Midterm I

• The exam is closed book, except for one 8.5" x 11" sheet on which you may write whatever you wish.
• Time allowed is exactly 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.

I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.

1. Intangible assets (5 points)
2. Firm-specific risk (5 points)
3. Covariance (5 points)
4. Capital Market Line (5 points)

II. Tropica Corp. has the following data available to you:

Balance Sheets as of December 31, 1996 and 1997:

 1996 1997 Assets Current Assets Cash 39,700 27,500 Marketable securities 1,000 11,000 Accounts Receivable (net) 81,500 72,700 Inventories 181,300 242,000 Total current assets 303,500 353,200 Fixed Assets: Land 112,000 112,000 Plant and equipment (net) 445,200 464,800 Total fixed assets 557,200 576,800 Other assets 13,300 21,500 Total assets 874,000 951,500 Liabilities and net worth Current liabilities: Accounts payable 71,200 83,000 Notes payable 50,000 140,000 Accrued Expenses 33,400 36,300 Total current liabilities 154,600 259,300 Long-term debt: Mortgage payable 106,000 90,800 Net worth: Common stock 225,000 230,000 Retained earnings 388,400 371,400 Total Net Worth 613,400 601,400 Total Liabilities and Net Worth 874,000 951,500

Note: Dividends paid were \$30,000 for 1996 and \$15,000 for 1997.

Income Statement:

 1996 1997 Net Sales 1,133,400 1,147,700 Cost of Goods Sold (excluding depreciation) 709,000 781,100 Depreciation 31,500 32,200 Gross Margin 392,900 334,400 Expenses Selling Expenses 172,500 227,000 General and Administrative Expenses 65,500 71,800 Other Expenses 22,200 25,000 Interest on debt 9,700 14,300 Total Expenses 269,900 338,100 Profit (loss) before taxes 123,000 (3,700) Federal Income Tax 56,600 (1,700) Net income (loss) 66,400 (2,000)

Compute Cash flow from Operations for Tropica for the year 1997, and using this, compute Net Cash Flows provided by Operating Activities as represented in the Statement of Cash Flows. (25 points)

(Bonus question) For what purpose might you compute these two different cash flow numbers? (5 points)

III. a. (5 points) You are walking down the corridor with your friend at work, Ms. Linda Tremple. Being very proud of yourself, you show her the following numbers that you’ve calculated as part of your duties as an investment analyst. She takes one look at these numbers and exclaims: "Oh no! These numbers violate the CAPM.!" What do you think she’s talking about, and why?

 Stock Estimate of Expected Return Standard Deviation of Returns Beta Estimate Bio-Gen 20% 35% 1.50 Boeing 12% 40% 1.03 Coca-Cola 22% 50% 1.20 General Electric 14% 20% 1.10

b. (20 points) You are a little shaken, but you continue with the report you’re preparing for your client. You need to come up with the expected return and variance of returns on a portfolio consisting of \$75,000 in Bio-Gen, and \$25,000 each in Boeing and Coca-Cola. You have the following information regarding the correlations between their returns: Correlations between returns on different stocks in your portfolio

 Bio-Gen Boeing Coca-Cola General Electric Bio-Gen 0.2 0.1 0.25 Boeing 0.5 0.6 Coca-Cola 0.7

(10 points) Assuming that your estimates are correct, what would the beta of your portfolio be?

(10 points) What would the weights of a portfolio consisting of Bio-Gen and Boeing alone be, if you wanted to minimize the variance of portfolio returns?

(10 points) If you wanted to create a portfolio consisting of only two stocks, which pair of stocks would you pick, if you wanted to minimize the variance of returns on the portfolio? Why?

II.  Even though the question asked for a computation of Cash flows from Operations and then to compute Net Cash Flows from Operating Activities, this solution provides a direct computation of Net Cash Flows from Operating Activities:

 1996 1997 Increase from 1996 to 1997 Outflows Assets Current Assets Cash 39,700 27,500 -12,200 Marketable securities 1,000 11,000 10,000 included in investing activity Accounts Receivable (net) 81,500 72,700 -8,800 -8,800 Inventories 181,300 242,000 60,700 60,700 Total current assets 303,500 353,200 49,700 Fixed Assets: Land 112,000 112,000 0 Plant and equipment (net) 445,200 464,800 19,600 -32,200 (Depreciation from Income Statement; difference between this number and 19,600 presumed to be purchase of assets) Total fixed assets 557,200 576,800 19,600 Other assets 13,300 21,500 8,200 assumed to be investments Total assets 874,000 951,500 Liabilities and net worth Current liabilities: Accounts payable 71,200 83,000 11,800 -11,800 Notes payable 50,000 140,000 90,000 -90,000 (If this is interpreted as financing, then it would not be included in operating cash flows.) Accrued Expenses 33,400 36,300 2,900 -2,900 Total current liabilities 154,600 259,300 104,700 Long-term debt: Mortgage payable 106,000 90,800 -15,200 Financing activity Net worth: Common stock 225,000 230,000 5,000 Retained earnings 388,400 371,400 -17000 2000 (Loss as show in Income Statement; the difference between Net Income and -17,000 is dividends paid) Total Net Worth 613,400 601,400 Total Liabilities and Net Worth 874,000 951,500 Net Cash (in)flows from Operations \$83,000

