not-for-profit businesses?
(30-2) Does the asymmetric information theory of capital structure apply to not-for-profit businesses? Explain.
(30-3) Does a not-for-profit firm’s marginal cost of capital (MCC) schedule have a
retained earnings break point? Explain.
(30-4) Assume that a not-for-profit firm does not have access to tax-exempt (municipal)
debt and thus gains no benefits from the use of debt financing.
a. What would be the firm’s optimal capital structure according to the cost-benefit trade-off theory?
b. Is it likely that the firm would be able to operate at its theoretically optimal
structure?
(30-5) Describe how social value can be incorporated into the NPV decision model. Do
you think not-for-profit firms would normally try to quantify net present social
value, or would they merely treat it as a qualitative factor?
(30-6) Why is corporate risk the most relevant project risk measure for not-for-profit
businesses?
(30-7) If all markets were informationally efficient, meaning that buyers and sellers
would have easy access to the same information, would firms gain any cost advantage by purchasing bond insurance (credit enhancement)?
Mini Case 30-21
Mini Case
Sandra McCloud, a finance major in her last term of college, is currently scheduling her placement inter-views through the university’s career resource center. Her list of companies is typical of most finance
majors: several commercial banks, a few industrial firms, and one brokerage house. However, she
noticed that a representative of a not-for-profit hospital is scheduling interviews next week, and the
position—that of financial analyst—appears to be exactly what Sandra has in mind. Sandra wants to
sign up for an interview, but she is concerned that she knows nothing about not-for-profit organizations
and how they differ from the investor-owned firms that she has learned about in her finance classes. In
spite of her worries, Sandra scheduled an appointment with the hospital representative, and she now
wants to learn more about not-for-profit businesses before the interview.
To begin the learning process, Sandra drew up the following set of questions. See if you can help her
answer them.
a. First, consider some basic background information concerning the differences between not-for-profit organizations and investor-owned firms.
(1) What are the key features of investor-owned firms? How do a firm’s owners exercise control?
30-22 Chapter 30 Financial Management in Not-for-Profit Businesses
Selected Additional References
(2) What is a not-for-profit corporation? What are the major control differences between
investor-owned and not-for-profit businesses?
(3) How do goals differ between investor-owned and not-for-profit businesses?
b. Now consider the cost of capital estimation process.
(1) Is the weighted average cost of capital (WACC) relevant to not-for-profit businesses?
(2) Is there any difference between the WACC formula for investor-owned firms and that for not-for-profit businesses?
(3) What is fund capital? How is the cost of fund capital estimated?
c. Just as in investor-owned firms, not-for-profit businesses use a mix of debt and equity (fund) financing.
(1) Is the trade-off theory of capital structure applicable to not-for-profit businesses? What about the asymmetric information theory?
(2) What problems do not-for-profit businesses encounter when they attempt to implement the trade-off theory?
d. Consider the following questions relating to capital budgeting decisions.
(1) Why is capital budgeting important to not-for-profit businesses?
(2) What is social value? How can the net present value method be modified to include the social value of proposed projects?
(3) Which of the three project risk measures—stand-alone, corporate, and market—is relevant to not-for-profit businesses?
(4) What is a corporate beta? How does it differ from a market beta?
(5) In general, how is project risk actually measured within not-for-profit businesses? How is project risk incorporated into the decision process?
e. Not-for-profit businesses have access to many of the same long-term financing sources as do investor-owned firms.
(1) What are municipal bonds? How do not-for-profit health care businesses access the municipal bond market?
(2) What is credit enhancement, and what effect does it have on debt costs?
(3) What are a not-for-profit business’s sources of fund capital?
(4) What effect does the inability to issue common stock have on a not-for-profit business’s cap-ital structure and capital budgeting decisions?
f. What unique problems do not-for-profit businesses encounter in financial analysis and planning?
What about short-term financial management?

