Case Studies in Finance Case 7: Kate Myers Basic Concepts: The Time Value of Money After graduating from Ohio State University with a degree in Finance, Kate Myers took a position as a stock broker with Merrill Lynch in Cleveland. Although she had several college loans to make payments on, her goal was to set aside funds for the next eight years in order to make a down payment on a house. After considering the various suburbs of Cleveland, Kate chose Lakewood as her desired future residency. Based on median house price data, she learned that a three-bedroom, two-bath house currently costs $98,000. To avoid paying Private Mortgage Insurance (PMI), Kate wanted to make a down payment of 20%. Because it will be eight years before Kate buys a house, the $98,000 price will surely not be the same in the future. To estimate the rate at which the median house price will increase, she considered the historical price appreciation in Lakewood. In the past, homes appreciated by nearly 4% per annum. Kate was satisfied with this estimation. errill Lynch provides several opportunities for Kate to invest the funds that will be devoted to the purchase of her future home. She feels that a balanced account containing stocks, bonds, and government securities would realistically achieve an annual rate of return of 8%. Questions 1. Taking into consideration the fact that the $98,000 home price will grow at 4% per year, what will be the future median home selling price in Lakewood in eight year .What amount will Kate Myers have to accumulate as a down payment if she does decide to buy a house in Lakewood? 2. Based on your answer from number 1, how much will have to be deposited into the Merrill Lynch account (which earns 8% per year) at the end of each month to accumulate the required down payment? 3. If Kate decides to make end-of-the-year deposits into the Merrill Lynch account, how much would these deposits be? Why is this amount greater than twelve times the monthly payment amount? 4. If homes in Lakewood appreciate by 6% per annum over the next eight years instead of the assumed 4%, how much would Kate have to deposit at the end of each month to make the down payment? What if the appreciation is only 2% per year? 5. If Kate decided to deposit d eposit her down payment funds in less risky certificates of deposit (CDs) earning only 4%, how much would she have to deposit at the end of each month to make the down payment? What if she pursued a more risky investment of growth stocks that have an expected return of 12%?
Case 8: Quilici Family Basic Concepts: The Time Value of Money Greg and Debra Quilici own a four bedroom home in an affluent neighborhood just north of San Francisco, California. Greg is a partner in the family owned commercial painting business. Debra now stays home with their child, Brady, who is age 5. Until recently, the Quilicis have felt very comfortable with their financial position. After visiting Lawrence Krause, a family financial planner, the couple became concerned that they were spending too much and not putting enough funds aside for both their child's future education needs and their own retirement. Greg earns $85,000 per year, but with the rising costs of education, their past contribution efforts have left them short of their financial goals. To estimate the amount of money the Quilicis need to begin putting away for future security some general information was obtained by their financial planner. The couple felt that the amount of money they currently contribute to their Koegh plan would be sufficient for their retirement needs. What they had not accounted for was Brady's education. Greg is an alumni of Stanford University, a private school with an extremely high tuition of approximately $20,000 per year. Debra graduated from the University of North Carolina at Chapel Hill. The tuition expense there is only $2,500 per year. When Brady turns 18, the couple wishes to send him to either of these exceptional universities. They have a slight preference for the much more local Stanford University. The problem, however, is that with the rate at which tuition is increasing the Quilicis are not sure they can raise enough money. To assist in the calculations, assume the tuition at both universities will increase at an annual rate of 5%. Living expenses are currently estimated at $6,000 per year at both schools. This expense is expected to grow at only 3% per year. Further assume the Quilicis can deposit their money into a growth oriented mutual fund at Neuberger & Berman Management, Inc., which has historically earned a 12% return per annum (1% per month). The couple wishes to have a pre-determined monthly amount automatically drafted from their checking account. When Brady starts college they will slowly liquidate the account by making an annual payment to Brady to cover tuition and living expenses at the beginning of each year for the four years he will be in college. Questions 2. Once Brady starts college what will his total expenses be in each of his four years? Again, give an answer for each university. 3. How much money will Greg and Debra have to deposit per month to allow Brady to attend Stanford University? How much money will have to be deposited per month to allow Brady to attend the University of North Carolina? (HINT: To answer this question you need to consider the costs of ALL four years.) 4. What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10%. How much will have to be deposited per month in order for Brady to attend each college? 5. What is the relationship between the amount that must be deposited monthly by the parents and the future increases in both tuition and living expenses?
