Finance One difference between industries with high leverage and low leverage is a split between the need for fixed assets (high leverage) and a reliance on intellectual capital (low leverage). Airlines need planes, construction companies need equipment, and communications and hotel companies need infrastructure capacity. This compares with computers, drugs, biological products, educational services and electronics, all of which rely heavily on intellectual property to derive value. The conclusion that one can draw from this is that firms with a need for more fixed assets are more likely to borrow to acquire those assets. The borrowing can be long-term, to match the useful life of the fixed assets. Moreover, the interest and depreciation expenses can offset some of the costs of paying down that debt. Companies that are IP-intensive expense their research & development costs, making equity a more natural form of financing, as it tends to match up better in terms of duration than debt with intellectual property. In addition, these firms can pay for their R&D expenses through their operating cash flow -- there is no need for a massive up-front investment that would potentially necessitate taking on debt. Future earnings and taxes might lead fixed-asset firms to use debt as well, since they will benefit from interest payments. Further, they are able roll over debt for new major capital investments; it is harder to have a new equity issue every few years to finance expansion.

Question 2

Gordon's position has merit, but is perhaps not as practical as made out to be. Debt does lower the cost of capital, so if AT&T had more debt, it would have a lower cost of capital. The company would also increase its ROE with more debt. Further, the nature of AT&T's business is that it is oriented towards high levels of fixed investment, and firms with high levels of fixed assets usually have higher levels of leverage, to align repayments with cash flows from those assets. So in principle, Gordon's argument works. However, the nature of AT&T's business today is that constant reinvestment in R&D and fixed infrastructure is required. The need for massive amounts of capital year over year to fuel this investment means that AT&T should avoid debt for financing as best it can. The more money the firm has to plow into debt repayment, the less it will have to make the investments it needs to stay competitive. Prior to the digital age, Gordon's argument would make sense. But for AT&T to remain competitive in the digital age, the company benefits from having a higher level of retained earnings to plow into the rapid R&D cycle. If AT&T started piling up debt, it would affect its ability to remain competitive as its free cash flow would go to debt service instead of service improvement.

Chapter 14

1. The new firm value with the new project will be $612.5 million. If equity is issued, that will be the new firm market value as well. If debt is issued, the market value of the equity should remain unchanged. However, the asset purchase will increase the overall value of the company. Any income from that purchase will be reflected in the increased value on a per share basis to the company. While using equity will increase the value of equity on a total basis, using debt will increase the per-share value of the equity.

2.

Current

Assets

517,500,000

Liabilities

0

Equity

517,500,000

Total L & Eq

517,500,000

3. a) The net present value of the project is $110.4 million (PV of $23 in perpetuity) - $95 = $15.4 million.

b. Stephenson will need to issue 2,753,623 million shares in order to raise sufficient funds for this purchase ($95,000,000 / $34.5).

c. The market value of the shares should reflect the expected future cash flows, so this includes the $15.4 million expected from the project. The market value of the company will be $627,900,000, with 17,753,623 shares outstanding. This gives a new share price of $35.37.

d.

AI/BP

Assets

612,500,000

Liabilities

Equity

612,500,000

Total L & Eq

612,500,000

The market value of the company's stock would still be $34.50 since it has not undertaken any action (the land purchase) to increase shareholder value.

4a. The market value of the company will be its current market value, plus the value of the purchase, less the value of the debt. The NPV of the purchase will be slightly different with the debt because of the tax impact of the interest payments. The new NPV of the project is $124.992 -- 95 = $29.92 million. Thus, the new market value of the firm will be $547.192 million.

b.

Market Value...

The firm value is higher but the equity value hasn't changed. Once the purchase has been made, more value is added to the firm, but again there has been no change in the shares outstanding, so the stock price is $42.50.
5. The debt option maximizes the share price of the firm's stock. This is because under the equity option, the amount of equity increases along with the value of the firm, such that only the added value of the project (above its cost) is added to the per-share equity price. With debt, the value of the stock is higher because firm value is higher while the equity value has not grown.

DQ 1, Chapter 3, Q. 3.

The performance of East Coast Yachts against the industry is roughly average. The current and quick ratios, indicating liquidity, are below average. Total asset turnover is around average, while the inventory and receivables turnovers are very good. This indicates a high level of efficiency in the company. The company has about average leverage for the industry and covers its interest in line with industry norms. Its margins are average, ROA is normal and ROE is higher than normal. Overall, ECY has performance that is roughly in line with industry norms, with a few outliers that indicate it is more efficient than norms but less liquid.

Current liabilities reflects the use of credit for purchases, often inventories. A company with healthy inventory turnover would be able to convert inventory purchases fast enough to keep current liabilities (esp. accounts payable) down. The ability of the company to pay its debt just from inventories also affects liquidity. There is no posted industry norm for this, but ECY is 0.46. Thus, if ECY can move its inventory, it will go a long way to paying its current liabilities. With a high inventory turn, this is a good measure of ECY.

DQ2, Chapter 13, 9.

The efficient market hypothesis is not disproved by the fact that some investors have enjoyed huge returns on their portfolios. The most important reason for this is that EMH always works on a risk-adjusted basis. This means that a portfolio that is 10% riskier than the market should expect returns that are 10% more volatile than those of the market. These investors may have achieved their huge gains by investing in very risky companies. Moreover, weak form EMH allows for investors to benefit from inside knowledge that has not been priced into the market. Whatever prohibitions might exist on insider trading, investors can still have knowledge that is not yet public, and trade on that knowledge. The greater the lag between the event occurring and the event registering in the markets, the greater likelihood that some investors will benefit from that lag. Weak-form EMH allows for this; strong-form does not. However, the notion of risk-adjusted rates of return is still critical for understanding EMH -- success above market returns is not an invalidation of EMH; success above risk-adjusted rates of return would be.

Ch 13, Closing Case

1. One of the implications for mutual fund investors is that sometimes actively managed funds perform well. Certainly, if one wishes to beat earn higher returns than the S&P, an actively-managed fund opens up that possibility.

2. The graph is not inconsistent with market efficiency. The funds might well have performed consistent with their risk levels. Earning a higher return than the S&P does not disprove efficient market hypothesis; earning a higher return on a risk-adjusted basis would. There is no evidence that the funds on the graph have the same risk or lower than the S&P 500. Further, performance against the market on a risk-adjusted basis is efficient over the long run. The sample size of time is too short to draw conclusions about the long-run performance of those funds.

3. The biggest equity decision to make with the 401(K) is how risky I want that portion to be. I could opt for the market risk, but given my investment horizon I might well opt for a riskier portfolio to seek higher long-run returns.

DQ1, Chapter 5, 6. Investors are seldom made whole with the "make whole" provision. A premium of 0.4% over Treasury is not consistent with the risk level of the firm. The YTM on the bond will reflect the actual credit quality of the bond, but ECY is not nearly large enough to have AAA credit, so…