(Solution Manual) Corporate Finance (European Edition)

Hillier, Ross, Westerfield, Jaffe, Jordan, 3

Business

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Solution Manual for Corporate Finance (European Edition), The downloadable file consists of 559 pages, and the total size of the file is 3.23 MB. Purchase now only for highly discounted price.

Author(s): Hillier, Ross, Westerfield, Jaffe, Jordan

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CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE 1. Finance relates to the decision -making and strategies of corporations. It is composed of three main elements. a. The capital budgeting or investment decision. b. The capital structure or financing decision. c. Short-term capital management. Each decision is framed within the general objective of maximizing firm value while ensuring that risk is appropriately managed. Think a family, with one parent earning the monthly salary and the other looking after the children. Every month, money comes into the house and there will be times when the family needs to spend money on items like furniture. This will usually come from savings. However, sometimes, the family will want to buy a car or a house and will need to take out a loan for the investment. At all times, the family must have enough cash and this applies every single day. This example concerns a family, but if you change the object to a corporation, the same decisions need to be made. When we talk about financial decisions relating to families, this is known as personal finance, whereas when we talk about corporations, we call this corporate finance. 2. The investment decision refers to investments in projects that produce a higher rate of return than the firm’s mi nimum hurdle rate. The financing decision refers to the optimal mix of debt and equity. Short -term capital management refers to activities related to working capital management that help ensure the liquidity and profitability of a company. The equity decis ion is explicitly a sub -component of the financing decision. 3. The statement assumes that the market is efficient and markets fully reflect the true value of the firm. In this context, t he goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions. 4. Financial markets are market places where buyers and sellers trade assets, and they facilitate the raising of capital (e.g. IPOs, SEOs, bond issues), the transfer of ris k (e.g. loans), the transfer of liquidity (e.g. the quick sale of assets such as stocks), and international trade (e.g. GDRs). 5. A depository receipt is a security carrying a legal claim on the cash flows from the deposited shares, and offers an indirect form of listing on a stock exchange. Companies often use depository receipts to circumvent listing problems in foreign markets. Wi th a depository receipt, a firm deposits a number of its own shares with a bank, which in turn NOTE: (For Complete File, Download link at the end of this File)Get all chapters complete files solutions manual download link below https://www.mediafire.com/file/lal8ih437 xzdt42/SM+Corporate+Finance+(European +Edition),+3e+Hillier,+ Ross,+Westerfield,+J affe,+Jordan.zip/file issues a depository receipt. If the issuing firm pays dividends, the bank transfers the cash flows to holders of the depository receipts, after deducting a small fee. Global depository receipts refer to depository receipts issued outside U.S. markets. 6. This is quite a difficult task for students but it is useful in getting them to read through news stories and to familiarise them with financial websites. The exp ectations of the instructor should not be too great and the question is very useful for a first lecture in a Corporate Finance class. This answer to this question is very much up to the student. Give them websites that they can visit to collect data includ ing Google, Yahoo! Finance, Reuters, and FT.Com. As an introductory question, it is an excellent way to get students to practically engage with the material and do their own research. You can even get them to prepare a presentation or do the question in gr oups. 7. Equity = Total Assets – Total Liabilities = €1,403 – €1,253 = €150 million Non -Current Assets = Total Assets – Current Assets = €1,403 - €619 = €784 million Non -Current Liabilities = Total Liabilities – Current Liabilities = €1,253 - €338 = €915 million 8. Step 1: Determine liability/equity ratio: €1,2538.35315€0liability equity== Step 2: To find the current weightings of debt and equity in the new funding, you must actually calculate a new ratio, liability/assets. 1,2530.89311,40€ € 3liability Assets== Step 3: The debt that is raised is thus € 89.31 million and equity is € 10.69 million. Step 4: Check the new liability/equity ratio. The new level of liabilities is € 1,342.31 million and the new level of equity is € 160.69 million. The new ratio is: 1,342.318.353160€ .69€liability equity== This is the same as the original liability/equity ratio. 9. There are three components to this transaction: a. Cash outflow of £100 million will appear in cash flow statement. Current assets (cash) will fall by £100 million. b. We now owe £3.4 billion. Given that it must be paid in 3 months, the amount will show up as an increase in current liabilities of £3.4 billion. c. Non -current assets will increase by £3.5 billion. 10. The payment of £1,200,000 in twelve months is less because the cash flow is a fter the majority of £100,000 monthly payments. An example can show the intuition behind this. Assume the monthly interest rate is 1 per cent (it can be anything as long as it is above 0 per cent). The present value of cash flows is thus: Annuity PV(CF) One PV(CF) Payment 1 £100,000 £99,009.9 0 2 £100,000 £98,029.6 0 3 £100,000 £97,059.01 4 £100,000 £96,098.03 5 £100,000 £95,146.57 6 £100,000 £94,204.52 7 £100,000 £93,271.81 8 £100,000 £92,348.32 9 £100,000 £91,433.98 10 £100,000 £90,528.7 0 11 £100,000 £89,632.37 12 £100,000 £88,744.92 £1,200,000 £1,064,939.07 PV £1,125,508 PV £1,064,939.07 11. You would choose the less risky project because both have the same expected value. In this case you would choose Project B, because the risk of losing and gaining money is less than in Project A. 12. Corporate social responsibility (CSR) is concerned with companies acting in a socially responsible manner with respect to the products they sell, the method of production, the firm’s relationship with local communities, and the firm’s relationship with its staff. Although some argue CSR is a waste of managerial time and investment in CSR should only occur if it generates a return greater than an alternative project, others b elieve CSR can become part of a company’s overall competitive advantage since it can strengthen its relationshi ps with important stakeholders. 