LUBIN SCHOOL OF BUSINESS
Pace University
Fin 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath
Summer 2009

Midterm

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.

1. (15 points) Read the following WSJ article from June 15, 2009 and answer the question below:

We had discussed in class how stock prices would drop when a firm announced an equity issue. In the case of Tom Tom, the company is raising money in two different ways -- one, it is planning to sell a €100 million stake to Cyrte Investments BV; and two, it is planning a rights issue. Would you say that the stock price should drop in this case, as well? Explain.

GPS-Device Maker TomTom to Sell New Shares By DANA CIMILLUCA

TomTom NV, a Dutch navigation-products maker, plans to raise about €430 million ($607 million) by selling new shares to alleviate a heavy debt burden.

TomTom said in a statement late Sunday that it plans to sell a roughly €100 million stake to Cyrte Investments BV, a Dutch technology investor, and Janivo Holding BV, an early investor in a predecessor of the company. It will also tap existing shareholders in a so-called rights issue.

The company is saddled with €1.4 billion in debt following its agreement to purchase fellow navigation firm Tele Atlas for €2.9 billion near the height of the merger boom in 2007. Amid slumping demand brought on by the global recession and increasing competition, investors have grown concerned that the company could violate the terms of its loans.

The proceeds of the share sales will be used to repay debt, the company said. Cyrte and Janivo will end up with a total stake of 8% in TomTom, whose lenders have agreed to relax the terms of its remaining debt.

TomTom's decision to invite investments from sophisticated investors with experience in the sector is aimed at increasing the odds that the rights issue will be well received by other shareholders.

Janivo is the investment vehicle of Holland's de Pont family, which made its fortune in the auto-import business and was an early investor in Tele Atlas. It sold its stake to TomTom for much more than the stake would now be worth.

The new investment is a bet by the family and Cyrte that in spite of current difficulties, demand for the company's navigation services will grow over the long term.

TomTom has been seeking to expand beyond its core market of personal GPS-navigation devices, or portable electronic units that provide maps and directions. It already has a deal with Renault SA to install navigation gear in the French auto maker's cars, and last week it said it will provide software for Apple Inc.'s iPhone.

The investment from Janivo and Cyrte also represents a bet that TomTom will benefit from the broadening use of its products for services such as traffic and weather reports. TomTom's maps are expensive to compile and maintain, making it difficult for new competitors to enter the business.

TomTom reported €213 million of sales in the first quarter, a decline of 31% assuming that the Tele Atlas deal had been completed in the year-earlier period. It had a net loss in the quarter of €33 million.

Investor concerns have hammered TomTom shares, which have recently traded at around €7, down from nearly €70 in late 2007. The stock surged 22% Friday in Amsterdam to €7.48 on enthusiasm over the Apple deal and hopes that the U.S. computer maker will buy a stake in TomTom. A person familiar with the matter said that doesn't appear likely. The share price gives the company a market value of €934 million.

2. (25 points) Answer any five of the following questions:

1. What is the rationale behind paying a firm's management with stock options?
2. How might societal objectives conflict with stockholder objectives?  How are these conflicts handled?
3. True or false: Industry-specific risk cannot be diversified away.  Explain your answer; no credit without explanation.
4. If the beta of a stock is 2, then it's return volatility will be twice the return volatility of the market portfolio. Is this statement true? Explain why or why not.
5. Consider a strategy that buys stocks that have done well in the previous year. According to some studies, such strategies earn an abnormally high return after adjustment for market beta risk. Provide an argument that this is not necessarily evidence against the efficient market hypothesis.
6. Provide two examples of conflicts between firm value maximization and societal value maximization. How might such conflicts be resolved?

3. a. (10 points) You are thinking of buying a piece of art that costs $473,565.20. The art dealer is proposing the following deal: you can take the art home with you today, provided you are willing to sign an agreement that you will pay $50,000/month for the next few months. The one question still to be determined is for how many months you are going to make payments. The art dealer is looking for a return of 1% per month. That seems like a not unreasonable deal to you because at 1% per month, the cost of the loan is more or less what you make on your investments elsewhere. Assuming that this is correct, what would be a fair value for the number of months?

b. (10 points) Subsequently, you realize that the comparison is not really correct because you are taking a risk on your investments and in comparing the return on your investments to the interest rate that the art dealer is charging, you are assuming that the risk is comparable, as well. You feel that you have a lot of assets that the art dealer could lay claim to, if you defaulted on the art loan and so, the art dealer should be willing to lend you the money at a rate that is 1 percentage point less per annum on an effective annual rate of return basis. You also want to spread out the payments over a different number of months. What would your counteroffer be to the art dealer in terms of what you would be willing to pay each month for the next 20 months?

4. You have the following data on end-of-day prices for Ford stock on the NYSE from Yahoo.

1. (5 points) Using this information, what is your estimate of the expected monthly return on Ford?
2. (5 points) What is your estimate of the standard deviation?
3. (5 points) How confident are you about your estimate of the expected monthly return?
4. (5 points) If you used your results to predict the stock price for June 1, 2009, what would that prediction be?

5. Suppose you have estimated the following Fama-French-Carhart (FFC) factor betas:

You have also estimated the average monthly return on the four (FFC) factor portfolios over the last eighty-odd years (as given in the table below). However, you believe that investors are much more risk-averse today and you increase each of the factor premiums by 10 basis points over and above the historical average.

1. (10 points) What is the required rate of return on GE according to the FFC model?
2. (10 points) Your friend Yevgeny believes that the CAPM is a much better model than the FFC model because the FFC is an empirical model, as opposed to the CAPM, which makes sense from a theoretical point of view. Suppose his estimate of the market beta of GE is the same as your estimate and he shares your views on the estimation of the market risk premium? If you believe that GE is currently properly priced, would Yevgeny believe that GE is properly priced, overvalued or undervalued?
3. (Bonus: 10 points) Do you agree with Yevgeny as to the superiority of the CAPM over the FFC model? Explain