Midterm 1

• Show all your computations and formulae.  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 by Susan Carey from the Wall Street Journal of 10/05/99 and answer the questions that follow:

US Air Mechanics to Vote on Labor Pact  As Union Continues to Prepare for Strike

Mechanics at US Airways Group Inc. vote Tuesday on a tentative labor agreement reached last month, just four days before they were scheduled to strike.

If the five-year pact is approved by a majority of the 7,500 mechanics and cleaners in the International Association of Machinists union, US Air, Arlington, Va., is expected to try to settle contracts with its 9,000 flight attendants and 10,000 customer-service agents.

If the mechanics reject the pact, however, the union has said it will give the airline 48 hours to position its airplanes and crews, and then walk off the job. It is expected that 6,200 ramp workers also represented by the union would honor the mechanics' strike, a scenario that potentially could shut down US Air, the nation's sixth-largest airline and a dominant player on the East Coast.

The pact is an improvement over an earlier deal the mechanics rejected in July, union leadership maintains. It promises a signing bonus valued at 5% of members' annual wages and an immediate 6% raise. After two years, workers would receive a lump-sum payment valued at 3% of their annual wages. Premiums paid to licensed mechanics also would increase from \$2.20 an hour to \$4 an hour after three years. The pact would provide further raises if the US Air workers fell behind the salaries of their peers at the four largest U.S. airlines.

A top-scale mechanic at US Air earns \$23 an hour, excluding the license premiums. A top-paid cleaner earns more than \$16 an hour. The group, which has been seeking a new contract since 1995, shot down an earlier 3 1/2-year agreement.

The union, which is endorsing the pact, held information meetings last week throughout the US Air system to brief members on the new tentative agreement. But turnout at some locations was low, with more vocal opponents showing up than contract supporters. The greater the number of union members who cast ballots today, the better the pact's chance of being approved, union officials said.

The mechanics last struck US Air in 1992. The airline managed to operate about 55% of its schedule. But during that four-day walkout, there were no sympathy strikes. This time, the ramp workers have pledged to respect a mechanics' strike. The Association of Flight Attendants union said its leadership will decide, once a strike is under way, whether to honor the mechanics' picket lines.

1. (20 points) Employees are stakeholders in the firm.  However, employees do not necessarily own shares in the firm.  This means that they might not act in the best interests of shareholders.  For example, the mechanics' strike described in the article above is clearly not in shareholders' interests.  How would you recommend that management (acting on behalf of shareholders) try to align employees incentives with those of shareholders?

2. (20 points) US Air has an advantage in its negotiations with the union, in that the mechanics might not be able to hold out for long, particularly if flight attendants do not respect the mechanics' picket line.  Is there any reason why management should not try to beat down the US Air union to as low a salary as possible?  I'm looking for an answer related to the question of firm objectives.

Note:  Use no more than one side of your answer book for each part.  Rambling answers will be penalized.

2. (30 points) You have recently won a jackpot in your state's lottery.  You have the following options:

a.       You receive \$160,000 at the beginning of each year for 31 years.  The income would be taxed at an average rate of 28%.  Taxes are withheld when the checks are issued.

b.      You receive \$1,750,000 now, but you do not have access to the full amount immediately.  The \$1,750,000 would be taxed at an average rate of 28 percent.  You are able to take \$446,000 of the after-tax amount now.  The remaining \$814,000 will be placed in a 30-year annuity account that pays \$72,664 on a tax-free basis at the end of each year.

Using a discount rate of 10 percent, which option should you select?

3.  a. (30 points) Appended is the balance sheet for AOL, Inc. for the last two years, with a template for the computation of cashflows.  Use this to prepare a Statement of Cash Flows for the year ending June 30, 1999, and reconcile beginning cash with ending cash.
Note: AOL pays no dividends.
Hint: remember that ending cash must work out to \$887, as in the balance sheet, else you’ve made a mistake.

b.      How is AOL financing its investments?

c.       If you were a supplier to AOL, would you feel comfortable continuing trade relations with AOL?  Or would you want to stop dealing with it?  Why or why not?

