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23 Dec 2018

1. What is do we mean by “risk” in the finance discipline? Pick a stock and calculate the “risk” based on the last 250 trading days.

14. Give an example (of each) of a test you could conduct that would refute strong form, semi-strong form, and weak form efficiency.

15. What is the pecking order theory? Name a company that probably uses pecking order in their capital budgeting decisions

16. What did Modigliani and Miller do that is significant in finance? What assumptions did they make to prove their hypothesis?

17. Look up the WACC of a large company and report the capital structure of the firm.

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Lelia Lubowitz
Lelia LubowitzLv2
26 Dec 2018

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Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a frim would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a firm would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. These assumptions are necessary for the M&M theory on capital structure. For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, the figure also shows that the debt costs are also going up; similarly, if the equity costs are going down, then the debt costs are going down also as the debt-to-value decreases. This is shown on page 500 in Figure 14.1. And, of course, the weights of debt and equity (0/100, 25/75, 50/50, 75/25, 100/0) count. But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example. So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

Questions:

1. Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

2. Assume you are doing a financial analysis for Kroger Inc. Here is one of the income statements that you analyze (all figures in $ Millions):

Which year does Kroger Incorporation have the highest tax shield and why? Be very specific.

Year

2006

2005

2004

Total Sales

60,553

56,434

53,791

Cost of goods sold

45,565

42,140

39,637

Selling, general & admin expenses

11,688

12,191

11,575

Depreciation

1265

1256

1209

Operating Income

2035

847

1370

Other Income

0

0

0

EBIT

2035

847

1370

Interest expense

510

557

604

Earnings before tax

1525

290

766

Taxes (35%)

534

102

268

Net Income

991

189

498

Trump Pump Company (FIN5303-01; Spring 2017)

Although you were hired as a financial analyst after completing your MBA, your first assignment at Trump Pump is with the firm’s marketing department. Part of the “Make Great Pumps Even Greater Again” campaign includes your boss lending you to the marketing department to help them develop some analytical procedures that the sales force can use to demonstrate the financial benefits of buying Trump Pump’s products. Trump pumps cost more because they use no parts from Mexico. To offset the price, each pump comes a coupon for a free tax credit on the next purchase from Trump Pump, a round of golf a Mar a Lago and a 14 ct. gold leaf “Trump” logo sticker for the front office door.

Trump Pump manufactures pump systems that are used in a wide variety of applications including water distribution, sewage treatment, petroleum refining, and pipeline transmission. The complete systems include sophisticated pumps, sensors, valves, and control units that continuously monitor the flow rate and the pressure along a line and automatically adjust the pump to meet pre-set pressure specifications. Most of Trump Pump’s systems are made up of standard components, and most complete systems are priced from $600,000 to $1,000,000. Because of the technical nature of the products, the majority of Trump Pump’s salespeople have a background in engineering, not finance and marketing.

As you think about this assignment, you quickly come to the conclusion that the best way to “sell” a system to a cost-conscious customer is to conduct a capital budgeting analysis to demonstrate the cost effectiveness of the system. Further, you conclude that the best way to begin is with an analysis for one of Trump Pump’s actual customers.

From discussions with the firm’s salespeople, you determine that a proposed sale to the Oklahoma City Water Department is perfect to use as an illustration. OKC Water is considering the purchase of one of Trump Pump’s standard water pump systems which costs $850,000, including delivery. It will cost OKC Water another $8,000 transportation and $40,000 to install the equipment. This expense (transportation and installation) will be added to the price of the equipment to determine the depreciable basis of the system. Also, the new pump will require an increase in working capital of $35,000. OKC Water will depreciate the pump system to zero using straight-line method for six years. They plan to sell the system at the end of nine years for $450,000. After the first year, OKC Water will be required to pay $11,000 per year for a service and maintenance contract with payments at the beginning of each year.

The system from Trump Pump would replace a pump that OKC Water is now using. That pump has been depreciated to a book value of zero but will be sold for $70,000 if the new system is purchased. OKC Water recently spent $70,000 just one year ago to upgrade their existing pump system. (OKC Water believes the $55, 000 for repairs should be a cost to the present evaluation because it did not increase the salvage value of their current pump.) By replacing the old pump, OKC Water should save $380,000 annually in pre-tax operating costs. OKC Water estimates that its cost of capital is 12% and its tax rate is 34%. If purchased, the new pump will be housed in a building owned by OKC Water and currently leased to a fishing guide service which pays OKC Pump $26,000 at the beginning of each year to use the building. Because of the noise, the fishing guide service will have to move out of the building.

After developing a capital budgeting analysis for the pump system, write a description of the analysis to be used by Trump Pump sales representatives to help sell the system to OKC Water. Remember that the analysis will be used to help non-finance sales representatives sell equipment to non-finance customers. The analysis must be understandable and clear. Show each step and calculation such that an intelligent person not trained in finance can understand. Also, include a spreadsheet that calculates your results (template included). Calculate Payback Period, Net Present Value, Internal Rate of Return, Profitability Index, and Modified Internal Rate of Return.

What is the project’s NPV? Could the NPV of this project be different for OKC Water than for some other company if both companies expect the same cash flows? Explain

What is the project’s IRR? Assuming the same cash flows, could the IRR for this project differ for OKC Water compared to another company? Explain.

Calculate the payback period. What are the disadvantages of the payback period? Does payback period provide any useful information regarding capital budgeting decisions?

Calculate the project’s MIRR. Why is MIRR considered to be superior to the IRR? How does MIRR differ from IRR?

Calculate the project’s Profitability Index.

Should OKC Water purchase the new pump system? Why?

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