Dr. P.V. Viswanath
Fall 2005 Exams
1. Read the following WSJ article and answer the questions below (15 points each):
Grant Thornton Expects to Weather Scandal of Client
The chief executive of Refco Inc.'s outside auditor, Grant Thornton LLP, said the accounting firm has ample resources to withstand the government probes and investor lawsuits it will face as a result of the brokerage firm's meltdown last week.
"We want to find out exactly what happened," he said. "I think companies are judged, and organizations are judged, by how they deal with these situations, because unfortunately, even with Sarbanes-Oxley [corporate-governance rules], there's no guarantee of catching all fraud. It's how we act in response to this that, I think, proves our character.... It's a difficult situation, but I'm very confident that our reputation will remain extremely strong."
Refco disclosed last week that its chairman and CEO, Phillip R. Bennett, at some point assumed responsibility for paying Refco $430 million of uncollectible debts owed by Refco customers, including some dating back to the late 1990s. The maneuver allowed Refco to show profits by avoiding write-offs.
Mr. Bennett had avoided detection, in part, through a series of transactions that resulted in a Summit, N.J., hedge fund, Liberty Corner Capital Strategy LLC, reflecting his obligations on its own balance sheet. In response to confirmation requests by Grant Thornton, Liberty Corner told the firm the debts were its own. Essentially, a Bennett-controlled investment firm rented the hedge fund's balance sheet. A lawyer for Liberty Corner, Kevin Marino, said the fund and its manager never intended to help in any deception of Grant Thornton, and that Liberty Corner is cooperating with authorities.
People familiar with the matter say Grant Thornton staff accountants raised questions with Refco in late September, during a routine quarterly review, that prompted executives at the futures-brokerage firm to dig into the hedge-fund transactions. The auditors' questions centered on what appeared to be an unusually high level of interest that Liberty Corner owed Refco on a debt that hadn't been closed out, these people said. Refco executives later notified Grant Thornton that the company had hired its own outside advisers to investigate. The inquiry culminated in an October board meeting at which Refco directors confronted Mr. Bennett, who was placed on leave, though Refco said he repaid his debt in cash.
Regulators are sure to press Grant Thornton for an explanation of why it missed Refco's accounting violations for so long. Grant Thornton's 2005 audit report flagged the potential for future problems by noting "significant deficiencies" in Refco's financial-reporting systems, including a lack of qualified personnel to prepare its financial statements.
"The auditors' responsibility is catching material fraud," said Edward Ketz, an accounting professor at Pennsylvania State University. "When you start talking about hundreds of millions of dollars, we expect the auditor to catch the fraud."
Grant Thornton has received inquiries from the Securities and Exchange Commission and the Public Company Accounting Oversight Board related to the Refco matter, people familiar with the matter say. It also has been named a defendant in at least two investor lawsuits against Refco and the Wall Street banks that underwrote Refco's August initial public offering of stock.
Additionally, Refco and Grant Thornton are among the defendants in a lawsuit filed in June in a New Jersey state court by a former Grant Thornton tax client, Joseph Stechler. The lawsuit claims Refco executed options trades to generate artificial losses for a Grant Thorton-recommended tax shelter that the Internal Revenue Service challenged in 2000. The defendants are contesting the suit.
Since Andersen's collapse, regulators and companies have worried that mounting litigation costs could cause another major auditing firm to fail. Grant Thornton, with $729 million in revenue for the year ended July 31, is one of the largest U.S. accounting firms outside the Big Four.
Grant Thornton has had occasional scrapes with authorities. Last year, without admitting or denying wrongdoing, it paid a $1.5 million penalty to settle SEC accusations that it aided accounting violations at former client MCA Financial Corp., a defunct mortgage-banking company. Its brand name also took a hit in 2003 over accounting fraud at Parmalat SpA, a dairy company whose auditors included Grant Thornton's former Italian affiliate, Grant Thornton SpA.
