Introduction to Finance

BUSFIN 1030
Professors Schlingemann & Rossell
Solutions Problem Set 1
1. Calculate the Cash Flow from Assets for CocaCola
CFA = OCF NCS additions to NWC
OCF = EBI ! de"reciation ta#
OCF = $%&'( ! ))%$*& +(&', = -.%/$.
NCS = )0%)*1 )*%$$1 ! ))%$*& = -)&%)(&
Additions to NWC = (%)'0 )%$*' = -$%.()
CFA = .%/$. )&%)(& $%.() = -)/%/10
!. Calculate the Cash Flow to Creditors for CocaCola
CF to creditors = interest net ne2 long3term 4orro2ing
CF to creditors = )%$*1 *%)&/ = -)%.$1
3. Calculate the Cash Flow to Shareholders for CocaCola
CF shareholders = di5idends net ne2 e67it8 raised
9i5idends = net income additions to retained earnings
9i5idends = *%(($ +*%&($, = -$//
CF to shareholders = $// 0%*** = -0%)**
". Show that the Cash Flow Identit# wor$s for CocaCola
CF identit8 = CFA = CF to creditors ! CF to shareholders
-)/%/10 = -)%.$1 -0%)**
%. &oes Pe'sico 'a# an# di(idends) If so* how much)
:es; -)../ +-*0', = -$%*''
+. Is Pe'sico a net raiser of cash from e,uit#* or do the# 'a# out to shareholders on
a net basis)
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// )
CF to shareholders = -$%*'' ! -)(0 = -$%1$1% hence Pe"siCo is 4oth "a8ing a di5idend
and is re"7rchasing shares on a net 4asis= So the8 "a8 o7t on a net 4asis=

-. Summari.e the sources and uses of cash for Pe'sico Inc. and cate/ori.e into
o'eratin/ acti(ities* in(estment acti(ities* and financin/ acti(ities.
O"erating Acti5ities
! Net Income )%../
! 9e"reciation )%$*(
! >ar?eta4le Sec7rities 9ecrease 0'$
Recei5a4les Increase */*
In5entories Increase $0(
Other C7rrent Assets Increase )*
! Acco7nts Pa8a4le Increase $1*
Other C7rrent @ia4ilities 9ecrease 1)'
otal *%$*$
In5estment Acti5ities
Net Ca"ital S"ending (%((0
9e"reciation )%$*(
Total 5,682
Financing Acti5ities
! Notes Pa8a4le Increase *%.$)
@ong3term 9e4t 9ecrease .)0
! Other @ong3term @ia4ilities Increase *11
9i5idend $%*''
E67it8 Re"7rchases )(0
otal 0**
0. 1ow can #ou chec$ whether #our cash flow statement from ,uestion - is
correct)
O"erating Acti5ities ! In5estment Acti5ities ! Financing Acti5ities = Change in Cash
Balance
*%$*$ 1%&0$ ! 0** = )%&)' = )%.$0 *)) +from Cash entr8 on 4alance sheet,
2. As a financial mana/er* should #ou worr# about the ne/ati(e net income of
CocaCola)
Not necessaril8% 4eca7se 2e ?no2 that the o"erating cash flo2 for Coca3Cola is e67al
-.%/$.= he negati5e net income is a res7lt of a large de"reciation amo7nt% 2hich is not
an act7al cash e#"ense=
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// $
10. 3hich firm has in(ested more in net wor$in/ ca'ital)
Coca3Cola has -$%.() in5ested in NWC% 2hile Pe"siCo has di5ested in NWC +-1%1(&,%
so clearl8 Coca3Cola has 4een in5esting more=
Consider the follo2ing other information ne#t to the information on the Balance Sheet
and Income Statement for Pe"sico Inc= and Coca3Cola Inc=;
N7m4er of Shares o7tstanding for Pe"sico = ))/ million% c7rrent share "rice = -1(
N7m4er of Shares o7tstanding for Coca3Cola = )// million% c7rrent share "rice = -&.
Sch2e""es Softdrin?s >icrosoft Softdrin? Ind7str8 A5g=
C7rrent Ratio )=$* )=1' )=/.
