Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

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Fall 2004


Quiz 1


  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.
  4. You must explain all your answers.

1. Define any five of the following terms (5 points each):

  1. Agency Costs
  2. Board of Directors
  3. Golden Parachute
  4. Poison Pills
  5. Super-majority Amendment
  6. Capital Market Efficiency
  7. Bond covenants
  8. Greenmail
  9. leveraged buyout
  10. social costs

2. The following article entitled, "When a Company Pays Others to Short Its Stock," appeared in the New York Times on September 22, 2004. Read the article and answer these questions.

  1. If you define an efficient market as one where all publicly available information is incorporated into prices, would you say that allowing firms like American Capital Strategies to arrange for the shorting of its shares as described in the article would make the market more or less efficient? (15 points)
  2. Why are efficient markets important in ensuring the proper utilization of society's resources by firms? (20 points)

WHO ever heard of a company arranging for others to short millions of shares of its stock, and paying them to do so?

That is what American Capital Strategies is doing. The company, based in Bethesda, Md., invests in small companies and has sometimes been the target of genuine short sellers - people who sell borrowed shares in the expectation that the share price will fall, enabling them to cover the loan with lower-priced shares.

American Capital on Tuesday announced an offering of 11.5 million shares at $31.60 a share. But only 2.5 million of those shares are to be sold by the company. The rest are to be borrowed by the underwriters from public investors and sold short with guarantees from the company that the short sale will be a profitable one for the underwriters.

Over the next year, the 9 million shares will be issued to the underwriters, led by Wachovia Securities and Citigroup and including J. P. Morgan, UBS, A. G. Edwards and Legg Mason.

They will use the shares to repay the borrowings, thus closing out their short positions.

Why bother? Why not just sell the shares directly?

A company executive did not return a telephone call yesterday, but the prospectus for the offering provided two rationales. First, it will make the company's earnings per share look better not to have the extra shares outstanding, even though the company is committed to selling the shares at set prices, which will decline over time to assure a profit for the underwriters.

Second, because American Capital is an investment company, its outstanding debt must not be higher than its equity in the assets, a value that it estimates every quarter. In the past, it explained, it has felt a need to be somewhat conservative in that, because a decline in the value of the assets could push the debt figure over the magic number. At the end of the second quarter, debt amounted to 79 percent of equity; 100 percent was the maximum allowed.

Now the company can allow the debt ratio to rise by borrowing more money, secure in the knowledge that it can "sell" more stock to the underwriters instantly if it needs to do so, by issuing stock to them.

The underwriters will profit by selling the shares short now and keeping the proceeds until the company chooses to issue new shares. Moreover, unlike normal short sellers, the underwriters are protected because the price they must pay for the shares will decline every quarter. The amounts by which the price will decline appear to be based on expected dividends on the shares.

One impact of the transaction is that American Capital's short position will soar. At the last count, in mid-August, the Nasdaq stock market reported that 3.2 million of the 81.2 million shares outstanding had been sold short. That number will rise by 9 million, and could make it harder for other short sellers to borrow shares to bet against the company.

If the underwriters have trouble borrowing shares, however, they can require the company to issue shares to them whenever they want.

Investors in American Capital were attracted by the company's high dividends, which have regularly been raised; the yield is now 9 percent.

Some who sold the stock short have suggested that the dividends are not really paid from profits, but from the company's new sales of stock. This is the sixth offering of shares in the last 12 months; there were offerings in September and November 2003 and in February, May and July of this year.

The company says the share offerings pay for new investments and that its profits more than justify the high dividends.

The share price fell 12 cents, to $31.60, yesterday.

The company estimates the value of its assets, after adjusting for debt, at $19.81 a share, well below the market price for the shares. That estimate is hard to evaluate because the company does not disclose operating results of the companies in which it invests, even though it controls most of the companies.

That results in the possibility - not allowed under accounting rules for normal companies but legal for investment companies like American Capital - that a wholly owned subsidiary could have big operating losses but produce a reported profit for its parent. That profit would reflect the accruing of interest on loans that American Capital made to the subsidiary. A normal company would report the subsidiary's loss as part of its own results, and would get no benefit from interest paid by the subsidiary.

American Capital shares plunged in 2002, when many of the companies in which it invested ran into problems, and the overall stock market was in a severe downturn. Its shares sold for as little as $15.17, and short sellers piled in; the number of shares sold short peaked at 14.2 million in December 2002, as the recovery began. The shares sold as high as $34.91 in February of this year.

Now the short interest is set to soar again. But this time the company will have encouraged the short selling to make its earnings look better.

