Bill miller and value trust case study solution

Case Studies in Finance links managerial decisions to capital markets and the expectations of investors. At the core of almost all of the cases is a valuation task that requires students to look to financial markets for guidance in resolving the case problem. These cases also invite students to apply modern information technology to the analysis of managerial decisions. In the Seventh Edition, 25% of the cases are new with many dating from 2011–2012, ensuring that your students are learning from the most relevant and current sources.

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Case Studies in Finance managing for corporate value creation

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Case Studies in Finance

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Case Studies in Finance

Managing for Corporate Value Creation

Seventh Edition

Robert F. Bruner Kenneth M. Eades Michael J. Schill

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CASE STUDIES IN FINANCE: MANAGING FOR CORPORATE VALUE CREATION, SEVENTH EDITION

Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2002, 1989, and 1975. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broad- cast for distance learning.

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Bruner, Robert F., 1949- Case studies in finance : managing for corporate value creation / Robert F. Bruner, Kenneth M. Eades,

Michael J. Scholl.––Seventh Edition. pages cm

Includes index. ISBN-13: 978-0-07-786171-1 (alk. paper) ISBN-10: 0-07-786171-X (alk. paper) 1. Corporations––Finance––Case studies. 2. International business enterprises––Finance––Case studies.

I. Eades, Ken M. II. Schill, Michael J. III. Title. HG4015.5.B78 2013 658.15––dc23 2012046392

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites.

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vii

In dedication to our wives

Barbara M. Bruner Kathy N. Eades

Mary Ann H. Schill

and to our children

Dedication

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Robert F. Bruner is Dean of the Darden Graduate School of Business Administration, Distinguished Professor of Business Administration and Charles C. Abbott Professor of Business Administration at the University of Virginia. He has taught and written in various areas, including corporate finance, mergers and acquisitions, investing in emerg- ing markets, innovation, and technology transfer. In addition to Case Studies in Finance, his books include Finance Interactive, multimedia tutorial software in Finance (Irwin/ McGraw-Hill 1997), The Portable MBA (Wiley 2003), Applied Mergers and Acquisitions, (Wiley, 2004), Deals from Hell: M&A Lessons that Rise Above the Ashes (Wiley, 2005) and The Panic of 1907 (Wiley, 2007). He has been recognized in the United States and Europe for his teaching and case writing. BusinessWeek magazine cited him as one of the “masters of the MBA classroom.” He is the author or co-author of over 400 case studies and notes. His research has been published in journals such as Financial Man- agement, Journal of Accounting and Economics, Journal of Applied Corporate Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, and Journal of Money, Credit, and Banking. Industrial corporations, financial institutions, and government agencies have retained him for counsel and training. He has been on the faculty of the Darden School since 1982, and has been a visiting professor at various schools including Columbia, INSEAD, and IESE. Formerly he was a loan officer and investment analyst for First Chicago Corporation. He holds the B.A. degree from Yale University and the M.B.A. and D.B.A. degrees from Harvard University. Copies of his papers and essays may be obtained from his website, http://www.darden.virginia.edu/ web/Faculty-Research/Directory/Full-time/Robert-F-Bruner/. He may be reached via email at brunerr@virginia.edu.

About the Authors

Kenneth M. Eades is Professor of Business Administration and Area Coordinator of the Finance Department of the Darden Graduate School of Business Administration at the University of Virginia. He has taught a variety of corporate finance topics including: capital structure, dividend policy, risk management, capital investments and firm valuation. His research interests are in the area of corporate finance where he has published articles in The Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, and Financial Management. In addition to Case Studies in Finance, his books include The Portable MBA (Wiley 2010) Finance Interactive, a multimedia tutorial software in Finance (Irwin/McGraw-Hill 1997) and Case Studies in Financial Decision Making (Dry- den Press, 1994). He has written numerous case studies as well as a web-based, interactive tutorial on the pricing of financial derivatives. He has received the Wachovia Award for Excellence in Teaching Materials and the Wachovia Award for Excellence in Research. Mr. Eades is active in executive education programs at the Darden School and has served as a consultant to a number of corporations and institutions; including many commercial banks and investment banks; Fortune 500 companies and the Internal Revenue Service. Prior to joining Darden in 1988, Professor Eades was a member of the faculties at The University

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of Michigan and the Kellogg School of Management at Northwestern University. He has a B.S. from the University of Kentucky and Ph.D. from Purdue University. His website is http://www.darden.virginia.edu/web/Faculty-Research/Directory/Full-time/Kenneth-M- Eades/ and he may be reached via email at eades@virginia.edu.

