Dr. P.V. Viswanath
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Fin 340 Valuation of the Firm

# Fall 2008 Exams

Midterm

Notes:

1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
3. You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
5. You must answer questions 1, 4 and 5. Answer any one of questions 2 and 3.

1. (20 points) I obtained data from Yahoo on the prices of Navistar (NYSE: NAV) and S&P Depository Receipts (AMEX: SPY) and regressed NAV returns on SPY returns, using data from January 2000 to Oct. 1, 2008. Here are the results from the Excel regression:

 Regression Statistics Multiple R 0.684666 R Square 0.468768 Adjusted R Square 0.462993 Standard Error 0.090519 Observations 94 ANOVA df SS MS F Significance F Regression 1 0.665188 0.665188 81.18226 2.76E-14 Residual 92 0.753826 0.008194 Total 93 1.419014 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Intercept 0.011599 0.00934 1.241861 0.217444 -0.00695 0.03015 SPY 1.896766 0.210515 9.01012 2.76E-14 1.478665 2.314867
1. (5 points) What is your estimate of NAV's beta?
2. (7 points) How confident are you that the beta is greater than the beta for the market portfolio?
3. (8 points) If you know that the riskfree rate over the period of the regression was 4.5% on average, would you say that the returns from holding NAV over the period of the regression were abnormally high, after adjusting for beta risk?
4. (5 points) How much of NAV's return variance is diversifiable?

2. (15 points) Here is the variance-covariance matrix for SPY, NAV and F (Ford Motors), using monthly return data from January 1993 to Oct. 2008:

 SPY NAV F SPY 0.0018 0.0029 0.0026 NAV 0.0029 0.0163 0.0063 F 0.0026 0.0063 0.0123

Compute the variance of monthly returns on a portfolio consisting of a investment of \$200 each in NAV and F, and \$600 in SPY.

3. Read the following article from the "Heard On the Street" column in the WSJ of October 10, 2008, and answer the questions below:

Sears Shares Seem Ripe for a Reduction

It's time for a markdown sale at Sears. Despite steadily declining same-store sales and plunging profitability over the past 18 months, Sears's stock is defying gravity. But a looming recession is likely to bring the retailer back to earth.

Even after coming way off its highs of last year, Sears's stock is trading at the nosebleed valuation of about 26 times this year's expected earnings. In comparison, discount retailers such as Wal-Mart Stores and Costco Wholesale -- both of which reported higher same-store sales in September, even as consumers deserted other stores -- are trading in the mid-to-high teens. Not to mention lower-profile retailers like TJX Cos., whose chains draw brand-conscious consumers looking for a bargain, which is trading at a multiple of about 11.

Part of the reason for the anomaly could be Sears's inclusion on the no-short-sale list; indeed, Thursday, after the ban expired, Sears fell sharply. Sears also benefits from a relatively small float, as several loyal investors have stuck by controlling shareholder Eddie Lampert. And the company has been steadily buying back stock, even as cash generation has slumped.

At some point, though, the faith in Mr. Lampert displayed by these investors may start to crumble. Recessions are the ultimate in Darwinian exercises for retailers. Every time there's a severe economic downturn, a smattering of big and small retail chains go bankrupt. Recent months have already seen a handful of specialty chains file for Chapter 11 bankruptcy protection, including Steve & Barry's, Linens 'n Things and Mervyn's. Others, like electronics chain Circuit City and drugstore operation Rite Aid Corp., face serious challenges. Sears says it has more than enough liquidity. But an extended downturn will test that.

1. (10 points) "Sears also benefits from a relatively small float, as several loyal investors have stuck by controlling shareholder Eddie Lampert." The article cites this as a reason for higher stock valuations for Sears. How would you bring this into your discounted cashflow valuation procedure?
2. (10 points) The article provides another reason for Sears's relatively higher valuation: "(p)art of the reason for the anomaly could be Sears's inclusion on the no-short-sale list." Can you explain why rationally this should be true? (Ignore the fact that Sears's higher valuation has persisted even after the expiry of the ban, which undercuts this explanation.)
3. (10 points) Come up with a rational explanation for Sears's higher valuation, in addition to the two discussed in parts a) and b).