3. The 10-K filing for Honeywell Industries fiscal year ended December 31, 2003 (filed March 4, 2004) says, under the rubric "Research and Development:" Research and development expense totaled $751, $757 and $832 million in 2003, 2002 and 2001, respectively. The filing for 2000 says: "Research and development costs for company-sponsored research and development projects are expensed as incurred. Such costs are classified as part of Cost of Goods Sold and were $818, $909 and $876 million in 2000, 1999 and 1998, respectively." The 10-K for 1997 says: "Research and development expense totaled $345, $353 and $318 million in 1996, 1995 and 1994, respectively." Research and development expense for 1997 was $349 million

The 2003 10-K filing also says: "The weighted average interest rate on short-term borrowings and commercial paper outstanding at December 31, 2003 and 2002 was 6.81 and 1.23 percent, respectively." Elsewhere, it is disclosed that the company had fixed rate debt outstanding with an average interest rate of 6.45 and 6.51 percent, as of Dec. 31, 2003 and 2002 respectively.

  1. Estimate the value of the research and development asset, as of Dec. 31, 2003. To get full credit, it is important that you explain your assumptions. (20 points)
  2. Operating Income for 2003 has been disclosed as $1,918 million. Compute the adjusted operating income if the company were capitalizing research and development rather than expensing it, as it currently does. (20 points)

Solutions to Quiz 1

1. Definitions:

  • Agency Costs: The term agency costs is often used to refer to the costs incurred by the firm due to the conflicts between management and shareholders, conflicts between shareholders and bondholders, etc. These may be out-of-pocket costs, as well as opportunity costs.
  • Board of Directors: These are elected representatives of the stockholders, who oversee the management of a publicly traded firm and look out for stockholder interests.
  • Golden Parachute: a provisoin in an employment contract that allows for the payment of a lump sum or cash flows over a period of time if the manager covered by the contract loses his/her job in a takeover.
  • Poison Pills: securities, whose rights or cash flows are triggered by hostile takeovers. They are part of anti-takeover strategies.
  • Super-majority Amendment: an amendment requiring a prospective acquirer to acquire more than the 51% that would normally be required to gain control.
  • Capital Market Efficiency: the extent to which information is reflected in stock prices.
  • Bond covenants: conditions in bond indentures that are designed to protect bondholders.
  • Greenmail: the practice of paying-off intending acquirers to avoid hostile takeovers.
  • leveraged buyout: buyouts that are financed to a large extent by debt.
  • social costs: public costs of corporate actions that are borne by society at large, but not necessarily reflected in the firm's private costs.

2. a. An efficient market is defined as one where all publicly available information is incorporated into prices. Certainly by allowing the company itself to sell its own stock short, the incorporation of negative information regarding the company would be speeded up. However, since the company does have superior access to information, one might argue that its short sales should not be anonymous; else liquidity in the stock might dry up, with buyers fearing that they might be trading with the (better informed) company itself. This, of course, would not be good for market efficiency.

Note that one should not confuse the optimality of a company's actions and market efficiency. In this particular case, the company is having underwriters short sell the stock. This will increase the number of shares outstanding. It's as if the underwriters are issuing stock. The company has promised to issue stock to the underwriters at a lower price. Normally the firm issues the shares and the underwriters/investment bankers arrange to sell the stock; in this case, the firm is going to issue the shares afterwards. If this is more expensive for the company, then this is certainly an inefficient way of raising equity. However, that does not make the market less efficient. Market efficiency says nothing about whether a firm is operating optimally -- it only talks about the market price of the stock correctly reflecting the value of the company's activities.

The company is not allowed by regulation to have excessively high debt; the issuance by the underwriters of shorted shares gives the company the freedom to borrow secure in the knowledge that it can issue shares to the underwrites if necessary. In other words, this gambit has allowed the company to work around the regulation. If the regulation is desirable, then the company's actions will be expensive for its current stockholders; if not, the company's actions will be bad for shareholders. Either way, though, as explained above, this says nothing directly about market efficient -- it does have implications for the company's market value.

b. Society's resources can be properly channeled to different activities if there is a way to tell which firms are increasing social value by their activities. If all costs of firms' activities are all borne by them and they get the benefit generated by of all of their activities, we can measure social value generated by the increase in the value of a firm. To the extent that a firm's value is maximized by maximizing stockholder wealth, we can use stockholder wealth as a proxy for firm value. This will be true if stockholders have no incentive to expropriate the wealth of other stakeholders in ways that are costly to the firm as a whole.

Under these circumstances, stockholder wealth maximization is the appropriate goal for managers. However, this is an quantity which is difficult to measure. It would help tremendously if we could replace this with stock price maximization, since stock prices are easy to observe. Management can then be rewarded or punished appropriately. However, using stock price maximization would achieve shareholder wealth maximization only if stock prices accurately reflected the worth of shares of stock. This is where market efficiency comes in.