A7ic? Ratio )=/& )=/) )=/$
otal 9e4t Ratio /=1) /=)* /=1.
imes Interest Earned *=(1 (1=' (=('
9a8Bs Sales in In5entor8 $0 &) $.
Recei5a4les 7rno5er & * &
otal Asset 7rno5er /='* /=(1 /=0.
Profit >argin /=/0 /=)( /=/.
Ret7rn on E67it8 /=$( /=$( /=$(
PCE ratio $=1 *0=( $=0
Dse the a4o5e information "l7s the s"ecific information for Pe"sico and Coca3Cola to
anal8Ee the "erformance for 4oth firms= >a?e s7re 8o7 7se all rele5ant information% 8et
4e concise and detailed% and ignore irrele5ant information= Dse all rele5ant 4enchmar?s in
8o7r anal8sis=
For all these answers, try to not just calculate the most recent relevant ratios, but
confront these ratios to useful benchmarks, like last years ratios, Coca-Cola, Schweppes,
and the Industry ratios. Comparing it to icrosoft is probably not meaningful given the
different nature of the industry.
11. Anal#.e and inter'ret the li,uidit# of Pe'sico in 1222.
C7rrent Ratio for Pe"siCo = /=11
A7ic? Ratio for Pe"siCo = /=($
he n7m4ers seem 5er8 lo2 com"ared to last 8ears n7m4ers +res"ecti5el8 )=(' and )=)$,%
and lo2 com"ared to the other com"etitors and the ind7str8 n7m4ers= For e#am"le% Coca3
Cola has 5al7es of )=11 and )=11 +4oth good relati5e to the ind7str8,= So% Pe"siCoFs
li67idit8 has decreased shar"l8 in the last 8ear and is 4elo2 2hat seems to 4e GnormalF=
For this ind7str8 one co7ld arg7e that in5entories are fairl8 li67id "ro4a4l8% 47t the dro"
in li67idit8 has not 4een ca7sed 48 a dro" in in5entories=
1!. Anal#.e and inter'ret the sol(enc# of Pe'sico in 1222.
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// *
@oo?ing for e#am"le at the 9e4tCHal7e ratio% 2e can see that for each dollar in total 5al7e
in the firm% '$I is financed thro7gh de4t% 2hereas in the "re5io7s 8ear this 2as &1I= So%
Pe"siCo has increased its financial le5erage= It seems high relati5e to Coca3Cola%
Sch2e""es and the ind7str8 4enchmar?= In terms of their a4ilit8 to ser5ice this de4t
+a4ilit8 to "a8 interest, 2e can loo? at the imes Interest Earned or the Cash Co5erage
Ratio= For Pe"siCo these n7m4ers are res"ecti5el8 0=/( and ))=00= Com"ared to the
a4o5e 4enchmar?s it seems that Pe"siCo is doing 2ell= Com"aring it to Coca3Cola
re67ires 7s to loo? as the cash co5erage ratio% 4eca7se Coca3Cola has a negati5e EBI=
Coca3Cola has a co5erage ratio of &=.* so again% Pe"siCo is doing 2ell in terms of 4eing
a4le to afford the interest% e5en tho7gh the8 ha5e more de4t than com"ara4le firms=
13. Anal#.e and inter'ret the asset mana/ement of Pe'sico.
9a8sF Sales in In5entor8 = *&1 C +.%**/C)%/)&, = (/ da8s= his seems a little high to the
ind7str8 and Sch2e""es n7m4ers= It seems 5er8 high com"ared to Coca3Cola% +J )da8,%
47t one co7ld 2onder if that is normal% gi5en the e#tremel8 lo2 in5entories for Coca3
Cola in )...=
Recei5a4les 7rno5er = .=)) +or% it ta?es them (/ da8s on a5erage to collect on their sales
4ased on the 9a8sF Sales in recei5a4les,= his com"ares fa5ora4l8 to the (0 da8s for
Coca3Cola% and definitel8 relati5e to the other t2o 4enchmar?s +&) da8s,=
otal Asset 7rno5er = /=.0& for Pe"sico% 2hich seems e#cellent com"ared 2ith the other
4enchmar?s that are all lo2er=
O5erall% the res7lts loo? normal to good% e#ce"t for the In5entor8 7rno5er=
1". Anal#.e and inter'ret the 'rofitabilit# of Pe'sico.
