Chapter 1

  1. C. Leverage multiplies losses, too, as it increases a company’s risk. Leverage multiplies both gains and losses, adding to overall risk. On the positive side, this multiplication can increase profits; in times of negative profitability, however, leverage increases the magnitude of losses.

  2. B. Companies in stable, predictable industries with reliable cash flows. Because leverage increases risks, the companies most likely to have high amounts of leverage are those whose business models expose them to the least amount of risk. Companies in new industries are typically risky, so financial risk would compound that business risk.

  3. D. Preferred stock dividends must be in even-numbered percentages (2 percent, 4 percent, etc.). Preferred stock is a form of equity and thus represents ownership in the business. However, it is “preferred” in the case of bankruptcy, where it receives payment before common stockholders, and in the case of dividends, in which preferred shareholders must receive a dividend before common stockholders are eligible.

  4. A. Gilead Sciences Inc.’s patent for the highly profitable hepatitis C treatment it developed in-house. A patent is a form of intellectual property and typically does not show up on a balance sheet as an asset unless and until the company that developed it is purchased by another company. In that case, it may show up as part of the goodwill asset. Cash accounts, such as Facebook holds, are cash assets; buildings are property, plant, and equipment assets; and payments owed to a company are accounts receivable assets.

  5. A. Subway, a fast-food restaurant company. Inventory turnover measures the number of times per year a company sells out its inventory. Companies that sell food—such as a grocery store or a fast-food restaurant company—typically sell out inventory faster and will have a higher inventory turnover. Since the grocery store also sells nonfood items (such as light bulbs and paper towels), the fast-food restaurant company likely has the highest inventory turnover. Bookstores can keep their items on the shelf for a long time with little concern, and airlines do not have physical inventory.

  6. B. Low receivables collection period. Retail companies typically have a low receivables collection period, since many of their customers pay immediately for the goods they purchase. The receivables collection period can be a good way to tell if a business typically sells to other businesses (with a long receivables collection period) or to customers (with a short receivables collection period). ROE, inventory turnover, and debt levels will be influenced largely by the type of item being sold, and none of these are uniform across all retailers.

  7. D. United States Steel Corporation, a steel manufacturer. For a company to owe BHP Billiton money, it would need to regularly purchase goods that a mining company would produce—raw ores for processing. BHP Billiton may owe money to Bank of America, Mining Recruitment Agency, or Sysco (i.e., they may be part of BHP Billiton’s accounts payable), but of the four options listed, only United States Steel Corporation, which buys raw ores to turn them into steel, would be likely to owe BHP Billiton money (and be part of its accounts receivable).

  8. B. Its suppliers. The current ratio measures how easily a company can pay its short-term liabilities with short-term assets. In other words, it measures how well the company can pay its bills. While all four of the listed parties would be interested in a company’s current ratio, suppliers would have the greatest interest—they are the ones owed those bills.

  9. B. False. While a high ROE is desirable, it is not always a good thing—the elements that make up that ROE can help to determine whether that ROE is sustainable or built on a foundation that will destroy the company. The Timberland case is an example of a high ROE that was created by leverage, rather than profitability.

10. A. Debt carries an explicit interest rate. Debt is unusual as a liability because it carries an explicit interest rate. Unlike equity, plain debt provides no ownership claim to the company, and equity is typically the residual claimant. Debt can be owed to anyone who loans money to a company, such as a bank, not only suppliers.

Chapter 2

  1. B. Increasing sales. The funding gap is calculated as days inventory + receivables collection period − payable period. You can decrease the funding gap by decreasing the days inventory or the receivables collection period, or by increasing the payable period. Increasing sales would not change the funding gap as measured in days, though it might increase the total amount you would need to finance because you would need more working capital overall.

  2. A. What constitutes economic returns (net profit or free cash flows); B. How to value assets (historical cost or future cash flows); and D. How to value equity (book value or market value). Finance and accounting disagree about economic returns (net profit or free cash flows), the value of assets (historic cost or future cash flows), and the valuation of equity (book values or market values). Both agree that inventory should be recorded on the balance sheet.

  3. B. $400 million and C. $500 million. Companies should invest in projects only where the present value is greater than the cost of investment in the project—in other words, they should invest in projects only where the net present value is greater than zero. In this case, only the $400 million and $500 million present values are greater than the $350 million cost of investment.

