Pace University
Fin 320 Advanced Financial Analysis
Spring 2001
Prof. P.V. Viswanath


1. (30 points) Read the excerpt from the WSJ of March 6, 2001, below, and answer the following question: 

Some Find Appeal in Foreign Small-Caps

Investors who want to diversify their portfolios by investing in international stocks should look at small companies, according to Robert Treich, who heads a team at Pictet International Management that specializes in international stocks with small market capitalizations.

That's because the stocks of large international companies, whether it is Nokia Corp. or Toyota Motor Corp., move more and more in tandem with their U.S. peers. The big companies share the same global marketplace, and increasingly feel the effects of the same ups and downs.

But this lockstep movement doesn't seem to apply to smaller companies, which also are getting a boost outside the U.S. from the rising number of venture-capital firms that are emerging to fund start-up companies, Mr. Treich said.

"Before, if you were a smart person in Europe, you could do one of two things -- go work for Nokia or move to the States," said Mr. Treich, whose London-based team manages roughly $1 billion in small-cap assets for institutional and wealthy individual investors in Europe, Canada and the U.S. "Now you can start your own company in Europe and get funding."

The value of venture-capital investment in Europe hit a record in 2000, and additional funding for small companies should eventually reach Japan, though it will be a long time before the venture-capital culture takes root in Asia, the fund manager said.

Also boosting the appeal of international investing is the expectation that the European economy this year will grow faster than the U.S. economy for the first time in a decade. The euro appears to be stabilizing after last year's steep decline against the dollar, which knocked several points off the performance of European mutual funds for U.S.-based investors.

Mr. Treich's team, part of the asset-management unit of Pictet & Cie., a 200-year-old Swiss private bank, successfully took advantage of the rise in the European small-cap sector the past two years by selecting companies using a bottom-up approach. Pictet doesn't hedge currencies, preferring instead to focus on stock picking.

Pictet International Small Companies Fund, with $26 million in assets, returned 6.6% last year, beating 98% of its peers, according to fund tracker Morningstar Inc. The fund was up 86% in 1999, ranking at the top 9% of its category. So far this year, the fund is down 9.8%, according to Morningstar.

The fund, which generally invests in companies whose capitalization, or market price times shares outstanding, is less than $2 billion, currently has 72% of its assets invested in Europe and 22% in Asia. Another 3% is in cash.

Mr. Treich is bullish on France, and has roughly a quarter of the team's portfolio invested in that country. He thinks France has a "very investor-friendly" small-cap market with a broad range of companies to pick from and ample liquidity. The country's macroeconomic conditions, with high consumer confidence and falling unemployment, also bode well for investors.

One example of Pictet's recent pick in France is Marionnaud Parfumeries, a perfume retailer. The company has aggressively bought smaller retailers and brand owners and created an efficient distribution channel in a traditionally fragmented market. It is now looking to enter Italy with a similar strategy, Mr. Treich said.

Meanwhile, Mr. Treich hopes to bring up the fund's weighting in Germany significantly from the current 11%, but he still sees too much risk there at the moment. "They are too reliant on export growth, and clearly things are slowing down," he said.

Pictet has been cutting its position in the United Kingdom. Mr. Treich feels the valuation of British companies has now become too high, and earnings warnings by some companies have provided a catalyst for unwinding some holdings. "We have trouble finding good things there," he said.

In Asia, Pictet has raised its weighting on Japan slightly to 14%, still lower than its normal allocation. The company's target is the consumer area that represents more than 60% of the economy. Joint Corp., a condominium builder in Tokyo, is one company that became part of the fund's portfolio recently.

While Mr. Treich still doesn't think recovery is imminent in Japan, he is positioned "just in case," so he won't miss out once it starts. "When something significant happens in Japan, it goes very quickly," the manager said.

  1. Glaverbel SA is a glass-making firm listed on the Belgian stock exchange.  Which would be greater, according to the hypothesis of Mr. Treich, the covariance between the returns on the Wilshire 5000 and the return on Nokia, or the covariance between the return on the Wilshire 5000 and the return on Glaverbel? Explain your reasoning.
  2. According to Morningstar, the Pictet International Small Companies Fund, run by Mr. Treich's team down 9.8% for the year.  This disproves Mr. Treich's hypothesis.  Do you agree?  Why or why not?
  3. If you were a US investor, and you were considering investing either in one of Mr. Treich's mutual funds, or in an alternate international fund run by Mr. Treich's competitor.  How would you measure the riskiness of these two candidate funds?

2. (30 points) The following is the correlation matrix between the returns on three stocks, computed using recent historical data (Source: Optimization Technology Center,

AT&T JP Morgan Walt Disney
AT&T1.0 0.47 0.44
JP Morgan0.47 1.0 0.55
Walt Disney0.44 0.55 1.0

The standard deviation of returns (measured using monthly data for the years 1996-2000; data source on the three stocks is 11.29% for AT&T (ticker symbol T), 10.94% for JP Morgan Chase (JPM) and 8.9% for Walt Disney (DIS).  What would be the variance of returns on a portfolio consisting of 50% in AT&T, 30% in JPM and 20% in DIS?

3.  (20 points) The 10-K405 report filed by AMR Corporation on March 27, 2000 ( with the SEC contained the following information on the firm's operating leases, its assets and liabilities, and its revenues and expenses.  Compute the capitalized value of the Operating Leases for 1999, and make the necessary adjustments to Operating Income for 1999.

The major part of AMR's debt constitutes secured variable and fixed rate indebtedness due through 2015, with effective rates from 6.232% - 9.597% (as of December 31, 1999).  Since the operating lease obligations are probably fixed rate and probably date from several years ago, the cost of debt that would be appropriate to capitalize them would be closer to the higher number (since interest rates have been dropping in the last few years); in any case, assume that the operating lease expenses are to be capitalized using a before-tax cost of debt of 9.597%.  

You may also make the simplifying assumption that Damodaran suggests, i.e. that the interest expense on the debt created by converting operating leases will be equal to the difference between the operating lease expense and the depreciation of the asset created by the operating leases (p.91).  Assume as well that the operating leases run through the end of 2016, and that the minimum annual required lease payments are equal for 2005 and beyond.