Midterm II

• The exam is closed book, except for one 8.5" x 11" sheet on which you may write whatever you wish.
• Time allowed is exactly 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.

I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.

1. Diversification
2. Markowitz portfolios
3. Intangible Assets

II. Here are the financial statements for TRW, Inc. for 1994 and 1995

Income Statement

 1995 1994 Sales 10172 9087 Cost of goods sold 8190 7270 Administrative and Selling expenses 1169 1168 Interest expense 95 105 Other expenses 10 9 Earnings before income tax 708 535 Income taxes 262 202 Net earnings (loss) 446 333

Dividends paid were \$134 in 1995 and \$126 in 1994.

Included in Cost of Goods Sold and Administrative and Selling expenses is Depreciation of property, plant and equipment, which amounted to \$433 in 1995 and \$402 in 1994.

 1995 1994 Assets Current Assets: Cash 59 109 Accounts Receivable 1428 1338 Inventories 534 470 Prepaid expenses 78 59 Deferred Income taxes 237 239 Total Current Assets 2336 2215 Property, Plant and equipment 2563 2489 Intangible Assets 658 656 Other Assets 333 276 Total Assets 5890 5636 Liabilities and Shareholders’ Investment Current liabilities: Short-term debt 133 122 Accrued compensation 385 346 Accounts payable 1388 1311 Notes payable 106 207 Total Current liabilities 2012 1986 Long-term liabilities 1165 1134 Long-term debt 541 694 Shareholders’ Investment: Common Stock 484 439 Retained Earnings 1688 1383 Total Shareholders’ Investment 2172 1822 Total Liabilities and Shareholders’ Investment 5890 5636

1. Compute Cash flow from Operations for 1995
2. Compute Net Cash flows from Operating Activities for 1995as defined in the Statement of Operating Activities

III. You have the following information:

 Asset Expected Return Standard Deviation of Returns Correlation with the market return A 12% 20% 0.4 B 25% 35% 0.5 C 30% 25% 0.3

1. Can you definitely say which stock is riskier? Why or why not?
2. If you invested \$10,000 in stock A and \$5,000 each in stocks B and C, what would your expected portfolio return be?
3. If the correlation coefficient between the returns on A and B is 0.2, that between A and C is 0.3 and that between B and C is 0.6, what is the standard deviation of returns on this portfolio?
4. If the standard deviation of returns on the market portfolio is 35%, what are the betas of the three stocks?
5. Is the pricing of the three stocks consistent with the CAPM? Why or why not?

Solutions:

II.

a. Cash flow from Operations = EBIT + Depreciation - Taxes = 708 + 95 + 433 - 262 = 974
Change in Working Capital = (2336-2012) - (2215-1986) = 95

b. Net Cash flow from Operating Activities = Cash flow from Operations - Interest - Change in Working Capital + Change in Cash = 974 - 95 - 95 + (-50) = 734.

III. a. It is not possible to say which stock is riskier, because we don’t have their betas.

b. The weights are 0.5, 0.25 and 0.25. Hence the expected portfolio return = 0.5(12) + 0.25(25) + 0.25(30) = 19.75%

c. The variance = (0.5)2(20)2 + (0.25)2(35)2 + (0.25)2(25)2 + 2(0.5)(0.25)(0.2)(20)(35) + 2(0.5)(0.25)(0.3)(20)(25) + 2(0.25)(0.25)(0.6)(35)(25) = 353.75; hence the standard deviation of returns on the portfolio = 18.8%

d. The beta is computed using the formula, Beta = Corr(Ri, Rm)[Std. dev(Ri)/Std. dev.(Rm)]

 Asset Expected Return Standard Deviation of Returns Correlation with the market return Covariance with market returns Beta A 12% 20% 0.4 280 0.23 B 25% 35% 0.5 612.5 0.5 C 30% 25% 0.3 262.5 0.21

e. No, because the expected returns do not increase with the betas.

Midterm III

• The exam is closed book, except for one 8.5" x 11" sheet on which you may write whatever you wish.
• Time allowed is exactly 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.

I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.

