Question 1

You are a financial manager that wants to know projected cash flows next year for decision-making purposes. Below is some financial statement information that is loosely based on Costco (symbol: COST) for the year ended August 30, 2015:

Income Statement (in millions $) Year Ended August 30, 2015

Sales Cost of Sales	116,200 101,100
Gross Income Selling, General, Administrative Expenses Depreciation Expenses	15,100 10,300 1,100
Operating Income (EBIT) Interest Expense	3,700 100
Pre-tax Income Tax	3,600 1,200
Net Income	2,400

Balance Sheet (in millions $) Year Ended August 30, 2015

Cash Net Receivables Inventory	6,400 2,000 8,900	Accounts Payable Short Term Debt Other Current Liabilities	12,300 1,300 3,000
Current Assets	17,300	Current Liabilities	16,600
Net Property, Plant, Equipment	16,100	Long Term Debt Other Long Term Liabilities	4,900 1,300
Total Assets	33,400	Total Liabilities	22,800
Total Stockholders? Equity	10,600
Total Liabilities and Equity	33,400

Assume the following: (1) net property, plant, and equipment for the year ended August 31, 2014 was $14,800 (in millions); (2) long-term debt for the year ended August 31, 2014 was $5,100 (in millions); (3) short-term debt and other long term liabilities will remain unchanged next year; (4) other current liabilities will be the same percentage of COGS in 2016 as it was in 2015.

1. a) Construct a pro-forma income statement for next year based on the assumption that sales will grow by 5.0 percent next year. Be clear about your work and assumptions.
2. b) Construct a pro-forma balance sheet for next year. Assume that the firm will buy another $2,000M in property, plant, and equipment. Also assume that a dividend of $3,000M will be paid out next year. If total assets are greater than total liabilities plus equity, correct this imbalance (i.e. the net funding need) by adding to long-term debt. If total assets are less than total liabilities plus equity, correct this imbalance by retiring long-term debt. Be clear about your work and assumptions and report how much you add to or subtract from long-term debt.
3. c) What is the projected free cash flow (FCF) for August 30, 2016? Use the following equation to solve for FCF: ???????????? = ???????????? ? ???????????????????? ? ?????????????, where ???????????? = ???????????? ???????????????????????? + ???????????????????????????????? + ????????????????????????????????????????????????. Make sure to show the individual numbers used in this equation. The free cash flows are the cash flows available for distribution to the firm?s investors (stockholders and bondholders).
4. d) The free cash flow is the cash available to pay out to your investors (i.e. your bondholders and stockholders). According to your pro-formas, how much do you plan to pay your investors in 2016 (this will be the sum of interest and dividend payments)? By how much does this exceed the free cash flow you calculated in part (c)?
5. e) Suppose that debt markets are not available to cover the net funding need calculated in part (b). Instead, you announce a reduction in capital expenditures in 2016 by this corresponding amount. The public believes this will reduce your long-term competitive position and thus revises its expectation of your long-term regular dividend growth rate downward. Specifically, the public originally thought the dividend growth rate was 3.5 percent, but because of this announcement, it now believes the growth rate is 3.0 percent. What is the change in the stock price of COST due to this announcement? Assume that the public values COST equity as a growing perpetuity with a $3B regular dividend payout next year. Also assume COST?s equity beta is 0.80, a risk-free rate of 3 percent, and a market risk premium of 6 percent. COST has 440M shares outstanding.

Question 2

Suppose you want to create a ?Butterfly Spread? option strategy based on COST call options. The butterfly spread will involve the following:

• ? Buying a call option with strike price $155
• ? Selling two call options with strike price $160
• ? Buying a call option with strike price $165 You want all of these options to have the same maturity of January 20, 2017.

