Pace University
Fall 2001
Prof. P.V. Viswanath

### Midterm

• Show the formula you are using to answer the quantitative questions.  Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary.  You do not have to show computations beyond this.  However, make sure that the numerical value of your answer makes sense in the context of the question.  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.

• Excessively verbose and irrelevant answers will be penalized.

Q. 1: Here is a press release from Nautica Enterprises, Inc., released on Nov. 2, 2001.  Please answer the following questions:

1. (8 points) Will the Stockholder Rights plan encourage or discourage takeovers of Nautica?  Explain your answer succinctly, but clearly.
2. (8 points) Is the plan good for the company's management?  Explain.
3. (9 points) Provide one argument as to why the plan is good for the company's stockholders, as well as one argument as to why the plan is bad for the company's stockholders.

## Nautica Enterprises, Inc. Adopts Stockholder Rights Plan

Nautica Enterprises, Inc. (NASDAQ: NAUT) today announced that its Board of Directors has adopted a Stockholder Rights Plan designed to preserve long-term value and protect stockholders against stock accumulations and other unfair tactics to acquire control of the Company.

The Company stated that the Rights Plan has not been adopted in response to any major purchase of its stock and the Company is not aware of any such major purchase. Rather, the Company has adopted the Rights Plan at this time in order to safeguard the interests of its stockholders. The Plan is intended to enable Nautica's stockholders to realize the long-term value of their investment in the Company and to encourage anyone seeking to acquire the Company to negotiate with the Board of Directors prior to attempting a takeover. Under the Plan, each stockholder -- at the close of business on will receive a dividend distribution of one right for each share of common stock held. The rights expire on November 12, 2011.

Each right entitles stockholders to purchase from Nautica 1/100 of a share of junior participating preferred stock at an exercise price of \$60. The rights will become exercisable only if a person or group (other than the current Chairman of the Board of the Company who currently beneficially owns approximately 13.3% of the common stock) acquires 15% or more of Nautica's common stock (an "Acquiring Person"), or commences a tender or exchange offer which, if consummated, would result in the person or group becoming an Acquiring Person. Prior to that time, the rights will not trade separately from the common stock.

If a person or group becomes an Acquiring Person, each right will then entitle all other stockholders to purchase, by payment of the exercise price, Nautica common stock (or a common stock equivalent) with a value of twice the exercise price. In addition, at any time after a person or group becomes an Acquiring Person and prior to the acquisition by such Acquiring Person of 50% or more of the outstanding common stock, the Board of Directors may, at its option, require each outstanding right (other than rights held by the Acquiring Person) to be exchanged for one share of common stock (or one common stock equivalent).

If a person or group becomes an Acquiring Person and Nautica is subsequently acquired in a merger or other business combination or sells more than 50% of its assets or earning power to any person, each right will entitle all other holders to purchase, by payment of the \$60 exercise price, common stock of the acquiring company with a value of twice the exercise price.

Nautica may redeem the rights at \$.01 per right at any time prior to the time that any person or group becomes an Acquiring Person.

Details of the Stockholder Rights Plan will be outlined in the Company's Form 8-K filing with the SEC and in a letter which will be mailed to all stockholders.

Q. 2. (25 points) A bank offers to lend you \$100,000, on condition that you will repay the bank in one payment of \$226,090.40 at the end of 14 years.  However, you don't want a large loan hanging over your head for that long.  You suggest to the manager of the bank that you be allowed to pay off the loan in twenty-eight equal payments, starting six months from now.  What will be the size of each semi-annual payment, if the bank is to charge you the same rate of interest on the new deal?

Q. 3. (25 points) Answer any five of the following questions in two or three sentences:

1. What is the required rate of return on a lottery ticket according to the Capital Asset Pricing model, and why?
2. What is the rationale behind paying a firm's management with stock options?
3. Stockholders of a firm with a lot of debt prefer to take riskier projects than stockholders of a comparable firm with less debt.  Why?
4. From a financial analyst's point of view, Research and Development expenses of a pharmaceutical firm should be amortized over a longer period than those of a software firm.  Why?
5. Why does diversification reduce firm-specific risk?
6. Assume that all of the debt on your books was borrowed three years ago, when the treasury bond rate was 7% and you were borrowing at 7.5%.  If the treasury bond rate today is 6%, and you are a riskier firm than you used to be, will the market value of your debt be greater than or less than your book value?  Explain.