13. There is no right or wrong answer to this question. However, the student is expected to discuss the pros & cons to a company of investing in CSR, and may back -up their answers with reference to empirical evidence. Pros could include a competitive edge gained by good PR, while cons could include the use of management time and company resources to non -core projects w ith very uncertain and subjective cash flow returns. 14. As the answer to question 6 suggests, the main reason firms choose different forms of financing relates to their cost. The financial manager should choose the funding flow that is cheapest and less ri sky. When firms are small, they are not able to list on stock exchanges and therefore they will only have access to private investment, be it a bank or a private investor. As they get bigger, stock exchanges become a viable option for funding and hence it can also be used. 15. Cash is a double -edged sword. Whereas a firm needs a minimum level cash to pay for bills, expenses, creditors, etc., having too much cash could tell investors that the firm is not investing in profitable new projects. Some questions will be asked to the management: a) Why are you not investing the money? B) Why are you not giv ing the cash back to shareholders? C) Are you wasting the cash in activities that are not value - maximizing ? Many companies that have lots of cash are targeted by other firms because there is a concern that the management of the cash -rich firm is not creating value. As a financial manager, you must have a very strong plan for why you are keeping cash and for what it is going to be used. 16. As a financ ial manager, the need to balance between the short and long term objectives of the firm is important. When the company is in trouble, the financial manager should manage financial planning to enhance short term liquidity to meet the firm’s obligations. The refore, in this case the objective of the firm will change from maximizing shareholders’ wealth to firm survival and bankruptcy avoidance. However, other options such as asset sell -off can also be undertaken in order to pay creditors. This is consistent with maximizing firm value over the longer term if the manager can ensure that the firm survives. 17. Socially responsible investment (SRI) involves the consideration of ethical, social, and environmental factors in investment selection. While some believe that investments inspired by ethical or moral belief lack focus on profit maximizing , others argue that at the margin the addition of non -financial benefits may persuade an investor or fund manager to opt for the ethical fund. Empirically, ethical funds do not significantly outperform non -ethical funds. Nevertheless, the SRI market is continuing to grow at a rapid rate. 18. It is true. The benefit of this question is that the student learns an important empirical observation without having to delve too much into d etail. Similarly, the more advanced student may be encouraged to do their own reading to find out more. 19. The main financial goal of any company must be to increase shareholder value, not profit. Profit is an accounting measure that reflects a notional leve l of business performance in the past. It includes non -cash allowances to account for depreciation in value of many large assets such as property, machinery, automobiles, etc. It also includes allowances for bills that have been received but not paid yet. Finally, it records sales as at the point of sale even though no cash has changed hands. Although accounting data is exceptionally important, for making financial decisions it should be secondary to cash flow information. 20. The objective of the firm will re main the same, which is to maximize the market value of existing owners’ equity. Principally , the goal does not change whether the company is private or public since good financial decisions increase the mar ket value of the owners’ equity and poor financia l decisions decrease it . 21. The manager can argue on the basis of cost implication s, since redundancy packages may be expensive. In addition, there could also be lawsuits, union activity all having a negative effect on firm image. Furthermore, redundancies may adversely affect the production process which will not only affect the firm’s sales but also its loyal customers. Instead the new owners can identify other cost centres where cost savings can be made. 22. a. Adding cost of living to retired employees will increase the cost to the company of the pension liability. This would reduce profitability and earnings per share. However, the cost of living adjustment may ensure that the workers value the company more and in turn become more productive. b. As long as the return on the additional investment is greater than the return that the company currently makes on its operations, the decision is a good one. c. Research and development investment is important in any new project. However, these expenditures tend to be high at the beginning and it is not certain whether the firm will reap any benefits from the investment. Research has shown that countries with high levels of technological innovation are likely to experience higher economic growth and so in general the benefits from R&D will be positive. The specificity of the R&D investment is also important. d. Redundancies will reduce costs although their nega tive impact can be many -fold. For example, the company may have to deal with unions, strikes, and exceptionally poor publicity. 23. Dealer s market are those markets where firms make continuous quotations of prices for which they stand ready to buy and sell money market instruments on their own inventory and at their own risk . Agency markets are those in which stockbrokers act as agents for customer s in buying or selling shares on most stock exchanges; an agent does not actually acquire the securities. A well -functioning financial system will utilize both systems. 