  4. B. $230,000. To determine the present value of an investment, add up all the discounted cash flows associated with that investment. In this case, adding each of the cash flows yields $480,000 ($90,000 + $80,000 + $70,000 + $60,000 + $180,000). The net present value of an investment is its present value minus its cost. In this case, that equals $230,000 ($480,000 − $250,000).

  5. C. Because depreciation isn’t a cash charge. Depreciation does not correspond to a cash outlay but does decrease net profit. So, economic returns that emphasize cash must add back depreciation and amortization.

  6. A. The present value of all future free cash flows from Facebook’s business, after netting out cash and debt, implies a Facebook stock value of $150. For any investment for which the net present value is greater than zero, anyone able to invest should do so. For a stock in the market, this demand should increase its price until the net present value is exactly zero. For the net present value to be exactly zero, the price for the stock must equal the present value of expected cash flows from that stock. In the case of Facebook stock, if it is traded at $150, that means that investors believe the present value of all future free cash flows to equity holders of that stock will be $150 as well.

  7. B. 52 days. The funding gap is calculated as days inventory + receivables collection period − payables period. For United States Steel, that yields a funding gap of 52 days (68 days + 33 days − 49 days).

  8. C. 2 percent. If you pay your supplier earlier, your funding gap will increase, and you will need to finance that increase with a loan from your bank. Currently, you are financing that period through not receiving the discount—which carries a rate of 2 percent. Therefore, a supplier offering you a 2 percent discount if you pay twenty days earlier is implicitly offering you a 2 percent interest rate on a twenty-day loan.

  9. B. No, the present value is still $50 million. In finance, sunk costs don’t matter, so the original cost of investment and the projected free cash flows are no longer relevant. All that matters is the current situation. In this case, the cost of investment is now zero (it has already been paid), and the present value of the investment is $50 million. That means the net present value of keeping the plant open is $50 million—which is positive—and the firm should choose to keep it open rather than shutting it down.

10. B. It is for all capital providers and is tax adjusted. Free cash flows are the cash flows available for all capital providers—both debt and equity. They are calculated using the following equation:

Free cash flow = EBIAT + depreciation & amortization
± change in net working capital
− capital expenditures

Chapter 3

  1. A. Long General Motors, short Ford. When constructing a hedge, you should find two companies that are similar, then buy (long) the one you think will outperform and sell (short) the one you think will not do as well. In this case, that means you should long (buy) General Motors and short (sell) Ford.

  2. B. It decreases the amount of risk in your portfolio, relative to the amount of return. Diversification is the process of using an increased number of stocks in your portfolio to decrease the overall risk. Because different companies perform in disparate ways, they are not perfectly correlated. So diversification can provide benefits to investors by reducing the variability of returns without reducing risk-adjusted returns.

  3. D. Investors can’t be certain if the company failed to meet its estimates because of coincidence or bad luck, or if the missed estimate is a signal that management is obscuring deeper problems. Stocks can be punished for missing earnings estimates because investors are uncertain about the source of the missed earnings. Because of the information asymmetry between investors and managers, investors often assume the worst possible explanation for earnings surprises. For example, in November 2016, Pfizer reported earnings of 61 cents per share, missing the consensus expectation of 62 cents per share. Despite only falling a single cent short, Pfizer’s stock dropped around 3.5 percent on the announcement.

  4. A. Bayer, a multinational chemical and pharmaceutical company. When constructing a hedge, you usually want to find a roughly comparable company. In this case, you should match Dow Chemical with Bayer, another chemical company. Diversification will reduce your overall risk, but it does not isolate the risk of Dow Chemical precisely and hedge that risk.

  5. B. Analysts are afraid to recommend “sell” for a company’s stock, because that company may not do business with their employer in the future. The company may retaliate by taking its business elsewhere, and this business is the principle source of revenue for the analyst’s employer. Investors investing in companies that do well and pension funds investing in high-quality companies are examples of good incentives, and CEOs typically reduce risks, perhaps excessively, when a large amount of their personal wealth is tied up in stock options.

  6. C. A sell-side firm. Most equity research analysts are employed by a sell-side firm. Sell-side firms, like investment banks, employ equity research analysts to provide ideas and information to their institutional investor clients on the buy side, which can lead those investors to direct more of their business through the investment bank that employs the analyst they like.

