Fin 320 Advanced Financial Analysis
Homework Assignments
Spring 2001
Prof. P.V. Viswanath

Assignments must be typed and submitted before the start of class on the due date.

Assignment 1

Read the article, "Bank Rules Are Eased for Stakes in Nonfinancial Firms," which appeared in The Wall Street Journal on 01/19/2001.  Answer the questions at the bottom of the article.  (You can find the article in the section on "Firm Objectives" in the Media Articles page on my website.)

Assignment 2

Assignment: Read the article, "Adjusting the cost approach for excess operating costs, environmental cleanup and other value reductions," by Hal Heaton in the Journal of Property Tax Management, New York; Winter 2001; Vol. 12, Iss. 3; pp. 26-34.  The article can be found in the Course Documents area in CourseInfo.  Answer the following questions:

  1. On page 27, the author says: "the cost of capital is not the appropriate rate to discount excess operating or environmental cleanup cash flows."  Explain why this is true.

  2. Look at Table 1.  The main point that the author is making, here, is that the excess operating costs have to be discounted at a different rate from that used to discount the cashflows of the efficient operation.  Can you advance a reason as to why revenues and costs should also be discounted at different rates?

  3. On page 32, the author gives examples of two accidents that have different outcomes, but the same expected cashflow.  He goes on to say that people would be more willing to pay a higher premium for insurance company to assume the liability of the second accident (with more extreme outcomes) than the first (with less extreme outcomes).  Does this fact about the willingness-to-pay of individuals imply that insurance premiums in a competitive market  would also be different?

Assignment 3

Choose a company from one of the following sectors, as defined by Yahoo:

Go to the Trading Room (W404), and research the company.  There will be other projects related to this company, that you will be required to do.  To get an idea of the sort of analysis that you should be aiming at, you can look at the projects submitted by Aswath Damodaran's students.  The actual projects that I will ask you to do will be explained in more detail during the term.  For now, work on the following project.

Write a report on your company, providing the following information:

Keep in mind the following principles:

The Trading Room can be accessed during the posted hours.

Assignment 4

Go to the PAC Room (Trading Room, W404).  Download historical price information on the stock that you worked on for Assignment 3, using the information given below, and compute market betas as described below:

Go to the PAC site.  Click on Intro to Bridge (U of I) in the menu at the bottom.  This will bring up a website, managed by the University of Illinois, in a new window.  Click on Excel Bridge Link in the menu at the bottom.  Follow the instructions under Getting Started, from point number 2.  (If you have difficulty in running Excel from Bridge, go to the Desktop and click on Excel directly.  If you have any questions, check with the Research Assistant on duty.)

Download daily closing price data on your stock for the last 3 years, starting from Dec. 29, 1997 to Dec. 29, 2000 (i.e. last trading days in 1998 and 2000).  (Specify custom on the Create-Link History applet, and also specify a sufficiently large number of periods.).  Do the same for the Dow Jones Index (&DJI), for the NYSE Composite (NYA), and for the Wilshire 5000 Total Market Index (TMW).  Compute the return on the stock and on the indexes.  If your stock pays dividends, get this information by using the command sym/CF/DIV/; to go beyond the time period shown on the first screen, use sym/CF/DIV/PG2, etc.  Then compute the daily return by using the formula, R8/11/99 = P8/11/99/P8/10/99-1, where Rt, Pt stand for the return and price on date t.  If a stock went ex-dividend on August 11, 1999, use the formula,  R8/11/99 = (P8/11/99+Div8/11/99)/P8/10/99-1, where Divt is the amount of the corresponding dividend.

Similarly, download monthly closing price data on your stock and on the three indices for the period Dec. 1994 to Dec. 2000.  Compute monthly returns, assuming that the dividends are paid at the end of the month in which they are actually paid.

Run three sets of regressions: 

  1. Regress the daily stock returns on the stock against the three different indexes; 

  2. Regress the monthly stock returns for the months 1/95 to 12/97 on the index returns for the corresponding period; 

  3. Regress the monthly stock returns for the months 1/98 to 12/00 on the index returns for the corresponding period.

Use Excel to run the regressions; interpret your results. (You can get more information on regression analysis from my website.  You may also want to consult the solution to Q. 2 on Midterm II in Spring 2000.)

Prepare a table as follows:

Monthly data Beg. 1995 - end 1997      
Monthly data Beg. 1998 - end 2000      
Daily data Beg. 1998 - end 2000      

If there are any differences, explain them.  Keep in mind also, the R2s of the regression, the standard errors of the estimates, and the characteristics of the firm and the indices over time.

Assignment 5

Choose a company from one of the following sectors, as defined by Yahoo:

Compute the weighted average cost of capital for the company.  Make sure that the company has public debt.  All other things being the same, you'll find it easier to get information for a better-known company than for a less well-known company.

You can use the following exam problems for hints on what sort of information you will need, as well as on how to process the information. 

Among other sources, you can also use:

Make sure your report is well researched, well analyzed, based on theory, and written up in a form easy to understand.  


Solution to Assignment 1

1. Commercial banks differ from other financial institutions in that they accept deposits from the public, and in particular, demand deposits.  In so doing, they provide liquidity to the country's economic system.  They also provide a system of using these demand deposits through bank checking.  Failure of such institutions would severely affect the liquidity, and hence the operation of the economic system.  The results of such failures were observed during the banking failures of the early 1930s, which culminated in the establishment of the Federal Reserve and of deposit insurance.  

As a result, banks are regulated, so that their riskiness and consequently, their default probability is reduced.  Furthermore, once deposit insurance exists, banks have an incentive to take risky positions.  Hence, it becomes even more important to put limits on the ability of commercial banks to take risky positions. 

2. Investment banks do not take deposits.  In fact, investment banks, as defined by Professor Campbell Harvey is "are (f)inancial intermediaries who perform a variety of services, including aiding in the sale of securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individual and institutional clients, and trading for their own accounts."  Hence the rational for regulation provided in question 1 above does not apply at all.     

3. According to The Corporate Governance Network, corporate governance "involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently."

Normally, individual shareholders play a small part in corporate governance because of the free-rider problem.  This problem essentially has to do with the fact that it would be very expensive for small individual shareholders to research and monitor the activities of the corporation, while the benefits of such monitoring would be obtained by all shareholders.  A large shareholder, such as a bank, on the other hand, would be willing to undertake such monitoring because they would have a large stake in the proper management of the firm.  Hence allowing banks to invest in the equity of corporations could improve their governance.

4. Since interest payments have to be made before dividends are paid out, and since debtholders are paid before equityholders in the event of bankruptcy, debt is less risky than equity.  Hence, if the objective is to prevent banks from taking extremely risky positions, it makes sense to distinguish between debt and equity.

Solutions to Assignment 2

1. Excess operating costs or environmental cleanup costs probably have different risks, compared to the risks of cashflows generated through the usual business operations of the company.  Hence, the discount rates used to discount them should also be different.

2. One could argue that revenues are more dependent on external economic factors, while costs, especially fixed costs are more predictable.  As a result, revenues should be discounted at a higher rate than costs.

3. Even though individuals may be willing to pay more to avoid accidents with extremely high negative payoffs (even if the probability of the event is negligible), competition from insurance companies should keep the price down.  For example, if the two accidents described on p. 32 both are uncorrelated across individuals, the insurance company's total payout for all policies will be close to the average value per payout times the number of policies.  Hence, competition should force the premium to be about the same for both accidents.

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