LUBIN SCHOOL OF BUSINESS
Pace University
Fin 320 ADVANCED FINANCIAL ANALYSIS
Spring 1999
Prof. P.V. Viswanath

• Practice question for Midterm I and suggested solution
• Midterm I
• Midterm I Solution
• Makeup Midterm I
• Partial Solutions to Makeup Midterm I
• Midterm II
• Midterm II Solution
• Final
• Final Solution

Practice Question for Midterm I

Read the following article and answer the questions given at the end.

Allstate Corp. Adopts A Takeover Defense Tied to Share Rights
The Wall Street Journal - 02/16/99

Brief Summary of Article: Allstate Corporation adopts a takeover defense by giving existing shareholders a greater share of value in the corporation relative to groups attempting to acquire 15% or more of the company's stock. Interestingly, the company also increased its dividend per share. The market, nevertheless, did not seem to like Allstate's actions. It would be worthwhile to take a closer look at management's stake in the company.

NORTHBROOK, Ill. -- Allstate Corp. adopted a share-purchase rights agreement intended as a defense against a potential hostile takeover. But Chairman Edward M. Liddy said the car and home insurer is "not aware of any takeover attempt at this time."

The agreement gives existing shareholders rights to buy a new series of "junior participating preferred stock." The rights would become exercisable 10 days after a person or group acquired or announced a tender offer for 15% or more of the company's common stock.

It's not uncommon for a company to adopt such a takeover defense when its stock is at depressed levels. Allstate is trading at a relatively low level of 1.9 times its per-share book value (the difference between a company's assets and its liabilities) and 11 times analysts' 1999 profit projections.

Specifically, stockholders of record on Feb. 26 will get a dividend distribution of one share-purchase right for each share outstanding of Allstate common stock. Each right, which will get tacked onto the common shares and trade with them, will entitle stockholders to buy 1/1,000th of a share of the new junior participating preferred stock at an exercise price of $150. If exercised, each 1/1,000th of a share of the new preferred would give the holder $300 of the company's common shares, diluting the stake of potential acquirers.

Allstate released the news after trading closed Friday. Its shares closed at $36.4375, down $1.50, in New York Stock Exchange composite trading.

Separately, Allstate increased its regular quarterly dividend, payable April 1 to shareholders of record at the close of business Feb. 26, to 15 cents, up 1.5 cents a share.

Questions:

1. Are such takeover defenses in the interest of shareholders? Why or why not?
2. Why might takeover defenses be attractive to management?
3. How would you interpret the fact that Allstate's stock was marked down on the news of the takeover defense adoption?
4. Is the dividend increase related to Allstate's attempts to ward off a takeover?

Suggested Answers:

1. The effect of the takeover defense is to reduce the value of the stocks that the potential acquirer may purchase, relative to the holdings of existing stockholders. Suppose the market price of the stock is below its true value, and management knows this. Then it would be appropriate for management to use such a tactic in order to prevent the stock from being bought up by the intending acquirer at too low a price.
2. Even if the takeover is in the best interests of shareholders, management will not necessarily gain by it. This is because managers frequently have human capital invested in the firm that is specific to the firm, and cannot be taken with them when they leave. If so, management would want to prevent some, otherwise desirable, takeovers. These takeover defenses help management to do this.
3. The reduction of Allstate’s stock price might indicate that the market believes that management’s actions are not in the best interests of stockholders.
4. Sometimes acquirers are interested in their targets because the targets have excessive cash reserves that are not be utilized optimally. Payment of increased dividends might decrease the desirability of Allstate by reducing its cash reserves.