Michael J. Schill is Associate Professor of Business Administration of the Darden Graduate School of Business Administration at the University of Virginia where he teaches corporate finance and investments. His research spans empirical questions in corporate finance, investments, and international finance. He is the author of numerous articles that have been published in leading finance journals such as Journal of Business, Journal of Finance, Journal of Financial Economics, and Review of Financial Studies, and cited by major media outlets such as The Wall Street Journal. Some of his recent research projects investigate the market pricing of firm growth and the corporate gains to foreign stock exchange listing or foreign currency borrowing. He has been on the faculty of the Darden School since 2001 and was previously with the University of California, Riverside, as well as a visiting professor at Cambridge and Melbourne. Prior to his doctoral work, he was a management consultant with Marakon Associates in Stamford and London. He continues to be active in consult- ing and executive education for major corporations. He received a B.S. degree from Brigham Young University, an M.B.A. from INSEAD, and a Ph.D. from University of Washington. More details are available from his website, http://www.darden.vir- ginia.edu/web/Faculty-Research/Directory/Full-time/ Michael-J-Schill/. He may be reached via email at schill@virginia.edu.

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Dedication vii About the Authors viii Contents x Foreword xiii Preface xiv Note to the Student: How To Study and Discuss Cases xxv Ethics in Finance xxxii

Setting Some Themes 1. Warren E. Buffett, 2005 To think like an investor 3 2. Bill Miller and Value Trust Market efficiency 23 3. Ben & Jerry’s Homemade Value creation and governance 39 4. The Battle for Value, 2004: FedEx Corp. vs. Value creation and economic profit 53

United Parcel Service, Inc. 5. Genzyme and Relational Investors: Science Value creation, business strategy and activist investors 75

and Business Collide?

Financial Analysis and Forecasting 6. The Thoughtful Forecaster Forecasting principles 101 7. The Financial Detective, 2005 Ratio analysis 119 8. Krispy Kreme Doughnuts, Inc. Financial statement analysis 125 9. The Body Shop International PLC 2001: Introduction to forecasting 143

An Introduction to Financial Modeling 10. Value Line Publishing: October 2002 Financial ratios and forecasting 161 11. Horniman Horticulture Analysis of growth and bank financing 175 12. Guna Fibres, Ltd. Forecasting seasonal financing needs 181

Estimating the Cost of Capital 13. “Best Practices” in Estimating the Cost Estimating the cost of capital 193

of Capital: Survey and Synthesis” 14. Roche Holdings AG: Funding the Genentech Cost of debt capital 219

Acquisition 15. Nike, Inc.: Cost of Capital Cost of capital for the firm 235 16. Teletech Corporation, 2005 Business segments and risk-return tradeoffs 243 17. The Boeing 7E7 Project specific risk-return 257

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Capital Budgeting and Resource Allocation 18. The Investment Detective Investment criteria and discounted cash flow 283 19. Worldwide Paper Company Analysis of an expansion investment 285 20. Target Corporation Multifaceted capital investment decisions 289 21 Aurora Textile Company Analysis of an investment in a declining industry 311 22. Compass Records Analysis of working capital investment 323 23 The Procter and Gamble Company: Scenario analysis in a project decision 337

Investment in Crest Whitestrips Advanced Seal

24. Victoria Chemicals plc (A): Relevant cash flows 349 The Merseyside Project

25 Victoria Chemicals plc (B): The Merseyside Mutually exclusive investment opportunities 357 and Rotterdam Projects

26. Star River Electronics Ltd. Capital project analysis and forecasting 365 27. The Jacobs Division 2010 Strategic planning 373 28. University of Virginia Health System: Analysis of an investment in a not-for-profit 381

