QUESTIONS FOR THE CASES

Topic: Investment Management Practice (focus on advances in empirical and theoretical

research in finance, market efficiency, models of capital market equilibrium, financial
instruments, and investment management)
Harvard Case: 9-203-026 Dimensional Fund Advisors
Copyright 2002, Harvard Business School Publishing, Boston Massachusetts

Dimensional Fund Advisors (DFA) was in June 2002 a $30 billion investment fund based in
Santa Monica, CA. A number of features made DFA an unusual fund:
1. A strongly professed belief that the capital markets are efficient
2. A passive, buy and hold investment approach
3. The use of academic research to define and assess its strategies
4. A specialization in the purchase of large blocks of small stocks at discount prices

This case uses the firm as a setting to teach you about the latest research in academic finance, at
the time, as well as to show how they can turn new findings into productive investment
strategies. The case pays particular attention to the cornerstones of DFA approach: the “size
effect” and the “value-growth effect.” To this end, the case presents detailed information on
research in capital markets (particularly the stock market), as well as on DFA’s history and
operations. The case explores the effect of research innovations on the firm, and considers
DFA’s new product: tax-managed passive funds.
Questions:
1. What is DFA’s business strategy? What do you think of the firm? Are the DFA people
really believers in efficient markets?
a. How does it add value for investors?
b. What are the pros and cons of the passive approach?
2. Do the Fama-French findings make sense? Should we expect small stocks to outperform
large stocks in the future? Value stocks to outperform growth stocks in the future?
a. What did Fama and French discover about the CAPM and beta?
b. How do you reconcile the empirical finds with CAPM theory?
3. Why has DFA’s small stock fund performed so well?
4. Discuss DFA’s trading strategy.
a. How does it work, and what are the costs and benefits?
b. Can DFA keep this competitive advantage in the future?
c. Why don’t competitors emulate DFA’s approach?
5. Is DFA’s tax-managed fund family likely to be successful, or remain just a small niche
market?
6. What should be the firm’s strategy going forward?

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 Topic: Interest-Rate Risk Management in a corporation (liability management)
Harvard Case: 9-293-123 Liability Management at General Motors Copyright 1993-1995, 2008,
Harvard Business School Publishing, Boston Massachusetts

This case is intended to show how a large industrial firm approached the management of its debt
portfolio. You will analyze the policy decisions made by the firm and the means by which these
policies were implemented. The case will also introduce you to a wide variety of derivative
instruments that are used to adjust a firm’s interest rate exposure. The case forces you to address
the sensibility and feasibility of managing interest rate exposure in the context of an industrial
corporation. It also illustrates the large gap between liability management policy and execution
and the fine line between managing interest rate exposure and speculating on interest rate
movements.

An analyst at General Motors charged with managing the structure of the auto maker’s debt must
decide whether and how to modify the interest rate exposure of the firm’s most recent debt
financing. The analyst must take into consideration GM’s liability management policy
guidelines, the firm’s existing interest rate exposure, his expectations of interest rates, and the
wide range of interest rate products available to him. He must decide whether to leave the fixed-
rate instrument unchanged or to enter into a swap, cap, interest rate option, or swap option
transaction.

Questions:

1. How will changes in interest rates affect General Motors’ business? Speculate on the
various ways in which changes in interest rates influence the demand for autos, the prices
the firm can charge, its input cost, etc. Apart from engaging in derivative instruments,
like those discussed in the case, how could a firm like GM control its exposure to interest
rates?
2. How does managing interest rate exposure differ for a bank and for an industrial firm like
GM?
3. What should be GM’s over-arching policy toward managing interest rate exposure? For
example, should GM seek to ensure that changes in interest rates do not affect operating
cash flow? The market value of the firm’s equity? GM’s ability to invest in new
technologies? Should it abandon all efforts to manage its interest rate exposure? What is
GM’s stated policies? How do you interpret these policies?
4. How has GM measured its exposure? How would you propose that GM measures its
exposure to interest rates? How would you propose that GM reports the interest rate
exposure of its business, and of its liabilities?
5. What is a “rate view?” What role does it play in the liability management policy at GM?
What role should it play in the liability management program? Why?
6. Explain each of the interest rate derivatives that Bello is considering (listed in Exhibit 7).
How do they work, and how would they affect the incremental interest rate exposure of
the five-year fixed-rate note that GM is about to issue? Assuming that each of the
instruments is fairly priced, what should Bello recommend? Why?