 Balance Sheet Outflows (In millions, except share data) 6/30/99 6/30/98 Change Operating Investing Financing ASSETS Cash and cash equivalents 887 677 210 Short-term investments 537 146 391 Trade accounts receivable 323 192 131 Other receivables 79 93 -14 Prepd expenses & oth current assets 153 155 -2 Total current assets \$1,979 \$1,263 716 Property and equipment at cost, net 657 503 154 Investments incl av-for-sale secs 2,151 531 1620 Product development costs, net 100 88 12 Goodwill, other intangible assets, net 454 472 -18 Other assets 7 17 -10 Total Assets \$5,348 \$2,874 2474 LIABILITIES Current liabilities: Trade accounts payable 74 120 -46 Oth accrued expenses and liabilities 795 461 334 Deferred revenue 646 420 226 Accrued personnel costs 134 78 56 Deferred network services credit 76 76 0 Total current liabilities \$1,725 \$1,155 570 Long-term liabilities: Notes payable 348 372 -24 Deferred revenue 30 71 -41 Other liabilities 15 7 8 Deferred network services credit 197 273 -76 Total liabilities \$2,315 \$1,878 437 Stockholders' equity: Common stock, \$.01 par value 11 10 1 Additional paid-in capital 2,703 1,431 1272 Unrealized gain on av-for-sale secs 168 145 23 Retained earnings 151 -590 741 Total stockholders' equity \$3,033 \$996 2037 Total Liabilities 5,348 2,874 2474

Solutions:

Q.    1a. There are several possibilities:

i.                     Management might offer to pay employees partly in stock
ii.                   Management might tie future pay increases to the profitability of the company.
iii.                  Management might restrict future pay increases to employees who stay with the company for a certain number of years.

1b.  If management tries to exploit its current advantage, it might be sending the wrong message to the employees and to future employees; it might need to provide costly guarantees in future negotiations or future hirings that it will not resort to the use of a temporary advantage.  In the present, it might cause employee resentment and reduce productivity.

Q. 2. The present value of option a) can be computed as an annuity with an annual flow of 160000(1-0.28) = 115200.  This works out to \$1,091,982.30.  This would be the PV if the flows occurred at the end of the year; however, we need to consider that the flows will occur at the beginning of the year.  This means that we need to multiply by 1.1 in order to account for the increased value: this works out to \$1,201,180.50.

Option b) can be evaluated as follows:

1,750,000(1-0.28) = \$1,260,000 is the amount that will be available after payment of taxes.  Of this, \$446,000 is available immediately; the remaining \$814,000 (1,260,000-446,000) will be placed in an annuity paying \$72,664 at the end of 30 years.  The present value of this flow, using the 10% discount rate is \$684,997.31.  To this, we add the \$446,000 that is immediately available, for a total PV of \$1,130,997.30.

Hence option a) is more valuable.

Q. 3:  Here is the completed template:

Note:

·        Key to keep in mind is that the sum of the operating, investing and financing flows have to add up to the change in cash and cash equivalents, i.e. 210.
·        No information is available about depreciation: either AOL's assets are not depreciable, or there is depreciation (with a corresponding higher value for investment in PP&E), but no precise information is available about it.

 Balance Sheet Outflows (In millions, except share data) 6/30/99 6/30/98 Change Operating Investing Financing ASSETS Cash and cash equivalents 887 677 210 Short-term investments 537 146 391 391 Trade accounts receivable 323 192 131 131 Other receivables 79 93 -14 -14 Prepd expenses & oth current assets 153 155 -2 -2 Total current assets \$1,979 \$1,263 716 Property and equipment at cost, net 657 503 154 154 Investments incl av-for-sale secs 2,151 531 1620 1620 Product development costs, net 100 88 12 12 Goodwill, other intangible assets, net 454 472 -18 -18 Other assets 7 17 -10 -10 Total Assets \$5,348 \$2,874 2474 LIABILITIES Current liabilities: Trade accounts payable 74 120 -46 46 Oth accrued expenses and liabilities 795 461 334 -334 Deferred revenue 646 420 226 -226 Accrued personnel costs 134 78 56 -56 Deferred network services credit 76 76 0 0 Total current liabilities \$1,725 \$1,155 570 Long-term liabilities: Notes payable 348 372 -24 24 Deferred revenue 30 71 -41 41 Other liabilities 15 7 8 -8 Deferred network services credit 197 273 -76 76 Total liabilities \$2,315 \$1,878 437 Stockholders' equity: Common stock, \$.01 par value 11 10 1 -1 Additional paid-in capital 2,703 1,431 1272 -1272 Unrealized gain on av-for-sale secs 168 145 23 -23 Retained earnings 151 -590 741 -741 Total stockholders' equity \$3,033 \$996 2037 Total Liabilities 5,348 2,874 2474 Total cashflows -711 1758 -1257

Here is the completed Statement of Cash Flows:

 Cash Flows from Operating Activities Net Income 741 Add Change in Accum Comprehensive Income 23 Less Change in Short term Investments -391 Less Change in Trade Receivables -131 Less Change in Other Receivables 14 Less Change in Prepaid Expenses 2 Add Change in Trade Payables -46 Add Change in Other Accrued Expenses 334 Add Change in Deferred Revenue (Current) 226 Add Change in Accrued Personnel Costs 56 Add Change in Longterm Deferred Revenue -41 Add Change in Longterm Deferred Network Services Credit -76 Cash Flows from Operations 711

 Cash Flows from Investing Activities Capital Expenditures (Change in PPE) -154 Other Investments -1620 Product Development -12 Increase in Goodwill 18 Other Assets 10 Cash Flows from Investments -1758

 Cash Flows from Investing Activities Repayment of Notes Payable -24 Increase in Other liabilities 8 New Equity Issued (Par Value) 1 New Equity Issued (Addnl Paid-up Value) 1272 Cash Flows From Financing 1257

 Beginning Cash 677 Add Cash Flows from Operations 711 Cash Flows from Investments -1758 Cash Flows From Financing 1257 Ending Cash 887

b. AOL is financing its investments mainly from new financing and from cashflows generated by operations.

c. AOL seems to have a reasonable cashflow from operations.  In fact, its cashflow from operations is almost the same as its Net Income.  Hence its current operations do seem to be profitable.  Hence, I would not be squeamish about continuing to supply AOL.  It is important to note, here, that as suppliers we are more interested in short term flows, i.e. cash flows from operations, rather than in long term investments and long term financing.

Midterm II

AHP, Warner-Lambert Discuss Merger --- Transaction for \$65 Billion Could Spur Consolidation Among Drug Companies
The Wall Street Journal - 11/03/1999
By Robert Langreth and Steven Lipin

American Home Products Corp. and Warner-Lambert Co. are in talks to merge in a \$65 billion deal that would unite two of the largest pharmaceutical companies in the world, according to people familiar with the situation.

Such a deal -- which would be the largest drug merger in history and one of the largest transactions ever -- could trigger a new wave of consolidation in what remains a relatively fragmented industry, despite some major deals in recent years.

Indeed, combining Warner-Lambert, of Morris Plains, N.J., with American Home, located just down the road in Madison, would bring together the companies behind such household names as Advil, Anacin and Chap Stick (American Home) and Dentyne gum and Certs breath mints (Warner-Lambert). American Home also makes Premarin, a fast-selling drug for menopause and osteoporosis, and Warner-Lambert manufactures blockbuster cholesterol drug Lipitor.

An announcement could come as soon as tomorrow, though, as is often the case with delicate merger talks, the discussions could fall through at the last minute.

Spokesmen for American Home and Warner-Lambert declined to comment.

The talks come at a time when American Home's stock has been hit by a series of product and legal-related setbacks. American Home recently took a \$4.75 billion charge to settle thousands of lawsuits related to the diet drugs Redux and Pondimin. American Home also is restructuring its struggling Cyanamid agricultural unit.

While its share price has perked up a bit in recent weeks, American Home has been concerned about the possibility of a hostile overture by a rival drug company, according to people close to the company. It recently adopted a "poison pill" shareholder-rights plan.

In New York Stock Exchange trading at 4 p.m., American Home shares fell 43.75 cents to \$50.375. Warner-Lambert shares fell \$1.5625 to \$78.4375, also on the Big Board.

American Home is poised to launch some promising new drugs, including a vaccine for pneumonia in children, but some of its strongest existing sellers, like Premarin, are aging and a deal with Warner-Lambert would greatly expand its portfolio of medicines.  As for Warner-Lambert, Wall Street analysts have expressed concerns about whether it has enough potentially profitable new drugs in its pipeline, though profit growth has been robust because of Lipitor's success.

American Home has looked for a merger partner in the recent past. Just last year, it announced a deal to merge with Monsanto Co. and held merger talks with SmithKline Beecham PLC. Both sets of talks fell through, partly because of issues about who would run the combined firm.

American Home's chairman, John Stafford, 62 years old, is expected to be chairman of the combined firm, and WarnerLambert's chairman, Lodewijk J.R. de Vink, who is nearly a decade younger, is likely to be chief executive, these people said. Under a scenario being discussed, the board of the combined company would be split evenly between the two sides.

American Home and Warner Lambert shareholders each are expected to end up with about 50% of the stock of the combined company. Under the structure being considered, AHP shares would be used to acquire the shares of Warner-Lambert.

The headquarters is expected to be at American Home's base in Madison.

