Download ECON366 - KONSTANTINOS KANELLOPOULOS

PROFESSOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: MBA-680-50-SUII14 Corporate Financial Theory
SEMESTER: Summer Session II
Exercises 26, 27 , 31
(with solutions)
Konstantinos Kanellopoulos
26th August 2014
PART I EXERCISES FROM CHAPTERS 26, 27 and 31
Exercise 1
Large businesses spend millions of dollars annually on insurance. Why? Should they insure against
all risks or does insurance make more sense for some risks than others?
Insurance companies have the experience to assess routine risks and to advise companies
on how to reduce the frequency of losses. Insurance company experience and the very
competitive nature of the insurance industry result in correct pricing of routine risks.
However, BP, for example, has concluded that insurance industry pricing of coverage for
large potential losses is not efficient because of the industry’s lack of experience with
such losses. Consequently, BP has chosen to self insure against these large potential
losses. Effectively, this means that BP uses the stock market, rather than insurance
companies, as its vehicle for insuring against large losses. In other words, large losses
result in reductions in the value of BP’s stock. The stock market can be an efficient riskabsorber for these large but diversifiable risks.
Insurance company expertise can be beneficial to large businesses because the insurance
company’s experience allows the insurance company to correctly price insurance
coverage for routine risks and to provide advice on how to minimize the risk of loss. In
addition, the insurance company is able to pool risks and thereby minimize the cost of
insurance. Rarely does it pay for a company to insure against all risks, however.
Typically, large companies self-insure against small potential losses.
Exercise 2
In September 2011 swap dealers were quoting a rate for five-year euro interest-rate swaps of
4.5% against Euribor (the short-term interest rate for euro loans). Euribor at the time was 4.1%.
Suppose that A arranges with a dealer to swap a € 10 million five-year fixed-rate loan for an
equivalent floating-rate loan in euros.
a) What is the value of this swap at the time that it is entered into?
b) Suppose that immediately after A has entered into the swap, the long-term interest rate
rises by 1%. Who gains and who loses?
c) What is now the value of the swap?
a.
The NPV of a swap at initiation is zero, assuming the swap is fairly priced.
b.
If the long-term rate rises, the value of a five-year note with a coupon rate of 4.5%
would decline to 957.30:
45
45
45
45
1045




 957.30
1
2
3
4
(1.055) (1.055)
(1.055)
(1.055)
(1.055) 5
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With hindsight, it is clear that A would have been better off keeping the
fixed-rate debt. A loses as a result of the increase in rates, and the dealer
gains.
c.
A now has a liability equal to: 1,000 – 957.30 = 42.70
The dealer has a corresponding asset.
Exercise 3
Is the total return swap on a bond the same as a credit default swap? Why or why not?
Both a total return swap on a bond and a credit default swap provide risk protection for bond
holder. However, each swap protects the owner of the bond against the occurrence of a different
event. The total return swap protects the bond holder against a decline in the market value of the
bond while the credit default swap provides insurance against a default by the issuer of the bond.
In a credit default swap, the owner of the bond pays an insurance premium (i.e., the spread) in
exchange for an insurance policy against a default by the issuer of the bond; in the event of a
default, the bond holder receives a payment from the seller of the swap (i.e., the seller of the
insurance) equal to the difference between the face value and the market value of the bond.
Therefore, in a credit default swap, the owner of the bond is assured of receiving the face value
of the bond. In a total return swap, the owner of the bond (i.e., the total return payer) pays the
total return on the bond to the total return receiver. The total return receiver pays an agreed upon
payment (often based on LIBOR) to the total return payer. If the market value of the bond
decreases, then the owner of the bond pays an amount equal to the interest on the bond less the
capital loss. However, if the total return is negative, then it represents an additional payment
from the total return receiver to the owner of the bond, thus providing the bond owner protection
against a decline in the market value of the bond.
