LUBIN SCHOOL OF BUSINESS
Pace University
FIN 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath
Fall 2010

Final

Notes:

• If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
• 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.
• You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
• You must explain all your answers. Answers without explanations may not receive any points.
• All questions are compulsory.
• Question 1 is a take-home question. You may use any existing on-line resources to answer it, but you may not ask any individual on the web or off, for help. I must receive your answer to Q. 1 by email at pviswanath@pace.edu by midnight Wednesday, December 15, 2010.

1. (15 points) Read the following article, "Film financing: Hedge funds say it's a wrap, but should they?" which appeared in the May 2009 issue of Euromoney and answer the questions below. Keep in mind that simplistic answers will not be sufficient. I will be looking to see if you have done any research as well as whether you have thought about the matter. Appropriate quotations from sources will be appreciated; you may want to also look at the article by Edward Fee, “The costs of outside equity control: Evidence from motion picture financing,” Journal of Business, Oct. 2002, vol. 75, n. 4, pp. 681 ff.

1. Why are the banks investing in slates of films rather than in individual films?
2. “Investing in film is a long-term commitment, and banks are notoriously short-term in their judgments.”  Why are banks short-term in their judgments? (Answer with respect to investment in the film industry.)
3. Using the opinions expressed in the article, what would you conclude about the beta of an investment in films?  Do you agree with this?  Why or why not?

Investing in studios' slates of films had become big business for hedge funds and banks over 2005 to 2008 with the two side partnering up to create vehicles. Studios, strapped for cash and keen to offload some risk of flops in return for shares in DVD and TV sales profits, had turned to Wall Street to help them. Deals were put together whereby hedge funds and banks invested alongside the studio in seven to 25 films to be made in the future. About $15 billion is estimated to have been invested in slates of films over the three-year period ending 2008. Merrill Lynch, Credit Suisse, Deutsche Bank, Goldman Sachs, Citigroup and JPMorgan all arranged co-financing deals with studios raising money from hedge funds and private equity firms. Hedge funds such as Dune Capital and Clark Investments also created co-financing vehicles.

Last year, though, the banks started backing out of film financing, with some, such as Citi, pulling out altogether. Gordon Clark of the Movie Portfolio Fund says he is not surprised. A former CFO of a bank, Clark says he knows all too well that Wall Street and films do not always go well together. "Investing in film is a long-term commitment, and banks are notoriously short-term in their judgments. They only started getting in to slate financing deals in 2005 and already they have pulled out."

Clark's firm looks to invest over at least a five-year period. "It can take two years to begin earning revenue from a movie, and then about five to seven years to collect the bulk of the revenue," he says.

Cut!

Breaking commitments halfway through a slate of films is damaging for the studios, which end up without partners, and can be costly for the hedge funds and banks, which might face lawsuits for breach of contract. Instead, Wall Street is trying to find speciality partners who can take over their side of the contract, often at a discount. It is good news for smaller funds with expertise in film financing.

Indeed, Clark says now is a good time to be in film finance. Films tend to do well in both good and bad economic situations and provide a hedge and diversification to investors. "The returns are uncorrelated with markets -- 2009 has been a record year so far for the film industry," he says. "Box office sales in January this year were the highest in any January on record for example."

The hedge funds and banks failed in their investments because of lack of expertise, Clark suggests. "The studios managed to construct the deals on their terms, often including the banks and hedge funds on films that were deemed to have less potential," he says. Sequels to best-selling films such as Spiderman were left out of deal contracts, while less attractive films, such as flop Poseidon Adventure, were included, for example. "People tend to jump in when there is a boom without truly knowing what they are getting into," says Clark. "There was a lack of real understanding but those who have a long-term interest in investing in movies stand to make good returns."

2. Mercer Corporation is an all-equity firm with 10 million shares outstanding and $96 million worth of debt outstanding. Its current share price is $66. Mercer's equity cost of capital is 8.5%. Mercer has just announced that it will issue $370 million worth of debt. It will use the proceeds from this debt to pay off its existing debt, and use the remaining $274 million to pay an immediate dividend. Assume perfect capital markets.

1. (5 points) Estimate Mercer's share price just after the recapitalization is announced, but before the transaction occurs.
2. (5 points) Estimate Mercer's share price at the conclusion of the transaction. (Hint: Use the market value balance sheet.)
3. (4 points) Suppose Mercer's existing debt was risk-free with a 4.54% expected return, and its new debt is risky with a 5.04% expected return. Estimate Mercer's equity cost of capital after the transaction.