Q. 4. (25 points) Briefly define any five of the following terms:

 Free Cash Flow to Equity Deferred Tax Asset Call market Greenmail Agency Costs Marginal Investor

Final Exam

• Show the formula you are using to answer the quantitative questions.  Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary.  You do not have to show computations beyond this.  However, make sure that the numerical value of your answer makes sense in the context of the question.  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. According to Bridge Information Services, GE's beta (based on daily observations for the last two years, using the S&P500) is 1.272; the same number for Security Capital Group (SCZ) is 0.185.  Estimate the beta of GE after the merger.  I do not require the correct number.  Just give me your estimate based on the information in the article.  You can provide a lower limit, an upper limit, or both, or a precise estimate. (8 points)

2. Based on the information that you have about SCZ, estimate its debt-to-assets ratio.  Explain your answer.  I will be looking more at your explanation rather than at the particular number your provide. (8 points)

3. The following two questions ask you to compare SCZ and GE (note General Electric Co. and not General Electric Capital Corp.).  Answer any one of the two, i. or ii.; if you answer both, I will only grade the first of the two):

1. Information asymmetry, as you will recall, refers to the market not knowing as much as the managers about the firm.  Because of information asymmetry, the securities issued by the firm may be mispriced by the market; as a result of not being able to get financing at a reasonable rate, managers might then decide to forgo some positive NPV projects.  Of the two firms, GE and SCZ, which, do you think, would have greater information asymmetry problems? Why? (9 points)

2. Of the two firms, GE and SCZ, which, do you think, would have higher bankruptcy costs?  Why? (9 points)

GE Capital Sets Agreement to Acquire Security Capital Group for \$4 Billion
By Matt Murray and Dean Starkman, 12/17/2001, The Wall Street Journal

GE Capital Corp., the large, acquisitive financial arm of General Electric Co., agreed to buy Security Capital Group, a real-estate holding company, for \$26 a common share, or about \$4 billion.

Under the deal structure, GE Capital will pay cash and likely include in its transaction the distribution of shares of ProLogis Trust, a Denver company that is the nation's largest warehouse owner and in which Security Capital owns a large stake. Based on Friday's closing price of ProLogis, GE would pay about \$2.9 billion in cash, and Security Capital would distribute ProLogis shares valued at about \$1.1 billion. The final amount of cash and ProLogis shares to be paid out could change based on fluctuations in the latter's share price. At 4 p.m. Friday in New York Stock Exchange composite trading, ProLogis was down 18 cents to \$21.70.

GE Capital also will pay a total of about \$50 million to a handful of Class A shareholders, whose shares will be valued at \$1,300 apiece, the companies said. GE Capital also will take on \$1.4 billion in debt, though it expects to get the same amount in cash, including proceeds from several recent sales of properties and company stakes made by Security Capital.

The purchase will beef up GE Capital's commercial real-estate business and demonstrates how GE's powerful financial arm, which currently has assets of about \$410 billion, is looking for assets it believes can do well even during a recession. GE Commercial Real Estate, which has about \$23 billion in assets, is gaining large positions in self-storage, grocery-anchored retail and parking, all of which it sees as unusually stable holdings. Security Capital has about \$5.2 billion in assets.

With some GE businesses hurt by the economic slowdown, including its aircraft-engines, plastics and NBC TV units, GE is counting on GE Capital, along with its power-systems and medical-systems units, to rack up big net-income gains to help the parent company continue to boost its size and overall earnings per share. With target prices down, moreover, cash-rich GE Capital -- whose largest-ever deal, the \$5.3 billion purchase of Heller Financial Inc., just closed in late October -- sees an opportunity to shop at better prices and often with less competition than there was even a year ago.