       AMR's subsidiaries lease various types of equipment and property,
including aircraft and airport and off-airport facilities. The future minimum
lease payments required under capital leases, together with the present value of
net minimum lease payments, and future minimum lease payments required under
operating leases that have initial or remaining non-cancelable lease terms in
excess of one year as of December 31, 1999, were (in millions):
                                                                 Capital              Operating
      Year Ending December 31,                  Leases                Leases
                                                         --------------        --------------
      2000                                               $         347         $       1,015
      2001                                                         329                 1,006
      2002                                                         280                   952
      2003                                                         198                   965
      2004                                                         249                   954
      2005 and subsequent                              1,081                12,169
                                                         -------------         -------------
                                                                 2,484(1)      $      17,061(2)
      Less amount representing interest            637
      Present value of net minimum
       lease payments                          $       1,847
      (1) Future minimum payments required under capital leases include $187
          million guaranteed by AMR relating to special facility revenue bonds
          issued by municipalities.
      (2) Future minimum payments required under operating leases include $6.5
          billion guaranteed by AMR relating to special facility revenue bonds
          issued by municipalities.
Accounts payable $1,115 $1,047
Accrued salaries and wages 849 917
Accrued liabilities 1,107 973
Air traffic liability 2,255 2,163
Current maturities of long-term debt 302 48
Current obligations under capital leases 236 154
------------ ------------
Total current liabilities 5,864 5,302
Deferred income taxes 1,846 1,470
Deferred gains 613 573
Postretirement benefits 1,669 1,598
Other liabilities and deferred credits 1,835 1,614
------------ ------------
5,963 5,255
Common stock - $1 par value; shares authorized: 750,000,000;
Shares issued: 1999 and 1998 - 182,278,766 182 182
Additional paid-in capital 3,061 3,075
Treasury shares at cost: 1999 - 34,034,110; 1998 - 20,927,692 -2,101 -1,288
Accumulated other comprehensive income -2 -4
Retained earnings 5,718 4,733
------------ ------------
6,858 6,698
------------ ------------
============ ============


   Cash                                                                           $         85     $         87
   Short-term investments                                                                 1,706             1,448
   Receivables, less allowance for uncollectible
     accounts (1999 - $57; 1998 - $19)                                                    1,134             1,225
   Inventories, less allowance for obsolescence
     (1999 - $279; 1998 - $214)                                                             708               596
   Deferred income taxes                                                                    612               443
   Other current assets                                                                     179               170
     Total current assets                                                                 4,424             3,969
   Flight equipment, at cost                                                             16,912            13,688
   Less accumulated depreciation                                                          5,589             4,976
                                                                                         11,323             8,712
   Purchase deposits for flight equipment                                                 1,582             1,624
   Other equipment and property, at cost                                                  3,247             2,999
   Less accumulated depreciation                                                          1,814             1,669
                                                                                          1,433             1,330
                                                                                         14,338            11,666
   Flight equipment                                                                       3,141             3,159
   Other equipment and property                                                             155               146
                                                                                          3,296             3,305
   Less accumulated amortization                                                          1,347             1,230
                                                                                          1,949             2,075
   Route acquisition costs, less accumulated amortization
     (1999 - $269; 1998 - $240)                                                             887               916
   Airport operating and gate lease rights, less accumulated amortization
     (1999 - $181; 1998 - $161)                                                             304               312
   Prepaid pension cost                                                                     257               304
   Other                                                                                  2,215         2,213
                                                                                          3,663             3,745
TOTAL ASSETS                                                                      $     24,374     $     21,455
                                                                                  ============     =========

Year ended December 31

1999 1998
Passenger - American Airlines, Inc. $14,707 $14,695
                - AMR Eagle 1,294 1,121
Cargo 643 656
Other revenues 1,086 1,044
--------------- ---------------
Total operating revenues 17,730 17,516
Wages, salaries and benefits 6,120 5,793
Aircraft fuel 1,696 1,604
Commissions to agents 1,162 1,226
Depreciation and amortization 1,092 1,040
Maintenance, materials and repairs 1,003 935
Other rentals and landing fees 942 839
Food service 740 675
Aircraft rentals 630 569
Other operating expenses 3,189 2,847
Total operating expenses 16,574 15,528
Interest income 89 114
Interest expense -393 -372
Interest capitalized 118 104
Miscellaneous - net      36     -1
   -150 -155
Income tax provision    350     719
Income from continuing operations 656 1,114
Income from discontinued operations, net of applicable income
Taxes and Minority Interest 265 200
Gain on Sale of Discontinued Operations, net of applicable income
TAXES 64 --
------------------ ------------------
NET EARNINGS $985 $1,314
============ ============

4. (20 points) (Source: Prof. Robert Crawford, Knowing you would possess a college grade intellect, your parents opened a savings account for you on your 1st birthday and made monthly deposits thereafter. Upon enrolling in college on your 19th birthday that account was valued at $32,000. Market rates of interest averaged 10% during that time period.

  1. How much would your parents have deposited each month to achieve that $32,000 value?
  2. What maximum college expenses would this $32,000 amount finance over 4 continuous years of enrollment (specify your answer in terms of the maximum amount per semester; assume that tuition is to be paid at the beginning of the term)?
  3. Suppose you borrowed your semi-annual college expenses determined in b) at a regular interest rate of 8% as long as you were attending school and invested your savings in the stock market. What annual certain rate of return would enable you to break even at the end of your college years after you paid off your loan upon graduating. If the probability the market would yield a zero market return in any year was 50%, what is the minimum non-zero return you would have to earn to break even?

5. (20 points) Read the following article from the March 7, 2001 Wall Street Journal and answer the questions that follow:

Management: Seasoning Compensation Helps TV Operation Improve Morale

BETHESDA, Md. — A few years ago, Mark Kozaki and other executives at Discovery Communications Inc. had a morale problem on their hands.

Some of the company's top achievers were earning the same salaries as slackers in the same position. In other cases, employees doing the same work as colleagues in other parts of the company, which is based in Bethesda, were being paid less.

The only way for managers to reward the workplace stars was to give them a bonus or promote them to another position; Discovery's compensation structure did not allow for big raises for people who remained in the same job.

