Dr. P.V. Viswanath

pviswanath@pace.edu

• Midterm
• Solutions to Midterm
• Final
• Solutions to Final

Lubin School of Business
MBA 673: Applying Financial Theory to Strategic Decision Making
Prof. P.V. Viswanath
Fall 2012

Midterm

• The midterm is closed book.
• Time allowed is 2.5 hours.
• Explain all your steps; correct answers without explanations may not be given any credit at all.
• Show all your computations and formulae. Make all your assumptions explicit. If your approach is correct, you will get some credit, even if your arithmetic answer is wrong. So concentrate on getting your logic right.
• If you answer a question, I have the discretion to award you some points, even if you are completely wrong. If you don't attempt the question at all, I can give you no points! So attempt every question.

1. (20 points) Read the article below (http://insight.kellogg.northwestern.edu/index.php/Kellogg/article/missing_in_aisle_5) and answer the following questions in no more than five sentences each:
   1. "In the short run, losses might not be noticed because losing the sale of Heinz ketchup to a single customer may be overshadowed by what the store saved in inventory cuts. But significant losses are incurred over time if regular customers who did not find their Heinz decide to shop elsewhere rather than risk wasting their time at a store frequently missing what they desire." If this observation is true, why would these retailers ignore the loss of regular customers?
   2. "According to Consumer Reports ratings, Matsa says, well-stocked grocery stores tend to be cleaner, have more courteous staff, and faster check-out lines." How would you explain this correlation?
      

   Missing In Aisle 5: When grocery stores borrow, consumer experience drops
   Based on the research of David A. Matsa
   
   In the hours before a dinner party, hosts often experience a sinking feeling when they discover a missing ingredient: parsley, seltzer water, or a baguette. With guests on the way, hosts have just one stab at getting the purchase right, so they choose their shop carefully.
   
   Moments like these matter in a study by David Matsa, an assistant professor of finance at Kellogg School of Management, who assessed inventory issues at grocery stores. These moments can occur regularly, not just before dinner parties but whenever selective or busy people go shopping. He found that stores with heavy debts to pay off tend to cut back on inventory to save money, but such moves can have unintended consequences over time.
   
   “Firms have to make a choice between investing more in the long run or paying off some of their debt obligation today. And many may decide to pay off loans by cutting back on quality,” Matsa explains. “But the cost of a lack of inventory is potentially very different in the short run than in the long run.”
   
   In the short run, losses might not be noticed because losing the sale of Heinz ketchup to a single customer may be overshadowed by what the store saved in inventory cuts. But significant losses are incurred over time if regular customers who did not find their Heinz decide to shop elsewhere rather than risk wasting their time at a store frequently missing what they desire.
   
   “If I go to a store once and they don’t have my brand of peanut butter, it’s annoying,” says Matsa, “but if they are out almost ten percent of the time, then I start thinking about doing my shopping somewhere else.”
   
   When stores borrow a considerable sum of money, they tend to run out of items 8 to 9 percent more often, estimates Matsa in a paper published in the American Economic Journal: Microeconomics. He calculated this number by traveling regularly to Washington, D.C. over the last five years to peruse the database used to calculate the U.S. Consumer Price Index, which tracks the prices of goods. The government sends employees to businesses to record the price of miscellaneous items each month in order to get a sense of how the economy is fairing. From information in the database, Matsa kept track of items gone missing. “When a surveyor goes out to Chicago, they may track the price of Captain Crunch cereal, and then I know it’s in stock,” he explains. Then, by looking at public account filings from grocery stores and a database that tracks highly leveraged transactions from firms, Matsa kept track of grocery store debt financing.
   
   Not Just Grocery Stores
   
   Matsa thinks that the behavior of grocery stores is applicable to other retailers too, suggesting a general link between borrowing money and cutting inventory. Secondly, he finds that the cost of cutting inventory may be higher than either economists or grocery store owners anticipate.
   
   For example, in 1986 Safeway took out multiple loans. Within two years they cut their inventory by $75 million. That cut-back saved Safeway $19 million annually but Matsa estimates that it reduced long-run profits by approximately $68 million—more than three times what they saved by cutting inventory.
   