Exercise 4
Phillip’s Screwdriver Company has borrowed $20 million from a bank at a floating interest rate of
2 percentage points above three-month Treasury bills, which now yield 5%. Assume that interest
payments are made quarterly and, that the entire principal of the loan is repaid after five years.
Phillip’s wants to convert the bank loan to fixed-rate debt. It could have issued a fixed-rate fiveyear note at a yield to maturity of 9%. Such a note would now trade at par. The five-year Treasury
note’s yield to maturity is 7%.
a) Is Phillip’s stupid to want long-term debt at an interest rate of 9%? It is borrowing from
the bank at 7%.
b) Explain how the conversion could be carried out by an interest rate swap. What will be
the initial terms of the swap? (Ignore transaction costs and the swap dealer’s profit.)
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One year from now short- and medium-term Treasury yields decrease to 6%, so the term
structure then is flat. (The changes actually occur in month 5.) Phillip’s credit standing is
unchanged; it can still borrow at 2 percentage points over Treasury rates.
c) What new swap payment will Phillip’s make or receive?
d) Suppose that Phillip’s now wants to cancel the swap. How much would it need to pay
the swap dealer? Or would the dealer pay Phillip’s? Explain.
a.
Phillips is not necessarily stupid. The company simply wants to eliminate
interest rate risk.
b.
The initial terms of the swap (ignoring transactions costs and the dealer’s profit)
will be such that the net present value of the transaction is zero. Phillips will
borrow $20 million for five years at a fixed rate of 9% and simultaneously lend
$20 million at a floating rate two percentage points above the three-month
Treasury bill rate which is currently a rate of 7%.
c.
Under the terms of the swap agreement, Phillips is obligated to pay $0.45
million per quarter ($20 million at 2.25% per quarter) and, in turn, receives
$0.40 million per quarter ($20 million at 2% per quarter). That is, Phillips has
a net swap payment of $0.05 million per quarter.
d.
Long-term rates have decreased, so the present value of Phillips’ long-term
borrowing has increased. Thus, in order to cancel the swap, Phillips will have to
pay the dealer. The amount paid is the difference between the present values of
the two positions:


The present value of the borrowed money is the present value of $0.45
million per quarter for 16 quarters, plus $20 million at quarter 16, evaluated
at 2% per quarter (8% annual rate, or two percentage points over the longterm Treasury rate). This present value is $20.68 million.
The present value of the lent money is the present value of $0.40 million
per quarter for 16 quarters, plus $20 million at quarter 16, evaluated at
2% per quarter. This present value is $20 million, as we would expect.
Because the rate floats, the present value does not change.
Thus, the amount that must be paid to cancel the swap is $0.68 million.
Exercise 5
Companies may be affected by changes in the nominal exchange rate or in the real exchange rate.
Explain how this can occur. Which risks are easiest to hedge against?
Solution
Suppose a firm has a known foreign currency income (e.g., a foreign currency
receivable). Even if the law of one price holds, the firm is at risk if the overseas inflation
rate is unexpectedly high and the value of the currency declines correspondingly. The
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firm can hedge this risk by selling the foreign currency forward or by borrowing foreign
currency and selling it spot. Note, however, that this is a relative inflation risk, rather
than a currency risk; e.g., if you were less certain about your domestic inflation rate, you
might prefer to keep the funds in the foreign currency.
If the firm owns a foreign real asset (like Outland Steel’s inventory), your worry is that
changes in the exchange rate may not affect relative price changes. In other words, you
are exposed to changes in the real exchange rate. You cannot so easily hedge against
these changes unless, say, you can sell commodity futures to fix income in the foreign
currency and then sell the currency forward.
Exercise 6
Ms. Rosetta Stone, the treasurer of International Reprints, Inc., has noticed that the interest rate
in Japan is below the rates in most other countries. She is, therefore suggesting that the company
should make an issue of Japanese yen bonds. Does this make sense?