"People felt that it was unfair," said Mr. Kozaki, who is senior vice president for administration and operations in the United States for Discovery, which owns the Discovery Channel, Animal Planet and 31 other cable networks.

The company found that its compensation structure was not just unfair, it was often counterproductive. Some people accepted promotions to jobs they were not equipped for, while others tried to switch to more generous departments in the company.

And so, in early 1998, Discovery began an overhaul of its compensation policy, switching to a pay-for-performance system that allowed for both big raises and bonuses.

Even though the traditional justification for maintaining a relatively fixed pay structure is to promote a sense of equity among employees, by abandoning it, Mr. Kozaki said, dissension in the ranks soon dissipated.

"It has eliminated many of the concerns about whether there is across- the-board fairness," he said. "There is not as much discussion or wondering or suspicion" as before.

Experts in employee compensation say more companies are shifting away from fixed pay structures that have long been the norm to more flexible performance-driven arrangements like Discovery's.

Though the old practice of keeping pay within narrow boundaries for workers in the same job classification still prevails, an increasing number of managers are realizing that they have to come to grips with the challenge of rewarding their best workers without raising labor costs significantly.

The solution for many companies is to hold automatic pay raises to a minimum, thus punishing mediocre employees, while lavishing merit raises and bonuses on the superstars.

The bonuses are increasingly based on measurements of both the individual's attainments and the company's overall profits and other results.

More than half of the 2,400 companies surveyed in 2000 by William M. Mercer Inc., a human resources consulting firm in New York, reported that they had performance-based incentive programs in place for both management and nonmanagement employees. And 49 percent said that they had increased the number of employees eligible for such programs since 1997.

"It's due to two issues," said Steven E. Gross, who runs the compensation consulting practice at Mercer. "Attraction and retention of good people, and companies trying not to raise their fixed costs."

And by linking bonuses to corporate results as well as individual attainments, he said, companies can share the wealth in good times, but can cut bonuses before jobs in bad times. "It self-corrects some of your costs," he said.

Mr. Gross said some studies suggested that every $1 invested in an employee incentive program could lead to a $2 increase in revenue, but he cautioned that so many variables had to be considered in making that calculation that conclusions were extremely tentative.

Managers, of course, have always been rewarded for doing well, but the expansion of financial incentives into the middle and lower ranks of the organization is a relatively recent phenomenon that has accelerated over the last decade, compensation experts say.

Late in 2000, as just one illustration, the New York law firm of Stroock & Stroock & Lavan announced that it would begin paying bonuses to junior lawyers based on their individual performance, a bounty once reserved for partners only.

At Discovery, which grew so quickly that the compensation structure long went unexamined, Mr. Kozaki said that attrition rates had fallen and complaints from employees were less frequent since the new policy went into effect. "Employees think they are being treated fairly," he said.

Under the old system, an information-technology specialist who was doing good work could not have received a raise when competitors' wages rose for comparable employees unless she was also promoted, said Anthony R. Amato, Discovery's vice president for compensation, benefits and human resources.

Under the new system, the specialist could receive a raise — rewarding good performance and also matching competitors — without being burdened with new management responsibilities that she was not ready for, he said.

"Historically, we weren't separating performance" of the individual employee, that employee's job and the wages paid by competitors from evaluation of that employee's readiness for more responsibility, Mr. Amato said. That meant that employees might be promoted too quickly if they did well or if it was necessary to give them a raise to keep them from defecting.

Now, Discovery provides two types of incentives to workers. First, all employees are eligible for a merit increase in salary. A computer program considers an employee's current base salary and an evaluation by that employee's manager, then recommends a minimum and maximum raise.

Second, every employee is eligible for a year-end bonus, which is a percentage of the employee's base pay. Again, the bonus is based in part on a manager's evaluation, but it incorporates the company's performance, too.

Sherner Sumter is an executive assistant who has worked at Discovery for a year and a half. Under the new pay structure, she is eligible for both a raise based on her manager's evaluation of her job performance and for a bonus of up to 10 percent of her salary. Her boss's evaluation of how well she does her job and how eagerly she shows initiative and takes on new responsibilities accounts for 80 percent of the potential bonus, while 10 percent is based on how her division does, and a final 10 percent is based on how the company as a whole does.

"It helps you to be motivated," Ms. Sumter said. The lure of higher pay has prompted her to take on "a lot of different projects" that she might otherwise not seek out, she said, like developing a system that allowed her department to respond more quickly and efficiently to requests from different networks. It has also inspired her to speak up more on ways her department could streamline some of its operations.

"I might go in and say, `What can we do to improve the way we manage the data?' " she said.

The technology that Discovery has developed to link individual bonuses to divisionwide and corporatewide performance sets the company apart, said Russell H. Miller, a partner at S.C.A. Consulting, a compensation adviser that helped Discovery come up with the structure — though not the computer system — for its compensation.

"They're on the leading edge of integrating those systems fully," he said, adding that S.C.A. did not have the technical skill to develop Discovery's system. "They are more sophisticated than I typically come across."

Discovery used Lotus Notes to develop a database that could take into consideration managers' evaluations of employees, overall corporate performance and employees' responsibilities to recommend a minimum and maximum bonus for individual employees.

Before the adoption of the new program, employees received an annual cost-of-living adjustment to their wages, usually a little above the rate of inflation for that year, said the company's president and chief operating officer, Judith A. McHale.

Although employees could receive bonuses, the only way to receive a raise was to be promoted.

Such promotions are not necessarily a good thing, Ms. McHale said, because doing one thing well does not necessarily mean that an employee is ready to be promoted to manage several people doing the same thing.

"We needed to be able to, within a job category, acknowledge that there are different levels of performance," she said.

The hard part of overhauling compensation is deciding how loud a message to send, Mr. Miller said. Overrewarding star performers could backfire by causing jealousy among co-workers and eroding their productivity, he said. And it is probably still too early to know whether Discovery's new incentive structure, which is still in its infancy, will have an adverse effect.

"The key is to make sure that you have a system or process that gives you the highest likelihood of success of accurate differentiation," Mr. Miller said. "The less arbitrary it is and the more objective it is, the better."