   “It’s not just about making a sale, but it’s about having enough inventory so that customers come back in the future,” Matsa explains. “Even if fewer than 1 in 100,000 customers switch stores, cutting inventory to this extent is unprofitable in the long run.”
   
   What’s more, some call inventory a barometer for how grocery stores perform otherwise. According to Consumer Reports ratings, Matsa says, well-stocked grocery stores tend to be cleaner, have more courteous staff, and faster check-out lines. Although his study did not quantify the effects of leverage or borrowing on these factors, he says they potentially suffer as grocery store owners save money in order to repay debt.
   
   Matsa’s numbers are estimations as a number of variables come into play. “When buying diapers, a customer might stick to a brand,” notes Matsa, “but with mustard it may not matter.” Also, customer pickiness varies. In this sense, senior citizens (who have time) and New Yorkers (who have many options) shop alike—preferring to go elsewhere when their specific item is not available—whereas other types of shoppers more readily excuse deficiencies.
   
   Taking out a large loan might help retail stores, but owners should be aware of other parts of their business that the loan may affect as they try to pay it back. More specifically, owners may want to resist the urge to cut inventory. “How a firm finances operations can have important effects on the operations themselves,” Matsa says. “Borrowing decisions and product decisions are more linked than some people may realize.”

2. You have the following information about two supermarket chains, Kroger and Whole Foods. These are the business summaries for the two firms from the Mergent database:
   Kroger operates retail food and drug stores, multi-department stores, jewelry stores, and convenience stores. As of Jan 28 2012, Co. operated, either directly or through its subsidiaries, 2,435 supermarkets and multi-department stores, 1,090 of which had fuel centers. In addition to the supermarkets, as of Jan 28 2012, Co. operated through subsidiaries, 791 convenience stores and 348 fine jewelry stores. In addition, 83 convenience stores were operated through franchise agreements. The convenience stores provide a range of staple food items and general merchandise and, in most cases, sell gasoline. Co. also manufactures and processes some of the food for sale in its supermarkets.
   Whole Foods Market owns and operates a chain of natural and organic foods supermarkets. Co.'s product selection includes, but is not limited to: produce, seafood, grocery, meat and poultry, bakery, prepared foods and catering, specialty (beer, wine and cheese), coffee and tea, nutritional supplements, vitamins, body care, educational products such as books, floral items, pet products and household products. As of Sep 25 2011, Co. operated 311 stores: 299 stores in 38 U.S. states and the District of Columbia; seven stores in Canada; and five stores in the U.K.
   
   Here is some additional information about the two chains, from their financial statements, for the year ending January 28, 2012 and January 29, 2011.
   Kroger Co. (NYS: KR) (in thousands)
   

   Sales	90,374,000		82,189,000
   Net income	596,000		1,133,000
   Interest expense	435,000		448,000
   Income tax	247,000		601,000
   Earnings before income tax	843,000		1,734,000
   Total current assets	7,325,000		7,621,000
   Cash & temporary cash investments	188,000		825,000
   Total current liabilities	9,105,000		8,070,000
   Current portion of long-term debt including obligations under capital leases & financing obligations	1,315,000		588,000
   Total assets	23,476,000		23,505,000
   Pension & postretirement benefit obligations	1,393,000		946,000

   Note that Total Long-term assets equal total assets less current assets
   
   Whole Foods Market
   

   Sales	10,107,787,000		9,005,794,000
   Net income	342,612,000		245,833,000
   Interest expense	3,882,000		33,048,000
   income taxes	209,100,000		165,948,000
   Income before income taxes	551,712,000		411,781,000
   Total current assets	1,453,144,000		1,161,519,000
   Cash & cash equivalents	212,004,000		131,996,000
   Total current liabilities	879,361,000		747,872,000
   Current installments of long-term debt & capital lease obligations	466,000		410,000
   Total assets	4,292,075,000		3,986,540,000

   
   Note that there are no operating long-term liabilities, such as pension liabilities, for Whole Foods, Inc. for the years under consideration.
1. (10 points) Compute the following ratios for the two chains for the year ending January 2012. Write your answers in the form of a table:
   1. Tax Rate
   2. Net Interest Expense After Taxes
   3. NOPAT
   4. Operating Working Capital
   5. Net Long-term assets
   6. Net Assets
   7. Operating ROA
   8. NOPAT Margin
   9. Operating Asset Turnover
2. (5 points) Which of the two firms can be better characterized as going with the volume strategy as opposed to the high profit margin strategy?
3. (10 points) Can you relate your conclusions in part (b) to the business summaries for the two firms?

