Dr. P.V. Viswanath

pviswanath@pace.edu

Exams

LUBIN SCHOOL OF BUSINESS
Pace University
Fin 647 Advanced Topics in Financial Management
Spring 2005
Prof. P.V. Viswanath

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.
5. Assume a tax rate of 40% where not provided.

Midterm

1. (10 points each) Read the following article and answer the questions below:

a.       How could Miguet force creditors to make concessions?  Don’t creditors have an iron-clad contract whereby the company has to pay them a coupon and bond face value?
b.      We learnt in class how difficult it is for shareholders to control the Board of Directors of a company.  How did shareholders managed to vote out Eurotunnel’s Board, according to you?  Use the information in the article and any other information provided below. 

According to the Eurotunnel website, http://www.eurotunnel.com/ukcMain/ukcCompany/ukcInvestorRelations/ukcShareholderInfo/ukpShareholderAnalysis, as of Dec. 31, 2003, 6% of Eurotunnel’s shares are hold by banks, 29% are held by institutions and 65% are held by individuals.

According to the Eurotunnel website, there was 6.4billion euros of debt, as of 12/31/03.  Of this, 0.4b was senior debt, 4.5 was junior debt, 1.5 billion consisted of Participation Loan notes, while equity consisted of 1.1b euros.

The share price, as of  March 13, 2005 was 0.24 euros. 

Eurotunnel's Board Is Ousted by Shareholders
Jo Wrighton and Greg Keller. Wall Street Journal. (Eastern edition). New York, N.Y.: Apr 8, 2004. pg. A.6

PARIS -- Creditors of Eurotunnel, the struggling operator of the underwater "Chunnel" linking Britain and France, are bracing for tough negotiations with new management after the unprecedented ouster of the European company's two top executives and the rest of its board by a shareholders' revolt.

French politician and publisher Nicolas Miguet rallied shareholders around his own team of directors, promising to defend small investors and force creditors to make concessions in the restructuring of Eurotunnel's debt of GBP 6.4 billion ($11.8 billion), much of which is now held by hedge funds.

Mr. Miguet's campaign struck a chord with Eurotunnel's 1.1 million, mainly French, small investors whose shares have plummeted in value. At a shareholder meeting in Paris, 63% of investors voted to oust Chairman Charles Mackay, Chief Executive Officer Richard Shirrefs and the rest of the Eurotunnel board. They also voted for a new team of directors, including Jacques Maillot, former head of travel agency Nouvelles Frontieres, who is expected to become Eurotunnel's new chairman.

The move marked the first time shareholders tossed out the management of a listed company in France.

But while shareholders celebrated -- Eurotunnel shares rose 7% on the news in Paris -- creditors warned they won't give much ground to stockholders. The company has a market capitalization of GBP 1.4 billion, just one-fifth of debt outstanding.

While the new management has yet to detail its restructuring plans, bondholders think part of the rescue would involve swapping Eurotunnel debt for equity, a classic restructuring step. However, instead of wiping out shareholders, as would normally happen, they think the Eurotunnel rebels would like to save some equity for shareholders.

Whatever their stance, a new Eurotunnel management is under pressure to reach an agreement with creditors. The company will start to face a debt-repayment crisis at the end of next year, when it has to make all of its interest payments in cash, under the terms of the last debt- restructuring pact in 1997, said Markus Niemeier, research analyst at Barclays Capital in London.

2. (30 points) You wish to buy a car.  Unfortunately, you don’t have any ready cash.  On the other hand, you just recently invested $200,000 in a private equity fund.  The fund manager will not give you your money back right away, unfortunately.  However, according to your calculations, your investment in the fund should grow at the average rate of 15% a year for the next 5 years, at the end of which you can cash out.

Of course, you still want your car right now!  What to do?  Luckily for you, your friendly banker is willing to lend you some money using your investment as collateral.  Your banker believes that your investment has a beta of 1.5, the market risk premium is 6% and that the current five-year T-bond rate is 4.5%.  He is willing to lend you 80% of the estimated market value of your investment so that you can buy your car.  The APR on the loan is 18% and the money is to be repaid in monthly installments, starting 13 months from now.  If there are 48 payments in all, what is the size of each payment?