Some resentment is probably inevitable, though, in any system that ranks some people as more valuable than others, he said. Whether such a system is fair, he added, "is a philosophical decision."

  1. "Giving Discovery's lower-level employees a performance-related bonus is just the same as giving top management bonuses related to the company's stock price performance," says a well-known mythical management consultant.  Argue against this hypothesis.
  2. How will the switch to performance-related bonuses affect Discovery's stock beta?


Solutions to Midterm

1a. The covariance between the returns on the Wilshire 5000 and the return on Nokia should be higher than the covariance between the return on the Wilshire 5000 and the return on Glaverbel.  This follows from the explanation in the article that "(t)hat's because the stocks of large international companies, whether it is Nokia Corp. or Toyota Motor Corp., move more and more in tandem with their U.S. peers."  Nokia is a large company, while Glaverbel is not (it's traded on the Belgian stock exchange, which, by and large, has no large companies listed).
1b. This is no disproof of Mr. Treich's hypothesis.  The 9.8% indicates the outcome in one instance, and that, too, in situations where the entire market was falling.  A better test would be to look at the volatility of the return on a portfolio that was partly invested in Mr. Treich's fund relative to one that was wholly invested in US stocks, or perhaps partly invested in US stocks and partly in large foreign companies.
1c. The appropriate measure of risk of the two funds would be the covariance of their returns with a large diversified US portfolio, such as the Wilshire 5000.

2. Using the formula in the text, we have
Var(Rp) = (0.5)2(11.29)2 + (0.3)2(10.94)2 + (0.2)2(8.9)2 + 2(0.5)(0.3)(11.29)(10.94)(0.47) + 2(0.3)(0.2)(10.94)(8.9)(0.55) + 2(0.2)(0.5)(11.29)(8.9)(0.44) = 78.4897.  Hence the standard deviation of portfolio returns is the square root of this number, or 8.86%.

3. Using the information in the section on "Leases," and using the assumption that the promised operating lease payments for 2005 and beyond are equally distributed from 2005 to 2016 to impute yearly lease payment amounts from 2000 to 2016; we then discount the imputed amounts using the rate of 9.597% as suggested in the problem.

Year Ending 12/31 Operating
Imputed yearly
2000 2000 $1,015 $1,015 926.3485
2001 2001 $1,006 $1,006 837.9433
2002 2002 $952 $952 723.7057
2003 2003 $965 $965 669.5155
2004 2004 $954 $954 604.0739

2005 and beyond

2005 $12169 $1,014 586.0352
2006   $1,014 534.85
2007   $1,014 488.1355
2008   $1,014 445.501
2009   $1,014 406.5903
2010   $1,014 371.0781
2011   $1,014 338.6676
2012   $1,014 309.0879
2013   $1,014 282.0917
2014   $1,014 257.4535
2015   $1,014 234.9671
2016   $1,014 214.4447
  Total $17,061 $8,230

This gives us a capitalized operating lease amount of $8,230 million.
Note:  The present value of the operating lease payments from 2005 to 2016 can also be computed using the PV of an annuity formula: (1014/0.0957)[1-(1.0957-12)]/1.09575.

In order to obtain the Adjusted Operating Income, we use Damodaran's assumption that the interest expense on the debt created by converting operating leases will be equal to the difference between the operating lease expense and the depreciation of the asset created by the operating leases.  This implies that

Adjusted Operating Income = Operating Income + Imputed Interest expense on operating leases = $1,156 + 8,230(0.0957) = $1943.61 million.

4. a. The future value (i.e. at age 19) of your parents' deposits is $32000.  The deposits are being made monthly starting at the beginning of the second year.  Hence, treating that date as time 0, i.e. 18 years prior to your enrolling in college), the present value of those deposits is (32000)/(1.1)18 = $5755.48.  The effective annual rate is 10%, hence the effective monthly rate is (1.1)(1/12) -1 = 0.797%.  Suppose the monthly payments were $C, then we can equate this to C + [C/0.007974][1-1.007974-(18x12-1)].  (Keep in mind that 1/x = x-1).  Solving, we find C = $55.52.
b. Since tuition would be paid at the beginning of the semester, we would have the equivalent of 1 immediate payment and 7 additional end-of-semester payments.  Now the effective annual rate is still 10%; hence the effective semi-annual rate is (1.1)0.5 -1 = 4.88%.  This time, we solve $32000 = C + [C/0.0488][1-1.0488-7], to get C = $4697.98.  Unfortunately, this would hardly pay tuition at Pace these days!
c. If, instead of using your parents' savings, you borrowed these $4697.98 every beginning-of-semester, at an effective annual interest rate of 8%, i.e. an effective semi-annual rate of (1.08)0.5 - 1 or 3.92%, we would have to pay back at the end of the 4 years, an amount equal to {4697.98 + [4697.98/0.0392][1-1.0392-7]}(1.08)4 = $44,863.31.
The break even annual rate of return on your investments would, therefore, be (44,863.31/32000)1/4 -1 or 8.81%.
If the probability of a zero return in each year were 50%, and the probability of a non-zero return of y% were also 50%, at the end of the four years, you'd have, on average, (1+y)(1+y)(1+0.00)(1.00) or (1+y)2.  Equating this to 1.08814, we find that y = 18.405%.

5. a. The article suggests that the employee's performance would be measured by his/her manager's evaluation; this is much more subjective than a stock price observation.  This makes it much more difficult a goal for the employee to shoot for, than the stock price is, for top management.  On the other hand, it might be argued that the link between the employee's performance and his/her manager's evaluation is more direct, and subject to less noise, than a top manager's performance and the stock price.
b. The switch to performance-related bonuses should decrease the stock beta, since employee payments will be more highly correlated with stock returns.  Fixed employee salaries are like debt and increase effective leverage.

Final Exam

1. You are trying to evaluate whether United Airlines has any excess debt capacity.  In 1995, UAL had 12.2 million shares outstanding at $210 per share and debt outstanding of approximately $3 billion (book as well as market value).  The debt had a rating of B and carried a market interest rate of 10.12%.  In addition, the firm had leases outstanding, with annual lease payments anticipated to be $150 million.  The beta of the stock is 1.26, and the firm faces a tax rate of 35%.  The treasury bond rate is 6.12%.

