Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

  Home/ FIN 647/ Exams/  

Fall 2003


Quiz 1

A. Explain the following terms briefly:

1. Marking to Market

2. Agency Costs

3. Capital Market Efficiency

4. Deferred Tax Asset

B. Answer any two of the following three questions briefly – no more than half a page each.
What is the role of stock analysts in corporate governance?
When is an obligation recognized as a liability according to GAAP?
What is the difference between purchase accounting and pooling accounting?

Solutions to Quiz 1

1. Marking to Market: The valuation of trading investments in balance sheets is required to be done at market value, according to GAAP rules. This is called marking-to-market. This ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at market levels each period.
2. Agency Costs: The costs incurred due to agency problems, i.e. conflicts of interest between different stakeholders in the firm, such as management and stockholders, or stockholders and bondholders. These costs could be out-of-pocket costs due to monitoring or compliance with contractual requirements, or they could be opportunity costs, such as the cost of suboptimal actions taken due to inadequate monitoring or due to excessively stringent contractual requirements.
3. Capital Market Efficiency: This refers to the extent to which information is incorporated in market prices of securities, as well as the speed of incorporation of such information.
4. Deferred Tax Asset: Companies that pay more in taxes than the taxes they report in the financial statements create an asset called a deferred tax asset. This reflects the fact that the firm’s earnings in future periods will be greater as the firm is given credit for the deferred taxes.

B. What is the role of stock analysts in corporate governance?
Ans: Stock analysts investigate all characteristics of a stock and all information about it that are relevant for pricing. Even though they may, themselves, not trade in it, for legal reasons, making this information available has two effects – one, it makes the market more efficient; and two, which is more relevant for corporate governance, it brings to light, what may be hidden by management, and what management could do, in order to increase the stock price.

When is an obligation recognized as a liability according to GAAP?
Ans. For an obligation to be recognized as a liability, it must meet three requirements:
a. It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date.
b. The firm cannot avoid the obligation.
c. The transaction giving rise to the obligation has to have happened.

What is the difference between purchase accounting and pooling accounting?
Ans. In purchase accounting, the purchase price is allocated to tangible assets first, and the excess is then allocated to intangible assets; the residual is allocated to goodwill. Goodwill must, then, be amortized over time. In pooling accounting, the book values of the assets of the acquiring and acquired firms are aggregated to create a consolidated balance sheet of the firm. This is no longer a permissible method of accounting for mergers under GAAP rules.

Quiz 2

1. You are trying to value CVS Corporation, a leading chain of drugstores. You have estimate the free cash flows to equity for the firm this year to be $400 million. You anticipate that these cash flows will grow at the rate of 15% a year for the next five years, 10% a year for the succeeding five years, and thereafter at the rate of 5% a year. The firm has a cost of equity of 11% and 400 million shares outstanding.
a. Estimate the total value of equity in CVS.
b. If the stock is trading at $36 today, and you are confident about your free cash flow estimates, where could you have gone wrong, assuming you believe that the current stock price is correct? Explain how you would bring your computations into line with the current stock price.

2. A local finance company quotes a 15% interest rate on one-year loans. So, if you borrow $20,000, the interest for the year will be $3000 with annual interest payments. Because you must repay a total of $23,000 in one year, the finance company requires you to pay $23,000/12 or $1,916.67 per month for the next 12 months. Assume that the payments would be made at the end of each month. What is the effective annual rate? Legally, what rate would have to be quoted (APR)? (Hint: Computing the EAR for this problem will require a trial-and-error procedure; so if you set up the problem and attempt to come up with an answer, I will give you full points for the EAR part.)

Solutions to Quiz 2

1. a. The total value of equity is simply the present value of the free cash flows to equity. The current FCFE is $400 m. Since this is growing at the rate of 15% per annum for the next 5 years, the FCFE at the end of the 5th year is $400(1.15)5. The FCFE at the end of the 6th year is $400(1.15)5(1.1), since the growth rate for the 6th year is 10% per annum. Arguing similarly, we find that the FCFE at the end of the 10th year is $400(1.15)5(1.1)5(1.05). Using the PV of an annuity formula, we can use these figures to find the PV of the FCFE from year 1 to year 5 to be = 2226.89. The PV of the FCFE from year 6 to year 10 works out to = 2323.53. Note that the last factor in this expression accomplishes the discounting to time zero. The PV of the FCFE from year 11 onwards works out to = 7985.85. Summing all these values gives us $12536.27 m. This yields a per share value of $31.34.

b. If the stock is trading at $36 today, and we are confident about your free cash flow estimates, then the only way that the stock price could be right is if the required rate of return were actually lower than the posited 11%. (Remember that estimated growth rates of FCFE are really estimates regarding future FCFE.)