2. Answer question a. in brief, and any one of questions b. or c.
3. KMG Chemicals (Nasdaq: KMGB) reported Net Income of 1763, 1917 and 2685 for the financial years ending July 31 for 2004, 2003 and 2002 respectively (all numbers in thousands, unless otherwise stated)..
Total Current Assets for the same dates were 15,281; 14,969; and 14,732. Cash and Cash equivalents were 974; 1,490; and 1,235. Total Current Liabilities were 7,258; 5,058; and 5,625. Capital Expenditures for the three years were $11,767; $276; and $1,361. Depreciation was $1,643; $1,423; and $1,391.
3. a. Free Cash Flow to Equity can be computed as Net Income + Depreciation - Change in Non-Cash Working Capital - Capital Expenditures. Using this definition, we can compute FCFE for 2004 as -$6.989m. and $2.515m for 2003.
b. FCFE, as we saw in part a. above was negative; this means that there was a substantial drop in FCFE from 2003 to 2004. Using this to predict FCFE to equity for the future in the way that Hoffa suggests would essentially mean that the business has no value. However, it is clear that the reason for the negative cashflow in 2004 is because of the very high capital expenditure figure. This could be because the company was taking advantage of a very profitable project, or it could be that there was a capital expenditure item that could not be spread over several years. Either way, it doesn't make sense to treat the drop in FCFE from 2003 to 2004 as symptomatic of further drops in the future. Hence I would not go with Hoffa's suggestion.
c. Using your friend's estimate of a FCFE for 2005 of $4.5m., and a 15% growth rate in FCFE, the FCFE for the future would work out as follows:
Note that the figure for 2011 is obtained by using the base figure of 9.051107 for 2010 and applying a growth rate of 3%. We then use a Gordon growth model formula to compute the value of the firm as of the end of 2011 as 9.322640564/(0.140485-0.03) or $84.37924m.
This uses an equity cost of capital of 14.0485%, which is derived using the CAPM: 4.33% + 1.767(5.5%), using the information from the problem. The table below shows the present values of the cashflows in the different years (where the number for 2010 includes the actual FCFE in that year of 9.051107 plus the terminal value computed above, of $84.37924m.
Summing up these present values, we get $66.80028, as of the end of 2005; to this, we add the FCFE number for 2005, which we have assumed to be $4.5m. This total is then discounted back to the end of October to get (66.80028+4.5)/(1.140485)(2/12) or 69.755158
Dividing by the number of shares outstanding, we get $8.02.
1. Read the following WSJ article and answer any two of the questions below (15 points each):
Pension Inquiry Shines Spotlight On Assumptions
Labor unions and the government's Pension Benefit Guaranty Corp. want to make sure big companies' pension funds are healthy enough to pay promised benefits to current and future retirees. The Securities and Exchange Commission, on the other hand, is grappling with another question: Did the companies tweak key financial assumptions of these plans to make the companies themselves look more flush?
The SEC, which refers internally to any such maneuvers as "reverse engineering," is probing whether companies had an eye on their shareholders, not their retirees, when they changed some financial assumptions in recent years, according to people familiar with the matter.
Such assumptions are used, say, in calculating the size of a plan's future pension obligations. The SEC's interest in the pension plans has been known for months, and details about the probe, including the focus on the financial assumptions, continue to surface.
A look at some of the assumptions involved in calculating the funding status of the plans at General Motors Corp., one of the companies under review, shows how small changes -- such as a quarter-point increase or decrease in the interest rate used to calculate the total liability -- can change the size of that obligation by billions of dollars. GM estimates that its plans, with about $100 billion in assets, were slightly overfunded at the end of 2004.
GM, which has said it is cooperating with the SEC's probe, declined to comment for this story. Boeing Co., Delphi Corp., Ford Motor Co., Navistar International Corp. and Northwest Airlines also have disclosed SEC inquiries about their pension plans, with some saying their accounting was proper. The agency hasn't accused any company of wrongdoing.