The Long-Term Acute Care Hospital organization Project

Management of the Firm’s Equity: Dividends and Repurchases 29. Gainesboro Machine Tools Corporation Dividend payout decision 393 30. AutoZone, Inc. Dividend and stock buyback decisions 409

Management of the Corporate Capital Structure 31. An Introduction to Debt Policy and Value Effects of debt tax shields 425 32. Structuring Corporate Financial Policy: Concepts in setting financial policy 431

Diagnosis of Problems and Evaluation of Strategies

33. California Pizza Kitchen Optimal leverage 449 34. The Wm. Wrigley Jr. Company: Capital Leveraged restructuring 467

Structure, Valuation, and Cost of Capital 35. Deluxe Corporation Financial flexibility 479 36. Horizon Lines, Inc. Bankruptcy/restructuring 497

Analysis of Financing Tactics: Leases, Options, and Foreign Currency 37. Carrefour S.A. Currency risk management 513 38. Baker Adhesives Hedging foreign currency cash flows 523 39. J&L Railroad Risk management and hedging commodity risk 529 40. Primus Automation Division, 2002 Economics of lease financing 541 41. MoGen, Inc. Convertible bond valuation and financial engineering 553

Contents xi

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8Valuing the Enterprise: Acquisitions and Buyouts42. Methods of Valuation for Mergers Valuation principles 569and Acquisitions43. American Greetings Firm valuation in stock repurchase decision 589 44. Arcadian Microarray Technologies, Inc. Evaluating terminal values 599 45. JetBlue Airways IPO Valuation Initial public offering valuation 617 46. Rosetta Stone: Pricing the 2009 IPO Initial public offering valuation 635 47. The Timken Company Financing an acquisition 655 48. Sun Microsystems Valuing a takeover opportunity 671 49. Hershey Foods Corporation: Bitter Corporate governance influence 693

Times in a Sweet Place 50. Flinder Valves and Controls Inc. Valuing the enterprise for sale 715 51. Palamon Capital Partners/TeamSystem Valuing a private equity investment 727

S.p.A. 52. Purinex, Inc. Financing the early-stage firm 745 53. Medfield Pharmaceuticals Valuing strategic alternatives 755

xii Contents

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The half-decade from 2008 to 2013 forced a series of “teachable moments” into the consciousness of leaders in both business and government. More such moments may be in the offing, given the unresolved issues stemming from the global financial crisis. What lessons shall we draw from these moments? And how shall we teach the lessons so that the next generation of leaders can implement wiser policies?

One theme implicit in most critiques and policy recommendations of this period entails the con- sequences of financial illiteracy. At few other times in financial history have we seen so strong an affir- mation of Derek Bok’s famous argument, “If you think education is expensive, try ignorance.” The actions and behavior of consumers, investors, financial intermediaries, and regulators suggest ignorance (naïve or otherwise) of such basic financial concepts as time value of money, risk-adjusted returns, cost of capital, capital adequacy, solvency, optionality, capital market efficiency, and so on. If ignorance is bliss, teachers of finance face a delirious world.

Now more than ever, the case method of teaching corporate finance is critical to meeting the diverse educational challenges of our day. The cases presented in this volume address the richness of the problems that practitioners face and help to develop the student in three critical areas:

• Knowledge. The conceptual and computational building blocks of finance are the necessary foun- dation for professional competence. The cases in this volume afford solid practice with the breadth and depth of this foundational knowledge. And they link the practical application of tools and con- cepts to a contextual setting for analysis. Such real-world linkage is an important advantage of case studies over textbook problem sets.

• Skills. Case studies demand decisions and recommendations. Too many analysts are content to calculate or estimate without helping a decision-maker fully understand the implications of the analysis. By placing the student in the position of the decision-maker, the case study promotes confidence and competence in making decisions. Furthermore, class discussions of cases promote skills in communication, selling and defending ideas, giving feedback, negotiating, and getting re- sults through teamwork—these are social skills that are best learned in face-to-face engagement.