...

Mr. Sanders (Security Capital's chairman and CEO) launched the company in 1991 as a way to rationalize and bring public an industry long dominated by secretive families and free-wheeling private developers. Based in Chicago and in Santa Fe, N.M., near Mr. Sanders's enormous ranch, Security Capital was designed as a kind of venture-capital and incubation firm for real-estate investment trusts.

By the late 1990s, it owned major stakes in important real-estate investment trusts, including ProLogis; Regency Centers Corp., Jacksonville, Fla., a large owner of strip centers anchored in grocery chains; Storage USA Inc., a Memphis, Tenn., self-storage company; Interpark, a manager and owner of parking facilities across the nation; and CarrAmerica Realty Corp., a big office owner based in Washington, D.C. Security Capital said Friday it would sell its stake in CarrAmerica. The sprawling entity also owned a handful of closely held concerns and even a Luxembourg-based European unit with stakes in U.S. real-estate companies.

2. Define any four of the following terms in brief (20 points):

1. Tracking Stock

2. Contingent Value Rights

3. Callable Debt

4. Puttable Bonds

3. Answer the following questions in brief (25 points):

1. What is the difference between a warrant and an option?

2. Why would a firm want to issue floating rate debt?

3. How would you come up with a synthetic rating for a firm that has debt that is not rated by a ratings firm like Moody's?

4. How would you estimate the beta for a firm that has just been established?

5. Which of these two companies would have higher asset betas, and why --

1. Deere & Co. (DE) -- DE manufactures and distributes farm equipment, machines used in construction, earthmoving and forestry, and equipment for commercial and residential uses.

2. AMN Healthcare Services is a temporary healthcare staffing company and a nationwide provider of travel nurse staffing services to hospitals and healthcare facilities throughout the United States.

4. (10 points) The following information has been extracted from the 10K filed by Shaw Group, Inc. (Ticker: SGR) on 11/29/2001 (Source: http://www.10kwizard.com):

In May 2001, the Company issued \$790 million (face value) of 20-year, zero-coupon, unsecured, convertible debt Liquid Yield Option (TM) Notes (the "LYONs") due 2021. The LYONs provided the holders with a yield-to-maturity of 2.25%.

According to Moody's Investor Service, the latest rating for SRG's long-term debt (opinion dated July 26, 2001) is Ba1.  The average yield on Baa-rated corporates, as of Dec. 18, 2001 (Source: Bridge Information Services), was 8.73.  Estimate how much of the value of SGR's convertible debt can be allocated to debt, and how much to equity.

5. (I ran a regression of monthly percentage price changes on DE (Rde)against percentage changes in the S&P 500 index (Rsp), using data from Bridge for the months January 1997-November 2001.  I estimated the following equation (the regression has an R2 of 11.34%):

Rde = -0.00065 + 0.602 Rsp

Here is some additional information I was able to obtain:

• As of December 17, 2001, the ask yield on the 5% T-bond maturing August 15, 2011 was 5.186% (Source: Bridge Information Systems).

• The average annualized 10 year T-bond rate for the same period, using monthly data from Economagic (http://www.economagic.com/em-cgi/data.exe/fedbog/tcm10y) is 5.67%.

1. How well did Deere and Co. during the period Jan. 1997-Nov. 2001, after adjusting for beta risk?  What would you conclude from this regression about whether DE is a good buy or not, today (20 points)?

2. Bonus question (10 points): Deere and Co. (using the Jul. 2001 balance sheet -- Source: Bridge Information Systems) had total liabilities of \$17,713m. (of which long term debt was \$6157m.) and stockholder's equity of \$4,331m.  Suppose Deere and Co. decided to issue new equity and pay off all of the long-term debt.  What would be Deere and Co.'s new equity beta.  Use the following for your computations: i) assume that the book value of DE's debt is a good measure of its market value; ii) treat all of DE's liabilities as leverage, not just its long-term debt; iii) DE's tax rate is 40%.

