1 Case 84 Filmore Enterprises Fundamental Concepts Directed Kathy Filgrade started Computer Products Corporation (CPC) in 1985 to design computer systems for individuals and small offices. The company produces machines and software

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Case 84

Filmore Enterprises

Fundamental Concepts Directed

Kathy Filgrade started Computer Products Corporation (CPC) in 1985 to design computer systems for individuals and small offices. The company produces machines and software to fit unique cus- tomer needs and sells the systems at reasonable prices. The company started small and put a heavy emphasis on customer service and education. Many of the initial customers were computer illiter- ate and appreciated the staff's willingness to explain the capabilities of computing in a direct and non-intimidating manner. Customers felt that the technicians could configure systems to meet their requirements and then provide the necessary instructions to operate them efficiently. As a result, cus- tomers developed a special relationship with the company and continue to patronize the store with sübsequent computer and software requirements.

CPC's reputation for quality and for friendly, knowledgeable employees allowed the company to expand rapidly. By March 1997 the company operated six "mega-stores" between Chicago and Milwaukee. The company is operating smoothly, and Kathy is interested in pursuing additional busi- ness opportunities. She does not want to open stores too far from her office because she feels the existing regional focus provides strong quality control. She also believes that the current geo- graphic market area is saturated with computer stores. Therefore, she is interested in identifying a related line of business in which to operate.

Kathy is aware of the growing demand for cyber-bars or cyber-cafes that are springing up throughout the country. These establishments provide ready access to computing resources, includ- ing the internet, in a relaxed atmosphere. They allow traveling business professionals, students, and others a place to work and socialize. Kathy believes that she can provide a competitive edge to this type of operation by offering on-site computer consultation. She is comfortable with the hard-

ware and software demands of this type of enterprise and can hire excellent consultants and instruc-

tors from her existing stores. However, she is interested in finding a partner to handle the food and

beverage aspect of the business.

While attending the board of trustees meeting for the local community college, Kathy men-

tioned her idea to another trustee, Randy Morely. Randy owns and operates Morely Distributors, the

local beverage company that he inherited from his father. He has worked at Morely Distributors

since graduation from college and assumed full responsibility for the business ten years ago. Randy

is an excellent businessman. He had worked with Kathy previously to develop a management infor-

mation system for his operation, which resulted in a general reorganization of the business. Those

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changes were instrumental in doubling the company's profitability. In spite of this success, Ra

feels he operates in his father's shadow. Ody Randy's prior association with Kathy was extremely positive. They worked well

though they approached issues from different points of view. Their distinct perspectives avoid problems with the new system and

strengthened the final project. He is very impressed the quality of Kathy's operation, and he thinks that the cyber-cafe would provide a perfect Joint venture in which to develop his own business reputation. Randy also believes that the local busi. ness environment is perfect for establishing this type of endeavor and that the business has profit potential. great

z. Due to his sales contacts, Randy is well connected with the restaurant industry. He

of a small chain of successful delicatessens that could be bought and expanded to include a computer area. He also knows several excellent restaurant managers who may be interested in running

and beverage part of the operation.

Kathy and Randy decided to pursue the development of a cyber-cafe and name it FilmOte Enterprises in order to provide additional room for diversification. They hired a consulting company to conduct a feasibility study. The study determined that strong local demand for this type of ser. vice exists, but start-up costs are high. In spite of the initial costs, breakeven is anticipated in three years, and the profit potential is excellent.

After the company establishes a solid track record, Kathy and Randy want to take Fi)more Enterprises public, through an initial public offering that would trade over the counter. They know

that most people are risk adverse and require a higher return for holding riskier investments. They

are interested in understanding these issues more fully. Therefore, they asked the consultants to prepare a discussion of risk and return. Since Kathy and Randy's current wealth is tied up in their

individual companies, they want the discussion to start with a formal explanation of the risk-and-

return relationship relative to ownership in a single company. They want the explanation expanded

to include risk and return issues important to potential investors who hold a portfolio of stocks

Finally, they are interested in understanding the risk of managerial decisions as opposed to investors

decisions and how investors' perceptions affect the "true risk" of corporate decisions.

To help make the discussion more concrete, the consultants contacted and obtained forecast

data from several major brokerage companies with which they had a close working relationship.