  1. (10 points) Estimate the current debt ratio for UAL.
  2. (10 points) Estimate the current cost of capital.
  3. (10 points) Based on 1995 operating income, the optimal debt ratio is computed to be 30%, at which point the rating will be BBB, and the market interest rate is 8.12%.  Estimate the change in firm value from going to the optimal.
  4. (10 points) Would the fact that 1995 operating income for airlines was depressed alter your analysis in any way?  Explain why.
2. Read the following article from the April 12, 2001 issue of the Wall Street Journal, and the additional information provided below it, and answer the following questions:
  1. (10 points) Will the proposed debt exchange change Pegasus's leverage ratio?  If yes, will it increase it or decrease it?  If it will not change the leverage ratio, what is the advantage of pursuing the debt exchange, from the company's point of view?
  2. (10 points) According to the information in the article, the new capital structure will provide more flexibility.  This seems to be good for everybody.  Is there any downside for the existing Golden Sky Systems debtholders?  Is there any reason they should not accept the offer? 

Pegasus Commun Files For Debt Exchange
Dow Jones Newswires

BALA CYNWYD, Pa. -- Pegasus Communications Corp.'s (PGTV) Pegasus Satellite Communications Inc. unit filed a registration statement with the Securities and Exchange Commission for a proposed exchange offer.

The offer is aimed at simplifying the company's capital structure and will allow more flexibility under its existing debt covenants.

Pegasus said in a press release Thursday it will offer 12 3/8% senior notes due 2006 in exchange for 12 3/8% series A and series B senior subordinated notes due 2006 of Golden Sky Systems Inc.

Pegasus will also offer 13 1/2% senior subordinated discount notes due 2007 in exchange for 13 1/2% series B senior discount notes due 2007 of Golden Sky DBS Inc.

Golden Sky Systems and Golden Sky DBS are both units of Pegasus Satellite.

Pegasus said it is also soliciting consents of Golden Sky Systems and Golden Sky DBS note holders for proposed amendments to their notes indentures.

Pegasus shares recently traded at $20.51, up 1 cent, on Nasdaq volume of 9,000 shares. Average daily volume is 448,410 shares.

Pegasus is a media company.


Here is some additional information on Pegasus that may be useful to you:

Firm Profile:

Pegasus is an independent distributor of DIRECTV with 1.1 million subscribers at February 29, 2000. The Company has the exclusive right to distribute DIRECTV digital broadcast satellite services to over 7.2 million rural households in 41 states. The Company distributes DIRECTV through the Pegasus retail network, a network in excess of 2,500 independent retailers. The company is also the owner or programmer of ten television stations affiliated with either Fox, UPN or the WB.


From Prospectus filed by Pegasus, Inc.," Offer to Exchange and Consent Solicitation April 27, 2001" with the SEC:

The proposed amendments to the Golden Sky Systems notes indenture would eliminate covenants that currently impose the following requirements, restrictions and prohibitions on Golden Sky Systems, certain of Golden Sky Systems' subsidiaries, or all of them:

Use the information provided below on Teligent, Inc. to answer the following three questions.  (Assume a market risk premium of 6.38%, and a riskfree rate of 5.74%):

3.  (20 points) Estimate the cost of capital for Teligent?  (Use all the information to come up with your answer; don't be wedded to a text-book approach.) 

4.  (10 points) What can you say about the optimal debt-to-equity ratio for Teligent, Inc. today?

5.  (10 points) What would you have said about the optimal debt-to-equity ratio for Teligent, Inc. at the end of 1997?  You may assume that Teligent's line of business has not changed since its inception.

Relevant Information on Teligent:

  1. Firm Profile (Source:
  2. Selected Financial Data from 10K submission to the SEC (Source:
  3. Additional Information on the firm's debt and Preferred Stock (From 10K submission to the SEC; Source:
    1. Maturities of Debt
    2. Fair Value of Financial Instruments
    3. Commitments and Contingencies
  4. Bond Ratings and Other Information (Source: Bridge Information Services)
  5. Consolidated Balance Sheets (Source:


A. Firm Profile on Teligent Inc. (Class A) (TGNT) (, April 30, 2001)

Teligent, Inc. is a full-service, facilities-based communications company that offers small and medium-sized business customers local and long distance telephony, high-speed data, and Internet access services over its digital SmartWave local networks. Teligent's SmartWave local networks integrate advanced fixed wireless technologies with traditional broadband wireline technology. The Company's digital wireless technology provides many of the advantages of fiber and can transport information within the network at up to 155 Megabits per second, via a point-to-point radio.


B. From information submitted to the SEC by Teligent, Inc. on 3/30/2001(Source:
The selected financial data presented below as of December 31, 2000, 1999, 1998, 1997 and 1996 and for the years ended December 31, 2000, 1999, 1998, 1997 and the period from March 5, 1996 (date of inception) to December 31, 1996, were derived from our audited financial statements. You should read this data together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our audited financial statements and related notes, included elsewhere in this Annual Report on Form 10-K.
Years ended December 31
(In thousands, except per share data)
2000 1999 1998 1997