4. (30 points) The article below (WSJ, October 22, 2008) describes how some companies have an advantage in bad times.  Of course, all the examples here have the advantage of hindsight.  As an equity analyst, you have to be able to look at a company and infer how that company might do in a downturn (or an upturn), and also how this would affect your valuation.  Furthermore, you have to decide why your valuation would be different because of that company characteristic.  That is, given that stock value is simply the present value of the discounted present value of free cashflow to equity, a firm can have a higher value only if its free cashflows are higher or its cost of equity is lower.  So you have to decide if the ability of the company to weather downturns implies a lower cost of equity (this has to be consistent with whatever model of asset pricing you believe in) or it has to imply higher free cashflows.  Furthermore, even if the company can weather downturns better, perhaps there are off-setting disadvantages – for example, perhaps it won’t be able to take advantage of opportunities in up-markets.  If this is so, it must be factored in, as well.  Keep all this in mind and answer any one of the following two sets of questions:

1. Southwest Airlines
1. Why was Southwest able to do well during the 2001 recession?  Which of these reasons were due to structural characteristics of Southwest that a Porter Analysis would have identified?  Which of these were simply smart moves that Southwest’s management made in 2001 (which other firms could also have made, but may not have)?
2. Do any of Southwest’s characteristics described in the article imply disadvantages in market booms?  Explain.
3. If you were valuing Southwest in 2000 (i.e. pre-recession), how would you have taken these Southwest characteristics into account in your valuation?
2. Intel
1. Why did Intel do better than AMD in the 2001 recession?  Which of these reasons were due to structural characteristics of Intel that a Porter Analysis would have identified?  Which of these were simply smart moves that Intel’s management made in 2001 (which AMD’s management could also have made, but may not have)?
2. Do any of Intel’s characteristics described in the article imply disadvantages in market booms?  Explain.
3. If you were valuing Intel in 2000 (i.e. pre-recession), how would you have taken these Intel characteristics into account in your valuation?

In Chaos Lies Opportunity, by Darrell Rigby and Steve Ellis
Lehman Brothers' headlong pitch into bankruptcy protection, Merrill Lynch's dramatic sale to Bank of America and the U.S. government's rescue of AIG have battered financial markets. But in the turbulence lies opportunity.
Like dangerous curves on a racetrack, economic downturns create more opportunities for companies to move from the middle of the pack into leadership positions than any other time in business.
Unlike straight-aways where leaders can thrive on raw power alone, steep curves require strategic finesse. That often results in dramatic differences in performance as leaders steer out of the curve.
Consider how Southwest Airlines surged ahead during the 2001 recession. With a clean balance sheet, a clear cost advantage and adroitly hedged fuel costs, the discount carrier grew at the expense of rivals. As others eliminated capacity and jobs, Southwest lowered fares to gain market share. It boosted advertising to trumpet its price advantage and built solid relations with labor by avoiding layoffs.
Southwest is not unique. About 24 percent more firms moved from the back of the pack to the front in the 2001 downturn compared with the subsequent period of economic calm, according to an eight-year study by Bain & Company that analyzed the net profit margins and sales growth of more than 2,500 companies. Meanwhile, about one-fifth of all leadership companies—those in the top quartile of financial performance in their industry—fell to the bottom quartile. By comparison only three-quarters as many companies made such dramatic gains or losses after the recession.
Recessions hit some industries harder than others, so staying alert matters. The variations get amplified in a globalizing, interdependent economy. That adds both opportunity and complexity. The opportunity is to shift focus to economically healthier regions, as Johnson & Johnson, GE and IBM did in the second quarter of 2008, reporting solid performance outside the U.S. The complexity arises from having to make long-term investments in global operations with less certainty than ever about where you will be exposed when the next downturn hits.
Many industry leaders fall from the top during recessions because they assume that a strong market position is an insurance policy against trouble. That approach breeds overconfidence. Executives postpone taking precautions or reach for the same levers they pulled in the past -- like hedging their bets by diversifying. When the downturn hits hard they usually over-react. They slash costs and staff indiscriminately, cut capital expenditures, squeeze suppliers, and avoid strategic acquisitions. Then when conditions improve, they must spend heavily to regain momentum.
The better approach: slow in, fast out—like a good driver heading into a sharp curve. Winners in recessions tend to brake quickly heading into a downturn by managing costs carefully and consistently. It's like downshifting to a lower gear to slow momentum and increase responsiveness. They focus on what the company does best, reinforcing the core business and spending to gain share. They aggressively monitor the competition to ensure they have the best possible line through the curve. That sets them up to accelerate at the apex of the curve, when the economy starts to improve. The farther you can see and the quicker you can turn, the faster you can safely corner.
In the 2001 recession, Intel Corp. timed its acceleration effectively to pull away from Advanced Micro Devices Inc., its scrappy rival in the chip business. Heading into the recession, AMD's heavy investment in product design was paying off, with AMD's revenues growing three times faster than Intel's.
Then the recession hit, catching the entire industry with too much capacity. As AMD's lack of profitability prevented it from investing in new production facilities, Intel seized the advantage. It invested in new facilities with state-of-the-art production capability and spent heavily to advertise its P4 processors. In the ensuing years, Intel's relative cost position improved dramatically and AMD had to slash 15 percent of its workforce. The momentum AMD had built quickly evaporated and a re-energized Intel remained the industry leader.
Another characteristic of companies adept in a downturn: they make bargain acquisitions to build up their core, even when it means taking calculated financial risks. As markets improve, they are well-positioned to accelerate. The latest example: Bank of America's planned acquisition of Merrill Lynch, which may turn out to be "the strategic opportunity of a lifetime," in the words of Ken Lewis, Bank of America's CEO.
For most industries, the optimal time to hit the brakes and downshift was months ago. The questions to be asking now are: Where is the apex of the curve, and how hard should we accelerate to take advantage of competitor mistakes? Who is in trouble and dumping valuable assets in order to survive? Can we add great people who are now available?
The companies with the right answers to those questions will have the inside track coming out of this downturn.

