SOLUTION TO THE CASES

Case #01 Time Value of Money

Objective:

The case illustrates the power of compounding within an unusual, real-world situation.
The case also gives students the opportunity to practice time-value-of-money calculations in a
real-world situation.

Case Discussion:

The case asks the student to imagine getting a bill for $125 billion that he or she didn’t
owe. The case involves a real-world situation. It actually happened to the residents, who are
called “burghers,” of the town of Ticino, Switzerland. A court in Brooklyn, New York, ordered
Ticino to pay a group of American investors. The investors had sued in the Brooklyn court over
a loss they claimed in connection with the 1967 failure of InterChange Bank, a tiny bank in
Ticino. The burghers had known about the suit, but thought the matter was trivial, and were
naturally stunned by the bill. Their lead lawyer quipped that if the judgment was upheld by the
higher courts, all of Ticino’s citizens would have to spend the rest of their lives flipping real
burgers (the kind you eat) at McDonald’s and Burger King to pay off the debt.

Just how much is $125 billion?

„ $418,213 per citizen of Ticino

„ Nearly half of the U.S. defense budget
The root of Ticino’s problem was a deposit made in 1966. The estate of one Sterling
Granville Higgins, a reputed swindler, deposited $600 million of options on Venezuelan oil and
mineral deposits in the InterChange Bank. The authenticity of these options was doubted by
some. Nevertheless, the deposit agreement required the bank to pay an interest rate of 1% per
week. (No wonder the bank failed the next year!) In October 1994, the New York State
Supreme Court in Brooklyn ruled that Ticino had to pay 1% interest per week compounded
weekly for the 7 years between the date of deposit and the date Ticino had the bank liquidated,
and interest at the rate of 8.54% APY for the remaining 21 years since the bank’s liquidation.

1. The $125 billion reported in the press was rounded but the original amount was precisely
$600 million. Assuming the time periods are exactly seven years at 1% per week and exactly
21 years at 8.54% APY, how much was the bill to the nearest dollar?
Answer: FV = PV x (1 + I)n = $600,000,000 x (1.01)52x7 = $22,445,604,554

TI BAII+ Solution is:

PV=-0.6, n=364, I=1, pmt=0, CPT FV⇒ $22.446 billion

FV = $22,445,604,554 x (1.0854)21 = $125,463,520,420.50

TI BAII+ Solution is:

PV=-22.446, n=21, I=8.54, pmt=0, CPT FV⇒ $125.464 billion

The answer to the nearest dollar is $125,463,520,421.

2. What is the APY over the entire 28 years as the $600 million grows to the exact amount you
calculated in question 1?

Answer: 600,000,000 = 125,463,520,420.50 / (1 + I)28 solve for I

(1+I)28 = 125,463,520,420.50 / 600,000,000 = 209.1059

1 + I = 209.1059(1/28) = 1.2102364

I = 0.2102364 or 21.024% APY

 TI BAII+ Solution is:

PV=-0.6, n=28, FV=125.464, pmt=0, CPT I⇒ 21.024%

3. Suppose Ticino could pay $5 billion per year. How long would it take to pay off the debt,
assuming interest continued to be charged at 8.54% APY? How long would it take at $12
billion per year?

Answer: At the 8.54% interest rate, the interest due for the first year is

.0854 x $125,463,520,420.50 = $10.71 billion. The $5 billion payment

does not even cover the interest, so the principal increases each year

(not decreases). The debt would never be paid off!

Suppose Ticino could pay $12 billion per year. How long would it take to pay off the debt,
assuming interest continued to be charged at 8.54% APY?

