Dr. P.V. Viswanath

 

pviswanath@pace.edu

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Fin 340 Valuation of the Firm
 
 

Spring 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 use any primary information available on the internet; i.e. you may not look at analyses of the companies involved; you may use your textbook.
  4. You must provide the answers on a Word document. Explain, as far as possible, all your answers on the Word document. However, you should also provide an Excel document, where you will provide supplementary information. Make your Excel document easy for me to interpret by explaining and labeling the content of cells.
  5. You must do problems 1 and 2. Of problems 3, 4 and 5, you may do any two in class. The Word and Excel files containing your solutions to the four problems that you do in class should be emailed by the time indicated by the exam proctor to finviswanath@gmail.com as well as uploaded to the digital dropbox on Blackboard. You are required to turn in the additional problem (supplementary submission) by email to finviswanath@gmail.com (Word document and Excel spreadsheet) by the end of the day. Only the problems done in class will be considered for the midterm grade, explicitly. However, if I decide that your solution to the third problem is inadequate, I will subtract ten points from your midterm grade.
  6. Please use the following naming convention for your exam submissions. For the in-class exam files, use firstname_lastname_midterm. For the supplementary submission, use firstname_lastname_supplementary.
  7. You must explain all your answers.
  8. You have up to 2 hours to complete the exam.

1. (20 points) The correlation matrix for the returns on Home Depot (HD), Verizon (VZ) and Delta (DEL) look like this (using monthly return data from January 1990 to September 2005):

 

hd

delta

vz

hd

1.00

0.38

0.17

delta

0.38

1.00

0.20

vz

0.17

0.20

1.00

The variance of monthly returns (and the standard deviations) for the three stocks over the same period are:

 

hd

delta

vz

Variances

0.0076

0.0181

0.0055

Std Dev

0.0873

0.1346

0.0739

Assume that these numbers are correct and compute the variance of returns on a portfolio, composed of 20% investment in Home Depot (HD), 35% in Delta and 45% in Verizon.
What is the standard deviation of returns on this portfolio?

2. (20 points) I regressed monthly returns (from July 1992 to December 2006) on Starbucks Corporation (SBUX: Nasdaq) on returns on the equally-weighted portfolio of NYSE/AMEX/NASDAQ stocks, using Excel. The output I obtained is the following:

Regression Statistics

 

 

 

 

 

Multiple R

0.353609

 

 

 

 

 

R Square

0.125039

 

 

 

 

 

Adjusted R Square

0.119952

 

 

 

 

 

Standard Error

0.109713

 

 

 

 

 

Observations

174

 

 

 

 

 

 

 

 

 

 

 

 

ANOVA

 

 

 

 

 

 

 

df

SS

MS

F

Significance F

 

Regression

1

0.295873

0.295873

24.58025

1.7E-06

 

Residual

172

2.070365

0.012037

 

 

 

Total

173

2.366238

 

 

 

 

 

 

 

 

 

 

 

 

Coefficients

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Intercept

0.018766

0.008605

2.180771

0.030558

0.001781

0.035752

ewretd

0.804807

0.16233

4.957848

1.7E-06

0.484392

1.125223

a) (6 points) What is your estimate of Starbucks’s beta?
b) (7 points) Could you reject the hypothesis (at the 95% confidence level) that Starbucks’s beta is 1.00? That is, its risk is the same as that of the overall market (assuming that CAPM beta measures risk correctly)?
c) (7 points) What proportion of the uncertainty regarding Starbuck’s stock returns is diversifiable? What proportion is unique?

3. (30 points) The 10K filing for Starbucks (filed Nov. 29, 2007) says:
Operating Leases

Starbucks leases retail stores, roasting and distribution facilities and office space under operating leases. The Company provides for an estimate of asset retirement obligation (“ARO”) expense at the lease inception date for operating leases with requirements to remove leasehold improvements at the end of the lease term. Estimating AROs involves subjective assumptions regarding both the amount and timing of actual future retirement costs. Future actual costs could differ significantly from amounts initially estimated. In addition, the large number of operating leases and the significant number of international markets in which the Company has operating leases adds administrative complexity to the calculation of ARO expense, as well as to the other technical accounting requirements of operating leases such as contingent rent.