The SEC also is looking at pension-accounting issues that don't involve assumptions but can help burnish a firm's financial statements, the people said. At the same time, the Financial Accounting Standards Board is scheduled to vote tomorrow on whether to take another look at pension-accounting rules. The FASB's existing rules have been criticized as allowing companies to distort their financial performance, and the board may consider stricter standards.
Many assumptions at issue are disclosed in footnotes of the companies' financial statements. On their face, a company's choices are difficult for outsiders to challenge. While an interest rate may look high or low, a company always could argue it made a good-faith estimate. But the SEC is using its subpoena power to dig into the thought processes, to determine if the estimates were made in good faith -- or were results-driven.
That is, did the companies come up with the desired result first, and then figure out which assumptions would get them there?
"The key to whether or not any of these companies will have a problem with the SEC will depend on how they support their pension assumptions," said David Zion, an analyst who specializes in accounting and taxation for Credit Suisse First Boston.
Here are three areas that SEC investigators are looking at:
Discount rate: Companies use discount rates to figure out the present value of things they need to pay in the future. Think of it this way: $1 million in cash 10 years from now is worth less than $1 million in cash today. How much less? Well, that's where the discount rate comes in.
To place a current value on future pension payments, companies typically look to prevailing interest rates for high-grade corporate bonds. The way the math works, the higher the discount rate, the lower the current value of the future liability -- and the better funded a plan would appear.
"A small change in the discount rate can make a big difference in whether you look well-funded," said Jack Ciesielski, a Baltimore-based expert on pension accounting who provides research to institutional investors. And thanks to the quirky current accounting rules, changes in the rate may have generated accounting gains that boosted net income.
Many auto makers, including GM and Ford, have lowered their discount rates in the past several years, as interest rates have fallen. GM's discount rate in 2004 was 5.75%, down from 7.8% in 1999, in line with a portfolio of bonds rated double-A by Moody's Investors Service Inc., according to GM. Each year the discount rate has decreased, GM's liability and annual pension expense have increased. GM's financial filings note that a 0.25% decrease in its discount rate would increase its annual pretax pension expense by $160 million and raise its pension-benefit obligation by $2.3 billion, according to financial filings.
Scott A. Taub, the SEC's deputy chief accountant, said companies need to be able to justify the chosen discount rate. "What would trouble me in terms of selection of the discount rate is if a company selected or changed its discount rate in an attempt to manage earnings," he said.
Expected rate of return: Under accounting rules, companies use an expected, or assumed, return on pension assets, rather than an actual return, to help smooth the impact of market swings on their pension plans' value in their financial statements. If actual returns turn out to be greater, or lower, than the expected return, the effects are filtered into the annual pension expense over a period of years.
At GM, a 0.25% increase in the expected return on assets lowers the company's pension obligation by $220 million, according to its financial filings.
From 1999 through 2002, GM assumed an expected return of 10%, and it has assumed 9% since then. Actual returns have varied, from 18.1% in 1999 to negative 7.3% in 2003. The company's average rate of return over the past 15 years has been about 9%, according to GM.
The FASB may consider requiring companies each quarter to adjust a plan's assets and liabilities on their balance sheets to "fair value," eliminating the smoothing technique.
Health-care inflation: In estimating a company's liability for health-care benefits to current and future retirees, companies must estimate health-care inflation. Companies are supposed to take into account recent experience and trends, according to SEC officials.
As of December, GM, which is the nation's largest private provider of health care, used 10.5% for its current inflation rate and 5% for a longer-term rate, according to its financial filings. Small changes mean big swings: A one-percentage-point increase in the health-care trend rate would increase GM's liability for these benefits by $8.4 billion and increase the annual expense by $543 million, its filings show. A decrease of similar size would shrink the liability by $7 billion and the expense by $384 million.
SEC investigators want to know if companies at some point in the past may have used an artificially high health-care liability figure, then subsequently reduced it, a reduction that would have had the effect of boosting earnings.