Final Solutions:

4. The market value of the convertible debt is 790/(1+0.025/2)40 = 504.99; the market value of the debt, if it were to be valued as straight debt would be 790/(1+0.0873/2)40 = 143.03.  The equity component is what is left, i.e. 504.99 - 143.03 = \$361.96m.

5. a. We first need to annualize the intercept -- (1-0.00065)12 - 1 = -0.00777 or -0.77% p.a.  The extent of overperformance is measured as intercept less (1-b)Rf, which works out to -0.0077 - (1-0.62)0.0567 = -0.0303388; i.e. Deere underperformed the market by 3.03%, after adjusting for risk.  Of course, this was in the past.  There is no justification in assuming that this will occur in the future.  The 3.03% underperformance was due to unexpected events.

b. The original levered (equity) beta from the regression was 0.602 (see regression).  Hence the unlevered beta = 0.602/[1+(1-0.4)(13382/4331)] = 0.2109.  (The debt/equity ratio is (17713-4331)/4331.)  If the long-term debt is repurchased, the leverage becomes (17713-4331-6157)/(4331+6157) = 0.688; hence the new levered beta = 0.2109 [1+(1-0.4)0.688] = 0.29807.

Final Exam Makeup

• Show the formula you are using to answer the quantitative questions.  Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary.  You do not have to show computations beyond this.  However, make sure that the numerical value of your answer makes sense in the context of the question.  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. Read the following article from the Wall Street Journal, February 25, 2002, and answer these questions:

1. Would you expect GM to have a high or a low debt-to-assets ratio?  Explain.

2. You have been asked to compute GM's debt-to-assets ratio.  Would you consider convertible debt to be completely debt for purposes of the computation?  If yes, why?  If not, how would you take it into account in the debt-to-assets ratio computation?

3. GM is accumulating a lot of cash.  What sort of firms would you expect to have a lot of cash in their balance sheets?  Give an example of such a firm.

GM Lifts Forecasts for Profit, Production, Plans Debt Offer

DETROIT -- General Motors Corp., riding stronger than expected performance in the U.S. auto market, raised its earnings outlook and production forecasts, and launched a \$2.5 billion debt securities issue as part of a program to shore up its balance sheet.

In a statement, GM Vice Chairman and Chief Financial Officer John Devine said "it is reasonable to expect that GM could generate \$10 per share in earnings by the middle of the decade." In 2001, GM reported net income of \$601 million, or \$1.77 a share, on revenue of \$177.3 billion.

GM's improved forecast buoyed the No. 1 auto maker's stock Monday on the New York Stock Exchange. In early trading, shares gained \$1.67 to \$54.78.

The optimistic outlook also comes after U.S. auto makers have offered significant incentives to boost sales and as the companies lay plans to reduce excess capacity in North America.

During a conference call Monday, Mr. Devine said GM's target is to get North American capacity utilization up to 100% "and get there as quickly as we can." GM is assuming gains from reducing idle capacity as part of its projection to earn \$10 a share by 2005, he said. GM will have to negotiate plant shutdowns with the United Auto Workers in the U.S. when their master contract expires next year, and with the Canadian Auto Workers in negotiations that begin this summer.

Debt Offering

But GM's move to sell \$2.5 billion in debt securities convertible to common shares was a reminder of the challenge the auto giant faces. The Detroit auto maker simultaneously is fighting a bruising price war in North America, is gearing up an ambitious new product program and is paying down huge pension and health-care obligations.

Mr. Devine said GM wants to strengthen its balance sheet by \$10 billion in 2002. Of that total, about \$4.2 billion is expected from the pending sale of Hughes Electronics Corp., an additional \$2.5 billion or more would come from the proposed sale of convertible debentures as soon as this week, and the remaining \$3.3 billion would be realized from improved cash flow, asset sales and other moves, a GM official said.

GM closed out 2001 with net cash in excess of debt of \$1 billion, and an additional \$3 billion allocated to a so-called Voluntary Employees Beneficiary Association trust to fund employee-benefit costs. GM had total cash and marketable securities at the end of 2001 of \$12.2 billion, below its \$13 billion target and \$1.1 billion less than a year earlier. GM also has unfunded pension liabilities of about \$9.1 billion, which it vows to reduce.