Elsewhere, the 10K says:
Rental expense under operating lease agreements was as follows (in thousands):

Fiscal Year Ended

 

Sept 30, 2007

 

 

Oct 1, 2006

 

 

Oct 2, 2005

 

 

 

Minimum rentals  retail stores

 

$

527,877

 

 

$

406,329

 

 

$

340,474

 

Minimum rentals  other

 

 

59,286

 

 

 

52,367

 

 

 

43,532

 

Contingent rentals

 

 

50,966

 

 

 

40,113

 

 

 

32,910

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

638,129

 

 

$

498,809

 

 

$

416,916

 

Minimum future rental payments under noncancelable operating leases as of September 30, 2007, are as follows (in thousands) :

Fiscal Year Ending

 

 

 

 

 

 

 

2008

 

$

691,011

 

2009

 

 

671,080

 

2010

 

 

629,696

 

2011

 

 

582,509

 

2012

 

 

526,684

 

Thereafter

 

 

1,915,603

 

 

 

 

 

 

 

Total minimum lease payments

 

$

5,016,583

 

 

The Company has subleases related to certain of its operating leases. During fiscal 2007, 2006 and 2005, the Company recognized sublease income of $3.6 million, $5.7 million and $4.3 million, respectively.

A footnote on p. 19 of the 10K states: In August 2007, the Company issued $550 million of 10-year notes with a stated interest rate of 6.25%. Operating income for the fiscal year ending 2007 was $1,053,945.

a) (15 points) If you were to capitalize the operating leases, what would be the number you’d enter on the liabilities side of Starbuck’s balance sheet for 2007?
b) (15 points) How would you adjust Starbucks’s operating income for the 2007 fiscal year to take into account the implicit financing costs on the operating lease liability?


4. (30 points) You have the following data regarding other firms in Starbucks industry (Special Eateries, Yahoo):

 

Beta

Market Capitalization

Total D/E ratio

 

STARBUCKS CP

1.11

$13.0 B

0.479

SBUX

TIM HORTONS INC.

0.9

$6.4 B

0.41

THI

PANERA BREAD A

0.87

$1.1 B

0.168

PNRA

CARIBOU COFFEE COMP

2.59

$50.9 M

0

CBOU

ORGANIC TO GO FOOD

-0.19

$38.9 M

0.724

OTGO.OB

Assume, now that you do not have Starbuck’s beta (or you don’t trust the number that you have). You decide to use the information regarding betas of the other firms in the industry to infer Starbucks’s stock beta. The problem is that you’re aware stock betas vary with financial leverage and hence you can’t simply look at the average beta of the other firms in the industry. You are, however, comfortable, in assuming that unlevered (i.e. asset) betas are essentially similar for all firms in a given industry.
a) (20 points) How would you use the given information to compute Starbucks’s beta? Assume that the tax rate for all companies is 35%.
b) (10 points) You now have three different beta estimates – one that you just computed, the second equal to 1.11 (from Yahoo) and the third from the regression above. Which of the three do you think is the best estimate of Starbucks’s beta?

5. (30 points) According to Starbucks’s 10K filing, “The credit rating agencies, Moody’s and Standard & Poor’s, currently rate the Company’s commercial paper P-2 and A-2, respectively, and its long-term debt Baa1 and BBB+, respectively.”
Information on http://www.bondsonline.com/Todays_Market/Corporate_Bond_Spreads.php reveals that bondspreads over the comparable Treasury securities are (in basis points, i.e. 1/100 of a percentage point):

1 yr

2 yr

3 yr

5 yr

7 yr

10 yr

30 yr

60

75

90

97

100

107

127

  • Assume an equity beta of 1.1 for Starbuck
  • Assume that the market risk premium is 5.5%
  • According to the WSJ, the yield on 30-year T-bonds (as of March 5, 2008) was 4.6%
  • The yield on 10-year T-bonds (as of March 5, 2008) is 3.69%.

Data from yahoo.com on SBUX’s balance sheet reveals the following:
Number of shares outstanding = 749,763, 000; the price per share as of the close of trading on March 5, 2008 (according to Yahoo) was $18.14.

Year ending

30 Sept 2007

1 Oct. 2006

2 Oct. 2005

Total Current Assets

1,696,487

1,529,788

1,209,334

Total Assets

5,343,878

4,428,941

3,514,065

Total Current Liabilities

2,155,566

1,935,620

1,226,996

Long Term Debt

550,121

1,958

2,870

Other Liabilities

65,086

48,215

16,230

Deferred Long Term Liability Charges

271,736

203,903

166,182

Minority Interest

17,252

10,739

11,153

Total Stockholder Equity

2,284,117

2,228,506

2,090,634

Compute the Weighted Average Cost of Capital that you would use to value Starbucks using the Discounted Free Cash Flow to the Firm model. Assume that the excess of current liabilities over current assets is financed at the cost of equity and that all long-term liabilities are financed at the cost of long-term debt. Make sure to use market values of assets wherever possible.

Solutions to Midterm

1. The variance of returns on the portfolio = (0.2)2(0.0076) + (0.35)2(0.0181) + (0.45)2(0.0055) + 2(0.2)(0.35)(0.38)(0.0873)(0.1346) + 2(0.35)(0.45)(0.2)(0.1346)(0.0739) + 2(0.2)(0.45)(0.17)(0.0873)(0.0739) = 0.0050842. The portfolio standard deviation is the square-root of this, viz. 0.071304 or 7.13%.