5. (Bonus question; 10 points): Read the excerpt from the Oct. 17, 2008 WSJ article below and answer the following question: What do you infer from this characteristic of food companies?  How would this affect your valuation of food companies?

Food Companies Sow Profit Growth
By LAUREN ETTER, JULIE JARGON, SCOTT KILMAN and AARON O. PATRICK
Grain and soybean prices have fallen by about 50% since their summer highs. But don't expect grocery prices to drop anytime soon.
Food companies are typically quick to pass along higher commodity costs on the way up, slower to reduce prices on the way down. That could bring a continuing run of profits for packaged-food companies even as consumers add higher food prices to the pressures they face from falling housing values and shrinking credit.

Solutions to Midterm

1.

1. NAV's beta is 1.8968
2. The p-value is almost zero. This means that there is a negligible probability that the true beta could be zero. As far as the likelihood that the true beta could be one (and we'd still see a sample beta of the magnitude seen here), the associated z-score would be (1.8968-1)/(0.2105) = 4.132. In this case, as well, this likelihood would be close to zero. Hence I would be pretty confident that NAV's beta is greater than unity, which is the beta of the market portfolio.
3. Keeping in mind that the returns used for the regression are monthly returns, we need to compute the monthly risk-free rate. This works out to 1.0451/12-1 = 0.003675 or 0.3675% per month. If NAV's returns over the estimation period were not abnormally high, we'd expect the intercept to be insignificantly different from (1-b)0.003675 = -0.0033. We see this is within the 95% confidence interval for the intercept. Hence we cannot reject the hypothesis that, adjusted for beta, NAV's returns are normal and in keeping with the CAPM.
4. Since the R2 is 46.88, 100-46.88, i.e. 53.12% of NAV's return variance is diversifiable.

2. The portfolio proportions are 60%, 20% and 20% for SPY, NAV and F; then, using the formula for portfolio variance, we find that the variance of returns on the portfolio is 0.003609 or a portfolio standard deviation equal to the square root of 0.003609, i.e. 6.01%.

3. a. Normally, we use as a discount rate, the return required by investors in general. However, in this case, if there is little change in the set of investors, then perhaps the discount rate used to establish a long-term price should be computed with respect to these long-term investors. However, for short-term valuations, it's necessary to use the marginal investors, who would not be these long-term loyal investors, since by definition they don't buy and sell on a regular basis. (According to this explanation, though, the current higher Sears valuations wouldn't be due to this fact.)

b. Investors would short sell stocks that they thought were overvalued. This information would also be relevant for stock valuation. Hence prices of stocks that had more short sales would be lower than they would otherwise be. Hence if short sales are not allwoed, this negative information would not be available to the market.

However, it's not entirely clear that this would explain the current phenomenon. Here's why. The reasoning presented above holds if short sales are permitted and investors engage (or don't engage) in short sales. In this case, short-sales were prohibited for a subset of stocks by the Federal Reserve. Hence, to the extent that the Fed Reserve used information about these companies' susceptibility to short sales that was not available to other traders, inclusion in the list of companies subject to the short-sales ban could have caused the stock price to drop.

c. One reason given in the article might be the liquidity that Sears claims it has. Another possibility is that Sears customers might be more loyal, that they might be more conscious of the Sears brand -- this might allow Sears to charge higher prices than the other retailers that are cited in the article, such as WalMart, Costco and TJX. A test of this hypothesis would be to look at other retailing stocks like Nordstrom that focus on higher profit margin, rather than higher volume.