 American Home Products Warner Lambert -- Headquarters: Madison, N.J. -- CEO: John R. Stafford -- 1998 Revenue: \$13.5 billion -- 1998 Net income: \$2.5 billion -- Market cap: \$65.8 billion -- Business: Pharmaceutical and health-care products; vaccines and other biotechnology products; agricultural- and animal-health products -- Some brands: Advil, Anacin, Centrum, Chap Stick, Preparation H, Premarin -- Headquarters: Morris Plains, N.J. -- CEO: Lodewijk J.R. de Vink -- 1998 Revenue: \$10.2 billion -- 1998 Net income: \$1.3 billion -- Market cap: \$67.0 billion -- Business: Pharmaceutical and health-care products -- Some brands: Lipitor, Schick, Halls, Listerine, Dilantin, Trident, Sudafed, Benadryl, Certs, Lubriderm, Neurontin

Here's some additional information from Yahoo (http://biz.yahoo.com/p/a/ahp.html) and (http://biz.yahoo.com/p/w/wla.html).

 American Home Products Warner Lambert Stock Beta 0.62 0.82 Long-Term Debt/Equity Ratio 0.39 0.39

a)       (20 points) What are the unlevered betas of American Home Products (AHP)and Warner-Lambert (WLA)?
b)      (20 points) Estimate the beta of the stock of the merged company, assuming that the merged company does not change any operating policies.  Assume a tax rate of 40%.  Ignore the minor differences in the sizes of the two companies.
c)      (5 points; bonus) How do you think the beta of the merged company will actually change, following the merger?  Explain your answer.
d)      (20 points) Estimate the one-year expected return on the two stocks.  You have access to the following additional information:

1. The current yield on 3-month T-bills is 5.103% (Source: http://www.bloomberg.com/markets/iyc.html)

2. The arithmetic average return on the US stock market in excess of the 3-month T-bill rate, computed over the period 1926-1990 is 8.41%.

3.  The arithmetic average return on the US stock market in excess of the yield on the 30-year Treasury bond, computed over the period 1926-1990 is 7.24%

4.  The geometric average return on the US stock market in excess of the 3-month T-bill rate, computed over the period 1926-1990 is 6.41%.

5. The geometric average return on the US stock market in excess of the yield on the 30-year Treasury bond, computed over the period 1926-1990 is 5.50%.  (Source for the data in items b. through e. above: Damodaran, Corporate Finance: Theory and Practice, p. 126)

e) (5 points; bonus) The actual average returns on AHP (using data for the last five years from http://chart.yahoo.com) is 30.25% p.a. and that on WLA is 42.61%.  Compare these numbers to your answers from d) above.  How would you explain the discrepancy, if any?

f)   (10 points) What do you think the correlation coefficient between the stock returns of the two companies would be?  Provide a numerical estimate and justify your answer.

g)    (20 points) Use your estimate in f) above to compute the variance of returns on a portfolio consisting of \$10,000 invested in American Health Products and \$20,000 in Warner-Lambert (assuming that the merger does not go through).  The following additional information is available:  The standard deviation of returns on WLA stock is 93.32% per year, computed using stock-split and dividend adjusted return data from Yahoo (http://chart.yahoo.com) for the last five years.  The same number for AHP is 93.76%.  (If you have not been able to answer part e), you can use any arbitrary figure for the correlation, other than zero.)

h)      (10 points) Compute the expected return on the portfolio in g) above, using your computations from d) above.

Solutions to Midterm II:

a) bL = bU[1+(1-t)(D/E)]; hence bU(AHP) = 0.62/[1+(1-0.4)(0.39)] = 0.50;
bU(WLA) = 0.82/[1+(1-0.4)(0.39)] = 0.6645.

b) Our estimate of the unlevered beta of the merged company is simply an unweighted average of 0.50 and 0.6645, or 0.5823; using the formula from part a), we can compute the levered beta to be 0.7185.

c) The beta might change if the merged company changed its operating policies.  For example, if it became more aggressive, that might increase the beta of the merged company above 0.7185.

d) Using the CAPM, E(RAHP) = 0.05103 + 0.62(0.0841) = 10.32% and E(RWLA) = 0.05103 + 0.62(0.0841) = 12%.

e) The answer in part d) above is simply the expectation given partial information.  First, the market risk premium is an expectation; and two, we have no special information on the company itself.  The higher numbers simply mean that circumstances turned out to be more favorable to the company than the market had expected.

f) The correlation coefficient would probably be moderately high, given that both companies are in the same industry; I would suggest a correlation coefficient of 0.8.

g) The portfolio variance = (1/3)2(93.76)2 + (2/3)2(93.32)2 + 2(1/3)(2/3)(93.76)(93.32)(0.8) = 7958.27; the standard deviation is the square root of 7958.27 = 89.21%

h) The expected return on the portfolio is (1/3)(10.32) + (2/3)(12) = 11.44%

Final Exam

• Show all your computations and formulae.  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.  And explain all your answers as much as possible.