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 7. As a director or institutional investor in GM, how would you evaluate the liability
management program at GM? What might you suggest should be studied or changed, and
why?
Topic: Interest Rate Risk Management in banking (Derivatives - use of concept of duration,
measurement of economic exposure))

Derivatives at Banc One (1994), by David Backus, Leora Klapper, and Chris Telmer

Banc One's share price was falling in the mid-1990s due to analyst and investor concern over the
bank's heavy use of interest rate derivatives. Dick Lodge, chief investment officer in charge of
the bank's investment and derivative portfolio, must recommend to the chief executive officer a
course of action to allay investors' fears and communicate to the market the reasons for Banc
One's use of derivatives. The bank uses interest rate swaps to manage the sensitivity of its
earnings to changes in interest rates and as attractive investment alternatives to conventional
securities. The objectives are: 1) to teach students how banks measure and control their interest-
rate exposure; 2) to show how derivatives, specifically swaps, can be used as synthetic
investments that are an alternative to traditional investments; 3) to highlight the salient
differences between traditional investments and these synthetic investments (credit, regulatory
capital, financial ratios, and liquidity); 4) to understand how the use of derivatives creates a need
for other risk-management strategies (basis swaps); and 5) to highlight one institution's
management policies to monitor and control derivatives activities.

Questions:

1. How does Banc One make its money? What does this say about its acquisition strategy
and the likely impact of Riegle-Neal Act? How is this acquisition strategy linked to its
stock price?
2. Do you agree with Ban One’s GAP calculations? Which if any of its assumptions do you
find questionable?
3. Does it make sense for Banc One (or any bank for that matter) to hedge? Explain why
you would or would not recommend that it hedge? If Banc One wanted to manage its
interest rate exposure without using swaps or other derivative instruments, what could it
do? Specifically, how could it move from being asset-sensitive to either neutral or mildly
liability-sensitive without using derivatives? What are the pros and cons of using swaps
versus these other means of adjusting the bank’s interest rate sensitivity? What impact do
they have on the bank’s interest rate sensitivity, liquidity, accounting ratios, and capital
ratios? In answering these questions, for example, do not tell me that interest rate swaps
increase a bank’s liquidity, because they do not. However, they provide opportunities for
a bank to do something that it might not be able to do as cheaply.
4. Was Banc One hedging or speculating? Quantify your answer and explain whether you
agree with its strategy.
5. Compute the bank’s duration gap and explain what the impact on the market value of
equity of an unanticipated change in interest rate.
6. What explanations do you have for the movements in Banc One’s stock price?

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 7. Explain amortizing interest rate swap and how they work. Why do you think Banc One
using them so extensively? That is, do they provide return opportunities that are not
available with other financial instruments? But does this come at a price? What is the
price in using amortizing interest rate swap?

8. What are basis swaps? Explain how they work. What are they designed to accomplish?
Why did Banc One increase its basis swap position?
9. How might its derivatives portfolio be damaging the bank’s stock price? What exactly
are analysts and investors worried about?
10. What should McCoy do? Hint: one option is to do nothing! But what are the other
options? Which would you recommend?

Topic: Foreign Exchange Risk (management of competitive exposures)

Harvard Case: 9-205-096 Foreign Exchange Hedging Strategies at General Motors: Competitive
Exposures Publication Date April 26, 2005, Harvard Business School Publishing, Boston
Massachusetts

Currency exposures that arise from transactions in foreign currencies are mostly addressed by
General Motors’ corporate hedging policy. The company’s hedging policy, however, does not
address all of the risks that GM faces from changes in exchange rates. Although GM sells few
cars in Japan, Eric Feldstein, Treasurer and Vice President of Finance at GM, reasons that an
anticipated depreciation of the yen against the U.S. dollar would give Japanese automakers a
sizable cost advantage relative to GM in the U.S. market, thus allowing them to take market
share away from GM and other U.S. car makers. GM’s competitive exposure to the yen is a
long-standing strategic concern among GM executives, but discussions on what to do about it
have been largely hypothetical. As a consequence, Feldstein aims to develop an analytic
framework to quantify GM’s yen exposure to all GM to better manage the risks that arise from
this competitive exposure.