4.

a. Southwest Airlines

1. The article identifies several reasons -- a clean balance sheet, i.e. little debt; lower costs, hedged fuel costs and good labor relations. None of these reasons would, on the face of it, be identified by a Porter Analysis, since Porter's method looks at industry characteristics. However, some of these characteristics may be derived form a Porter analysis, as well. One way to look at Southwest Airlines situation is to say that Southwest's product is so differentiated from its rivals that there is essentially no competition for it. Hence its customers are more willing to ride with it, and even willing to pay a premium (relative to costs, that is). Furthermore, switching costs are low in the airline industry (except for frequent flier programs); this means that in times of recession, low operating leverage pays off in terms of a cost advantage.
2. Having fuel costs hedged is an advantage if actual spot fuel prices are going up; however, it's a disadvantage in times of lower fuel prices, since the company is forced to pay the pre-contracted higher prices. This, by the way, is what is happening currently with Southwest.
3. The low debt and the hedged position would translate into lower betas. Better labor relations might also mean a lower beta if this means that labor is willing to be more flexible -- willing to take pay cuts in bad times in exchange for higher wages in good times. Lower operating costs may simply mean higher cashflows.

Intel

1. The article identifies one main reasons for Intel's doing well in the 2001 recession. AMD had built up a lot of production capacity, which works well if demand is really high. However, this can be a liability in the IT hardware industry where product life-cycles are short. As a result, as demand suddenly flagged, AMD found itself with a lot of capacity that turned out to be less useful in producing the newer chips that had been designed by the time the economy improved. Intel, not being saddled with a lot of capacity was able to time its investment better. In other words, Intel didn't take risks by overextending itself. It is not clear how this could have been identified in a Porter Analysis. It has more to do with different strategies adopted by Intel versus AMD. Intel decided to go the less risky route, while AMD decided to take more risks.
2. If the market had not turned down, AMD would have been in a better situation than Intel -- so in that sense, Intel was just lucky (or maybe it had better forecasting ability).
3. Intel would have had a lower beta because its ups and downs would have been less severe, compared to AMD.

5. It looks like buyers in the packaged-food industry have less bargaining power -- maybe because of lower price elasticity of demand, caused, in turn, by advertising that generates preferences for specific brands. This would result in lower betas, in general. Furthermore, this would also mean that the industry would have higher debt-capacity than would otherwise be true; this would allow firms in the industry to benefit from greater interest deductions for tax purposes.

Final

Notes:

1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
3. You may bring in sheets with formulas, but no worked-out examples.
5. You have 2 hours to complete the exam; please make sure to attempt all the questions, so I can give you partial credit, if necessary.

Kroger Sales Rise 9%; Net Declines on a Charge
Wall Street Journal, December 10, 2008, By David Kesmodel

Kroger Co. said its quarterly profit fell 6.3%, largely because of a charge related to Hurricane Ike, but the supermarket giant's revenue jumped 9% as its low prices and store brands enticed shoppers battered by the U.S. recession.

The Cincinnati-based retailer also increased its earnings guidance for the full year. Its shares were off 6.7% at \$25.47 in 4 p.m. New York Stock Exchange composite trading Tuesday, however, because its profit forecast for the current quarter was slightly below analysts' projections.

Kroger said net income for its fiscal third quarter ended Nov. 8 dropped to \$237.7 million, or 36 cents a share, from \$253.8 million, or 37 cents a share, a year earlier. Revenue climbed to \$17.6 billion from \$16.1 billion.

Excluding an after-tax charge equal to three cents a share related to insurance costs for Ike, which damaged Kroger stores, the company said profit would have been \$253.6 million, or 39 cents a share.

Analysts had predicted earnings of 38 cents a share and revenue of \$17.4 billion, according to a Thomson Reuters survey.

David Dillon, Kroger's chief executive, told analysts in a conference call that he is "feeling pretty good about things, given the environment we're operating in." He said Kroger's strategy of lowering prices, which has reduced its gross margins, "continues to resonate well with customers."

Kroger's same-store sales, a key barometer of the health of grocery stores, rose 5.6%, one of the highest rates in the industry and an improvement from the second-quarter rate of 4.7%. The figures exclude sales of gasoline at stores with fuel pumps.

The retailer's profit partly was damped by higher food inflation, which has affected the grocery industry throughout this year. Kroger said its product-cost inflation in the latest quarter was roughly 6%.

Mr. Dillon also said Kroger "could have done a better job of managing expenses in the quarter."