2. a. Starbuck’s beta estimate is 0.80
b. No, we can’t reject the hypothesis that Starbucks’s beta is one at the 95% confidence level because the confidence interval includes 1.
c. The R2 is 0.125. Hence 12.5% of Starbucks’s equity risk is non-diversifiable, and the rest is diversifiable.

3. 2. Minimum lease payments after 2012 are 1,915,603, which is about 4 times the amount of the last payment in 2012. Hence, assume that the actual payments after 2012 are divided equally over four years, i.e. from 2013 to 2016, or 1,915,603/4 = 478,900.

The cost of debt is 6.25%; hence we can compute the present values (i.e. as of end of fiscal year 2007).

2008

691,011

650,363.29

2009

671,080

594,451.49

2010

629,696

524,981.64

2011

582,509

457,074.39

2012

526,684

388,960.44

2013

478,900

332,867.35

2014

478,900

313,286.92

2015

478,900

294,858.28

2016

478,900

277,513.67

 

 

3,834,357.48  

Hence the operating leases would show up on the assets side, as well as on the liabilities side as $3,834,357.48 (in thousands)
Since the operating lease payment in 2007 was $638,129, as of the end of fiscal year 2006, the present value of the operating lease liability would have been 3,834,357.48/(1.0625) + 638,129 = 4,246,936.04
The financing cost of the lease liability would have been, then, for 2007, this time times 0.0625, or $265,433.50
The adjusted operating income, therefore, would have been the reported operating income plus the lease financing cost, i.e. 1,053,945 + 265,433.50 = $1319378.50.

4. a. The unlevered betas can be computed using the formula: Unlevered beta = Levered beta/(1+taxrate*(D/E ratio)).

 

Beta

Market Cap (in 000s)

Total D/E ratio

Tot assets
(in 000s)

Unlevered beta

STARBUCKS CP

1.11

$13.0 B

0.479

19227000

 

TIM HORTONS INC.

0.9

$6.4 B

0.41

9024000

0.710619818

PANERA BREAD A

0.87

$1.1 B

0.168

1284800

0.78434908

CARIBOU COFFEE COMP

2.59

$50.9 M

0

50900

2.59

ORGANIC TO GO FOOD

-0.19

$38.9 M

0.724

67063.6

-0.129198966

We can then take a weighted average of the unlevered betas, weighting each firm by the size of its assets.
We have D/E and we have the market cap. Therefore, (D/E)*(Market Cap) = D. Hence total assets equal (1+D/E)*(Market Cap). Now taking the weighted average of the unlevered betas, we get 0.723.

We now leverage the beta back up using the previous formula again, that is:
Levered beta = (Unlevered beta)*[1+taxrate*(D/E ratio)]
This yields a levered beta for Starbucks equal to 0.949

b. The best beta estimate is probably 1.11. The first estimate uses data going back to 1990, so some of that data is probably out-dated. The beta of 0.949 that we just computed assumes that the unlevered betas of all the other firms is the same as that of Starbucks. Some of these firms are very small and specialized and probably do not resemble Starbucks. Hence this beta may not be a good estimate.
The Yahoo beta is estimated using the most recent data and is, therefore, probably the best. However, the betas are really not statistically significantly different from each other.

5. The required rate of return on Starbucks’s equity is 4.6% + 1.1(5.5) = 10.65%; it makes sense to use the riskfree rate on the bonds with the longest maturity, which, in our case, are the 30-year bonds. The spread for Starbucks’s bonds is 107 basis points, since the bonds are 10 year maturity bonds. Hence the required market yield is 3.69% + 1.07% = 4.76%.

Now, Working Capital for the fiscal year ended 30 Sept. 2007 is 1696487 – 2155566 = -459,079. So, if we recompute the balance sheet by moving current liabilities to the left hand side, we’d have “Total Adjusted Assets” = Total Assets – Total Current liabilities or 5343878 - 1696487 = $3,647,391. If we assume that all other long-term liabilities are also funded at the same rate as the 10 year debt, we have $3647391 - $2,284,117 = $904195 financed at the rate of 4.76%, while the remainder, i.e. 2284117 would be financed at 10.65%. However, this measure of stockholder’s equity is book-value.

To get a market value measure we take the number of shares outstanding and multiply by the price per share; this yields = 13.6007 billion. However, our other numbers are measure in thousands, so we write this as 13600701. The total amount financed is $13600701 + $904195 = $14,504,896. Hence the proportion financed at 4.76% is 0.0623 (904,195/14,504,896), while the rest, viz. 0.9377 is financed at 10.65%. Assuming a 35% tax rate, we get a WACC = (0.9377)(10.65) + (0.0623)(1-0.35)(4.76) = 10.18.