•  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.

•  Although to answer some questions correctly, you will need the answers to previous questions, I will evaluate each question independently.  Hence, even if you have not been able to answer a previous question, do not skip the following questions.  Make an arbitrary assumption about the answer to the previous question and proceed with the following questions.

1.      (10 points) For ABM Industries, for the most recent period, compute the ratio of debt to total liabilities, the ratio of equity to total liabilities, and the ratio of preferred stock to total liabilities.  Use the following guidelines in your computation:

•  Ignore the value of current assets and liabilities

• Compute the value of debt as equal to the sum of Long Term Debt plus Other Long Term Liabilities

• Use the market value of equity as of July 30, 1999 as the value of equity

• Use the book value of preferred stock as the value of preferred stock.

• Let the value of total liabilities be the sum of these three quantities.

2.      (10 points) Estimate the before-tax cost of debt.

3.      (10 points) Estimate the marginal tax rate for the company and the after-tax cost of debt.

4.      (10 points) Estimate the cost of equity capital.

5.      (10 points) Estimate the cost of preferred stock.

6.      (10 points) Compute the weighted average cost of capital, using your results from parts 1-5.

7.      (10 points) Suppose ABM paid off all of its debt with a new stock issue.  Compute  the new cost of capital of the firm.

8.      (15 points) Compute the resultant change in value of the firm.

9.      (15 points) Why, do you think, did ABM increase its dividend (see Dec. 21, 1999 news item from Yahoo)?  Explain using the theories of dividend policy that we discussed in class (no more than one page of your exam booklet).

10.  (10 points) Bonus question: How does the fact that ABM’s debt is privately held affect its optimal debt-equity ratio?

Attachments:

ABM Industries Incorporated provides air conditioning, elevator, engineering, janitorial, lighting, parking and security services. Clients include thousands of commercial, industrial and institutional customers who outsource these services in hundreds of cities across North America. The Company's nine divisions operate in three functionally oriented segments: Janitorial, Public Service and Technical. The Company's Janitorial Divisions segment provides janitorial cleaning services as well as janitorial supplies and equipment to its customers. The Company's Public Service Divisions segment provides parking facility services, commercial security and investigative services, and "bundled" facility services to their customers. The Technical Divisions segment provides its customers with a wide range of elevator, engineering, HVAC (heating, ventilation and air conditioning), and lighting services through its four divisions.

Closing price for ABM Stock as of July 30, 1999 was \$27.8125 (http://chart.yahoo.com)
Closing price for ABM Stock as of December 21, 1999 was \$20.6875 (http://chart.yahoo.com)
Average Annual Percentage Change of the S&P 500 from 1962 to 1999 was 8.75%.
The average dividend yield for the S&P 500 from 1962 to 1999 was about 4%.
The yield on the 3-mth Treasury bill was 5.514% on Dec. 22, 1999.
The yield on the 1-year Treasury bill was 5.926% on Dec. 22, 1999.
The yield on the 30 year Treasury bond was 6.451% on Dec. 22, 1999.

Annual Assets (’000\$)

 FISCAL YEAR ENDING 7/31/99 10/31/98 10/31/97 10/31/96 10/31/95 Cash 2048 1,844 1,783 1,567 1,840 Receivables 283,718 260,549 234,464 183,716 158,075 Inventories 22,383 22,965 21,197 16,492 19,389 Other Current Assets 45,045 38,950 34,072 31,980 30,563 Total Current Assets 353,194 324,308 291,516 233,755 209,867 Prop, Plant & Equipment, Net 32,736 27,307 26,584 22,570 61,648 Investments and Long Term Receivables 14,031 12,405 12,900 15,941 5,988 Deferred Charges 29,569 27,509 25,426 22,046 18,745 Intangibles 105,818 102,776 100,313 76,366 69,279 Deposits and Other Assets 9,017 7,058 7,512 9,092 8,447 TOTAL ASSETS 544,365 501,363 464,251 379,770 334,973

Annual Liabilities (000\$)