Profit >argin% Ret7rn on E67it8% and Ret7rn on Assets are res"ecti5el8% 0=.I% *)=)I% and
0=0I= We canFt 7se the n7m4ers for Coca3Cola for )... here 4eca7se the8 in5ol5e
negati5e net income= We need to refer to the 4enchmar?s a4o5e instead= he
"erformance% 4ased on the "rofit margin and the ret7rn on e67it8 seem to 4e in line 2ith
the 4enchmar?s ROE is some2hat 4etter than the norm=
Co7ld 2e find the Ret7rn on Assets for Sch2e""es for e#am"leK :es% 4eca7se 2e ?no2
that for each dollar in total assets +see the de4t3to35al7e ratio,% Sch2e""es has 1) cents in
de4t% and (. cents in e67it8= Lence% if Sch2e""es has M dollars in e67it8% 2e ?no2 that
Sales C M = /=$(= he total assets m7st 4e M C /=(.% 2hich means that Sales C +M C /=(., =
))='&I= So% the "rofita4ilit8 relati5e to Sch2e""es is lo2er 4ased on the total assets of
the firm% 47t 4etter 2hen meas7red against e67it8=
1%. Inter'ret and comment on the P45 ratio of Pe'sico.
Pe"siCo has )../ C ))/ = -)0=/. earnings "er share% res7lting in a PCE ratio of $=..= For
Coca3Cola 2e canFt do this 4ased on the negati5e earnings= Com"ared to the other t2o
rele5ant 4enchmar?s% this seems to 4e a GnormalF 8et slightl8 higher 5al7e= It indicates
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// (
that some gro2th is e#"ected for this and the other soft drin? com"anies% 47t that
in5estors are not nearl8 as m7ch 2illing to "a8 high "rices for c7rrent earnings 2hen
com"ared to >icrosoft for e#am"le= For Pe"siCo% in5estors are 2illing to "a8 three times
the c7rrent earnings% 2hereas for >icrosoft the8 are 2illing to "a8 more than *0 times the
c7rrent earnings= his is most li?el8 reflected in the different nat7re of the t2o ind7stries
and the e#"ected gro2th "otential 2ith each ind7str8=
6ther 7uestions
)&= S7""ose 8o7r 47siness has gone 4an?r7"t= After selling all of 8o7r 47sinessBs assets%
8o7r 47siness still o2es -$1/%///=
a= S7""ose the 47siness is organiEed as a limited "artnershi" in 2hich 8o7
and 8o7r "artner each s7""lied 1/I of the initial -$//%/// in5estment= If
8o7 are the general "artner and the other "artner is a limited "artner% ho2
m7ch of the -$1/%/// do 8o7 o2e and ho2 m7ch does 8o7r "artner o2eK
!"S#$%& 'ou each supplied ()**,***. +he limited partner has limited liability and
owes his,her full ()**,***. +he remainder, ()-*,*** is what you owe, because as a
general partner you have unlimited liability.
4= Lo2 m7ch of the -$1/%/// do 8o7 o2e if the 47siness is organiEed as a
sole "ro"rietorshi"K
!"S#$%& 'ou owe to full (.-*,***, because of unlimited liability.
c= S7""ose the 47siness is organiEed as a cor"oration in 2hich 8o7 o2n 1/I
of the shares o7tstanding "7rchased for -$//%/// 2hen the com"an8 2ent
"74lic= Lo2 m7ch of the -$1/%/// do 8o7 o2eK
!"S#$%& 'ou have limited liability as a shareholder, so you can not owe more than what
the value of your shares is. Since the value of your shares will drop to /ero, you lost the
(.**,*** but you do not owe anything beyond that.