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.
  4. You must explain all your answers.
  5. You must attempt question 1. Do any two of the following three questions.
  6. 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.

1. Read the article below and the additional information provided to answer these questions:

  1. (10 points) If you were forecasting Exxon's Capital Expenditures, what would you forecast for 2008 to 2012? Explain your answer fully; take into account as much information as possible.
  2. (5 points) Evaluate critically the article's allegation that Exxon is not spending enough on capital outlays?
  3. (7 points) Let us assume for now that you believe that Exxon is not spending enough (independent of your answer in part b.). What implications would that have for you as an analyst estimating Exxon's share price? Explain in as much detail as you can as to what quantities you would modify in your analysis and cashflow forecast.
  4. (5 points) How would you take into account the information about Chevron's capital expenditures in forecasting Exxon's capital expenditures?
  5. (6 points) What other information would you search for in coming up with a better forecast of Exxon's capital expenditures?
  6. (7 points) How would you incorporate the information in the expenditure breakdown as provided in the Capital and Exploration Expenditure section of Exxon's 10K for 2008 (item A. of the additional information) in evaluating whether Exxon is spending enough or not?

Exxon's Stingy Capital Spending May Haunt It
April 16, 2008; Page B2, WSJ

Exxon Mobil Corp. doesn't make many mistakes. In the often-chaotic petroleum business, its careful budgeting and efficient operations are widely admired.

But Exxon's stingy approach to capital spending -- amid skyrocketing oil prices -- could be a target of second-guessing for years to come. With crude oil hitting a record above $113 a barrel Tuesday, the payoff for extracting more petroleum is enormous. Until very recently, Exxon hasn't been sprinting to win that race.

Consider these numbers. In 2007, Exxon spent 5.3% of revenue on exploration and capital outlays, down from 6.5% in 2003. The actual dollar amounts did increase, to $20.9 billion from $15.3 billion. But they didn't keep pace with Exxon's overall revenue growth, let alone soaring oil prices. Crude climbed to about $92 from $34 a barrel during that period.

Meanwhile, the Irving, Texas, oil giant poured cash into stock buybacks. In 2007, Exxon repurchased $31.8 billion of its shares, up five-fold from the amount acquired in 2003. That activity helped earnings per share. It didn't increase oil output.

Wall Street analysts generally have cheered this financial conservatism, on the notion that big oil companies tend to waste money when they start drilling with too much gusto. But some now wonder if Exxon played it too safe. Benchmark Co. analyst Mark Gilman mutters about the company's "moribund" exploration program.

"Exxon has consistently been the most cost-disciplined of the big oil companies," says Morgan Stanley analyst Doug Terreson. "They most likely believe that the historic rise in oil prices isn't sustainable. Otherwise they would be spending a lot more than they have."

Exxon keeps a tight lid on its internal oil-price forecasts, but analysts say it has acted as if it wants to make sure its spending decisions still make sense in a world of $65 or even $40 per barrel oil. In moderation, such "stress testing" is an essential part of good budgeting. Taken to extremes, it can stifle almost any initiative.

Last month, Exxon finally announced a big boost in drilling efforts. Rex Tillerson, the company's chief executive, said exploration and capital spending for 2008-2012 were being raised at least 20% beyond previous forecasts. That amounts to outlays of more than $125 billion over that five-year period.

Part of the increase simply reflects higher costs for oil projects, Mr. Tillerson told analysts, as boom times send both labor and equipment rates soaring. But he also hinted at greater optimism within Exxon about what projects are worth pursuing. "Some things are moving ahead that we were not as prepared to put in the outlook last year," Mr. Tillerson said.

Exxon officials say they like their competitive position. Current or planned projects range from Greenland to New Zealand. They include a wide mix of conventional oil and gas, heavy oil, liquefied natural gas and deepwater initiatives. Spokesman Gantt Walton calls the company's resource base of 72 billion oil-equivalent barrels "the largest and highest quality in the industry."

Even with the cautious capital spending of recent years, Exxon has added reserves slightly faster than it has drawn them down. But making new projects pay off will take years.

What's more, countries such as Venezuela and Russia have become more assertive about the terms on which foreign oil companies can operate within their boundaries. That's made it harder for companies such as Exxon to roam the globe as profitably as they used to.

"So many places are off limits," says J. Bennett Johnston, a former Chevron Corp. director and senator from Louisiana who runs Johnston & Associates, a political-consulting firm in Washington. He contends that Exxon and other major oil companies are "going about as fast as they can."

Exxon isn't under any obligation to push every dollar of its sturdy profits -- $40 billion last year -- into dubious exploration efforts. But its recent strategy of focusing heavily on share repurchases can't go on forever, either. By some calculations, if Exxon sticks to its current buyback rate, its last share of publicly traded stock will disappear in 15 years.