1. a) Go to Yahoo! Finance and search for Costco (symbol: COST), then click on the ?Options? tab, then select ?January 20, 2017? in the dropdown box below the stock price to obtain a list of COST options with approximately three months to expiration. The ?Ask? price is the price at which you can buy an option while the ?Bid? price is the price at which you can sell an option. Report the bid and ask prices for each of the three call options described above. Also report the date, time, and stock price when you retrieved these options prices.
2. b) Like in class, provide the payoff function for each range of strike prices in which the stock price in could land at expiration. There are four ranges in which the stock price could land at expiration: ? ????????165
3. c) Graph the payoff of the option strategy as a function of ????????.
4. d) What is the net cost of this butterfly spread? Remember to use the bid price when you sell a call option, and the ask price when you buy a call option. You receive money when you sell an option and pay money when you buy an option.
5. e) What kind of price movement are we betting on with this strategy? (no calculations needed for this question)
6. f) Suppose you buy a COST call option that has a strike price equal to $150 and expiration on January 20, 2017. Because the strike price is less than the current stock price, this option is considered ?in-the-money.? Report the ask price of this call option and the current stock price of COST. Suppose you immediately exercise this call option. What is your payoff? Why do you think the payoff is less than the (ask) price at which you bought this option?

Question 3

You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back the $200M you are owed at that time. The current market value of the firm is $240M, although it is unknown what the market value will be next year.

1. a) Provide the payoff diagram for the bondholder next year with the final market value of the firm on the x-axis.
2. b) The financial manager of the firm currently has to make one of two choices:
   • ? Choice 1 (Do Nothing): under this choice, the market value of the firm will equal either $220M or $260M next year, with equal probability.
   • ? Choice 2 (Take a Huge Risk): under this choice, the market value of the firm will equal either zero or $400M next year with equal probability. Assume that the bondholders and shareholders have to maintain their positions until firm liquidation next year. For each choice, provide the expected market value of the firm and the expected payoffs to the bondholders and shareholders next year. If the manager is acting in the best interests of the shareholders, which choice would he make?
3. c) The financial manager, acting in the best interests of the shareholders, takes the huge risk. This is detrimental to the bondholder because there is now a chance that he will not be repaid the $200M he is owed. If you were the bondholder and wanted to completely protect yourself against the state of the world where the firm does not pay you back, would you buy a (call or put) option on the final market value of the assets of the firm, and at what strike price?
4. d) This option you purchase has a price of $95M. You decide to borrow the $95M, in order to pay for the option, at a 10% interest rate. The loan plus interest must be repaid in one year. What is your total expected payoff (bond + option ? loan repayment) in one year? Would you be better off purchasing the option?

Firms that go bankrupt are typically unable to fully repay all bondholders. A bondholder can protect himself from this event by purchasing a ?Credit Default Swap?, an agreement in which he pays a third counterparty a fee (or a sequence of fees over time) and, in exchange, the third counterparty will repay the bondholder what he is owed in the event that the firm goes bankrupt and cannot repay what the bondholder is owed (you also hand over the bond to that third counterparty).