• Attributes of character. Popular outrage over the crisis focused on shady ethics. The duty of agents, diligence in the execution of professional responsibilities, breaches of trust, the temptations of self- dealing, and outright fraud intrude into retrospective assessments of what might otherwise be dry and technical analyses of the last decade. It is no longer possible or desirable to teach finance as a purely technical subject devoid of ethical considerations. Ultimately, teaching is a moral act: by choosing worthy problems, modeling behavior, and challenging the thinking of students, the teacher strength- ens students in ways that are vitally important for the future of society. The case method builds attrib- utes of character such as work ethic and persistence; empathy for classmates and decision-makers; social awareness of the consequences of decisions and the challenging context for decision-makers; and accountability for one’s work. When students are challenged orally to explain their work, the ensuing discussion reveals the moral dilemmas that confront the decision maker. At the core of transformational teaching with cases is growth in integrity. As Aristotle said, “Character is destiny,” a truism readily apparent in the ruinous aftermath of the global financial crisis.

As with the sixth edition of this book, I must commend my colleagues, Kenneth Eades and Michael Schill, who brought this seventh edition to the public. They are accomplished scholars in Finance and masterful teachers—above all, they are devoted to the quality of the learning experience for students. Their efforts in preparing this volume will enrich the learning for countless students and help teachers world-wide to rise to the various challenges of the post-crisis world.

Robert F. Bruner Dean and Charles C. Abbott Professor of Business Administration Distinguished Professor of Business Administration Darden Graduate School of Business Administration University of Virginia Charlottesville, Virginia October 8, 2012

Foreword

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The inexplicable is all around us. So is the incomprehensible. So is the unintelligible. Interviewing Babe Ruth* in 1928, I put it to him “People come and ask what’s your system for hitting home runs—that so?” “Yes,” said the Babe, “and all I can tell ‘em is I pick a good one and sock it. I get back to the dugout and they ask me what it was I hit and I tell ‘em I don’t know except it looked good.”

—Carl Sandburg†

Managers are not confronted with problems that are independent of each other, but with dynamic situations that consist of complex systems of changing problems that interact with each other. I call such situations messes . . . Managers do not solve problems: they manage messes.

—Russell Ackoff‡

Orientation of the Book

Practitioners tell us that much in finance is inexplicable, incomprehensible, and unin- telligible. Like Babe Ruth, their explanations for their actions often amount to “I pick a good one and sock it.” Fortunately for a rising generation of practitioners, tools and concepts of Modern Finance provide a language and approach for excellent perform- ance. The aim of this book is to illustrate and exercise the application of these tools and concepts in a messy world.

Focus on Value

The subtitle of this book is Managing for Corporate Value Creation. Economics teaches us that value creation should be an enduring focus of concern because value is the foundation of survival and prosperity of the enterprise. The focus on value also helps managers understand the impact of the firm on the world around it. These cases harness and exercise this economic view of the firm. It is the special province of finance to highlight value as a legitimate concern for managers. The cases in this book exercise valuation analysis over a wide range of assets, debt, equities, and options, and a wide range of perspectives, such as investor, creditor, and manager.

Linkage to Capital Markets

An important premise of these cases is that managers should take cues from the cap- ital markets. The cases in this volume help the student learn to look at the capital markets in four ways. First, they illustrate important players in the capital markets such as individual exemplars like Warren Buffett and Bill Miller and institutions like

Preface

*George Herman “Babe” Ruth (1895–1948) was one of the most famous players in the history of American baseball, leading the league in home runs for 10 straight seasons, setting a record of 60 home runs in one season, and hitting 714 home runs in his career. Ruth was also known as the “Sultan of Swat.”

†Carl Sandburg, “Notes for Preface,” in Harvest Poems (New York: Harcourt Brace Jovanovich, 1960), p.11.

‡Russell Ackoff, “The Future of Operational Research is Past,” Journal of Operational Research Society, 30, 1 (Pergamon Press, Ltd., 1979): 93–104.