Exxon's other big alternative could be to use some of those repurchased shares to finance a major acquisition. But at current oil prices, almost any logical target is far more expensive than it was a few years ago.

The company could just wait until oil prices stumble and acquisitions become cheaper. But the way energy markets are behaving, and the way global demand for energy keeps climbing, that could be a long, lonely vigil.

______________

Here is some additional information from various sources:

  1. Information from Exxon's 10K for the fiscal year ended Dec. 31, 2007, issued on Feb. 28, 2008 (Capital and Exploration Expenditures section)
  2. Information from Exxon's 10K for 2007 (Liquidity and Capital Resources Section)
  3. Information on the meaning of upstream and downstream from http://www.maverickenergy.com
  4. Information from Chevron's 10K for the financial year ended Dec. 31, 2007, issued on Feb. 28, 2008.
  5. Sales and Revenue Income for several years (from Exxon's 10K for 2007)

A: From Exxon's 10-K for 2007: Capital and Exploration Expenditures

     2007

   2006

     U.S.

   Non-U.S.

   U.S.

   Non-U.S.

     (millions of dollars)

Upstream (1)

   $ 2,212    $ 13,512    $ 2,486    $ 13,745

Downstream

     1,128      2,175      824      1,905

Chemical

     360      1,422      280      476

Other

     44              130      9
    

  

  

  

Total

   $ 3,744    $ 17,109    $ 3,720    $ 16,135
    

  

  

  

 

(1) Exploration expenses included.

Capital and exploration expenditures in 2007 were $20.9 billion, reflecting the Corporation’s continued active investment program. The Corporation expects annual expenditures to range from $25 billion to $30 billion for the next several years. Actual spending could vary depending on the progress of individual projects.

Upstream spending of $15.7 billion in 2007 was down 3 percent from 2006, mainly due to timing of project implementation and related expenditures. During the past three years, Upstream capital and exploration expenditures averaged $15.5 billion. The majority of these expenditures are on development projects, which typically take two to four years from the time of recording proved undeveloped reserves to the start of production from those reserves. The percentage of proved developed reserves has remained relatively stable over the past five years at over 60 percent of total proved reserves, indicating that proved reserves are consistently moved from undeveloped to developed status. Capital and exploration expenditures are not tracked by the undeveloped and developed proved reserve categories. Capital investments in the Downstream totaled $3.3 billion in 2007, an increase of $0.6 billion from 2006, as a result of new investment in China and higher environmental expenditures. Chemical 2007 capital expenditures of $1.8 billion were up $1.0 billion from 2006 due to increased investment in Singapore and China to meet Asia Pacific demand growth.

____________________

B: Further, in the Liquidity and Capital Resources Section in Exxon's 10K for 2007:

To support cash flows in future periods the Corporation will need to continually find and develop new fields, and continue to develop and apply new technologies and recovery processes to existing fields, in order to maintain or increase production. After a period of production at plateau rates, it is the nature of oil and gas fields eventually to produce at declining rates for the remainder of their economic life. Averaged over all the Corporation’s existing oil and gas fields and without new projects, ExxonMobil’s production is expected to decline at approximately 6 percent per year, consistent with recent historical performance. Decline rates can vary widely by individual field due to a number of factors, including, but not limited to, the type of reservoir, fluid properties, recovery mechanisms, and age of the field. Furthermore, the Corporation’s net interest in production for individual fields can vary with price and contractual terms.

The Corporation has long been successful at offsetting the effects of natural field decline through disciplined investments and anticipates similar results in the future. Projects are in progress or planned to increase production capacity. However, these volume increases are subject to a variety of risks including project start-up timing, operational outages, reservoir performance, crude oil and natural gas prices, weather events, and regulatory changes. The Corporation’s cash flows are also highly dependent on crude oil and natural gas prices.

The Corporation’s financial strength, as evidenced by its AAA/Aaa debt rating, enables it to make large, long-term capital expenditures. Capital and exploration expenditures in 2007 were $20.9 billion, reflecting the Corporation’s continued active investment program. The Corporation expects spending in the range from $25 billion to $30 billion for the next several years. Actual spending could vary depending on the progress of individual projects. The Corporation has a large and diverse portfolio of development projects and exploration opportunities, which helps mitigate the overall political and technical risks of the Corporation’s Upstream segment and associated cash flow.

__________________

C. Extract from website (http://www.maverickenergy.com/history.htm):

All of the oil world is divided into three: 1) The "upstream" comprises exploration and production; 2) The "midstream" are the tankers and pipelines that carry crude oil to refineries, and; 3) The "downstream" which includes refining, marketing, and distribution, right down to the corner gasoline station or convenient store. A company that includes together significant upstream and downstream activities is said to be "integrated".