Answer: Using the present value of an annuity equation:

 (1 + r ) n − 1
PV = CF  n  solve or n.
 r (1 + r ) 

PV 1 1
= −
CF r r (1 + r ) n

r ( PV )
1− = (1 + r ) − n
CF
  r ( PV ) 
ln1 −  = − n ln(1 + r )
 CF 

 r ( PV )   .0854(1255 . )
ln 1 −  ln 1 − 
 CF   12 
n=− =− = 27.29 years
ln(1 + r ) ln(1+.0854)

TI BAII+ Solution is:

PV=-125.5, i=8.54, FV=0, pmt=12, CPT n⇒ 27.29 years

It would take 27.29 years to pay off the debt.

Subsequent Event:

To the burghers’ relief, the judgment was thrown out on appeal. This no doubt restored
the confidence of the good burghers of Ticino in the American system of justice! (Of course,
they would tell you that in Switzerland, such a crazy lawsuit would never have been allowed in
the first place.)
Case #02 Valuing Stocks
The goal is to value the company under both investment plans and to choose the better
investment plan.

The discount rate is the 11% that investors believe they can earn on similar-risk investments, not
the 15% return on book equity. Return on equity is useful, however, for computing the growth
rate of dividends under the rapid growth scenario. Starting in 2008, in the rapid growth scenario,
two-thirds of earnings will be paid out as dividends, and one-third will be reinvested. Therefore,
the sustainable growth rate as of 2008 is:

return on equity × plowback ratio = 15% × 1/3 = 5%

Valuation based on past growth scenario:

The firm has been growing at 5% per year. Dividends are proportional to book value and have
grown at 5% annually. Dividends paid in the most recent year (2007) were $7.7 million and are
projected to be $8 million next year, in 2008. The value of the firm is therefore:

DIV2008 $8 million
Value 2007 = = = $133.33 million
r−g 0.11 - 0.05

The value per share is: $133.33 million/400,000 = $333.33

Therefore, it is clear that Mr. Breezeway was correct in advising his relative not to sell for book
value of $200 per share.

Valuation based on rapid growth scenario

If the firm reinvests all income for the next five years (until 2012), dividends paid in that year
will reach $14 million, far greater than in the constant growth scenario. However, shareholders
will have to give up dividend payments until 2012 in order to achieve this rapid growth. The
value of the firm in 2012 will be:

DIV2013 $14.7 million

Value 2012 = = = $245 million
r−g 0.11 - 0.05

The value of the firm as of the year 2007 is the present value of this amount plus the present
value of the dividend to be paid in 2012, which is projected to be $14 million. (Remember, there
will be no dividend flows in the years leading up to 2012.)
 14 + 245
Value 2007 = = $153.70 million
1.115

Value per share is: $153.70 million/400,000 = $384.25

Thus, it appears that the rapid growth plan is in fact preferable. If the firm follows this plan, it
will be able to go public — that is, sell its shares to the public — at a higher price.
Case #03 Capital Budgeting / Cost of Capital
Objective:

This case illustrates that the cost of capital for a firm can differ from the cost of capital
for each of its businesses. When a firm has multiple businesses, it is important to use the cost of
capital appropriate to the particular project under consideration, rather than the firm’s overall
cost of capital, when evaluating a proposed project.

Case Discussion:

Diageo PLC’s annual report explains that Diageo’s investments are expected to generate cash
returns that exceed its “long-term cost of capital,’ which Diageo estimated to be approximately
10% at its recent year-end. Diageo has three main lines of business: restaurants, alcoholic
beverages, and food items. Diageo did not report costs of capital separately for these three
businesses. This case asks the student to calculate the cost of capital for Diageo’s restaurant
business.

The case provides the following data:

Cash and marketable securities $1,498 million (approximates market value)

Short-term debt $706 million (approximates market value)

Long-term debt $8,509 million ($8,747 million market value)

Common shares outstanding 788 million

Year-end share price $55.875

Income tax rate 34%

Diageo’s beta 1.00

Diageo’s long-term borrowing rate 6.75%

Riskless returns Market risk premium

Short-term 5.13% 8.40%

Intermediate-term 5.50 7.40

Long-term 6.00 7.00

Answers to Questions:

1. Diageo subtracts the value of its portfolio of short-term investments, which is held outside
the United States and is not required to support day-to-day operations, from its total debt
when calculating its “net debt ratio.” Use Diageo’s net debt ratio to calculate Diageo’s
overall WACC.