Answer any three of the following four questions (15 points each; no more one paragraph each):

3. A law firm is considering representing homeowners, whose real estate tax bill has gone up. There are two possible billing options: a) to have the homeowner pay a fixed fee; b) to take a fixed proportion of the tax savings, if any, of the homeowner, following the firm's representation of the homeowner at the tax hearing. If all you know about this firm is that it has a large amount of debt, which of these two billing options do you think the firm would take?
   (Here's a snippet from an illustrative news item from the WSJ of November 6, 2011: ..the collapse of Howrey LLP, a prominent global law firm that specialized in corporate litigation. The firm, which dissolved in March, owed its creditors $107 million when it went under, bankruptcy-court papers show.)



4. A firm that has serious cashflow problems with its bondholders breathing down its neck. A financial analyst has the following opinion regarding the firm: "This firm will invest more in improving product quality because, now more than ever, it needs customers to be attracted to its products." Do you agree with him? Why or why not? Explain.



5. Firms with more debt will behave more aggressively against competitors. This can be true in certain circumstances and false in other circumstances. Explain.



6. Richfield Hospitality is, among other things, a hotel management company. Its website (http://www.richfield.com/) says the following in two different places:
   • Grounded in 40 years of hospitality management experience and financial stability, Richfield maximizes asset health, RevPAR and market share for clients including the ability to provide sponsorship equity.
   • Richfield can provide up to 25% sponsorship equity for acquisitions and joint ventures with either existing owners or with capital partners seeking to acquire assets and/or re-capitalization opportunities. Fully-funded and with access to capital, Richfield is positioned to acquire assets 100%, create joint ventures, provide sliver equity, or execute pure management contracts. We carry no debt, and we have a solid history of strong cash positions. Potential clients respond positively to our ability to extend favorable and flexible business terms including minority investments, working capital loans, and other terms tailored to specific client projects and assets.

   The first claim emphasizes Richfield's financial stability. The second claim touts the fact that Richfield has no debt and has strong cash positions. Why should this be important to its clients; they are, after all, not investing in Richfield Hospitality -- neither in its debt, nor in its equity. Explain in one paragraph.

Solution to Midterm

1. a. The reason why stores with heavy debts tend to cut back on inventory, in spite of the possible losses in terms of customer satisfaction is that customer satisfaction tends to pay off in the medium and long-term. In the short-term, it requires new investment in the form of inventory. For leveraged firms, the benefits of new investment go to existing debtholders, even though the new monies have to come from equity-holders. As a result, such investments are reduced; once the firm takes on debt, such actions are optimal for the firm.

The issue is not that firms with debt want to pay them back to achieve lower debt levels. It can't be just that. Lower debt financing will mean higher equity financing; the firm can't keep levels of opertation fixed with lower capital overall! You can't think of debt service payments as costs of doing business and not think of equity service payments in the same way! The issue is not that the retailers want to pay off short-term debt, it's that they _don't_ want to raise new debt. There is sometimes a tradeoff between the two, and paying off short-term debt is simply the flip-side of not wanting to raise new money.

b. Well-stocked grocery stores tend to be cleaner, have more courteous staff, and faster check-out lines. Well-stocked grocery stores require higher investment in inventory. Faster check out lines and courteous staff require short-term investment in labor costs and labor training. (Even though labor costs are generally accounted for in the income statement from an accounting point of view, in fact some of these expenses are investments because they lead to repeat purchases.) In other words, as we have explained in part a), low debt stores have better inventory. For the same reason, they would also tend to have faster check out lines, courteous staff and be cleaner. And high debt stores exhibit the opposite phenomenon. This is the reason for the correlation.

