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essentials corporate finance
Corporate Finance 4th Edition David Hillier - Solutions
Hedging Strategies If a firm is selling futures contracts on lumber as a hedging strategy, what must be true about the firm’s exposure to lumber prices?
Hedging Commodities Bubbling Crude Corporation, a large Texas oil producer, would like to hedge against adverse movements in the price of oil because this is the firm’s primary source of revenue. What should the firm do? Provide at least two reasons why it probably will not be possible to achieve
Sources of Risk A company produces an energy-intensive product and uses natural gas as the energy source. The competition primarily uses oil. Explain why this company is exposed to fluctuations in both oil and natural gas prices.
Hedging Commodities If a textile manufacturer wanted to hedge against adverse movements in cotton prices, it could buy cotton futures contracts or buy call options on cotton futures contracts. What would be the pros and cons of the two approaches?
Option Explain why a put option on a bond is conceptually the same as a call option on interest rates.
Transaction versus Economic Exposure What is the difference between transactions and economic exposure? Which can be hedged more easily? Why?
Hedging Exchange Rate Risk If a U.S. company exports its goods to Japan, how would it use a futures contract on Japanese yen to hedge its exchange rate risk?Would it buy or sell yen futures? Does the way the exchange rate is quoted in the futures contract matter?
Futures Quotes Refer to Table 25.2 in the text to answer this question. Suppose you purchase a March 2012 cocoa futures contract on November 22, 2011, at the last price of the day. What will your profit or loss be if cocoa prices turn out to be$2,431 per metric ton at expiration?
Put and Call Payoffs Suppose a financial manager buys call options on 50,000 barrels of oil with an exercise price of $95 per barrel. She simultaneously sells a put option on 50,000 barrels of oil with the same exercise price of $95 per barrel.Consider her gains and losses if oil prices are $90,
Cash Management What options are available to a firm if it believes it has too much cash? How about too little?
Agency Issues Are stockholders and creditors likely to agree on how much cash a firm should keep on hand?
Short-Term Investments Why is a preferred stock with a dividend tied to short-term interest rates an attractive short-term investment for corporations with excess cash?
Agency Issues It is sometimes argued that excess cash held by a firm can aggravate agency problems (discussed in Chapter 1) and, more generally, reduce incentives for shareholder wealth maximization. How would you describe the issue here?
Calculating Float In a typical month, the Jeremy Corporation receives 140 checks totaling $124,000. These are delayed four days on average. What is the average daily float?
International Capital Budgeting Suppose it is your task to evaluate two different investments in new subsidiaries for your company, one in your own country and the other in a foreign country. You calculate the cash flows of both projects to be identical after exchange rate differences. Under what
International Capital Budgeting An investment in a foreign subsidiary is estimated to have a positive NPV after the discount rate used in the calculations is adjusted for political risk and any advantages from diversification. Does this mean the project is acceptable? Why or why not?
International Borrowing If a U.S. firm raises funds for a foreign subsidiary, what are the disadvantages to borrowing in the United States? How would you overcome them?
International Investment If financial markets are perfectly competitive and the Eurodollar rate is above that offered in the U.S. loan market, you would immediately want to borrow money in the United States and invest it in Eurodollars. True or false? Explain.
Using Exchange Rates Take a look back at Figure 31.1 to answer the following questions:a. If you have $100, how many euros can you get?b. How much is one euro worth in dollars?c. If you have 5 million euros, how many dollars do you have?d. Which is worth more, a New Zealand dollar or a Singapore
Using Spot and Forward Exchange Rates Suppose the spot exchange rate for the Canadian dollar is Can$1.05 and the six-month forward rate is Can$1.03.a. Which is worth more, a U.S. dollar or a Canadian dollar?b. Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if
Interest Rate Parity Use Figure 31.1 to answer the following questions. Suppose interest rate parity holds, and the current six-month risk-free rate in the United States is 1.9 percent. What must the six-month risk-free rate be in Great Britain? In Japan? In Switzerland?
The International Fisher Effect You observe that the inflation rate in the United States is 1.8 percent per year and that T-bills currently yield 2.3 percent annually.What do you estimate the inflation rate to be in:a. Australia if short-term Australian government securities yield 4 percent per
Spot versus Forward Rates Suppose the spot and three-month forward rates for the yen are ¥80.13 and ¥78.96, respectively.a. Is the yen expected to get stronger or weaker?b. What would you estimate is the difference between the inflation rates of the United States and Japan?