Because of forecast uncertainty, the consultants developed security returns for five scenarios with

corresponding probabilities of occurrence for the financial instruments listed in Table l. Specifically,

the table lists data for short-term and long-term treasuries, publicly traded stocks for a regional

restaurant chain (referred to as EAT), two companies with operations similar to CPC and Morely,

and an index fund designed to mirror the performance of small stocks as represented by the NAS

DAQ. The statistical properties for CPC were left incomplete so that they could be used for learn-

ing tools during the discussion. The consultants also developed partial data on portfolios composed

of CPC-Morely, CPC-EAT, and Morely-EAT in order to explain how diversification helps investors

and why it is important for determining investors' required return. The consultants' research indi-

cated that Filmore Enterprises should be similar to a company comprised of 40% computer and

restaurant business. The portfolio data for such a company is included in Table 2.

As an employee of the consultant company, you have been assigned to develop and lead the

meeting with Kathy and Randy. To help prepare for the meeting, you have been provided the fol-

lowing questions.

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TABLE 1 Returns on Alternative Investments

Estimated Rates of Return Long-Run State

the Economy Prob. NASDAQ

of

Recession

Below avg. Average

Above avg.

Boom

Expected return Variance

Std deviation

0.10

0.20

0.40

0.20

0.10

Coef of var (CV) Beta coefficient

T-Bills

4.5

4.5

4.5

4.5

0.0

0.00%

0.00

0.00

T-Bonds

10.0%

7.0

5.0

3.0

2.0

5.0

2.23%

0.43 -0.22

CPC -18.00% -8.00

11.00

26.00

35.00

1.53

MORELY 18.00%

14.00

6.00

-1.00 -11.(n

65.8

8.11%

1.42

—0.77

EAT -13.00% —6.00

10.00

20.00

30.00

161.9

12.72%

1.50

1.22

Index

-13.00% -2.00 11.00

17.00

22.00

103.4

10.17%

1.23

1.00

l. Expected returns on stocks consist of an expected dividend yield plus an expected capital

gains yield. The dividend yield is relatively predictable, but the capital gains yield is uncer- tain. Therefore, most of the variation between the high and the low returns shown in the

table result from uncertainty about the stocks' prices and the resulting capital gains or losses.

2. Returns on T-bonds during a given year consist of interest income plus capital gains if bond

prices rise, or capital losses if prices decline. An increase in interest rates will lead to falling

bond prices, while a decline in rates will lead to rising bond prices. Interest rates tend to rise

during recession and fall during booms.

3. Betas are most appropriate for stocks. They are questionable for long-term bonds, primarily

because bond returns are not included in the market index.

TABLE 2

Returns on Portfolios

Long-Run State

of the Economy

Recession

Below avg.

Average

Above avg.

Boom

Expected return

Variance

Std deviation

of

Prob.

0.10

0.20

0.40

0.20

0.10

CPC

Morely

Portfolio

CPC

EAT

-15.00% —6.80

10.40

22.40

32.00

8.98%

197.1

14.04%

1.56

Morely

EAT

2.50%

4.00

8.00

9.50

9.50

7.10%

6.1

2.47%

0.35Coef var (CV)

2.

@ 1998 South-Western, a part of Cengage Leaming

o QUESTIONS

l. Calculate the expected rate of return for each of the financial assets listed in Table I

complete the expected return row for Table l. Based solely on the expected returns, which

of the investments appears the best and worst? Discuss the impact on returns for general

changes in the economy for CPC, Morely, and EAT.

2. Considering U.S. Treasuries are guaranteed by the U.S. government, answer the following

questions.

a. Is the T-bill return independent of the state of the economy? Briefly explain. Do T-bills promise completely risk-free returns? Explain.

b. Why do T-bond returns vary? Why are T-bond returns high when the market returns are

c. How would returns on corporate bonds that Filmore Enterprises might issue compare with those for T-bonds? Would your answer be dependent on the potential bond rating of Filmore Enterprises?

3. Basing a decision solely on expected returns is appropriate only for risk-neutral individuals. Since most people are risk averse, risk is an important consideration for the decision.

a. Two possible measures of risk are the standard deviation and the coefficient of variation. Calculate the standard deviation and coefficient of variation for CPC returns and com- plete the related blanks in Table l.

b. Compare the risk and expected return relationships among all six assets listed in Table I. Explain the apparent discrepancies with the normal risk and return tradeoff.

