1

MBA COLLABORATION PROGRAM

--- = e ---





CORPORATE FINANCE BMCF5103


2

ASSIGNMENT





LECTURER : Dr. TUAN TRAN
STUDENT : TRINH MANH TIN
ID No. : 2447579
CLASS : MBAOUM0312_2B



E 08-2013 ^

Table of Contents


Answer ...................................................................................................................................... 3
Question 1 ................................................................................................................... 3
Question 2 ................................................................................................................... 10
Question 3 ................................................................................................................... 12
Question 4 ................................................................................................................... 15
Question 5 ................................................................................................................... 18
Question 6 ................................................................................................................... 27
Question 7 ................................................................................................................... 27
Question 8 ................................................................................................................... 28
References ................................................................................................................... 32



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Question 1: Agency problem
a. What are the major of functions of the financial manager?
A financial manager is a person who takes care of all the important financial functions of
an organization. The person in charge should maintain a far sightedness in order to ensure
that the funds are utilized in the most efficient manner. His actions directly affect the
Profitability, growth and goodwill of the firm.
Following are the main functions of a Financial Manager:
[1] Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a


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financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt
[2] Allocation of Funds
Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered
The size of the firm and its growth capability
Status of assets whether they are long term or short tem
Mode by which the funds are raised.
These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity
[3] Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm. Profit arises due to many factors such as
pricing, industry competition, state of the economy, mechanism of demand and supply,
cost and output. A healthy mix of variable and fixed factors of production can lead to an
increase in the profitability of the firm. Fixed costs are incurred by the use of fixed
factors of production such as land and machinery. In order to maintain a tandem it is
important to continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of production which


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has gone thrown wear and tear. If this is not noted then these fixed cost can cause huge
fluctuations in profit.
[4] Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and
calculates the risk involved in this trading of shares and debentures. Its on the discretion
of a financial manager as to how distribute the profits. Many investors do not like the
firm to distribute the profits amongst share holders as dividend instead invest in the
business itself to enhance growth. The practices of a financial manager directly impact
the operation in capital market.
Beside the above functions of financial managers, we also have the other definitions
which are expressed in such below 07 summarized functions:
- Forecasting and Planning
- Financing Decision
- Investment Decision
- Dividend Decision
- Financial negotiation
- Cash Management
- Evaluating financial performance
- Dealing with relevant parties in the Financial Markets


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b. What are the factors that affect the market value of a firms common stock?
There are limits to the supply of any company's stock, even though that number might be
in the millions of shares. If more investors want to own the stock than there are shares
available for sale, the market value of the stock rises. If more investors want to sell their
stock than there are available buyers, the stock's market value drops. While supply and
demand dictates the market price of a stock, many factors also influence supply and
demand.
There are three major factors that affect the market value of a firms common stock:
Supply and Demand
The primary factor that determines the market value of any stock is supply and demand,
according to the New York Stock Exchange. There are limits to the supply of any
company's stock, even though that number might be in the millions of shares. If more
investors want to own the stock than there are shares available for sale, the market value
of the stock rises. If more investors want to sell their stock than there are available
buyers, the stock's market value drops. While supply and demand dictates the market
price of a stock, many factors also influence supply and demand
New Products
A company that frequently introduces new products may experience an increase in
the value of its common stock. This often results from increased consumer interest in the
company.
Targets
Financial analysts set certain expectations for larger corporations. These
expectations are built in to the price of common stock shares. If a company exceeds


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analyst expectations, the value of the shares often rises. If the company fails to meet
expectations, share prices often fall.
Financial Performance and Profits
Companies that make money are typically more valuable than companies that lose
money, though there are exceptions. A company that grows its earnings on a consistent
basis is also more likely to hold its value than a company with erratic earnings growth. A
company's value is also influenced by how consistently it meets or exceeds earnings
expectations set forth by analysts. A company that consistently meets its expectations is a
more desirable investment to most investors than a company that consistently falls short
of expectations. Finally, companies that perform well in both good and bad economic
times usually see their performance rewarded by increases in their stock price.
Corporate profits or losses have a strong influence on the value of a company's common
stock. If a company is profitable, the stock price often remains stable or increases. If a
company posts a loss, the stock prices often fall.
Economic Trends
The market value of stocks can be affected by economic trends that might have little or
nothing to do with the individual company's performance. For example, if the whole
country is experiencing an economic boom, the market price of an individual stock might
rise in tandem with other stocks. If a company is part of a specific industry group that
experiences a sudden downturn, its stock price can tumble even if the company is
producing solid financial results.
News and Emotions
Breaking news can influence how investors perceive a particular company or the
economy as a whole. News can have a positive or detrimental affect on stock prices,
sometimes driving the price of different stocks in different directions. For example, news