Case Studies in Finance Case 9: Wal-Mart Basic Concepts: Risk and Return Analysis Marvin Brown is a savvy investor who is always looking for a sound company to include in his portfolio of stocks and bonds. Being somewhat risk-averse, his main objective is to buy stock in firms that are mature and well-established in their respective industries. Wal-Mart is one of the stocks Marv is currently considering for inclusion in his portfolio. Wal-Mart has four major areas of business: traditional Wal-Mart discount stores, Supercenters, Sam's Clubs, and international operations. Although Wal-Mart was established over 50 years ago, it continues to achieve growth through expansion. The Supercenter concept, which combines groceries and general merchandise, is extreme success as 75 new Supercenters were opened last year alone. Another 95 will be opening over the next two years. Sam's clubs have also seen success as 99 Pace stores (Pace is one of Sam's former Competitors) were converted to Sam's stores in 1995. In addition to taking over competitor stores, Sam's also opened 22 new stores of its own. Internationally, the picture is equally as rosy. In Canada, 122 former Woolco stores were converted to Wal-Mart discount stores. Expansion has reached Mexico and Hong Kong as well, as 24 Clubs and Supercenters and 3 "Value Clubs" were established, respectively. Wal-Mart plans to continue its reign as the world's largest retailer through expansion by developing the previously discussed 95 Wal-Mart discount stores, 12 new Supercenters and 9 new Sam's Clubs. Internationally, 20 to 25 new stores will be built in Hong Kong, China, Argentina, Brazil and Canada. In order to determine if Wal-Mart is a "good buy," Marv has to perform several analyses. First, he must calculate the returns on Wal-Mart's common stock over the past eight quarters as an indicator of how the stock might perform over the next year. He must then calculate the standard deviation of the stock as a proxy for its risk. To aid in his calculation, Marv has gathered the following stock price and dividend data. Table 1 Quarterly Stock Prices June 2002 55.01 March 2002 $61.22 December 2001 $57.41 September 2001 $49.32 June 2001 $48.54 March 2001 $50.16 December 2000 $52.69 September 2000 $47.67 Table 2 Quarterly Dividend Payments Date Dividend Payment June 19, 2002 $0.08 March 20, 2002 $0.08 December 19, 2001 $0.07 September 19, 2001 $0.07 June 20, 2001 $0.07 March 21, 2001 $0.07 December 20, 2000 $0.06 September 13, 2000 $0.06
Questions 1. Calculate the returns for each of the seven quarters. 2. Calculate the standard deviation of the returns from question 1. 3. Assume that Wal-Mart has a Beta of 1.2, the risk-free rate of interest (i.e. as proxied by the return on a 3-month treasury bill) is 5.25%, and the return on the market is 12.2% annually (as proxied by the return on the Standard & Poor's 500). Based on CAPM, what is the required rate of return on Wal-Mart's stock? 4. Using your answer from question 3, if Wal-Mart had an expected return of 14%, would Marv be well advised to purchase the stock? At what minimum expected rate of return would Marv be encouraged to buy the stock? 5. Marv has based his buy decision on quarterly d 3. Assume that Wal-Mart has a Beta of 1.2, the risk-free rate of interest (i.e. as proxied by the return on a 3-month treasury bill) is 5.25%, and the return on the market is 12.2% annually (as proxied by the return on the Standard & Poor's 500). Based on CAPM, what is the required rate of return on Wal-Mart's stock?