)'= :o7r friend started a s7ccessf7l indoor golfing range in Pitts47rgh fi5e 8ears ago= She
is c7rrentl8 the sole o2ner of the 47siness= After m7ch tho7ght she has decided to
e#"and her 47siness to other mar?ets 2ithin the D=S= She realiEes s7ch an e#"ansion
re67ires additional ca"ital=
a= Wo7ld 8o7 recommend that she change the organiEational form of the com"an8K
If so% 2hich t8"e of organiEational form sho7ld the 47siness ta?eK
!"S#$%& Corporation is the more obvious form of organi/ation. 0ecause of limited
liability, easy transfer of ownership, and unlimited life of the organi/ation, investors are
more likely to provide the firm with financing means.
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// 1
4= What are the ad5antages of this form o5er the c7rrent organiEational form of the
47sinessK
!"S#$%& See above answer.
c= What are the disad5antagesK
!"S#$%& ore costly to organi/e and potential agency problem and conflicts between
shareholders and creditors and between shareholders and managers.
d= If 8o7 recommend not changing the organiEational form% 2hat are the ad5antages
and disad5antages to 8o7r friend remaining a sole "ro"rietorshi"K
!"S#$%& !dvantages& "o costs incurred from changing to the corporate form and no
agency conflicts. 1isadvantages& limited life, difficult to transfer ownership, difficult to
raise financing, unlimited liability.
e= 9escri4e some mechanisms that e#ist to alle5iate agenc8 conflicts 2ithin a
cor"oration=
!"S#$%& write better contracts between agents and principals, threat of takeovers,
board of directors, design performance-based compensation and incentive schemes.
)0= Clonetic @a4s% Inc= has earnings 4efore interest and ta#es of -)./%///= Interest
e#"ense for the 8ear is -*1%/// and the firm has declared that -1/%/// in di5idends
2ill 4e distri47ted= Calc7late the after3ta# earnings for Clonetics ass7ming a (/I ta#
on ordinar8 income=
!"S#$%&
EBI -)./%///
Interest 3-*1%///
Earnings 4efore ta#es -)11%///
a# N (/I 3-&$%///
Earnings after ta#es -.*%///
).= Ne2l8 released financial statements re"ort that the firmBs net income is -) million%
the 4oo?35al7e of shareholdersB e67it8 is -$=1 million% the n7m4er of shares
o7tstanding is )=1 million and the "rice "er shares is -/=0/=
i= Lo2 m7ch are shareholders 2illing to "a8 for each dollar of earnings of
the firmK
!"S#$%&
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// &
PCE ratio = "rice "er share C earnings "er share = +-/=0/, C +-) million C )=1 million, = )=$%
so in5estors are 2illing to "a8 -)=$/ for each -) in c7rrent earnings=
ii= What is the 4oo?3to3mar?et ratio for the com"an8K Based on 8o7r ans2er%
2o7ld 8o7 recommend 478ing this stoc?K E#"lain=
!"S#$%&
BC> = 4oo? 5al7e of e67it8 C mar?et 5al7e of e67it8 = -$=1 million C +-/=0/ O )=1
million, = $=/0* +Or% the >ar?et3to3Boo? = ) C $=$/0* = /=(0,= his n7m4er is telling 8o7
that in5estors on a5erage do e#"ect the f7t7re to 4e 2orse than the c7rrent stat7s of the
firm% 2hich 2o7ld not 4e a good sign= :o7Fd "ro4a4l8 2ant to sell% altho7gh one 2o7ld
need to ?no2 2hether the stoc? is o5er or 7nder3"riced=
8ime 9alue of :one# 7uestions
$/= A famo7s r7nning 4ac? P7st signed a -)0 million contract "ro5iding -* million a 8ear
for si# 8ears= A less famo7s r7nning 4ac? signed a -)( million fi5e38ear contract
"ro5iding -( million no2 and -$ million a 8ear for fi5e 8ears= Who is 4etter "aid if
the interest rate is &IK
!"S#$%& Con5ert each cash flo2 to the same time "eriod 4efore ma?ing a com"arison=
For e#am"le% disco7nting each cash flo2 to the "resent 5al7e gi5es 7s;
Ass7me "a8ments ta?e "lace in 8ear )% $% etc=
PHFA>ODS =
=

&
, /& = ) +
)
)
/& = /
* - million
-)(%'1)%.'$=.0
Ass7me that after the initial "a8ment of -( million% the remainder gets "aid o7t in 8ears
)% $% etc=
PH@ESS FA>ODS = -( million !