24. A cut in costs will increase profit in the statement of earnings/income. This is because expenses will decrease. The additional profit would appear in the statement of financial position or balance sheet as an increase in equity or retained earnings. 25. The founders assigned to themselves the shares that gave them more rights so that they effectively control the company. A drawback is that dual class shares create an inferior class of shareholders. 26. We go into Financial Statement Analysis in a lot more detail in Chapter 3. In this question, we will look at the statements of ABB Ltd in a very basic way. The main insight is that the firm has accumulated a lot of assets in relation to its liabilities. The re is also a significant increase in current liabilities in relation to long -term liabilities. However, the level of current assets has increased at the same level. Investigation would be required to determine what is actually driving the increase in curre nt liabilities. 2010 (SFr millions) 2009 (SFr millions) 2008 (SFr millions) 2007 (SFr millions) 2006 (SFr millions) Current Assets 18,327 18,241 17,523 16,734 12,692 Non -Current Assets 7,915 6,868 6,344 5,680 5,485 Total Assets 26,24 2 25,10 9 23,867 22,414 18,17 7 Current Liabilities 12,102 10,541 11,499 10,468 9,027 Non -Current Liabilities 3,378 4,598 4,301 4,02 4 4,78 5 Total Liabilities 15,480 15,139 15,800 14,492 13,812 Total Equity 10,762 9,970 8,067 7,922 4,365 Total Liabilities plus Equity 26,242 25,109 23,867 22,414 18,177 Total Assets/Total Liabilities 1.6952 20 1.658564 1.51057 1.546646 1.31603 Total Current Assets/Total Non - Current Assets 2.315477 2.655941 2.762137 2.946127 2.313947 Total Current Liabilities/Total Non - Current Liabilities 3.582593 2.292518 2.673564 2.601392 1.886520 Total Current Assets/Total Current Liabilities 1.514378 1.730481 1.523872 1.598586 1.406004 27. The net investment is Sfr500 million and this could be funded by an issue of equity or debt. 28. Several things could happen to ABB’s statement of financial position and is determined by how we treat the Sfr500 million payment. In the first instance (2011), total non - current assets and non -current liabilities will increase by Sfr500 million. In 2013, the Sfr500 million will be paid off meaning that non -current liabilities will decrease by Sfr500 million as will current assets. The statement of financial position looks like this for 20 11 and 20 13: 2011 (SFr millions) 2013 (SFr millions) Current Assets 18,327 17,827 Non -Current Assets 8,415 8,415 Total Assets 26,742 26,242 Current Liabilities 12,102 12,102 Non -Current Liabilities 3,878 3,378 Total Liabilities 15,980 15,480 Total Equity 10,762 10,762 Total Liabilities plus Equity 26,742 26,242 29. An analysis of ABB non-current liabilities /equity ratios show that they have been decreasing year on year from 1.10 (2006) to 0.31 in 2010. Assume that the desired non- current liabilities /equity ratio is 0.31. This would mean that 0.31 or Sfr157 million of the Sfr500 million investment would be fu nded by debt and Sfr343 million would be funded by equity. In this situation the statement of financial position would be: 2011 (SFr millions) Current Assets 18,327 Non -Current Assets 8,415 Total Assets 26,742 Current Liabilities 12,102 Non -Current Liabilities 3,535 Total Liabilities 15,637 Total Equity 11,105 Total Liabilities plus Equity 26,742 30. Yes. The main theme of UK and Germany regulation is similar which is on addressing investor protection and protection of quality of the information that market participants receive. The later will ensure that investors are informed before making decisions and enhance confidence which is cruci al element for any well -functioning financial market. 31. The balance sheet model of Merck for 2010 and 2011 is given below: 2010 Assets € million Liabilities € million Current Assets 5,664.20 Current Liabilities 3,359.60 Non -Current Assets 16,723.80 Non -Current Liabilities 8,656.60 Shareholder Equity 10,371.80 Total Assets 22,388.00 Total Liability & Shareholders’ Equity 22,388.00 Net Working Capital 2,304.60 2011 Assets €million Liabilities €million Current Assets 6,397.2 Current Liabilities 4,362.20 Non -Current Assets 15,722.90 Non -Current Liabilities 7,264.50 Shareholder Equity 10,493.40 Total Assets 22,120.10 Total Liability & Shareholders’ Equity 22,120.10 Net Working Capital 2,035.00 The company has stayed rather stable between the two years. Total assets are similar. However, a closer look shows that there has been a shift from non -current assets and liabilities to shorter term current assets and liabili ties. Current liabilities have increased by more than current assets and so net working capital has fallen. 32. Student s should be encouraged to explore potential scenarios and solutions. There are, of course, many solutions to the YPF problem and no single solution dominates all others. The purpose of this question is to get students to put themselves in the shoes of a financial manager to understand that corporate finance is not mechanistic but inherently risky. 33. There is no one correct way to struct ure a stock exchange system and the exact structure is endogenously determined by the participants and liquidity of the exchange. The London Stock Exchange attempts to cover all bases by capturing the liquidity provided by dealers for small illiquid compan ies and the liquidity provided by public traders on the electronic order book for large high volume companies. 