A possible answer is that some retailers are smart, and these retailers have well-stocked stores, are cleaner, have more courteous staff and faster check-out lines. Other retailers are stupid and these retailers don't know how to run a business and they are bad in all respects. Hence the correlation. However, these firms should lose money and go out of business. So we shouldn't see that many of them. Furthermore, according to this argument, if therre are all these bad businessmen, we shouldn't see good business sense if we do an empirical study; this is not true. Hence the stupid retailer/smart retailer argument is a bad one, especially when there are alternate answers available, as suggested in the article.

2.a.

b. Kroger has a higher Operating Asset Turnover; hence it is better characterized as going with a volume strategy. Whole Foods, on the other hand, has a lower operating asset turnover, but a higher profit margin.

c. This is consistent with the business summaries. Kroger's stores are retail food and drug stores, multi-department stores, jewelry stores, and convenience stores. The convenience stores, in particular, sell staples and general merchandise. These are not high profit margin items. Whole Foods, on the other hand, sells natural and organic foods, which are high profit margin items. The number of stores is not relevant for these conclusions. It is possible to have a single store that focuses on inexpensive, staples and a chain of many stores (like Gap) for example, that focuses on branded, high-margin goods.

3. The article from the WSJ indicates that there are, indeed law firms that have a fair amount of equity -- enough to be in danger of bankruptcy -- just like the firm in the question. We already know that firms with a lot of debt tend to take more risk. The second option of taking a proportion of the tax savings is riskier and so, this debt-laden law firm is likely to take that option. Of course, it makes sense from an incentive point of view, as well.

We should not confuse the risk issue with the timing issue. First of all, there is no reason to assume that clients are unaware of the time value of money. Hence if they were required to pay upfront, they would demand to pay less. Second, it's possible to have the client, even in the second option, pay a fixed amount early and get a refund -- the question is not asking about the timing, solely about the uncertainty. Finally, we are not told that the firm is in financial distress, just that it has a lot of debt. If the firm were in financial distress, it might chose options that paid up early, even taking the time value of debt into account; all we know is that it has a lot of debt.

One could argue that law firms should not have a lot of debt because of the nature of their product, and that our firm should try and reduce its debt. Even granting that, it's not clear how option one would reduce debt more than option two. Perhaps option two would be better because the firm has more control of the outcome, since it has an incentive to provide better service and clients would be willing to pay a higher percentage on average of their tax savings than otherwise. According to this argument, option two would allow the firm to reduce its debt faster.

4. We have seen that firms in financial distress tend to invest less in long-term projects in preference to projects that bring in cash right away. This is because financing is difficult for firms in financial distress, which have debt -- the benefits from new money goes first to the existing debtholders; as a result, the new bondholders have to be promised high payouts, and this makes investment in new projects less attractive. Investment in product quality is of this kind, and so even though high product quality is important, it tends to get pushed off.

5. A competitor that believes the market leader will fight to keep its market share will be reluctant to aggressively expand its own market share.  Hence the market leader can capture a strategic advantage if it credibly commits to protecting its market share aggressively.

When aggregate demand for a product is highly uncertain, higher output generally increases risk because it leads to higher profits when product demand turns out to be high, but lower profits when demand turns out to be low. Since higher leverage increases a firm’s appetite for risk, the greater a firm’s leverage, the greater its incentive to produce at a higher level of output. Not wishing to drive the price down to where no firm profits, competitors will accommodate the firms’ high output by producing at a lower level.

On the other hand, we also know that debt financing makes a firm more reluctant to invest new funds. Hence a leveraged firm might be less willing to act aggressively, when less leveraged competitors would be more willing to jump in and invest.

Hence the impact of debt on competitive aggressiveness is ambiguous. If agressiveness requires taking risk, leveraged firms would do be more inclined to do so; however, if aggressiveness requires investment of funds, leveraged firms would not be optimally situated for such action.

6. A hotel management company provides management services to hotels. Such services require medium-term investments by the management company in the hotels that they are managing in terms of money, manpower and time. The return for such services are in the form, most often, of a fixed payment. The management company, therefore, is like a creditor and, as such, is interested in the financial health of its clients. Recognizing that the hotel management companies have to make investments to assure quality, hotels will not want resource-constrained management companies, since we know that resource-constrained companies often make sacrifices in terms of quality and other long-term investments.