=

1
, /& = ) +
)
)
/& = /
$ - million
-)$%($(%'$'=1(
$)= :o7 4elie5e 8o7 2ill need to ha5e sa5ed -1//%/// for 8o7r s7""lemental healthcare
acco7nt 48 the time 8o7 retire in (/ 8ears in order to li5e comforta4l8= If the interest
rate is (=1I "er 8ear% ho2 m7ch m7st 8o7 sa5e each 8ear to reach 8o7r retirement
goalK
!"S#$%& 7se the f7t7re 5al7e ann7it8 form7la and sol5e for C;
[ ] 1' = &') % ( - ) , /(1 = ) +
/(1 = /
/// % 1// -
(/
= = C
C
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// '
$$= :o7 ha5e decided to 478 a ne2 B>W Q3* the dealer 2ill sell 8o7 for -((%/// 2ith
8o7r trade in= he financing that the dealer is offering is a 138ear loan at &=1I +APR,
and the first loan "a8ment is d7e one3month from no2=
a= Ass7me all loan "a8ments are made at the end of the month= Ri5en the
interest rate on the loan% 2hat is 8o7r monthl8 "a8mentK
!"S#$%; his a Present Hal7e Ann7it8 "ro4lem% 2here 8o7 ha5e to sol5e for C in the
form7la;

+
=
&/
, ) +
)
) /// % (( -
r r
C
= Note that the "a8ments are made e5er8 month% so 2e need
a monthl8 interest rate= >onthl8 rate = APR C )$ = /=//1()& = r=
=

= C
C
&/
, //1()& = ) +
)
)
//1()& = /
/// % (( -
-0&/=.)
4= B8 ma?ing fi#ed monthl8 "a8ments on 8o7r loan% 8o7 are re"a8ing the
"rinci"le amo7nt o5er fi5e 8ears= his "rocess of "a8ing off a loan 48
ma?ing reg7lar "rinci"al red7ctions is called amorti.in/ the loan= For
8o7r first monthl8 loan "a8ment% 2hat amo7nt of 8o7r "a8ment goes to
re"a8ing 8o7r "rinci"le and ho2 m7ch to re"a8ing 8o7r interestK
!"S#$%; Note that 2hen 8o7 ma?e 8o7r first "a8ment% at that time 8o7 ha5e 8o7 f7ll
amo7nt of de4t o7tstanding +-((%///, o5er 2hich 8o7 ha5e to "a8 interest= Lence% 8o7
o2e /=//1()& O -((%/// = -$*0=*/ in interest= Ri5en that 8o7 "a8 a total of -0&/=.)% it
im"lies that -&$$=&) is "aid to2ard red7cing 8o7r "rinci"al=
c= Lo2 m7ch of 8o7r "rinci"al ha5e 8o7 re"aid after three monthsK
!"S#$%; Similarl8 as a4o5e% letBs find first for the second month 2hat 2e ha5e "aid off=
:o7r de4t is no2 red7ced from -((%/// to -((%/// 3 -&$$=&) = -(*%*''=*.= So% for the
second month 8o7r interest "a8ment is /=//1()& O -(*%*''=*. = -$*(=.&= his im"lies a
"rinci"al red7ction of -0&/=.) 3 -$*(=.& = -&$1=.1= For the third "a8ment% 8o7 2ill "a8
/=//1()& O -($%'1)=(( = -$*)=1' in interest and -0&/=.) 3 -$*)=1' = -&$.=*( in
"rinci"al red7ction= In total 8o7 ha5e "aid off -&$$=&) ! -&$1=.1 ! -&$.=*( = -)%0''=./
after * months=
$*= A "iece of e67i"ment costs -1//%///= :o7 forecast that it 2ill "rod7ce cash inflo2s
of -)//%/// in :ear )% -$1/%/// in :ear $% and -*//%/// in :ear *= he o""ort7nit8
cost of 8o7r firmBs ca"ital +interest, is )$I "er 8ear= Sho7ld 8o7 478 this e67i"mentK
!"S#$%& :ESS
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// 0