____________________________

D. Information from Chevron's 10K for the financial year ended Dec. 31, 2007, issued on Feb. 28, 2008:

Capital expenditures for Chevron (as reported in the Consolidated Statement of Cashflows) were $16.678b, $13.813b and $8.701b in 2007, 2006 and 2005 respectively. However, including expensed exploration expenditures, assets acquired and Chevron's share of exploratory expenditures by affiliates, these same numbers worked out to $20.026b, $16.611 and $11.063b respectively for those three years. In fact, under the heading Capital and Exploratory Expenditures, this is what the firm's 10K statement had to say:

Total reported expenditures for 2007 were $20 billion, including $2.3 billion for Chevron’s share of expenditures by affiliated companies, which did not require cash outlays by the company. In 2006 and 2005, expenditures were $16.6 billion and $11.1 billion, respectively, including the company’s share of affiliates’ expenditures of $1.9 billion and $1.7 billion in the corresponding periods. The 2005 amount excludes $17.3 billion for the acquisition of Unocal.

Of the $20 billion in expenditures for 2007, 78 percent, or $15.5 billion, related to upstream activities. Approximately the same percentage was also expended for upstream operations in 2006 and 2005. International upstream accounted for about 70 percent of the worldwide upstream investment in each of the three years, reflecting the company’s continuing focus on opportunities that are available outside the United States.

In 2008, the company estimates capital and exploratory expenditures will be 15 percent higher at $22.9 billion, including $2.6 billion of spending by affiliates. About three-fourths of the total, or $17.5 billion, is budgeted for exploration and production activities, with $12.7 billion of that amount outside the United States.

E. Sales and Revenue Income for several years (obtained from the 10K statement for 2007, in millions of dollars):

2007 2006 2005 2004 2003
Sales and Other Operating Revenue 390,328 365,467 358,955 291252 237,054
Earnings 26,497 26,230 24,349 16,675 14,502
Downstream 9,573 8,454 7,992 5,706 3,516
Chemical 4,563 4,382 3,943 3,428 1,432
Corporate and Financing -23 434 -154 -479 1510
Income from Continuing Operations 40,610 39,500 36,130 25,330 20,960
Cumulative effect of accounting change, net of income tax 550
Net Income 40,610 39,500 36,130 25,330 21,510

2. Investopedia shows you how you can get P/E ratios and other comparative information for firms industry-by-industry. If you follow their procedure for the Apparel Store industry (http://www.investopedia.com/offsite.asp?URL=http://biz.yahoo.com/p/industries.html), you can get comparables data. Assume you are comparing hte price-to-book ratios of the 13 largetst banks in the United States in 2000. The following table summarizes information on all the firms for which Yahoo provides data, excluding those for which data on P/E ratios and Debt/Equity Ratios are listed as NA (not available or not applicable):

Description
Market Cap P/E ROE % Debt to Equity Price to Book Net Profit Margin (mrq) Price To Free Cash Flow (mrq)
Citi Trends
286.82M 20.38 11.089 0.022 2.078 6.226 40.142
Abercrombie & Fitch Co.
6.26B 13.978 31.465 0.027 3.868 17.637 24.796
Wet Seal Inc.
331.94M 15.652 18.662 0.028 2.592 6.799 39.681
Gap Inc.
13.41B 17.388 18.353 0.044 3.132 5.668 17.988
Zumiez, Inc.
592.53M 23.646 19.525 0.048 3.832 9.827 19.914
Cache Inc.
169.71M 44.52 4.255 0.064 1.971 -3.032 NA
Guess? Inc.
3.86B 20.553 34.037 0.082 5.873 10.725 45.025
Foot Locker Inc.
1.98B 38.994 2.146 0.097 0.87 5.735 13.341
Men's Wearhouse Inc.
1.26B 9.011 18.735 0.113 1.551 2.769 27.683
Ross Stores Inc.
4.50B 17.763 27.764 0.155 4.673 5.719 25.014
Stage Stores Inc.
523.05M 11.014 9.719 0.193 1.004 6.691 7.817
Dress Barn Inc.
779.34M 10.419 17.235 0.284 1.534 2.145 60.211
Casual Male Retail Group, Inc.
170.11M 411 1.963 0.32 0.935 0.477 NA
Genesco Inc.
471.23M 73.552 2.054 0.368 1.169 0.695 5.632
Jones Apparel Group Inc.
1.44B 5.69 0.984 0.389 0.717 1.999 -15.339
J. Crew Group, Inc.
2.94B 31.32 133.032 0.891 20.93 6.24 42.092
Tween Brands, Inc.
466.40M 10.426 18.567 0.897 2.386 7.908 7.503
Retail Ventures Inc.
240.75M 5.464 152.795 0.913 1.392 -27.816 NA
Limited Brands Inc.
6.01B 9.328 27.754 1.312 2.748 11.874 6.751
Collective Brands, Inc.
659.07M 15.819 6.087 1.312 0.937 -5.999 35.434
Nordstrom Inc.
7.77B 12.362 43.544 2.239 7.035 8.434 30.229
Apparel Stores
77.73B 15.8 18 0.593 3.44 4.9 57.5
  1. (8 points) In a comparison across firms, what factors affect the PE ratio?
  2. (7 points) How would you rank the following industries in terms of PE ratio - i.e., which would have the highest PE ratio, which second and which third - Cigarettes, Cement, Communication Equipment? Why?
  3. (15 points) The three firms in the above table for which data was not available for Price-to-Free Cashflow were eliminated and a regression of the P/E ratio on the following variables was run for the remaining observations: Market Capitalization, ROE (in %), Debt-to-Equity Ratio, Price-to-Book Ratio, Net Profit Margin, Price-to-Free Cashflow. Consider the results of the regression, as given below, and explain the signs of the coefficients for ROE and Price-to-Book.