 FISCAL YEAR ENDING 7/31/99 10/31/98 10/31/97 10/31/96 10/31/95 Notes Payable 12,252 2,475 12,975 4,935 5,361 Accounts Payable 35,462 34,992 34,555 27,091 25,453 Current Portion of Long Term Debt 891 865 1,393 902 679 Accrued Expenses 119,304 113,965 103,472 79,006 80,477 Income Taxes Payable 8402 5,527 1,364 1,864 2,270 Total Current Liabilities 176311 157,824 153,759 113,798 114,240 Long Term Debt 24,929 33,720 38,402 33,664 22,575 Other Long Term Liabilities (Retirement Plans and Insurance Claims) 69,297 65,885 67,877 61,615 49,972 Total Liabilities 270,537 257,429 260,038 209,077 186,787 Preferred Stock1 6,400 6,400 6,400 6,400 6,400 Common Stock Net 223 216 205 195 94 Capital Surplus 93,047 79,904 63,416 48,548 40,627 Retained Earnings 174,158 157,414 134,192 115,550 101,065 Shareholder Equity 267,428 243,934 204,213 170,693 148,186 Total Liabilities and Net Worth 544,365 501,363 464,251 379,770 334,973

Note: 1. Series B 8% Senior Redeemable Cumulative Preferred Stock

D.    Income Statement  (000\$) (From Disclosure):

 FISCAL YEAR ENDING For 9 mths ending 7/31/99 10/31/98 10/31/97 10/31/96 10/31/95 Net Sales 1,202,811 1,501,827 1,252,472 1,086,925 965,381 Cost of Goods Sold 1,045,844 1,298,423 1,076,078 940,296 830,749 Gross Profit 156,967 203,404 176,394 146,629 134,632 Selling, General and Administrative Expenses 110,585 142,431 126,755 105,943 100,481 Income before Depreciation and Amortization 46,382 60,973 49,639 40,686 34,151 Interest Expense 1527 3,465 2,675 2,581 2,739 Income Before Income Tax 44,855 57,508 46,964 38,105 31,412 Provision for Income Tax 18,391 23,578 19,725 16,385 13,193 Net Income 26,464 33,930 27,239 21,720 18,219 Outstanding Shares (’000s) 21,954 21,601 20,464 19,489 9,366

From the section entitled “LONG-TERM DEBT AND CREDIT AGREEMENT,” in the Company’s 1998 Annual Report to Stockholders

During the third quarter of 1997, the Company replaced its \$125 million syndicated line of credit expiring September 22, 1999 with a new \$125 million syndicated line of credit expiring July 1, 2002. Effective November 1, 1997, the agreement was amended to increase the amount available to \$150 million. The unsecured revolving credit facility provides, at the Company's option, interest at the prime rate or IBOR+0.35%. The facility calls for a commitment fee payable quarterly, in arrears, of 0.12% based on the average, daily, unused portion. For purposes of this calculation, irrevocable standby letters of credit issued in conjunction with the Company's self-insurance program plus cash borrowings are considered to be outstanding amounts.

As of October 31, 1998, the total outstanding amount under this facility was \$101 million comprised of \$30 million in loans and \$71 million in standby letters of credit. The interest rate at October 31, 1998 on loans outstanding under this agreement ranged from 5.54% to 6.16%. The Company is required, under this agreement to maintain financial ratios and places certain limitations on dividend payments. The Company is prohibited from paying cash dividends exceeding 50% of its net income for any fiscal year.

In February 1996, the Company entered into a loan agreement with a major U.S. bank which provides a seven-year term loan of \$5 million. This loan bears interest at a fixed rate of 6.78% with annual payments of principal, in varying amounts, and interest due February 15, 1997 through February 15, 2003. The long-term debt of \$34,585,000 matures in the years ending October 31 as follows: \$865,000 in 1999; \$859,000 in 2000; \$895,000 in 2001, \$30,907,000 in 2002, \$981,000 in 2003,and \$78,000 in subsequent years.

(Note: Interbank Offered Rate IBOR is the rate of interest at which banks lend to other prime banks.  This is essentially the same as LIBOR or London Interbank Offered Rate)

Long-term debt at October 31, 1998 is summarized as follows:

 (in thousands of dollars) 1997 1998 Notes payable to bank with interest at 5.54 - 8.25% \$ 34,000 \$ 30,000 Note payable to bank with interest at 6.78% 4,777 4,104 Note payable to insurance company with interest at 9.35% 636 0 Notes payable with interest at 8.75% 238 177 Other 144 304 39,795 34,585 Less current portion 1,393 865 \$ 38,402 \$ 33,720

(The prime rate is defined by The Wall Street Journal as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks.) (data obtained from HSH Associates: http://www.hsh.com):

 Date Prime Rate 30-Sep-98 8.25% 16-Oct-98 8.00% 18-Nov-98 7.75% 01-Jul-99 8.00% 25-Aug-99 8.25% 17-Nov-99 8.50%

G.    History of Recent 6-month maturity average LIBOR rates
(data obtained from HSH Associates: http://www.hsh.com) (LIBOR is an abbreviation for "London Interbank Offered Rate," and is the interest rate offered by a      specific group of London banks for U.S. dollar deposits of a stated maturity. LIBOR is used as a base index for setting rates of some adjustable rate financial instruments.)