A stock with a beta of 0.5 is
1. exactly half as volatile as the market portfolio
2. less than half as volatile as the market portfolio
3. more than half as volatile as the market portfolio

2. Why would low-beta stocks outperform the market during market declines?
3. Are the betas in the list of ten below historical betas, or are they prospective betas?
4. What is the implicit definition of the market portfolio in the estimation of these betas?
5. Pick any stock from the list of ten below and explain, based on its industry membership, why it has a high beta.
6. Many economists believe that the economy is in a recovery phase and predict that the stock market will do much better than T-bills over the next year. Assuming the truth of this forecast, explain which of the ten stocks below you would buy.

SmartMoney Stock Screen / High-Beta Stocks
Jack Hough. Wall Street Journal. (Eastern edition). New York, N.Y.: Jan 13, 2005. pg. D.2

DON'T LET A HIGH BETA dissuade you from buying an otherwise promising growth stock.

Beta is a measure of volatility. It's based on a statistical comparison of the fluctuations of a given company's share price versus the fluctuations of an index -- usually the Standard & Poor's 500- stock index -- over a certain time period. A stock with a beta of 0.5, for example, is said to be only half as volatile as the S&P 500; a stock with a beta of 2.0 is doubly so. A stock with a negative beta zags when the S&P 500 zigs.

Bearish and safety-first investors usually look for low-beta stocks -- those with betas of, say, 0.5 and lower -- because these have shown a tendency to outperform the S&P 500 during broad market declines. But low-beta stocks also tend to underperform during surges. So bullish or aggressive investors might wish to search specifically for high betas.

The 10 stocks on the list below have betas of 2.0 or higher; that is, they've shown at least twice the volatility of the S&P 500 over the past three years. All have posted share-price gains of at least 12% over the past 26 weeks (again, about double that of the S&P 500), and have had their current-year and next-year earnings consensuses boosted within the past four weeks. All have topped earnings expectations, on average, in their past four quarterly reports, and have debt/capital ratios of 0.4 or lower. Finally, all are projected to boost their earnings by at least 12% annually over the next five years.

To get an idea of how expensive each stock is relative to its growth prospects, give its price/earnings-to-growth, or PEG, ratio a look. The measure is calculated by dividing a company's price/earnings multiple by its projected long-term earnings growth rate. Stocks with PEGs near or below 1.0, in particular, are considered possible bargains.

As always, please research thoroughly any stocks on our list before buying them.

When Volatility Is a Good Thing

These 10 stocks carry high betas as a result of their rapid price gains.

4. Philip Morris is examining the costs of equity and capital it uses to decide on investments in its two primary businesses – food and tobacco.  It has collected the following information on each business:

·           The average beta of publicly traded stocks in the tobacco business is 1.10 and the average debt/equity ratio of such firms is 20%.

·           The average beta of publicly traded firms in the food business is 0.809, and the average debt/equity ratio of such firms is 40%.

Philip Morris has a beta of 0.95 and a debt ratio of 25%; the pre-tax cost of debt is 8%.  The treasury bond rate is 7% and the corporate tax rate is 40%.  The market risk premium is estimated to be 5%.

a.       (10 points) Estimate the cost of capital for the tobacco business; also estimate the cost of capital for the food business.

b.       (10 points) Estimate the cost of capital for Philip Morris, as a firm

c.      (10 points) Having looked at your estimates of the cost of capital for the tobacco and food divisions at Philip Morris, the financial managers have come back with a question.  Where, they want to know, does the substantial risk posed by tobacco lawsuits show up in the costs of capital that you have estimated?  Respond.

Solutions to Midterm

1. a. Creditors do have a contract whereby the company has to pay them a coupon and bond face value. However, there are often provisions in bankruptcy law, whereby a company may be allowed to suspend payments to its creditors if doing so is necessary for the company to maintain itself as a going concern. The key word, here, is suspend. Once a company enters into bankruptcy there is a procedure in place, whereby the company has to be reorganized or liquidated. In principle, the creditors are not supposed to lose out at all; and the purpose of the suspension of payments is only supposed to prevent an unwarranted scramble for repayment on the part of creditors that might force an otherwise healthy company into bankruptcy -- this would be akin to a trading halt on an exchange, in a company's stock, if the price starts dropping precipitously because of investor panic.