Answer: The market value of Diageo’s stockholder’s equity is $44,030 (788 million shares
times $55.875 per share) and thus,

Diageo’s net debt ratio = Total debt - Short-term investments

Total assets – Short-term investments

= __706 + 8,747 – 1,498__ = 15.30%

(706 + 8,747 – 1,498 + 44,030)

Diageo’s overall WACC is

WACC = (1-L)re + L(1-T)rd where T=0.34, rd = 6.75%, and L = 0.1530

Now find the return on equity using CAPM, re = rf + β(rm - rf), where β = 1.00:

For short-term investment: re = 5.13+1.00(8.40) = 13.53%

For medium-term investment:re = 5.50+1.00(7.40) = 12.90%

For long-term investment: re = 6.00+1.00(7.00) = 13.00%

So, the WACC range is:

For short-term investment: WACC=(1-0.1530)13.53+0.1530 (1-.34)6.75= 12.14%

For medium-term investment:WACC=(1-0.1530)12.90+0.1530 (1-.34)6.75= 11.61%

For long-term investment: WACC=(1-0.1530)13.00+0.1530 (1-.34)6.75= 11.69%

When using the WACC in capital budgeting, select the figure that best matches the life of the
capital investment project. For example, to evaluate investing in a long-term asset, Diageo
would use a WACC of 11.69% (assuming that the asset’s risk profile mirrors Diageo’s overall
risk profile).

Exhibit S-11-1 provides information concerning publicly traded restaurant firms.

2. Should Diageo use its overall cost of capital to evaluate its restaurant investments? Under
what circumstances would it be correct to do so?

Answer: If the risk profile of the restaurant business is the same as the parent company,
then using the overall WACC would be appropriate. Also, if the restaurant business is
evaluating an investment that has higher risk than the existing restaurant investments, then it
would be appropriate to use a higher WACC in the analysis of that higher-risk investment.

3. Estimate the cost of capital for Diageo’s restaurant business.

Answer: First, convert the leveraged betas to unleveraged betas using equation (11.6) in the text:

(1 − L ) β
βA =
1 − TL
The unleveraged betas for all the firms in Exhibit 11-5 are calculated and shown in Exhibit S-11-
1. What is the best proxy for the true unleveraged beta of Diageo’s restaurant business? This
answer considers two proxies. The unleveraged beta for the industry is calculated in two ways.
Exhibit S-11-1 calculates a simple arithmetic average, 0.99, and a capitalization-weighted
average, 0.93. An argument can be made for each answer.
Next assume that the tax rate for the restaurant business is the same as for Diageo, 34%. Use
equation (11.4) in the text to estimate the WACC:

The unleveraged required return on equity ranges using the 0.93 beta estimate are:

For short-term investments: WACC = 5.13 + 0.93(8.40) = 12.94%

For medium-term investments: WACC = 5.50 + 0.93(7.40) = 12.38%

For long-term investments: WACC = 6.00 + 0.93(7.00) = 12.51%

The unleveraged required return on equity ranges using the 0.99 beta estimate are:

For short-term investments: WACC = 5.13 + 0.99(8.40) = 13.45%

For medium-term investments: WACC = 5.50 + 0.99(7.40) = 12.83%

For long-term investments: WACC = 6.00 + 0.99(7.00) = 12.93%

4. Explain why there is a difference between Diageo’s overall cost of capital and the cost of
capital for its restaurant business.

