LUBIN SCHOOL OF BUSINESS
Pace University
Fin 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath
Fall 2007
Midterm

Notes:

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 any two of the questions below (10 points each):

1. Honeywell and 3M were down 4.6% and 6.5%, much more than Caterpillar, which dropped 3.5%. If this was the only information you had to go by, what would you say about their market betas?
2. Is there any other information in the article that would cause you to be cautious about the inference in part (a)? Explain.
3. Based on what you know of the businesses that McDonald's, 3M and Caterpillar are in, what can you say about their betas?
   3M Company (3M) is a diversified technology company with a global presence in various businesses, including industrial and transportation, healthcare, display and graphics, consumer and office, safety, security and protection services, and electro and communications.
   Caterpillar Inc. operates in three principal lines of business: Machinery, Engines and Financial Products. Machinery deals with the design, manufacture, marketing and sales of construction, mining and forestry machinery.
   McDonald's Corporation primarily franchises and operates McDonald's restaurants in the food service industry. These restaurants serve a varied, yet limited, value-priced menu in more than 100 countries around the world.

The Dow’s Three Stooges
Posted by David Gaffen, October 19, 2007, 10:55 am

It’s an earnings-driven breakdown on the Dow Jones Industrial Average today, as three of the four components that reported prior to today’s opening were responsible for a good chunk of the losses on the 30-stock average in the morning.
3M, Honeywell and Caterpillar are leading the charge lower.

Stocks are continuing to sink, reacting to the brief bump-up in oil over $90 a barrel and another bout of weakness in the U.S. dollar as investors continue to express concern over the possibility of sluggish economic growth, but with dollar-induced inflation from overseas. Industrials are leading the major indexes lower, as the Morgan Stanley Cyclicals Index is off 1.9%.

“Because the risks are not fully known as yet, a lot of attention is being paid to forward guidance that is murky, and I think if a company gives murky guidance the market is not giving it benefit of the doubt,” says Alan Gayle, director of asset allocation at Trusco Capital Management.

Among those issuing clouded guidance was industrial equipment giant Caterpillar, which was down 3.5% % after the company missed expectations and lowered forthcoming guidance. Fellow components Honeywell and 3M are worse, falling 4.6% and 6.5%, respectively, as the latter said it would be slowing its pace of stock buybacks.

Combined, the three stocks account for 96 points of negative drag on the Dow, with 3M’s massive drop making up 50 points of that fall-off. The lone earnings reporter to buck the trend was McDonald’s, which was off fractionally, contributing little to the Dow’s move.

2. I collected (using a program written by Michael Kishinevsky) price data on McDonald's (MCD) and the NYSE Composite Index for the period Oct. 2002 to Sept. 2007, and then computed returns on the MCD and the NYSE Index. I then regressed MCD returns on NYSE returns and obtained the following output.

Answer the following questions using the information above:

1. (5 points) What is McDonald's beta according to this regression?
2. (10 points) How closely does McDonald's move with the market? Are you surprised? What piece of information from the regression are you using to answer this question?
3. (10 points) Can you reject the hypothesis that McDonald's beta is one? Explain.
4. (10 points)

Subsequently, I ran another regression, this time using data for the second half of the period. The results are given below:

Regression Statistics
Multiple R	0.634874
R Square	0.403065
Adjusted R Square	0.380956
Standard Error	0.03953
Observations	29
ANOVA
	df	SS	MS	F	Significance F
Regression	1	0.028488	0.028488	18.23106	0.000216
Residual	27	0.04219	0.001563
Total	28	0.070678
	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	0.005243	0.008339	0.628723	0.534814	-0.01187	0.022353
0.01798	1.448386	0.339218	4.269784	0.000216	0.752369	2.144403


What is your estimate of McDonald's beta from the new results for the second-half of the subperiod? How different is it from your answer in (a)? Can you explain the size of the discrepancy (if it's large, explain why, and if it's not large, give the reason why it's not large).

3. 3M Company operates as a diversified technology company. It operates in six segments: Industrial and Transportation; Health Care; Display and Graphics; Consumer and Office; Safety, Security, and Protection Services; and Electro and Communications. It's market capitalization is $62b. and its beta is 0.8, according to Yahoo. The table below gives the proportion of sales contributed by each segment, according to the 2006 10-Ks filed by the company in February 2007.

You have the additional information re other firms in the Security and Protection Services industry (Source: Yahoo):

1. (10 points) Compute the market value of assets for each of the firms in the table above.
2. (10 points) Use the numbers computed in (a) to estimate the asset beta for the Security and Protection Services sector (assuming these four firms are representative of the industry)
3. (10 points) Use this information to estimate the beta of the rest of 3M (other than the Security and Protection Services segment).
4. (10 points) Suppose you now believe that due to structural changes in the economy, the asset beta of the Security and Protection Services sector needs to be raised by 20%. Estimate the new beta of 3M.

4. (10 points) Answer any three of the following questions in no more than half a page each.

1. Is it good to make insider trading illegal? Can you think of reasons why insider trading should be made legal?
2. The uncertainty regarding a firm's returns that is unrelated to the market is called idiosyncratic risk. The uncertainty regarding a firm's returns that is related to the market is called systematic risk. The sum of idiosyncratic and systematic risks is called the total risk and is equal to the variance of the firm's return. Consider the proportion of a firm's returns that is accounted for by systematic risk. Would this proportion be higher for smaller firms or larger firms? Why?
3. Why does the Board of Directors not always function well to control the CEO's activities?
4. Would a geometric average of historical returns a better forecast of future returns if investors have a long-term horizon or would an arithmetic average be better?
5. Why is the beta the more appropriate measure of risk of an asset, rather than its return variance?
6. When is regression inapproriate to estimate a firm's beta?

Solutions to Midterm

1.

1. It looks like this is a market-wide slowdown. Hence, I would say that Caterpillar, Honeywell and 3M, all had large betas, with their magnitudes in that same order. If we can interpret the Morgan Stanley Cyclicals Index as a measure of what's happening to the market overall, we'd have betas of 3.5/1.9 (= 1.84), 4.6/1.9 (=2.42) and 6.5/1.0 (=6.5), overall.
2. There are some cautions in interpreting these numbers as betas. Since the slowdown, apparently, is due to the drop in the dollar and increase in oil prices, stock price declines would be related to how exposed the firms were to exchange rate risk and how dependent they were, directly or indirectly, on oil. Further, if the downturn is earnings driven, perhaps some of the firms with very steep declines are those that had unexpectedly low drops. For these firms, the beta, as measured above, might be too high.
3. Firms and industries producing capital goods and consumer durables are usually hard hit by recessions. Two factors explain this:
   * Postponability – Within limits, purchases of durable goods can be postponed. During recessions, producers frequently delay the purchase or more modern production facilities and the construction of new plants, whereas in good times, capital goods are often replaced before they completely depreciate. Similarly, during recessions, households often delay the purchase of big-ticket items, including automobiles, white goods, and so on.
   * Monopoly Power – Many industries producing capital goods and consumer durables are found in high concentration, i.e. a small number of large firms dominate the market. These firms can set above-competitive prices to increase their profit. When recession hits, these firms are reluctant to lower prices since this would upset the industry price structure, possibly sparking a price war. This reluctance means that the initial effects of a drop in demand are primarily a decline in production and an increase in employment.
   If we use this perspective, we see that Caterpillar's profits would fluctuate a lot more with the business cycle than McDonald's. 3M's products cater partly to businesses and partly to consumers and hence they would be in an intermediate position. Hence, we'd expect Caterpillar to have the highest beta, followed by 3M and then McDonald's. According to Yahoo, 3M has a beta of 0.8, while Caterpillar has a beta of 1.69, and McDonald's has a beta of 1.74. Of course, this analysis ignores the other characteristics of the goods, themselves, as well as the debt/equity ratios. McDonald's has a D/E ratio of 0.542, while Caterpillar and 3M have debt/equity ratios of and 3.189 and 0.477 respectively. This partly clarifies the picture, but the high beta of McDonald's is still unexpected, if we think of McDonald's product as a necessity. It is possible that competition for low-margin staple foods has transformed the fast-food industry into a primarily high-margin, non-necessity producing industry.

2.

1. McDonald's beta is 1.407973, according to the regression.
2. The R-squared tells us how closely McDonald's moves with the market. The R-squared here, is 38.84%; that is, 38.84% of the variance in the return on McDonald's can be explained by market movements. It is not particularly huge.
3. The standard error of the beta is 0.234014; hence the estimated beta is (1.407973-1)/0.234014 or 1.74 standard deviations larger than a beta of one. The chances of getting an estimated beta this large, if the true underlying beta were 1 is less than 10%; hence one could reject the null hypothesis of a unit beta. Under other assumptions, it would be even easier to reject a unit beta.
4. The beta in the second period is very similar to the beta in the overall period from Oct. 2002 to Sept. 2007. This suggests that McDonald's did not change its operations too much between the first period and the second period.

3.