  7. A. Analysts will work hard to provide accurate valuations for companies; B. High-ranking analysts may “herd” by choosing valuations similar to other analysts to protect their position in the rankings; and D. Low-ranked analysts may make outlandish and contrary predictions, hoping that a lucky break will propel them to the top of the rankings. Because analysts are compensated based on rankings, they will work to ensure their rankings are high. This may provide good incentives, such as working hard to provide accurate valuations, and bad incentives, such as herding to protect their position or making bold, outlandish predictions to rise quickly through the ranks. Herding behavior among analysts has been found to exacerbate the information asymmetry problem by reducing the quality of analyst reports, creating more earnings surprises and, consequently, more volatility in the market.

  8. C. The sell side. Initial public offerings are a sale of stock. As such, they are managed by sell-side firms. Facebook’s IPO—with a peak market capitalization of $104 billion—was one of the largest in internet history and was underwritten by three investment banks: Morgan Stanley, JP Morgan, and Goldman Sachs.

  9. B. Buys companies, improves them, and then sells them to another private investor or the public markets. The private equity industry has grown rapidly in the last few decades. A report from McKinsey & Co. indicated that private equity assets under management had risen to $5 trillion by 2017.¹

10. D. The principal-agent problem. In this case, the real estate agents—the agents—are not working as hard or as well on behalf of the owners—the principals—as they do when they are working on behalf of themselves. A 1992 article in the Journal of the American Real Estate and Urban Economics Association by Michael Arnold² analyzed three methods of realtor compensation structures (fixed-percentage commission, flat fee, and consignment) and found that impatient sellers are best served by a fixed-percentage commission (in which the realtor receives a percentage of the final price as a commission), while patient sellers are best served by a consignment (in which the seller receives a predetermined amount and the realtor receives any payment above that amount).

Chapter 4

  1. A. Returns to capital that exceed costs of capital and B. Reinvesting profits to grow. Value creation comes from three sources: returns to capital that exceed the costs of capital, reinvested profits for growth, and doing both for long periods of time. Earnings per share is an accounting measure that does not capture value creation, and gross profits—sales minus cost of goods sold—tell us nothing about whether operating expenses then offset those gross profits.

  2. B. A measure of how much a stock price moves with the broader market. In an environment where diversification is costless and most investors hold the entire market, the relevant measure of risk for a company is its correlation with the market portfolio—this is beta. For example, if Apple has a beta of 1.28, this means that, on average, when the market goes up by 10 percent, Apple stock goes up by 12.8 percent; if the market goes down 10 percent, Apple stock goes down by 12.8 percent.

  3. C. Division C. Using a beta that’s inaccurately high will cause the cost of equity to be inaccurately high, which causes the cost of capital to be too high. This will result in the present values for projects being too low, and the company will shy away from these projects. Conversely, a beta that’s too low will cause the cost of equity to be too low, the cost of capital to be too low, and present values to be too high, causing the company to overinvest. In this case, using the average beta of 1.0 is too low for division C, so the company will overinvest in that division.

  4. A. Your lender can tell you what your current borrowing costs are. The lender identifies the cost of debt from a combination of the risk-free rate and a credit spread based on the riskiness of a company (it does not do this by multiplying the company’s current ratio by its credit rating). Calculating the cost of debt by subtracting the cost of equity from the WACC is backward—you determine the WACC from costs, not vice versa.

  5. B. Less than 1. When returns to capital are lower than costs of capital, market-to-book ratios are less than 1. In this case, free cash flows going into the future will be discounted each year at a greater rate (the cost of capital) than they are growing (the return to capital). In such a situation, the owners of the company should consider shutting down operations, as the company is destroying value by continued operation.

  6. B. False. Up to a certain point, company value can be increased by adding leverage through tax benefits created by interest payments on debt (in countries that allow interest payments to serve as tax deductions). At some point, the company will reach its optimal capital structure; adding further leverage will increase the costs of financial distress faster than the benefits gained from the tax code.

  7. B. Take the risk-free rate and add the product of your equity beta and the market risk premium. Following the capital asset pricing model, the cost of equity is the risk-free rate, plus beta times the market risk premium. In 1990, William Sharpe, Harry Markowitz, and Merton Miller jointly received a Nobel Prize recognizing their contributions to the development of the CAPM during the 1960s.

  8. A. Higher costs of equity. Following the capital asset pricing model, the cost of equity is the risk-free rate, plus beta times the market risk premium. Higher betas, therefore, produce higher costs of equity. Since the cost of equity represents the return that shareholders expect from companies, this implies that shareholders expect higher returns from high-beta industries than low-beta industries.

