Case Study Financial Management

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FINANCIAL MANAGEMENT-CASE 2 |

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CRISTINA CARRILLO

BEN GRAHAMVIRGINIA MARTINEZPABLO MEDINA |

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A. JANUARY 2005

(A.1) Firm values

We need E[EBIT] and r0.

Due to V=E+D= E[EBIT]/r0 :

| E[EBIT] | r0 | V |

Firm 1 | 2000 | 8% | 25000 |

Firm 2 | 480 | 8% | 6000 |

Firm 3 | 700 | 8% | 8750 |

(A.2) Share values

We need the value of equity and the number of shares in order to compute share values.

| V | D | E | Nºshares | Share Value |

Firm 1 | 25000 | 7000 | 18000 | 4125 | 4.36 |

Firm 2 | 6000 | 0 | 6000 | 4800 | 1.25 |

Firm 3 | 8750 | 7050 | 8000 | 3312.5 | 2.0 |

| | D=interests/rD | E=V+D | Net profit/EPS | E/nºshares |

(A.3) Expected return on equity

| V | D | E | r0 | rD | rE |

Firm 1 | 25000 | 7000 | 18000 | 8% | 5% | 9.16% |

Firm 2 | 6000 | 0 | 6000 | 8% | 5% | 8% |

Firm 3 | 8750 | 750 | 8000 | 8% | 5% | 8.28% |

(A.4) Weighted average cost of capital

| V | D | E | r0 | rD | rE | WACC |

Firm 1 | 25000 | 7000 | 18000 | 8% | 5% | 9.16% | 8% |

Firm 2 | 6000 | 0 | 6000 | 8% | 5% | 8% | 8% |

Firm 3 | 8750 | 750 | 8000 | 8% | 5% | 8.28% | 8% |

B. APRIL 2005

(B.1) knowing that the prospectus will be read by potential investors and by financial analysts (these will issue future recommendations and publish price targets on the shares of the firm), what advice do you give the financial director of Firm 1 regarding the inclusion of his paragraph. Why?

Our recommendation would be not to include this paragraph in the prospectus, due to the fact that it states a contradiction that investors and analysts will surely realize. The paragraph says that the firm has managed to get higher returns for shareholders maintaining its level of risk.

Firm 1 is the most leveraged of all three companies and therefore it’s the riskiest for shareholders. This higher risk is evidenced in the higher expected return on...