Pace University
Fin 320 Advanced Financial Analysis
Fall 2002
Prof. P.V. Viswanath


Q. 1: Here is a recent article from Barron's.  Please answer the following questions.  No more than half a page for each.

  1. (5 points) "...the move to sell the British operations came only weeks after TXU Chairman and Chief Executive Erle Nye reportedly said that he "liked the prospects" of TXU Europe, and that the businesses "could be sold for a gain.""  The move referred to in this sentence is the sale of most of TXU's British power businesses for about $2.1 billion in cash to Germany's E.On.  Couldn't Erle Nye hold that $2.1 is indeed a sale for a gain, but a gain relative not to book value, but relative to whatever value TXU could have got from the British businesses if they had done anything else?  Is there necessarily an ethical problem here, or a legal problem, or simply different ways of looking at the facts?
  2. (10 points) Why would the TXU CEO want to issue false and misleading statements, as is being claimed in certain lawholder suits?  What sorts of possibilities can you envisage?  How would you research this question?
  3. (10 points) Do you think directors of a company should be required to hold equity in the company?  Why?  Wouldn't they be more objective if they didn't hold shares?
What didn't they know, and why didn't they know it?
Barron's, Oct 28, 2002


If ever there were a time to wonder "who's in charge here" about American business, now would be it, given all the corporate surprises investors have endured over the past year or so-not to mention the renewed interest in such onetime ho-hum topics as "corporate governance."

One of the latest tales of the unexpected was the recent announcement by Dallas utility TXU that it would slash its dividend 80%, sell most of its British power businesses for about $2.1 billion in cash to Germany's E.On, and take an equity write-off of as much as $4.5 billion related to its problems in Europe.

Curiously, the move to sell the British operations came only weeks after TXU Chairman and Chief Executive Erle Nye reportedly said that he "liked the prospects" of TXU Europe, and that the businesses "could be sold for a gain."

The stock plunged more than 30% in one day on news of the dividend cut, and investors since have filed several class-action suits, charging TXU and some of its officers and directors with issuing false and misleading statements. A spokeswoman said TXU hadn't seen the full filings, and couldn't comment.

But as questions swirl over whether management adequately disclosed its concerns about the European operations earlier this month, when it warned analysts it wouldn't meet earnings estimates, other questions are arising about why some board members apparently were as uninformed about the state of TXU's affairs in Europe as anyone else.

Days before TXU shaved its quarterly dividend to 12.5 cents a share from 60 cents, several directors purchased a total of nearly 16,000 shares. Although one, a former engineering muck-a-muck at Texas A&M, bought some of his 900 shares for slightly below the $12.94 at which TXU closed the day of the dividend cut, another bought 10,000 shares for $17 to $21.50 apiece; a third picked up 5,000 for $16.35 each.

The spokeswoman said the directors, who meet only four times a year, aren't required to own any TXU shares. But she noted they are still snapping them up, "because it's a good buy and the board members believe in the company."

Q. 2. (25 points) You have been asked to value a 30-year, $1000 face value bond, issued by CVS with the following features.  The coupon rate for the first 10 years will be 6%of the face value.  The coupon rate for the second 10 years will be 7% of face value.  Thereafter, the coupon payment will increase at the rate of 5% per annum (coupon growth will be based on the dollar coupon the previous year).  Write out the time line of cashflows, and estimate the value of this bond, if CVS is rated AA.  (AA-rated bonds are trading at a default spread of 0.25% over the 10-year treasury bond rate of 4.50%.) 

Q. 3.  (25 points) Provide brief definitions for the following terms:

  1. standard error of the beta estimate
  2. operating leverage
  3. Bond covenants
  4. Treasury Stock
  5. Jensen's alpha

Q. 4. (25 points) Short questions:

  1. How would you measure a beta for a new firm in a new industry?
  2. When is an obligation recognized as a liability according to GAAP?
  3. Why might managers want to provide information to the markets?
  4. If a firm's equity beta is 1.2, and the market risk premium is 6% p.a., what is the required rate of return on the firm's assets, if its debt-to-assets ratio is 0.5?  Note that the 1-year Treasury note yields 3%, while the 10-year Treasury bond yields 5%; the firm's marginal tax rate is 40%.
  5. What are some of the ways that a conflict between stockholders and bondholders might manifest itself?

Solutions to Midterm

2. The PV of the cash flows for the first 10 years can be computed simply as .  The cash flows for the following 10 years have a present value equal to   .  The final ten years have cashflows growing at the rate of 5% per annum; the present value of the cashflows during those ten years equals .  To this, we need to add the present value of the repayment of the principal, which is .  Adding all these values, together, we get 468.98 + 344 + 280.3636 + 248.53 = 1341.87

3. a. The standard error of the beta estimate is a measure of the imprecision with which the regression beta is estimated.  The standard error is used to construct confidence intervals for the beta.
b. Operating leverage refers to the use of fixed costs to obtain a higher operating profit margin.  Operating leverage is measured by the sensitivity of operating profit to sales.
c. Bond covenants are conditions written into bond indentures that make it more difficult for the firm to expropriate bondholders.  Examples are restrictions on dividend payments, and the requirement to present audited accounts.
d. Treasury stock is stock that the firm has purchased from investors and is holding for future use.

