The Importance of Debt Rating Companies
AFIN808
CORPORATE FINANCE
SOLUTIONS TO QUESTIONS FROM TOPIC ONE
1
QUESTION 1.7
F&H continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends.
Unlike those confirmed doubters, we have confidence in the long run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market.
F&H has a rigorous CAPEX approval process, and we are confident of returns of around 8% on investment. That is a far better return than F&H earns on its cash holdings.
The CFO went on to explain that F&H invested excess cash in short‐term US government securities, which are almost entirely risk‐free but offered only a 4% rate of return.
2
a. Is a forecasted 8% return in the encabulator business necessarily better than a
4% safe return on short term US government securities? Why or why not?
b. Is F&H’s opportunity cost of capital 4%. How in principle should the CFO determine the cost of capital?
a. Assuming that the encabulator market is risky, an 8% expected return on the
F&H encabulator investments may be inferior to a 4% return on U.S. government securities. b. Unless their financial assets are as safe as U.S. government securities, their cost of capital would be higher. The CFO could consider what the expected return is on assets with similar risk.
3
QUESTION 1.8
We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example the manager might:
a. Make shareholders as wealthy as possible by investing in real assets.
b. Modify the firms investment plan to help shareholders achieve a particular time‐consumption c. Choose high or low risk assets to match shareholders risk preferences.
d.
CORPORATE FINANCE
SOLUTIONS TO QUESTIONS FROM TOPIC ONE
1
QUESTION 1.7
F&H continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends.
Unlike those confirmed doubters, we have confidence in the long run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market.
F&H has a rigorous CAPEX approval process, and we are confident of returns of around 8% on investment. That is a far better return than F&H earns on its cash holdings.
The CFO went on to explain that F&H invested excess cash in short‐term US government securities, which are almost entirely risk‐free but offered only a 4% rate of return.
2
a. Is a forecasted 8% return in the encabulator business necessarily better than a
4% safe return on short term US government securities? Why or why not?
b. Is F&H’s opportunity cost of capital 4%. How in principle should the CFO determine the cost of capital?
a. Assuming that the encabulator market is risky, an 8% expected return on the
F&H encabulator investments may be inferior to a 4% return on U.S. government securities. b. Unless their financial assets are as safe as U.S. government securities, their cost of capital would be higher. The CFO could consider what the expected return is on assets with similar risk.
3
QUESTION 1.8
We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example the manager might:
a. Make shareholders as wealthy as possible by investing in real assets.
b. Modify the firms investment plan to help shareholders achieve a particular time‐consumption c. Choose high or low risk assets to match shareholders risk preferences.
d.