2. (10 points each) Shown below is a regression of the return on GM stock against the return on the NYSE composite, using price data from Moneyline (Note: dividends have not been factored in.) Answer the questions below using the information from the regression analysis:
3. (10 points each) Answer any three of the following questions:
1. a. I would figure out the beta of the payouts, first. That is, I would need to know how the payouts would vary if market conditions changed. For example, if it is true that there would be more people retiring in a down market (maybe fuelled by GM's layoffs in such a situation), the beta of the payouts would be negative. Once I have the beta, I would multiply it by the market risk premium and add the riskfree rate to it. This would give me the correct discount rate to apply to the expected payouts to get the present value of the payouts. As far as the riskfree rate is concerned, since this is a longterm "project," I would use the 10-year Treasury bond yield.
Insofar as estimating the beta, I would use scenario analysis. Alternatively, I could look at the covariance between payouts on GM's pension plan in the past with the return on the market portfolio. See part b. for an alternate approach.
b. There is no reason to believe ex ante that the risk is diversifiable. For example, in the scenario above, the risk would not be diversifiable. The standard approach seems to assume that the promised amounts are fixed ex-ante, and therefore, what we have is essentially a debt obligation of the company. However, since pension payments get priority, they would be compared to a high-grade bond of the company. In this case, however, the risk is not considered diversifiable, since corporate bankruptcy risk is likely to be correlated with market movements.
c. If markets are efficient, there should be no market reaction, since there is really no new information.
2. a. Since the estimated beta is 1.3801, I would expect GM to go up by 1.3801(1%) or 1.3801%. Therefore, the best estimate of GM's price would be 24.5(1.013801) or $24.838
b. The lower and upper 95% confidence intervales are 0.8452 and 1.915; this means that the likelihood that the true beta is beyond these limits is only 5%. Hence it is unlikely that the true beta would be as high as 3.5.
c. The R2 of the regression is 0.3150. Hence 31.5% of the variance of returns on GM stock can be explained by market movements.
d. We have to look at the intercept minus (1-beta)(riskfree rate); if this is positive, it means that the stock outperformed the market, after adjustment for risk. This quantity works out to -0.0111-(1-1.3801)(0.005) = -0.0092, which is less than zero. Hence GM did not outperform the market.
3. a. If Mitsubishi Motors had a different risk/beta profile than the rest of DaimlerChrysler, it would not be appropriate to use a historical beta, which would include the effect of Mitsubishi Motors, for the future. However, one could argue that both are auto companies, and hence the historical estimate can be used.
If the Mitsubishi Motors segment has a higher beta than the rest of DaimlerChrysler, then using the historical beta would mean that we would be using a higher beta estimate for DaimlerChrysler's capital budgeting decisions than would be appropriate. In this case, we would be setting too high a hurdle rate, and we would be rejecting projects that should be accepted.
b. False; a stock with a lower beta could have a higher return variance if it had a lot of diversifiable firm-specific risk.
c. You should take the five year T-bill rate and add to it the beta of hte fund times your estimate of the market risk premium. This is the hurdle rate that you should use.
d. We know that Var(Ri) = beta2Var(Rm) + Var(idiosyncratic risk). Furthermore, R2 = [beta2Var(Rm)]/Var(Ri). Hence, in this case, we have the R2 of the regression equal to 0.5.
1. Define, in brief, four of the following terms (20 points):
2. Read the following article, "UsingCredit Markets: Holders of Corporate Bonds Seek Protection From Risk" from the Wall Street Journal of Dec. 17, 2005 by Christine Richard and answer the questions below:
Bond covenants, which disappeared from the investment-grade corporate-bond market for more than a decade, and other terms aimed at protecting bondholders are making a comeback.
After months of being on the losing side of shareholder-friendly actions -- such as leveraged buyouts, mergers and acquisitions, asset sales, special dividends and stock buybacks -- bondholders are demanding that they be compensated for the risk corporations will continue to reward shareholders at their expense.
"It's happening one company at a time, but it's building, and at some point it will become systemic," said Andrew Harding, chief investment officer of fixed income at Allegiant Asset Management.