Case Studies in Finance Case 10: Intel Basic Concepts: Portfolio Risk and Return Analysis Michael Frank is an individual investor who is currently considering the purchase of $4,000 worth of Intel's common stock. Mike already has a significant amount invested in the computer industry, but he feels Intel will be one of the leading companies in the future. One of the reasons for this perceived future success is the Research and Development being done in the area of parallel supercomputers. Justin Rattner, Intel's former scientist of the year, is a leading researcher in parallel supercomputing. Parallel supercomputing breaks down a complex problem into many, easier to manage components. Further, all of these components can be manipulated simultaneously. It is analogous to Tom Sawyer getting all his friends to paint the fence. The speed of parallel computers is much faster than their larger and supposedly faster computers competitors. Computer chip manufacturers are concerned primarily with speed and the size of the components necessary to generate the speed. With Intel leading the way in this emerging area, Mike feels he should own their stock. One concern Mike has is how the inclusion of Intel's common stock will affect the overall return and risk of the computer stocks he currently owns. Presently, Mike holds $2,000 worth of IBM, $3,500 in Compaq, and $4,500 in Apple. To determine the impact of the purchase of $4,000 worth of Intel, Mike has calculated the expected annual returns over the next eight years for each of the four stocks. The expected returns for each are shown in the table below.
Years into the future Expected Return for each Company (%) IBM Compaq Apple Intel 1 6.2 0.1 -4.2 4.8 2 7.8 2.8 6.6 10.2 3 6.9 -1.9 12.2 11.3 4 -4.1 2.9 7.8 1 8.1 5 8.9 7.7 4.3 6.6 6 10.2 15.1 -2.1 -1.8 7 15.3 19.3 8.4 2.7 The beta of Intel is projected to be 1.1 over the next eight years. The betas of IBM, Compaq, and Apple assumed to be 0.7, 1.6, and 1.0, respectively. Mike wants to see what affect the purchase of Intel will have on the beta of his overall portfolio. He is assuming the beta of each firm will remain constant over the eight year period. Questions 1. Calculate the expected return for each of the next eight years without the inclusion of Intel. 2. Calculate the expected return for each of the next eight years with the inclusion of Intel. 3. Calculate the standard deviation for each of the next eight years without the inclusion of Intel. 4. Calculate the standard deviation for each of the next eight years with the inclusion of Intel. 5. Calculate the beta of the portfolio both with and without Intel. 6. We have assumed that beta will be constant over the next eight years. How realistic is this assumption. That is, does beta tend to remain constant over time? 7. Which measure of risk is more appropriate when considering Intel's inclusion into Mike Frank's portfolio, standard deviation or beta?
Case Studies in Finance Case 23: Southwest Airlines Capital Budgeting: One Project - Accept/Reject Decision The airline industry is extremely cyclical. That is, when the economy does well, so too do airlines. In recent years, the airline industry has found itself with too many seats and too few passengers. Some experts point to the past deregulation of the industry while others argue that technological advances such as teleconferencing are responsible. Several airlines such as Continental, America West, Eastern, and Trans World Airlines, have filed for Chapter 11 Bankruptcy. Some have fully recovered, while others have been forced to liquidate (Chapter 7). Narrowing profit margins have prompted airlines to develop creative survival tactics. Southwest Airlines has successfully found its niche in the industry by providing direct flight service to less traveled routes such as those to and from smaller cities. Since these routes do not generate nearly as much revenue as major city routes, Southwest has found ways to reduce its costs. Costs are reduced by following a no frills policy that the travelers refer to as "peanut flights." This means that instead of serving costly meals (the quality of which passengers have historically complained about anyway), Southwest serves just a bag of peanuts and a soft drink. With the recent success of short, direct flights, Southwest is considering the purchase of one such additional route. Before an airline applies to the federal government for a new route, a lengthy analysis is performed to determine the feasibility of the route. Expenses to consider include airport costs such as gate and landing fees and labor costs such as local baggage handlers and maintenance workers. Many times the airline will provide its own employees to load and unload luggage or to provide upkeep for their planes, but in the case of Southwest, they have so many small cities to service that the outsourcing of these jobs is not uncommon. Table 1 provides a summary of the after-tax cash flows associated with the acquiring of a additional small route. All costs and revenues are reflected by the following numbers. Table 1 Projected Net Cash flows (in Millions of Dollars) Year Net Cash flow 0 -$20.8 1 $4.5 2 $6.3 3 $5.2 4 $3.9 5 $2.1 6 $1.3 7 $0.5 Questions 1. What is the project's NPV assuming Southwest has a discount rate of 10%? How do we interpret the NPV? 2. What is the project's IRR? How is this measure different from the NPV? What is the interpretation of this number? 3. Calculate the project's Payback Period. 4. Assuming that Southwest has a required payback period of 5 years and a hurdle rate of 10%, should Southwest accept the additional route? Based on the project's NPV, should it be accepted? If conflicting conclusions occur, which criteria would you follow? 5. When will conflicts likely occur among the three criteria?
