SOLUTION FOR MANAGERIAL FINANCE

BMMF5103

PART A:
Question 1:
a) Within the financial markets, there are three principal sets of players that interact.
Discuss.
Answer: Within the financial markets there are three principal sets of players that interact:
1. Borrowers: Those who need money to finance their purchases. This includes businesses
that need money to finance their investments or to expand their inventories as well as
individuals who borrow money to purchase a new automobile or a new home.
2. Savers (Investors): Those who have money to invest. These are principally individuals
who save money for a variety of reasons, such as accumulating a down payment for a home
or saving for a return to graduate school. Firms also save when they have excess cash.
3. Financial Institutions (Intermediaries): The financial institutions and markets that help
bring borrowers and savers together. The financial institution you are probably most familiar
with is the commercial bank, a financial institution that accepts deposits and makes loans,
such as Bank of America or Citibank, where you might have a checking account. However,
as we discuss in the next section, there are many other types of financial institutions that bring
together borrowers and savers.
The three basic principles of financial marketing are savers, borrowers, and intermediaries.
The one thing that is wellknown, without borrowers, savers and financial institutions what we
refer to as banks the financial market could not work. Savers or investors are people that
always put a little moneyaside for rainy days. Borrowers are like most people or companies
that need money for buying anew home or business or making improvements to one or the
other. Intermediaries better known as a commercial bank for example Wells Fargo, Bank Of
America, and Fifth/third Bank just toname a few. These financial institutes try to match the
right investor with the right borrower. Theway that these institutes do this is by using the
money that you have deposited in to an account. All in all The financial markets facilitate
the movement of money from savers, who tend to beindividuals, to borrowers, who tend to
be businesses. In return for the use of the savers money, borrowers provide the savers with a
return on their investment (Titman, Martin, & Keown,2011).

b) The role of securities markets is to bring investors together with businesses looking
for financing. Explain the four-step process of raising money in the securities market.
Answer: We can think of the process of raising money in the securities markets in terms of
the four step process:
Step 1. The firm sells securities to investors. Corporations raise money in the securities
markets by selling either debt or equity. When the firm initially sells the securities to the
public it is considered to take place in the primary markets. This is the only time the firm
receives money in return for its securities.
Step 2. The firm invests the funds it raises in its business. The corporation invests the cash
raised in the security market in hopes that it will generate cash flows - for example, it may
invest in a new restaurant, a new hotel, a factory expansion, or a new product line.
Step 3. The firm distributes the cash earned from its investments. The cash flow from the
firms investments is reinvested in the corporation, paid to the government in taxes, or
distributed to the investors who own the securities issued in Step 1. In the latter case, the cash
is distributed to the investors that loaned the firm money (that is, bought the firms debt
securities) through the payment of interest and principal. Cash is paid to the investors that
bought equity (stock) through the payment of cash dividends or the repurchase of the shares
of the firms previously issued stock.
Step 4. Securities trading in the secondary market. Immediately after the securities are sold
to the public, the investors who purchased them are free to resell them to other investors.
These subsequent transactions take place in the secondary market.

Question 2:
a) Answer: This problem can be solved by calculating the PV of each coupon interest
payment, plus the PV of the face value. However, an easier approach is to first calculate the PV
of the bond under the assumption that all the coupon interest is paid; then deduct the PV of the
payments that are skipped and add the PV of the payments made at maturity. The bond's value,
ignoring skipped and repaid coupons, is $817.43.
The PV of skipped coupons is:
PV = $70/(1.09)8 + $70/(1.09)9 + $70/(1.09)10 = $96.93.
At maturity, an extra (3 $70) = $210 will be paid. The PV of this $210 is $37.47. Thus the
value of the bond is ($817.43 - $96.93 + $37.47) = $757.97.

b) Answer:
Bond Value = Coupon payment [l-l/(l+i)n] / i + Par value / (l+i)n
980=100*(1-(1/(1+i)^7))/i+1000/(1+i)^7
YTM = i = 10.42%