Moreover, the client hotels, too, have to make an investment in terms of money and time. If the management strategy doesn't work out, they have to switch management companies and possibly strategies. Switching from one management company to another is costly because of the switch-over costs both in terms of money and in terms of suboptimal operation of the hotels. There is also a lot of uncertainty, both for employees and for the hotel's long-term and repeat clients. Hotels, therefore, would prefer not to have to switch management companies. If a management company goes bankrupt, such a switch will be necessitated. As a result, hotels would be interested in the financial well-being of the management companies to avoid such switches.

Lubin School of Business
MBA 673: Applying Financial Theory to Strategic Decision Making
Prof. P.V. Viswanath
Fall 2012

Final

• The exam is closed book.
• Time allowed is 2.5 hours.
• Explain all your answers; correct answers without explanations may not be given any credit at all.
• Make sure that your answer is clear and concise. Confused and rambling answers will lose points.
• If you answer a question, I have the discretion to award you some points, even if you are completely wrong. If you don't attempt the question at all, I can give you no points! So attempt every question.

1. (40 points) Read the article below from The Economist of June 18, 2009 and answer the following questions (use no more than one page maximum for each answer):
   
   
   1. What are the pros and cons, for corporations, of using over-the-counter as opposed to exchange-traded derivatives for hedging?
   2. Why would banks lend more cheaply to firms that hedge?
   3. How might hedging influence a corporation's ability to compete with rivals? What are some of the factors that would affect a corporation's ability to use hedging as a competitive tool?
   4. "ThyssenKrupp, a German industrial firm, hedges its currency exposure each time it signs a large export order, for example. Similarly Rolls-Royce, a British aerospace company, is active on foreign-exchange markets because most of its revenues are in dollars but many of its costs are paid in pounds." Why do ThyssenKrupp and Rolls-Royce hedge foreign exchange exposure? Why don't they let investors offset this risk through diversification?
      

      Corporate hedging gets harder: The perils of prudence
      
      WARREN BUFFETT, one of the world's most famous investors, once called derivatives “financial weapons of mass destruction”. Central bankers worry that those sold “over the counter”, meaning outside exchanges, threaten the stability of the whole financial system. Yet firms that rely on derivatives to limit their exposure to swings in commodity prices, interest rates or exchange rates cannot get enough of them—literally.

      Several firms using derivatives in an attempt to manage such risks have suffered huge losses of late, on paper at any rate. Among the hardest hit have been airlines, many of which paid to protect themselves from higher fuel prices last year when the oil price peaked at $147 a barrel. Because oil now costs much less, many have had to write down the value of those contracts, even if they are not due to be settled for years. The losers included Cathay Pacific Airways, which made paper losses of close to $1 billion, Ryanair, Air France-KLM and Southwest.

      Nonetheless, firms seem as keen to hedge as ever. According to a study by Greenwich Associates, a consultancy, big American, European and Asian firms hedged 55% of their exposure to fuels last year, up from 45% the year before. Even some of the airlines that posted large losses on derivatives tied to the oil price are buying more of them. Ryanair recently said that it has entered contracts to fix the price of 90% of its fuel for the first nine months of this year, almost twice the proportion it had hedged in January. Cathay Pacific, meanwhile, is buying instruments that will protect it from falling as well as rising fuel prices.

      The main reason for this enthusiasm, says David Carter, an academic at Oklahoma State University and one of the authors of several papers studying fuel hedging in the airline industry, is that banks are normally more willing to lend to firms that have reduced their risks by hedging. That in turn allows them, for instance, to buy cheap assets from ailing rivals.

      Far from suppressing firms' appetite for derivatives, the turmoil in the world's financial markets has increased it. Of the big corporations Greenwich surveyed last year, 38% used options to manage currency fluctuations, up from 28% a year earlier, and the volume of currency options they bought had increased by about a third. In general, the use of interest-rate and currency options has risen dramatically in recent years (see chart).