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Chapter 29

Pension Plan Management

ANSWERS TO END-OF-CHAPTER QUESTIONS

 

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Questions

(29-1) Define each of the following terms:
a. Defined benefit plan
b. Defined contribution plan
c. Profit sharing plan
d. Cash balance plan
e. Vesting
f. Portability
g. Fully funded; overfunded; underfunded
h. Actuarial rate of return
i. Employee Retirement Income Security Act (ERISA)
j. Pension Benefit Guarantee Corporation (PBGC)
k. FASB reporting requirements
l. Funding strategy
m. Investment strategy
n. Asset allocation models
o. Jensen alpha
p. “Tapping” fund assets
q. Retiree health benefits

(29-2) Suppose you just started employment at a large firm that offers a defined benefit plan, a cash balance plan, and a defined contribution plan. What are some of the factors that you should consider in choosing among the plans?

(29-3) Suppose you formed your own company several years ago and now intend to offer your employees a pension plan. What are the advantages and disadvantages to the firm of both a defined benefit plan and a defined contribution plan?

(29-4) Examine the annual report of any large U.S. corporation. Where are the pension fund data located? What effect does this information have on the firm’s financial condition?

(29-5) A firm’s pension fund assets are currently invested only in domestic stocks and bonds. The outside manager recommends that “hard assets” such as precious met-als and real estate, and foreign financial assets, be added to the fund. What effect would the addition of these assets have on the fund’s risk/return trade-off?

(29-6) How does the type of pension fund a company uses influence each of the following:
a. The likelihood of age discrimination in hiring?
b. The likelihood of sex discrimination in hiring?
c. Employee training costs?
d. The likelihood that union leaders will be “flexible” if a company faces a changed economic environment such as those faced by the airline, steel, and auto industries in recent years?

(29-7) Should employers be required to pay the same “head tax” to the PBGC irrespective of the financial condition of their plans?

Problems

(29-1) The Certainty Company (CC) operates in a world of certainty. It has just hired Mr. Jones, age 20, who will retire at age 65, draw retirement benefits for 15 years, and die at age 80. Mr. Jones’s salary is $20,000 per year, but wages are expected
to increase at the 5 percent annual rate of inflation. CC has a defined benefit plan in which workers receive 1 percent of the final year’s wage for each year employed. The retirement benefit, once started, does not have a cost-of-living adjustment. CC earns 10 percent annually on its pension fund assets. Assume that pension contribution and benefit cash flows occur at year-end.

a. How much will Mr. Jones receive in annual retirement benefits?
b. What is CC’s required annual contribution to fully fund Mr. Jones’s retirement benefits?
c. Assume now that CC hires Mr. Smith at the same $20,000 salary as Mr. Jones. However, Mr. Smith is 45 years old. Repeat the analysis in
parts a and b under the same assumptions used for Mr. Jones. What do the results imply
about the costs of hiring older versus younger workers?
d. Now assume that CC hires Ms. Brown, age 20, at the same time that it hires Mr. Smith. Ms. Brown is expected to retire at age 65 and to live to age 90.
What is CC’s annual pension cost for Ms. Brown? If Mr. Smith and Ms. Brown are doing the same work, are they truly doing it for the same pay?
Would it be “reasonable” for CC to lower Ms. Brown’s annual retirement benefit to a level that would mean that she received the same present value as Mr. Smith?

(29-2) Houston Metals Inc. has a small pension fund that is managed by a professional portfolio manager. All of the fund’s assets are invested in corporate equities. Last year, the portfolio manager realized a rate of return of 18 percent. The risk-free
rate was 10 percent and the market risk premium was 6 percent. The portfolio’s beta was 1.2.
a. Compute the portfolio’s alpha.
b. What does the portfolio alpha imply about the manager’s performance last year?
c. What can the firm’s financial manager conclude about the portfolio manager’s performance next year?

(29-3) Consolidated Industries is planning to operate for 10 more years and then cease operations. At that time (in 10 years), it expects to have the following pension
benefit obligations:
Years                          Annual Total Payment
11–15                         $2,500,000
16–20                         2,000,000
21–25                         1,500,000
26–30                         1,000,000
31–35                         500,000

The current value of the firm’s pension fund is $6 million. Assume that all cash flows occur at year-end.
a. Consolidated’s actuarial rate of return is 10 percent. What is the present value of the firm’s pension fund benefits?
b. Is the plan underfunded or over funded?