Questions:
1. Why is GM worried about the level of the yen?
2. Define and identify competitive exposure.
3. How important is GM’s competitive exposure to the yen?
4. How would you go from the information in the case about competitive interactions with
Japanese manufacturers to a value exposure for GM?
Are there less information-intensive methods that might allow you to assess the
competitive exposures of GM, specifically, or other firms more generally? How would
you implement such a method? See Rohan Williamson, “Exchange rate exposure and
competition: evidence from the automotive industry,” Journal of Financial Economics 59,
Issue 3 (March 2001.

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 Topic: Capital Budgeting Decisions

Harvard Case: 5-289-005 E.I. du Pont de Nemours & Co.: Titanium Dioxide
Publication Date January 28, 1992, Harvard Business School Publishing, Boston Massachusetts

This case involves Du Pont’s decision to expand substantially its capacity in the titanium dioxide
(Ti02) market in an attempt to preempt competitors during a period of excess demand. Given a
capital expenditure program that would reach $500 million by 1985, this decision clearly
represented a major strategic allocation of capital for Du Pont that required careful industry and
competitor analysis as well as careful financial analysis. The former is particularly necessary in
view of the exceptionally long period of time over which the benefits of this project were
expected to accrue. When you complete your discussion of this case you will have an
understanding that the potential of the project to create value depends heavily upon the
defensible competitive advantage that Du Pont expected to build in the Ti02 market. Quantitative
financial analysis, while generally supportive of the decision to expand capacity, is probably less
compelling than the strategic analysis as a reason for Du Pont to adopt the growth strategy in
Ti02.

Questions:

1. What are Du Pont’s competitive advantages in the Ti02 market as of 1972? How
permanent or defensible are they? What must Du Pont do to retain its competitive
advantages in the future?
2. Given the forecasts provided in the case, estimate the expected incremental free cash
flows associated with Du Pont’s growth strategy and maintain strategy for the Ti02
market. How much risk and uncertainty surround these future cash flows? Which strategy
looks most attractive?
3. How much competitors respond to Du Pont’s choice or either strategy in the Ti02 market?
What other factors should Du Pont consider in making this decision?
4. What strategy should Du Pont pursue?
Note: in 1972, bond yields and the inflation rate were approximately as follows:
Long-term treasuries =6.2%
Aaa corporate bonds =7.2%
Baa corporate bonds =7.8%
Inflation rate (CPI) =3.2%

Topic: Mergers & Acquisitions

Harvard Case: 5-214-067 Mylan Laboratories’ Proposed Merger with King Pharmaceutical
Publication Date February 12, 2014, Harvard Business School Publishing, Boston Massachusetts

Mylan Labs is a $4bn pharmaceuticals company. It is primarily manufacturing generics but has
recently developed a branded blood pressure drug called Nebivolol. Mylan Labs will need a sales

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force to market this new drug and King Pharmaceuticals already has a sales force targeted at
cardiologists, making it an attractive target. The companies hope to achieve $100m in annual
synergies from combining forces. Mylan agrees a stock-for-stock merger with King at a ratio
implying a 61% control premium. NYSE rules require both companies’ stockholders to approve
the deal. On hearing of the deal Carl Icahn buys nearly 10% of Mylan and argues that the deal
should be dropped; he announces his own offer for Mylan. Meanwhile, Perry Capital, holding
around 3% of King, buys 10% of Mylan, but hedges its exposure using derivatives.

You should take away the following from this case:

1. Be able to value the stated synergies from the deal using a DCF or multiples based
approach.
2. Be able to consider whether Mylan’s offer for King is too generous; be able to look at the
control premium and use multiples analysis to value King; be able to discuss why
pharmaceuticals companies may be difficult to value without access to detailed
information (for example expiring patents).
3. Be able to infer from the market reaction to the announcement of the Mylan-King merger
the expected value of the combined companies and the market’s view of the winner and
loser from the deal.
4. Be able to use the subsequent trading prices of the two companies to back out a
probability with which the market expects the merger to be consummated, and to discuss
merger strategies.
5. Be able to consider why a hedge fund might have incentives to engage in so-called
“empty voting” around a controversial merger, and think about the mechanics about how
acquiring a voting stake without accompanying economic interest can be achieved.
6. And understand how regulation might influence transactions of this type.