Solution
If international capital markets are competitive, the real cost of funds in Japan must be
the same as the real cost of funds elsewhere. That is, the low Japanese yen interest rate is
likely to reflect the relatively low expected rate of inflation in Japan and the expected
appreciation of the Japanese yen. Note that the parity relationships imply that the
difference in interest rates is equal to the expected change in the spot exchange rate. If
the funds are to be used outside Japan, then Ms. Stone should consider whether to hedge
against changes in the exchange rate, and how much this hedging will cost.
Exercise 7
In April 2007, an American investor buys 1,000 shares in a Mexican company at a price of 500
pesos each. The share does not pay any dividend. A year later she sells the shares for 550 pesos
each. The exchange rate when she buys the stock is 10.9815 pesos per 1 U.S. dollar. Suppose
that the exchange rate at the time of sale is peso 12.0 / $.
a) How many dollars does she invest?
b) What is her total return in pesos? In dollars?
c) Do you think that she made an exchange rate profit or loss? Explain.
Solution
a.
Pesos invested = 1,000  500 pesos = 500,000 pesos
Dollars invested = 500,000/10.9815 = 45,531.12
b.
Total return in pesos 
(550  500)  (1000)
 0.10  10.0%
500 1000
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Dollars received = (550  1000)/12.0 = 45,833.33
45,833.33  45,531.12
 0.0066  0.66%
45,531.12
There has been a return on the investment of 10% but a loss on the exchange rate.
Total return in dollars 
c.
Exercise 8
Carpet Baggers, Inc., is proposing to construct a new bagging planet in a country in Europe. The
two prime candidates are Germany and Switzerland. The forecasted cash flows from the proposed
plants are as follows:
Germany
(millions of
euros)
Switzerland
(millions of
Swiss francs)
C0
C1
C2
C3
C4
C5
C6
IRR(%)
-60
10
15
15
20
20
20
18,8%
-120
20
30
30
35
35
35
12,8%
The spot exchange rate for euros is $1.3/€, while the rate for Swiss francs is SFr1.5/$. The interest
rate is 5 % in the United States, 4 % in Switzerland, and 6 % in the euro countries. The financial
manager suggested that, if the cash flows were stated in dollars, a return in excess of 10% would be
acceptable.Should the company go ahead with either project? If it must choose between them,
which should it take?
Solution
NPVG   78 
12.877 19.134 18.953 25.033 24.797 24.563





 $10.12
1.10
(1.10) 2 (1.10) 3 (1.10) 4 (1.10) 5 (1.10) 6
NPVS   80 
13.462 20.386 20.582 24.244 24.477 24.712





 $10.26
1.10
(1.10) 2 (1.10)3 (1.10) 4 (1.10)5 (1.10) 6
Sample calculations:
 1.05 
(1.3  10)  
  12.877
 1.06 
 20   1.05 


  13.462
 1.5   1.04 
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Since both projects have a positive NPV, both should be accepted. If the firm must
choose, then the Swiss plant is the better choice. Note that the NPV calculation is in
dollars and implicitly assumes currency hedging.
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Exercise 9
If investors recognize the impact of inflation and exchange rate changes on a firm’s cash flows,
changes in exchange rates should be reflected in stock prices. How the stock price of each of the
following Swiss companies would be affected by an unanticipated appreciation of a Swiss franc of
10%. Assume that only 2% of the appreciation can be attributed to increased inflation in the rest of
the world (relative to the Swiss inflation rate).
a) A Swiss airline: More than two-thirds of its employees are Swiss. Most revenues come
from international fares set in U.S. dollars.
b) Nestle: Fewer than 5% of its employees are Swiss. Most revenues are derived from sales of
consumer goods in a wide range of countries with competition from local producers.
c) UBS: Forty percent of the employees work in Switzerland. The bank’s Group Treasury
periodically hedges any non-Swiss franc monetary positions.