Answer: The main reason for the higher cost of capital for the restaurant business is its greater
business risk. Applying equation (11.6), Diageo’s overall unleveraged beta is

(1 − 0.1767)(1.00) 706 + 8,747

BA = = 0.88, Note : L = = 0.1767
1 − (0.34)(0.1767) 706 + 8,747 + 44,030

which is less than the unleveraged beta for Diageo’s restaurant business. The higher beta for the
restaurant business reflects its greater riskiness as compared to Diageo’s other businesses.
Case #04 Corporate Financing / Business Investment Rules
Objective:

This case asks the student to calculate the incremental cash flows and use the NPV and IRR
methods to evaluate Boeing’s investment project to build a new plane. This project, because
of its size and importance to Boeing, was potentially a “make-or-break” investment for the
firm. It was therefore critical to Boeing to “get it right” when it performed the capital
budgeting analysis.

Case Discussion:

By the time Boeing announced the newest addition to its fleet, much of the preliminary
work was already computed. The new plane was an enormous undertaking. Research and
development, begun two and a half years earlier, would cost between $4 billion and $5 billion.
Production facilities and personnel training would require an additional investment of $2.0
billion, and $1.7 billion in working capital would be required. Exhibit 6-4 furnishes profit,
depreciation, and capital expenditure projections for the project.

The case also provides the following information:

Boeing’s beta 1.06

Boeing’s market-value debt ratio 0.02

Boeing’s new issue rate for long-term debt 9.75%

Riskless return 8.75%

Market risk premium 8.00%

Boeing’s marginal income tax rate 34%

The case asks the students to determine whether Boeing should proceed with the project.

Answers to Questions:

1. Calculate the NPV, IRR, and payback for the project.

Answer: First, the research and development expenditures made over the past two and a half
years are sunk costs. These costs cannot be recovered by either continuing or stopping the
project. Therefore, they are not considered to be incremental cash flows at this point in time.

Next calculate the annual CFATs. These are calculated as the after-tax profit, plus the
depreciation, less the capital expenditures. The CFATs are calculated in Exhibit S-6-1.

Next estimate Boeing’s cost of equity capital using the CAPM:

re = rf + β(rm - rf) = 8.75% + 1.06(8.0%) = 17.23%

The WACC for the project is:

WACC = (1-L)re + L(1-T)rd = (1 - .02)17.23 + .02(1-.34)9.75 = 17.01%

To find the NPV, discount each of the CFATs in Exhibit S-6-1 using the 17.01% discount rate.
Add these present values to find the NPV:

NPV = $690.2 million.

To find the IRR of the project, we need to find the discount rate that causes the discounted cash
flows to sum to zero. For those students who are iterating, start at an interest rate higher than the
cost of capital. The answer is:

IRR = 19.27%

The payback period for the project is the point in time at which the cumulative CFATs are zero.
After the sixth year, the project begins generating positive cash flows. Approximately 2 years
and 10 months later, the project has ‘paid back’ the negative cash flows of the first six years.
The payback period for this project is 8 years and 10 months.

Be sure to remind your students that the payback period is not a useful measure of the
value of a capital budgeting project because it does not take into account the time value of
money. This method would bias the decision against the project because of the long length of
time necessary to build and equip the manufacturing plants and produce the first plane.

2. On the basis of your analysis, do you think Boeing should have continued with this
project? Explain your reasoning.

Answer: On the basis of this analysis, Boeing made the right decision. The project adds value to
the company (positive NPV), and has an expected return that exceeds the WACC (IRR>WACC).

However, before making the final decision, Boeing should conduct a sensitivity analysis.
That is, what would be the decision if Boeing forecast sales to be 5% less each year? 10% less?
What would be the decision if Boeing forecast 5% higher labor costs per year? If the decision to
continue the project is not very sensitive to these changes, then Boeing would be even more
confident in its decision. If the decision seems to be sensitive to these inputs, then Boeing would
want to take a closer look at its expectations regarding those inputs.