Date of inception to Dec. 31, 1996

Statement of Operations Data: (1)          
Revenues $152,072 $31,304 $960 $3,311 $1,386
Cost and expenses:          
Cost of services 325,119 207,538 79,342 10,229 1,625
Sales, general and administrative 262,806 205,589 123,958 33,854 8,290
Restructuring and asset impairment 34,585 -- -- -- --
Stock-based and other noncash compensation 28,377 31,451 32,164 89,111 4,071
Depreciation and amortization 133,544 45,742 14,193 6,454 164
--------- --------- --------- --------- ---------
Total costs and expenses 784,431 490,320 249,657 139,648 14,150
--------- --------- --------- --------- ---------
Loss from operations -632,359 -459,016 -248,697 -136,337 -12,764
Interest income 25,052 18,933 34,510 3,246 --
Interest expense -133,286 -88,347 -66,880 -4,954 -879
Equity in losses of international ventures -6,605 -- -- -- --
Other expense -60,788 -483 -404 -9 10
--------- --------- --------- --------- ---------
Net loss ($807,986) ($528,913) ($281,471) ($138,054) ($13,633)
--------- --------- --------- --------- ---------
Accrued preferred stock dividends -41,870 -2,906 -- -- --
--------- --------- --------- --------- ---------
Net loss applicable to common stockholders ($849,856) ($531,819) ($281,471) ($138,054) ($13,633)
========= ========= ========= ========= =========
Basic and diluted net loss per common share ($14.19) ($9.95) ($5.35) ($2.94) ($0.29)
Weighted average common shares outstanding 59,897 53,423 52,597 46,951 46,258
OTHER DATA:          
EBITDA (2) ($435,853) ($381,823) ($202,340) ($40,772) ($8,529)
Cash used in operating activities -669,116 -313,379 -76,628 -33,260 -6,046
Cash used in investing activities -296,385 -354,774 -153,621 -115,755 -3,709
Cash provided by financing activities 785,763 692,199 221,595 572,613 11,058

                                                    2000             1999       1998             1997              1996
BALANCE SHEET DATA (In thousands):      
Cash and cash equivalents    $ 260,555   $440,293   $416,247          $ 424,901    $  1,303
Working capital (deficit)       249,750     342,706   302,408             441,316    (6,978)
Property and equipment, net         560,534     402,989   180,726                 8,186        3,545
Intangible assets, net        187,976       96,418     83,857       60,354           -
Total assets     1,209,476  1,131,843      763,434             607,380   19,145
Long-term debt, less current portion     1,435,070     808,799     576,058             300,000          -
Convertible redeemable preferred stock       520,658    478,788            -                    -                -
Stockholders' (deficit) equity    (960,585)  (441,917)      31,053       285,146      10,425

(1)     Certain amounts in the prior periods' financial statements have been reclassified to conform to the current year's presentation.
(2)     EBITDA consists of earnings before interest, taxes, depreciation, amortization, stock-based and other non-cash compensation charges and restructuring and asset impairment charges. While not a measure under generally accepted accounting principles ("GAAP"), EBITDA is a measure commonly used in the telecommunications industry, and we include it to help you understand our operating results. Although you should not assume that EBITDA is a substitute for operating income determined in accordance with GAAP, we present it to provide additional information about our ability to meet future debt service, capital expenditures and working capital requirements. See the Financial Statements and the related notes. Since all companies and analysts do not calculate these non-GAAP measurements the same way, the amount may not be comparable to other calculations. ________________________________________________________________________ 

C. Additional Information on the firm's debt and Preferred Stock (Source:, 3/30/2001) 


    Maturities of long-term debt at December 31, 2000 are as follows (in

        2002...............................................         $  50,520
        2003...............................................           110,267
        2004...............................................           135,731
        2005...............................................           139,555
        Thereafter.........................................          998,997

Long-term debt consists of the following (in thousands):
                                                                 DECEMBER 31,
                                                                                  2000           1999
                                                                              -----------   ---------
    11.5% Senior Notes due 2007.........................  $  300,000      $300,000
    11.5% Senior Discount Notes due 2008................345,331         308,799
    Credit Facility.....................................                   789,739         200,000
                                                                                  -----------     ---------
                                                                             $1,435,070       $808,799
                                                                        ===========     =========

    The Credit Facility is structured into three separate tranches consisting of
a term loan facility, a delayed draw term loan facility and a revolving credit
facility, each of which has a final maturity of eight years. Interest accrues on
$575.0 million of outstanding borrowings based on a floating rate tied to the
prevailing LIBOR rate and adjusts based on the attainment of certain key revenue
and leverage benchmarks. The remaining $214.7 million accrued interest at a
fixed rate of 11.125% per annum. The Company incurred commitment and other fees
in connection with obtaining the Credit Facility totaling $19.9 million, which
is being amortized over eight years. The Credit Facility contains certain
financial and other covenants that restrict, among other things, the Company's
ability to (a) incur or create additional debt, (b) enter into mergers or
consolidations, (c) dispose of a significant amount of assets, (d) pay cash
dividends, or (e) change the nature of its business. The amounts outstanding
under the Credit Facility are subject to mandatory prepayments in certain


    The fair value of the Company's financial instruments classified as current
assets or liabilities, and investments approximate their carrying value. At
December 31, 2000, the estimated fair value and carrying amounts of the
Company's Senior Notes, Senior Discount Notes and the Company's Series A
cumulative convertible redeemable preferred stock, par value, $.01 per share
("Series A Preferred Stock") are as follows (in thousands):

                                                        FAIR VALUE   CARRYING AMOUNT
                                                        ----------   ---------------
    Senior Notes......................................        $40,500        $ 300,000
    Senior Discount Notes.............................   $37,400        $ 345,331
    Series A Preferred Stock..........................   $18,185        $ 520,658

    The Series A Preferred Stock has an annual dividend rate of 7 3/4% payable
quarterly and dividends are cumulative from the date of issuance. Dividends must
be paid in additional shares of Series A Preferred Stock through December 3,
2004, and may be paid in either cash or additional shares of Series A Preferred
Stock, at the option of the Company, thereafter.

    The Series A Preferred Stock is convertible into Class A Common Stock by the
holders at any time at a initial conversion price of $57.50, but may be called
by the Company after five years and, if still outstanding, must be redeemed in
2014. The holders of the Series A Preferred Stock have voting rights equal to
the rights held by holders of Class A Common Stock.


