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Questions and Answers of Corporate Finance

What more could be done by boards of directors and shareholders to ensure that managers pursue long-term value creation?
Explain the conservation of value principle. What decisions might it affect?
How does return on invested capital (ROIC) affect a company’s cash flow? Explain the relationship between ROIC, growth, and cash flow.
How should a company decide which risks to hold and which to hedge?
How much cash flow risk should a company take on? How should it manage risks with extreme outcomes that could potentially bankrupt the company but are very unlikely to occur?
Which type of business, a software company or an electric utility, would benefit more from improving ROIC than from increasing growth? Why?
Why does organic growth often create more value than growth from acquisitions? Describe how different types of organic growth might create different amounts of value.
What is the conservation of value principle? Provide some examples of where it might apply.
What is financial engineering? When does it create value?
Apply the conservation of value principle to acquisitions.
What is the total returns to shareholders (TRS) figure and why is it important?
Given that TRS is not a clean measure of management performance and is therefore a flawed basis for management compensation, how should a company gauge management performance? What measures should it
What is the expectations treadmill and how does it affect managers’ ability to deliver above-average TRS over long periods of time?
What are the potential reasons why TRS over short periods of time may not reflect the actual performance of a company and its management?
What actions (good and bad) might managers take when investors have already-high expectations and managers desire to outperform peers on TRS?
If a company performs perfectly in line with expectations, how will its TRS react in theory? How will its TRS react in practice? Why?
Why is the old way of decomposing TRS (into changes in earnings, changes in P/E, and dividend yield) not the best way to understand a company’s performance?
From a value-creation perspective, is it more important for a company to know where to compete or how to compete? That is, is it more important to play in the right markets or to be the best player
Identify and discuss real examples of companies with a competitive advantage based on customer lock-in as opposed to product innovation. Which do you expect to sustain a high ROIC for a longer time?
Why do companies operating within the pharmaceutical and biotechnology industries typically sustain higher ROICs than firms in the technology, hardware, and equipment industries?
Why are competitive advantages based on brands, as in the consumer goods industry, often more important for long-term value creation than advantages based on product quality or innovation?
Explain the difference between ROICs excluding and ROICs including goodwill for U.S. companies: what does this difference imply and why has it increased so much over the past decade?
Discuss why, within the broader health care sector, ROIC can be declining for health-care facility companies but increasing for health-care equipment companies.
Discuss the three generic sources of a company’s growth, their relative importance for its growth, and what this means for a company’s strategy.
For which type of company is additional growth likely to create more value: a high-ROIC company in a mature market or a low-ROIC company in a fast-growing market? Give reasons for your answer.
Why could growth through a series of bolt-on acquisitions create more value than growth through a single large acquisition? (Consider premium paid and synergies created for each individual
Identify and discuss an example where growth in market share through a price war created long-term value for a company.
Why do company growth rates typically converge much more quickly toward the average rate across all companies than their rates of ROIC, given that both ultimately depend on the underlying product
Discuss why the ranking of industries by growth varies more over time than their ranking by ROIC.
If growth fromgaining market share through product promotion and pricing rarely creates much value, why do most consumer goods companies put so much effort into it?
Exhibit 6.18 presents the income statement and reorganized balance sheet for BrandCo, an $800 million consumer products company. Using the methodology outlined in Exhibit 6.5, determine NOPLAT for
BrandCo currently has 50 million shares outstanding. If BrandCo’s shares are trading at $19.16 per share, what is the company’s market capitalization (value of equity)? Assuming the market value
Using free cash flow computed in Question 1 and the weighted average cost of capital computed in Question 2, estimate BrandCo’s enterprise value using the growing-perpetuity formula. Assume
Assuming the market value of debt equals today’s book value of debt, what is the intrinsic equity value for BrandCo? What is the intrinsic value per share? Does it differ from the share price used
What are the three components required to calculate economic profit? Determine BrandCo’s economic profit in year 1.
Using economic profit calculated in Question 5 and the weighted average cost of capital computed in Question 2, value BrandCo using the economicprofit- based key value driver model. Does the
Using the methodology outlined in Exhibit 6.16, determine equity cash flow for year 1. Use the growing-perpetuity formula (based on equity cash flow) to compute BrandCo’s equity value. Assume the
Exhibit 7.15 presents the income statement and balance sheet for Companies A, B, and C. Compute each company’s return on assets, return on equity, and return on invested capital. Based on the
Why does the return on assets differ between Company A and Company B? Why do companies with equity investments tend to have a lower return on assets than companies with only core operations?
Why does the return on equity differ between Company A and Company C? Is this difference attributable to operating performance? Does return on assets best reflect operating performance? If not, which
Exhibit 7.16 presents the income statement and balance sheet for HealthCo,a $665 million health care company. Compute NOPLAT, average invested capital, and ROIC. Assume an operating tax rate of 25
Using the reorganized financial statements created in Question 4, what is the free cash flow for HealthCo in the current year?