Final Exam

1. Read the following article from the New York Times of December 7, 2002, and answer the questions below:

For the second time in seven weeks, Standard & Poor's has downgraded the long-term corporate credit rating of the Interpublic Group of Companies in New York, this time to one level above junk status. Citing "liquidity concerns" related to Interpublic debt due in May and December 2003, Alyse Michaelson, a credit analyst, downgraded the Interpublic rating yesterday to BBB-, from BBB; it was downgraded to that level from BBB+ on Oct. 18. Interpublic also remains on Standard & Poor's Credit Watch with negative implications; it was placed there in August after disclosing accounting irregularities that eventually amounted to $181.3 million in noncash charges. Moody's Investors Service has also downgraded the debt of Interpublic, the giant agency company whose holdings include Deutsch and McCann-Erickson. Interpublic's debt totaled $2.9 billion as of Sept. 30.

a. (15 points) How would the debt-to-assets ratio of Interpublic be affected by this announcement of the credit rating downgrade?  Your friend, who is a financial analyst following Interpublic says that, even though he was surprised by the announcement, ultimately it doesn't matter one way or another because the company's debt-to-assets ratio will not be affected.  "This is not going to change the book value of Interpublic's debt.  So its financial leverage will remain what it was last week," says your friend.  Do you agree with him?  Explain.

b. (25 points) The Interpublic Group of Companies, Inc. is a group of advertising and specialized marketing and communication services companies that together represent a significant resource of marketing and advertising expertise. The Company provides its clients with communications expertise in four broad areas: Advertising, which includes advertising and media management; Marketing Communications, which includes client relationship management, public relations, sales promotion, event marketing, on-line marketing and specialized sectors such as healthcare, diversity and corporate identity; Marketing Intelligence, which includes custom marketing research, brand consultancy and database management; and Marketing Services, which includes sports and entertainment marketing, corporate meetings and events, retail marketing and other marketing and business services. [Source: (December 13, 2002)].

Based on this description, do you expect Interpublic to have a high or a low debt-to-assets ratio?  Explain with complete reasoning.

2. a. (10 points) In a recent article (Dec. 10, 2002) in the Wall Street Journal, "So, Will Stock Dividends Get Back Their Respect?," Mr. Clifford Asness of AQR Capital Management is quoted as making the following statement: "When firms don't pay dividends, they tend to squander the money."  Keeping Mr. Asness's argument in mind, how would you rate the following statement: "All other things being the same, firms with high leverage ratios pay less dividends."  Is this true or false?  Answer strictly with respect to Mr. Asness's statement.  Explain your answer.

b. (20 points) Give a brief summary (no more than one side; I will not read more than that) of how you would go about deciding the appropriate dividend policy for a firm.  Make sure that your answer is legible.

3. You have been asked to analyze the capital structure of IPG, Inc..  IPG has 40 million shares outstanding, selling at $20 per share, and a debt-equity ratio (in market value terms) of 0.25.  The beta of hte stock is 1.15, and the firm currently has an AA rating, with a corresponding market interest rate of 10%.  THe firm's income statement is as follows:

EBIT $150 million
Interest Expense $20 million
Taxable Income $130 million
Taxes $52 million
Net Income $78 million

The current T-Bond rate is 8%.

  1. (10 points) What is the firm's current weighted average cost of capital?

  2. (10 points) The firm is proposing borrowing an additional $200 million in debt and repurchasing stock.  If it does so, its rating will decline to A, with a market interest rate of 11%.  What will the weighted average cost of capital be if it makes this move?

  3. (10 points) What will the new stock price be if the firm borrows $200 million and repurchases stock (assuming rational investors)?

Solutions to Final Exam

1. a.  The market value of the debt will surely drop; it is irrelevant that the book value of debt will remain the same.  However, the impact of the news on equity is likely to be even greater.  For this reason, the debt-to-assets ratio might well increase.

b. IPG is a service company and probably has most of its assets in the form of reputation, human capital etc.  These are the sort of assets that cannot be used to support debt.  On the other hand, LPG is in trouble, right now and because of that its debt-equity ratio might well be temporarily high, although LPG might well want to restructure its liabilities to replace debt with equity.

2.a. Considering Mr. Asness statement, we would look at the discipline characteristics of debt and dividends.  In this respect, both debt and dividends perform a similar function.  Consequently, firms with high dividends would not need to have high financial leverage in order to discipline their managers.

3. a. Market Value of Equity = 40 million * $ 20 = 800
Cost of Equity = 8% + 1.15 (5.5%) = 14.33%
Cost of Capital = 14.33% (0.8) + 10% (1-.4) (0.2) = 12.66% 

b. If the firm borrows $ 200 million and buys back stock, Equity will drop to $ 600 million
New Debt/Equity Ratio = 400/600 = 0.67
Unlevered Beta = 1.15 / (1 + 0.6*0.25) = 1.00
New Beta = 1.00 (1+0.6*0.67) = 1.40
New Cost of Equity = 8% + 1.40 (5.5%) = 15.70%
New Cost of Capital = 15.70% (0.6) + 11% (1-0.4) (0.4) = 12.06%

c. Increase in firm value from moving to optimal = (0.1266-0.1206)(1000)/.1206 = $49.75
Increase in Stock Price = $ 49.75/40 = $1.24