  9. D. Because they create value by having returns greater than the cost of capital. Positive NPV projects have returns greater than the cost of capital, and as we saw in chapter 2, NPV is a method of determining which projects create value. NPV considers the discounted free cash flows of a project, and those cash flows are discounted at the cost of capital. When all free cash flows are summed up in this manner, they will only net to a positive number if the returns of the project are greater than its costs of capital.

10. A. Reinvest as many of its profits as possible. Value creation comes from three sources: returns to capital greater than the cost of capital, reinvestment in growth, and time. In this situation, since the company already has returns to capital greater than its costs of capital, it should reinvest as much as possible to maximize value creation. We’ll look at the alternative to reinvestment—distributions to shareholders—in greater length in chapter 6.

Chapter 5

  1. C. $112.5 billion. When conducting scenario analysis, the objective is to determine expected values. Expected values are a weighted average based on the likelihood of each scenario occurring. In this case, take the weighted average of $50 billion (times 25 percent), plus $100 billion (times 50 percent), plus $200 billion (times 25 percent), which equals the expected value of $112.5 billion. This expected value should be the highest bid because it is the amount you expect the company to be worth. If you bid solely based on the best-case scenario, you would have to reach that best case just to have an NPV of zero.

  2. C. $500 million. If you value the company at $500 million and estimate $50 million in synergies, and you wish to keep all the synergies to yourself, you should not pay more than $500 million for the company. If you bid more than $500 million—such as $550 million—you would be giving all the synergies to the shareholders of the lumber company.

  3. A. The market believes that Yum! Brands has more growth opportunities than Wendy’s or McDonald’s. A price/earnings (P/E) ratio is a multiple that can be traced back to a growing perpetuity formula. In the denominator of that formula is the discount rate minus the growth rate. Therefore, companies with higher P/E ratios need to have either a lower discount rate or a higher growth rate. While we can’t be certain of the exact values for these companies, only Yum!, with more growth opportunities, provides a possible explanation for why its P/E ratio is higher than either Wendy’s or McDonald’s.

  4. C. Value destruction, transfer of wealth from acquirer to target. Your company lost value while your target gained value, which indicates a transfer of value from acquirer to target. Target shareholders gained $25 million in value, while your shareholders lost value, so this wasn’t a case of splitting synergies; it was a transfer of your value to the target. Also, since the value you lost was greater than the value the target gained, that indicates value destruction. Imagine now that the two companies are one entity, and that entity has both gained $25 million and lost $50 million—the net loss of $25 million is value destruction.

  5. C. Current assets to current liabilities. P/E, enterprise value/EBITDA, and market capitalization/EBITDA are all valuation multiples. These values—price, enterprise value, or market capitalization—are all expressions of value, so these multiples are valuation multiples. The current ratio—current assets to current liabilities—does not indicate value. While it is a useful ratio, especially for suppliers, it doesn’t provide any information about the valuation of a company.

  6. C. A discount rate of 9 percent and 3 percent growth. An enterprise value to free cash flow ratio can be thought of as a growing perpetuity formula in which the numerator is 1 (because the multiple will be multiplied by free cash flows to determine total valuation) and the denominator is the discount rate minus the growth rate. If the enterprise value to free cash flow ratio is 16.1, then (r − g) in the growing perpetuity formula (the denominator) for Goodyear must be equal to 1/16.1. That works out to roughly 6 percent, so the discount rate minus the growth rate must equal 6 percent. In this case, only one option (9 percent and 3 percent) works as an explanation.

  7. D. $10,000. Using a growing perpetuity formula, you can calculate the value of this educational opportunity as $1,000/(13% − 3%), or $10,000. This value should then be the maximum you are willing to pay.

  8. D. The project with an IRR of 25 percent is probably preferable, but you should conduct a DCF analysis. The first rule with IRR is you should never invest in a project with an IRR lower than the WACC. Since both projects have IRRs higher than the WACC, you need a way to compare them. However, because IRR is not a good measure of value creation, it is not possible to tell based solely on the IRR which project will create more value. The project with an IRR of 25 percent is likely to produce more value, but an NPV analysis will provide the right answer.