34. This is another question that gets students to undertake their own research. Instructors should give every encouragement to creative choices of companies. CHAPTER 2 CORPORATE GOVERNANCE 1. A sole proprietorship is a business owned by one person, a partnership is a business with shareholder -managers called partners. Most partners will have unlimited liability although some partners will have limited liability. A corporation is a business with limited liability shareholders who do not normally manage the firm. The weaknesses and strengths of each business form are as follows: Corporation Partnership Liquidity and marketability Shares can be exchanged without termination of the corporation. Shares can be listed on a stock exchange. Shares are subject to substantial restrictions on transferability. There is usually no established trading market for partnership shares . Voting rights In single -tier board structures, usually each share of equity entitles the holder to one vote per share on matters requiring a vote and on the election of the directors. Directors determine top management. Some voting rights by limited partners. However, general part ners have exclusive control and management of operations. Taxation Corporations may have double taxation: Corporate income is taxable, and dividends to shareholders are also taxable. Each country has its own approach to how it deals with double taxation and may give a full or partial rebate on the corporate tax payment . Partnerships are not taxable. Partners pay personal taxes on partnership profits. Reinvestment and dividend payout Corporations have broad latitude on dividend payout decisions. Partnerships are generally prohibited from reinvesting partnership profits. All profits are distributed to partners. Liability Shareholders are not personally liable for obligations of the corporation. Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability. Continuity of existence Corporations may have a perpetual life. Partnerships have limited life. Sole proprietorships have roughly the same weaknesses and strengths as partnerships primarily because shareholders are normally managers and have unlimited liability. 2. Clearly the bidder thinks that the £3 .50 is money well spent and that your firm has untapped value that the market does not ap preciate. Managers have many agendas, including job safety. However, it is also possible that they do not believe that the bidding company will be good for the company over the longer term. 3. As firms become more complex, the agreements between shareholders and operational considerations necessarily become more complex and problematic. Clearly, since a sole proprietorship has only one owner, there is no need for an agreement between shareholders. The big difference between partnerships and corpor ations is the separation of ownership and control. Since partners also tend to manage a partnership, there are less governance problems to deal with. This is not the case in corporations. 4. The ability of corporate executives to trade the shares of their ow n company impinges upon several principles. Principle 1 is affected because it deals with regulation and the fairness of the governance system. Principle 2 is clearly involved because the trading of shares involves shareholders and their rights. Principle 3 is important because corporate executives who are also shareholders will have more information about the firm than other outside shareholders. Corporate insider trading affects principle 5 because the insider transactions should be promptly disclosed to outside stakeholders. Corporate executives are on the board of directors and this is covered under principle 6. 5. Regulators around the world reviewed corporate governance principles following the financial crisis from 2007 – 2009. In the UK this resulted in the UK Stewardship Code (2012), which provided guidance for long term shareholders and differentiate them from short term traders. The Code covers 7 principles which calls on institutional investors to disclose how they will enact corporate gov ernance change and scrutinize company conduct. It is hard to say which is the most important or whether the Code has weaknesses as all the principles have value, and the Code itself addresses a prior weakness of UK corporate, which traditionally emphasize d the value of a corporate dialogue between institutional shareholders and companies. The Code builds on this by setting out a good practice of engagement that all institutional shareholders can aspire to. However, only time will tell whether the Code has been effective and encouraged institutional engagement. 6. A limited company can either be public or private. The main similarities are: • investor l iability is limited to the amount of money he or she has invested. • a company is a separate legal person /entity • shares can be transferred without affecting the existence of the company • main goal is to create value to the equity owners The differences between private and public companies are: • Public corporations are permitted to offer shares for sale or advertise to the public. • Public corporations require minimum share capital to be issued and allotted in order to carry out business • Public corporations are subject to rigorous regulatory requirements • In private companies directors are more likely to be maj or shareholders. A good example of a private corporation is a family firm. In public firms, directors are less likely to be major shareholders. • In public corporations, the shareholders and managers are likely to be two distinct groups. That is, there will be some separation of ownership of the firm and control of the firm. In private corporations, this is significantly less likely to be the case. Public listing is not necessarily an optimal situation for a firm to be in. The costs of listing on an exchange are potentially higher than other forms of financing. In addition, many emerging market countries do not have enough public investment capital to fund lots of publicly listed firms. This is borne out by the small number of public companies that are listed in emerging markets. 7. Corporate behaviour in bank -based financial systems would be different from market - based financial systems because of the nature of financing between the two financial systems. In a bank based financial system, companies will strive to meet the requirements set out by their chief financiers, which are banks. Banks, as a major source of funding, will influence corporate risk taking behaviour and encourage longer investment horizons. On the other hand, corporations in market base d environment must satisfy the needs of the investing public, who naturally focus on share price performance. 