However, where the bankruptcy law gives existing shareholders or existing management, discretion as to how to file the reorganization plans, bondholders might be willing to forego some of their rights or payments, in order to ensure a speedy conclusion to the bankruptcy proceedings. This is particularly important because the ability to wait is, in itself, a sort of call option that can only be beneficial to stockholders. European Law is, in general, not as debtor-friendly as US law; still the law there is also getting more debtor-friendly over time.

Finally, management can often take actions that expropriate bondholder value because no contract, least of all, a bond indenture, is complete.

b. In this case, even though a large percentage of the shares were diffusely held -- 65% -- still, 35% were held by banks and institutions, and so, only 16% more was needed from the shares held by individuals, in order to vote against the managemetn slate of candidates for the Board of Directors. It is also possible that even though 65% of shares were held by individuals, this percentage may not have been held diffusely -- in other words, there might have been some large blocks amongst the 65%.

2. The expected value of your investment in the private equity fund, after five years is 200,000(1.15)⁵ = $402,271.44. This investment has a beta of 1.5; hence the required rate of return on this investment is 4.5 + 1.5(6) = 13.5%, using the CAPM. Hence the market value of this investment is 402271.44/(1.135)⁵=$213,569.82. The banker will lend 80% of this, or $170,855.86. The APR on the loan is 18%; hence the effective monthly rate is 18/12 or 1.5%.

Payments, however, don't start until 13 months from now; so it is as if we have a loan that will be made in a year's time with monthly payments starting the next month. If we look at it, this way, the value of the loan, in 12 months time, rises to 170,855.86(1.015)¹² = $204,278.37. We can, now, use the annuity formula to find the value of each of the 48 monthly payments, by solving 204,278.37 = (C/0.015)[1-(1/1.015))⁴⁸] or C = $6000.68.

3. a. A stock with a beta of 0.5 is more than half as volatile as the market portfolio, because in addition to market related uncertainty stocks also have idiosyncratic volatility. Of course, this idiosyncratic volatility does not "count" in terms of being priced by the market, but it contributes to the volatility, nevertheless, if not to risk.
b. A low-beta stock is a stock that moves less than the market, in whatever direction the market is moving. Hence, in times of market declines, a low-beta stock would tend to decline less than the market -- and hence outperform the market.
c. The betas in the list below are historical betas, as it says: "they've shown at least twice the volatility of the S&P 500 over the past three years."
d. By referring to beta as the comparison of a companys' share price relative to the fluctuations of the Standard & Poor's 500, the article is implicitly defining the S&P 500 as the market.
e. Tibco Software, which is in the Business Software and Services industry would, obviously, see its sales rise when the rest of the economy is doing well, since it sells to other business. This would imply a positive beta. However, more than that, business would buy software, i.e. invest in new productive assets only if they saw the economy continuing to do well. If the economy were predicted to do moderately well in the future, businesses would not buy new software. Hence, Nvidia's stock would reflect amplified market movements in the case of a robust market, while in the case of a sour economy, Nvidia's stock would plummet as businesses would immediately cut their purchases of business software, which would be seen as contra-indicated "investments." In economic terms, demand for business software is a derived demand.
f. If the report is true, then the stock with the highest beta would be best, which in this case, is Nvidia.

4. a. If Philip Morris desires to use its own debt ratio of 25% for all its business, then the computation of the levered beta to be used for its tobacco business is as follows: the unlevered beta for firms in the tobacco business is 0.982; lever up this using Philip Morris' debt ratio of 25% to get 1.1784. Hence the cost of equity is 7 + 1.1784(5.5) = 13.481. The cost of capital is (0.75)(13.481) + (0.25)8(1-0.4) = 11.31%.

The cost of capital for the food business is computed similarly. The unlevered beta for firms in the food business is 0.645; lever up this using Philip Morris' debt ratio of 25% to get 0.774. The cost of equity is 7 + 0.774(5.5) = 11.257%. The cost of capital is (0.75)(11.257) + (0.25)8(1-0.4) = 9.643%

b. It would make no sense to compute Philip Morris' firm cost of capital, since it is an arbitrary mix of different businesses. However, we could compute the average cost of equity for Philip Morris as 7 + 0.95(5.5) = 12.225, and the cost of capital as (0.25)(8)(1-0.4) + (0.75)(12.225) = 10.369%

c. One might argue that litigation risk is diversifiable, and should not be included in the costs of capital.