MINI CASE STUDY

Southeast Tile Distributors Inc. is a building tile wholesaler that originated in Atlanta but is now con-sidering expansion throughout the region to take advantage of continued strong population growth.
The company has been a “mom and pop” operation supplemented by part-time workers, so it currently
has no corporate retirement plan. However, the firm’s owner, Andy Johnson, believes that it will be nec-essary to start a corporate pension plan to attract the quality employees needed to make the expansion succeed. Andy has asked you, a recent business school graduate who has just joined the firm, to learn
all that you can about pension funds, and then prepare a briefing paper on the subject. To help you get started, he sketched out the following questions:
a. How important are pension funds to the U.S. economy?
b. Define the following pension fund terms:
(1) Defined benefit plan
(2) Defined contribution plan
(3) Profit sharing plan
(4) Cash balance plan
(5) Vesting
(6) Portability
(7) Fully funded; over funded; underfunded
(8) Actuarial rate of return
(9) Employee Retirement Income Security Act (ERISA)
(10) Pension Benefit Guarantee Corporation (PBGC)
c. What two organizations provide guidelines for reporting pension fund activities to stockholders?
Describe briefly how pension fund data are reported in a firm’s financial statements. (Hint: Consider both defined contribution and defined benefit plans.)
d. Assume that an employee joins the firm at age 25, works for 40 years to age 65, and then retires.
The employee lives another 15 years, to age 80, and during retirement draws a pension of $20,000
at the end of each year. How much must the firm contribute annually (at year-end) over the
employee’s working life to fully fund the plan by retirement age if the plan’s actuarial rate of return
is 10 percent? Draw a graph that shows the value of the employee’s pension fund over time. Why is
real-world pension fund management much more complex than indicated in this illustration?
e. Discuss the risks to both the plan sponsor and plan beneficiaries under the four types of pension
plans.
f. How does the type of pension plan influence decisions in each of the following areas:
(1) The possibility of age discrimination in hiring?
(2) The possibility of sex discrimination in hiring?
(3) Employee training costs?
(4) The militancy of unions when a company faces financial adversity?
g. What are the two components of a plan’s funding strategy? What is the primary goal of a plan’s
investment strategy?

Free Download Chapter 25 Solution Manual Financial Management by Brigham

Chapter 25

Mergers, LBOs, Divestitures, and Holding Companies

ANSWERS TO END-OF-CHAPTER QUESTIONS

 

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Questions

(25-1) Define each of the following terms:

a. Synergy; merger

b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger

c. Friendly merger; hostile merger; defensive merger; tender offer; target company; breakup value; acquiring company

d. Operating merger; financial merger

e. Adjusted present value (APV) model

f. Free cash flow to equity

g. Purchase accounting

h. White knight; proxy fight

i. Joint venture; corporate alliance

j. Divestiture; spin-off; leveraged buyout (LBO)

k. Holding company; operating company; parent company

l. Arbitrage; risk arbitrage

(25-2) Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate, and (4) congeneric. Explain the significance of these terms in merger analysis with regard to (a) the likelihood of governmental intervention and (b) possibilities for operating synergy.

(25-3) Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good idea. Might a tender offer be used?

(25-4) Distinguish between operating mergers and financial mergers.

(25-5) Distinguish between the APV, FCFE, and corporate valuation models.

Self-Test Problem Solution Appears in Appendix A

(ST–1)

Valuation

Red Valley Breweries is considering an acquisition of Flagg Markets. Flagg currently has a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in common equity. Its federal-plus-state tax rate is 40%. After the acquisition, Red Valley expects Flagg to have the following FCFs and interest payments for the next 3 years (in millions):

Year 1                    Year 2                   Year 3

FCF                                        $10.00                   $20.00                   $25.00

Interest expense             28.00                     24.00                     20.28

After this, the free cash flows are expected to grow at a constant rate of 5%, and the capital structure will stabilize at 35% debt with an interest rate of 7%.

a. What is Flagg’s unlevered cost of equity? What are its levered cost of equity and cost of capital for the post-horizon period?

b. Using the adjusted present value approach, what is Flagg’s value of operations to Red Valley?

