# In the first lesson of this course - Expert Answers

QUESTION 1

In the first lesson of this course, we learned that the goal of financial management is to maximize the value of shareholders’ wealth. Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework of maximizing stock price, or are they essentially ignored? Use specific scenarios to illustrate your answer.

For Question 2, answer question letters a, b, and c.

According to a May 9, 2011 article in the Wall Street Journal, chief executive officers (CEOs) at the biggest U.S. companies saw their pay jump sharply in 2010, as boards rewarded them for strong profit and share-price growth with bigger bonuses and stock grants. The median value of salaries, bonuses, and long-term incentive awards for CEOs of 350 major companies increased by 11% to $9.3 million, according to a study of proxy statements conducted for the Wall Street Journal by management consultancy Hay Group. The Journal measured CEO pay by total direct compensation, which includes salary, cash bonuses, and the value of granted stock, stock options and other long-term incentives given for service in fiscal 2010.

What component of CEO pay do you think most aligns the interests of stockholders and CEOs? Explain.

What component of CEO pay do you think least aligns the interests of stockholders and CEOs? Explain. Why do you think companies compensate their executives using this component even though it least aligns the interests of shareholders and management?

QUESTION 4

Do you think a stock price that rises faster than a CEO's pay indicates that the pay is justified? Explain.

QUESTION 5

You are considering three insurance settlement offers. The first offer includes annual payments of $5,000, $10,000, $15,000, etc., where the payment for each year is $5,000 more than the payment for the previous year, over the next ten years. The first payment of $5,000 will be made exactly one year from today and the last payment, equal to $50,000 will be made ten years from today. The second offer is the payment of one lump sum amount today. The third offer is to receive an equal amount at the end of each year, over the next ten years. Assume there are no tax effects and your discount rate is 12% per year.

What is the minimum amount that you will accept today if you are to select the lump sum offer?

What is the minimum amount of each of the 10 equal annual payments that you should be willing to accept?

QUESTION 6

b) Joan Collins wishes to choose the best of four immediate-retirement annuities available to her. In each case, in exchange for paying a single premium today, she will receive equal annual end-of-year cash benefits for a specified number of years. She considers the annuities to be equally risky and is not concerned about their differing lives. Her decision will be based solely on the rate of return she will earn on each annuity. The key terms of each of the four annuities are shown in the following table.

Calculate the rate of return on each of the four annuities Joan is considering. Given Joan's stated decision criterion, which annuity would you recommend?

Annuity

Rate of Return

A

10.00%

B

13.60%

C

12.86%

D

12.00%

The annuity B should be selected as it will provide highest rate of return.

Question 4 involves answering parts a, b, c, d, and e.

BobaFett, a financial analyst for Jabba Investments, a mutual fund management company, must evaluate the risk and return of two stocks, X and Y. The firm is considering adding these stocks to its diversified stock portfolio. To assess the return and risk of each stock, Boba gathered data on the annual dividends and beginning- and end-of-year prices of each stock over the immediately preceding 10 years, 2002–2011. These data are summarized in the accompanying table. Boba's investigation suggests that both stocks, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each stock over the past 10 years. Boba believes that each stock's risk can be assessed in two ways: in isolation and as part of the firm's diversified portfolio of stocks. The risk of the stocks in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital assets pricing model (CAPM) can be used to assess the stock's risk as part of the firm's portfolio of stocks. Applying some sophisticated quantitative techniques, Boba estimated betas for stocks X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free rate is currently 7% and that the market return is 10%. Note: you may find it easier and time effective to solve the problems using Excel or any other spreadsheet software. If you do, please use the drop box to submit your spreadsheet file.

Calculate the annual rate of return for each stock in each of the 10 preceding years, and use those values to find the average annual return for each stock over the 10-year period.

Use the returns calculated in part (a) to find (i) the standard deviation and (ii) the coefficient of variation of the returns for each stock over the 10-year period 2002–2011.

QUESTION 9

c) Use your findings in parts (a) and (b) to evaluate and discuss the return and risk associated with each stock. Which stock appears to be preferable? Explain.

QUESTION 10

d) Use the CAPM to find the required return for each stock. Compare this value with the average annual returns calculated in part

QUESTION 11

e) Compare and contrast your findings in parts (c) and (d). What recommendations would you give Boba with regard to investing in either of the two stocks? Explain to Boba why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each stock.

QUESTION 12

For Question 5, answer parts a and b.

Explain what is meant by a company’s cost of capital. Why is it important for a company to know its cost of capital? Explain.

QUESTION 13

Assume that you have been hired as a consultant by Bluefield Corporation, a major producer of chemicals and plastics, including plastic grocery bags, Styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. Bluefield Corporation has 500 million shares of common stock outstanding, 75 million shares of preferred stock outstanding, and 25 million 11% semiannual coupon bonds outstanding, par value $1,000 each. The common stock currently sells for $40 per share and has a beta of 1.2, the preferred stock currently sells for $75 per share and pays an annual dividend of $7 per share, and the bonds have 15 years to maturity and sell for 93.5 percent of par. The market risk premium is 6%, the yield on Treasury bills is 4%, and Bluefield’s tax rate is 35%. What is the firm’s weighted average cost of capital?

