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Case # 1

In your role as a consultant at a wealth management firm, you have been assigned a very powerful client who holds 1 million shares of Cisco Systems, Inc., purchased on February 28, 2003. In researching Cisco, you discovered that they are holding a large amount of cash. Additionally, your client is upset that the Cisco stock price has been somewhat stagnant as of late. The client is considering approaching the Board of Directors with a plan for half of the cash the firm has accumulated but can’t decide whether a share repurchase, or a special dividend would be best. You have been asked to determine which initiative would generate the greatest amount of money after taxes, assuming that with a share repurchase your client would keep the same proportion of ownership. Because both dividends and capital gains are taxed at the same rate (20%), your client has assumed that there is no difference between the repurchase and the dividend. To confirm, you need to “run the numbers” for each scenario.

1.Go to finance.yahoo.com, enter the symbol for Cisco (CSCO), and click “Search” then click on “Statistics”.

a.Record the current price and the number of shares outstanding.

b.Click “Balance Sheet” under “Financials.” When the income statement appears, place the cursor inside the statement and right-click. Select “Export to Microsoft Excel” from the menu. If this option does not appear, then copy and paste the information.

2.Using one-half of the most recent cash and cash equivalents reported on the balance sheet (in thousands of dollars), compute the following:

a.The number of shares that would be repurchased given the current market price.

b.The dividend per share that could be paid given the total number of shares outstanding.

3.Go to http://finance.yahoo.com to obtain the price at which your client purchased the stock on February 28, 2003.

a.Enter the symbol for Cisco and click “Search.”

b.Click “Historical Data”; enter the date your client purchased the stock as the start date and the end date and hit “Enter.” Record the adjusted closing price.

4.Compute the total cash that would be received by your client under the repurchase and the dividend both before taxes and after taxes. Use the combined Ontario tax rates for 2019 and make the simplifying assumption that there is no U.S. withholding taxes on either capital gains or dividends.

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5.The calculation in step 4 reflects your client’s immediate cash flow and tax liability, but it does not consider the final payoff for the client after any shares not sold in a repurchase are liquidated. To incorporate this feature, you first decide to see what happens if the client sells all remaining shares of stock immediately after the dividend or the repurchase. Assume that the stock price will fall by the amount of the dividend if a dividend is paid. What are the client’s total after-tax cash flows (considering both the payout and the capital gain) under the repurchase of the dividend in this case?

6.Under which program would your client be better off before taxes? Which program is better after taxes, assuming the remaining shares are sold immediately after the dividend is paid?

7.Because your client is unlikely to sell all 1 million shares today, at the time of dividend/repurchase, you decide to consider two longer holding periods: Assume that under both plans the client sells all remaining shares of stock 5 years later, or the client sells 10 years later. Assume that the stock will return 10% per year going forward. Also assume that Cisco will pay no other dividends over the next 10 years.

a.What would be the stock price after 5 years or 10 years if a dividend is paid now?

b.What would be the stock price after 5 years or 10 years if Cisco repurchases shares now?

c.Calculate the total after-tax cash flows at both points in time (when the dividend payment or the share repurchase takes place, and when the rest of the shares are sold) for your client if the remaining shares are sold in 5 years under both initiatives. Compute the difference between the cash flows under both initiatives at each point in time. Repeat assuming the shares are sold in 10 years.

8.Repeat Question 7 assuming the stock will return 20% per year going forward. What do you notice about the difference in the cash flows under the two initiatives when the return is 20% and 10%?

Case # 2

You are a senior financial analyst with IBM in its capital budgeting division. IBM is considering expanding in Australia due to its positive business atmosphere and cultural similarities to the United States.

The new facility would require an initial investment in fixed assets of 5 billion AUD, and an additional capital investment of 3% would be required each year in years 1 to 4. All capital investments would be depreciated straight line over the five years that the facility would operate. First-year revenues from the facility are expected to be 6 billion AUD and grow at 10% per year. Cost of goods sold would be 40% of revenue; the other operating expenses would amount to 12% of revenue. Net working capital requirements would be 11% of sales and would be required the year prior to the actual revenues. All net working capital would be recovered at the end of the fifth year. Assume that the tax rates are the same in the two countries, that the two markets are internationally integrated, and that the cash flow uncertainty of the project is uncorrelated with changes in the exchange rate. Your team manager wants you to determine the NPV of the project in U.S. dollars using a cost of capital of 12%.

1.Go to the NASDAQ website (www.nasdaq.com).

a.Enter the ticker symbol for IBM (IBM) in the “Enter Symbol” box.

b.Click on “Financials” in the menu on the left, and then “Income Statement”. When the income statement appears, place the cursor inside the statement and right-click. Select “Export to Microsoft Excel” from the menu. If this option does not appear, then copy and paste the information.

2.Obtain exchange rates and comparable interest rates for Australia at the Bloomberg website (www.bloomberg.com).

a.Click on “Currencies” in the drop-down menu. Export the currency table to Excel and paste it into the same spreadsheet as the IBM income statement.

b.Click back to the prior webpage and click on “Rates & Bonds.” Next, click on “Australia” to get the interest rates for Australia. Right-click and export the table to Excel; paste it into the spreadsheet.

c.Go back to the webpage and click on “U.S.” Download the Treasury data and paste it into the spreadsheet.

3.You may have noticed that the one-year and four-year rates are not available at Bloomberg.com for the U.S. Treasury. Go to the U.S. Treasury website (www.treas.gov).

a.To find the one-year rate, type “yield curve” into the search box at the top of the page and select the second link that appears. Be sure it is not the link for the “real” rates. Export the yields into Excel into the same spreadsheet as the other data. Add the one-year yield to the other Treasury rates.

b.To find an estimate of the four-year yield, calculate the average of the three- and five-year yields from the Treasury yield curve.

4.In your Excel spreadsheet, create a new worksheet with a timeline for the project’s expected cash flows.

a.Compute the tax rate as the four-year average of IBM’s annual income tax divided by annual earnings before tax.

b.Determine the expected free cash flows of the project.

5.Note that the free cash flows you calculated in Question 4 are in Australian dollars. Use Equation 22.2 to determine the forward exchange rates for each of the five years of the project. Then use the forward rates to convert the cash flows to U.S. dollars.

6.Compute the NPV of the project in U.S. dollars using the 12% required return given by your team manager.

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