8. Corporate governance is important to the shareholders of a firm because of different interests between shareholders and management in principal -agent relationship . Corporate governance aligns the interest of these parties, and other group s/ stakeholders. Corporate governance is not a one -shoe -fits-all concept. Firms have different corporate governance requirements based on their sizes, forms, cul tures, and complexities. Imposing the same governance structures on all firms would hinder growth and the risk - taking opportunities that determine the return to the shareholders. 9. Corporate governance structures are required to manage conflicts of interest at all times. Subcommittees are essential in furthering this objective. If remuneration, for example, were set by the Board of Directors, there is a built -in bias to overpay the executives of the company and waste shareholders’ money. Thus, it sho uld be set by a committee which is independent of the Board and can take a balanced and unbiased view to determining the appropriate level of pay. 10. American model: • Rules based approach, with company law based on common law • Governance regulated by legal st ature and mandatory rules which are inherently inflexible • Basic governance model is a unitary board • CEO and Chairman often the same person • Predominance of independent Directors • SEC and listing requirements call for mandatory audit, nomination, and remunera tion committees • Shareholders tend to have more influence over corporate affairs UK / Commonwealth model: • British model influenced many countries of the Commonwealth • Principles based approach, with Codes of good practice determining corporate governance procedures, not the law • Company law based on common law • ‘Comply or explain’ principle in the UK, which is respected internationally • Role of regulator is to ensure investors have accurate information on which to base their decisions • Unitary boar ds a common feature • All codes in the Commonwealth, although slightly different in detail, call for independent NEDs, audit, nomination, and remuneration committees, and the separation of the roles of the CEO and Chairman • Shareholders tend to have more inf luence over corporate affairs Continental Europe model: • Company law based on civil law • Two tier boards a common feature • Banks and other creditors have a greater influence over corporate affairs • Corporate governance practices tend to have a social component, consistent with the social contract found in many European countries • Critici zed for lacking independent Directors Japanese model: • Reflects the social cohesion within Japanese society • The Japanese attitude towards corporate governance stems from 3 concepts: obligation, family, and consensus • Company law based on civil law • Board of Directors tends to be very large • Corporate governance code emphases the view that stakeholder welfare should be part of a company’s strategic objectives • However, when the Japanese economy faced stagnation in the 1990s its stakeholder -oriented approach to corporate governance was questioned. Company laws have since developed to reflect a more US -type approach, with more emphasizes placed on the needs of shareholders Asian model: • Family based model • Company law based on civil law • Boards tend to play a supportive role to the real exercise of power, through developing relationships between key players • Many companies in Asia are in the hands of Chinese firms • International acco unting standards converging Forces for convergence among different countries: • Codes published by international bodies such as the OECD • Globali zation , as firms have operations in many countries • International institutional investors often demand various corp orate governance practices Forces for divergence among countries: • Legal differences in company law • Stock market differences such as ownership concentration • Cultural differences • Standards in the legal process 11. Supervisory boards, like the Sharia board, can be of use when the objectives of a firm are tied to social, environmental or ethical issues. The purpose of such a board is to guide executives in making the correct decisions with respect to the company’s remit. An example of a supervisory boar d that may work in a separate area is that of football teams. In this situation, the supervisory board would consist of fan representatives and they would guide the executive board on football decisions. Other areas include firms where public oversight is required, such as the banking sector. 12. In a general partnership all partners agree to provide some fraction of the work and cash and to share the profits and losses. Each partner is liable for all of the debts of the partnership. A partnership agreement sp ecifies the nature of the arrangement. Limited part nerships permit some of the partners to have limited liability and who are legally liable only to the amount of cash each has contributed to the partnership. Limited partnerships usually require that (1) at least one partner be a general partner and (2) the limited partners do not participate in managing the business. Firms choose to be partnerships instead of limited liability corporations because it is inexpensive and easy to set up a partnership ra ther setting up a limited liability corporation. 13. Although a sole proprietorship is the cheapest to set up , it has disadvantages such as a limited ability to raise funds, a limited life , and unlimited liability. The sole proprietor may reduce these proble ms by forming a partnership. Other partners are expected to bring in extra cash to finance business activities , and the scope of the firm can be widened. However, a partnership does not resolve all the problems such as transferability of ownership, unlimit ed liability and the ability to raise money from the public. In order to remove these hurdles a partner ship may convert to a limited corporation . 14. The student should give a brief outline of each UK code based on lecture notes and/or personal readings. A di agram may be used to illustrate the evolution of the Codes. The main ones are: • Cadbury 1992 • Greenbury 1995 • Hampel 1998 • Combined Code 1998 • Turnbull 1999 • Myners 2001 • Higgs 2003 • Smith 2003 • Tyson 2008 • Walker Review 2009 15. Yes, it is possible to improve one governance principle and weaken another. For example, Principle II ( 2004 OECD Principles of Corporate Governance ) encourages firms to ensure that the rights of shareholders are maintained and promoted. However, that may weaken the rights of other stakehold ers (Principle IV -2004 OECD Principles of Corporate Governance ) such as employees and communities. Many examples can be given here and lecturers should encourage students to come up with their own solutions. 