Solution
a.
Revenues are in dollars, expenses are in Swiss francs: SwissAir stock price will
decline.
b.
Both revenues and expenses are in a wide range of currencies, none of which
is tied directly to the Swiss franc: Nestle stock price will be unaffected.
c.
Non-Swiss franc monetary positions are hedged, expenses are in Swiss francs:
UBS stock price will be unaffected or may increase, depending on the nature of
the hedge.
Exercise 10
Respond to the following comments.
a. “Our cost of debt is too darn high, but our banks won’t reduce interest rates as long as we’re
stuck in this volatile widget-trading business. We’ve got to acquire other companies with safer
income streams.”
b. “Merge with Fledgling Electronics? No way! Their P/E’s too high. That deal would knock 20
percent off our earnings per share.”
c. “Our stock’s at an all-time high. It’s time to make our offer for Digital Organics. Sure, we’ll
have to offer a hefty premium to Digital stockholders, but we don’t have to pay in cash. We’ll
give them new shares of our stock.”
Solution
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a.
This is a version of the diversification argument. The high interest rates reflect
the risk inherent in the volatile industry. However, if the merger allows
increased borrowing and provides increased value from tax shields, there will
be a net gain.
b.
The P/E ratio does not determine earnings. The efficient markets hypothesis
suggests that investors will be able to see beyond the ratio to the economics of
the merger.
c.
There will still be a wealth transfer from the acquiring shareholders to the
target shareholders.
Exercise 11
As treasurer of Leisure Products, Inc., you are investigating the possible acquisition of
Plastitoys. You have the following basic data:
Vi
You estimate that investors currently expect a steady growth of about 6 percent in Plastitoys’
earnings and dividends. Under new management this growth rate would be increased to 8 percent
per year, without any additional capital investment required.
a. What is the gain from the acquisition?
b. What is the cost of the acquisition if Leisure Products pays $25 in cash for each share of
Plastitoys?
c. What is the cost of the acquisition if Leisure Products offers one share of Leisure Products for
every three shares of Plastitoys?
d. How would the cost of the cash offer and the share offer alter if the expected growth rate of
Plastitoys were not changed by the merger?
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Solution
a.
Use the perpetual growth model of stock valuation to find the appropriate
discount rate (r) for the common stock of Plastitoys (Company B):
0.80
 20  r  0 .10  10.0%
r  0 .06
Under new management, the value of the combination (AB) would be the value of
Leisure Products (Company A) before the merger (because Company A’s value is
unchanged by the merger) plus the value of Plastitoys after the merger, or:
 $0.80 
  $114,000,0 00
PVAB  (1,000,000  $90)  600,000  
 0.10  0 .08 
We now calculate the gain from the acquisition:
Gain PVAB  (PVA  PVB )
Gain  $114,000,0 00  ($90,000,0 00  $12,000,00 0)  $12,000,00 0
b.
Because this is a cash acquisition:
Cost = Cash Paid – PVB = ($25  600,000) – $12,000,000 = $3,000,000
c.
Because this acquisition is financed with stock, we have to take into consideration
the effect of the merger on the stock price of Leisure Products. After the merger,
there will be 1,200,000 shares outstanding. Hence, the share price will be:
$114,000,000/1,200,000 = $95.00
Therefore:
Cost = ($95  200,000) – ($20  600,000) = $7,000,000
d.
If the acquisition is for cash, the cost is the same as in Part (b), above:
Cost = $3,000,000
If the acquisition is for stock, the cost is different from that calculated in Part (c).
This is because the new growth rate affects the value of the merged company.
This, in turn, affects the stock price of the merged company and, hence, the cost
of the merger. It follows that:
PVAB = ($90  1,000,000) + ($20  600,000) = $102,000,000
The new share price will be:
$102,000,000/1,200,000 = $85.00
Therefore:
Cost = ($85  200,000) – ($20  600,000) = $5,000,000
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