Questions:

1. Does this deal create value? Is this a good deal for Mylan? For King?
2. Shareholders in both Mylan and King must vote in favor of the merger for it to go ahead.
What does the reaction of the firms’ stock prices to the announcement of the merger
suggest about how each group should vote?
3. Use the information contained in the market prices to form an assessment of the
likelihood of the merger being consummated.
4. What is Perry Capital trying to achieve and why? Consider the various ways in which
they could structure their trade in order to achieve this end. Should the SEC aim to
prevent future similar trades, and if so, how?

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 Topic: Shareholder Value and the Conglomerate Structure.

Case: Ivey Publishing W14241-PDF-ENG Canadian Pacific Ltd: Unlocking Shareholder Value
in a Conglomerate.

Canadian pacific Ltd. (CPL) was a Canadian conglomerate that operated five companies in
different business segments: PanCandian Energy (oil and gas), Canadian Pacific Rail (railway),
CP Ships (shipping), Canadian Pacific Hotels and Resorts (hotels), and Fording Coal (mining).
At the time of the case in Mid-January 2001, CPL’s share price traded at a persistent discount of
12% to 30% to a sum-of-parts valuation of the individual businesses.

The CEO David O’Brien must decide the best way to unlock shareholder value. His options are
(1) divest one or more companies, (2) to spin-off and list one or more companies, or (3) to spin-
off and list all five companies simultaneously. This final strategy is referred to by O’Brien and
his advisors as the “starburst strategy.” The status quo is not an attractive alternative, as CPL’s
share price has underperformed the market, and there is a risk that an activist investor may target
the company.

The case objectives are (1) to understand the merits and drawbacks of the conglomerate
structure; (2) to illustrate how as asset restructuring, such as a corporate divestiture or a spin-off,
can add shareholder value to a company; (3) to learn how to value a company through sum-of-
parts using trading multiplies of comparable companies; (4) to examine how taxes can affect
corporate decision-making; and (5) to discuss the importance of credit ratings and ratios.

Assigned questions:

1. How has CPL evolved as a company? Why did a conglomerate structure make sense for
CPL in the past: does it still make sense?
You need to develop a table with one column identifying the original rationale for the
conglomerate structure and a second column answering whether the original rationale
makes sense in the environment that the firm was facing at the time of the case.

2. How are CPL’s businesses currently performing? Which one contributes to the most to
CPL’s sales and net income? Which one is the most profitable? Which one is the riskier?
For each line of CPL’s business unit calculate the following:
a. % of CPL sales for each company
b. % of net income of CPL for each company
c. Each company’s EBITDA revenue margin
d. Each company’s net income margin
e. Each company’s ROA
f. Each company’s EBIT interest coverage
g. Each company’s EBITDA interest coverage
h. Each company’s debt/asset ratio

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3. How large is CPL’s conglomerate discount? How might it be measured?
a. For each business, identify a set of comparable companies – this can be found in
Exhibit 6 of the case. What do you do with these numbers?
b. Calculate the appropriate trading multiple (e.g., EV/EBITDA) by averaging the
trading multiple for the comparable companies
c. To arrive at an implied enterprise value, multiply the EBITDA for each business by
the appropriate EV/EBITDA multiple.
d. Sum the implied enterprise values across businesses, and compare the total to the
actual enterprise value for the conglomerate

Why use a median value for a market multiple instead of an average?

4. What options was David O’Brien considering to address this conglomerate discount?
Please discuss the criteria for choosing among the options. How did taxation affect the
attractiveness of each of these options? You need to compare the after tax proceeds from
a divestiture versus a spin-off for each line of business.

[Show the hypothetical taxes payable for each business based on an arbitrary sale price.
Let’s assume each business can be sold for double its adjusted tax base (2x book value).]

5. If CPL pursued the starburst strategy, how much of CPL’s corporate debt should be
allocated to each of the new companies? To determine debt capacity for each line of
business:
a. Determine target EBITDA interest coverage ratios for each business based on (1)
rating targets, and (2) comparable companies.
b. Create pro forma statements in an Excel spreadsheet, where you need to allocate
existing CPL debt to each line of business.
c. Calculate the new interest expense, and add this amount to existing interest expense
to get the pro forma interest expense.
d. Calculate the pro forma EBITDA interest coverage ratio based on the new quantity of
debt.
e. Iterate until the EBITDA interest coverage ratios for each business meet the targets
from step (a).