16. Bank -based systems: • Banks are central are cen tral to the funding of companies and so may well be able to exercise some control via the board structure • On the one hand, banks can acquire information about the firm and can thus improve capital allocation and overall corporate governance. This can impro ve investment efficiency and add to overall economic growth • Banks can also develop long term relationships with firms and add strategic value Market -based systems: • Financial markets are the main intermediary • Can enhance risk management and corporate control since market -based economies offer more sophisticated, flexible, and tailor -made risk management solutions • Requires external market discipline Common vs Civil law: • Common law is developed through court rulings and is based on precedents. It is more flexible and can adjust quickly to events. Corporate governance procedures can therefore react and change more quickly • Civil law is developed through regulations and codes of laws and is therefore less flexible • Common law often provides better c reditor protection • However, civil law can provide better protection for minority shareholders 17. Students should take most of their answer from section 2.4, which goes into the OECD principles in a lot of detail. They should also be encouraged to develop their own ideas as to the most important principle and come up with their own examples. 18. Students should consider the different principles of corporate governance that are discussed in Section 2.4 and reflect on the main issues pertaining to a poor country. In these environments, governance at the government level is just as (and even more) important as governance in corporations. As such, Principle I is likely to be of most importance in the first instance. 19. The Audit committee is one of the sub -committees of the Board of Directors and will normally report to it. It is responsible for overs ight of fin ancial reporting disclosure , regulatory compliance, and risk management . Members of the committee are drawn from members of the company's board of directors. The c hairperson of the committee is also elected from among the members. The duties of an a udit committee include: a. Oversee and promote risk management . b. Ensure appropriate audit work is undertaken and of high quality . c. Review internal and external audit reports . d. Review corporate governance statements . e. Report to the governing body. Students are ex pected to come up with their own examples of flawed audit processes. Recent years have provided many good examples! 20. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, w ho in turn appoint the firm’s management. An agency relationship occurs whenever the owner of wealth (the principal) contracts with someone else (the agent) to manage his or her affairs . This separation of ownership from control in the corporate form of or ganization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. 21. We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of equity in the United Kingdom and the growing activism of these large shareholder groups may lead to a r eduction in agency problems for U.K. corporations and a more efficient market for corporate control. 22. Governments have different objectives to shareholders. Whereas shareholders wish to maximize the value of their own investment, governments are more conce rned with maximizing social welfare. This can sometimes contradict that of shareholders. For example, several governments purchased the shares of financially stricken banks in 2008. Shortly afterwards, they put pressure on the banks to lend to smaller comp anies and give mortgages, even though the banks themselves felt that the lending decisions were not value maximizing . In terms of receiving a good return for taxpayers, the government may not be pursuing the best policy. In the case of RBS, for example, wh ich was the world’s largest bank by assets at the time of its bailout by the UK government, a shrinking of operations and a transformation from a multinational to domestically focused bank will lead to a fall in its share price. While such a policy may be optimal for social welfare, it will likely lead to the bank being re -privatized at a discounted price relative to the government’s average buy -in price. 23. A stakeholder is any party which has an interest in the operations of the company, either directly or indirectly. Examples include shareholders, employees, creditors, customers, suppliers, normal citizens, etc. In a two tier board system, the board structure is divided into two parts consisting of the supervisory and executive board. The supervisory boar d is composed of outside shareholders and other stakeholders, such as employee groups (trade unions) and banks (capital providers). A good example of a supervisory board is DaimlerChrysler AG , which was comprise d of 20 members - half of which were elected by shareholders at the Annual Meeting. The ot her half comprises members elected by the company’s employees who work in Germany (Annual report, 2008). The supervisory board can hire or fire any member of the executive board. The latter is composed of execut ive directors who direct the day to day operations of the firm. In a unitary board, the executive and non -executive directors sit on the same board and it is very rare for stakeholders such as employees to be represented. 