• Diversification
• Markowitz portfolios
• Intangible Assets

II. Here are the financial statements for TRW, Inc. for 1994 and 1995.

Income Statement

 1995 1994 Sales 10172 9087 Cost of goods sold 8190 7270 Administrative and Selling expenses 1169 1168 Interest expense 95 105 Other expenses 10 9 Earnings before income tax 708 535 Income taxes 262 202 Net earnings (loss) 446 333

Dividends paid were \$134 in 1995 and \$126 in 1994.

Included in Cost of Goods Sold and Administrative and Selling expenses is Depreciation of property, plant and equipment, which amounted to \$433 in 1995 and \$402 in 1994.

 1995 1994 Assets Current Assets: Cash 59 109 Accounts Receivable 1428 1338 Inventories 534 470 Prepaid expenses 78 59 Deferred Income taxes 237 239 Total Current Assets 2336 2215 Property, Plant and equipment 2563 2489 Intangible Assets 658 656 Other Assets 333 276 Total Assets 5890 5636 Liabilities and Shareholders’ Investment Current liabilities: Short-term debt 133 122 Accrued compensation 385 346 Accounts payable 1388 1311 Notes payable 106 207 Total Current liabilities 2012 1986 Long-term liabilities 1165 1134 Long-term debt 541 694 Shareholders’ Investment: Common Stock 484 439 Retained Earnings 1688 1383 Total Shareholders’ Investment 2172 1822 Total Liabilities and Shareholders’ Investment 5890 5636

1. Compute Cash flow from Operations for 1995
2. Compute Net Cash flows from Operating Activities for 1995as defined in the Statement of Operating Activities

III. You have the following information:

 Asset Expected Return Standard Deviation of Returns Correlation with the market return A 12% 20% 0.4 B 25% 35% 0.5 C 30% 25% 0.3

1. Can you definitely say which stock is riskier? Why or why not?
2. If you invested \$10,000 in stock A and \$5,000 each in stocks B and C, what would your expected portfolio return be?
3. If the correlation coefficient between the returns on A and B is 0.2, that between A and C is 0.3 and that between B and C is 0.6, what is the standard deviation of returns on this portfolio?
4. If the standard deviation of returns on the market portfolio is 35%, what are the betas of the three stocks?
5. Is the pricing of the three stocks consistent with the CAPM? Why or why not?

Solutions:

II. a. Cash flow from Operations = EBIT + Depreciation - Taxes = 708+95 + 433 - 262 = 974

b. Change in Working Capital = (2336-2012) - (2215-1986) = 95; Net Cash flow from Operating Activities = Cash flow from Operations - Interest - Change in Working Capital + Change in Cash = 974 - 95 - 95 + (-50) = 734.

III. a. It is not possible to say which stock is riskier, because we don’t have their betas.

b. The weights are 0.5, 0.25 and 0.25. Hence the expected portfolio return = 0.5(12) + 0.25(25) + 0.25(30) = 19.75%

The variance = (0.5)2(20)2 + (0.25)2(35)2 + (0.25)2(25)2 + 2(0.5)(0.25)(0.2)(20)(35) + 2(0.5)(0.25)(0.3)(20)(25) + 2(0.25)(0.25)(0.6)(35)(25) = 353.75; hence the standard deviation of returns on the portfolio = 18.8%

 Asset Expected Return Standard Deviation of Returns Correlation with the market return Covariance with market returns Beta A 12% 20% 0.4 280 0.23 B 25% 35% 0.5 612.5 0.5 C 30% 25% 0.3 262.5 0.21

e. No, because the expected returns do not increase with the betas.

Final Exam

• The exam is closed book.
• Time allowed is exactly 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. (20 points) Here is an excerpt from a February 7, 1997 New York Times article: Encore for '96 Plan to Hike Taxes on Business

The budget plan also tries to clarify a long-standing dispute over the distinction between debt and equity, which the tax code treats differently but which have become increasingly blurred with the large volumes of bonds with maturities of more than 40 years and zero-coupon convertible debt. If the proposals are adopted, the law would treat those products as equities, rather than bonds, eliminating favorable tax treatment.

Why might bonds with maturities of more than 40 years and zero-coupon convertible debt blur the distinction between debt and equity?

2. (20 points) The New York Times ran the following article on May 14, 1997 (partially reproduced below) that describes the dividend policies of four firms, IBM, Digital, Intel and Microsoft. On the face of it, it seems strange that all these firms are in the same industry, yet have differing dividend policies. Can you explain the difference? 10 Years Later, IBM Sets New High in Changed Market

An aside on Digital: It was an early adherent to the theory, which it did well in selling to Wall Street, that dividends do not matter because it is better for a company to plow its profits back into the business. As a result, owners of that stock in the last decade have not only lost money -- Digital's price is down 81 percent from August 1987 -- they have not gotten any dividends that would cushion the blow.