PART B:
Question 1:
a) Common stock does not offer its owners a promised interest payments, maturity
payment or dividend. Explain the three-step procedure to value common stock.
Answer: Three Step Procedure for Valuing Common Stock:
1. Estimate the amount and timing of future cash flows the common stock is expected to
provide.
2. Evaluate the riskiness of the future dividends, and determine the rate of return an investor
might expect to receive from a comparable risky investment, which becomes the investors
required rate of return.
3. Calculate the present value of the expected dividends by discounting them back to the
present at the investors required rate of return.
Let's take a look at these three steps. Each of these three steps relies on one of our basic
principles: Step 1 relies on Principle 3: Cash Flows Are the Source of Value, Step 2 relies on
Principle 2: There Is a Risk-Return Tradeoff, and Step 3 relies on Principle 1: Money Has a
Time Value. In Step 1, we estimate the amount and timing of future cash flows. If you bought
a share of common stock and never sold it, the only cash flow you would ever receive would
be the dividends that the firm paid. Step 2 involves an estimate of the required rate of return,
whereas Step 3 involves calculating the present value of the future cash flows, discounted at
the required rate of return. What this all means is that the value of a common stock is equal
to the present value of all future dividends.
b) The growth rate in dividends and the investors required rate of return to go up and
down caused by determinants. Discuss the real determinants of the P/E ratio.
Answer: The simplest model for valuing a stock is to assume that the value of the stock is
the present value of the expected future dividends. Since equity in publicly traded firms could
potentially last forever, this present value can be computed fairly simply if you assume that
the dividends paid by a firm will grow at a constant rate forever. In this model, which is called

the Gordon Growth Model, the value of equity can be written as:

The cost of equity is the rate of return that investors in the stock require, given its risk. As a
simple example, consider investing in stock in Consolidated Edison, the utility that serves
much of New York city. The stock is expected to pay a dividend of $2.20 per share next year
(out of expected earnings per share of $3.30), the cost of equity for the firm is 8%, and the
expected growth rate in perpetuity is 3%. The value per share can be written as:

Generations of students in valuation classes have looked at this model and some of them have
thrown up their hands in despair. How, they wonder, can you value firms like Microsoft that
do not pay dividends? And what you do when the expected growth rate is higher than the cost
of equity, rendering the value negative? There are simple answers to both questions. The first
is that a growth rate that can be maintained forever cannot be greater than the growth rate of
the economy. Thus, an expected growth rate that is 15% would be incompatible with this
model; in fact, the expected growth rate has to be less than the 4%5% that even the most
optimistic forecasters believe that the economy (U.S. or global) can grow at in the long
term.[2] The second is that firms that are growing at these stable growth rates should have
cash available to return to their stockholders; most firms that pay no dividends do so because
they have to reinvest in their businesses to generate high growth.
To get from this model for value to one for the price-earnings ratio, you will divide both sides
of the equation by the expected earnings per share next year. When you do, you obtain the
discounted cash flow equation specifying the forward PE ratio for a stable growth firm.

To illustrate with Con Ed, using the numbers from the previous paragraph, you get the
following:
Forward PE for Con Ed = ($2.20 / $3.30) / (.08 .04) = 16.67

