SOLUTIONS TO QUESTIONS FROM TOPIC ONE
F&H continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns of around 8% on investment. That is a far better return than F&H earns on its cash holdings.
The CFO went on to explain that F&H invested excess cash in short‐term US government securities, which are almost entirely risk‐free but offered only a 4% rate of return.
a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short term US government securities? Why or why not? b. Is F&H’s opportunity cost of capital 4%. How in principle should the CFO determine the cost of capital?
a. Assuming that the encabulator market is risky, an 8% expected return on the F&H encabulator investments may be inferior to a 4% return on U.S. government securities.
b. Unless their financial assets are as safe as U.S. government securities, their cost of capital would be higher. The CFO could consider what the expected return is on assets with similar risk.
We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example the manager might:
a. Make shareholders as wealthy as possible by investing in real assets. b. Modify the firms investment plan to help shareholders achieve a particular time‐consumption
c. Choose high or low risk assets to match shareholders risk preferences. d. Help balance shareholders cheque‐books.
But in well functioning capital markets, shareholders will vote for only one of these goals. Which one? Why?
Shareholders will only vote for (a) maximize shareholder wealth. Shareholders can modify their pattern of consumption through borrowing and lending, match risk preferences, and hopefully balance their own checkbooks (or hire a qualified professional to help them with these tasks).
Why may market based financial systems be better in supporting innovation and in releasing capital from declining industries?
Financial markets offer entrepreneurs greater diversity of financing sources. They also send clearer signals when an industry is in decline and are less likely to bail the firms out.
What is meant by dual‐class equity? Do you think it should be allowed or outlawed?
A company with dual‐class equity has two classes of common stock with different voting rights. For example, one class may receive 10 votes per share. One of the best known examples of a company with dual‐class equity is Google; the founders own a class of common stock with extra voting rights, which makes it easier for them to maintain control over the firm. Some may dislike this unequal voting power. Others may be perfectly comfortable with the arrangement, as long as the terms are openly disclosed (and presumably priced into the shares at issuance).
A machine costs $380,000 and is expected to produce the following cash flows: Year 1 2 3 4 5 6 7 8 9 10 Cash Flows 50 57 75 80 85 92 92 8 68 50 If the cost of capital is 12% what is the machines NPV?
$50,000 $57,000 $75,000 $80,000 $85,000
$92,000 $92,000 $80,000 $68,000 $50,000