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investment banks, commercial banks, rating agencies, hedge funds, merger arbi- trageurs, private equity firms, lessors of industrial equipment, and so on. Second, they exercise the students’ abilities to interpret capital market conditions across the eco- nomic cycle. Third, they explore the design of financial securities, and illuminate the use of exotic instruments in support of corporate policy. Finally, they help students understand the implications of transparency of the firm to investors, and the impact of news about the firm in an efficient market.

Respect for the Administrative Point of View

The real world is messy. Information is incomplete, arrives late, or is reported with error. The motivations of counterparties are ambiguous. Resources often fall short. These cases illustrate the immense practicality of finance theory in sorting out the issues facing managers, assessing alternatives, and illuminating the effects of any par- ticular choice. A number of the cases in this book present practical ethical dilemmas or moral hazards facing managers—indeed, this edition features a chapter, “Ethics in Finance” right at the beginning, where ethics belongs. Most of the cases (and teach- ing plans in the associated instructor’s manual) call for action plans rather than mere analyses or descriptions of a problem.

Contemporaneity

All of the cases in this book are set in the year 2000 or after and 40 percent are set in 2006 or later. A substantial proportion (25 percent) of these cases and technical notes are new, or significantly updated. The mix of cases reflects the global business environment: 45 percent of the cases in this book are set outside the United States, or have strong cross-border elements. Finally the blend of cases continues to reflect the growing role of women in managerial ranks: 28 percent of the cases present women as key protagonists and decision-makers. Generally, these cases reflect the increasingly diverse world of business participants.

Plan of the Book

The cases may be taught in many different combinations. The sequence indicated by the table of contents corresponds to course designs used at Darden. Each cluster of cases in the Table of Contents suggests a concept module, with a particular orientation.

1. Setting Some Themes. These cases introduce basic concepts of value creation, assessment of performance against a capital market benchmark, and capital market efficiency that reappear throughout a case course. The numerical analysis required of the student is relatively light. The synthesis of case facts into an important framework or perspective is the main challenge. The case, “Warren E. Buffett, 2005,” sets the nearly universal theme of this volume: the need to think like an investor. “Bill Miller and Value Trust,” explores a basic question about performance measurement: what is the right benchmark against which to evaluate success? “Ben & Jerry’s Homemade, Inc.” invites a consideration of “value” and the ways to measure it. The case entitled, “The Battle for Value, 2004: FedEx Corp. vs. United Parcel Service, Inc.” uses

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“economic profit” (or EVA®) to explore the origins of value creation and destruction, and its competitive implications for the future. A new case, “Genzyme and Relational Investors: Science and Business Collide?”, poses the dilemma of managing a public company when the objectives of the shareholders are not always easily aligned with the long-term objectives of the company.

2. Financial Analysis and Forecasting. In this section, students are introduced to the crucial skills of financial-statement analysis, break-even analysis, ratio analysis, and financial statement forecasting. The section starts with a note, “The Thoughtful Forecaster”, that provides a helpful introduction to financial state- ment analysis and student guidance on generating rational financial forecasts. The case, “Value Line Publishing: October 2002”, provides students an exposure to financial modeling with electronic spreadsheets. “Horniman Horticulture” uses a financial model to build intuition for the relevancy of corporate cash flow and the financial effects of firm growth. The case, “Krispy Kreme Doughnuts, Inc.,” confronts issues regarding the quality of reported financial results. “Guna Fibres” asks the students to consider a variety of working capital decisions, including the impact of seasonal demand upon financing needs. Other cases address issues in the analysis of working-capital management, and credit analysis.

3. Estimating the Cost of Capital. This module begins with a discussion of “best practices” among leading firms. The cases exercise skills in estimating the cost of capital for firms and their business segments. The cases aim to exercise and solidify students’ mastery of the capital asset pricing model, the dividend-growth model, and the weighted average cost of capital formula. “Roche Holdings AG: Funding the Genentech Acquisition” is a new case that invites students to estimate the appropriate cost of debt in the largest debt issuance in history. The case provides an introduction to the concept of estimating required returns. “Nike, Inc.: Cost of Capital” presents an introductory exercise in the estimation of the weighted average cost of capital. “Teletech Corporation, 2005,” explores the implications of mean-variance analysis to business segments within a firm, and gives a useful foundation for discussing value-additivity. “The Boeing 7E7,” presents a dramatic exercise in the estimation of a discount rate for a major corporate project.

