Case Studies in Finance: Managing for Corporate Value Creation 7th Edition solution manual

 
Because the case states that it would take 12 to 18 months for the deal to acquire PacifiCorp to close, the instructor may wish to solicit a present value for Berkshire Hathaway’s offer for the equity portion of PacifiCorp. An appropriate discount rate may be derived using the capital asset pricing model (CAPM). Footnote 13 in the case explains that the yield on the 30-year U.S. Treasury bond was 5.76% and that Berkshire’s beta was 0.75, and the case states that the long-run market return was 10.5%. So Berkshire’s cost of equity may be estimated as 9.32%. Using this rate to discount Berkshire’s $5.1 billion offer over 12 or 18 months, we get a present value of about $4.7 billion.
 
Berkshire’s offer for PacifiCorp was, therefore, roughly in line with the range of peer firm valuations. This does not explain why the market reacted so positively to the news of the acquisition. It is possible that the investors perceived potential synergies between PacifiCorp and MidAmerican, but in the highly regulated and regionally focused electric-utility business, such synergistic benefits may be weak. Was there perhaps something in Buffett’s record as an investor that led to the market’s response?
 
Buffett’s record
 
Discussion questions 4 and 5

The case affords three opportunities to analyze Berkshire Hathaway’s historical record.
 
Berkshire Hathaway’s historical wealth creation: The case offers a range of evidence about shareholder wealth creation at Berkshire Hathaway. The case gives a rate of 24% compound annual growth in stock prices from 1965 to 1995. In comparison, wealth creation for large firms averaged 10.5% per year over the same period. The first chart in the case helps students visualize the supernormal performance of Berkshire Hathaway. Novices to finance should be encouraged to consider how difficult it is to beat the market by such a wide margin.
 
Berkshire’s experience with MidAmerican: Data in the case and case Exhibit 6 give information with which to perform a simple analysis of Berkshire’s return on investment in MidAmerican. Beginning in 2000, Berkshire Hathaway made an outlay of $1.642 billion for an eventual 80.5% economic interest in MidAmerican. Berkshire’s economic interest in MidAmerican was composed of both equity and debt investments such that the cash flows to Berkshire included interest payments, common dividends, and preferred dividends. Therefore, Berkshire’s return on investment can be approximated by computing Berkshire’s share of MidAmerican’s free cash flows, the cash flows available to all debt and equity claims. The income statement and balance sheet data in case Exhibit 6 may help us derive Berkshire’s share of MidAmerican’s free cash flows from 2001 to 2004, revealing that Berkshire had an internal rate of return (IRR) on this investment of 71%. Exhibit TN2 presents those calculations.
 
Berkshire’s experience with equity investments: The data in case Exhibit 3 give a foundation for a simple assessment of the major equity investments by Berkshire. With a class of novices, the instructor could motivate them to observe that all those issues have market values considerably higher than their costs. With a class of students more experienced in finance, it would be possible to estimate a holding-period return for Berkshire’s investments in the Big Four. Using the information in this exhibit and its footnote, we find that Berkshire’s investments in American Express, Coca-Cola, Gillette, and Wells Fargo generated a compound annual growth rate of 16.07%. Students could be encouraged to compare this return with the long-term return for all large stocks, 10.5%.
Buffett’s Investment Philosophy
 
Discussion questions 6 and 7

Buffett’s investment philosophy reads mostly like a summary of the theory of modern finance. As the subheadings in the case indicate, the elements of the philosophy are as follows:
 
1.   Economic reality, not accounting reality
2.   Account for the cost of the lost opportunity
3.   Focus on the time value of money
4.   Focus on wealth creation
5.   Invest on the basis of information and analysis
6.   The alignment of agents and owners is beneficial to firm value
 
Buffett strongly disagrees, however, with three other elements of modern finance:
 
1.   Use of risk-adjusted discount rates: The method he uses seems rather similar to the certainty equivalent approach to valuation (i.e., discount certain cash flows at a risk-free rate). Although it seems doubtful that the cash flows he discounts are truly certain, the very fact that he matches riskless cash flows with a risk-free discount rate implies an approach consistent with the risk-and-return logic of the CAPM.