Dr. P.V. Viswanath
|Courses/ FIN 647|
Summer 2007 Exams, FIN 647
1. Read the following WSJ article and answer the questions below:
DLF Rides India's Land Boom
NEW DELHI, India -- Executives from Indian property giant DLF have been traveling the globe with a pitch likely to attract many investors: Ride India's real-estate boom via the nation's largest initial public offering.
By area of completed residential and commercial developments, New Delhi-based DLF is India's biggest property developer. It is offering 10% of the company in an IPO that at the top end of the range could raise $2.36 billion. Shares will be priced between 500 rupees and 550 rupees ($12.37 and $13.61), and will be on sale from Monday through Thursday. Trading on India's National Stock Exchange and Bombay Stock Exchange is set to start in the first week of July.
The offer will be roughly twice the size of India's biggest IPO to date, according to research firm Thomson Financial. That was by oil-and-gas company Cairn India, which raised $1.18 billion in December.
With India's economy ripping along, so is real estate. Moody's Investors Service and ICRA Ltd. have cited market participants as forecasting that Indian property development will be worth $90 billion in 2015, compared with $12 billion in 2005.
Given expectations like those, DLF's offer has generated significant attention and support.
"DLF is the best way to get exposure to Indian real estate, given its size, quality and credentials," Mumbai financial-services firm Edelweiss said in a research note.
The firm, which hasn't done any investment-banking work for DLF, says it believes the company is a growth story and its shares will become the standard way of playing Indian real estate.
But some analysts say investors in DLF might find ownership to be a bumpy ride. They say that in the past there have been concerns about corporate governance and DLF's treatment of minority shareholders. (Earlier, the Singh family that controls DLF had a listed company. When that company delisted in 2003, some retail shareholders continued to hold stakes.)
K.P. Singh, a property entrepreneur and head of the Singh family, has transformed DLF into a powerhouse of residential and commercial real estate with a massive portfolio of land. The company has almost single-handedly turned the once-sleepy Delhi suburb of Gurgaon into a popular residential and business district that has become a glass-and-steel icon of the new India. However, some analysts say the company's focus on Gurgaon is a negative for investors, because it effectively concentrates a large portion of risk in one spot.
Singh family members make up a third of the company's board, including the posts of chairman and vice chairman. According to the prospectus, the family and businesses connected to them will directly or indirectly control more than 87.43% of the shares after the IPO. At present, they own 97.42% of the company.
When DLF unveiled plans to list its shares last year, a number of minority shareholders came forward to say they had been treated poorly by the company, said people knowledgeable about the situation. In its listing prospectus, DLF said it and India's market regulator, SEBI, had received numerous complaints from shareholders saying they hadn't had the opportunity to participate in a previous debenture issue.
A government investigation exonerated the company of any wrongdoing but suggested it allow minority shareholders to participate in the debenture issue to settle their grievances, according to those people. DLF did so, and then reapplied for a listing in January this year.
Analysts at Macquarie Bank cited "poor management of conflict by DLF, evidenced by its minority shareholder debenture issue" as a one reason for caution. Macquarie hasn't done any investment-banking work for DLF.
At a recent news conference, Vice Chairman Rajiv Singh pledged that DLF would treat its shareholders well and said all retail investors should feel "safe and secure."
DLF had to adjust its prospectus for the IPO after SEBI tightened rules surrounding valuation of land banks and disclosure of asset ownership. After the new rules were unveiled, DLF incorporated the requirements, and its IPO was approved.
But the stop-go listing process has taken some of the edge off interest in the stock, in the view of Sharmila Joshi, vice president of institutional sales at Mumbai-based Asit C. Mehta Investment Intermediaries.
To be sure, the IPO has many supporters, in part because of DLF's size in a fast-growing market. The stock also is expected to become a core holding of many India-dedicated funds.
Edelweiss estimates that DLF's existing land bank has a net asset value of 512 to 517 rupees a share. It says the IPO also provides growth opportunities not included in that valuation, such as a tie-up with Hilton International -- already unveiled by DLF -- to develop hotels across India.
"It's an industry leader, so it will have a premium over normal players in the sector," says Jigar Shah, head of research at Mumbai-based K.R. Choksey Shares & Securities.
DLF plans to use the IPO proceeds to help pay for more land and development rights, construction and loan servicing.
The IPO is taking place at a time when listed Indian property companies have been experiencing tough times as a result of higher interest rates and government measures to cool the property market.
In a May 4 note that made no specific comment on DLF, Citigroup noted that India's property sector had "corrected sharply" from highs in December and had been "extremely volatile" in the past two to three months. Citigroup Global Markets India is a joint bookrunner for DLF's IPO.
Given the real-estate sector's negative sensitivity to higher interest rates, Citigroup said, "we see more downside than upside at current levels."