4. Suppose investors create a 2-stock portfolio by investing $100,000 in CPC and $100,000 in Morely.

a. Calculate the expected return for each state of the economy, and then compute the expected return for the portfolio. Complete the related blank in Table 2.

b. Compute the standard deviation for the portfolio, and compare it to the standard deviation of the individual stocks. Complete the related blanks in Table 2.

c. In general, how would risk be affected if you formed another portfolio composed of CPC

and EAT? Explain how the correlation coefficient affects the level of diversification in

the CPC-Morely and the CPC-EAT portfolios.

d. Explain what would happen to the expected return and standard deviation as the portfolio

mix changes. If you are using the spreadsheet model for the case, determine the expected

re-turn and standard deviation for a series of CPC-Morely portfolios starting with 0% CPC

and increasing the percentage by 10 points for each iteration.

SL!ppose an investor has a portfolio consisting of just one randomly-selected stock. What

happens to the risk as the investor adds more and more randomly-selected stocks to the port-

folio? Illustrate your answer with a graph showing "portfolio standard deviation" on the

Ocal axis and ''number of stocks" on the horizontal axis.

6. Answer the following questions relating to diversification. a. What implication does diversification have for investors? b. If an investor decides to hold a I-stock portfolio and as a result is exposed

compensated to more risk

for than diversified investors, could the non-diversified investor expect to be all his or her risk? That is, could the investor earn a risk premium large enough to

com-

pensate for that part of the total risk that diversification could have eliminated? c. Explain the difference between total risk, diversifiable risk, and market risk.

1998 South-Western. a part of Cengage Learning

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d. How might the desire for diversification of individual retirement funds affect the structure of U.S. investments?

7. Change Table I by substituting Year 1 through Year 5 for the states of the economy. a. Plot the characteristic lines for CPC, Morely, and T-bills showing the returns on the index

(the market) on the X-axis and the returns on the asset on the Y-axis. Estimate (by visual inspection) the slope for each line. If you are using the spreadsheet model, compute the slope coefficients. How do these compare to the betas provided in Table 1?

b. What is the significance of the distance between the plot points and the regression line, that is, the errors?

c. What do betas measure, and how are they used in risk analysis? d. Develop a chart depicting the beta and expected return for each security, determined from

the data provided by the investment bankers. Does the risk and return relationship appear reasonable relative to the market?

8. Using T-bonds as a risk-free rate and the NASDAQ index as the market, a. Plot the Security Market Line (SML). b. Calculate the required rate of return for CPC, Morely, and EAT based on the Security

Market Line. Compare the required return from the SML with the expected return from Question l. Explain the decision to either buy or sell each of the stocks, given this infor- mation.

c. Are the stocks in equilibrium? If not, how would equilibrium be restored?

9. Filmore Enterprises is expected to be similar to a company composed of 40% CPC and EAT.

a. Compute the beta coefficient for a 40/60 portfolio of CPC-EAT and then determine its required rate of return. How does the required return compare with the expected return from Table 2? Explain why you would or would not purchase this portfolio.

b. Suppose Kathy and Randy decided to provide a greater share of the up-front capital so that the long-term debt ratio was below that represented by the CPC-EAT portfolio. What impact would this have on Filmore Enterprises' risk and required return on equity?

10. The SML might shift in response to various economic changes. A change in the SML affects security prices and rates of return. a. Suppose investors raised their expectations for inflation by 4 percentage points over cur-

rent estimates as reflected in the 5.2% T-bond rate. Explain the effect this would have on the SML and on the returns required on high- versus low-risk securities.

b. Disregard Question IOa and assume that investors' risk aversion increased enough to cause the market risk premium to rise by 4 percentage points. Explain what effect this would have on the SML and on returns of high-risk versus low-risk securities.

c. Discuss the kinds of changes Questions IOa and 10b would have on short-run and long- run effects; for example, might an increase in expected inflation lead to lower returns in the short run followed by higher returns in the long run?

ll. Rather than focusing on risk from an investors' decision-making perspective, consider the

risk of corporate decisions and how investors' perceptions affect the "true risk" of corporate decisions.

a. Why is it important for operating managers to be cognizant of the way investors look

at risk?

b. Suppose a particular decision appears particularly risky to investors (for instance, it

would make the firm look risky), but the firm's managers, who know more about the situ-

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ation than investors, think the decision is really not very risky. How might this situation affect the decision to accept a particular project based on each of the following factors? (l) The project can be financed with internal funds; therefore, the firm does not need to

sell securities to undertake the project. (2) The project is very large, and securities must be sold to finance it. (3) The project is long-term; therefore, it will take years for the company to complete the

project and begin receiving cash flows. (4) The project is short-term, so the company can complete it and receive cash flows

within a few months. c. How would your answers to Question 1 1b change if the project appeared safe to

investors, but the company managers knew that it was quite risky?