 Month Rate June 1999 5.633 July 1999 5.68 August 1999 5.913 September 1999 5.974 October 1999 6.144 November 1999 6.063

A regression of the monthly return on ABM on the monthly percentage change in the S&P500 for the 59 months, Jan. 1995 to November 1999 yielded the following regression equation:

RABM = 0.000429 + 0.7543 RSP500
R2 of the regression: 0.1449
T-statistic for the slope coefficient of the regression: 3.108228

I.       Dividend per share history (from http://chart.yahoo.com):

 Date Cash Dividend Date Cash Dividend 13-Oct-99 0.14 13-Jan-97 0.1 13-Jul-99 0.14 9-Oct-96 0.09 13-Apr-99 0.14 11-Jul-96 0.17 13-Jan-99 0.14 11-Apr-96 0.17 13-Oct-98 0.12 10-Jan-96 0.17 13-Jul-98 0.12 11-Oct-95 0.15 13-Apr-98 0.12 12-Jul-95 0.15 13-Jan-98 0.12 7-Apr-95 0.15 10-Oct-97 0.1 9-Jan-95 0.15 11-Jul-97 0.1 7-Oct-94 0.13 11-Apr-97 0.1

J.      Earnings per share history
(from Disclosure, except for the year ending Oct. 1999, which is from http://biz.yahoo.com)

 Fiscal Yr ending Eps (\$) 10/31/99 1.65 10/31/98 1.570761 10/31/97 1.331069 10/31/96 1.114475 10/31/95 1.945227 10/31/94 1.676318 10/31/93 1.440647

K.    Summary of Recent News Items pertaining to ABM
from http://biz.yahoo.com/n/a/abm.html on Dec. 21, 8:00 p.m. (all times are Eastern)

Tuesday December 21, 1999

·        ABM Industries Inc raises dividend - Reuters Securities - 1:54 pm

·        ABM Industries Increases Quarterly Dividend by 11% - Business Wire - 1:47 pm

ABM Industries Increases Quarterly Dividend by 11%
(http://biz.yahoo.com/bw/991221/ca_abm_ind_1.html)
Tuesday December 21, 1:47 pm Eastern Time
Company Press Release

SAN FRANCISCO--(BUSINESS WIRE)--Dec. 21, 1999--The Board of Directors of ABM Industries Incorporated (NYSE:ABM - news) today declared an all-time high quarterly cash dividend of 15.5 cents per common share for payment on February 3, 2000, to stockholders of record on January 14, 2000.

This will be ABM's 135th consecutive quarterly cash dividend, and is 11% greater than the 14 cents per share that were paid in each of the four previous quarters.

Just last week, ABM reported over \$1.6 billion in annual revenues (up 9%) and diluted net income per share of \$1.65 (up 15%) for the fiscal year that ended on October 31, 1999.

Monday December 13, 1999

·        ABM Industries Q4 results - Reuters Securities - 3:12 pm

·        ABM Industries Reports \$1.6 Billion in Annual Revenues and a 15% Increase in Net Income Per Share - Business Wire - 2:55 pm

Friday December 10, 1999

·        ABM Industries On the Grow from Alaska to Florida - Business Wire - 6:01 am

Tuesday November 30, 1999

·        Amtech Elevator Services Awarded General Motors Contract - Business Wire - 9:08 am (Note: Amtech Elevator Service is a wholly-owned subsidiary of ABM Industries)

Thursday November 18, 1999

·        ABM Janitorial Services Scores At STAPLES Center - Business Wire - 6:03 am (Note: ABM Janitorial Services is a wholly-owned subsidiary of ABM Industries)

Tuesday November 2, 1999

·        Promotions in the Officer Corps of ABM Industries Incorporated - Business Wire - 2:09 pm

Monday October 18, 1999

·        Henrik Slipsager to Succeed Jack Egan as president of American Building Maintenance - Business Wire - 5:14 pm (Note: American Building Maintenance Company is a wholly-owned subsidiary of ABM Industries)

Friday October 8, 1999

·        Ampco System Parking Receives Sioux City Parking Contract - Business Wire - 12:15 pm (Note: Ampco System Parking is a wholly owned subsidiary of ABM Industries)