  9. A. Too high a growth rate in the terminal value; B. Basing his growth rate on the industry; and C. Basing a purchase price on the company’s value, not the equity value. A terminal value with a growth rate significantly higher than the overall economy implies that the company will eventually take over the world—with an overall economic growth rate between 2 percent and 4 percent, the 6 percent chosen is too high. Additionally, your assistant is suggesting a bid that includes synergies, which transfers all the value from the acquisition to the target, not to your company. Finally, he is recommending a price that doesn’t consider the $50 million in debt and $10 million in cash, which will make the equity valuation lower than that $100 million valuation of the company. He did do one thing right—choosing a growth rate in the near term based on the industry is a good practice, since companies within the same industry likely have similar growth rates.

10. A. A project with an NPV of $100 million. Projects with positive NPV are value creating, because they consider all the value above the costs of the project and the costs of capital. The payback period and IRR are problematic and cannot determine with certainty if a project is value creating, so we don’t want to use those. A PV is an accurate measure of the value of the project, but does not tell you anything about value creation because it does not factor in the cost of investment (for example, if this project cost $250 million, it would be value destroying).

Chapter 6

  1. A. Signaling. Stock buybacks do not create value, but they may send a signal to the market that corporate management believes its stock price is undervalued; accordingly, this can cause the stock price to rise. This explanation comes back to information asymmetry. If the people with the relevant information think that their stock price is an attractive investment, other investors may want to follow.

  2. B. Realization of synergies and C. Cultural integration. After the acquisition, due diligence and accurate terminal growth rates become less important because the valuation and bid are complete; the values placed on them have already been paid. Cultural integration and the realization of synergies remain important concerns that Bayer should pay attention to. If it does not give them appropriate attention, then the value gained from the acquisition will likely not be as much as the valuation used to determine the $66 billion purchase price.

  3. A. Use the $1 million for the organic growth project. Companies should always invest in positive NPV projects when available, as these create value for the company, while distributing cash in the form of dividends and buybacks does not.

  4. D. Shareholders can diversify on their own and do not need the company to do it for them. The finance principle is that managers shouldn’t do for shareholders what shareholders can do for themselves. In some countries, however, conglomerates may be able to overcome some frictions in labor, product, or capital markets and therefore create value.

  5. A. Share repurchases can be taxed at a favorable rate compared to dividends (using the capital gains tax rate instead of the income tax rate) and B. Share repurchases signal that the company thinks its stock is undervalued. Shareholders may prefer share buybacks because they are taxed at the preferential capital gains tax rate instead of the income tax rate at which dividends are taxed and because they send a signal that corporate management thinks its shares are undervalued. Dividends do not dilute the value of existing shares nor do they destroy value—they are value-neutral. That different groups of shareholders might prefer different capital allocation decisions is called the “clientele effect,” where companies will establish policies around what their shareholders’ preferences are.

  6. D. Scenario analysis. Overpaying is a concern before the bidding process and the acquisition, and scenario analysis allows the company to determine a more accurate value before they begin bidding. Cultural integration occurs after the valuation process, and maximizing synergy valuation during the valuation will likely result in overpayment, rather than reducing the risk of it.

  7. B. Signaling. Issuing equity is a value-neutral activity; however, it can often cause the stock price to decrease. This is because of signaling, as investors wonder why the company isn’t confident enough to invest in the project using debt or internal financing. Shareholders might ask, If the company thought that the investment would create value, why wouldn’t it want to keep that value for its existing capital providers? Because of information asymmetry, shareholders might conclude that the company is bringing in new investors because it lacks confidence in its ability to create value.

  8. A. To increase EPS to meet a target and B. To send a false signal that the CEO believes her stock is undervalued. A share buyback decreases the number of shares outstanding, which can increase EPS (because it decreases the denominator). An unscrupulous CEO might do this to meet a target (perhaps for a bonus package). Also, since investors see share buybacks as a signal from management that the share is undervalued, an unscrupulous manager could use this assumption to manipulate the stock price, counting on the signaling effect to increase stock values.

  9. A. Positive NPV projects. Dividend distributions and stock buybacks are value-neutral—only positive NPV projects create value. While stock prices may rise through stock buybacks because of signaling, this is not creating value; it is merely providing more information to shareholders that the value of the company may be higher than they thought.

10. A. Synergies not realized; B. Overpayment for the acquired company; and C. Cultural clashes. An acquisition can fail for all these reasons. Different costs of capital should be considered during the valuation process, but should not determine the success or failure of the acquisition.