Kroger is projecting full-year earnings of \$1.88 to \$1.91 a share, excluding the charge related to the hurricane. It had earlier projected \$1.85 to \$1.90 a share, while analysts were pegging earnings at \$1.92 a share.

The company estimates fourth-quarter profit of 49 cents to 52 cents a share, citing in part expectations for sluggish holiday spending. Analysts had projected earnings of 53 cents a share, according to Thomson Reuters.

_____________________

The following table (from NetAdvantage) provides revenues in millions of dollars for Kroger Co. (fiscal year ending January). Second set of numbers provide growth rate over sales in same quarter, previous year (except for last line).

2008 2007 2006 2005 2004 2003 2002
1Q 20,726 19,415 17,948 16,905 16,266 15,667 15,102
2Q 16,139 15,138 13,865 12,980 12,351 11,927 11,485
3Q 16,135 14,999 14,020 12,854 12,141 11,696 11,382
4Q 17,235 16,859 14,720 13,695 13,034 12,470 12,129
Year 70,235 66,111 60,553 56,434 53,791 51,760 50,098
2008 2007 2006 2005 2004 2003
1Q 6.75% 8.17% 6.17% 3.93% 3.82% 3.74%
2Q 6.61% 9.18% 6.82% 5.09% 3.55% 3.85%
3Q 7.57% 6.98% 9.07% 5.87% 3.80% 2.76%
4Q 2.23% 14.53% 7.48% 5.07% 4.52% 2.81%
Year 6.24% 9.18% 7.30% 4.91% 3.92% 3.32%

The following table from NetAdvantage provides other details from the Income Statement (in millions of dollars):

 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 Revenue 70,235 66,111 60,553 56,434 53,791 51,760 50,098 49,000 45,352 28,203 Operating Income 3,657 3,508 3,300 3,003 3,147 3,676 3,567 3,397 3,125 1,410 Depreciation 1,356 1,272 1,265 1,256 1,209 1,087 973 907 961 430 Interest Expense 474 488 510 557 604 600 648 675 652 267 Pretax Income 1,827 1,748 1,525 290 770 1,973 1,711 1,508 1,129 713 Eff Tax Rate 35.4% 36.2% 37.2% NM 59.1% 37.5% 39.0% 41.6% 43.5% 36.9% Net Income 1,181 1,115 958 -100 315 1,233 1,043 880 638 450

The table below shows the same information, but with the numbers for each year as a percentage of revenues for that year:

 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 Revenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Operating Income 5.21% 5.31% 5.45% 5.32% 5.85% 7.10% 7.12% 6.93% 6.89% 5.00% Depreciation 1.93% 1.92% 2.09% 2.23% 2.25% 2.10% 1.94% 1.85% 2.12% 1.52% Interest Expense 0.67% 0.74% 0.84% 0.99% 1.12% 1.16% 1.29% 1.38% 1.44% 0.95% Pretax Income 2.60% 2.64% 2.52% 0.51% 1.43% 3.81% 3.42% 3.08% 2.49% 2.53% Net Income 1.68% 1.69% 1.58% -0.18% 0.59% 2.38% 2.08% 1.80% 1.41% 1.60%

CORPORATE OVERVIEW (from NetAdvantage): Kroger is one of the largest U.S. supermarket chains, with 2,486 supermarkets as of February 2008. The company's principal operating format is combination food and drug stores (combo stores). In addition to combo stores, KR also operates multi-department stores, marketplace stores, price-impact warehouses, convenience stores, fuel centers, jewelry stores, and food processing plants. Total food store square footage exceeded 145 million as of February 2008.

Retail food stores are operated under three formats: combo stores, multi-department stores, and price-impact warehouse stores. Combo stores are considered neighborhood stores, and include many specialty departments, such as whole health sections, pharmacies, general merchandise, pet centers, and perishables, such as fresh seafood and organic produce. Combo banners include Kroger, Ralphs, King Soopers, City Market, Dillons, Smith's, Fry's, QFC, Hilander, Owen's, Jay C, Baker's, Pay Less and Gerbes.

Multi-department stores offer one-stop shopping, are significantly larger in size than combo stores, and sell a wider selection of general merchandise items, including apparel, home fashion and furnishings, electronics, automotive, toys, and fine jewelry. Multi-department formats include Fred Meyer, Fry's Marketplace, Smith's Marketplace and Kroger Marketplace. Many combination and multi-department stores include a fuel center.

Price-impact warehouse stores offer everyday low prices, plus promotions for a wide selection of grocery and health and beauty care items. Price-impact warehouse stores include Food 4 Less and Foods Co.