24. Institutional shareholders are in creasingly becoming instrumental in demanding good corporate governance in companies in which they invest, (e.g. NAPF in UK and C alPERS in US). The main reason why institutions are important in corporate governance is because they are normally the largest shareholders in the firm. As representatives of their investee base, they should take the role of owners in monitoring firms. With respect to country specific regulations, the student should review their own countries corporate governance code and take a view on the effectiveness of the code. 25. In agency theory, the underlying contract between the principal (shareholders) and agent (management) is based in maximising the principal’s wealth. One aspect of corporate governance is to align the interests of managers and shareholders. Given that bondholders’ interests may not be fully convergent with shareholder interests, bondholders protect their interests through bond indentures that restrict the activities of management. We would expect managers to pu rsue the objectives of shareholders only if their interests are the same as that of the shareholders. This can be done through appropriate executive compensation contracts. In most situations, the shareholder and bondholder objectives will be the same. How ever, when a firm is in financial distress, these may differ and then shareholder objectives will naturally take precedence. This is why we have bond indentures. 26. The student would be expected to carry out this research themselves. 27. The board is a supreme body that represents shareholders’ interest within the company. It sets strategies and the direction of the company. An effective board is more likely to influence major decisions which enhance shareholders value. In evaluating board performance, t he following issues should be taken into account; board attendance, independence of board members, contribution of each member, ability of members to work as a team etc. Boards provide long term strategic direction of the company which can influence its l ong term well -being. Hiring an independent and objective consultant can give confidence to the shareholders that the board is performing efficiently and making the right decisions. 28. As managers build up their shareholdings, they become more like equity holders. This effect will grow in strength as managers’ shareholdings get larger. At moderate levels of shareholdings, managers will have a significant stake in the company but can also make more money or power out of extracting wealth from the company throug h the purchase of executive jets, company cars, excessive administrative support and other wealth destroying behaviour. When this happens, we say that managers are entrenched. Examples are in abundance for managerial entrenchment in corporations and it is up to the student to find these in their own research activities. 29. How much is too much? The simplest answer is that there is a market for executives just as there is for all types of labour. Executive compensation is the price that clears the market. • Financial crisis partly caused by excessive risk taking, which some argue is due to excessive pay (e.g. large bonuses for corporate takeovers in the case of RBS). Capping bonus pay may therefore remove the incentive to take unnecess ary risks • Addresses politic al concern of inequality Arguments against bank bonus cap: • May encourage top executives to move elsewhere (e.g. to the US) • Weakening the link between pay and performance may also remove the incentive to innovate and improve shareholder value • To compensate for capped bonuses, Boards may increase bankers’ fixed salaries so that overall remuneration is unchanged. However, this could make banks more vulnerable in a business downturn since fixed pay is harder to reduce than bonus pay. 30. State sharehold ers have different objectives to private companies. Whereas private firms have an overriding objective to earn profits for their shareholders, the government tends to have political objectives such as maximizing social welfare. These can conflict when the government wishes to develop infrastructure that is not necessarily consistent with maximizing shareholder value. In the YPF case, the Argentinian government surprised the shareholders by nationalizing the firm suddenly. Only time will tell how this affect s the shareholders of the firm. CHAPTER 3 FINANCIAL STATEMENT ANALYSIS AND LONG TERM PLANNING 1. This question requires students to do some reading beyond their textbook, but is important as it gives students a more in -depth understanding of how to analyse financial statements. a) Window dressing refers to the actions taken by a company to approve the appearance of their financial statements. b) 3 of the most common techniques (others could be accepted): - Withhold expenses so they are recorded at a later date - Accelerate revenues through ‘improved’ revenue recognition rules - Creation of a ‘cookie -jar’, such as through the estimation of bad debt write - offs or future pension plans. If these turn out to be lower than expected, management has financial slack they can tap in to if they want to create an earnings boost. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially comple te, not necessarily wh en the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 2. a) The book value of an asset is its original purchase cost, adjusted for any subsequent changes, such as for impairment or depreciation. Market value is the price that could be obtained by selling an asset on a competitive, open market, and is determined by prevailing supply & demand conditions. b) Market values can never be negative. Imagine a share of equity selling for –£20. This would mean that if you placed an order for 100 shares, you would get the shares along with a cheque for £2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 3. Negative operating cash flow is not n ecessarily a bad sign if the company is a start -up, or if the cash flow deficit is negative (e.g. the company has used up its cash resources to finance an acquisition or invest in a new project. If negative cash flow is chronic (i.e. permanent) then this i s likely to be the result of underlying weaknesses such as low revenues or high costs. 4. Time trend analysis gives a picture of changes in the company’s financial situation over time. Comparing a firm to itself over time allows the financial manager to eval uate whether some aspects of the firm’s operations, finances, or investment activities have changed. Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industr y or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate ac tions to take to adjust these ratios if appropriate. Both allow an investigation into what is different about a company from a financial perspective, but neither method gives an indication of whether the difference is positive or negative. For example, sup pose a company’s current ratio is increasing over time. It could mean that the company had been facing liquidity problems in the past and is rectifying those problems, or it could mean the company has become less efficient in managing its current accounts. Similar arguments could be made for a peer group comparison. A company with a current ratio lower than its peers could be more efficient at managing its current accounts, or it could be facing liquidity problems. Neither analysis method tells us whether a ratio is good nor bad, both simply show that something is different, and tells us where to look. 5. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its ope rations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 6. ROA measures the company’s return on i ts assets, whereas ROE measures the company’s return on its equity. ROE is therefore a better measure of the company’s performance , since the goal of a company is to maximize shareholder wealth, and this ratio shows the company’s performance in achieving t his goal over the period. 7. a. Building Statement of Financial Position : AEB Systems plc Statement of Financial Position 01-Jun-15 Assets Liabilities & Owners' Equity £ in billion £ in billion Current assets 6.642 Current liabilities 11.283 Non-current assets 16.521 Non-current liabilities 6.589 Owners' equity x 23.163 23.163 Owners' equity £5.291 billion b. Building NWC statement: £ in billion Current assets 6.642 Current liabilities 11.283 Net working capital -4.641 8. a. Wheeler & Fox Income Statement 31-Dec-15 (£ in million ) Sales 38,440 Total operating costs -37,133 Gross Profit 1,307 Tax -487 Net Income 820 b. Wheeler & Fox Statement of Retained Earnings 31-Dec-15 (£ in million) Net income 820 Dividend -238 Addition to retained earnings 582 9. P/E = 6.35; Share Price = SKr71 .70; EPS = 71.70/6.35 = SKr11 .29 10. Market Values and Book Values Statement of Financial Position Before Sale (€ in Million) After Sale (€ in Million) Non -Current Assets 4 0.8 Net Working Capital 0.9 4.1 Total Assets 4.9 4.9 Non -current liabilities 2.2 2.2 Equity 2.7 2.7 4.9 4.9 If the firm is following IFRS, the accounting value of the building should be the same as the market value. This is because buildings should be revalued on an annual basis. 11. a. Calculating taxes Herrera NV, Dutch firm Marginal tax rate Taxable income 0.20 0.235 0.255 € 273,000 € 25,000 € 35,000 € 213,000 5,000 8,225 54,315 Total tax € 67,540 b. Company’s average tax rate = Total tax amount/taxable income = (€ 67,540.00/ € 273,000.00) x 100 = 24.74% If Herrera NV made an additional euro, the tax on that euro would be 25.5 cents, so marginal tax rate is 25.5%. 12. Net Cash Flow Statement of Cash Flow £ million £million Net Revenues 6,065 Net Non -Cash Expenses 2,380 Interest expense 3,410 Cash Flow From Operating Activities 5,035 Cash Flow From Investing Activities -3,270 Dividends -1,380 Cash Flow From Financing Activities -1,380 Net Cash Flow 385 13. Calculating net capital spending Net capital spending = NCA end – NCA beg + Depreciation Morena's Driving School Year £ million Non -current assets 2015 4.2 Non -current assets 2016 4.7 Net non -current assets 0.5 14. The long -term debt account will increase by €16 million, the amount of the new long -term debt issue. Since the company sold €20 million new shares of equity with a €1 par value, Ordinary Share account will increase by €20 million. The capital surplus accou nt will increase by €32 million, the value of the new shares sold above its par value. Since the company had a net income of €14 million, and paid €8 million in dividends, the addition to retained earnings was €6 million, which will increase the accumulate d retained earnings account. So, the new long -term debt and shareholders’ equity portion of the balance sheet will be: Last Year Changes Current Year Long -term debt € 60,000,000 € 16,000,000 € 76,000,000 Preference shares 18,000,000 18,000,000 Ordinary shares (€1 par value) 25,000,000 20,000,000 45,000,000 Capital surplus 49,000,000 32,000,000 81,000,000 Accumulated retained earnings 89,000,000 6,000,000 95,000,000 € 241,000,000 € 315,000,000 15. This question requires that students undertake their own study. Given that the year of available accounts for Experian and First Group will change as the book ages, we have not provided a solution for this question. This is because the solution will change depending on the finan cial year of accounts the student is able to source. The equation that students should use is given below: Net income Sales AssetsROE = × × Sales Assets Total equity Return on assets = Profit margin × Total asset turnover × Equi ty multiplier 16. Since we have the ratio , D/TA , it is easy to calculate the ratio, E/TA (= 1 – D/TA). Since ROA is Net Income/TA, we calculate ROE as ROA/(E/TA) Firm A Firm B D/TA 0.7 0.3 ROA 0.2 0.3 E/TA 0.3 0.7 Return on Equity 0.666666667 0.428571429 Firm A has the biggest Return on Equity Add: Depreciation 0.925 Net capital spending 1.425 17. Ratios and foreign companies Profit margin = Net income/ sales =-£3.47 /£18.197 = -19.07 % a. The quotation in pounds sterling does not make any difference to a Spanish investor. This is bec ause if pounds are converted (translated) into euros at the prevailing exchange rate, the profit margin ratio remains the same. b. Calculation of exchange rate £/€ = £18.197 /€24.73 = £0.7358 /€1 -£3.47 /£0.7358 /€ = -€4.71 58 billion 18. The Cash Coverage Ratio is (EBIT + Depreciation)/Interest £ million Revenues 1,027 Costs 817 EBIT 210 Depreciation 12 EBIT + Depreciation 222 Interest Expense £29 Cash Coverage Ratio 7.66 19. Days’ Sales in Receivable This is a multi -step problem involving several ratios. It is often easier to look backward to determine where to start. We need receivables turnover to find days’ sales in receivables. To calculate receivables turnover, we need credit sales, and to find credit sales, we need total sales. Since we are given the profi t margin and net income, we can use these to calculate total sales as: PM = 0.086 = NI / Sales = €173,000 / Sales; Sales = €2,011,628 Credit sales are 75 per cent of total sales, so: