Pace University
Fin 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath

Fall 2005
Exam I


  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. Read the following WSJ article and answer the questions below (15 points each):

  1. You could explain what happened at Refco in two ways: one, you could say that there was a corporate governance failure. The corporate structure was not well crafted; this led to conflicts of interests that culminated in Mr. Bennet’s being charged with fraud; two, you could say it was just chance that led to the occurrence of fraud at Refco, in spite of a good governance structure. What do you see in the article that might lead you to decide that one explanation is better than the other?
  2. If you were an internal Refco investigator, looking into the causes of the Refco incident, what information would you look for, to help you distinguish between the two hypotheses?
  3. (Bonus; 10 points) Financial economists often claim that “accounting doesn’t matter,” in the sense that if a change of accounting rules does not lead to a direct change in cashflows, then there will be no impact on firm value. Their argument is that investors will compute the cashflow implications of a firm’s accounting statements, no matter what the stated accounting earnings numbers are. Hence, if the available information remains unchanged, markets will see through any accounting calculations.
    Accountants, on the other hand, often believe that investors use accounting earnings numbers directly. Hence, accounting numbers matter, and two different sets of accounting rules that lead to different accounting earnings computations will lead to the market valuing the company differently, even if the implied cashflow calculation would be the same under both sets of accounting rules.
    The article talks about some financial and accounting manipulations that allowed Mr. Bennett to keep one step ahead of the regulators. (See paragraph beginning, “Mr. Bennett had avoided detection, in part, through a series of transactions …”) Based on the information in the article, would you say that this supports the financial economists’ position or the accountants’ position as described above.

Grant Thornton Expects to Weather Scandal of Client
October 17, 2005; Page C1

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.

  1. (20 points) In the New York Times of Oct. 24, we have the following discussion in an article entitled "How to Slow Runaway Executive Pay" by Gretchen Morgenson. In this article, Mr. Woolard, the former chief executive of DuPont and the current chairman of the New York Stock Exchange's compensation committee says that typically, compensation committees are not independent of the chief executive. As a result, executive pay rockets upwards. As he puts it,
    "The compensation committee talks to an outside consultant who has surveys that you could drive a truck through and pay anything you want to pay, to be perfectly honest," Mr. Woolard says. "The outside consultant talks to the H.R. vice president, who talks to the C.E.O. The C.E.O. says what he'd like to receive. It gets to the H.R. person who tells the outside consultant. And it pretty well works out that the C.E.O. gets what he's implied he thinks he deserves, so he will be respected by his peers."
    In the quote below, he suggests a way to get around this.

    "It starts with an examination of the average pay given to the handful of senior managers running a company's divisions; the chief executive's compensation is then based on a premium set to those pay levels.
    "We took the level of the senior v.p.'s, the people who make very major decisions about the businesses underneath them," Mr. Woolard recalled. "And we asked the outside consultant to make a survey of how other companies pay people at that level, which is not escalating greatly. Then we put a cap on the C.E.O.'s total compensation not exceeding 50 percent of that." The chief executive, therefore, is taken out of the peer-group horse race that propels pay into the stratosphere.

    What do you think of this proposal? Evaluate it critically.
  2. (20 points) What is the rationale behind paying a firm's management with stock options?
  3. (20 points) When is an obligation recognized as a liability according to GAAP? According to the definition, should an operating lease be recognized as a liability and shown in the balances sheet as such?

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.

  1. (10 points) Compute the free cash flow to equity for the years 2004 and 2003. (Hint: Free Cash flow to equity can be computed as Net Income + Depreciation - Change in Non-Cash Working Capital - Capital Expenditures.)
  2. (10 points) You are interested in valuing KMGB stock. Your friend, Hoffa, argues that you should use the free cash flow to equity (FCFE) numbers for the last two years (2003 and 2004) to estimate growth rates in FCFE for the next ten years, then assume an annual growth rate of 5% after that. He says discounting those FCFE numbers will give you a good estimate of the true current value of KMGB stock. Do you agree with his method of estimating FCFE for KMGB stock? Explain why or why not.
  3. (10 points) You just don't have the time to follow the procedure in b. above, because of all the assignments that your professor has given you. So you simply ask your friend to do some analysis. He comes up with an estimate of FCFE for 2005 of $4.5 million. You further assume a growth rate in FCFE of 15% for the next 5 years (until 2010; based on Yahoo information), followed by relatively flat FCFE growth of only 3% per annum thereafter. The stock beta, according to Yahoo, is 1.767. The yield on the Treasury bond maturing in August 2012 is 4.33%. You believe that a good estimate of the market risk premium is 5.5%. Given that there are 8.79 million shares outstanding, what is your estimate of the share price of KMGB?
  4. (10 points, bonus) The price, as of 1:12 p.m. on October 24, 2005 was $7.25. Comment on why there is a difference between the price that you derived in c. above and the current market price.


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.
2004 2003 2002
Net Income 1763 1917 2685
Capital Expenditures 11,767 276 1,361
Depreciation 1,643 1,423 1,391
Current Assets 15281 14969 14732
Cash 974 1490 1235
Current Liabilities 7,258 5,058 5,625
Non-Cash Working Cap 7,049 8,421 7,872
Change in NC WC -1,372 549
FCFE -6,989 2,515

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:

2005 2006 2007 2008 2009 2010 2011
4.5 5.175 5.95125 6.843938 7.870528 9.051107 9.322640564

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.

2006 2007 2008 2009 2010
FCFE 5.175 5.95125 6.843938 7.870528 93.43035
Present Value 4.537543 4.5754 4.613572 4.652063 48.42171

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.