But, bondholders have begun to seek shelter.
Recently, Laboratory Corp. of America included a last-minute covenant in its $ 250 million bond sale requiring it to buy its bonds at $101 if there's a change of control and the company's credit rating is subsequently cut to junk.
The medical diagnostics company is rated Baa3 by Moody's Investors Service and triple-B by Standard & Poor's. That's already close to the bottom of the investment-grade spectrum. The company's use of proceeds -- to help fund a recently announced $500 million stock-repurchase plan -- didn't make bondholders feel any more secure. While the rating agencies affirmed LabCorp's debt on the buyback announcement, investors saw further risks.
The company has appeared on a number of lists that regularly circulate on Wall Street highlighting potential candidates for a leveraged buyout based on a variety of financial metrics. But, that it would be required to include change- of-control covenant language took some off guard, including the company.
"We were surprised that some of the prospective bondholders asked us if we would put that clause into the bond," said Brad Smith, executive vice president of corporate affairs at LabCorp.
Mr. Smith said that the company has publicly stated in the past that it intends to maintain investment-grade credit ratings.
He said he believed the request reflected "a more generic concern of bondholders rather than a specific concern about the company."
While covenants are common in the junk-bond market, they've been nearly unheard of in the investment-grade market since the leveraged-buyout bonanza of the late 1980s, which culminated in the hostile takeover of RJR Nabisco, noted Martin Fridson, publisher of Leverage World.
"But now companies are getting downgraded as the result of change of control, the private-equity market has been very active, and there's renewed caution," he said.
The diverging fortunes of Georgia-Pacific Corp. bondholders following the announcement that it was being acquired by Koch Industries Inc. appears to have been a final straw for the market, said Mr. Fridson. While Koch has an issuer rating just shy of triple-A, it said it wouldn't guarantee the bonds, causing securities without safeguards to drop $12 on a face value of $100.
"Those who didn't have covenant protection were left hanging," said Mr. Fridson.
Bondholders were well attuned to that risk when diversified paper company Temple-Inland Inc. came to market several weeks later.
That company was required to provide a special provision on its sale of $500 million of bonds by investors who feared that interest in Temple-Inland by shareholder activist Carl Icahn could lead to higher leverage in a move to boost the company's share price.
The provision kicks in if the bonds are downgraded to junk. It requires the company to give investors an additional 0.25 percentage point every time Moody's or S&P downgrades the bonds by one notch. The increase was capped at two percentage points.
3. Answer the following questions (15 points each):
4. (20 points) Sento Corporation, which is a global provider of call and contact center solutions for customer service, had a net loss of $25 in the fiscal year ending March 2001 (all figures in '000s unless otherwise stated). It had depreciation of $1204 and capital expenditures of $2995. Its current assets were $8181 and its current liabilities were $4523. Its revenues for the same period were $26104. Assume that Sento's revenues have been growing at the rate of 10% since 1999 and that Sento has been maintaining its working capital at the same ratio to revenue from 1999 to 2001 (inclusive). In the year ending March 2001, Sento had debt of $2,571 and Total Assets of $12,142. Assume that Sento intends to maintain the same debt-ratio for the next few years. How much could Sento afford to pay in dividends during fiscal year 2001?
4. Working Capital in fiscal 2001 is $8181 - $4123 = $4058; since the ratio of Working Capital to Revenue is being maintained and revenue has increased 10%, working capital must have increased 10%. Hence Working Capital last year must have been 3658/1.1, and hence the increase in working capital = 3658 - 3658/1.1 = 332.55.
The debt-equity ratio is 2571/12142 = 0.2117. Hence the amount that can
be paid out in dividends = FCFE = Net Income - (Capital Expenditures -
Depreciation)(1- Debt Ratio) - change in Non-cash Working Capital (1-Debt
Ratio) = -25 - 332.55(1-0.2117) - (2995-1204)(1-0.2117) = -$1698.9, which,
of course, means that no dividends can be paid.