    Regression Statistics
    Multiple R 0.575026
    R Square 0.330654
    Adjusted R Square -0.03444
    Standard Error 16.0179
    Observations 18


     
    Coefficients
    Standard Error
    t Stat
    Intercept 26.04142 9.328261 2.79167
    Market Cap (in mils.) -0.00055 0.001238 -0.44228
    ROE % -1.48137 0.893216 -1.65846
    Debt to Equity -3.26532 7.16697 -0.45561
    Price to Book 10.0126 5.448706 1.837611
    Net Profit Margin (mrq) -0.32376 0.933526 -0.34681
    Price To Free Cash Flow (mrq) -0.08211 0.242584 -0.33849

3. a. (10 points) According to Yahoo (http://finance.yahoo.com/q/ks?s=goog), Google's beta as of Dec. 10, 2007 was 1.21. Assume that the market risk premium was 6% per annum. The 10 year T-bond on that date yielded 4.15% (http://finance.yahoo.com/). What is the rate of return that investors should have required then, to invest in Yahoo, according to the CAPM?
b. ( 15 points) The Free Cash Flow to Equity for Google is $1.09b., according to Yahoo (actually, this is Levered Free Cash, as defined at http://help.yahoo.com/l/us/yahoo/finance/tools/research-12.html). This is the cashflow that Google had available to it, in 2006, after it took care of its short-term and long-term investment needs, and after adjusting for payments to and from bondholders. According to some researchers, this could be considered a measure of how much the company could afford to pay out in dividends. Google had, at that time, 312.84m. shares outstanding, and it sold for $718.42 as of the end of trading on Monday, December 10, 2007. If you believe that Google's trading price is correct, what was the implied rate of growth of dividends, assuming that Google would grow at the same rate of growth forever? (Hint: If you use the usual formula to compute the growth rate, you should get a surprising answer.)
c. (5 points) Does your answer make sense? If not, how would you change your assumptions about Google's growth?

4. Research and Development costs for Exxon, as obtained from various 10K statements are provided below:

Year
R&D expenditures
(in mils of $)
2007 814
2006 733
2005 712
2004 649
2003 618
2002 631
2001 603
2000 564
1999 630
1998 753
1997 763
  1. (20 points) Capitalize the R&D expenditures appropriately. What number would you show in Exxon's 2007 balance sheet for the R&D asset?
  2. (10 points) Compute the adjusted operating income for Exxon for 2007. Reported Operating Income (from Yahoo) was 71,879 million dollars.

Solutions to Final

1. a. Given the justifications in b and d below, I see no reason in not believing Exxon's management, which seems to target a growth rate of about 6% in capex outlays over the next five years (for a total of $125b.).

b. It is difficult to conclude one way or the other whether Exxon is spending too little. What is clear is that it has been pursuing a conservative exploration policy -- and that seems to be continued in the near future. If one believes that oil prices are going to stay high, this might seem overly conservative. But given that exploring has been restricted in many oil-rich countries, increasing capex might require a more aggressive M&A in order to acquire greater rights to explore in Africa and Asia. In any case, the greater risk for new investments might justify Exxon's current capital expenditure policy.

c. If I believe that Exxon is not spending enough on capital outlays, then it would affect Exxon's ability to generate revenues and cashflows in the future and would probably affect its growth rate negatively. Hence I would reduce Exxon's valuation.

d. Chevron's capital expenditures were $20.026b, $16.611 and $11.063b for 2007, 2006 and 2005, which indicates growth of 20.5% and 50% for 2007 and 2006 respectively. For 2008, the company expects to increase capital spending by 15%.

Capital and Exploration expenditures for Exxon for 2007 and 2006 were 20,853 million ($3,744 + $17,109) and $19,855 million ($3,720 + $16,135), for a growth rate of 5%. For 2008, the company expects to spend $125 billion over 2008-2012. This indicates a growth rate of about 6% per annum over that five-year period.