IBM has always paid a dividend, which it has just raised to 40 cents a quarter, up from 35 cents but well below the \$1.10 quarterly it was paying when the stock last was hitting new highs. Since August 1987, a holder who stuck with IBM has collected \$31.08 in dividends for each share.

The new technology leaders are closer to Digital, at least in dividend philosophy. Microsoft has never paid a dividend; while Intel has been making payouts since 1992, they are not exactly generous. It now pays 5 cents a quarter, or 20 cents a year -- a dividend yield on the current stock price of \$152.375 of one-tenth of 1 percent a year.

3. (40 points) CSI Corporation is a mid-sized transportation firm with 10 million shares outstanding, trading at \$25 per share and debt outstanding of \$50 million, yielding 10%. The beta of the equity is 1.20, and the yield on the 30 year Treasury bond is 6%. It is estimated that if the firm borrows \$100 million and buys back stock, the cost of debt will rise to 11%. Estimate the expected change in the stock price if the expected growth rate in operating earnings over time is 5%. The company is in the 40% tax bracket.

4. (20 points) Gaulois, Inc. is a publicly traded tobacco company that is expecting to experience a 10% annual decrease in revenues, expenses, working capital and depreciation for each of the next three years. The company paid off all outstanding debt at the beginning of last year and had net income of \$48m. in the year just ended. Management has decided to dramatically change the focus of the company to specialize in the telecommunications industry. Toward that end, the managers have decided to forego any additional capital expenditures in the tobacco business for the next three years in order to build a "war chest" to be used to acquire a presence in the target industry. Using the information shown below, determine how large the war chest will be at the end of three years if management keeps the payout ratio at its current level. (You may assume that Gaulois will invest any retained earnings in a money market account that will earn 10% per year. Furthermore, the current balance of the cash account is earmarked for maintaining the existing lines of business, so it shouldn’t be included in your calculations.)

Income Statement for Year Just Ended

 Revenues \$500,000,000 - Expenses \$350,000,000 - Depreciation \$ 70,000,000 EBIT \$80,000,000 - Taxes \$32,000,000 Net Income \$48,000,000 Dividends Paid \$24,000,000

Non-cash working capital = \$70,000,000.

Solutions:

1. Zero-coupon convertible debt has a high probability of being converted; hence it is closer to equity than to debt. Long maturity bonds are more sensitive to the fortunes of the firm as a whole since payouts on these bonds continue for a long time. This also makes them closer to equity. The key point to be made is that the IRS assigns tax deductibility based on the equity-ness of a security, which, in turn, is essentially a question of how sensitive the security’s value is, to changes in the value of the firm.

2. You need to take into account several factors. The industry is, in general, high growth, and, as such, has a low payout ratio, as characterized by the zero payout policies of Microsoft and Digital. However, IBM, being an established firm, might already have established a clientele that likes the higher payout ratio that it initiated when it was behaving like a more mature firm in its monopolistic guise. It’s funds raising costs might also be lower. Intel’s minimal payout ratio might be also due to its being somewhat older than Microsoft, and also its relatively less innovative profile.

3. The cost of equity capital before the debt-equity swap = 6% + 1.2(5.5%) = 12.6%. The after-tax cost of debt = 10%(1-0.4) = 6%. The market value of equity = \$250m., and the market value of debt is assumed to be \$50m. The WACC = (250/300)(12.60%) + (50/300)6%) = 11.51%

The unlevered beta = 1.2/[1+(1-0.4)0.2] = 1.071

The debt ratio after the swap is approximately 150/300 = 0.5; hence the beta after the swap = 1.071[1+(1-0.4)1] = 1.714. The cost of equity capital = 6% + 1.714(5.5%) = 15.43%; the after-tax cost of debt = 6.6%; the WACC is approximately (0.5)6.6% + (0.5)15.43% = 11.01%

The change in the value of the firm = \$300m.(0.115 - 0.1101)/(0.1101-0.05) = \$24.23m.; hence the stock price rises \$24.23m./10m. = \$2.42 at the announcement of the capital restructuring.

4.

 Current Next year in 2 yrs in 3 yrs EBIT 80 72 64.8 58.32 Depreciation 70 63 56.7 51.03 Working Capital 70 63 56.7 51.03 Change in WC -7 -6.3 -5.67 Net Income 48 43.2 38.88 34.992 Dividends 24 21.6 19.44 17.496 Increase in Cash 91.6 82.44 74.196

If these funds are invested at 10%, the size of the war chest will be 91.6(1.1)2 + 82.44(1.1) + 74.20 = \$275.72m.