Problems Answers Appear in Appendix B

The following information is required to work Problems 21-1 through 21-4.

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt. Vandell’s debt interest rate is 8%. Assume that the risk-free rate of interest is 5% and the market risk premium is 6%. Both Vandell and Hastings face a 40% tax rate.

EASYPROBLEM1

(25-1)

Valuation

Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year; its beta is 1.4. What is the value of Vandell’s operations? If Vandell has $10.82 million in debt, what is the current value of Vandell’s stock? (Hint: Use the corporate valuation model from Chapter 13.)

INTERMEDIATEPROBLEMS2–3

(25-2)

Merger Valuation

Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000 per year for 3 years, after which the current target capital structure of 30% debt will be maintained. Interest in the fourth year will be $1.472 million, after which interest and the tax shield will grow at 5%. Synergies will cause the free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years 1 through 4, respectively, after which the free cash flows will grow at a 5% rate. What is the unlevered value of Vandell, and what is the value of its tax shields? What is the per share value of Vandell to Hastings Corporation? Assume that Vandell now has $10.82 million in debt.

(25-3)

Merger Bid

On the basis of your answers to Problems 21-1 and 21-2, indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition.

CHALLENGINGPROBLEMS4–6

(25-4) Merger Valuation with

Change in Capital Structure

Assuming the same information as for Problem 21-2, suppose Hastings will increase Vandell’s level of debt at the end of Year 3 to $30.6 million so that the target capital structure is now 45% debt. Assume that with this higher level of debt the interest rate would be 8.5%, and assume that interest payments in Year 4 are based on the new debt level from the end of Year 3 and a new interest rate. Again, free cash flows and tax shields are projected to grow at 5% after Year 4. What are the values of the unlevered firm and the tax shield, and what is the maximum price that Hastings would bid for Vandell now?

(25-5) Merger Analysis

Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt; its target ratio is just 25%, with the cost of debt 9%. If the acquisition were made, Marston would operate Conroy as a separate, wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Marston also would increase the debt capitalization in the Conroy subsidiary to wd= 40%, for a total of $22.27 million in debt by the end of Year 4, and pay 9.5% on the debt. Marston’s acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars) in Years 1–5:

Year                       Free Cash Flows               Interest Expense

1                              $1.30                                                     $1.2

2                              1.50                                                        1.7

3                              1.75                                                        2.8

4                              2.00                                                        2.1

5                              2.12                                                        ?

In Year 5, Conroy’s interest expense would be based on its beginning-of-year (that is, the end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are projected to grow at a rate of 6%. These cash flows include all acquisition effects. Marston’s cost of equity is 10.5%, its beta is 1.0, and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk premium is 4.5%.

a. What is the value of Conroy’s unlevered operations, and what is the value of Conroy’s tax shields under the proposed merger and financing arrangements?

b. What is the dollar value of Conroy’s operations? If Conroy has $10 million in debt outstanding, how much would Marston be willing to pay for Conroy?

(25-6)

Merger Valuation with

Change in Capital Structure

VolWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Bulldog Cable Company (BCC), a regional cable company. VolWorld’s analysts project the following post-merger data for BCC (in thou-sands of dollars, with a year end of December 31):

2010       2011       2012      2013      2014      2015

Net sales                                                                             $450       $518       $555       $600       $643

Selling and administrative expense                          45           53           60           68           73

Interest                                                                                40           45           47           52           54

Total net operating capital                           $800       850         930         1,005     1,075     1,150