2. Answer any three of the following four questions (5 points each):
3. In looking at HOLX, you have come up with the following quantity forecasts (all numbers in millions):
4. Hologic, Inc., together with its subsidiaries, develops, manufactures, and distributes diagnostic and medical imaging systems for serving the healthcare needs of women. It focuses on mammography and breast care, and osteoporosis assessment. (Source: http://finance.yahoo.com). Hologic (HOLX) identifies three different segments in reporting operating income: Mammography/Breast Care, Osteoporosis Assessment and Other. Since it is difficult to identify assets devoted entirely to one segment or another, you have decided to use revenue information to compute the relative importance of each segment for HOLX. Revenues (in thousands) for the year ending September 2006 are identified in the 10K filings as follows -- Mammography: 335,795, Osteoporosis: 80,162, Other: 46,723.
You have identified five other pure play companies (i.e. single-segment companies) with the following characteristics (the following information is not factual). All these firms are of relatively equal size.
Hologic, itself, has a debt-equity ratio of 0.05 (taking into account the capitalized value of its opeating leases).
5. (10 points) You believe that the market risk premium is about 6% and that HOLX's beta is 2.08. The yield on 10 year Treasuries is 5.116% (WSJ, June 8, 2007). Further, for the latest quarter (ending March 31, 2007) the company reported income tax expense (in thousands) of $12,650 on taxable income of $34,284. (http://finance.yahoo.com). If the firm reports an average coupon rate, for its outstanding debt, of 6.14%, what is its weighted average cost of capital (WACC)? Assume that its debt-equity ratio is about 0.05.
1.a. Real estate stocks probably have betas greater than one. This is because they represent land, which is a capital good. The demand for land is a demand derived from the demand for other goods. There is also a real option component to the value of land; this causes land to fluctuate more relative to the market compared to other assets.
b. According to the article, "When DLF unveiled plans to list its shares last year, a number of minority shareholders came forward to say they had been treated poorly by the company, said people knowledgeable about the situation. In its listing prospectus, DLF said it and India's market regulator, SEBI, had received numerous complaints from shareholders saying they hadn't had the opportunity to participate in a previous debenture issue." It sounds like minority shareholders have not had a routine way to express their opinion of the way the firm is being run. Allowing them to choose a director to represent their interests might be one way to give them a voice.
c. The family current owns 97.42% of the company. Hence the minority interest is 2.58%. The article estimates that the new equity issue could raise $2.36b. at the top range of $13.61. Hence the new equity issue is 2.36b/13.61 or 173,401,900 shares. We also know that after the IPO, the family's interest will drop to 87.43%.
Suppose X is the number of shares outstanding right now. Then, the number of shares with the family now is 0.9742X. The number of total shares after the IPO will be X+173401900. Hence 0.9742X/(X+173401900)=0.8743. Solving, we find 0.9742X = 0.8743X +(0.8743*173401900) or X = 1,517,570,382 shares, assuming that the family does not buy any of the newly issued shares. The expected trading range is 500 to 550 rupees. The market value of the current minority shareholders, therefore, is (0.0258)*1,517,570,382*525 or Rs. 20,555,490,824 or about Rs. 20.5b.
d. One answer to this question is simply that the Rs. 517 estimate for the existing properties is too high. Another is that the other growth prospects are not as large as they are made out to be. There may also be a minority discount because of the governance problems this company has had. Finally, the very fact of equity issuance is often a signal that the existing shares are overvalued.
2. a. The objective of share price maximization is valid only if markets are efficient. This is because the ultimate objective is either shareholder wealth maximization or firm value maximation. If markets are not efficient, then maximizing share prices may not maximize firm or equity wealth because market prices do not reflect true values.
b. The required rate of return on a lottery ticket is zero because the return on a lottery ticket is uncorrelated with market returns. As a result, all the uncertainty is diversifiable.
c. This means that 70% of the variation in HOLX's equity returns over that time period can be explained by movements in the value of the market.
d. The 95% confidence interval is 1.95 + (1.96)(0.45) and 1.95 - (1.96)(0.45) or 2.832 and 1.068.
3. The Free Cash Flow to Equity for the year ending June 2008 is:
or $72m. However, the numbers provided here do not include capital expenditures. We assume this is zero; however, if this is not so, we need to subtract capital expenditures, as well, to get the Free Cash Flow to Equity. (An alternate assumption might be that Net Capital Expenditures are zero -- that is capital expenditures equal depreciation.)
b. Assuming an increase of FCFE of 15% for the next year (2008-2009), we get 72(1.15) or $82.8m. Growth thereafter is at 3% p.a. Hence the value, as of June 2008, of future FCFE is 82.8/(0.15-0.03) = $690m. Discounting this back to the present, we get 690/1.15 or 600. The FCFE for the year ending June 2008, itself is 72; discounting this back to June 2007 gives us 72/1.15 or 62.6087. Adding the two, we get 662.6087. Adding the value of cash to this, we end up with 662.6087+25 = $687.6087m.
4. a. HOLX consists of three segments. We will find HOLX's beta by looking at the betas of the pure-plays in the three segments. Testing Inc. has a stock beta of 2; we use the information provided to compute its unlevered or asset beta as 2/(1+(1-0.2)0.5) = 1.428571. Similarly, Women Care's asset beta works out to 1.469388. Not having information on the sizes of the two companies, we weight them equally to get an asset beta for the Mammograph segment of 1.44898.
We use a similar technique to get the asset beta estimate for the Osteoporosis segment, which works out to 2.257378. Since the sole firm in the "Other" segment has no debt, its asset beta is the same as its equity beta, which is 0.6.
We must now find a weighted average of these three asset betas. Unfortunately, we don't have the relative asset sizes of the three segments in HOLX. We therefore use the relative revenues of 335,795 for Mammograph, 80,162 for Osteoporosis and 46,723 for Other. With these weights, we get a composite asset beta of (335795*1.44898 + 80162*2.257378 + 46723*0.6)/(335795 + 80,162 + 46,723) or 1.503307.
We then find HOLX's equity beta as 1.503307*(1+(1-0.4)*(0.05)) = 1.548406.
b. The Yahoo estimate is computed simply by running a regression of the returns on HOLX over the last five years on the market return. HOLX's exposure to the different segments could have changed from then to now. If so, a bottom-up beta would provide a better estimate.
5. The average tax rate is 12650/34284 = 0.368977.
The WACC is (.05/1.05)(6.14)(1-0.368977) + (1/1.05)(5.116+2.08*6) = 16.94259%
1. Walgreen's Net Income for the year ended August 2006 was $1,750,600,000. Here are other numbers for the same time period (unless otherwise indicated) (in millions of dollars):
To this, we add the amount of cash currently at hand, 919.9, to get a grand present value of $51570.37. Dividing by the number of shares outstanding, we get $51570.37m./997.44m. or $51.70 per share. (Interestingly enough, the closing stock price as of June 26, 2008 was $43.73!)
1) (Note that the information in this question is not factually complete) You are trying to evaluate whether United Airlines has any excess debt capacity. UAL has 12.2 million shares outstanding at $210 per share and debt outstanding of approximately $3 billion (book as well as market value). The debt has a rating of B and carries a market interest rate of 10.12%. The beta of the stock is 1.26, and the firm faces a tax rate of 35%. The treasury bond rate is 6.12%. Assume a market risk premium of 5.5%.
2) (40 points) Please read the following article in the New York Times of June 29, 2007 and answer any two of the questions below:
3) (10 points each) Answer any three of the following questions:
1. a. The cost of equity capital is 6.12% + 1.26(5.5) = 13.05%; the cost of debt capital, after-tax is 10.12(1-0.35) = 6.578. The firm's equity is valued at 12.2(210) = $2562m. or $2.562 billion. It's debt is worth $3 billion. Hence the debt/equity ratio is 3/2.562 or 1.171, and the debt-capital ratio is 3/5.562, while the equity-capital ratio is 2.562/5.562. The WACC, then, equals (3/5.562)(6.578) + (2.562/5.562)(13.05) = 9.559%.
b. If we go to a 30% debt-capital ratio or a 3/7 debt/equity ratio, we have to recompute the WACC. The current beta = 1.26; the unlevered beta = 1.26/[1+(1-0.35)1.171] = 0.71545. Hence the levered beta at a debt ratio of 30% = 0.71545(1+(1-0.35)(0.3/0.7) = 0.9148; the cost of equity = .0612 + 0.9148(.055) = 0.1115. The WACC = (0.3)(1-0.35)(.0812) + (0.7)(.1115) = 9.39%.
The value of the firm will go up by (5.562)(0.09559 - 0.0939)/(0.0939) = $100.471 million.
2. a. Bondholders are upset because the amount of collateral that they
will be able to rely on will decrease drastically. This would, of course,
reduce the value of their bonds. Even though the total value of the three
segments might increase -- although this is not certain -- this gain will
be enjoyed only by the stockholders; the bondholders will end up losing.
3. a. The three main agency costs of debt are due to: i) taking of excessive risk by the stockholders of a leveraged firm, ii) payment of excessive dividends to stockholders and iii) taking on of excessive debt. All of these actions could reduce the value of the firm. This loss of value would be the agency cost of debt.
3. b. Indirect bankruptcy costs should be highest for:
3. c. From the description of Sento Corporation, it looks like it is primarily a service firm with not a lot of tangible assets -- consequently, one might have expected to find that it had much lower leverage. On the other hand, according to Yahoo, the industry debt/equity ratio is 0.55, where the industry is defined as Information Technology Services. On of the largest firms in the industry, EDS has a ratio of 0.393, while a smaller firm, Stanley, Inc. (SXE) has a ratio of 0.281. Perhaps the explanation is that we're not dealing with a technology firm, which might be involved in cutting edge technological developments; rather this is a firm and an industry that is using, now relatively standard, tools to service other firms. Hence cashflows are much more stable and these firms can, therefore, support more debt than an average technology firm. Also, it's possible that this particular firm has more debt because it might not have done well in the recent past causing it's equity to drop in value thus pushing up its debt/equity ratio.
3.d. Detailed covenants might protect bondholders; on the other hand, they would reduce the flexiblity of the firm and cause it to lose out on promising positive NPV investments -- consequently, it might be worth it for bondholders not to strangle the firm too much with covenants, but rather rely on the firm's desire to establish a good reputation in the market.
3.e. The Modigliani-Miller hypothesis says that the market value of a
firm is independent of its capital structure.