6. Calculate the project's Modified Internal Rate of Return (MIRR). What c ritical assumption does the MIRR make that differentiates it from the IRR? 7. Where does the value of MIRR fall relative to the discount rate and IRR?
Case Studies in Finance Case 24: Acclaim Entertainment Capital Budgeting: Multiple Projects with Unequal Lives Acclaim Entertainment, Inc. is a mass marketer of interactive entertainment software whose games can be played on such well known video game systems as Nintendo and Sega. Some of their more successful games include Mortal Kombat I and II, NBA Jam I and II, Maximum Carnage, Virtual Bart (Simpson), and NFL Quarterback. Acclaim h as also obtained licenses from True Lies, Batman Forever, and Spiderman. The interactive entertainment industry is characterized by rapid technological change and as such, no single hardware system has achieved long-term dominance. Accordingly, Acclaim focuses its production efforts on the development of software for the hardware systems the dominate the interactive entertainment market at a given point in time or in the very near future. Presently, Acclaim has licensing agreements with three industry leaders: Sony Computer Entertainment of America (SCE), Nintendo, and Sega. Acclaim is currently in the design/production stage of a new version of Mortal Kombat. Since the previous versions of the game were extremely successful, Acclaim is not greatly concerned with the acceptance of the game by the general public. It is concerned, however, with the hardware platform that should be chosen to distribute the game. Since licensing agreements are extremely short term, Acclaim wonders which of the three hardware companies should carry Mortal Kombat. For example, the licensing agreement with SCE expires in December two years from now. The Nintendo agreement expires in December of this year and the Sega contract expires in December of next year. While these contracts expire and have traditionally been renewed every few years, there is no guarantee they will be successfully renewed or extended in the future A further consideration involves the costs charged by each company. SCE, Nintendo, and Sega charge their licensees a fixed amount per unit based on chip configuration, memory capacity, and market price. This charge covers manufacturing, printing and packaging of the unit, as well as a royalty for the use of their respective names, proprietary information and technology. Furthermore, these charges are subject to adjustment at the discretion of SCE, Nintendo, and Sega. To offset the expenses of licensing fees, Acclaim must speculate on the ability of the three hardware platforms to access enough end-users to make their games profitable. Nintendo and Sega hold a grater share of the market, but SCE charges lower licensing fees. In general, the product life cycle in the interactive software business is from one month up to eighteen months with the majority of sales occurring within the first three months after introduction. Although titles older than eighteen months may still be available for sale, Acclaim generally actively markets only its ten to fifteen most recently released titles. Mortal Kombat represents somewhat of an exception to the rule. Being one of the most successful products, Mortal Kombat's most feared competitor will be the prospect of the next version o Mortal Kombat. There has currently been no discussion of the number of games that will be produced in the series. Acclaim's management has assembled the following projected net cash flows associated with the distribution of Mortal Kombat. These net cash flows reflect all licensing fees, productions costs, advertising expenditures, revenues, etc. Table 1 Time (end of year) Net cash flow (in millions) SCE Nintendo Sega 0 -$40 -$40 -$40
1 $34 $44 $41 2 $10 $16 $18 3 $5 $4 4 $1 Questions 1. What is the Payback Period for Mortal Kombat when marketed under the three different hardware companies? Assuming a required payback period of 1 year, which company would you allow to carry the new product? 2. Assuming a discount rate of 10%, what is the Net Present Value (NPV) under each system? Under which system, if any, would you be willing produce Mortal Kombat? 3. What are the Internal Rates of Return (IRR) under each marketer? Which marketer(s) has/have acceptable IRRs? 4. Thus far we have assumed that Mortal Kombat will be marketed through only one hardware system. Under this assumption, the projects are mutually exclusive. If we explore the possibility of allowing more than one company to market Mortal Kombat, which company(ies) would you allow to market the product? Base your answer on the three criteria from the above questions. 5. Mortal Kombat will have a different life span depending on the hardware system Acclaim chooses. Since the lives of the three projects are not equal, can a comparison truly be made based on conventional NPV measures? Calculate the ANPV, which marketer would you choose to sell the product through if the projects were mutually exclusive? What if they were independent?