FIN 320 - Managerial Finance Problem Set 2 Due: Sept. 19, 2016 Question 1 You are a financial manager that wants to know projected cash flows next year for decision-making purposes. Below is some financial statement information that is loosely based on Costco (symbol: COST) for the year ended August 30, 2015: Income Statement (in millions $) Year Ended August 30, 2015 Sales Cost of Sales Gross Income Selling, General, Administrative Expenses Depreciation Expenses Operating Income (EBIT) Interest Expense Pre-tax Income Tax Net Income 116,200 101,100 15,100 10,300 1,100 3,700 100 3,600 1,200 2,400 Balance Sheet (in millions $) Year Ended August 30, 2015 Cash Net Receivables Inventory 6,400 Accounts Payable 2,000 Short Term Debt 8,900 Other Current Liabilities Current Assets 17,300 Current Liabilities Net Property, Plant, Equipment 16,100 Long Term Debt Other Long Term Liabilities Total Assets Total Liabilities Total Stockholders' Equity 33,400 Total Liabilities and Equity 12,300 1,300 3,000 16,600 4,900 1,300 22,800 10,600 33,400 Assume the following: (1) net property, plant, and equipment for the year ended August 31, 2014 was $14,800 (in millions); (2) long-term debt for the year ended August 31, 2014 was $5,100 (in millions); (3) short-term debt and other long term liabilities will remain unchanged next year; (4) other current liabilities will be the same percentage of COGS in 2016 as it was in 2015. a) Construct a pro-forma income statement for next year based on the assumption that sales will grow by 5.0 percent next year. Be clear about your work and assumptions. b) Construct a pro-forma balance sheet for next year. Assume that the firm will buy another $2,000M in property, plant, and equipment. Also assume that a dividend of $3,000M will be paid out next year. If total assets are greater than total liabilities plus equity, correct this imbalance (i.e. the net funding need) by adding to long-term debt. If total assets are less than total liabilities plus equity, correct this imbalance by retiring long-term debt. Be clear about your work and assumptions and report how much you add to or subtract from long-term debt. c) What is the projected free cash flow (FCF) for August 30, 2016? Use the following equation to solve for FCF: = , where = + + . Make sure to show the individual numbers used in this equation. The free cash flows are the cash flows available for distribution to the firm's investors (stockholders and bondholders). d) The free cash flow is the cash available to pay out to your investors (i.e. your bondholders and stockholders). According to your pro-formas, how much do you plan to pay your investors in 2016 (this will be the sum of interest and dividend payments)? By how much does this exceed the free cash flow you calculated in part (c)? e) Suppose that debt markets are not available to cover the net funding need calculated in part (b). Instead, you announce a reduction in capital expenditures in 2016 by this corresponding amount. The public believes this will reduce your long-term competitive position and thus revises its expectation of your long-term regular dividend growth rate downward. Specifically, the public originally thought the dividend growth rate was 3.5 percent, but because of this announcement, it now believes the growth rate is 3.0 percent. What is the change in the stock price of COST due to this announcement? Assume that the public values COST equity as a growing perpetuity with a $3B regular dividend payout next year. Also assume COST's equity beta is 0.80, a risk-free rate of 3 percent, and a market risk premium of 6 percent. COST has 440M shares outstanding. Question 2 Suppose you want to create a \"Butterfly Spread\" option strategy based on COST call options. The butterfly spread will involve the following: Buying a call option with strike price $155 Selling two call options with strike price $160 Buying a call option with strike price $165 You want all of these options to have the same maturity of January 20, 2017. a) Go to Yahoo! Finance and search for Costco (symbol: COST), then click on the \"Options\" tab, then select \"January 20, 2017\" in the dropdown box below the stock price to obtain a list of COST options with approximately three months to expiration. The \"Ask\" price is the price at which you can buy an option while the \"Bid\" price is the price at which you can sell an option. Report the bid and ask prices for each of the three call options described above. Also report the date, time, and stock price when you retrieved these options prices. b) Like in class, provide the payoff function for each range of strike prices in which the stock price in could land at expiration. There are four ranges in which the stock price could land at expiration: 165 c) Graph the payoff of the option strategy as a function of . d) What is the net cost of this butterfly spread? Remember to use the bid price when you sell a call option, and the ask price when you buy a call option. You receive money when you sell an option and pay money when you buy an option. e) What kind of price movement are we betting on with this strategy? (no calculations needed for this question) f) Suppose you buy a COST call option that has a strike price equal to $150 and expiration on January 20, 2017. Because the strike price is less than the current stock price, this option is considered \"in-the-money.\" Report the ask price of this call option and the current stock price of COST. Suppose you immediately exercise this call option. What is your payoff? Why do you think the payoff is less than the (ask) price at which you bought this option? Question 3 You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back the $200M you are owed at that time. The current market value of the firm is $240M, although it is unknown what the market value will be next year. a) Provide the payoff diagram for the bondholder next year with the final market value of the firm on the x-axis. b) The financial manager of the firm currently has to make one of two choices: Choice 1 (Do Nothing): under this choice, the market value of the firm will equal either $220M or $260M next year, with equal probability. Choice 2 (Take a Huge Risk): under this choice, the market value of the firm will equal either zero or $400M next year with equal probability. Assume that the bondholders and shareholders have to maintain their positions until firm liquidation next year. For each choice, provide the expected market value of the firm and the expected payoffs to the bondholders and shareholders next year. If the manager is acting in the best interests of the shareholders, which choice would he make? c) The financial manager, acting in the best interests of the shareholders, takes the huge risk. This is detrimental to the bondholder because there is now a chance that he will not be repaid the $200M he is owed. If you were the bondholder and wanted to completely protect yourself against the state of the world where the firm does not pay you back, would you buy a (call or put) option on the final market value of the assets of the firm, and at what strike price? d) This option you purchase has a price of $95M. You decide to borrow the $95M, in order to pay for the option, at a 10% interest rate. The loan plus interest must be repaid in one year. What is your total expected payoff (bond + option - loan repayment) in one year? Would you be better off purchasing the option? Firms that go bankrupt are typically unable to fully repay all bondholders. A bondholder can protect himself from this event by purchasing a \"Credit Default Swap\