Translation Exposure Atreides International has operations in Arrakis. The balance sheet for this division in Arrakeen solaris shows assets of 34,000 solaris, debt in the amount of 12,000 solaris, and equity of 22,000 solaris.a. If the current exchange ratio is 1.20 solaris per dollar, what does
Using the Exact International Fisher Effect From our discussion of the Fisher effect in Chapter 6, we know that the actual relationship between a nominal rate, R , a real rate, r , and an inflation rate, h , can be written as follows:1 + r = (1 + R)y(1 + h)This is the domestic Fisher effect.a. What
What are the pros and cons of the international sales plan? What additional risks will the company face?Larissa Warren, the owner of East Coast Yachts, has been in discussions with a yacht dealer in Monaco about selling the company’s yachts in Europe. Jarek Jachowicz, the dealer, wants to add
A company’s first public equity issue is called an IPO for initial public offering. IPOs are generally underpriced. That is, the stock price in the aftermarket is normally above the issue price.
Announcements, Surprises and Expected Returns What is the difference between an expected return and observed return? Is it possible to predict the surprise component of an observed return?
Systematic versus Unsystematic Risk You own equity in Lewis-Striden Drugs plc. Suppose you had expected the following events to occur last month:(a) The government would announce that real GNP had grown 1.2 per cent during the previous quarter.The returns of Lewis-Striden are positively related to
Systematic Risk and Betas What is data mining? Is there anything wrong with measuring the performance of an Irish growth fund portfolio manager against a benchmark composed of Greek equities?
Portfolios and Factor Models You have recently been employed as a finance consultant to Bread plc.The CEO wants to use an APT model to estimate the required return on the company’s stock, and the risk factors he plans to use in his model are the stock market risk premium, the inflation rate, and
Betas and Expected Returns Why does the market portfolio lie on the security market line? What does it mean if a security lies below the security market line? What would happen to the returns of the security if traders exploit any possible arbitrage opportunities?
APT Your manager tells you that, for the APT to be useful, the number of systematic risk factors must be small. Is your manager right? Explain.
Other Alternatives to CAPM You have been given an assignment to calculate the expected return on a listed firm in Malawi. What are the issues you would face and what are some possible solutions to this problem?
APT As financial director of Renault SA, you have been tasked with estimating the required return on the company’s equity. What risk factors should you use? Explain your choice.
Market Model versus the Fama and French (2016) Model What are the differences between the Fama and French (2016) model and the market model? Would you use this model in Europe? Explain why, or why not.
Price-based Pricing Models You are concerned about instability in the stock market and have decided to use a price-based model. Explain why you would choose this model and the weaknesses in such an approach. What other methods could you use to address market instability?
Factor Models You plan to purchase a company and wish to estimate the expected return on its equity using a three-factor model. You believe the appropriate factors are the market return, the percentage change in GNP and the oil price return. The market is expected to grow by 6 per cent, GNP is
Factor Models Suppose a factor model is appropriate to describe stock returns for a company, with information about these factors set out in the table below. The expected return on the stock is 10.5 per cent.Factor β Expected Value Actual Value GNP growth 2.05 3% 3.5%Inflation −2 5.5% 5%(a) What
Factor Models Suppose the Fama–French (2016) five-factor model is appropriate to describe the returns of an equity. Information about those five factors is presented in the following table:Factor β Expected Value (%) Actual Value (%)(Rm − rf) 1.50 8.4 8.1 HML −1.40 3.1 3.8 SMB −0.67 9.5
Factor Models Suppose the Carhart (1997) factor model is appropriate to describe the returns on an equity. The current expected return on the equity is 10.5 per cent. Information about the factors is presented in the following table:Factor β Expected Value (%) Actual Value (%)(Rm − rf) 1.04 3.5
Factor Models Suppose equity returns can be explained by the Fama–French three-factor model:R = ¯R + β ( R M − r f ) + γHML + δSMB + εAssume there is no firm-specific risk. The information for each equity is presented here:β γ δEquity A 1.20 0.90 0.20 Equity B
Multifactor Models Suppose equity returns can be explained by the Fama–French three-factor model.The firm-specific risks for all equities are independent. The following table shows the information for three diversified portfolios:β γ δ E[R](%)Portfolio A 0.75 1.20 0.04 18 Portfolio B 1.60
Market Model Assume that the market model is given by:R i,t = α + β R M,t + ε i,t In this equation, Ri,t represents the return on asset i at time t; RM,t represents the return on a portfolio containing all risky assets in the same proportion at time t; and both RM,t and εi,t are
Portfolio Risk You are forming an equally weighted portfolio of equities. Many equities have the same beta of 0.84 for factor 1 and the same beta of 1.69 for factor 2. They also have the same expected return of 11 per cent. Assume a two-factor model describes the return on each of these