KR also operates convenience stores, jewelry stores, and food processing plants. The company's 782 convenience stores offer a limited assortment of staple food items and general merchandise, and, in most cases, sell gasoline. Convenience store banners include Kwik Shop, Loaf N' Jug Mini Mart, Quik Stop markets, Tom Thumb Food Stores, and Turkey Hill Minit Markets. With 394 jewelry stores, the company is one of the largest U.S. jewelry retailers. Jewelry stores operate under banners such as Barclay Jewelers, Fred Meyer Jewelers, and Littman Jewelers. In addition, KR operates 42 manufacturing plants, consisting of 18 dairies, 11 deli or bakery plants, five grocery products plants, three beverage plants, three meat plants, and two cheese plants.

CORPORATE STRATEGY. Kroger aims to increase shareholder value through its dividend program and sustained earnings growth created by strong identical store sales, slight operating margin improvement, and continued share repurchases. At the beginning of 2008, the company held the number one or number two market share position in 39 of its 44 major markets, which consist of nine or more stores. The company strives to grow market share as this allows it to leverage fixed costs over a wider revenue base.

To generate identical store sales growth and market share gains, the company adheres to its Customer 1st strategy. This strategy focuses company efforts on improving employee communications and training; using customer research and loyalty data analysis to personalize stores on a market by market and store by store basis; improving customer loyalty by improving customers' shopping experience (improved convenience and accessibility through multiple store formats, store cleanliness and security, reducing checkout wait times, etc.); and pricing within an acceptable range of discounters' prices so that price becomes a neutral factor in customers' shopping decisions.

As an important part of its merchandising strategy, KR offers about 14,400 private label items. Products are sold in three tiers. Private Selection is a premium quality brand, designed to meet or beat the gourmet or upscale national or regional brands. The banner brand (Kroger, Ralphs, King Soopers, etc.) represents the majority of KR's private label items, and is designed to be equal to or better than the national brand. The Kroger Value brand is designed to deliver good quality at an affordable price. About 43% of corporate brand volume is manufactured in the company's plants.

FINANCIAL TRENDS. In the five years through FY 08, the company experienced a compound annual growth rate (CAGR) for revenues of 6.3%, reflecting increased same-store sales and square footage expansion. As of February 2008, the company was targeting EPS of \$1.83 to \$1.90 for FY 09, up 8% to 12% from operating EPS of \$1.69 in FY 08. To achieve its EPS target, the company expects to achieve identical food store sales growth, excluding fuel sales, of 3% to 5%, and square footage growth of approximately 2.0% to 2.5%. KR expects capital expenditures for FY 09 of \$2.0 billion to \$2.2 billion, excluding acquisitions. The company reduced shares outstanding by 12% between 2003 and 2008. As of February 2008, \$941 million remained under a \$1 billion stock repurchase program that directors approved in January 2008.

Using the information above, answer the following questions. Please interpret statements by management cautiously -- do not take them as automatically true; at the same time, you don't have to ignore them, either.

1. (5 points) Forecast revenues for fiscal year 2009 (ending Jan. 2009). Explain. (Keep in mind that this is not so much a forecast, since it's already mid-December and fiscal 2009 ends Jan. 2009 -- so it's more of an estimate than a forecast!)
2. (10 points) Forecast revenues for fiscal years 2010 through 2012. How would the competitive environment in the retail sector that Kroger operates in affect your forecast of Kroger's revenues? Explain.
3. (10 points) Forecast operating profit margins for 2009 through 2012. Explain.
4. (5 points) How long would you set the forecast period at? What stable growth rate would you assume? What drivers would you use to determine the stable growth rate? Explain.
5. (10 points) What would you infer from the pattern of behavior of depreciation as a fraction of revenue over time?
6. (10 points) Can you make any inferences about Kroger's financial leverage? Is it too high or too low? Explain.
7. (5 points) Quoting David Dillon, Kroger's chief executive, the article tells us that Kroger's strategy of lowering prices, which has reduced its gross margins, "continues to resonate well with customers." Interpret Dillon's statement, in the light of the information in the last table.