Midterm I

• The exam is closed book.
• Time allowed is exactly 1 hour and 30 minutes.
• 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.
• Write legibly; I cannot guarantee any credit for what I cannot read, even if it is correct.
• If an answer contains two contradictory statements, you may get no credit for the answer, even if one of the statements is correct.
• 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 Matt Murray from the Wall Street Journal of 2/12/99 and answer the following question:
The market for corporate control is the market where shareholder groups inside the company and would-be shareholder groups outside the company fight for control of the company through tender offers, proxy fights, takeover, mergers, acquisitions and tender offers. The underlying function that the market for corporate control performs is to ensure that management’s actions do not stray too far from what would benefit shareholders. Would you say that the case of Mellon Bank represents a failure of the market for corporate control? Why or why not?

Mellon Bank Continues to Fight Battle for Independence --- It Kept Bank of New York at Bay, but Skeptical Shareholders Still Circle

Last year, Mellon Bank Corp. got squeezed by an unwanted suitor. This year, it is still feeling the pressure from shareholders.
Martin G. McGuinn, who took over as chairman of Pittsburgh-based Mellon on Jan. 1, has moved quickly, shaking up senior management and planning the sale of several underperforming units to shore up shareholder support and boost performance amid continuing takeover talk. Mellon, perennially mentioned as a desirable takeover target, has been feeling some heat since it unilaterally rejected a $22.1 billion takeover offer from Bank of New York Co., which threw in the towel in May.
Shareholders openly wondered whether Mellon could do better alone than with Bank of New York, especially after profit and revenue growth slowed a bit amid the economic tumult of mid-1998. In the words of Rob Sharps, the bank analyst at Mellon's second-largest institutional shareholder, T. Rowe Price Associates Inc., "They've got a lot to prove. It'll be quite some time before people stop comparing their stock to the value of the Bank of New York stock they turned down." T. Rowe Price owns about 6.5 million Mellon shares.
Using a simple, admittedly imprecise formula, a number of analysts estimate that the stock value of the combined institutions today would be in the range of $90 a share. That's well above Mellon, which rose $1.5625 to $66.75 in composite trading on the Big Board yesterday. As inexact as that figure is, however, it adds to the pressure on Mr. McGuinn, especially since many analysts believe Bank of New York could spring again. "He's got his marching orders to make the franchise worth $90 a share in a very short time," says Eric Rothman, an analyst at Stephens Inc. in Little Rock, Ark.
Bank of New York won't comment.
Adding to the challenge is the long shadow of Mr. McGuinn's successor, Frank V. Cahouet. Though Mr. Cahouet, an often abrasive manager, wasn't always well-liked personally on Wall Street, he was viewed widely as a commanding figure who saved Mellon from the brink of failure and reshaped it as a highly profitable asset manager and mutual-fund provider. Next to him, Mr. McGuinn looked like a less charismatic manager with big shoes to fill.
But so far, the new chairman has acted like a man under the microscope. Two weeks after taking over, he placed on the block three low-returning businesses -- the credit-card portfolio, mortgage operations and automated-teller machine processing -- to focus on higher-returning businesses such as asset management. Mellon is trying to free up capital to invest in higher-returning businesses. "The biggest job we have is keeping the revenue growing," Mr. McGuinn says. "That's what will drive our shares."
Meanwhile, in Mellon's corporate-banking business, which has the worst returns of its major operations, bankers are under orders to assess the profitability of each relationship. Corporate clients are getting pushed to consider Mellon's cash-management and other operations, which are far more profitable than classic corporate banking. Those that bite might win more favorable terms on a wider array of products. Those that balk might find Mellon asking them to take their corporate-banking business elsewhere.
"The broad sense I'm getting is they are less wed to the notion they have to emphasize traditional banking to be as successful," says Judah Kraushaar, a bank analyst at Merrill Lynch & Co. "Once, you had to be a big corporate bank. Here there's a little healthier skepticism."
Mr. McGuinn also says he plans to deploy the freed-up capital -- analysts expect the unit sales alone to generate as much as $600 million -- to mollify shareholders. The company plans to begin buying back stock as soon as this summer. It hopes to continue making niche acquisitions that bolster its profitable, fee-generating businesses such as mutual funds. And Mr. McGuinn says he plans to invest money in marketing, product development and salary incentives at some of the bank's existing businesses such as Dreyfus Crop., the mutual-fund company that Mellon, sometimes accused of being tightfisted, acquired in 1994.
"Clearly, investing in our businesses is one of the highest priorities," Mr. McGuinn says in a clear departure from his predecessor. "We see opportunities, for example, outside the United States in asset-management and trust and custody. Our higher-growth businesses like that demand continuous investment."
That talk is having an effect. "We like what we see," says Kevin Holt, bank analyst at Strong Capital Management in Milwaukee, which owns about 450,000 shares and was highly critical of the company's rejection of Bank of New York. "Focusing on some of the not-so-strong parts of the bank, i.e. the commercial bank, is positive. He's sending a strong message."
Mr. McGuinn sent another strong message during his first week on the job, when he ousted a longtime vice chairman and former rival, David R. Lovejoy. The move stunned many insiders because Mr. Lovejoy had been a close ally of Mr. Cahouet. Outside the firm, many saw the action as a sign that Mr. McGuinn wanted to assert an image as tough as his predecessor -- possibly to alert Bank of New York and others that he is no pushover. "Marty's actions are those of someone who intends to run his company as an independent entity," says Michael Mayo, an analyst at Credit Suisse First Boston. "Nothing that Marty's done has given any indication that Mellon wants to join up with someone else."
Mr. McGuinn says he won't comment on personnel matters. But in general, he wants to position Mellon to go "to the next level, to be able to continue our growth and make sure shareholders will see tremendous appreciation in our investment. As a corollary to that, it means we continue to control our own destiny, and the team can show it's being very active and be very decisive in trying to do what's right."
Shareholders seem to like what they have seen so far, but Mr. McGuinn's term is still young. "They're doing the right types of things," says T. Rowe Price's Mr. Sharps, "but the jury's still out."