In the first lesson of this course, we learned that the goal of financial management is to maximize the value of shareholders’ wealth. Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework of maximizing stock price, or are they essentially ignored? Use specific scenarios to illustrate your answer.

For Question 2, answer question letters a, b, and c.

According to a May 9, 2011 article in the Wall Street Journal, chief executive officers (CEOs) at the biggest U.S. companies saw their pay jump sharply in 2010, as boards rewarded them for strong profit and share-price growth with bigger bonuses and stock grants. The median value of salaries, bonuses, and long-term incentive awards for CEOs of 350 major companies increased by 11% to $9.3 million, according to a study of proxy statements conducted for the Wall Street Journal by management consultancy Hay Group. The Journal measured CEO pay by total direct compensation, which includes salary, cash bonuses, and the value of granted stock, stock options and other long-term incentives given for service in fiscal 2010.

What component of CEO pay do you think most aligns the interests of stockholders and CEOs? Explain.

What component of CEO pay do you think least aligns the interests of stockholders and CEOs? Explain. Why do you think companies compensate their executives using this component even though it least aligns the interests of shareholders and management?

QUESTION 4

Do you think a stock price that rises faster than a CEO's pay indicates that the pay is justified? Explain.

QUESTION 5

You are considering three insurance settlement offers. The first offer includes annual payments of $5,000, $10,000, $15,000, etc., where the payment for each year is $5,000 more than the payment for the previous year, over the next ten years. The first payment of $5,000 will be made exactly one year from today and the last payment, equal to $50,000 will be made ten years from today. The second offer is the payment of one lump sum amount today. The third offer is to receive an equal amount at the end of each year, over the next ten years. Assume there are no tax effects and your discount rate is 12% per year.

What is the minimum amount that you will accept today if you are to select the lump sum offer?

What is the minimum amount of each of the 10 equal annual payments that you should be willing to accept?

QUESTION 6

b) Joan Collins wishes to choose the best of four immediate-retirement annuities available to her. In each case, in exchange for paying a single premium today, she will receive equal annual end-of-year cash benefits for a specified number of years. She considers the annuities to be equally risky and is not concerned about their differing lives. Her decision will be based solely on the rate of return she will earn on each annuity. The key terms of each of the four annuities are shown in the following table.

Calculate the rate of return on each of the four annuities Joan is considering. Given Joan's stated decision criterion, which annuity would you recommend?

Annuity

Rate of Return

A

10.00%

B

13.60%

C

12.86%

D

12.00%

The annuity B should be selected as it will provide highest rate of return.

Question 4 involves answering parts a, b, c, d, and e.

BobaFett, a financial analyst for Jabba Investments, a mutual fund management company, must evaluate the risk and return of two stocks, X and Y. The firm is considering adding these stocks to its diversified stock portfolio. To assess the return and risk of each stock, Boba gathered data on the annual dividends and beginning- and end-of-year prices of each stock over the immediately preceding 10 years, 2002–2011. These data are summarized in the accompanying table. Boba's investigation suggests that both stocks, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each stock over the past 10 years. Boba believes that each stock's risk can be assessed in two ways: in isolation and as part of the firm's diversified portfolio of stocks. The risk of the stocks in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital assets pricing model (CAPM) can be used to assess the stock's risk as part of the firm's portfolio of stocks. Applying some sophisticated quantitative techniques, Boba estimated betas for stocks X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free rate is currently 7% and that the market return is 10%. Note: you may find it easier and time effective to solve the problems using Excel or any other spreadsheet software. If you do, please use the drop box to submit your spreadsheet file.

Calculate the annual rate of return for each stock in each of the 10 preceding years, and use those values to find the average annual return for each stock over the 10-year period.

Use the returns calculated in part (a) to find (i) the standard deviation and (ii) the coefficient of variation of the returns for each stock over the 10-year period 2002–2011.

QUESTION 9

c) Use your findings in parts (a) and (b) to evaluate and discuss the return and risk associated with each stock. Which stock appears to be preferable? Explain.

QUESTION 10

d) Use the CAPM to find the required return for each stock. Compare this value with the average annual returns calculated in part

QUESTION 11

e) Compare and contrast your findings in parts (c) and (d). What recommendations would you give Boba with regard to investing in either of the two stocks? Explain to Boba why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each stock.

QUESTION 12

For Question 5, answer parts a and b.

Explain what is meant by a company’s cost of capital. Why is it important for a company to know its cost of capital? Explain.

QUESTION 13

Assume that you have been hired as a consultant by Bluefield Corporation, a major producer of chemicals and plastics, including plastic grocery bags, Styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. Bluefield Corporation has 500 million shares of common stock outstanding, 75 million shares of preferred stock outstanding, and 25 million 11% semiannual coupon bonds outstanding, par value $1,000 each. The common stock currently sells for $40 per share and has a beta of 1.2, the preferred stock currently sells for $75 per share and pays an annual dividend of $7 per share, and the bonds have 15 years to maturity and sell for 93.5 percent of par. The market risk premium is 6%, the yield on Treasury bills is 4%, and Bluefield’s tax rate is 35%. What is the firm’s weighted average cost of capital?

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