6. What would be the implied price per share for each business in a spin-off?
There are calculations that we need to do here (see the Excel spreadsheet)

7. As CEO of CPL, which strategy would you recommend and why?

Topic: Dividend Policy & Corporate Governance

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 Harvard Case: 5-296-072 Dividend Policy at FPL Group, Inc.
Publication Date January 19, 1996, Harvard Business School Publishing, Boston Massachusetts

A Wall Street analyst has just learned that FPL Group (the holding company for Florida
and Light, the country’s fourth largest electric utility) may decide to freeze its dividend at
$2.48 per share or possibly cut the dividend at the company’s upcoming annual meeting.
The decision not to increase the dividend will end a 47-year streak of annual dividend
increases—the longest streak among utilities and the third longest streak among publicly
traded U.S. companies. In response to the news, FPL’s stock price is down 6%. The
protagonist, Kate Stark, a fictitious equities analyst, must decide whether to revise her
investment recommendation on FPL in light of this new information. This case describes
the U.S. electric power industry as it enters the final stages of deregulation in the mid-
1994. The case details FPL financial position and the steps taken by CEO James
Broadhead to improve FPL’s competitive position in an era of increasing competition.
Stark must decide whether a change in financial strategy, including a possible change in
dividend policy, will accompany this change in competitive strategy. This case help you
to understand the theoretical and practical implications of dividend policy. It allows us to
discuss Miller & Modigliani’s theory of dividend irrelevance. In addition, the case
illustrates what security analysts do and the role of public information in determining
stock prices. When you are done with this case, you should know:

1. What factors firms consider when establishing a dividend policy.

2. What factors make dividend policy “relevant” (i.e., signaling, taxes, transactions
costs, and agency conflicts)
3. What factors lead firms to change dividend policy
4. How a firm’s competitive and financial strategies are related

Questions:
1. Why do firms pay dividends? What, in general, are the advantages and disadvantages of
paying cash dividends?
2. What are the most important issues confronting the FPL Group in May 1994?
3. From FPL’s perspective, is the current payout ratio appropriate? Would a higher payout
ratio be more appropriate? A lower payout ratio?
4. From an investor’s perspective is FPL’s payout ratio appropriate?
5. As Kate Stark, what would you recommend regarding investment in FPL’s stock—buy,
sell, or hold?

Thunderbird Case: TB0460 Ferrari: Valuing the Prancing Horse

Thunderbird School of Global Management, a unit of the Arizona State University Knowledge
Enterprise
Ferrari—the prancing horse—had opened at the top end of its target price range--$52 per share in
the U.S.—raising nearly $1 billion for Ferrari’s owner, Fiat. Like most IPOs, the share price of
RACE (the ticker symbol for Ferrari) settled in the weeks following the launch. But now may
analysts and mutual fund managers were all asking the same thing: Was Ferrari a promising
equity or simply another of the equity eye candy IPO to hit the market in recent years? You are

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expected to combine discounted cash flow analysis and comparables valuation (multiples) in an
effort to project Ferrari’s value. You will first construct the baseline valuation analysis presented
in the case, and then use that baseline analysis to explore a variety of business issues via
sensitivities and scenario analysis to create a range of valuations for Ferrari. Those values and
analyses are then combined with multiples. The case will allow us to have a discussion of the
significance of growth to a firm’s potential value prospects.

Questions:
1. What do you believe is key to Ferrari’s brand value? What does Ferrari need to do over
time to retain and potentially build that value?
2. What is the primary target market for Ferrari sales?
3. What are the primary challenges facing Ferrari’s continued success as a publicly traded
company?
4. How does Ferrari’s financial performance compare to other global automakers?
5. How is it that Ferrari has been able to achieve such high gross and operating margins
compared to others?
6. What are the fundamental principles of the discounted cash flow valuation of Exhibit 5?
7. What key variable inputs or assumptions are of most critical interest for Ferrari’s
valuation?
8. What do you think is a relevant range of values for Ferrari’s DCF valuation?
9. What conclusion can you draw from the comparables analysis? Are these in any
significant way different from what the DCF analysis shows?
10. What is Ferrari worth?

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