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An investor is considering 4 investments, A, B, C and leaving his money in the bank. The payoff from each investment is a function of the economic climate over the next 2 years. The economy can expand or decline. The following payoff matrix has been developed for the decision problem. What is the opportunity loss when ❝A❝ is Investment alternative and ❝Decline❝ is state of nature?

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Irving Heathcote
Irving HeathcoteLv2
28 Sep 2019

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Lehman Brothers Repo 105 Manipulation


On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York. Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later their bankruptcy proceeding became the largest ever filed. How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors ‘funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors ‘funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit-generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return a bank lends funds at than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will only invest with a bank if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event the bank suffers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows:

Leverage Ratio= Total Assets

Shareholders’ Equity (the bank’s own capital)

In its simplest form, the Repo 105 mechanism—a multiple-step technique combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction undertaken near the end of a reporting period designed to reduce the leverage ratio, but the impact of which was essentially reversed just after the beginning of the next reporting period. This reduction and reversal process was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact, and what they should have done and did do during their audit process. As well, the role and responsibility of LB’s management and the board of directors has come into question.

Why Did Lehman Brothers Fail?

According to the Bankruptcy Examiner’s Report 4 by Anton Valukas, LB failed for several reasons, including:

•The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and therefore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested.

•A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets…on capital of approximately $25 billion,” a ratio of 28:1.

•Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down” in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.

•A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. •A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand.

•In March 2008, Bear Stearns, a rival investment house began to falter and nearly collapsed, putting the spotlight on LB which was considered the next most vulnerable.

•Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time the Securities and Exchange Commission (SEC) and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity.

•In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”

•On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct.

The Repo 105 Mechanism and Impact

There are three kinds of repo transactions: (1) ordinary; (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report. Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2 percent fee (interest charge) or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated. 10 Schematically, an ordinary repo transaction sequence can be represented as follows: A Repo 105 transaction sequence is different in that prior to the reporting date:

(1) the initial transaction is treated as a sale not a borrowing; (2) the cash received is used to pay off liabilities; and then after the reporting date (3) LB borrows funds elsewhere to repurchase the securities sold including a 5 percent interest charge. The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount.

The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.

Balance Sheet and Leverage Impacts of Lehman Repo Transactions

In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm. Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved non-liquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel. LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2 percent, 5 percent and 8 percent, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash at a cost of 2 percent, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to manage LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows:

“A senior member of Lehman’s Finance Group considered Lehman’s Repo 105 program to be balance sheet “window-dressing” that was “based on legal technicalities.”

Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.” When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “V[ery] close…anything that moves is getting 105’d.”

The reduction in leverage ratios achieved through the use of Repo 105 and 108 transactions are shown below:

According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for determining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).” Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report,

Eileen Fahey, an analyst at Fitch, said that she had never heard of repo transactions being accounted for as true sales on the basis of a true sale opinion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billions of securities inventory—regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.” Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counterparty and was obligated to repurchase them shortly thereafter. (Note that this was similar to the usage Enron made with its Special Purpose Entities.)

The timing of the use of Repo 105 transactions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph:

At the end of each quarter LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter.

LB’s Accounting Analysis

LB’s Repo 105 transactions were undertaken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows:

Accounting for Transfers and Servicing of Financial Assets

A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28).

b. Each transferee (or, if the transferee is a qualifying special purpose entity (paragraph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34).

c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47−49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).

SFAS 140 comments further in Paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98 percent collateralization or as little as 102 percent overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5 percent, and therefore greater than the 2 percent collateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they didn’t have the funds available to fund substantially all of the repurchase cost.

To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.” Such an opinion was possible under U.K. law, but not under U.S. law, but the opinion was addressed to LBIE thus necessitating transfers to LBIE so that the transactions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.

According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.

However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistle-blower letter to senior LB management expressing concerns about possible LB Ethics Code violations about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the Examiner,

Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities;”(3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”

Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.