2. You need to borrow $300,000 to buy your yacht. The bank kindly agrees to lend you the money at an effective annual interest rate of 12% (note; this is not an APR). The terms of the loan are as follows. You will pay the bank a fixed sum of money at the end of every month for 10 years, plus $50,000 at the end of the 10 years. The first payment is to be made one month from now. What is the amount of the monthly payment?

3. Here are the balance sheet and income statement for Suprema, Inc. for 1996 and 1997:

Income Statement (in ’000s):

Additional Information:

• Preferred Dividends for 1997 were $1,000.
• Common Dividends for 1997 were $5,000.
• The company sold $20,000 of common stock to reduce note payable.
• The company issued $4,000 of preferred stock.

Prepare the Statement of Cash Flows for Suprema for the year 1997, and reconcile beginning cash with ending cash (Hint: remember that ending cash must work out to $0, as in the balance sheet, else you’ve made a mistake.)

Solutions to Midterm I:

1. One could claim that the market for corporate control has actually worked in the case of Mellon Bank, even though Mellon was successful in warding off the Bank of New York’s takeover attempts. The reason is that if the underlying function of takeovers, etc. is to ensure that the assets of a corporation are used optimally, that function seems to have been fulfilled. Thus, Mr. McGuinn seems to have undertaken an evaluation of the profitability of Mellon’s divisions, and plans to sell those that are non-performing. The freed-up capital is to deployed partly in investments in profitable fee-generating businesses, but part of it is also to be returned to investors, thus reducing free cash-flow and incentives to misuse it. These actions are all directed to increasing the value of the firm. Furthermore, and importantly, it is clear that these actions were caused directly by the attempted Bank of New York takeover; this is what enables us to claim that the market for corporate control has worked.

It must, however, be acknowledged that the price of Mellon’s shares is nowhere near the price that analysts estimate would have obtained if the Bank of New York had succeeded. This suggests that Mellon’s assets are perhaps not being optimally used.