Case 25: Capital Budgeting: Projects with Dissimilar Risks When most people hear the name Philip Morris, they think of tobacco, or more specifically, Marlboro cigarettes. What most people do not realized is that the food products Philip Morris markets generate more sales revenue for the firm. Recognizable brand names include Kraft, Post, Maxwell House, and Entenmann's. Philip Morris is considering the introduction of two new products. The first product is a new breakfast cereal called Post Blueberry Morning. Post is an established name in the cereal market with a market share of 16.7%. Getting shelf space is extremely difficult and costly for most new products because grocery stores traditionally charge slotting fees. Slotting fees are fixed amounts that companies must pay to gain ideal shelf locations for their products. Post, however, feels less pressure from grocery stores because of the consumer demand for their products. With the consumer preference for Post brand cereal, Philip Morris feels that introducing Post Blueberry Morning will be a low risk venture. The second new product Philip Morris is considering the introduction of is a Gourmet Hazel Nut coffee that will be sold under the Maxwell House family of products. Maxwell House is also established in its market, but the coffee industry itself is more risky than the high profit margin breakfast cereal market. Coffee profits are strongly affected by the general swings in the commodity's price due to uncontrollable factors such as weather. From month to month the price of coffee fluctuates making profits from coffee sales fluctuate as well. In performing a capital budgeting analysis, Philip Morris recognizes that these two products should not be considered to be of equal risk. Therefore, traditional net present value analysis should not be used to decide which product, if any, to produce. To help the company decide how to handle the perspective investments, their finance department forecasted the projects' expected net cash flows. Both projects have an expected life of seven years. Table 1 shows the projected net cash flows associated with both projects. Table 1 Year Net cash flow Gourmet Hazel Nut Net cash flow Post Blueberry Morning 0 -$4,000,000 -$2,500,000 1 $1,000,000 $803,000 2 $1,200,000 $521,000 3 $750,000 $235,000 4 $950,000 $400,000 5 $880,000 $498,000 6 $500,000 $612,000 7 $206,000 $519,000 Since the two projects have dissimilar risks, the finance department felt it would be appropriate to indicate how certain they were about their estimates of the net cash flows associated with each project. These certainty equivalents are shown in Table 2.
Table 2 Year C.E. Gourmet Hazel Nut Net cash flow Post Blueberry Morning 0 1.00 1.00 1 .80 .95 2 .70 .90 3 .60 .85 4 .50 .80 5 .40 .75 6 .30 .70 7 .20 .65 The appropriate discount rate for an average risk project for Philip Morris is 10%. They feel that because the Gourmet Hazel Nut project is more risky than average, a risk-adjusted discount rate of 12% should be used. Finally, the risk-free rate of return is currently 5%. Questions 1. If you assume the two projects are of equal risk, what is the net present value (NPV) of each project? Because the projects are independent, which project(s) would you accept? 2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV using the RiskAdjusted Discount Rate (RADR). 3. Using the certainty equivalents method, calculate the projects' NPV. Does your accept/reject decision change? 4. Explain the concept of certainty equivalents. Start with a definition and then explain fully. 5. How do certainty equivalents adjust cash flows for risk and time. How does this adjustment compare to the way RADRs treat risk and time?