      But in the second half of last year, such hedging declined for the first time since 2001, according to the International Swaps and Derivatives Association, an industry group. Thanks largely to the credit crunch, banks are selling fewer derivatives at a higher cost. Many firms, especially those with weaker credit ratings, have simply been frozen out of the market for derivatives by banks' reduced willingness to carry risk. Bankers say that only the few airlines with the highest credit ratings have been able to add to their hedge books in recent months to take advantage of lower oil prices.

      The bankers' reluctance stems from the nature of hedging contracts which, although not officially loans, nonetheless create liabilities between banks and their customers which grow or shrink as the underlying variable changes. Thus many of the airlines that had hedged their fuel consumption when oil prices were higher built up huge notional debts to banks, even though no money was due to change hands until the contracts reached the end of their lives, by which time oil prices could have risen again. The amounts concerned can easily grow to exceed the internal limits that banks place on their exposure to particular clients or even industries, preventing them from extending additional credit or writing new contracts.

      It is not just airlines that are affected. Indian textile exporters, for instance, complain that their banks are not allowing them to take on new currency hedges because of paper losses on contracts tied to the dollar. Pension funds are being affected too, mainly because some specialised derivatives, including certain types of hedges against inflation, completely dried up for a time last year.

      Those hedges that are available have become much more expensive. That is partly because markets are less liquid and less competitive since the collapse of Lehman Brothers last September. But banks are also now explicitly charging for the credit risk that they assume when writing a derivative contract. Estimates of the additional cost that companies are paying to hedge risks vary from firm to firm and product to product, particularly as they depend on the creditworthiness of those who are buying them. But some in the industry talk of bank fees rising from less than 0.1% of the value of a deal to as much as 2%.

      For many firms, such costs are prohibitive. The main victims are big exporters of manufactured goods. ThyssenKrupp, a German industrial firm, hedges its currency exposure each time it signs a large export order, for example. Similarly Rolls-Royce, a British aerospace company, is active on foreign-exchange markets because most of its revenues are in dollars but many of its costs are paid in pounds.

      Ever since the collapse of Lehman Brothers last year, firms have been worrying about whether they will ever be able to collect on the hedging contracts they have bought if their bank collapses. John Grout of the Association of Corporate Treasurers, an industry group, says that some perfectly solvent banks have wriggled out of derivative contracts by invoking obscure break clauses that they had previously promised their customers they would never use.

      Banks, meanwhile, fear that some of their cash-strapped customers may default. The result, says one banker involved in advising firms, is that many of them are asking firms to post collateral for the money they owe on derivative contracts. In effect many are edging towards the sorts of arrangements that regulators are thinking about imposing more broadly: moving most derivatives onto exchanges and having them centrally cleared.

      Yet such arrangements, too, are deeply troubling for many big firms. By turning paper losses into real ones they represent, in effect, a massive withdrawal of credit. Timothy Murphy, the foreign-currency risk manager for 3M, a large manufacturing company, gave warning in testimony before a subcommittee of America's Congress earlier this month that mandatory clearing of derivatives would “add significant capital requirements for end-users, adding significant costs, discouraging hedging, and diverting scarce capital”. The only thing more dangerous than having too many derivatives floating around the financial system, it seems, may be having too few of them.

2. (20 points) Answer any one of the following questions with respect to the "Risk Management at Apache" case. Use no more than one page for each answer.
   1. What are some of the non-financial (i.e. operational) strategies available to Apache to manage its risk? Mention at least two and explain how they would work.
   2. How might hedging of Apache's price risk help or hinder its managerial performance evaluation? Explain.
      
      
3. (20 points) On June 19th Walgreens, a US-based pharmacy chain, said that it would buy 45% of Alliance Boots, Europe's largest player in the drugs-distribution business. (See Economist, Jun 23rd 2012). According to the Economist, in the first stage of the deal the firm will assume $3.5 billion of Alliance Boot's debt; in the second stage it will take on the rest of Alliance Boots's outstanding debt, which amounted to more than £7 billion in March. Walgreen's domestic competitors are Rite-Aid, CVS, MedcoHealth Solutions and Express Scripts. Explain how you think this additional debt will affect Walgreen's competitive strategies in the domestic market. Give examples of specific actions that Walgreens is likely to take. Make explicit any assumptions that you make. Clarity of answer is very important. If your answer is unclear or confused, you will lose points. Use no more than 1 to 1.5 pages for your answer.
   