2. The present value of the balloon payment of $50,000 is 50,000/(1.12)¹⁰ = $16,098.66. Hence the present value of the annuity payments = $300,000 - $16,098.66 = $283,901.34. Now, if the effective annual interest rate is 12%, the monthly rate can be computed as (1.12)^1/12 - 1 = 0.9489%. Using the annuity formula, we can compute the annual payment as $3973.12.

3. Note: In this solution, I’ve taken the approach that everything that is current has to do with operations. This is not necessarily the only assumption that can be made. Credit is given even if it is assumed that some items, such as Bank Overdraft and Notes Payable, are financing items; and that other items like Marketable Securities are investment items.

Makeup Midterm I

•  The exam is closed book.

• Time allowed is exactly 1 hour and 30 minutes.

• 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.

• Write legibly; I cannot guarantee any credit for what I cannot read, even if it is correct.

• If an answer contains two contradictory statements, you may get no credit for the answer, even if one of the statements is correct.

• 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. Here is an excerpt from a Feb. 25, 1999 WSJ article, entitled “Executive Compensation.”  Answer the questions below, using no more than two sides of a page.

Conventional wisdom suggests that stock-option grants send a powerful signal that the interests of management are aligned with those of shareholders. But investors are well advised to be less optimistic.

 The standard stock-option plan clearly fails the "reward for superior performance" test. The exercise price is equal to the market price on the day the options are granted and remains fixed over the entire option period, typically 10 years. These options reward executives for any share-price increase -- even if the increase is substantially below that realized by industry peers or the overall market. 

This isn't unusual. L.E.K. Consulting looked at the gains of chief executive officers of Dow Jones Industrial Average companies on options granted from 1993 to the end of 1998. We found that for CEOs of the 26 companies that were part of the Dow industrials throughout the period, 60% of those gains were for performance below the average of their Shareholder Scoreboard industry group. 

What executive-compensation signals should investors look for in 1999 and beyond? On the positive side, look for companies that announce plans that target a higher level of performance than standard stock options. 

A number of companies, such as Colgate-Palmolive Co., Monsanto Co. and Transamerica Corp., have recently introduced premium-priced stock-option plans. Premium-priced options have an exercise price 25%, 50% or, less commonly, 100% above the market price on the day the options are granted. For a 10-year option, these exercise prices require annual appreciation rates in the company's stock of about 2%, 4% and 7%, respectively, before they are "in the money." 

Better yet, look for companies that announce indexed option plans that link exercise prices to movements in either an industry or broader market index. These options don't reward underperforming executives simply because the market is rising, but instead reward superior management regardless of the state of the stock market. 

On the negative side, beware of companies that play by different rules when the safety net of a sustained bull market is removed. Specifically, they lower the exercise prices of out-of-the-money options or shift the executive-compensation mix from options back to the salary and cash-bonus combination that prevailed before the stock market began its rise in the 1980s. 

1. What is behind the theory that stock options align management interests with stockholder interests?

2. Why do most stock option plans fail to fit this theory?

 2. You have been hired to run a pension fund for TelDet, Inc., a small manufacturing firm.  The firm currently has $5 million in the fund and expects to have cash inflows of $2 million a year for the first five years followed by cash outflows of $3 million a year for the next five years.  Assume that interest rates are at 8%.

1. How much money will be left in the fund at the end of the tenth year?

2. If you were required to pay a perpetuity after the tenth year (starting in year 11 and going through infinity) out of the balance left in the pension fund, how much could you afford to pay?

 3. You have the following financial statements for CMP Media, Inc. for the years 1996 and 1997.  Construct a statement of cash flows for 1997 that will allow you to reconcile the change in cash from end-of-year 1996 to end-of-year 1997.