In comparison to Chevron, therefore, Exxon's capital spending seems to be anemic.

This is true, even if we only focus on upstream capital outlays, which are the focus of the article. Chevron seems to be keeping the upstream/total Capex constant, meaning that the growth rates for the total capex are the same as the growth rates for the upstream component.

e. I would look at how closely Exxon keeps to its R&D announcements. I would also look more closely at industry dynamics -- if Chevron is outpacing Exxon so much in capex, Exxon may be planning to increase R&D without necessarily broadcasting that fact.

f. There are several pieces of information provided in part A. Upstream capital expenditures actually decreased from 2006 to 2007. This is in stark contrast to Chevron. Even though the 10K explains that this is due to the "timing of project implementation and related expenditures," it is clear that new capex spending in 2007 was not being increased. Further, the statement that "(t)he percentage of proved developed reserves has remained relatively stable over the past five years at over 60 percent of total proved reserves, indicating that proved reserves are consistently moved from undeveloped to developed status" indicates that capex outlays are not accelerating in any way -- they are stable.

2.a. The payout ratio can be written as P/E = (Payout Ratio)(1+g)/(k-g). Hence, it is affected directly by the payout ratio, the growth rate in earnings and the stock's required rate of return. Indirectly, it's affected by all the factors that affect the above-mentioned direct factors, such as, e.g. the stock's beta risk.

b. Cigarettes would have the lowest PE ratio, then cement and then communications equipment, for two related reasons. Cigarettes have a low price elasticity of demand and hence the cigarette industry has a low beta and a low required rate of return. Cement is somewhat more responsive to economy-wide factors, but it probably has a low growth rate of earnings, as well. Communications equipment stocks have a high beta, as well as a high growth rate; hence their PE ratio is highest.

c. ROE has a marginally significant negative coefficient, while Price-to-Book has a positive and significant coefficient. Price-to-Book is affected by the same factors as PE; thus, P/B = (Payout ratio)(1+g)(ROE)/(k-g), while P/E = (Payout Ratio)(1+g)/(k-g). Hence it makes sense for P/E and P/B to be positively correlated. ROE is probably negatively correlated with P/E because it is defined as E/(BV of equity). Hence earnings will enter the P/E ratio negatively (all other things being kept constant), while it will affect the ROE positively.

It should also be kept in mind that this is not a very good regression if the purpose is to estimate the P/E ratio for a particular firm, because the P/B ratio is a quantity that should be thought of as being jointly determined with P/E rather than as an independent variable in such a regression.

3.a. The required rate of return in Google would be, using the CAPM formula, 4.15% + 1.21(6%) = 11.41%

b. Free Cash Flow to Equity per share for 2006 (assuming the calendar year is the fiscal year), using the numbers provided would be 1090/312.84 or $3.484. If we use this as a measure of Google's dividends last year, and assume that Google's dividends are growing at the same rate forever, we would have 718.42 = 3.484(1+g)/(0.1141-g). Solving, we find that 718.42(0.1141) - 718.42g = 3.484+3.484g. In other words, g = 10.87%.

c. It is unlikely that Google will continue to grow forever at a rate of 10.87%. Since the economy as a whole does not grow that rapidly, if Google does grow so rapidly, it will eventually constitute the entire economy! We must, therefore assume that Google will grow very rapidly for a finite number of years, but then grow at a more sedate pace thereafter. It will therefore end up being a large part of the economy but not the bulk of the economy, as would transpire if we assumed a perpetual growth rate of 10.87%.

4. a.

Year R&D expenditures % Unamortized at beg 2007 Amortization for 2007 Unamortized portion at yr end
2007 814 0 814
2006 733 1 73.3 659.7
2005 712 0.9 71.2 569.6
2004 649 0.8 64.9 454.3
2003 618 0.7 61.8 370.8
2002 631 0.6 63.1 315.5
2001 603 0.5 60.3 241.2
2000 564 0.4 56.4 169.2
1999 630 0.3 63 126
1998 753 0.2 75.3 75.3
1997 763 0.1 76.3 0
Total Amortization in 2007 665.6 3795.6

Assuming that the amortization life is 10 years, we amortize 1/10th of R&D expenses every year; further, if we assume that the R&D expenses are incurred at the end of the year, the current year's expenses are not amortized at all. For this year's amortization, we take 1/10th of R&D expenses from 1 yr before, 2 yrs before,…, 10 yrs before. Total amortization for 2007 works out to $665.6, while the total value of the yet-to-be-amortized R&D asset is $3795.6 million.

b. The adjusted operating income for Exxon for 2007 will be 71,879 + 814 - 665.6 = $72,027.4 million.


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