Exhibit S‐6‐1

Projected CFATs for Boeing’s new plane

(Dollars in millions)

After‐Tax Capital

Year Profit Depreciation Expenditures CFAT

1 ‐597.30 40.00 400.00 ‐957.30

2 ‐947.76 96.00 600.00 ‐1,451.76

3 ‐895.22 116.40 300.00 ‐1,078.82

4 ‐636.74 124.76 200.00 ‐711.98

5 ‐159.34 112.28 182.91 ‐229.97

6 958.62 101.06 1,741.42 ‐681.74

7 1,718.14 90.95 2.12 1,806.97

8 1,503.46 82.72 ‐327.88 1,914.06

9 1,665.46 77.75 67.16 1,676.05

10 1,670.49 75.63 ‐75.21 1,821.33

11 1,553.76 75.00 ‐88.04 1,716.80

12 1,698.99 75.00 56.73 1,717.26

13 1,981.75 99.46 491.21 1,590.00

14 1,709.71 121.48 32.22 1,798.97

15 950.83 116.83 450.88 616.78

16 1,771.61 112.65 399.53 1,484.73

17 1,958.48 100.20 ‐114.91 2,173.59

18 1,691.19 129.20 178.41 1,641.98

19 1,208.64 96.99 627.70 677.93

20 1,954.39 76.84 144.27 1,886.96

21 2,366.03 65.81 100.51 2,331.33

22 2,051.46 61.68 ‐463.32 2,576.46

23 1,920.65 57.96 ‐234.57 2,213.18

24 2,244.05 54.61 193.92 2,104.74

25 2,313.63 52.83 80.68 2,285.78

26 2,384.08 52.83 83.10 2,353.81

27 2,456.65 52.83 85.59 2,423.89

28 2,531.39 52.83 88.16 2,496.06

29 2,611.89 47.52 90.80 2,568.61

30 2,699.26 35.28 93.53 2,641.01

31 2,785.50 28.36 96.33 2,717.53

32 2,869.63 28.36 99.22 2,798.77

33 2,956.28 28.36 102.20 2,882.44

34 3,053.65 16.05 105.26 2,964.44

Case #05 Risk and Return
The increase in debt causes an increase in the equity beta in view of the increased financial risk
resulting from the increase in the obligated payments on debt.

β Unlevered = Current Beta/[1+Debt Equity] = 1.75/[1+0.40] = 1.75/1.40 = 1.25

β Levered = β Unlevered [1+Debt/Equity]

β Levered = (at D/E ratio of 50 per cent) = 1.25 (1+0.5) = 1.875

β Levered = (at D/E ratio of 60 per cent) = 1.25(1+0.6)= 2.0

With increase in the debt level in Ranbaxy Ltd, the beta would increase from 1.75 (current) to
1.875 (for 50 per cent debt-equity ratio) and 2.0 (for 60 per cent debt-equity ratio). Risk of the
company is independent of the financing decision. Only the risk of equity holders increases with
the use of debt.
Case #06 Cost of Capital

Cost of debentures: A B C
l(1‐t)/MV of (Rs 6.5/Rs (Rs
debentures (%) ‐ 125)x100 5.2/Rs80)x100
5.2 6.5
Cost of Equity:
(Rs 2.7/Rs (Rs 4/Rs (Rs 2.88/Rs
Dt/P0 (%) 15)x100 20)*100 12)*100
18 20 24

WEIGHTED AVERAGE COST

OF CAPITAL
AFTER‐TAX
SOURCE AMOUNT COST(%) TOTAL COST
COMPANY A :

Equity 600,000 18 108,000

Debentures 0 0 ‐

600,000 18 108,000
COMPANY B :

Equity 500000 20 100,000

Debentures(1000 x
Rs125) 125000 5.2 6,500

625000 17.04 106,500

COMPANY C :

Equity 600,000 24 144,000

Debentures(2500 x
Rs80) 200,000 6.50 13,000

800,000 19.63 157,000

OVERALL COST OF
CAPITAL:
A = 0.18
B = 0.17
C = 0.196