    In May 2000, the Company announced a comprehensive network services
agreement (the "Network Services Agreement") with Level 3 Communications, Inc.
("Level 3"). Under the Network Services Agreement, the Company will acquire dark
fiber and other assets. At December 31, 2000, the Company had recorded $6.6
million of assets acquired under capitalized leases related to this agreement.
Commitments for additional capital expenditures totaling $54.1 million at
December 31, 2000 are as follows (in thousands):

    2001........................................................    $ 31,957
    2002........................................................         5,134
    2003........................................................         5,134
    2004........................................................         5,134
    2005........................................................         5,134
    Thereafter..................................................       1,574
                                                                         $ 54,067
    The Company leases various operating sites, rooftops, storage, and
administrative offices under operating leases. Rent expense was $58.1 million,
$28.0 million and $10.9 million for the years ended December 31, 2000, 1999 and
1998, respectively. Future minimum lease payments by year, and in the aggregate,
at December 31, 2000, are as follows (in thousands):

    2001........................................................     $ 64,099
    2002........................................................        61,543
    2003........................................................        57,270
    2004........................................................        45,765
    2005........................................................        28,105
    Thereafter..................................................      80,827
                                                                        $ 337,609

D. Bond Rating and Other Information (Source: Bridge Information Services, April 30, 2001)

Moody’s Rating: Ca 
S&P Rating: CC
Yield-to-maturity on Senior Note, maturing 3/1/2008: 195.075%
Yield-to-maturity on Senior Note, maturing 12/01/07: 704.297%
E. Consolidated Balance Sheet (Source:, April 30, 2001)
2000 1999
 Current assets:    
    Cash and cash equivalents  $     260,555       $     440,293
    Short-term investments          96,635              116,610
    Accounts receivable, net          37,267               12,673
    Prepaid expenses and other current assets           28,394               17,914
    Restricted cash and other investments             5,374               38,224
                                                           --------------      --------------
      Total current assets          428,225              625,714
 Property and equipment, net        560,534              402,989
 Intangible assets, net         187,976               96,418
Investments in and advances to international ventures
and other assets                                        
       32,741                6,722
      Total assets $   1,209,476       $   1,131,843
                                                       ==============      ==============
 Current liabilities:    
    Accounts payable    $     107,410       $     239,139
    Accrued expenses and other            71,065               43,869
      Total current liabilities        178,475              283,008
 Long-term debt       1,435,070              808,799
 Other noncurrent liabilities        35,858                3,165
Series A cumulative convertible redeemable
preferred stock 
      520,658              478,788
 Stockholders' deficit:    
    Common stock            637                  547
    Additional paid-in capital        808,835              519,607
    Accumulated deficit     (1,770,057)            (962,071)
                                                     -------------- --------------
      Total stockholders' deficit       (960,585)            (441,917)
      Total liabilities and stockholders' deficit  $   1,209,476       $   1,131,843
F. Other Information (Source:, April 30, 2001) 
Beta: 2.91
Closing Stock Price: 69 cents.

G. Teligent Ousts CEO, Monday April 30 6:49 PM ET, Associated Press

VIENNA, Va. (AP) - Teligent Inc., a provider of local wireless networks, announced the ouster of its chief executive Monday as it confirmed IDT had acquired a stake in the company. The company also said it received a debt extension.

The Vienna-based company said IDT Corp., an international telecommunications carrier, bought a nearly 34 percent interest in Teligent from AT&T Corp.'s Liberty Media unit last week.

The acknowledgement came as Teligent said in a statement that former AT&T executive Alex Mandl ``will not continue'' as chairman and chief executive. Yoav Krill, managing director of IDT's European division, was named chief operating officer and acting CEO. IDT chairman, CEO and treasurer Howard Jonas was appointed as chairman of Teligent's board of directors.

Teligent also said its creditors agreed to extend until May 15 a Monday deadline to obtain $350 million in additional financing. The company received the extension from Chase Manhattan Bank, Goldman Sachs Credit Partners, Toronto Dominion Bank and other lenders, company spokesman Mike Kraft said Monday.

``We needed additional funds as a company,'' Kraft said. ``The banks lifted the ceiling in terms of the amount of debt the company could take on.''

The company had until Monday to supply documentation on vendor financing of at least $250 million, and convertible notes totaling at least $100 million.

That deadline was pushed from April 30 to May 15. If Teligent misses the new deadline, it will be in default.

Shares of Teligent rose 22 cents to close at 69 cents per share Monday on the Nasdaq Stock Market.

Solution to Final Exam

1.  a. Current market value of equity = 12.2(210) = 2562.  If we capitalize lease payments at the same rate as the debt, we get a present value of 150.0/0.1012 = 1482.  This is a high estimate, since the actual life of the lease payments is probably lower.  The market value of the debt itself is 3000m.  Hence, the debt/equity ratio = (1482+3000)/2562 = 1.75, or a debt ratio of 0.6364. 

b. The cost of equity = .0612 + 1.26(0.055) = 0.1305.  The WACC = (0.6364)(1-0.35)10.12% + (0.3636)13.05% = 8.93%

c. The current beta = 1.26; the unlevered beta = .  Hence the levered beta at a debt ratio of 30% = 0.5895(1+(1-0.35)(0.3/0.7) = 0.7537; the cost of equity = .0612 + 0.7537(.055) = 0.10265.  The WACC = (0.3)(1-0.35)(.0812) + (0.7)(.10265) = 8.77%.  The firm value at this optimum = (2562+1482+3000)[1+(.0893-.0877)/0.0877] = 7173.1423m. (which includes the capitalized value of lease payments).

d. Yes, if 1995 operating income was depressed, the estimated bond rating is probably biased downwards.  Hence, the true firm value is probably higher.

2. a. The proposed debt exchange should not change the leverage ratio, at least the leverage ratio based on market value.  This is because existing bondholders will not be willing to accept new bonds with a value lower than the price of the old bonds.  However, if the company, acting on behalf of shareholders wants to do the swap badly enough, they might be willing to offer new bonds worth more than the value of the old bonds. This might increase the leverage ratio.  However, the leverage ratio might also go down.  The reason for this has to do with why the firm is interested in the debt exchange.  Since many of the existing restrictive covenants would be eliminated with the new bonds, there would be more flexibility for the managers; they might, therefore, be able to finance positive NPV projects that they might have had to forego under the old setup.  This would raise the value of the existing shares.  Whether the leverage ratio will increase or not will depend on how much of this increased value, the shareholders will have to give up to bondholders in order to induce them to accept the exchange.

b. The increased flexibility will allow managers to do various things that they would not have been able to, previously.  For example, they can now take on additional debt (cf. the second covenant in the list); they can pay additional dividends (cf. the third covenant in the list); the manager can enter businesses that were formerly prohibited.  As explained in the webnotes, these could all be used to expropriate bondholder wealth.