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of an impending war might cause defense stocks to rise but cause entertainment stocks to
fall. News of increases in interest rates or commodities can also affect the value of a
company. Money is an emotional subject and sometimes emotions trump reason when it
comes to stock investments, resulting in market prices being driven up or down far
beyond what is justified by the company's performance.
c. What are the disadvantages of profit maximization and stockholder wealth
maximization as the goals of the firm?
- Profit maximization is the most money a firm can make after expenses are paid.
This is a goal that all businesses for profit set. Once you pay the employees, fixed costs,
and variable.
Profit maximization is the focus of a company on their profits ahead of everything else.
This means that they will use all of the resources they have to increase profits. This
process sounds like a win-win situation, but it does come with some disadvantages,
namely risk. Using this type of strategy causes some risks to the company. It is possible
to lose all market value if the market takes a turn while all resources are set to creating a
profit.
Risk
Pursuing a profit maximization strategy comes with the obvious risk that the company
may be so entrenched in the singular strategy meant to maximize its profits that it loses
everything if the market takes a sudden turn. For example, a company may find that it
gets the most profit selling the Wii gaming system, so instead of keeping a balanced
inventory, it invests solely in buying Wiis to sell. If the Wii goes out of favor or the
makers of the Wii begin to limit the price that can be charged for the system, the
company that relied solely on its investment in Wiis could lose everything. Similarly, if a
company focuses only on maximizing its profit, it may miss opportunities for investment
and expansion.


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Expectation and Goodwill
You also need to consider consequences of profit maximization. If a company pursues a
profit maximization strategy, it creates an environment where price is a premium and
cutting costs is a primary goal. This, in turn, creates a perception of the company that
could lead to a loss of goodwill with customers and suppliers; for instance, a company
may win subsequent contracts with a client by bidding the first job low. It also creates an
expectation of shareholders to see immediate gains, rather than realizing profits over
time.
Cash Flow
For all its drawbacks, profit maximization carries the big advantage of creating cash flow.
When maximizing profit is the primary consideration, investments, reinvestments and
expansions are typically tabled. The company simply makes do on what it has. This can
create a more cost-efficient environment. In the mean time, the profits keep building,
producing a healthy bottom line and increasing the firms amount of available cash.
Sometimes profit maximization is used entirely to create an influx of cash so the firm can
reduce its debt or save up for expansion.
Financing and Investors
Some degree of profit maximization is always present. The goal of a company is to create
profits. It has to profit from its business to stay in business. Moreover, investors and
financiers in the company may require a certain level of profits to secure funds for
expansion. Further, a company has to perform well for its shareholders; they expect a
return on their investments. As such, maximizing that profit is always a consideration to
some extent.
- Shareholder wealth is the appropriate goal of a business firm in a capitalist society.
In a capitalist society, there is private ownership of goods and services by individuals.


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Those individuals own the means of production to make money. The profits from the
businesses in the economy accrue to the individuals. Wealth maximization is generally
preferred because it considers (1) wealth for the long term, (2) risk or uncertainty, (3) the
timing of returns, and (4) the stockholders` return. Timing of returns is important; the
earlier the return is received, the better, since a quick return reduces the uncertainty about
receiving the return, and the money received can be reinvested sooner.
The disadvantages of stockholder wealth maximization as the goals of the firm:
1. Offers no clear relationship between financial decisions and stock price.
2. We cant lead to management anxiety and frustrations.
3. We cant promote aggressive and creative accounting practices.
Finance managers are the agents of shareholders and their job is to look
after the interest of the shareholders. The objective of any shareholder or investor
would be good return on their capital and safety of their capital. Both these
objectives are well served by wealth maximization as a decision criterion to
business.
Question 2: Decision tree
A firm has an opportunity to invest in a machine which will last 2 years, initially cost
$125,000, and has the following estimated possible after-tax cash inflow pattern: year 1,
there is a 40 percent chance that the after-tax cash inflow will be $45,000, a 25 percent
chance that it will be $65,000, and a 35 percent chance that it will be $90,000. In year 2,
the after-tax cash flow possibilities depend on the cash inflow that occurs in year 1; that
is, the year 2 cash flows are conditional probabilities. Assume that the firms after-tax
cost of capital is 12 percent. The estimated conditional after-tax cash inflows and
probabilities are given below.


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Year 0 Year 1 Year 2


($125,000)
Cash

inflow
Probability

Cash

inflow
Probability

Probability NPV

$45,000 0.4
$30,000 0.3 ($60,905.61) 0.12 ($7,308.67)

$60,000 0.4 ($36,989.80) 0.16 ($5,918.37)

$90,000 0.3 ($13,073.98) 0.12 ($1,568.88)

$65,000 0.25
$80,000 0.2 ($3,188.78) 0.05 ($159.44)

$90,000 0.6 $4,783.16 0.15 $717.47

$100,000 0.2 $12,755.10 0.05 $637.76

$90,000 0.35
$90,000 0.1 $27,104.59 0.035 $948.66

$100,000 0.8 $35,076.53 0.28 $9,821.43

$110,000 0.1 $43,048.47 0.035 $1,506.70

1 ($1,323.34)

If After-tax cash flow at
year 1 = $ 45,000
If After-tax cash flow = $
65,000
If After-tax cash flow = $
90,000
If After-tax
cash flow at
year 2 = $
45,000
Probability If After-tax
cash flow at
year 2 = $
65,000
Probability If After-tax
cash flow at
year 2 = $
90,000
Probability
30,000 0.3 80000 0.2 90000 0.1
60,000 0.4 90000 0.6 100000 0.8
90,000 0.3 100000 0.2 110000 0.1

a. Drawing out the decision tree which shows the possible after-tax cash inflow
in each year?