Arbitrage Pricing Theory The returns on three equities, A, B and C, are given by the following:R A=2.4% + 0.5 F 1 R B = 4.6% + 1.2 F 1 − 0.5 F 2 R C=4.1% –0.4 F 1 + 0.6 F 2(a) Are the returns correlated? Explain.(b) Assume that you have another equity, D. This equity’s
Factor Models The UK is found to have two factors, GDP growth and the inflation rate, that generate the returns of all equities. The expected GDP growth rate in the next year is 2 per cent and the expected inflation rate is 1.5 per cent. Pinto plc has an expected return of 10 per cent, a GDP growth
APT There are two equity markets, each driven by the same common force F with an expected value of zero and standard deviation of 10 per cent. There are many securities in each market; thus you can invest in as many stocks as you wish. Due to restrictions, however, you can invest in only one of the
APT Assume that the following market model adequately describes the return-generating behaviour of risky assets:R it = α i + β i R Mt + ε it Here:Rit = the return for the ith asset at time t RMt = the return on a portfolio containing all risky assets in some proportion at time t RMt
APT Assume that the returns of individual securities are generated by the following two-factor model:R it = E ( R it ) + β ij F 1t + β i2 F 2t Here:Rit is the return for security i at time t F1t and F2t are market factors with zero expectation and zero covariance.In addition, assume
Factor Models The returns on Ericsson, Electrolux and Swedbank are generated as follows:R it = α i + β i,SMB R SMB + β i,HML,RHML + ε it Name α(%) βHML βSMB Ericsson 3 1.2 −0.3 Electrolux 5 0.9 −0.25 Swedbank 7 −0.5 1.3 How would you determine the return on an equally
Factor Models Prove that the portfolio-weighted average of a security’s sensitivity to a particular factor is the same as the covariance between the return of the portfolio and the factor divided by the variance of the factor if the factors are uncorrelated with each other.
Factor Models How can the return on a portfolio be expressed in terms of a factor model? What is the minimum number of factors needed to explain the expected returns of a group of five securities if the securities’ returns have no firm-specific risk? Why?
Factor Models Consider the following two-factor model for the returns of three securities. Assume that the factors and epsilons have means of zero. Also, assume the factors have variances of 0.1 and are uncorrelated with one another.r˜ A = 0.13 + 0.6 F˜ 1 + 0.4 F˜ 2 + ∈˜ A r ˜
Factor Models A portfolio manager wants to create a simple portfolio from only two stocks, A and B.The returns for stocks A and B are given by the following equations:R A = 0.09 − 1 F INF + 1 F GDP + ε A and R B = 0.12 − 2 F INF + 4 F GDP + ε B The manager forms
The expected return on an asset having zero betas (with respect to both factors) is 0.03. According to the APT, what are the approximate equilibrium returns on each of the two equities? (25 marks)Assume a two-factor APT model is appropriate for asset returns, and there are an infinite number of
Discuss what the theoretical results in the APT say about the number of factors used in this question.(25 marks)Assume a two-factor APT model is appropriate for asset returns, and there are an infinite number of assets in the economy. Two factors drive expected return: the percentage change in GDP
The APT expected return relationship looks very similar to the security market line that was derived in the capital asset pricing model. Review the differences between the APT and CAPM. (25 marks)Assume a two-factor APT model is appropriate for asset returns, and there are an infinite number of
You determine that there are two factors under the APT that affect the portfolios you have constructed for your limited clientele, who invest only in gold equities: the rate of inflation and the growth rate of all gold stocks in relation to the growth rate of all commodity equities. You determine
For a large-company equity mutual fund, would you expect the betas to be positive or negative for each of the factors in a Fama–French (2016) multifactor model?Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read
The SMB, HML, RMW, CMA factors, and risk-free rates for the USA are available at Ken French’s website:mba.tuck.dartmouth.edu/pages/faculty/ken.french/. Download the monthly factors and save the most recent 60 months for each factor. The historical prices for each of the mutual funds can be found
What do you observe about the beta coefficients for the different mutual funds? Comment on any similarities or differences.Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read several articles concerning the risk
If the market is efficient, what value would you expect for alpha? Do your estimates support market efficiency?Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read several articles concerning the risk factors that can
Which fund has performed best considering its risk? Why?Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read several articles concerning the risk factors that can potentially affect asset returns, and she has decided
NPV, Sensitivity Analysis, Break-even Analysis, and Scenario Analysis ‘NPV is just a tool and as with any tool, it can be dangerous in the wrong hands.’ Discuss this statement. In what way do sensitivity analysis, break-even analysis and scenario analysis improve things? Surely they are just
Monte Carlo Simulation Explain the rationale underlying Monte Carlo simulation. How does it improve upon other forms of sensitivity analysis? Does it have any weaknesses? If so, what are they? How could you improve on the methodology?