E&Y’s Reaction

Ernst & Young faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the web. That letter was originally published without the opening and closing paragraphs by Francine McKenna on March 20, 2010, on www.retheauditors .com. E&Y’s letter, which is shown below, 38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at www.contrarianpundit.com.

(Same letter as in the picture)

23 March 2010

To:

Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. Ernst & Young was Lehman Brothers ’independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments •EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ERNST & YOUNG •Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. •The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions •There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as“Repo 105”transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. •As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. •The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were“sham transactions”designed to off-load Lehman’s“bad assets”are inaccurate. •Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. •The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. •While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. •Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. •If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters.Handling of the Whistleblower’s Issues •The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on atleast three occasions during June and July 2008. •In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. •Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at

With best regards,

(letter ends)


Lehman’s Risk Management

LB was a major player in a field that involved many varieties of risk, and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was“1x leverage…or $17 billion, [and] $5 billion for Repo 108 transactions.” Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007. Recognizing that the levels of $40 to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy.

Questions

2. What is leverage and why is it so important?

IRJAF-Toruga Actions for 'IRJAF-Toruga'

Abstract This case study on project evaluation is applicable for beginning courses in corporate finance or finance strategy. Two alternative investment options are available to evaluate. Challenges are presented with the inclusion of equity, bank debt, and bonds in the capital structure. Each investment option need to be evaluated carefully and decision should be made on the basis of thorough analysis of the data available using various capital structure and capital budgeting techniques. Keywords: Beta, Corporate Finance, Cost of Capital, Internal Rate of Return, Net Present Value JEL Code: C10, G31, G32

Introduction

Brooks Hamilton recently accepted a job with Tortuga Fishing Equipment Company1 (Tortuga) in the company’s finance department. His first few assignments were fairly straightforward and Brooks relied on his background in both accounting and finance to get his career off to a great start. His manager, the company’s Chief Financial Officer (CFO) was impressed with his work and decided to put Brooks on a new assignment. The firm was embarking on a new project which would define its future over the upcoming years. Given the importance of the project and high degree of visibility with the firm’s senior management, Brooks was flattered to be asked to assist and eager to show that he was up to the task. The finance department was tasked with preparing an analysis to make a decision between two competing project plans which could very well decide the future of Tortuga in the competitive fishing equipment industry. The Chief Executive Officer (CEO) wants to have an answer from finance and expects a thorough analysis very quickly.

The Company

Tortuga is an Islamorada, Florida based company specializing in manufacturing high-end fishing rods and reels. Tortuga was founded by a retired university professor who fished all of his life and wanted to create the best equipment possible to handle a variety of fishing conditions and fish species. He partnered with an engineer who ran a machine shop to produce some prototype reels and supplied these to commercial fishing captains as test market research. The equipment produced by Tortuga was a significant improvement over the current line available and orders were strong. Through the years, the company made some modest improvements to their original prototype and had become an industry leader. Tortuga’s products are used by tournament fishing teams around the world. Over the past decade, tournament fishing has grown to become a big business with corporate endorsements and prize money. This growth has made what was once a recreational vocation into a full-time profession for some anglers. The company recently launched an extensive research and development effort focused on a new flyrod and reel designed for one particular species of fish, the Atlantic Tarpon (Megalops atlanticus). Tarpon are long-lived fishes that migrate in the warmer climes of the Caribbean Sea, Gulf of Mexico, and along the Atlantic Ocean coastlines. Although the fish can reach lengths of eight feet (~2.4 meters) and weights of 280 pounds (127 kilograms), they inhabit the shallow flats and exhibit acrobatic leaps when hooked. These traits make tarpon a popular game fish for anglers. Fishing gear needs to be sturdy to handle the power of these fish and Tortuga had developed products for this niche market which were allowing anglers to be successful in their angling pursuits. Recently, several sponsors had come together to launch competitive angling events called tournaments, where the best anglers vie to catch, and then release, the most and largest tarpon. Winners may receive up to $50,000 in a single weekend tournament and the difference between winning and losing could be a few pounds. With so much money at stake, tournament teams purchase the best gear available and are always looking for any competitive advantage with their equipment. Tortuga is looking to capitalize on this trend by offering a new line called the Tortuga Tarpon Classic. This new line incorporates the latest material and design improvements and is predicted to be the “gold standard” for all serious tournaments anglers. Tortuga plans to offer the Tortuga Tarpon Classic to recreational anglers as well to capture the growing demand by affluent anglers who want the same high-quality gear as the professionals.