3. Garnet Corporation is considering issuing risk-free debt, or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 25%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 35%.

1. (3 points) If the risk-free interest rate for debt is 8%, what is the cost of capital for risk-free preferred stock?
2. (5 points) What is the after-tax debt cost of capital for the firm? Which security is cheaper for the firm?

4. Zymase is a biotechnology startup. Researchers at Zymase must choose one of three different research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable.

1. (3 points) Which project has the highest expected payoff?
2. (4 points) Suppose Zymase has debt of $35 million due at the time of the project's payoff. Which project has the highest expected payoff for equity holders?
3. (4 points) Suppose Zymas has debt of $120 million due at the time of the project's payoff. Which project has the highest expected payoff for equity holders?
4. (4 points) If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agency cost to the firm from having $35 million in debt due?

5. If it is managed efficiently, Remel Inc. will have assetts with a market value of $50.8 million, $101.3 million or $149.3 million next year, with each outcome being equally likely. However, managers may engage in wasteful empire building, which will reduce the market value by $5.3 millino in all cases. Managers may also increase the risk of the firm, changing the probbability of each outcome to 48%, 10% and 42% respectively.

1. (4 points) What is the expected value of Remel's assets if it is run efficiently?
2. (8 points) Suppose Remel has debt due in one year as shown below. For each case, indicate whether managers will engage in empire building, and whether they will increase risk. What is the expected value of Remel's assets in each case?
   1. $41.5 million
   2. $47.9 million
   3. $90.1 million
   4. $97.4 million
3. (8 points) Suppose the tax savings from the debt, after including investor taxes, is equal to 9% of the expected payoff of the debt. The proceeds of the debt, as well as the value of any tax savings, will be paid out to shareholders immediately as a dividend when the debt is issued. What is the expected value of Remel's assets, including the tax savings, for each debt level in part (b)? Which debt level in part (b) is optimal for Remel?

6. On Monday, November 15, 2004, TheStreet.Com reported: "An experiment in the efficiency of financial marktes will play out Monday following the expiration of a $4.10 dividend privilege for holders of Moft Industries." The story went on: "The stock is currently trading ex-dividend both the special $4 payout and Moft Industries' regular 10-cent quarterly dividend, meaning a buyer doesn't receive the money if he acquires the shares now." Moft Industries stock ultimately opened for trade at $27 on the ex-dividend date (November 15), down $4.10 from its previous close.

1. (3 points) Assuming that this price drop resulted only from the dividend payment (no other information affected the stock price that day), what does this decline in price imply about the effective dividend tax rate for Moft Industries? Explain all calculations.
2. (3 points) Based on this information, which investors are most likely to be the marginal investors (the ones who determine the price) in Moft Industries stock? Individual investors; pension funds; or corporations? Explain.

7. You are on your way to an important budget meeting. In the elevator, you review the project valuation analysis you had your summer associate prepare for one of the projects to be discussed:

Looking over the spreadsheet, you realize that while all of the cash flow estimates are correct, your associate used the flow-to-equity valuatino methods and discounted the cash flows using the company's equity cost of capital of 11%. However, the project's incremental leverage is very different from the company's historical debt-equity ratio of 0.20: for this project, the company will instead borrow $80 million upfront and repay $20 milliion in year 2, $20 million in year 3, and $40 million in year 4. Thus the project's equity cost of capital is likely to be higher than the firm's, not constant over time -- invalidating your associate's calculation.

Clearly, the FTE approach is not the best way to analyze this project. Fortunately, you have your calculator with you, and with any luck you can use a better method before the meeting starts.

1. (4 points) What is the present value of the interest tax shield associated with this project?
2. (5 points) What are the free cashflows of the project (not the free cashflows to equity)?
3. (4 points) What is the best estimate of the project's value from the information given?

8. (15 points) Answer any three of the following questions:

1. Name two industries that use very little debt relative to equity? Explain why these firms use so little debt.
2. Explain the underinvestment problem.
3. Explain how dividend capture works.
4. "All firms with the same marginal tax rates have the same tax advantages of debt." Comment.
5. What are the advantages of share repurchases over dividends as a way of returning cash to shareholders?