4. Capital Budgeting and Resource Allocation. The focus of these cases is the evaluation of investment opportunities and entire capital budgets. The analytical challenges range from simple time value of money problems (“The Investment Detective”) to setting the entire capital budget for a resource-constrained firm (“Target Corporation”). Key issues in this module include the estimation of Free Cash Flows, the comparison of various investment criteria (NPV, IRR, payback, and equivalent annuities), the treatment of issues in mutually exclusive invest- ments, and capital budgeting under rationing. This module features several new cases. The first is “The Procter and Gamble Company: Crest Whitestrips Ad- vanced Seal”, which asks the student to value a new product launch but then con- sider the financial implications of a variety of alternative launch scenarios. The second new case, “Jacobs Division”, presents students an opportunity to consider the implications of strategic planning processes. And finally, “UVa Hospital System: The Long-term Acute Care Hospital Project”, is an analysis of investment

xvi Preface

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decision within a not-for-profit environment. In addition to forecasting and valuing the project’s cash flows, students must assess whether NPV and IRR are appropriate metrics for an organization that does not have stockholders.

5. Management of the Firm’s Equity: Dividends and Repurchases. This module seeks to develop practical principles about dividend policy and share issues by drawing on concepts about dividend irrelevance, signaling, investor clienteles, bond- ing, and agency costs. The first case, “Gainesboro Machine Tools Corporation”, concerns a company that is changing its business strategy and considering a change in its dividend policy. The case serves as a comprehensive introduction to corporate financial policy and themes in managing the right side of the balance sheet. The sec- ond case is new to this edition. “AutoZone, Inc.” is a leading auto parts retailer that has been repurchasing shares over many years. The case serves as an excellent ex- ample of how share repurchases impact the balance sheet and presents the student with the challenge of assessing the impact upon the company’s stock price.

6. Management of the Corporate Capital Structure. The problem of setting capital structure targets is introduced in this module. Prominent issues are the use and creation of debt tax shields, the role of industry economics and technol- ogy, the influence of corporate competitive strategy, the tradeoffs between debt policy, dividend policy, and investment goals, and the avoidance of costs of distress. The case, “California Pizza Kitchen,” addresses the classic dilemma entailed in optimizing the use of debt tax shields and providing financial flexibility—this theme is extended in another case, “Deluxe Corporation” that asks how much flexibility a firm needs. “Horizon Lines, Inc.” is a new case about a company facing default on a debt covenant that will prompt the need for either Chapter 11 protection or a voluntary financial restructuring.

7. Analysis of Financing Tactics: Leases, Options, and Foreign Currency. While the preceding module is concerned with setting debt targets, this module addresses a range of tactics a firm might use to pursue those targets, hedge risk, and exploit market opportunities. Included are domestic and international debt offerings, leases, currency hedges, warrants, and convertibles. With these cases, students will exercise techniques in securities valuation, including the use of option-pricing theory. For example, “Baker Adhesives” explores the concept of exchange-rate risk and the management of that risk with a forward-contract hedge and a money-market hedge. “MoGen, Inc” presents the pricing challenges associ- ated with a convertible bond as well as a complex hedging strategy to change the conversion price of the convertible through the purchase of options and issuance of warrants. A new case, “J&L Railroad”, presents a commodity risk problem for which students are asked to propose a specific hedging strategy using financial contracts offered on the open market or from a commercial bank.

8. Valuing the Enterprise: Acquisitions and Buyouts. This module begins with an extensive introduction to firm valuation in the note “Methods of Valuation: Mergers and Acquisitions.” The focus of the note includes valuation using DCF and multiples. This edition features four new cases in this module. The first new case, “American Greetings”, is provides a straightforward firm valuation in the context of a repurchase decision and is designed to be an introduction to firm