Financial Information

Tortuga began with a modest amount of capital that the founder had managed to save during his years in academia. As the firm grew, its financing needs expanded as well. Through the years Tortuga had developed and maintained a strong relationship with a large bank which provided short-term working capital funds in the form of a revolving line of credit. When a funding need arose, Tortuga would draw from this line of credit and then repay the short-term draw as cash flowed back to Tortuga. The $200 million revolving line of credit currently has $25 million drawn at an interest rate of 3-month Libor plus 350 basis points2. The remaining $175 million credit line can be assumed to have no fees associated with it3. Brooks looks up the most recent 3- month U.S. dollar Libor rate and sees that it is 1.50%. Long-term financing was also in place in two forms. After several years of revenue and earnings growth, Tortuga issued five million shares of common stock at an issue price of $10 per share. The firm used this $50 million in funding to increase production lines and build a global presence by opening an additional manufacturing facility in Panama. Brooks finds the current price per share for Tortuga to be $16. Two years ago, Tortuga issued a 10-year bond for $50 million face value. Each $1,000 par bond carries a coupon of 8.5%. The bond pays interest semi-annually and is currently trading in the market at 102.50 as a percent of par. The company has a 34% corporate tax rate. The firm calculates its required return on equity with the Capital Asset Pricing Model (CAPM) using a 4.0% historical Treasury rate for the risk-free rate and 6.0% as the historical market risk premium4. CAPM = Risk-free rate + beta (Market Risk Premium) The annual stock returns versus the market are shown in Figure 1 below for the past 10 years. Beta is calculated by regressing Tortuga stock returns on the Standard & Poor’s (S&P) 500 returns. There are a variety of methods for calculating beta. Brooks could find beta by regressing five years of weekly Tortuga returns of the S&P 500. He could use five years of monthly returns or two years of weekly returns. Each of these is a valid sample period. One well-known data source provides an “adjusted” beta which is determined by first calculating a “raw” beta by regressing two years of weekly security returns on the market. This is then adjusted by taking 2/3 of the raw beta plus 1/3 of one. This adjusts the beta to be closer to one, since beta is not stationary and should naturally move towards one through time as a firm expands. Brooks only has 10 years of annual data available at the time and decides to conduct the analysis with this information to get a quick response. He will check his result with more data points before submitting his final report to the CFO.