   Business Summary (from Yahoo): Walgreen Co., together with its subsidiaries, operates a network of drugstores in the United States. It provides consumer goods and services, pharmacy, and health and wellness services through drugstores, as well as through mail, and by telephone and online. The company sells prescription and non-prescription drugs; and general merchandise, including household products, convenience and fresh foods, personal care, beauty care, photofinishing, and candy products, as well as home medical equipment, contact lenses, vitamins and supplements, and other health and wellness solutions. It also provides specialty pharmacy services for managing complex and chronic health conditions; customers infusion therapy services consisting of administration of intravenous medications for cancer treatments, chronic pain, heart failure, and other infections and disorders; and clinical services, such as laboratory monitoring, medication profile review, nutritional assessments, and patient and caregiver education. In addition, the company operates Take Care Clinics to treat patients, give prescriptions, and administer immunizations and other vaccines. As of December 4, 2012, it operated 8,030 drugstores in 50 states, the District of Columbia, and Puerto Rico. The company also operates approximately 700 worksite health and wellness centers, and in-store convenient care clinics in the United States. Walgreen Co. was founded in 1901 and is based in Deerfield, Illinois.
   
   
4. (30 points) Answer any five of the following questions. Use no more than half a page for each answer.
   1. You are a strategy consultant to a manufacturing firm, which has a very good R&D department. Based on a Dupont analysis, you can see that the firm has been pursuing a volume strategy. Nevertheless, the firm's return on assets has been anemic of late. What would you recommend for this firm? Give specific recommendations and explain the reasoning behind your advice.
   2. Researchers have found that firms that have their headquarters in smaller cities wait longer to go public. What might be the reason for this and how would this affect your decision to locate your firm's head office?
   3. How might a firm use debt as a commitment device to convince competitors to back off?
   4. Name one disadvantage of excess cash from the viewpoint of a firm's strategic bargaining position. Explain.
   5. What sort of managerial employees should care more about a firm's financial leverage?
   6. Name two strategies by which a firm can manage its risk using financial securities without laying out any money? Explain.
   7. What are the four different categories of risk management techniques? Give examples.

Solutions to Final

1.

1. Over-the-counter derivatives are tailored specifically to the needs of the hedger; exchange-traded derivatives have basis risk, either because the underlying spot is different or the times don't match. On the other hand, exchange-traded derivatives are cheaper, more liquid and have less counterparty risk.
2. Firms that hedge have less cashflow volatility; this would be a good reason for banks to lend more cheaply to them.
3. Hedging can ensure that the firm is not left with insufficient financial resources, allowing a competitor to mount an attack. Hedging can also allow firms to guarantee prices credibly; this can be an important competitive pricing tool. These factors are relevant if the firms does not have other internal financial resources or access to financial resources from elsewhere, such as a line of credit. Also, if the norm in the industry is not to hedge, it may not be that important to hedge. Companies in industries where there are a lot of competitors may also not feel sufficient pressure to hedge.
4. Investors could offset some of this risk through diversification. However, thse firms may be more knowledgeable about the movement of the exchange rates if they do a lot of their business internationally. A much more important reason, though, is that with hedging, the firm's cashflows are less volatile and hence bankruptcy risk is lower, the cost of capital is lower and cashflows are more predictable, making for better planning.

2.

1. Here are some operational strategies available to Apache:
   1. Apache could spread its risk by investing in domestic and international properties; it could also invest in international properties in different parts of the world thus diversifying its exposure to political risk.
   2. It could speeding up or slow down its pumping operations -- speeding them up when prices are high and slowing them down when prices are low; this would allow partially fixed costs to vary somewhat with revenues.
   3. It could look for different kinds of buyers, such that demands across buyers would not be highly correlated.
   4. Enter into long-term contracts, so that demand would be more predictable.
   5. Have debt contracts that are payable in oil, or where the payments are related to oil (though this might be construed as a financial strategy).
2. Hedging would reduce the impact of external factors on outcomes. Managerial competence and knowledge would be more closely related to performance. This would make it more equitable, as well as more effective to tie pay to performance.