3. Honeywell's research is in Aerospace, automotive and engineered materials. This research is probably both for the more efficient manufacture of existing products as well as for the development of new products. Typically, one would expect research in this industry to have long-lived impact. Hence, it would not be inappropriate to assume a life of, say, 9 years for R&D (which also happens to be the number of years for which we have R&D data available, assuming that the current year's outlay will start producing results only one year from now). (If sufficient data were available, one might have made an argument for an even longer R&D life.)

a. Under the maintained assumptions, above, the value of the R&D asset, as of the end of 2003 would be $3742.89 million.

b. The adjusted operating income would be $1918 + $751 - $617.44 = $2051.56. (We add back the R&D outlay for this year, then subtract out the amount that would be amortized in 2003.)

Life of R&D


R&D Outlay
Amortized in 2003
Unamortized Balance
2003 751 0 751.00
2002 757 84.11 672.89
2001 832 92.44 647.11
2000 818 90.89 545.33
1999 909 101.00 505.00
1998 876 97.33 389.33
1997 349 38.78 116.33
1996 345 38.33 76.67
1995 353 39.22 39.22
1994 318 35.33 0.00
Total expense for 2003
Total value of R&D asset in 2003

Quiz 2


  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.
  4. You must explain all your answers.

1. You wish to buy a house for $400,000. You have $100,000 with you, but you need to borrow the remainder. Your bank can earn 12% per annum on alternative investments having the same risk as lending to you. If you want to repay the loan in equal monthly instalments over 36 months, what is the minimum monthly payment that the bank will have to require you to pay (10 points)? What is the minimum APR that the bank will have to quote you (5 points)?

You want to reduce your monthly payments over the next three years because you don't expect to have sufficient cashflow over that period. However, at the end of the three years, you expect to come into an inheritance of $200,000. If you commit to a balloon payment of $200,000 at the end of the three years (and an immediate payment of $100,000 from the funds available to you right now), what will your monthly payment have to be for the next 36 months to enable you to buy the house (10 points)?

2. (25 points) You are thinking of buying shares in Skyline Corp. (NYSE: SKY) as a long-term investment. According to Yahoo (http://finance.yahoo.com/q/ks?s=SKY), the annual dividend that SKY has paid over the past year is 72 cents/share. Revenue growth over the past financial year has been 3% per annum, but earnings growth has actually been negative. However, you believe that SKY has much better earnings potential for the future. You look to see what analysts following SKY think, but you find, unfortunately, that there are no analyst reports available for free through Yahoo. Still, noting that most of the stock is held by institutions and a sizeable chunk is held by insiders, you conclude that earnings growth and dividend growth over the next five years will be 10% per annum, and after that it will be about 3 percent per year for the foreseeable future.

The yield on the 10-year Treasury bond, according to Bloomberg (http://www.bloomberg.com/markets/index.html) is 4.09%. According to Yahoo, SKY's beta is 0.67. If the market risk premium over the riskfree rate has been approximately 5.5% over the last 80 years or so, estimate the price of SKY stock today. You may assume that the dividend is paid annually, and that the next dividend is due in just about a year.

Solutions to Quiz 2

1. You need to borrow $300,000. The opportunity cost for the bank is 12% p.a. This is, clearly, an effective annual rate; it’s not possible to interpret it as an APR rate, since no periodicity of flows has been mentioned in connection with these alternative investments. Hence, the effective monthly rate that you need to use to figure out the monthly payments for your mortgage can be found as (1.12)1/12-1, which works out to 0.949% per month. The monthly payment is going to be the solution to . This works out to $9876.62 per month.

Now if you expect to be able to pay $200,000 at the end of the three years, then you have reduced the present value of the monthly mortgage payments by 200000/(1.12)3 or $152,356.05. Hence to find the new monthly payment, we solve . This works out to $5189.97.

2. The required rate of return on your SKY investment will be 4.09 + 0.67(5.5) or 7.775%, according to the CAPM. According to the information available, the dividend next year is going to be 0.72(1.1). This growth will continue for 5 years. The present value of these dividends will be given by the annuity formula as , which works out to $3.83.

At the end of year 6, the dividend per share would be (0.72)(1.1)5(1.03). Using this, we can compute the value as of the end of year 5 of all future dividends as (0.72)(1.1)5(1.03)/(0.0775-0.03) or 25.14. Bringing this back to the present, we get 17.31. Adding this to the $3.83, which is the present value of dividends for the next five years, we get an estimated share price of $21.14.

Quiz 3

Solutions to Quiz 3


Quiz 4


Solutions to Quiz 4