On Monday, GM tried to focus attention on its improved outlook for its huge North American auto business. GM said it now expects U.S. vehicle sales of 16 million this year, and plans to increase its 2002 North American production plan by more than 100,000 vehicles to 5.1 million vehicles. GM said its first quarter North American production will be about 20,000 vehicles, or 1.5%, more than planned.

Based on those new production plans, GM raised its profit target for the first quarter to \$1.20 a share from \$1 a share, not including results of its Hughes Electronics unit or a projected restructuring charges at GM Europe. GM didn't forecast a net-income figure in its news release.

For all of 2002, GM told investors it expects earnings of \$3.50 a share, an increase of 50 cents a share, before counting results from Hughes, which lost \$525 million last year, and write-downs at its money-losing European unit.

GM's proposed sale of convertible debentures comes on the heels of rival Ford's successful sale of \$5 billion in convertible debt in January. Merrill Lynch & Co. and Morgan Stanley Dean Witter & Co. are the lead underwriters for the GM debentures.

2. Define the following terms in brief (25 points):

1. Free cash flow

2. Underwriting guarantee

3. Rights Offering

4. Shelf Registration

5. Convertible Preferred Stock

3. Answer the following questions in brief (20 points):

1. Both the debt and the equity of a firm would be riskier, the higher its debt-equity ratio.  Since the cost of capital for the entire firm is a weighted average of the costs of debt and equity, it is clear that a firm with a higher leverage ratio will have a higher cost of capital than a firm with a lower leverage ratio.  Show why this statement is not necessarily true.

2. What sorts of firms would tend to have high indirect costs of bankruptcy?

3. Name at least two different advantages of debt.

4. How would you estimate the marginal tax rate of a firm?

4. (10 points) The following information has been extracted from the 10K filed by Shaw Group, Inc. (Ticker: SGR) on 11/29/2001 (Source: http://www.10kwizard.com):

In May 2001, the Company issued \$790 million (face value) of 20-year, zero-coupon, unsecured, convertible debt Liquid Yield Option (TM) Notes (the "LYONs") due 2021. The LYONs provided the holders with a yield-to-maturity of 2.25%.

According to Moody's Investor Service, the latest rating for SRG's long-term debt (opinion dated July 26, 2001) is Ba1.  The average yield on Baa-rated corporates, as of Dec. 18, 2001 (Source: Bridge Information Services), was 8.73.  Estimate how much of the value of SGR's convertible debt can be allocated to debt, and how much to equity.

5. (I ran a regression of monthly percentage price changes on DE (Rde)against percentage changes in the S&P 500 index (Rsp), using data from Bridge for the months January 1997-November 2001.  I estimated the following equation (the regression has an R2 of 11.34%):

Rde = -0.00065 + 0.602 Rsp

Here is some additional information I was able to obtain:

• As of December 17, 2001, the ask yield on the 5% T-bond maturing August 15, 2011 was 5.186% (Source: Bridge Information Systems).

• The average annualized 10 year T-bond rate for the same period, using monthly data from Economagic (http://www.economagic.com/em-cgi/data.exe/fedbog/tcm10y) is 5.67%.

1. How well did Deere and Co. during the period Jan. 1997-Nov. 2001, after adjusting for beta risk?  What would you conclude from this regression about whether DE is a good buy or not, today (20 points)?

2. Bonus question (10 points): Deere and Co. (using the Jul. 2001 balance sheet -- Source: Bridge Information Systems) had total liabilities of \$17,713m. (of which long term debt was \$6157m.) and stockholder's equity of \$4,331m.  Suppose Deere and Co. decided to issue new equity and pay off all of the long-term debt.  What would be Deere and Co.'s new equity beta.  Use the following for your computations: i) assume that the book value of DE's debt is a good measure of its market value; ii) treat all of DE's liabilities as leverage, not just its long-term debt; iii) DE's tax rate is 40%.