3. One way to compute the cost of capital is to calculate a weighted-average cost of capital.  The case of Teligent is problematic in several respects.  One the one hand, we have estimates of the market value of several portions of the debt and the convertible preferred equity.  On the other hand, the firm is clearly in financial distress, and this has to be taken into account.

Let us look at the different categories of capital in the firm's balance sheet:

Type Book Value Market Value Cost of capital
Convertible Redeemable Preferred Stock 520,658 18,185 24.30  3
Equity (960,585) 41,328 24.30  3
Senior notes (maturing 3/1/2008) 345,331  37,400 16.125% 2
Senior notes (maturing 12/01/07) 300,000  40,500 16.125% 2
Fixed rate portion of Credit Facility 214,700 149,8001 13.625% 2
Floating rate portion of Credit Facility 575,000 575,0001 12.375% 2
Total 862,213

1 The senior notes have lost about 88% of their value, having been issued (from the Selected Financial Information in Section B) in 1997 and 1998.  The credit facility increased from $200,000 in 1999 to $789,739 in 2000; given the gradually deteriorating circumstances of the firm, it may be reasonably conjectured that the fixed part of the Credit Facility was obtained in 1999, with the floating part having been negotiated in 2000.  If 88% of the senior notes value was lost over 1998-2000, and the firm was deteriorating exponentially, one way to estimate the decrease in value would be to guess that the rate of decline double from year to year; this would give us a value decline of 88*(2/3) or approximately 60% in the first year and 28% in the second year.  This would give a market value of the fixed part of the credit facility of (214,700)*(0.7) = $149,800.  Since the coupon on the floating rate part is recomputed every year, and since it probably has the greatest seniority, it is not unreasonable to assume that its market value is close to its book value.

Regarding the debt, we see that the yields are very high.  However, this is computed with respect to promised payments; hence if we use the market value of these bonds, then the YTM numbers are irrelevant; it would be more appropriate to use a yield on comparable debt recently issued, if available.  The most recent portion of the firm's debt seems to be the credit facility, as can be seen by comparing the figures for 1999 and 2000 in section C providing additional information on the firm's debt and preferred stock.  This credit facility has two components: one part, which pays interest using a floating rate tied to LIBOR, and the second part, which has a fixed rate of 11.125%.  Given the fact that the credit facility was negotiated fairly recently, and given that there are a lot of covenants tied to the facility including mandatory prepayments in certain circumstances, it is likely that this part of the firm's liabilities will have decreased in value, the least; and of the two parts, the floating rate part would be more resistant to value loss. 

The market yields on the firm's floating rate portion is 11.125% at a minimum.  However, it is probably not very much higher than that, given that short-term investments of $428,225 and Property, Plant and Equipment valued at book of $560,534.  Given that rating spreads seem to jump by about 1.25% for each drop in the rating of bonds (information on spreads not provided in the exam), the yield on the floating rate portion may be estimated to be 12.375%, with an additional 2.5% tacked on for the fixed part of the credit facility, and a higher 5% tacked on for the other types of debt, which seem to have less protection (if we assume the corresponding ratings differentials between the different kinds of debt).  Of course, we do not have much information on which to base ourselves; these figures are more in the nature of educated guesses.  On the other hand, since the floating rate part of the credit facility accounts for the largest part of the value of all the liabilities, the final cost of capital estimate will be fairly robust to our estimates of the costs of capital of the other liability categories.  This yields 13.625% for the fixed part of the credit facility and 16.125 for the senior notes.

3  If we use the CAPM, and the beta of 2.91 provided from Yahoo, we would get a cost of capital of 5.74 + 2.91(6.38) = 24.30%; as conjectured above, the firm would probably call the convertible preferred, and so it would make sense to just add it to the straight equity for our computational purposes.  Nevertheless, the 2.91 beta value from Yahoo is based upon the past, and may be an under-estimate.  On the other hand, the firm is probably going to revise its operating plan to a less risky one; hence we are justified in staying with a beta value of 2.91 for now.

It must also be noted that the firm has additional commitments in the form of operating leases, which should be considered equivalent to debt.  We have not explicitly taken these into account.  If we did, this would increase the cost of capital somewhat.

Also, the before-tax cost of debt is also the same as the after-tax cost of debt, since the firm is far from having any taxable income.

The category market value weights are (18,185+41,328)/862,213 = 0.069 for equity; (37,400+40,500)/862,213 = 0.09 for the lower rated categories of debt; 149,800/862,213 or 0.174 for the fixed part of the credit facility debt, and 575000/862,213 or 0.667 for the floating part of the credit facility.  The estimated weighted average cost of capital works out to 0.069(24.3) + 0.09(16.125) + 0.174(13.625) + 0.667(12.375) = 13.75%.

Although this seems to be a very low figure for a firm in financial distress, the news item in Section G that reports a 34% purchase of Teligent's equity and imminent vendor financing and convertible notes indicates that Teligent is still very much a going concern, and hence that a 13.75% cost of capital is defensible.  

Another way of looking at the reasonableness of this figure is to compute the implicit asset beta.  In our case, this works out to (13.75-6.75)/6.83 or 1.02.  This does seem to be somewhat low, although it must be realized that we are now discussing asset betas and not stock betas.  If we wish to raise the asset beta to 1.20 (a 20% increase), this would raise the cost of capital for the firm to about 13.95%, which is still in the same ballpark.

4. The firm is clearly over-leveraged, especially if we take into account the nature of the firm's operations and the nature of the firm's assets.  Considering furthermore the volatility of income that the firm has operating losses, there are no tax advantages of debt for the foreseeable future.  However, the firm needs financing in the short run, in order to continue to operate.  Issuing equity at this time is unlikely to be an inexpensive operation.  Hence it would make sense to obtain short- or medium-term debt financing right now.  Vendor financing could be justified on the same terms, i.e. expediency.

5. The undesirability of debt in the firm's capital structure today is no different from the situation at the end of 1997.  At that time, the prospects of the firm were much better.  However, the nature of the firm's cashflow was still very volatile, and the firm had a lot of growth options.  Hence, it would have been difficult to justify debt even then.  An argument could have been made for vendor financing in terms of risk-sharing with vendors.