2. The payments are equal to $1916.67 per month for 12 months, while the amount borrowed equals $20,000. Using these numbers and figuring out the implicit discount rate, we find that it is equal to 2.218% a month or an APR of 26.62%. You have to solve the equation 20000 = PV(annuity of 1916.67, no. of periods = 12) to get the 2.218%. The EAR = (1.02218)12 - 1 = 0.3012 or 30.12%

Quiz 3

FIN 647 Advanced Topics in Management Fall 2003
Quiz 3

A. Explain the following terms briefly:

1. implied market risk premium

2. market portfolio

3. marginal investor

4. beta

B. Answer any two of the following three questions briefly – no more than half a page each. Make sure you explain everything.

  1. A stock with a high return variance will have a higher beta than one with lower return variance. True or False?
  2. John holds all his money in manufacturing stocks. A good measure of the risk of his portfolio is the beta of his portfolio. True or False?
  3. Why is beta the right measure of risk in a CAPM world?

Solutions to Quiz 3

A: Definitions

1. Implied market premium: the premium implicit in the pricing of the market portfolio of risky assets today is called the implied market premium.

2. The market portfolio refers to the portfolio of all assets in the economy.

3. The marginal investor: the marginal investor in a stock at a given point in time is the investor that is most likely to be trading the stock at that point in time. This is also the investor whose trading determines the price of that stock at that time.

4. The beta of an asset is the measure of the non-diversifiable risk of that asset. It measures the sensitivity of that asset's returns to changes in the return on the market portfolio.

B.1. A stock with a high return variance need not have a higher beta than one with a lower return variance because a lot of the variance on the first stock could be due to diversifiable risk.

B. 2. John's portfolio beta is not a good measure of the risk of John's portfolio, because John is actually bearing a lot of diversifiable risk, while the beta only measures the non-diversifiable risk of the portfolio. In other words, John's portfolio beta would be a downward biased measure of his portfolio's true risk.

B.3. The beta, which measures the market or non-diversifiable risk of a security is the correct measure of risk in a CAPM world because all rational investors would diversify as much of their portfolio risk as possible (Remember there are no transactions costs.) Hence only non-diversifiable risk is borne by investors.

Quiz 4

Notes: Each question carries 10 points. Do not use more than half a page for each question.

  1. Verizon Communications is engaged in the following business, according to Yahoo:
    Verizon Communications Inc. is engaged in the provision of communications services. Verizon companies are providers of wireline and wireless communications in the United States, with 135.8 million access line equivalents and 32.5 million wireless customers. The Company is also a directory publisher. Its global presence extends to 32 countries in the Americas, Europe, Asia and the Pacific through four segments: domestic telecom, which serves a territory consisting of 135.8 million access line equivalents in 29 states and the District of Columbia; domestic wireless, which provides wireless voice and data services, paging services and equipment sales in the United States; international, which includes international wireline and wireless communications operations and investments in the Americas, Europe, Asia and the Pacific, and information services, which is engaged in print and online directory publishing and is a content provider for electronic communications products and services
    Explain, in no more than a couple of paragraphs, if Verizon should, optimally, have a high debt-to-equity ratio or a low debt-to-equity ratio. Give your reasons. Use bullet points to the extent you can.
  2. Your friend is the logical type. He argues as follows: "Both the debt and the equity of a firm would be riskier, the higher its debt-equity ratio. Since the cost of capital for the entire firm is a weighted average of the costs of debt and equity, it is clear that a firm with a higher leverage ratio will have a higher cost of capital than a firm with a lower leverage ratio." Show why your friend is not necessarily correct.
  3. Why might a bank impose more covenants on a firm than would bondholders on a corporate bond issue?

Solutions to Quiz 4

  1. Verizon Communications is a multi-segment company. Certain of its segments are in mature industries. For example, its domestic telecom industry. The company has a lot of fixed assets across all lines of business, but especially in its land-line service. The high level of fixed assets would allow it to have a high leverage ratio. Furthermore, given the mature and partially regulated nature of this segment, cashflows are relatively secure. Some of its customers also have fixed-term contracts, whereby they pay ahead of time for a month or more; this, too, provides more certainty of cashflows. The worldwide nature of the business also means additional diversification, which in turn means lower cashflow volatility.
    On the other hand, Verizon's cell-phone business is less regulated, and it's a rapidly growing business with new technology that goes obsolete fairly quickly; it's assets, therefore, have a short life, relatively.
  2. Even though the cost of debt and the cost of equity go up with higher leverage, the cost of debt is still less than the cost of equity, and a higher leverage ratio means that the weight placed on the lower cost debt is also going up; hence a higher leverage ratio does not have to mean a higher weighted average cost of capital, in spite of the fact that both the cost of equity and the cost of debt are rising.
  3. A bank can impose more covenants on a firm because the cost of renegotiating covenants is lower. With a bond, the trustee cannot unilaterally negotiate with the firm; he needs approval from bondholders, which can be costly. So even if bondholders want more covenants, they would trade-off the potential wealth expropriation against higher renegotiation costs and lower flexibility.
    It is also possible that newer firms tend to go to banks, rather than to the capital markets. These firms may have higher agency costs, and hence the optimal level of covenants would be higher. According to this reason, there is self-selection of firms who go to banks.