 Income Statement 

 Balance Sheet 

 Dividends paid in 1996 were $20,000, while dividends paid in 1997 were $25,944.30 

Notes: No common stock was repurchased during this period
            No plant and equipment was sold during this period  

Partial Solutions to Makeup Midterm I

2. Compute the present value, and then carry the funds forward.  Thus, the PV of the inflow of funds is computed by using the present value of an annuity formula.  This gives us (2/.08)[1-(1.08)^-5] = 7.98542; along with the initial $5, that makes $12.98542.  The future value, at time 10, of these monies is: $12.98542(1.08)¹⁰ = 28.0345.  Now the value at the end of year 5 of the outflows equals (3/.08)[1-(1.08)^-5] = 11.97813; carrying this forward to year 10, we get 11.97813(1.08)⁵ = 17.5998.  Subtracting that from 28.0345, we get an end-of-year 10 value of $10.4347 m.

If this were to be distributed as a perpetuity, the annual payments would be 10.4347(0.08) = $0.83478m.

Midterm II 

• The exam is closed book.

• Time allowed is exactly 1 hour and 30 minutes.

• 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.

• Write legibly; I cannot guarantee any credit for what I cannot read, even if it is correct.

• If an answer contains two contradictory statements, you may get no credit for the answer, even if one of the statements is correct.

• 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 WSJ article from March 15, 1999 and answer this question, using no more than two sides of a page.  Rambling answers will be penalized.

• Why should earnings-protection insurance not make sense from a shareholder’s point of view?

• Bonus: (no more than half of one side): What arguments can you marshal for the idea that firms should hedge against return (not earnings) volatility?

Manager's Journal: Reducing Risk Doesn't Pay Off

Reliance National announced recently that it will soon begin offering "earnings-protection insurance." That  is, it will write insurance policies to cover companies against lower-than-expected earnings resulting from  uncontrollable events ranging from a product flop, to a supplier that goes bust, to a key customer who  defects.

The idea behind earnings insurance, like other forms of insurance, is to reduce risk. Earnings insurance is  only the latest strategy available to risk-averse managers; in the past they have formed conglomerates and  employed derivatives for the same purpose. On the surface, such strategies would seem to make sense.  After all, stockholders dislike risk. In the stock market, the essence of risk is the volatility of returns.  Thus, it would seem that if a company can smooth out its earnings through various forms of risk  management, it will keep the stockholders happy and the stock price high. Why didn't somebody think of  this before? There's got to be a catch.

Indeed there is. Stockholders don't care if earnings are hurt by uncontrollable events. At least diversified  stockholders don't care. And because it is irrational not to diversify, we don't really need to worry about  stockholders who don't diversify. A diversified stockholder -- one who has spread his money across 20 or  more different stocks -- has effectively eliminated the risk that goes with investing in any individual  company, without any sacrifice of return. For every company that underperforms compared with  expectations, there will almost certainly be one that overperforms.

If a rational investor has already avoided company-specific risk through diversification, how would he  view the news that a company in which he owns stock has bought an insurance policy covering the same  risk? Not favorably. From the point of view of the diversified shareholder, earnings insurance is a waste  of money.

This is not to say that there will not be takers for such insurance. Management may think that the  stockholders care. The problem is that a manager whose compensation is tied to earnings may have an  ulterior motive. It is obvious why he might see earnings insurance as a good idea. Fortunately for  shareholders, few managers have their incentive compensation tied to earnings these days. Most receive  stock options and therefore should not be much interested in any financial gimmick that might adversely  affect stock price.

Earnings insurance has other problems, too. For one, smart stockholders would not view the proceeds of  an insurance policy as the dollar-for-dollar equivalent of the same amount of earnings. Earnings provide  shareholders not only with money, but also with information about how well a company is managed. If a  disaster happens once, it can happen again. Stockholders will perceive more risk even if the insurance  company ponies up the difference. The price of the stock will drop, insurance or no insurance.

What's more, earnings insurance will not cover the one risk that stockholders might like to see covered. It  won't pay if the shortfall is due to fraud or other wrongdoing by management. This is a risk that can't be  diversified away. Fraud always hurts; there are no gainers to balance out the losers. That's why the courts  waive the business-judgment rule, which ordinarily protects management from judicial second-guessing, if  there is self-dealing or a similar wrong.