The PE ratio will increase as the expected growth rate increases; higher growth firms should
have higher PE ratios, which makes intuitive sense. ThePE ratio will be lower if the firm is a
high-risk firm and has a high cost of equity. Finally, the PE ratio will increase as the payout
ratio increases, for any given growth rate. In other words, firms that are more efficient about
generating growth (by earning a higher return on equity) will trade at higher multiples of
earnings.
The price-earnings ratio for a high growth firm can also be related to fundamentals. When
you work through the algebra, which is more tedious than difficult, the variables that
determine the price-earnings ratio remain the same: the risk of the company, the expected
growth rate and the payout ratio, with the only difference being that these variables have to
be estimated separately for each growth phase.[3] In the special case in which you expect a
stock to grow at a high rate for the next few years and grow at a stable rate after that, you
would estimate the payout ratio, cost of equity and expected growth rate in the high growth
period and the stable growth period. This approach is general enough to be applied to any
firm, even one that is not paying dividends right now
Looking at the determinants of price-earnings ratios, you can clearly see that a low priceearnings ratio, by itself, signifies little. If you expect low growth in earnings (or even negative
growth) and there is high risk in a firm's earnings, you should pay a low multiple of earnings
for the firm. For a firm to be undervalued, you need to get a mismatch: a low price-earnings
ratio without the stigma of high risk or poor growth. Later in this chapter, you will examine
a portfolio of low PE stocks to see if you can separate the firms that have low PE ratios and
are fairly valued or even overvalued from firms that have low PE ratios that may be attractive
investments.
Question 4:
a) Answer:
Factor
Market

Weights

Book

Debt

42,830

0.359

Preferred Stock

10,650

Common Equity

65,740

Weights

Costs

Market

Book

40,000 0.488

8.5%

3.05

4.15

0.090

10,000 0.122

10.6%

0.95

1.29

0.551

32,000 0.390

25.3%

13.94

9.87

119,220 1.000

82,000 1.000

17.94

15.31

Use WACCs 17.9%

15.3%

b) Answer:
Cost from retained earnings: ks = D0 (1 + g) / P0 + g = 6.50 (1 + 9%) / 60 + 9% = 20.81%
Cost of equity from new stock: ke = D0 (1 + g) / [(1 F) P0] + g = 6.50 (1 + 9%) / [(112%)60] + 9% = 22.42%

Question 5:
a) Answer:
First thought: gaming industry should be a much more predictable and ongoing activity,
thereby making debt financing less risky.
So, one would expect to see heavier weighting in debt for the gaming industry. Many times
we think of Venture capital (mostly equity)when thinking of IT Companies, especially startups or new ventures.
So, if we're trying to minimize weighted average cost of capital, we may just be comparing
apples and oranges here (underlying assets).
In a nutshell, (if that's possible) in the ideal world for an economist the total market value of
everything (all the securities issued) by a firm would have to be governed by the (1) earning
power and (2) risk of its underlying real assets and (or hence) would be independent of capital
structure (the mix of debt and equity).
Some financial managers might think that they can increase total value by increasing the
proportion of debt, but under real-world conditions (all other variables remaining
unchanged)the added risk to the shareholders will raise the required yields on equity just
enough to offset the seeming gains from using lower cost debt.
Bottom line, debt will be more accessible to the gaming industry. And those willing to take
more risk will be more willing to finance (typically through equity) the potential breakout
gains from a new IT companies.
Optimal capital structure will always be elusive when we get past the mathematics of Finance
101, and when trying to incorporate (or accommodate) current economic conditions and risk
tolerance it gets even more nebulous.
Further, when we add comparing two fundamentally different industries, the question itself
becomes suspect.
b) Answer:

A firm is considering two alternative capital structures, and has calculated its profitability at
various EBIT levels under each structure. What should the firm do if its projected EBIT is:
- Below the indifference point? In this case, choose the capital structure with the lower
degree of financial leverage. If EBIT is below (to the left of) the financing indifference point,
higher financial leverage would decrease EPS (lower return) as it increases the volatility of
the EPS stream (higher risk). However, lower financial leverage would increase EPS (higher
return) and decrease the volatility of the EPS stream (lower risk), the combination preferred
by risk-averse investors.
- Above the indifference point? In this case, the choice of capital structure is not obvious,
since there is a tradeoff between the effects of financial leverage on risk and return. If EBIT
is above (to the right of) the indifference point, higher financial leverage would increase EPS
(higher return) but also increase the volatility of the EPS stream (higher risk). Lower financial
leverage would decrease EPS (lower return) and decrease the volatility of the EPS stream
(lower risk). Further analysis is required to identify which capital structure provides investors
with the best risk-return combination.