:ear Cash Flo2 Present Hal7e Factor Present Hal7e
) )//%/// )C+)=)$, 0.%$01=')
$ $1/%/// )C+)=)$,$ )..%$.0=('
* *//%/// )C+)=)$,* $)*%1*(=/'
8otal Present 9alue %0!*110.!%
he cost of the e67i"ment is -1//%/// and the "resent 5al7e of the cash inflo2s
generated from the "iece of e67i"ment is -1/$%))0=$1= he net "resent 5al7e of this
in5estment is -1/$%))0=$1 3 -1//%/// or -$%))0=$1= he com"an8 sho7ld 478 the
e67i"ment 4eca7se the "7rchase ma?es them -$%))0=$1 4etter off=
$(= :o7 ha5e P7st o"ened the mail4o# and fo7nd 8o7r ann7al entr8 form for this seasonBs
P74lishers Clearingho7se s2ee"sta?es in 2hich ten million dollars 2ill 4e gi5en
a2a8 in the TS7"er"riEeT= Before 8o7 send in 8o7r 2inning entr8% ho2e5er%
P74lishers 2ants 8o7 to ma?e a to7gh decision= Lo2 do 8o7 2ant the mone8K Lere
are the o"tions listed +notice the amo7nt "aid al2a8s adds 7" to -)/ million,;
O"tion )= Dnited States reas7r8 4onds iss7ed in 8o7r name 2hich% if held to
mat7rit8% 2ill "a8 -$1/%/// a 8ear for */ 8ears% "l7s a final
"a8ment of -$=1 million in the */th 8ear +$1/%///*/!$=1 million
= -)/ million,=
O"tion $= -) million cash no2% -$//%/// 8earl8 "a8ments at the 4eginning of
the ne#t */ 8ears +i=e=% the first -$//%/// is made in )$ months,
"l7s a -* million "a8ment in the */th 8ear +) million!$//%///*/
!* million = -)/ million,=
O"tion *= -1//%// no2% -$1/%/// 8earl8 "a8ments at the 4eginning of the
ne#t $0 8ears +i=e=% the first -$1/%/// is made in )$ months, "l7s a
-$=1 million "a8ment in the */th 8ear +1//%/// ! $1/%///$0!$=1
million = -)/ million,=
Ass7me all "a8ments come in at the 4eginning of the 8ear= h7s% the first 8earl8 "a8ment
is made )$ months from no2 and the "a8ment in 8ear */ is made */ 8ears from no2=
he rele5ant disco7nt rate on long3term g7aranteed cash flo2s s7ch as those descri4ed
a4o5e is ' "ercent "er 8ear com'ounded semiannuall#=
a?ing into acco7nt the time 5al7e of mone8% 2hich o"tion 2o7ld 8o7 choose and 2h8K
!"S#$%&
Calc7late the PH of these * o"tions% and com"are the 5al7es;
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// .
First% 2hat interest rate do 2e 7seK Since all the "a8ments are ann7all8% 2e need an ann7al
rate that ta?es into acco7nt the semi3ann7al com"o7nding;
EAR = U ) ! +/=/' C $,V
$
= /=/')$$1
O"tion ); PH+o"tion), =

*/
, /')$$1 = ) +
)
)
/')$$1 = /
/// % $1/ -
"l7s the PH of $=1 million in
8ear */ = $=1 million C +)=/')$$1,
*/
% so in total; ;3*301*-22."!
PH+o"tion$, = -) million !

*/
, /')$$1 = ) +
)
)
/')$$1 = /
/// % $// -
!
*/
, /')$$1 = ) +
*million
=
;3*03!*3-3.00
PH+o"tion*, = -1//%/// !
+

$0
, /')$$1 = ) +
)
)
/')$$1 = /
/// % $1/ -
*/
, /')$$1 = ) +
1 = $ million
=
;3*01+*0-!.00
O"tion $ is "referred% since it has the highest "resent 5al7e=
Intro to Finance 3 Pro4lem Set ) 3 < Schlingemann $/// )/