2. Research and Development Expenses for Deere and Co., according to the 10K filed by the company, for the year ended Oct. 10, 2007 are as shown below in millions of dollars:

 2007 817 2006 726 2005 677 2004 612 2003 577 2002 528 2001 590 2000 542 1999 458 1998 445

Company Profile (http://finance.yahoo.com/q/pr?s=DE): Deere & Company engages in the manufacture and distribution of products and services for agriculture and forestry worldwide. It operates in four segments: Agricultural Equipment, Commercial and Consumer Equipment, Construction and Forestry, and Credit. The Agricultural Equipment segment offers a line of farm equipment and related service parts, including tractors; combine, cotton, and sugarcane harvesters; tillage, seeding, and soil preparation machinery; sprayers; hay and forage equipment; integrated agricultural management systems technology; and precision agricultural irrigation equipment. The Commercial and Consumer Equipment segment provides equipment, products, and service parts for commercial and residential uses, such as tractors for lawn, garden, commercial, and utility purposes; mowing equipment, including walk-behind mowers; golf course equipment; utility vehicles; landscape and nursery products; irrigation equipment; and other outdoor power products. The Construction and Forestry segment offers a range of machines and service parts used in construction, earthmoving, material handling, and timber harvesting, including backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; excavators; motor graders; articulated dump trucks; landscape loaders; skid-steer loaders; and log skidders, feller bunchers, log loaders, log forwarders, log harvesters, and related attachments. Its products and services are marketed primarily through independent retail dealer networks and retail outlets. The Credit segment primarily finances sales and leases by dealers of new and used agricultural, commercial and consumer, and construction and forestry equipment. It also provides wholesale financing to dealers of the foregoing equipment, provides operating loans, finances retail revolving charge accounts, offers certain crop risk mitigation products, and invests in wind energy generation. The company was founded in 1837 and is based in Moline, Illinois.

1. (5 points) What is the life over which you would capitalize R&D expenses? Use the firm description above. Make any other appropriate assumptions necessary. Explain your arguments.
2. (10 points) What is the capitalized value of R&D expenses that you would put in a revised balance sheet for 2007? Assume that R&D outlays affect cashflows only in the year following their expenditure.
3. (5 points) Is it appropriate to use straight line amortization to amortize R&D? Justify your answer.
4. (5 points) For the year ended Oct. 10, 2007, Net Income was \$1822m. Income of the Consolidated Group before Income Taxes was \$2676m. Interest expenses were \$1151m. Compute Deere and Co.'s operating income after adjusting for the capitalization of Research and Development outlays.

3. (30 points) Answer any three of the following questions:

1. Free Cashflows to the firm is the sum of Free Cashflows to Equity plus Interest payments to bondholders. Is this true or not? Explain.
2. There is no reason to consider changes in cash as part of reinvestment, when computing free cashflow because cash is always nonproductive. That is why we compute reinvestment in short-term capital as change in non-cash working capital rather than simply change in working capital. True or not true? Explain.
3. Figuring out the optimal capital structure of a firm is an integral part of valuation. Explain.
4. When would you use a dividend discount model instead of a free cashflow model?
5. Discounted Cashflow Valuation is unreliable because there are so many assumptions that the analyst needs to make. Relative Valuation, on the other hand, is more definitive and less subject to the whims and biases of the analyst. Do you agree or disagree? Explain your answer

Solutions to Final

1.