Real Options When Apple launched its smartwatch, the NPV from the project was negative. However, the company proceeded with the project. Why do you think this was?
Decision Trees When should you stop decision tree analysis on a capital budgeting project? Explain using an example.REGULAR
Sensitivity Analysis and Break-even Point A retail clothing firm is evaluating the development of a new range of all-weather coats. These coats contain an internal solar battery to provide heating whenever the garment is worn. The solar batteries cost £3.2 million to make and the expectation is
Scenario Analysis A retail clothing firm is evaluating the development of a new range of all-weather coats. These coats contain an internal solar battery to provide heating whenever the garment is worn.The solar batteries cost £3.2 million to make and the expectation is that the project will last
Financial Break-even L.J.’s Toys has just purchased a £200,000 machine to produce toy cars. The machine will be fully depreciated using 20 per cent reducing balances over its five-year economic life. Each toy sells for £25. The variable cost per toy is £5, and the firm incurs fixed costs of
Option to Wait Your company is deciding whether to invest in a new machine. The new machine will increase cash flow by €280,000 per year. You believe the technology used in the machine has a 10-year life; in other words, no matter when you purchase the machine, it will be obsolete 10 years from
Decision Trees Ang Electronics has developed a new wearable ring that continually checks blood pressure during the day. If the ring is successful, the present value of the payoff (when the product is brought to market) is £20 million. If the ring fails, the present value of the payoff is £5
Option to Wait Versus Immediate Investment Global Investments has hired you as a financial consultant to advise them on whether to enter the shoe market, an investment opportunity that has an initial outlay of £35 million. During a board meeting, the CEO tells you that due to the upcoming summer
Decision Trees B&B has a new baby powder ready to market. If the firm goes directly to the market with the product, there is only a 55 per cent chance of success. However, the firm can conduct customer segment research, which will take a year and cost €1 million. By going through research, B&B
Financial Break-even Analysis You are considering investing in a company that cultivates truffles for sale to local restaurants. Use the following information:Sales price per truffle £100.00 Variable costs per truffle £72.00 Fixed costs per year £340,000 Depreciation per year £20,000 Tax rate
Scenario Analysis You have been given the following figures to assess the viability of a new portable hospital scanner. It is expected you will be able to capture 10 per cent of the total market of 1.1 million units. The market price will be €400,000 and the unit variable cost is 90 per cent of
Break-even Intuition Consider a project with a required return of R per cent that costs £I and will last for N years. The project uses straight-line depreciation to zero over the N-year life; there are neither salvage value nor net working capital requirements.(a) At the accounting break-even
Project Analysis You are considering a new product launch. The project will cost £460,000, have a four-year life and have no salvage value; depreciation is 20 per cent reducing balance. Sales are projected at 150 units per year; price per unit will be £24,000; variable costs are 75 per cent of
Project Analysis McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for£700 per set and have a variable cost of £320 per set. The company has spent £150,000 for a marketing study that determined the company will sell 55,000 sets per year for seven years. The marketing
Decision Trees Young screenwriter Carl Draper has just finished his first script. It has action, drama and humour, and he thinks it will be a blockbuster. He takes the script to every film studio in town and tries to sell it but to no avail. Finally, ACME studios offers to buy the script for either
Accounting Break-even Samuelson GmbH has just purchased a €600,000 machine to produce calculators.The machine will be fully depreciated using the 20 per cent reducing balance method over its economic life of five years and will produce 20,000 calculators each year. The salvage value of the
Real Options Petrofac Ltd, the international provider of oil and gas building facilities, has entered into an agreement with a number of Kenyan oil exploration firms to support development of oil wells in the Turkana region after a very large oil well was found there in 2012. The cost of setting up