Friday September 24, 1999

·        ABM Engineering Receives ISO 9002 Certification - Business Wire - 12:04 pm (Note: ABM Engineering Services is a wholly-owned subsidiary of ABM Industries)

Wednesday September 22, 1999

·        ABM Industries Incorporated Announces Stock Repurchase Program - Business Wire - 6:08 pm

Solutions:

1. The book value of preferred stock is 6400 from the balance sheet for 7/31/99
The value of debt is the sum of Long-term Debt plus Other Long Term Liabilities, i.e. 24,929 + 69,297 = 94,226
The value of equity is the market value of equity on 7/30/99, which is equal to the market price on that date (27.8125) times the number of shares outstanding (21,954), which works out to 610,595.

Hence the total value of the liabilities equals 6400 + 94,226 + 610,595 = 711,221.  The ratio of debt to total liabilities is 94,226/711,221 = 13.25%
The ratio of the value of preferred stock to total liabilities equals 6400/711,221 = 0.90%
The ratio of the value of equity to total liabilities equals 610,595/711,221 = 85.85%
2. We could compute the historical cost of the different sources of debt capital.  However, what is important for the firm is the cost at the margin, looking ahead.  We see that the firm has the opportunity to draw on its line of credit.  In this case, its cost would be either prime, which is, using the numbers from the end of November, 8.5%, or IBOR + 0.35%.  Now, the average IBOR for the month of November was 6.063 according to the information from HSH Associates.  Rates have gone up somewhat since then.  Hence, we might add about 25 basis points (more or less arbitrary, based on personal feel for the change in rates) to the average LIBOR rate and then add the premium of 35 basis points.  This gives us a before-tax debt cost of 6.063 + 0.25 + 0.35, or approximately 6.66%.
3. The marginal tax rate could be computed by looking at how much taxes have increased from one year to the next divided by how much taxable income has increased.  If we apply this idea to 1997 and 1998, we get the marginal tax rate estimate = (23,578-19,725)/(57,508-49,964) = 51%.  If we apply it to 1998 and the numbers for the first nine months of 1999, we get the marginal tax rate estimate = (23,578-18,391)/(57,508-44,855) = 41%.   This seems much more reasonable for too reasons: one, the numbers are more recent; and two, the actual maximum statutory rate is about 40% currently.  Using this number of 40%, we can estimate the after-tax cost of debt as being (1-0.4)(6.66) = 4%
4. We can use the CAPM to get an estimate of the cost of equity capital.  The beta of the stock using the information from the regression is 0.75.  The riskfree rate that would be appropriate in this case would be the 30-yr treasury bond yield, which is currently 6.451%.  The expected return on the market could be taken to be the average total return on the S&P 500 over the last 30 or so years, which works out to 8.75% + 4%.  Hence the cost of equity capital works out to 6.451 + 0.75(12.75 – 6.451) = 11.175%
5. The cost of preferred stock can be estimated as the rate of the preferred stock dividend, which is 8% (in the absence of better information).
6. The weighted average cost of capital equals 0.08(.009) + 0.04(0.1325) + .1175(0.8585) = 10.69%
7. If we lump preferred stock along with the common stock, in terms of the riskiness of the common stock, the relevant number for the current debt-equity ratio is 13.25/(100-13.25) = 0.1527.  Hence the unlevered beta would be given by 0.75/[1+(1-0.4)(0.1527)] = 0.687.  The new cost of equity would be 6.451 + 0.687(12.75 – 6.451) = 10.78%.  Hence the WACC = 0.08(0.009) + 0.1078(0.991) = 10.68%
8. The change in the value of the firm can be computed as Current firm value*(Change in WACC)/New WACC.  Using the total value of liabilities as defined in question 1 to be the firm value, we can compute this as 711,221*(0.1069-.1068)/0.1068 = 665.94.  Hence the firm value would have increased by \$665.94 (in ’000s), assuming that this would not have affected the operating cash flows.
9. ABM’s earnings are going up; hence to maintains its payout ratio, it would have to increase dividends.  On the other hand, given the growth rate of earnings, and the number of new contracts that ABM has obtained, one would have expected the firm to use the increased earnings for reinvestment.  Perhaps the management feels that the firm’s stockholders expect a certain dividend yield and/or that the stock price is below its true value.
10. The fact that the debt is privately held means that it would be easier for it to be renegotiated if the firm ran into problems.  Hence, it probably could afford a higher debt-equity ratio, for that reason.  On the other hand, private debt probably costs more, which would argue for a lower debt ratio.