You decide to look closer at HealthCo’s current-year tax reconciliation footnote. The table reports $35 million in statutory taxes, a $5 million credit for manufacturing investments, and a one-time
Many companies hold significant amounts of excess cash, that is, cash above the amount required for day-to-day operations. Does including excess cash as part of invested capital distort the ROIC
JetCo is a manufacturer of high-speed aircraft. The company generates $100 million in operating profit on $600 million of revenue and $800 million of invested capital. JetCo’s primary competitor,
Using the data presented in Question 1, decompose ROIC into operating margin and capital turnover for each company. Which ratio is the key determinant of ROIC: operating margin or capital turnover?
DefenseCo announces a purchase of Gulf Aviation for $1.1 billion in cash. Consequently, Gulf Aviation’s invested capital with goodwill and acquired intangibles rises from $600 million to $1.1
Gulf Aviation generates $800 million in revenue per year, with no material growth. The consolidated revenues for DefenseCo are $1.5 billion in year1, $1.8 billion in year 2 (the year of the
Using an Internet search tool, locate Procter & Gamble's investor relations web site. Under "Financial Reporting," you will find the company's 2009 annual report. In the annual report's section
Which interest coverage ratio, EBITDA to interest or EBITA to interest, will lead to a higher number? When is the EBITDA interest ratio more appropriate than the EBITA ratio? When is the EBITA
Using an Internet search tool, locate Procter & Gamble's investor relations web site. Under "Financial Reporting," you will find the company's 2009 annual report. In 2009, the company reported
Exhibit 9.14 presents the income statement and balance sheet for PartsCo, a$900 million supplier of machinery parts. Next year, the company is expected to grow revenues by 15 percent to $1,035
Using the methodology outlined in Exhibit 9.10, forecast the operating items on next year's balance sheet for PartsCo. Forecast each balance sheet item as a function of revenue, except inventory
Using the methodology outlined in Exhibit 9.12, forecast the financing items on next year's balance sheet for PartsCo. Assume long-term debt remainsat $215 million, no external equity is raised, and
The chief financial officer of PartsCo has asked you to rerun the forecast of the company's income statement and balance sheet at a growth rate of 5 percent. If the company generates more cash than
The Federal Reserve Bank of St. Louis provides extensive interest rate and economic data. Using an Internet search tool, find the web site: "St. Louis Fed: Economic Data-FRED." In the FRED database's
Exhibit 10.13 presents free cash flow and economic profit forecasts for ApparelCo, a $250 million company that produces men's clothing.ApparelCo is expected to grow revenues, operating profits, and
Since growth is stable for ApparelCo, you decide to start the continuing value with year 3 cash flows (i.e., cash flows in year 3 and beyond arepart of the continuing value). Using the key value
Using the economic profit formula, what is the continuing value for ApparelCo as of year 5? Using discounted economic profit, what is the value of operations for ApparelCo? What percentage of
Since growth is stable for ApparelCo, you decide to start the continuing value with year 3 economic profits (i.e., economic profits in year 3 and beyond are part of the continuing value). Using the
A colleague suggests that a 6 percent growth rate is too low for revenue, profit, and cash flow growth beyond year 5. He suggests raising growth to 12 percent in the continuing value. If NOPLAT
SuperiorCo earns a return on invested capital of 20 percent on its existing stores. Given intense competition for new stores sites, you believe new stores will only earn their cost of capital.
