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Introduction to Finance
BUSFIN 1030
Professors Schlingemann & Rossell Solutions Problem Set 1
1. Calculate the Cash Flow from Assets for Coca-Cola CFA = OCF – NCS – additions to NWC OCF = EBIT + depreciation – tax OCF = –2,674 + 11,236 – (–467) = $9, NCS = 18,135 – 13,225 + 11,236 = $16, Additions to NWC = 4,178 – 1,237 = $2, CFA = 9,029 – 16,146 – 2,941 = – $10, 2. Calculate the Cash Flow to Creditors for Coca-Cola CF to creditors = interest – net new long-term borrowing CF to creditors = 1,235 – 3,160 = – $1, 3. Calculate the Cash Flow to Shareholders for Coca-Cola CF shareholders = dividends – net new equity raised Dividends = net income – additions to retained earnings Dividends = – 3,442 – (–3,642) = $ CF to shareholders = 200 – 8,333 = – $8, 4. Show that the Cash Flow Identity works for Coca-Cola CF identity = CFA = CF to creditors + CF to shareholders
- $10,058 = – $1,925 – $8, 5. Does Pepsico pay any dividends? If so, how much? Yes: $1990 – (–$387) = $2, 6. Is Pepsico a net raiser of cash from equity, or do they pay out to shareholders on a net basis?
CF to shareholders = $2,377 + $148 = $2,525, hence PepsiCo is both paying a dividend and is repurchasing shares on a net basis. So they pay out on a net basis.
7. Summarize the sources and uses of cash for Pepsico Inc. and categorize into operating activities, investment activities, and financing activities. Operating Activities
- Net Income 1,
- Depreciation 1,
- Marketable Securities Decrease 872
- Receivables Increase 303
- Inventories Increase 284
- Other Current Assets Increase 13
- Accounts Payable Increase 253
- Other Current Liabilities Decrease 517 Total 3, Investment Activities
- Net Capital Spending 4,
- Depreciation 1, Total –5, Financing Activities
- Notes Payable Increase 3,
- Long-term Debt Decrease 918
- Other Long-term Liabilities Increase 355
- Dividend 2,
- Equity Repurchases 148 Total 833 8. How can you check whether your cash flow statement from question 7 is correct? Operating Activities + Investment Activities + Financing Activities = Change in Cash Balance 3,232 – 5,682 + 833 = 1,617 = 1,928 – 311 (from Cash entry on balance sheet) 9. As a financial manager, should you worry about the negative net income of Coca-Cola?
12. Analyze and interpret the solvency of Pepsico in 1999. Looking for example at the Debt/Value ratio, we can see that for each dollar in total value in the firm, 72% is financed through debt, whereas in the previous year this was 65%. So, PepsiCo has increased its financial leverage. It seems high relative to Coca-Cola, Schweppes and the industry benchmark. In terms of their ability to service this debt (ability to pay interest) we can look at the Times Interest Earned or the Cash Coverage Ratio. For PepsiCo these numbers are respectively 8.04 and 11.88. Compared to the above benchmarks it seems that PepsiCo is doing well. Comparing it to Coca-Cola requires us to look as the cash coverage ratio, because Coca-Cola has a negative EBIT. Coca-Cola has a coverage ratio of 6.93 so again, PepsiCo is doing well in terms of being able to afford the interest, even though they have more debt than comparable firms. 13. Analyze and interpret the asset management of Pepsico. Days’ Sales in Inventory = 365 / (9,330/1,016) = 40 days. This seems a little high to the industry and Schweppes numbers. It seems very high compared to Coca-Cola, (< 1day), but one could wonder if that is normal, given the extremely low inventories for Coca- Cola in 1999. Receivables Turnover = 9.11 (or, it takes them 40 days on average to collect on their sales based on the Days’ Sales in receivables). This compares favorably to the 48 days for Coca-Cola, and definitely relative to the other two benchmarks (61 days). Total Asset Turnover = 0.986 for Pepsico, which seems excellent compared with the other benchmarks that are all lower. Overall, the results look normal to good, except for the Inventory Turnover. 14. Analyze and interpret the profitability of Pepsico. Profit Margin, Return on Equity, and Return on Assets are respectively, 8.9%, 31.1%, and 8.8%. We can’t use the numbers for Coca-Cola for 1999 here because they involve negative net income. We need to refer to the benchmarks above instead. The performance, based on the profit margin and the return on equity seem to be in line with the benchmarks – ROE is somewhat better than the norm. Could we find the Return on Assets for Schweppes for example? Yes, because we know that for each dollar in total assets (see the debt-to-value ratio), Schweppes has 51 cents in debt, and 49 cents in equity. Hence, if Schweppes has X dollars in equity, we know that Sales / X = 0.24. The total assets must be X / 0.49, which means that Sales / (X / 0.49) = 11.76%. So, the profitability relative to Schweppes is lower based on the total assets of the firm, but better when measured against equity. 15. Interpret and comment on the P/E ratio of Pepsico.
PepsiCo has 1990 / 110 = $18.09 earnings per share, resulting in a P/E ratio of 2.99. For Coca-Cola we can’t do this based on the negative earnings. Compared to the other two relevant benchmarks, this seems to be a ‘normal’ yet slightly higher value. It indicates that some growth is expected for this and the other soft drink companies, but that investors are not nearly as much willing to pay high prices for current earnings when compared to Microsoft for example. For PepsiCo, investors are willing to pay three times the current earnings, whereas for Microsoft they are willing to pay more than 38 times the current earnings. This is most likely reflected in the different nature of the two industries and the expected growth potential with each industry. Other Questions
- Suppose your business has gone bankrupt. After selling all of your business's assets, your business still owes $250,000. a. Suppose the business is organized as a limited partnership in which you and your partner each supplied 50% of the initial $200,000 investment. If you are the general partner and the other partner is a limited partner, how much of the $250,000 do you owe and how much does your partner owe? ANSWER: You each supplied $100,000. The limited partner has limited liability and owes his/her full $100,000. The remainder, $150,000 is what you owe, because as a general partner you have unlimited liability. b. How much of the $250,000 do you owe if the business is organized as a sole proprietorship? ANSWER: You owe to full $250,000, because of unlimited liability. c. Suppose the business is organized as a corporation in which you own 50% of the shares outstanding purchased for $200,000 when the company went public. How much of the $250,000 do you owe? ANSWER: You have limited liability as a shareholder, so you can not owe more than what the value of your shares is. Since the value of your shares will drop to zero, you lost the $200,000 but you do not owe anything beyond that.
- Your friend started a successful indoor golfing range in Pittsburgh five years ago. She is currently the sole owner of the business. After much thought she has decided to expand her business to other markets within the U.S. She realizes such an expansion requires additional capital. a. Would you recommend that she change the organizational form of the company? If so, which type of organizational form should the business take?
i. How much are shareholders willing to pay for each dollar of earnings of the firm? ANSWER: P/E ratio = price per share / earnings per share = ($0.80) / ($1 million / 1.5 million) = 1.2, so investors are willing to pay $1.20 for each $1 in current earnings. ii. What is the book-to-market ratio for the company? Based on your answer, would you recommend buying this stock? Explain. ANSWER: B/M = book value of equity / market value of equity = $2.5 million / ($0.80 × 1. million) = 2.083 (Or, the Market-to-Book = 1 / 2.2083 = 0.48). This number is telling you that investors on average do expect the future to be worse than the current status of the firm, which would not be a good sign. You’d probably want to sell, although one would need to know whether the stock is over or under-priced. Time Value of Money Questions
- A famous running back just signed a $18 million contract providing $3 million a year for six years. A less famous running back signed a $14 million five-year contract providing $4 million now and $2 million a year for five years. Who is better paid if the interest rate is 6%? ANSWER: Convert each cash flow to the same time period before making a comparison. For example, discounting each cash flow to the present value gives us: Assume payments take place in year 1, 2, etc. PVFAMOUS = (^) (^6) ( 1. 06 ) 1 1
- 06 $ 3 million $14,751,972. Assume that after the initial payment of $4 million, the remainder gets paid out in years 1, 2, etc. PVLESS FAMOUS = $4 million + (^) (^5) ( 1. 06 ) 1 1
- 06 $ 2 million $12,424,727.
- You believe you will need to have saved $500,000 for your supplemental healthcare account by the time you retire in 40 years in order to live comfortably. If the interest rate is 4.5% per year, how much must you save each year to reach your retirement goal? ANSWER: use the future value annuity formula and solve for C:
045 $ 500 , 000 40 C C
You have decided to buy a new BMW Z-3 the dealer will sell you for $44,000 with your trade in. The financing that the dealer is offering is a 5-year loan at 6.5% (APR) and the first loan payment is due one-month from now. a. Assume all loan payments are made at the end of the month. Given the interest rate on the loan, what is your monthly payment? ANSWER : This a Present Value Annuity problem, where you have to solve for C in the formula: 60 ( 1 ) 1 $ 44 , 000 1 r r C . Note that the payments are made every month, so we need a monthly interest rate. Monthly rate = APR / 12 = 0.005416 = r. ^ C C ( 1. 005416 )^60 1 1
005416
b. By making fixed monthly payments on your loan, you are repaying the principle amount over five years. This process of paying off a loan by making regular principal reductions is called amortizing the loan. For your first monthly loan payment, what amount of your payment goes to repaying your principle and how much to repaying your interest? ANSWER : Note that when you make your first payment, at that time you have you full amount of debt outstanding ($44,000) over which you have to pay interest. Hence, you owe 0.005416 × $44,000 = $238.30 in interest. Given that you pay a total of $860.91, it implies that $622.61 is paid toward reducing your principal. c. How much of your principal have you repaid after three months? ANSWER : Similarly as above, let's find first for the second month what we have paid off. Your debt is now reduced from $44,000 to $44,000 - $622.61 = $43,377.39. So, for the second month your interest payment is 0.005416 × $43,377.39 = $234.96. This implies a principal reduction of $860.91 - $234.96 = $625.95. For the third payment, you will pay 0.005416 × $42,751.44 = $231.57 in interest and $860.91 - $231.57 = $629.34 in principal reduction. In total you have paid off $622.61 + $625.95 + $629.34 = $1,877. after 3 months.
- A piece of equipment costs $500,000. You forecast that it will produce cash inflows of $100,000 in Year 1, $250,000 in Year 2, and $300,000 in Year 3. The opportunity cost of your firm's capital (interest) is 12% per year. Should you buy this equipment?
ANSWER:
Calculate the PV of these 3 options, and compare the values: First, what interest rate do we use? Since all the payments are annually, we need an annual rate that takes into account the semi-annual compounding: EAR = [ 1 + (0.07 / 2)]^2 = 0. Option 1: PV(option1) = 30 ( 1. 071225 ) 1 1
- 071225 $ 250 , 000 plus the PV of 2.5 million in year 30 = 2.5 million / (1.071225)^30 , so in total: $3,381,799. PV(option2) = $1 million + 30 ( 1. 071225 ) 1 1
- 071225 $ 200 , 000
- (^30) ( 1. 071225 ) 3 million = $3,832,373. PV(option3) = $500,000 + 28 ( 1. 071225 ) 1 1
- 071225 $ 250 , 000 ( 1. 071225 )^30
- 5 million = $3,816,072. Option 2 is preferred, since it has the highest present value.