Tax rate after merger: 35%

Cost of goods sold as a percent of sales: 65%

BCC’s pre-merger beta: 1.40

Risk-free rate: 6%

Market risk premium: 4%

Terminal growth rate of free cash flows: 7%

If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in the income statements are assumed to occur at the end of the year. BCC currently has a capital structure of 40% debt, which costs 10%, but over the next 4 years Vol-World would increase that to 50%, and the target capital structure would be reached by the start of 2015. BCC, if independent, would pay taxes at 20%, but its income would be taxed at 35% if it were consolidated. BCC’s current market-determined beta is 1.4. The cost of goods sold is expected to be 65% of sales.

a. What is the unlevered cost of equity for BCC?

b. What are the free cash flows and interest tax shields for the first 5 years?

c. What is BCC’s horizon value of interest tax shields and unlevered horizon value?

d. What is the value of BCC’s equity to VolWorld’s shareholders if BCC has $300,000 in debt outstanding now?

SPREADSHEETPROBLEM

(25-7)

Build a Model: Merger Analysis

Start with the partial model in the fileCh21 P07 Build a Model.xlson the textbook’s Web site. Wansley Portal Inc., a large Internet service provider, is evaluating the possible acquisition of Alabama Connections Company (ACC), a regional Internet service provider. Wansley’s analysts project the following post-merger data for ACC (in thousands of dollars):

2011       2012       2013       2014       2015

Net sales                                                             $500       $600       $700       $760       $806

Selling and administrative expense          60           70           80           90           96

Interest                                                                30           40           45           60           74

If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in the income statements are assumed to occur at the end of the year. ACC currently has a capital structure of 30% debt, which costs 9%, but Wansley would increase that over time to 40%, costing 10%, if the acquisition were made. ACC, if independent, would pay taxes at 30%, but its income would be taxed at 35% if it were con-solidated. ACC’s current market-determined beta is 1.4. The cost of goods sold, which includes depreciation, is expected to be 65% of sales, but it could vary some-what. Required gross investment in operating capital is approximately equal to the depreciation charged, so there will be no investment in net operating capital. The risk-free rate is 7%, and the market risk premium is 6.5%. Wansley currently has $400,000 in debt outstanding.

a. What is the unlevered cost of equity?

b. What are the horizon value of the tax shields and the horizon value of the unlevered operations? What are the value of ACC’s operations and the value of ACC’s equity to Wansley’s shareholders?

Mini Case

Hager’s Home Repair Company, a regional hardware chain that specializes in“do it yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help.

The table below indicates Zona’s estimates of LL’s earnings potential if it came under Ha-ger’s management (in millions of dollars). The interest expense listed here includes the interest

(1) on LL’s existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,”the code name given to the target firm. If acquired, LL will face a 40% tax rate.

Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’s capital structure, which is 20% debt. Zona realizes that Lyons Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed in the table. Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free cash flows after 2015 will grow at a constant rate of 6%. Following are projections for sales and other items.

2010       2011       2012       2013       2014       2015

Net sales                                                                             $60.00   $90.00   $112.50 $127.50 $139.70

Cost of goods sold (60%)                                              36.00     54.00     67.50     76.50     83.80

Selling/administrative expense                                                 4.50        6.00        7.50        9.00        11.00

Interest expense                                                             5.00        6.50        6.50        7.00        8.16

Total net operating capital                           $150       150         157.50   163.50   168         173.00

Hager’s management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are

(1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below re-placement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

b. Briefly describe the differences between a hostile merger and a friendly merger.

c. What are the steps in valuing a merger?

d. Use the data developed in the table to construct the L division’s free cash flows for 2011 through 2015. Why are we identifying interest expense separately when it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the free cash flow?

e. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?

f. What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the L division’s cash flows beyond 2015? What is LL’s value to Hager’s shareholders? Suppose another firm were evaluating LL as an acquisition candidate. Would it obtain the same value? Explain.

g. Assume that LL has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade (made several weeks ago) was at a price of $11 per share.