S˜ao Paolo Foods is a Brazilian producer of breads and other baked goods.Over the past year, profitability has been strong and the share price has risen from R$15 per share to R$25 per share. The
S˜ao Paolo Foods (introduced in Question 1) is considering a leveraged recapitalization of the company. Upon announcement, management expects the share price to rise by 10 percent. If the company
Your company, EuropeCo (a conglomerate of food, beverages, and consumer products), has announced its intention to purchase S˜ao Paolo Foods (introduced in Question 1). If the German risk-free rate
In 2009, the median price-to-earnings ratio for the S&P 500 was 11.1. If the long-run return on equity is 13.5 percent and the long-run growth in GDP is expected to be 6.7 percent (3.5 percent real
Market betas are typically computed with five years of monthly data or two weeks of yearly data. For computational simplicity, we present only 12 data points. Using a spreadsheet regression package
You are analyzing a distressed bond with one year to maturity. The bond has a face value of $100 and pays a coupon rate of 5 percent per year. The bond is currently trading at $80. What is the yield
MarineCo manufactures, markets, and distributes recreational motor boats.Using discounted free cash flow, you value the company's operations at $2,500 million. The company has a 20 percent stake in a
MarineCo has unfunded pension liabilities valued at $200 million, recorded as a long-term liability. MarineCo has detailed a potential legal judgment of$100 million for defective engines in its
To finance customer purchases, MarineCo recently started a customer financing unit. MarineCo's income statement and balance sheet are provided in Exhibit 12.8. Separate MarineCo's income statement
In Question 3, we computed ROE based on an equity calculation equal to the difference between finance receivables and debt related to those receivables.Why might this ROE measurement lead to a result
You are valuing a company using probability-weighted scenario analysis.You carefully model three scenarios, such that the resulting enterprise value equals $300 million in Scenario 1, $200 million in
You are valuing a technology company whose enterprise value is $800 million. The company has no debt, but considerable employee options (10 million in total). Based on option pricing models, you
You are valuing DistressCo, a company struggling to hold market share.The company currently generates $120 million in revenue, but its revenue is expected to shrink to $100 million next year. Cost of
You decide to value a steady-state company using probability-weighted scenario analysis. In Scenario 1, NOPLAT is expected to grow at 6 percent and ROIC equals 16 percent. In Scenario 2, NOPLAT is
A colleague recommends a shortcut to value the company in Question 2. Rather than compute each scenario separately, he recommends averaging each input, such that growth equals 4 percent and ROIC
Using an Internet search tool, locate Procter & Gamble's investor relations web site. Under "Financial Reporting," you will find the company's 2009 annual report. In the annual report's section
Using an Internet search tool, locate Procter & Gamble's investor relations web site. Under "Financial Reporting," you will find the company's 2009 annual report. In Note 11 of the 2009 annual
Exhibit 14.12 presents market and profit data for three companies. Using this data, compute enterprise-value-to-EBITDA and enterprise-valueto- EBITA for Companies 1 and 2. Is the net difference
Exhibit 14.12 presents market and profit data for three companies. If Company 3 has nonoperating assets valued at $50 million, what are thecompany's appropriate enterprise-value-to-EBITDA and
You are valuing multiple steady-state companies in the same industry.Company A is projected to earn $160 in EBITA, grow at 2 percent per year, and generate ROICs equal to 15 percent. Company B is
You are valuing multiple steady-state companies in the same industry. Company A is projected to earn $160 in EBITA, grow at 2 percent per year, and generate ROICs equal to 15 percent. Company C is
Two companies have the same long-term prospects concerning growth and ROIC. One of the companies temporarily stumbles during a new product launch, and profits drop considerably as the company
LeverCo is financed entirely by equity. The company generates operating profit equal to $80 million. LeverCo currently trades at an equity value of $900 million. At a tax rate of 25 percent, what is
Explain how long-term price-to-earnings ratios in the U.S. stock market of around 15 times are consistent with long-term expected stock returns of around 6 to 7 percent a year in real terms.
Analysis of stock market eras over the past 50 years shows that inflation was the single most important driver of total returns to shareholders (TRS) for the market as a whole. Discuss why inflation
Why are differences in companies’ value creation more apparent from comparing their market-value-to-capital multiples than their market-valueto- earnings multiples?
Discuss what pattern you would expect over time for market-value-tocapital and market-value-to-earnings multiples in an industry where earnings show little long-term growth but high cyclicality.
Assume a company’s price-to-earnings ratio varies randomly in the band of values between 12 and 18 over time. For simplicity, assume its earnings are stable for the next 10 years and no dividends
In many companies executive compensation is linked to the company’s annual TRS (or margin of TRS above its peers). Discuss pros and cons of using TRS as a basis for executive compensation.
Exhibit 15.1 shows how (cumulative) returns on investments in the equity market index have consistently exceeded returns on investments in government bonds over the past 200 years. This being the
Fundamentals explain less of the variation in TRS than in market-valuet-o- book-value or market-value-to-earnings ratios (as measured by the R2 shown in Exhibits 15.7 and 15.10). This holds true even
Many corporate executives focus on earnings per share (EPS) and attempt to manage reported earnings in order to meet analysts’ expectations. Can managers succeed in protecting the stock price of
Give an example of how to boost reported quarterly earnings by using accruals, and describe the implications for reported earnings in the next quarter. What is the risk involved in using accruals to
If a company’s value is not driven by its short-term earnings, why do investors spend so much time analyzing a company’s annual or even quarterly earnings announcements?
What risk does a company run once it starts to manage its earnings to meet analysts’ targets year after year?
Empirical research shows that goodwill impairments have no impact on a company’s share price. But these impairments do reflect an auditor’s best estimate of the value lost in an acquisition by
Explain how changing from last-in first-out (LIFO) to first-in first-out (FIFO) might lead to a change in a company’s intrinsic value in some countries but not in others.
As a rule, cross-listings for companies with a home listing in a mature capital market do not offer material benefits. Discuss how and why this might be different for companies based in emerging

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