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Calculation:
- Joint probability: 0.12 = 0.4*0.3
- NPV at 12%: ($60,905.61) = ($125,000) + $45,000/1.12 + $30,000/1.12
2

- Expected NPV: ($7,308.67) = ($60,905.61) * 0.12

b. Calculating the expected NPV, which is the weighted average of the
individual path NPVs where the weights are path probabilities?
According to part A we have:
NPV expected = -$1,323.34 (negative) = The firm should reject the project.
The expected NPV is the weighted average of the individual path NPVs where
the weights are the path probabilities.
Question 3: The lease purchase decision
Initial investment
($125,000)
Probability
0.4
$45,000
Probability
0.3
$30,000
Probability
0.4
$60,000
Probability
0.3
$90,000
Probability
0.25
$65,000
Probability
0.2
$80,000
Probability
0.6
$90,000
Probability
0.2
$100,000
Probability
0.35
$90,000
Probability
0.1
$90,000
Probability
0.8
$100,000
Probability
0.1
$110,000


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Cost of machine

Lease proposal

$100,000

Purchase proposal

$100,000
Terms of payment 5 years 5 years
Interest rate 12% 10%
Down payment
Monthly lease payment at the end of year (A) $23,216
Monthly loan payment (B) $26,381
Depreciation Straight line
Residual purchase price 0% 0%
Corporate tax bracket 50% 50%
After tax cost of capital 8% 8%

We have: PV = C/I * [1-1/(1+i)
t
]
Lease:
Compute the present value of the after tax cash value outflows associated with
the leasing alternative. Begin by finding the annual lease payment:

Year
Lease
payment
(1)
Tax saving
(2)
After-tax
cash
outflow (3)
= (1)-(2)
PV at 8%
(4)
PV of cash
outflow
(5)=(3)*(4)
0 $23,210

$23,210 $1.0000 $23,210
1 $23,210 $11,605 $11,605 $0.9260 $10,745


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2 $23,210 $11,605 $11,605 $0.8570 $9,949
3 $23,210 $11,605 $11,605 $0.7940 $9,212
4 $23,210 $11,605 $11,605 $0.7350 $8,530
5 $0 $11,605 ($11,605) $0.6810 ($7,898)

$53,749

Purchase: If the asset is purchased, the firm is assumed to finance it entirely with a
10% unsecured term loan. Straight line depreciation is used with no salvage value.
Therefore, the annual depreciation is $20,000 ($100,000 / 5 years). In this alternative,
first find the annual loan payment by using:

Then, calculate the interest by setting up a loan amortization schedule.


(1) (2) (3)=(2)(10%) (4)=(1)-(3) 5=(2)-(4)
Year
Loan
Payment ($)
Beginning
of Year
Principal ($)
Interest ($)
Principa
l ($)
End of
Year
Principal ($)
1 26,381 100,000 10,000 16,38
1
83,619
2 26,381 83,619 8,362 18,01
9
65,600
3 26,381 65,600 6,560 19,82
1
45,779
4 26,381 45,779 4,578 21,80
3
23,976
5 26,381 23,976 2,398 23,98
3




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Loan
Payments
Interest
Expense
Depreciatio
n Expense
Net After Tax
Cash Buy
Present
Value
Discounted
Cash Flow
Year
(1) (2) (3)
(4)=(1){50
%*[(2)+(3)]}
(5) (6)= (4)(5)
1 $26,381 $10,000 $20,000 $11,381 0.9259 $10,538
2 26,381 8,362 $20,000 12,200 0.8573 10,459
3 26,381 6,560 $20,000 13,101 0.7938 10,400
4 26,381 4,578 $20,000 14,092 0.735 10,358
5 26,381 2,398 $20,000 15,182 0.6806 10,333
$131,905 $31,898 $100,000 $65,956 $52,087

Therefore PV of borrowing = $52,087 is less than PV of leasing = $53,749, so we
decide to purchase the asset because we can cost =$53,749 - $52,087 = $1,662
Question 4: CAPM and APT
a. Differentiate the CAPM and APT?
The fundamental assumption of APT is that the value of a stock is determined by a
number of factors that include several macro factors as well as those that are specific to a
company. First there are macro factors that are applicable to all companies and then there
are the company specific factors. The following equation is employed to find the
expected rate of return of a stock.
In an interesting way, the same formula is used to calculate the rate of return in case of
CAPM too, which is also known as the Capital Asset Pricing Model. But, the difference


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is in the way a single non-company factor and a single measure correlation are used
among price of asset and the factor in case of CAPM while there are numerous aspects
and diverse measures of relationships between asset price and various factors in APT.
b. During a 5-year period, the relevant results for the aggregate market are that
the r
f
(risk-free rate) is 8 percent and the r
m
(return on market) is 14 percent. For
that period, the results of four portfolio managers are as follows:


Portfolio
Manager
Average Return (%) Beta
A 13 0.80
B 14 1.05
C 17 1.25
D 13 0.90

i. Calculate the expected rate of return for each portfolio manager and
compare the actual returns with the expected returns.
We have:
i
= R
f
+ *(
M
- R
f
)
Portfolio
Manager
Average
Return(%)
Beta

Expected Return as per
CAPM

A 13 0.80 12.8


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B 14 1.05 14.3
C 17 1.25 15.5
D 13 0.90 13.4

ii. Based on your calculations, select the manager with the best performance.
Out of four portfolio manager, portfolio manager A and C have positive performance
because actual average return is higher than return as per CAPM but portfolio manager C
has best performance.
(The Portfolio Manager C with actual returns = 17% is higher than the expected return =
15.5%)
iii. What are the critical assumptions in the capital asset pricing model (CAPM)?
What are the implications of relaxing these assumptions?
The CAPM establishes a linear relationship between the required rate of return of a
security and its systematic or un diversifiable risk or beta.
R
s
stands for return expected on the security,
R
f
stands for risk-free return,
R
m
stands for return from the market portfolio and
stands for beta.
Ri = R
F
+
i
(R M R
F
)
The CAPM is based on a list of critical assumptions, some of which are as follows:


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Investors are risk-averse and use the expected rate of return and standard deviation of
return as appropriate measures of risk and return for their portfolio. In other words, the
greater the perceived risk of a portfolio, the risk-averse investor expects a higher return to
compensate the risk.
Investors make their investment decisions based on a single-period horizon, i.e., the next
immediate time period.
Transaction costs in financial markets are low enough to ignore and assets can be bought
and sold in any unit desired. The investor is limited only by his wealth and the price of
the asset.
Taxes do not affect the choice of buying assets.
All individuals assume that they can buy assets at the going market price and they all
agree on the nature of the return and risk associated with each investment.
c. Suppose a three-factor APT holds and the risk-free rate is 6 percent. You are
interested in two particular stocks: A and B. the returns on both stocks are related
to factors 1 and factors 2 as follows: r = 0.06 + b1(0.09) b2(0.03) + b3(0.04)
The sensitivity coefficients for the two stocks are given below:
Stock b1 b2 b3
A 0.70 0.80 0.20
B 0.50 0.04 0.20

Calculate the expected returns on both stocks. Which stock requires a higher
return?


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For Stock A: R
A
= 0.06 + (0.7)(0.09) (0.8)(0.03) + (0.2)(0.04) = 0.107
For Stock B: R
A
= 0.06 + (0.5)(0.09) (0.04)(0.03) + (0.20)(0.04) = 0.1118
Conclusion: Stock B requires a higher return, indicating that it is the riskier of the two.
Part of the reason is that its return is substantially more sensitive to the third economic
force than that of Stock A.
Question 5: Risk and returns of portfolios
The spreadsheet that comes with this assignment includes price data for 10
American stocks and the S&P 500. For all
a. Compute the returns for each stock and for the S&P500?
Return of IBM = (117.64 81.29)/81.29 = 45%
Return of CSCO = (21.88 20.92)/20.92 = 4.6%
Return of HPQ = (41.72 19.17)/19.17 = 117.6%
Return of GS = (164.72 84.44)/84.44 = 95%
Return of F = (6.78 13.58)/13.58 = -50%
Return of K = (47.92 36.78)/36.78 = 30%
Return of MRK = (30.99 36.51)/36.51 = -15%
Return of KR = (21.36 15.17)/15.17 = 40.8%
Return of BA = (42.37 46.07)/46.07 = -8%
Return of C = (2.73 36.51)/36.51 = -92.5%
Return of VFINX = (90.36 92.11)/92.11 = -2%


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IBM
Cisco HP Goldma
n-Sachs
Ford Kellogg Merck Kroger Boein
g
Citigrou
p
S&P 500
VFINX
CSCO HPQ GS F K MRK KR BA C
Return 45% 4.6% 117.6
%
95% -50% 30% -15% 40.8% -8% -92.5% -2%

b. Compute the mean, variance, and standard deviation of each stock's return
(both monthly and annual)
Mean:
Variance:


Standard deviation:

COMPUTING THE RETURNS
Date IBM
Cisco
CSCO
Hewlett-
Packard
HPQ
Goldman-
Sachs
GS
Ford
F
Kellogg
K
Merck
MRK
Kroger
KR
Boeing
BA

Citigro
up
C
Vanguar
d Index
500 fund
VFINX
02-08-04 -2.57% -10.90% -11.90% 1.64% -4.21% 1.35% -0.85% 4.51% 3.25% 5.49% 0.39%
01-09-04 1.24% -3.58% 5.10% 3.93% -0.46% 1.62% -30.10% -6.31% -1.14% -5.43% 1.05%
01-10-04 4.57% 5.95% -0.45% 5.64% -6.70% 0.79% -5.25% -2.65% -3.39% 1.49% 1.51%


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01-11-04 5.07% -2.42% 6.93% 6.28% 8.38% 2.18% -11.10% 6.79% 7.48% 0.86% 3.97%
01-12-04 4.50% 2.99% 5.10% -0.69% 3.21% 2.18% 15.07% 8.10% -3.40% 7.37% 3.34%
03-01-05 -5.38% -6.85% -6.79% 3.84% -9.80% -0.05% -13.59% -2.53% -2.28% 1.80% -2.49%
01-02-05 -0.71% -3.50% 5.99% 0.87% -4.05% -0.88% 12.22% 5.05% 8.74% -1.87% 2.08%
01-03-05 -1.31% 2.66% 5.75% 1.09% -10.96% -1.66% 3.28% -11.53% 6.16% -5.99% -1.78%
01-04-05 -17.93% -3.53% -6.96% -2.71% -20.75% 3.81% 4.64% -1.64% 1.79% 5.34% -1.93%
02-05-05 -0.83% 11.63% 9.53% -9.11% 9.08% 1.74% -4.42% 6.15% 7.52% 0.30% 3.12%
01-06-05 -1.80% -1.66% 4.69% 4.53% 2.61% -2.34% -4.00% 12.64% 3.24% -1.86% 0.13%
01-07-05 11.76% 0.37% 4.60% 5.45% 5.61% 1.95% 0.84% 4.23% 0.02% -5.11% 3.64%
01-08-05 -3.22% -8.33% 11.99% 3.39% -7.38% 0.66% -8.20% -0.58% 1.89% 0.61% -0.92%
01-09-05 -0.50% 1.69% 5.37% 8.95% -1.16% 1.73% -3.67% 4.24% 1.38% 3.94% 0.79%
03-10-05 2.05% -2.66% -4.07% 4.07% -15.72% -4.34% 3.63% -3.40% -4.98% 0.56% -1.68%
01-11-05 8.47% 0.51% 5.65% 2.03% -2.26% 0.40% 5.37% -2.28% 5.73% 6.85% 3.69%
01-12-05 -7.84% -2.42% -3.29% -0.97% -5.22% -1.95% 7.86% -2.99% 2.95% -0.05% 0.03%
03-01-06 -1.10% 8.13% 8.54% 10.26% 11.73% -0.74% 8.13% -2.57% -2.78% -4.10% 2.61%
01-02-06 -1.07% 8.61% 5.08% 0.03% -7.41% 3.85% 1.03% 8.51% 6.64% 0.62% 0.25%
01-03-06 2.75% 6.83% 0.50% 10.52% -0.13% -0.62% 2.16% 1.60% 6.96% 1.83% 1.23%
03-04-06 -0.15% -3.38% -1.29% 2.30% -12.13% 5.03% -2.33% -0.51% 6.84% 6.63% 1.33%
01-05-06 -2.65% -6.25% -0.28% -6.00% 3.00% 2.27% -2.18% -0.41% 0.10% -1.30% -2.94%
01-06-06 -3.94% -0.77% -1.92% -0.35% -3.29% 2.78% 9.02% 8.37% -1.62% -2.15% 0.13%
03-07-06 0.78% -8.83% 0.71% 1.77% -3.10% -0.54% 10.03% 4.77% -5.64% 0.12% 0.60%
01-08-06 4.89% 20.69% 13.63% -2.72% 22.70% 5.71% 1.61% 4.04% -2.92% 3.15% 2.34%
01-09-06 1.19% 4.40% 0.56% 12.93% -3.40% -2.36% 3.26% -2.87% 5.14% 0.63% 2.53%
02-10-06 11.94% 4.88% 5.45% 11.69% 2.32% 1.57% 8.08% -2.86% 1.27% 0.98% 3.19%


22

01-11-06 -0.12% 10.90% 1.83% 2.61% -1.83% -0.47% -2.04% -4.38% 10.66% -0.16% 1.87%
01-12-06 5.54% 1.55% 4.51% 2.31% -7.93% 0.56% -1.21% 7.24% 0.35% 11.61% 1.39%
03-01-07 2.04% -2.63% 4.95% 6.39% 7.93% -1.59% 2.61% 10.40% 0.81% -1.02% 1.48%
01-02-07 -6.17% -2.59% -9.53% -5.03% -2.74% 1.74% -1.35% 0.40% -2.21% -8.04% -1.99%
01-03-07 1.41% -1.59% 2.20% 2.39% -0.25% 3.15% 0.88% 9.71% 1.87% 1.89% 1.11%
02-04-07 8.10% 4.63% 4.85% 5.80% 1.88% 2.83% 15.25% 4.35% 4.50% 4.34% 4.32%
01-05-07 4.59% 0.67% 8.14% 5.44% 3.66% 2.56% 1.95% 2.96% 8.21% 2.62% 3.42%
01-06-07 -1.28% 3.40% -2.23% -6.29% 12.18% -4.15% -4.44% -7.49% -4.50% -6.05% -1.69%
02-07-07 5.01% 3.74% 3.09% -13.87% -10.16% 0.04% -0.31% -8.02% 7.29% -9.67% -3.14%
01-08-07 5.67% 9.90% 6.97% -6.77% -8.58% 6.43% 1.03% 2.65% -6.39% 1.82% 1.49%
04-09-07 0.94% 3.72% 1.06% 20.82% 8.35% 1.93% 3.76% 7.03% 8.22% -0.44% 3.66%
01-10-07 -1.43% -0.21% 3.72% 13.59% 4.38% -5.91% 11.97% 3.01% -6.29%
-
10.78% 1.57%
01-11-07 -9.54% -16.54% -1.01% -8.97% -16.64% 2.90% 1.86% -1.90% -5.98%
-
21.68% -4.28%
03-12-07 2.74% -3.45% -1.20% -5.25% -10.97% -3.02% -1.47% -7.37% -5.64%
-
12.32% -0.70%
02-01-08 -0.93% -9.98% -14.36% -7.31% -1.35% -9.23% -23.16% -4.82% -5.02% -3.25% -6.20%
01-02-08 6.50% -0.45% 8.86% -16.25% -1.67% 6.53% -3.98% -4.55% 0.01%
-
17.26% -3.30%
03-03-08 1.12% -1.24% -4.35% -2.53% -13.24% 3.56% -14.61% 4.63% -10.72%
-
10.16% -0.45%
01-04-08 4.72% 6.24% 1.49% 14.78% 36.75% -2.68% 0.25% 7.04% 13.20% 16.52% 4.75%
01-05-08 7.38% 4.13% 1.52% -8.14% -19.45% 1.87% 2.39% 1.74% -2.03%
-
13.07% 1.28%
02-06-08 -8.80% -13.87% -6.07% -0.86% -34.62% -7.61% -2.33% 4.35% -23.07%
-
26.71% -8.83%


23

01-07-08 7.67% -5.61% 1.32% 5.29% -0.21% 9.99% -13.59% -2.06% -7.28% 12.60% -0.83%
01-08-08 -4.62% 8.95% 4.62% -11.55% -7.35% 3.19% 8.09% -2.07% 7.64% 1.62% 1.43%
02-09-08 -3.99% -6.40% -1.28% -24.77% 15.35% 3.00% -11.12% -0.51% -13.36% 7.71% -9.31%
01-10-08 -22.95% -23.87% -18.89% -32.18% -86.48% -10.67% -1.97% -0.07% -8.99%
-
39.46% -18.39%
03-11-08 -12.49% -7.17% -8.17% -15.79% 20.56% -14.92% -14.68% 1.06% -19.94%
-
49.89% -7.45%
01-12-08 3.09% -1.46% 3.04% 6.62% -16.10% 1.73% 14.34% -4.63% 0.10%
-
21.20% 1.07%
02-01-09 8.52% -8.51% -4.33% -4.43% -20.26% -0.35% -6.30% -16.03% -0.84%
-
63.37% -8.78%
02-02-09 0.95% -2.71% -17.98% 12.61% 6.72% -10.70% -16.53% -8.07% -28.70%
-
86.15% -11.27%
02-03-09 5.15% 14.06% 10.23% 15.19% 27.38% -6.06% 11.69% 2.64% 12.37% 52.28% 8.41%
01-04-09 6.31% 14.15% 11.53% 19.23% 82.14% 13.95% -9.83% 1.88% 11.84% 18.69% 9.14%
01-05-09 3.46% -4.34% -4.62% 12.04% -3.92% 3.46% 12.89% 5.73% 12.30% 19.86% 5.46%
01-06-09 -1.77% 0.81% 12.00% 1.97% 5.42% 7.40% 2.76% -3.34% -5.38%
-
22.52% 0.22%
01-07-09 11.92% 15.97% 7.64% 11.08% 11.06% 2.86% 10.29% -3.18% -0.31% -8.43% 6.44%
Monthly
statistics
Mean 0.62% 0.07% 1.30% 1.11% -1.16% 0.44% -0.27% 0.57% -0.14% -4.32% -0.03%
Variance 0.0042 0.0062 0.0049 0.0096 0.0379 0.0023 0.0084 0.0032 0.0066 0.0369 0.0021
Standard
deviation 6.46% 7.89% 6.97% 9.81% 19.46% 4.81% 9.17% 5.62% 8.15% 19.20% 4.63%
Annuali
zed
statistics
Mean 7.39% 0.90% 15.55% 13.36% -13.89% 5.29% -3.28% 6.84% -1.67%
-
-0.38%


24

51.87%
Variance 0.0500 0.0746 0.0582 0.1154 0.4545 0.0278 0.1009 0.0379 0.0797 0.4424 0.0258
Standard
deviation 22.37% 27.32% 24.13% 33.98% 67.42% 16.66% 31.77% 19.47% 28.23% 66.51% 16.05%

c. Regress each stock's returns on the S&P500, computing: alpha, beta, R2
Regressions on S&P 500
IBM
Cisco
CSCO
Hewlett-
Packard
HPQ
Goldman-
Sachs
GS
Ford
F
Kellogg
K
Merck
MRK
Kroger
KR
Boeing
BA
Citigroup
C
Alpha 0.006428 0.001128 0.013293 0.011594 -0.01077 0.004578 -0.00247 0.005846 -0.00101 -0.04228
t-alpha 0.94867 0.152133 2.013376 1.222276 -0.52676 0.84024 -0.22549 0.851801 -0.12974 -2.37659
Beta 0.837844 1.188304 1.040223 1.43159 2.518985 0.525129 0.825129 0.445352 1.208069 2.936106
t-slope 5.729872 7.428523 7.300684 6.993229 5.708113 4.466613 3.493099 3.00707 7.197027 7.647191
R-
squared 0.361454 0.487555 0.478886 0.457464 0.3597 0.255939 0.17381 0.134877 0.471753 0.502058

d. For the first four stocks: IBM, Cisco, Hewlett-Packard, Goldman-Sachs;
Compute the variance covariance matrix of these four stocks
Variance-covariance matrix, uses VarCovarFunction
IBM CSCO HPQ GS
IBM 0.0042 0.0028 0.0024 0.0031
CSCO 0.0028 0.0063 0.0036 0.0032


25

HPQ 0.0024 0.0036 0.0049 0.0021
GS 0.0031 0.0032 0.0021 0.0098


Correlation matrix, uses C
IBM CSCO HPQ GS
IBM 1.0000 0.5461 0.5259 0.4765
CSCO 0.5461 1.0000 0.6455 0.4051
HPQ 0.5259 0.6455 1.0000 0.3086
GS 0.4765 0.4051 0.3086 1.0000


e. Using the mean return of each stock as its expected future return, compute
the mean,
variance and standard deviation of returns, covariance, and correlation for the
following
portfolios:
Variance-covariance matrix
IBM CSCO HPQ GS


26

IBM 0.004241 0.002828 0.002405 0.003069
CSCO 0.002828 0.006324 0.003606 0.003187
HPQ 0.002405 0.003606 0.004934 0.002144
GS 0.003069 0.003187 0.002144 0.009782

Port. A 0.25 0.25 0.25 0.25
Port. B 0.6 0.25 0.4 -0.25


Port A Port B
Mean 0.007751 0.006283
Variance 0.003735 0.004299
Sigma 0.061113 0.065566
Covariance 0.00305


f. Draw the sigma/mean frontier for convex combinations of these two
portfolios?



27




g. Can you find a portfolio or stock which is superior to the portfolios in the
convex combination? If so, show it and explain how you found it. What does this
say about the efficiency of these two portfolios?

S&P
500
Portfolio Portfolio
Stock IBM Cisco HP GS Ford Kellogg Merck Kroger Boeing Citigroup VFINX A B
Mean 0.62% 0.07% 1.30% 1.11% -1.16% 0.44% -0.27% 0.57% -0.14% -4.32% -0.03% 0.78% 0.63%
SD 6.06% 7.89% 6.97% 9.81% 19.46% 4.81% 9.17% 5.62% 8.15% 19.20% 4.63% 6.06% 6.50%
CV 9.8378 105.455 5.3742 8.8066 -16.811 10.9074 -33.568 9.8522 -58.409 -4.4425 -144.94 7.8183 10.3481

Question 6: M&M Proposition I (with corporate taxes)
ACB Company expects an EBIT of $10,000 every year forever. ABC
can borrow at 7 percent. Suppose ABC currently has no debt, and its
cost of equity is 17 percent. If the corporate tax rate is 35 percent, what is
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 11.00%
R
e
t
u
r
n
s

Sigma
GS


28

the value of the firm? What will the value be if ABC borrows $15,000 and
uses the proceeds to repurchase stock?
With no debt, ACB's WACC is 17%. This is also the unlevered cost of capital. The
after tax cash flow is $10,000*(1 - 0.35) = $6,500, so the value of ACB is
V
U

= $6,500/0.17 = $38,235.
After the debt issue, ACB will be worth the original $38,235 plus the present value
of the tax shield. According to M&M Proposition I with taxes, the present value of the
tax shield = T
C
x D = 0.35 x $15,000 = $5,250, so ACB is worth
V
U