Earnings insurance as a way of hedging risk is part of a trend that goes back decades. The primary  motivation for the conglomerate mergers of the 1960s and 1970s was earnings management. The idea was  that assembling an array of different companies under one umbrella would yield a smooth earnings stream  at the holding-company level. But stockholders soon discovered that they could diversify much more  cheaply and easily by adjusting the stocks in their portfolio or buying shares in a mutual fund.

Conglomerate stocks thus fell into disfavor. Why buy prepackaged diversification in the form of a  conglomerate, in which the CEO has no substantive focus, when you can roll your own portfolio and  adjust the mix of business with a simple phone call to your broker? In the end, the conglomerate mergers  of the '60s and '70s became the targets of the bust-up takeovers of the '80s. Nor did the trend end then:  Last week's breakup of RJR Nabisco came after its stock had languished for a decade since the 1988  merger.

More recently, companies have turned to various derivative instruments to manage risk. Aside from the  well-publicized losses of Procter & Gamble, Gibson Greetings and others from derivatives gone wrong,  what do derivatives do for stockholders even when they work as intended? Not much. As far as a  diversified stockholder is concerned, company-specific risks from interest rate fluctuations, currency  translation, or volatile commodity prices all come out in the wash. Some companies win, some lose. Only  the average matters.

A few companies seem to recognize that stockholders dislike risk management. Homestake Mining, for  example, generally does not attempt to hedge with gold futures. Rather it allows the risk of changing gold  prices to pass through to its investors who may hedge either by owning a stock of a gold user or through  options.

First conglomerate mergers, then derivatives -- earnings insurance is more of the same. Smart  stockholders won't like it. Sell short. 

2. Here are the prices and betas, as of March 17, 1999 for three stocks that I own: 

 a.       If I have 100 shares of each company in my portfolio, compute the portfolio proportions for each stock. 

You have the following additional information on these stocks’ standard deviations (in percentages, on diagonal) and correlation coefficients (off-diagonal numbers):

 b.      Compute the standard deviation of returns on your portfolio.

c.       If the expected return on the market portfolio is 15%, and the yield on the one-year T-bill is 5%, what is the required rate of return on your portfolio?

 Solutions:

1. There are three reasons given in the article as to why earnings insurance doesn’t matter for shareholders:

One, Shareholders don’t need companies to diversify because they can do it directly themselves and probably at cheaper cost.  

Two, a firm’s performance in terms of earnings signals whether the firm is good or not.  Hence a particular earnings debacle has two effects on the value of a shareholder’s stock: one, its impact due to a reduction in current earnings; and two, its impact due to the information it contains on future earnings debacles, not all of which are insured.  Since earnings insurance cannot be complete (that is, covering all kinds of eventualities), a given earnings shortfall will have a greater negative impact on the stock price beyond the amount that the insurance company will pay up.  The second kind of effect will not be covered by insurance, unless we know that all earnings shortfalls will be insured for ever.

Finally, shareholders are also hurt by earnings shortfalls due to fraud; but earnings insurance won’t cover this.

2. a. The portfolio proportion for KO is given by 68.06/(68.06+78.56+60.88) = 32.80%
The portfolio proportion for ASND = 78.56/(68.06+78.56+60.88) = 37.86%
The portfolio proportion for MBI = 60.88/(68.06+78.56+60.88) = 29.34%

 b. Portfolio Variance = (0.328)²(20)² + (0.3786)²(30)² +(0.2934)²(40)²
                                    +  2(0.328)(0.3786)(20)(30)(0.3)
                                    +  2(0.328)(0.2934)(20)(40)(0.4)
                                    +  2(0.2934)(0.3786)(40)(30)(0.6) = 576.02

The standard deviation = (0.328)^0.5 = 24%

c. First compute the beta of the portfolio: b_p = (.328)b_KO+(0.3786)b_ASND+(0.2934)b_MBI= 1.549; now applying the CAPM, we see that the required rate of return on the portfolio, and hence the expected return in a properly functioning market is: 5% + 1.549(15%-5%) = 20.49%

Final

• The quiz is closed book.