Abandonment Decisions Allied Products is considering a new product launch. The firm expects to have an annual operating cash flow of AED60 million for the next six years. Allied Products uses a discount rate of 14 per cent for new product launches. The initial investment is AED200 million. Assume
Expansion Decisions Applied Nanotech is thinking about introducing a new surface cleaning machine.The marketing department has come up with the estimate that Applied Nanotech can sell 10 units per year at £0.3 million net cash flow per unit for the next five years. The engineering department has
Scenario Analysis You are the financial analyst for a tennis racket manufacturer. The company is considering using a graphite-like material in its tennis rackets. The company has estimated the information in the following table about the market for a racket with the new material. The company
The Capital Budgeting Process This question takes a step back from the quantitative analysis and makes you think about how you would manage a capital budgeting project in a firm. You have just graduated from university and taken up your first job in a local distribution firm. The firm stores
Scenario Analysis Consider a project to supply Italy with 40,000 tons of machine screws annually for automobile production. You will need an initial €1,500,000 investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates
Abandonment Decisions Consider the following project for Hand Clapper. The company is considering a four-year project to manufacture clap-command garage door openers. This project requires an initial investment of €10 million that will be depreciated using the 20 per cent reducing balance method
Abandonment Decisions M.V.P. Games has hired you to perform a feasibility study of a new video game that requires a $9 million initial investment. M.V.P. expects a total annual operating cash flow of $1,750,000 for the next 10 years. The relevant discount rate is 12 per cent. Cash flows occur at
Financial Break-even The Wheatchopper Company is considering the purchase of a new harvester.Wheatchopper has hired you to determine the break-even purchase price in terms of present value of the harvester. This break-even purchase price is the price at which the project’s NPV is zero. Base your
Sensitivity Analysis Unmondo SpA is proposing to replace its manufacturing machinery with more modern equipment geared towards 3D printing. The new machinery costs €9 million (the existing machinery has no value). The attraction of the 3D printer is that it is expected to cut manufacturing costs
Option to Abandon You own an unused gold mine that will cost $800,000 to reopen. If you open the mine, you expect to be able to extract 1,000 ounces of gold a year for each of three years. After that, the deposit will be exhausted. The gold price is currently $2,000 an ounce, and each year the
Options to Abandon and Expand Grace and Danger plc is introducing a new product this year. If its luminous golf balls (with integrated beeper) are a success, the firm expects to be able to sell 50,000 units a year at a price of £60 each (they will not go missing so you will pay a lot for them!).
You are the financial analyst for Weir Group plc, the global engineering firm. The company is considering the development of a new slurry pump in its existing products. The pump is expected to improve market share for the company if it is fully integrated into its existing product line-up. With the
Explain the difference between sensitivity analysis, scenario analysis and break-even analysis. In the context of the problem in Part 1, what do you think is the most appropriate investment appraisal method?Explain your answer. (25 marks)
Bunyan Lumber Ltd harvests timber and delivers logs to timber mills for sale. The company was founded 70 years ago by Pete Bunyan. The current CEO is Paula Bunyan, the granddaughter of the founder. The company is currently evaluating a 5,000-acre forest it owns in the Scottish Highlands. Paula has
Let us return to the cement Practical Case Study from Chapter 7. The executives of the cement company have decided to go ahead with the investment appraisal and have retained you for the more detailed analysis.In any capital budgeting investigation, you need an estimate of future net cash flows,
Valuation: The Multi-period Case You have taken out a loan that requires annual payments of £110 for each of the next two years. You wish to pay back the loan over four years. Should the payment be £55 per year? Should it be more or less? Explain your answer.
What is a Firm Worth? What is discounted cash flow (DCF) valuation? Can it be used to estimate the value of companies? What businesses could we value using DCF valuation? What are the advantages and disadvantages of such an approach?REGULAR
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