Figure 1 Returns on Tortuga Stock versus the Standard & Poor 500 Year Tortuga Return S&P 500 Return Year Tortuga Return S&P 500 Return 1 12 7 2 22 16 3 -2 -3 4 14 9 5 9 8 6 19 21 7 16 17 8 -10 -5 9 7 9 10 12 14 Source: Author After Brooks calculates beta he employs formula (1) above along with the risk-free rate and market risk premium to determine the cost of equity. The firm’s weighted average cost of capital is a function of its equity market capitalization, cost of equity, short- and long-term debt amounts and costs, and the tax rate. Using formula (2) below, Brooks can find the firm’s weighted average cost of capital (WACC). WACC = Rd * D + Re*(E/D+E) where: WACC = weighted average cost of capital Rd = Cost of Debt Rd1 (1-marginal tax rate) Rd1= Company’s before tax rate D= weighted percent of debt E= weighted percent of equity Re = Cost of equity Rf +B*(Rm-Rf) Rf= risk free rate B= Beta, the owners will need to calculate beta Rm= equity risk premium Tortuga Tarpon Classic The company has two separate research teams working on the project and they develop two distinctly different fishing combinations. The two rod and reel combinations are test marketed with guides and past tournament champions and demand forecasts are determined. Most fishing gear has a relatively short life due to continual product innovation. Manufacturing of the two combinations is estimated to require an upfront cost of $5 million to retool the machine shop. The process for manufacturing the two combinations differ and ongoing variable costs are not the same. The net cash flows for the entire ten year expected life of the product is shown in Table 2 as Project A and Project B (all figures are $thousands of net cash flow). Project A focuses on hand tooled fishing equipment which results in a more labor intensive process, but also allows for personalized features for customers. The price charged for customization offset the slower hand tooling process to generate substantial net cash flows. Part of the upfront $5 million includes the costs of training more machinists in the art of hand tooling, which is similar to watch making but with a few less moving parts. Project A is anticipated to generate lower cash flows in the early years due to the length of time required to get machinists who are adept at hand tooling to customer specifications. In fact, during the first year there will be continued expenses to attain these skills which causes year one net cash flows to be negative. Over time the cash flows increase as more machinists gain proficiency. The project is expected to experience lower cash flows towards the end of its life due to market saturation. Due to the quality of the reels, they are built to last and seldom fail or wear out. Technological obsolescence is certain although Tortuga will be investing cash flows into research and development to launch the next generation at the conclusion of the Tortuga Tarpon Classic life cycle. Project B employs a mechanized approach to large scale production of standardized equipment. Although the approach does not allow for personalization, it does allow Tortuga to build its inventory quickly and capture positive net cash flows immediately. The upfront expense is almost completely devoted to tooling equipment procurement and the number of units produced will be much higher and at lower price points than the approach of Project A. At the end of both projects life it is assumed that there will be zero salvage value as the pace of innovation will require a complete re-tooling for the next generation and the useful life of the equipment will have been fully realized. Brooks realizes that he will need to calculate the firm’s cost of capital discount rate and apply this to the cash flow projections of both projects. He recalls all of the assignments he completed at university and is thankful to have been so well-prepared for this task. He gets a cup of coffee, sits down at his desk, and gets to work. Figure 2 Project Net Cash Flows for Tortuga Fishing Equipment ($thousands) Year Project A Project B 1 -900 950 2 200 950 3 900 950 4 1800 950 5 2500 950 6 2500 950 7 1800 950 8 1200 950 9 800 950 10 200 950 Source: Author Since Brooks is new to his role, you have been asked to review his work and assess the financial viability of the projects. Given the importance of this decision you are helping to make sure the firm makes the right choice. Notes: 1. Fictitious company created to illustrate corporate finance principles. 2. Libor is an acronym for London Interbank Offered Bank, which is a standard floating interest rate benchmark for credit facilities. A basis point is equal to 1/100th of 1%. One percent is 100 basis points. 3. Typically a bank will charge a facility fee for the entire credit facility, $200 million in this case and an interest rate based on utilization. We assume no facility fee for simplicity. 4. The risk-free rate is determined based on the geometric average of the long-term Treasury. The market risk premium is calculated based on the difference between the geometric return on the Standard & Poor’s 500 index and the long-term Treasury.

Specific Questions 1. Using the Capital Asset Pricing Model, what is the required rate of return on equity, E (cost of equity) for Tortuga? 2. what are the weights of equity and debt in the capital structure? (Rd & Re) 3. Using the information provided, what is the firm’s weighted average cost of capital (WACC)? 4. What are the net present value (NPV), internal rate of return (IRR), and Payback Periods for Projects A & B? 5. What decision rules will you use to help Tortuga reach a decision? 6. What are the strengths and weaknesses of each of the evaluation tools?

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