• Time allowed is 2 hours.

• Explain all your steps; correct answers without explanations may not be given any credit at all.

• 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 your answer is not clear and legible, I will deduct points.

 Using the information provided below on Columbia/HCA, answer the following questions below.

 I.

1. Compute the cost of equity for Columbia. (10 points)

2. Compute the after-tax cost of debt. (10 points)

3. Compute Columbia’s debt-equity ratio as the ratio of Long Term Debt to Common Shareholders Equity (Including Minority Interest).  (5 points)

4. What percentage of Columbia’s return is explained by market movements? (5 points)

5. Compute the covariance of returns between Columbia and the NYSE (5 points).

6. Compute the weighted average cost of capital using your answer in part c) above.  (5 points)

7. Estimate the growth rate of Columbia’s earnings. (10 points)

8. Suppose Columbia wishes to swap $3 billion of debt for equity.  Assume that the swap will reduce Columbia’s cost of debt by 1%.  Compute the new weighted average cost of capital.  Estimate the impact of this capital structure change on the market value of the entire firm. (10 points)

 II. Can you explain the company’s debt-equity ratio.  Would you recommend any changes?  Why or why not?  Use no more than one page for your answer.  (20 points)

 III. Can you explain the firm’s dividend policy? Would you recommend any changes?  Why or why not? Use no more than one page for your answer. (20 points)

1. Financial Statement Information from Disclosure.

2. Financial Information from the Wall Street Journal’s website.

3. General Information from the Wall Street Journal’s website.

4. General Information from Columbia’s website.

5. Bond Information

6. Regression of Columbia stock returns on the NYSE Composite Index returns

 A. Financial Statement Information from Disclosure.

 Balance Sheet as of 12/31/97

 
INCOME STATEMENT (000'S) 

 B. Financial Information from the Wall Street Journal’s website. 

 C. General Information from the Wall Street Journal’s website.

COL, together with its subsidiaries, operates hospitals and related health care entities. As of 12/98, COL operated 281 hospitals and 102 outpatient surgery centers. (From http://interactive.wsj.com/)

 D. General Information from Columbia’s website.

Columbia/HCA owns and operates over 300 hospitals and other healthcare facilities with approximately 60,000 licensed beds in 36 states, England and Switzerland. We are dedicated to providing healthcare services that meet each community's local healthcare needs, integrating various services to deliver patient care with maximum efficiency. (From http://www.columbia-hca.com/)

 E. Bond Information

The yield on the 30-year T-bond as of 5/7/99 was 5.81%, while the yield on the one-year T-bill as of 5/7/99 was 4.78% (http://www.bloomberg.com/markets/C13.html)

According to Standard and Poor’s Rating Service, Columbia’s unsecured bonds are rated B+.  Historically, bonds with this rating yield about 3% over the T-bond rate, according to Table 18.9 in Damodaran’s book, Corporate Finance: Theory and Practice.

 F. Regression Information

A regression of the monthly Columbia stock return on the NYSE Composite return for the period June 1994 to April 1999 yields the following results:

R_Columbia = -0.0156 + 1.1744 R_NYSE
R² = 0.21
Using the same data, the volatility of Columbia stock and the NYSE Composite was estimated as follows:
The standard deviation of R_Columbia = 9.74% per month
The standard deviation of R_NYSE = 3.8% per month

 Solutions:

I a. In order to compute the cost of equity, we need to use the CAPM.
Cost of equity, k_e = 5.81% + 1.1744(5.5) = 12.27%, where the beta is obtained from the slope of the market model regression, provided in part F.