= $38,235 + $5,250 = $43,485.
Question 7: Minimum level for EBIT
We can calculate the break-even EBIT. At any EBIT above this, the increased
financial leverage will increase EPS.
Under the old capital structure, the interest bill is $80,000,000 x 0.09 =
$7,200,000.
There are 10 million shares of stock, so, ignoring taxes, EPS =
(EBIT - $7,200,000)/10,000,000
Under the new capital structure, the interest expense will be $125,000,000 x
0.09 = $11,250,000. Furthermore, the debt rises = $125,000,000 - $80,000,000
= $45,000,000.
This amount is sufficient to repurchase = $45,000,000/$45 = 1,000,000 shares
of stock, leaving = (10,000,000 - 1,000,000) = 9,000,000 outstanding. EPS
is thus (EBIT - $11,250,000)/9,000,000
We set the two calculations equal to each other and solve for the break-


29

even EBIT: (EBIT - $7,200,000)/10,000,000 = (EBIT -
$11,250,000)/9,000,000
EBIT = $47,700,000
Verify that, in either case, EPS is $4.05 when EBIT is $47,700,000.
Question 8: Stock mergers and EPS
a. How does a merger differ from other acquisition forms?
Mergers and acquisitions (abbreviated M&A) is an aspect of corporate strategy, corporate
finance and management dealing with the buying, selling, dividing and combining of
different companies and similar entities that can help an enterprise grow rapidly in its
sector or location of origin, or a new field or new location, without creating a subsidiary,
other child entity or using a joint venture.
- The differences between merging and acquiring are important to valuing,
negotiating and structuring a clients transaction. Acquiring another business lets owners
- Establish a base. Obtain a going concern in a particular location.
- Establish a niche. Bring in more business of a certain type.
- I ncrease productivity and profitability. Increase output with unchanged fixed
costs, yielding higher profit.
- Expand geographic coverage. Obtain entry into adjacent market areas.
- I ncrease prestige. Drive company value up.
Merging offers the above advantages and additional ones, such as :
- Succession planning. A way to secure retirement though new ownership.


30

- Reduced work level. A way to share responsibility among more people.
- Security of a larger organization. A way to cope with larger competitors.
b. What is the difference between a purchase and a pooling of interests?
The several major differences between pooling and purchases method of business
combination accounting:
Item PURCHASE METHOD
POOLING OF
INTERESTS METHOD
Book Value Typically higher than
pooling method.
Typically lower than
purchase method, as no
goodwill asset is created.
Earnings Trend
Typically lower than the
pooling method because pre-
acquisition income
statements are not combined.
Typically higher than
purchase method because
income statements are
combined retroactively.
Sales Trend
Typically distorts growth
perception of the acquiring
company, as much of its
sales growth can be
attributed to the acquisition.
Typically more accurate than
the purchase method, as
income statements are
combined retroactively.
Earnings Per
Share
Typically lower than the
pooling method.
Typically higher than the
purchase method, as the
income statement is
combined for the entire
reporting period, rather than


31

as of the acquisition date.
ROA & ROE Typically lower. Typically higher.

c. What are the relevant incremental cash flows for evaluating a merger
candidate?
To determine the incremental value of an acquisition, we need to know the incremental
cash flows. These are the cash flows for the combined firm less what A and B could
generate separately. In other words, the incremental cash flow for evaluating a merger
is the difference between the cash flow of the combined company and the sum of the
cash flows for the two companies considered separately. We will label this incremental
cash flow as CF.
CF = EBIT + Depreciation - Tax Capital requirements
= Revenue - Cost - Tax Capital requirements
So, the merger will make sense only if one or more of these cash flow components are
beneficially affected by the merger. The possible cash flow benefits of mergers
and acquisitions thus fall into four basic categories: revenue enhancement, cost
reductions, lower taxes, and reductions in capital needs
+ Consider the following information for two all-equity firms, A and B:
Firm A Firm B
Total earnings $3,000 $1,100
Shares 600 400


32

outstanding
Price per share $70 $15

Firm A is acquiring Firm B by exchanging 100 of its shares for all the shares in B.
What is the cost of the merger if the merger firm is worth $63,000? What will
happen to Firm As EPS? Its PE ratio?
The firm A will have = 600 + 100 = 700 shares outstanding. Total value is $63,000, the
price per share is $63,000/700 = $90 higher than price of firm A = $70.
The f irm Bs stockholders end up with 100 shares in the merged firm, the cost of the
merger = 100 x $90 = $9,000.
The combined firm B will have = $3,000 + $1,100 = $4,100 in earnings, so Bs EPS =
$4,100/700 = $5.86 is higher than Firm A's EPS = $3,000/600 = $5.
The old PE ratio of Firm A was =$70/5 = 14%.
The new firm is = $90/5.86 = 15.36%
The end.








References:
+ Lectures in Corporate Finance of Dr. Tuan Tran
+ Stephen A. Ross, Randolph W. Westerfiel, Jeffrey Jaffe (2010): Corporate


33

finance (9
th
Ed), McGraw Hill.