Should Hager’s make an offer for Lyons Lighting? If so, how much should it offer per share?

h. How would the analysis be different if Hager’s intended to recapitalize LL with 40% debt costing 10% at the end of 4 years? This amounts to $221.6 million in debt as of the end of 2014.

i. There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?

j. What method is used to account for mergers?

k. What merger-related activities are undertaken by investment bankers?

l. What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private?

m. What are the major types of divestitures? What motivates firms to divest assets?

n. What are holding companies? What are their advantages and disadvantages?

Free Download Chapter 26 Solution Manual Financial Management by Brigham

Chapter 26Multinational Financial ManagementANSWERS TO END-OF-CHAPTER QUESTIONS

 

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QUESTIONS

(26-1) Define each of the following terms:

a. Multinational corporation

b. Exchange rate; fixed exchange rate system; floating exchange rates

c. Trade deficit; Devaluation; revaluation

d. Exchange rate risk; convertible currency; Pegged exchange rates

e. Interest rate parity; purchasing power parity

f. Spot rate; forward exchange rate; Discount on forward rate; premium on forward rate

g. Repatriation of earnings; political risk

h. Eurodollar; Eurobond; international bond; foreign bond

i. The euro

(26-2) Under the fixed exchange rate system, what was the currency against which all other currency values were defined? Why?

(26-3) Exchange rates fluctuate under both the fixed exchange rate and floating exchange rate systems. What, then, is the difference between the two systems?

(26-4) If the Swiss franc depreciates against the U.S. dollar, can a dollar buy more or fewer euros as a result?

(26-5) If the United States imports more goods from abroad than it exports, foreigners will tend to have a surplus of U.S. dollars. What will this do to the value of the dollar with respect to foreign currencies? What is the corresponding effect on foreign investments in the United States?

(26-6) Why do U.S. corporations build manufacturing plants abroad when they could build them at home?

(26-7) Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.

(26-8) What is a Eurodollar? If a French citizen deposits $10,000 in Chase Manhattan Bank in New York, have Eurodollars been created? What if the deposit is made in Barclay’s Bank in London? Chase Manhattan’s Paris branch? Does the existence of the Eurodollar market make the Federal Reserve’s job of controlling U.S. interest rates easier or more difficult? Explain.

(26-9) Does interest rate parity imply that interest rates are the same in all countries?

(26-10) Why might purchasing power parity fail to hold?

SELF-TEST PROBLEMS (SOLUTIONS APPEAR IN APPENDIX A)

(ST-1) Suppose the exchange rate between U.S. dollars and EMU euros is 0.98 = $1.00, and the exchange rate between the U.S. dollar and the Canadian dollar is $1.00 = C$1.5291. What is the cross rate of euros to Canadian dollars?

PROBLEMS Answers appear in Appendix B

(26-1) A currency trader observes that in the spot exchange market, 1 U.S. dollar can be exchanged for 9 Mexican peso or for 111.23 Japanese yen. What is the cross rate between the yen and the peso; that is, how many yen would you receive for every peso exchanged?

 (26-2) Six-month T-bills have a nominal rate of 7%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 5.5%. In the spot exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange rate?

(26-3) A television set costs $500 in the United States. The same set costs 725 euros. If purchasing power parity holds, what is the spot exchange rate between the euro and the dollar?

(26-4) If British pounds sell for $1.50 (U.S.) per pound, what should dollars sell for in pounds per dollar?

(26-5) Suppose that 1 Swiss Franc could be purchased in the foreign exchange market for 60 U.S. cents today. If the Franc appreciated 10% tomorrow against the dollar, how many Franc would a dollar buy tomorrow?

(26-6) Suppose the exchange rate between the U.S. dollar and the Swiss Franc was SFr1.6 = $1, and the exchange rate between the dollar and the British pound was £1 = $1.50. What was the exchange rate between Swedish Franc and pounds?

(26-7) Assume that interest rate parity holds. In both the spot market and the 90-day forward market 1 Japanese yen equals 0.0086 dollar. The 90-day risk-free securities yield 4.6% in Japan. What is the yield on 90-day risk-free securities in the United States?