b.      The marginal tax rate can be computed as the tax paid in 1997 divided by the taxable income, which works out to 206,000/470,000 = 44%.  The before tax cost of debt can be computed as the treasury bond rate of 5.81% plus the 3% spread, or 8.81%.  This gives us an after-tax rate of 8.81(1-0.44) = 4.93%

c.       Columbia’s debt-equity ratio measured as the ratio of Long Term debt to Common Shareholders’ Equity works out to 9276 m./8086 m. = 1.1472; this yields a debt ratio of 0.534

d.  Since the R² is 0.21, 21% of Columbia's return is explained by market movements.

e.  Columbia's beta equals the covariance between the returns on Columbia and the NYSE, divided by the variance of returns on the NYSE.  Hence the covariance itself equals the beta multiplied by the NYSE return variance, i.e. (1.1744)(0.038)² = 0.001696.   

f.      Hence the weighted average cost of capital = 0.534(4.93) + (1-0.534)(12.27) = 8.35%

g.       The growth rate can be estimated by looking at the growth rate in earnings per share over the last five years.  However, over the last year, the growth rate is not properly defined, because earnings in 1997 were negative, according to the chart on the WSJ’s website (part B.)  We could ignore that year; the average growth rate then works out to (1.6/1.46 + 2.24/1.6 – 0.37/2.24)/3 – 1 = -0.07 or –7%.  Alternatively, if we just use the earnings growth rate over the five years as a unit, we get (0.59/1.46) – 1 = -0.06 or -60%.  There doesn’t seem to be a strong reason to believe that the company is in a tailspin, especially since it seems to have recovered from 1997 to 1998.  So, we could go with the –7%, as a conservative estimate.  (note that the WSJ information on 1997 income is inconsistent with the information in the Income Statement.  This is because the Income Statement does not include information on Extraordinary Charges.

h.        If Columbia reduced debt by $3 billion and increased equity by the same amount, the debt-equity  ratio would become 6276/11086 = 0.566, for a debt ratio of 0.566/1.566 = 0.36.
The unlevered beta is 1.1744/(1+(1-0.44)1.1472) = 0.715; the new levered beta = 0.715(1+(1-0.44)0.566) = 0.942; hence the cost of equity capital = 5.81+0.9429(5.5) = 10.99%.
The after-tax cost of debt becomes (8.81-1)(1-0.44) = 4.374%
The weighted average cost of capital = (0.36)(4.374) + (0.64)(10.99) = 8.608%, which is higher than the previous cost of capital.
The previous firm value was $22b. as of Dec. 1997. 
The new firm value = (in billions) 22 – 22(0.08608 – 0.0835)(1-0.07)/(0.08305+0.07) = 22 – 0.344 = $21.66 billions. 

II.                 The company’s current debt ratio is 53%, which is quite high.  This is supported by the high proportion of Property, Plant and Equipment and Tangible Assets in the balance sheet (10,230 + 1,077)/22,002 = 51.4%.  Also, the company’s unleveraged beta is below 1.0.  However, the product sold by the company is difficult to evaluate, and for this reason, it might be better to have a lower debt ratio.  The company’s earnings have also been quite volatile over the five years for which data is available.  This would also suggest that the debt ratio is too high.  A reduction in debt would be recommended. 

III.               The dividend per share of 8 cents seems rather low, given the level of earnings in 1994, 1995 and 1996.  However, the earnings in subsequent years shows an earnings volatility which would justify the low payout ratio.  Furthermore, the high debt ratio would suffice to impose market discipline on management; dividends would not be necessary for that purpose.  On the other hand, the high degree of leverage may mean that there are covenants that prevent that payment of a higher level of dividend.  Finally, if we take the growth rate estimate, derived above, seriously, the dividend payout should be increased because there are insufficient investment opportunities.  If, however, results for 1996 and 1997 are not to be taken as temporary, dividends should be kept low to provide for additional funds for investment.

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