1. To estimate fiscal 2009 revenues, we need to estimate first and second quarter revenues and forecast fourth quarter revenues. Third quarter revenues for fiscal year 2009 were up about 9% (according to the article). However, fourth quarter 2008 revenues were up only 2.23% from 2007 revenues. Although Kroger's strategy is to seize market share, this seems not to have worked well towards the end of 2007. Hence, it is not unlikely that the 9% increase for the third quarter was a gradual increase. Under this assumption, I estimated first quarter and second quarter revenue increases over the previous year to be 3% and 5% respectively and the increase for the fourth quarter to continue at 9%, as in the third quarter. Even though the economy is hurting, Kroger's low-cost merchandise seems to be attracting shoppers from other competitors.
With these assumptions, revenues would be 21348, 16946, 17600 and 18786 for the four quarters of 2009. This provides a full-year estimate of \$74,680m. in revenues for Kroger, or a growth in year-to-revenues of 6.33%
2. We have to make some kind of assumption about how Kroger would fare in the current environment. Consistent with the assumptions in part (a), we could assume that Kroger would continue to take away market share from competitors. However, the declining economy may not allow a continued rise in sales at this rate. Hence, I would forecast a growth in annual revenue of 8% in 2010, and 6% in 2011 and 2012. This assumes that the economy will continue to deteriorate in 2010 and 2011, but recover somewhat in 2012. The partial recovery in 2012 is assumed to enable sales increases in 2012 at the level of 2011, rather than at a lower rate.
3. Operating Profit margins over the last four years have been about 5.3%; and in 2008 were 5.21%. Now net income in the third quarter of fiscal 2009 actually fell 6.3% in spite of a rise in revenue of 9%. This must mean a severe drop in net profit margin. Assuming operating revenues also dropped 6.3% for all of 2009 (along with the 6.3% drop in net income for the third quarter), this implies an operating margin of 0.0521(1-0.063)/[(1+0.0633) = 4.59%. Operating profit margins probably will have to drop further in 2010 and 2011 to 4% and 3.8% before recovering somewhat to 4.5%.
4. The length of the forecast period would depend on how long it would take for Kroger to reach equilibrium in its industry. At the moment, we see that Kroger is still taking market share from its competitors. This indicates that Kroger has not reached a stable situation yet. Nevertheless, in spite of increased capital expenditures, we see that Kroger is buying back shares, i.e. reducing its equity. This suggests that Kroger is on the way to a stable situation. I would suggest another 10 years for the forecast period, followed by a stable period. I would use a stable growth rate of about 4%, slightly less than the economy growth rate. This is because Kroger's products are mainly staples and their income elasticity of demand is low. Other drivers (in addition to disposable income) of the company's growth rate would be population, which is probably also not growing rapidly.
5. Depreciation as a percentage of revenue has been lower for the last two years, compared to the four previous years. This is probably consistent with a slow reduction in capital expenditures over time -- or at least a deceleration. This is consistent with Kroger's move towards stability. I would expect Kroger to have a similar level of depreciation, slowly going down even further over time.
6. From the fact that the company is involved in a share buyback program, we may infer that the company feels that the firm is over-leveraged. Since the stock repurchase program is part of a long-term strategy going back to 2003, it's probably not because the directors feel that the shares are undervalued.
7. Gross margins have decreased from the higher levels of 1999-2003; however, since then operating margins have declined much more slowly. Hence it is not clear that Kroger is pursuing a strategy of price reductions as aggressively as Mr. Dillon seems to be suggesting. However, except for the end of fiscal 2008, revenues have steadily increased. On the other hand, in order to evaluate Mr. Dillon's statement, we really need to know how same-store sales have reacted. In the most recent quarter, we do know that they rose about 5.6%, up from 4.7% the previous year. This supports Mr. Dillon's statement.

2.

1. If we're talking about research on alternative models, then the appropriate life to consider would be model life. However, part of the research is probably about improvement of the technology itself. The life of such R&D is probably longer -- perhaps about five years before competitors develop their own technology or adapt Deere's technology or reverse-engineer it. So I will use a life of 5 years to amortize R&D.
2. Under the assumption that 2007 R&D is only to be amortized in the following year (since these outlays only affect revenues in the following year), we have zero amortization of the \$817m. in that year. Hence we amortize the R&D outlays for the five previous years. This gives us a value of the R&D asset of 2164.2m.

 R&D expenses Unamortized portion Amortization Unamortized value 2007 817 1 0 817 2006 726 0.8 145.2 580.8 2005 677 0.6 135.4 406.2 2004 612 0.4 122.4 244.8 2003 577 0.2 115.4 115.4 2002 528 0 105.6 0 2001 590 0 0 0 2000 542 0 0 0 1999 458 0 0 0 1998 445 0 0 0 Total Amortization 624 Value of R&D asset 2164.2

3. We use straight-line depreciation, but it's probably not appropriate if we wanted to actually measure the rate at which the R&D outlays in a given year would cease to affect revenues in the coming years. We would probably use some form of accelerated depreciation.
4. Operating Income is Income before taxes plus interest expenses; this gives us \$3827. Adjusted Operating Income is 3827+817-624 = \$4020m.

3.

1. This is not true because FCFF is not really the sum of all cash flows to equity and debtholders, but rather the cashflows to equityholders of a similar, but unlevered firm. Hence to get FCFF from FCFE, we have to add after-tax interest payments plus increase in net debt.
2. Many analysts do compute reinvestment in short-term capital as change in non-cash working capital. However, this is more a question of convenience. In actuality, cash is necessary for the firm to conduct its business. Consequently, at least some if not all of changes in cash should be considered as part of reinvestment.
3. To the extent that the firm is already optimally levered, we don't need to worry about leverage. Else we have to consider the improvement in the firm's value if it moved from its current capital structure to its optimal level.
4. If the firm is paying dividends and its payout ratio is stable, then a dividend discount model may make more sense than another free cashflow model. The other issue is that if the firm is not paying its free cashflow to equity as dividends, then a dividend discount model would underestimate the true value that the firm could achieve. However, to the extent that there is not a good model for corporate control, this issue is not as relevant.
5. All assumptions that are made in discounted cashflow valuation also need to be made in relative analysis. The only difference is that sometimes these assumptions are made implicitly.