(26-8) In the spot market 7.8 pesos can be exchanged for 1 U.S. dollar. A compact disc costs $15 in the United States. If purchasing power parity holds, what should be the price of the same disc in Mexico?

(26-9) You are the vice-president of International InfoXchange, headquartered in Chicago, Illinois. All shareholders of the firm live in the United States. Earlier this month, you obtained a loan of 5 million Canadian dollars from a bank in Toronto to finance the construction of a new plant in Montreal. At the time the loan was received, the exchange rate was 75 U.S. cents to the Canadian dollar. By the end of the month, it has unexpectedly dropped to 70 cents. Has your company made a gain or loss as a result, and by how much?

(26-10) Early in September 1983, it took 245 Japanese yen to equal $1. More than 20 years that exchange rate had fallen to 108 yen to $1. Assume the price of a Japanese manufactured automobile was $8,000 in September 1983 and that its price changes were in direct relation to exchange rates.

a. Has the price, in dollars, of the automobile increased or decreased during the 20-year period because of changes in the exchange rate?

b. What would the dollar price of the car be assuming that the car’s price changes only with exchange rates?

(26-11) Boisjoly Watch Imports has agreed to purchase 15,000 Swiss watches for 1 million Francs at today’s spot rate. The firm’s financial manager, James, has noted the following current spot and forward rates:

                                                                U.S. DOLLAR/FRANC                       FRANC/U.S. DOLLAR

Spot                                                       1.6590                                                   0.6028

30-day forward                                                 1.6540                                                   0.6046

90-day forward                                                 1.6460                                                   0.6075

180-day forward                               1.6400                                                   0.6098

On the same day, Churchill agrees to purchase 15,000 more watches in 3 months at the same price of 1 million Francs.

a. What is the price of watches, in U.S. dollars, if it is purchased at today’s spot rate?

b. What is the cost, in U.S. dollars, of the second 15,000 batch if payment is made in 90 days and the spot rate at that time equals today’s 90-day forward rate?

c. If the exchange rate for the Swiss Franc is 0.50 to $1 in 90 days, how much will have to pay for the watches(in U.S. dollars)?

(26-12) Assume that interest rate parity holds and that 90-day risk-free securities yield 5 percent in the United States and 5.3 percent in Britain. In the spot market 1 pound equals 1.65 dollars.

a. Is the 90-day forward rate trading at a premium or discount relative to the spot rate?

b. What is the 90-day forward rate?

(26-13) After all foreign and U.S. taxes, a U.S. corporation expects to receive 3 pounds of dividends per share from a British subsidiary this year. The exchange rate at the end of the year is expected to be $1.60 per pound, and the pound is expected to depreciate 5% against the dollar each year for an indefinite period. The dividend (in pounds) is expected to grow at 10% a year indefinitely. The parent U.S. Corporation owns 10 million shares of the subsidiary. What is the present value in dollars of its equity ownership of the subsidiary? Assume a cost of equity capital of 15 percent for the subsidiary.

(26-14)

Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida.  Until now, the company has confined its operations and sales to the United States, but its CEO, George Gaynor, wants to expand into Europe.  The first step would be to set up sales subsidiaries in Spain and Sweden, then to set up a production plant in Spain, and, finally, to distribute the product throughout the European Common Market.  The firm’s financial manager, Ruth Schmidt, is enthusiastic about the plan, but she is worried about the implications of the foreign expansion on the firm’s financial management process.  She has asked you, the firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management.  The tutorial will be presented at the next board of director’s meeting.  To get you started, Schmidt has supplied you with the following list of questions.

a.       What is a multinational corporation?  Why do firms expand into other countries?

b.      What are the six major factors which distinguish multinational financial management from financial management as practiced by a purely domestic firm?

c.       Now assume Citrus Products begins producing the same liter of orange juice in Spain.  The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronas.  What is the dollar profit on the sale?

d.      Briefly describe the current International Monetary System.  How does the current system differ from the system that was in place prior to August 1971?

e.       Remaining questions are also available in the solution… ok