LUBIN SCHOOL OF BUSINESS
Fin 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath
1. Read the following WSJ article and answer the questions below (15 points each):
Grant Thornton Expects to Weather Scandal of Client
By JONATHAN WEIL, Staff Reporter of THE WALL STREET JOURNAL
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.
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.
|Non-Cash Working Cap||7,049||8,421||7,872|
|Change in NC WC||-1,372||549|
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.