3. Walgreen has split the acquisition into two parts – the first part consists of acquiring 45% of Alliance Boots.  Since this is less than 50%, Walgreen can keep the debt off its books.  However, once it completes the second part, it will have to show all of the debt on its books.  The likely purpose of this (as suggested by Reuters but as can be inferred from Walgreen's actions) is as follows: “S&P expects Walgreen and Boots to use the time between the first and second phases to pay down their respective debt loads with free cash flow, so that the combined company will have room on its balance sheet for the next chunk of liabilities taken on to help pay for the remaining 55% stake.”

This means that Walgreen will probably be taking an aggressive stance in the marketplace in order to generate cashflow.  What exactly does this mean?
The industry we are talking about is the drugstore chain business, primarily.  Even though it is necessary to make real-estate investments in order to open a drugstore, this does not require a tremendous amount of planning; financing for this purpose is also relatively easy, since the primary asset is extremely fungible (of course, right now, the real estate market is not so liquid, but this situation is not likely to persist for very long).  Furthermore, profit margins are probably not likely to be very large – the product is fairly commoditized; the main route to profitability is likely to be volume.  Consequently, the industry is best labeled a Bertrand industry.  As such, cost cutting is the most likely approach to increasing cashflows. 

This analysis seems not to be consistent with the Chevalier (1995) study that found that supermarket firms that had LBOs increased prices (though they lost market share). However, this may be true primarily of LBOs where the actors are particularly interested in quicker exits than managers with firm-specific capital. Alternatively, if Walgreens believes that it can retain customers because of higher quality of service, it may well increase prices.  However Walgreens is not considered necessarily a high quality supplier.  Hence in metropolitan areas where it has a lot of competition, it may cut prices, but in areas where it does not have much competition, it may increase prices.  This may also be true in terms of its wellness clinics and its stores that have such wellness clinics.

4.

1. There may be a mismatch between the firm's resources and the firm's strategy. Given that it has a good R&D department, it might want to consider coming up with product enhancements that would allow the firm to increase profit margins. Alternatively, if it has manufacturing strengths rather than marketing strengths, it may want to consider using its R&D department to come up with cheaper and more efficient ways of manufacturing/packaging its product. This would allow it to keep to a volume strategy, but nevertheless to increase profit margin.
2. According to the research that has been done regarding this, the reason seems to be that financial analysts have better access to firm information if they are located in financial centers. This is because information is transmitted not only through documents, but also through word of mouth. Hence being located in or close to a financial centre reduces financial asymmetry. A firm doing an IPO has to confront the problem that investors/investment bankers will not will be willing to pay as much for shares of a firm about which they do not know much. Hence firms located in smaller cities wait longer until they are more established before they go to market.
   If an entrepreneur is interested in an early exit, therefore, s/he might want to locate in a larger city.
3. The existence of larger than usual amounts of debt means that firms have to produce cashflows quickly in order to pay off their debt. This can be a life-and-death issue for them. Hence they would be willing to take risks that other firms might not. The existence of this debt also means that their aggressiveness is not simply posturing because the firm has committed to the higher leverage, which cannot be easily undone. This may convince competitors not to confront such a firm.
4. If debt is a commitment device because it signals that the firm is short on financial resources, the availability of excess cash is a negative signal. Hence it may be difficult to get labor or acquisition targets (or competitors) to back off, under these circumstances.
5. Managerial employees who have human capital that is specific to the firm should care about the firm's going bankrupt and hence about the firm's financial leverage.
6. One way that this can done is through a self-financing collar, e.g. by buying a put and selling a call on the commodity that the firm sells. This would provide a floor for the price at which the firm can sell the commodity, but at the expense of a cap on the profits it can make if the commodity price rises. A second way would be by selling a forward/futures contract. Both of these strategies may, however, require putting up of margin money, however. An over-the-counter forward contract entered into with a bank that is familiar with the company may be achieved without initial margin.
7. The four different categories of risk management techniques are a)risk avoidance, b)loss prevention and control c) risk retention (or self-insurance), and d)risk transfer (hedging, insurance etc.)

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