Dr. P.V. Viswanath
 Home Bio Courses Research Economics/Finance on the Web Student Interest

### Fall 2010

Midterm Practice

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.
• Do any 7 of questions 2-10.
• Question 11 is a take-home question; you must turn it in by midnight tomorrow night.

1. Answer any four questions from those below:

1. Explain how the financial system facilitates the sharing and transfer of risk. Provide three different examples.
2. What is adverse selection? Give an example of adverse selection in the context of a corporation.
3. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?
4. How is the role of the stock market in stock value maximization?
5. Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate?
6. What are the determinants of expected rates of return on assets in an economy?

2. Are there any disadvantages to requiring by law that a certain proportion of all directors be independent, i.e. that they not have any direct connection with the firm's operations?

3. Problem 25, page 48, Chapter 2.

4. Problem 16, page 46, Chapter 2.

5. Problem 17, page 76, Chapter 3.

6. Problem 13, page 75, Chapter 3.

7. Problem 45, page 125, Chapter 4.

8. Problem 29, page 124, Chapter 4.

9. Problem 39, page 152, Chapter 5.

10. Problem 23, page 150, Chapter 5.

11. Read the article, "Is It Time to Scrap the Fusty Old P/E Ratio?" by Ben Levisohn, WSJ, Sept. 4, 2010 and answer the questions posed (Go to Media Articles and click on Interpreting Financial Statements).

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. Answers without explanations will not receive full points.
• Answer any seven of questions 1-8. The first seven questions carry 10 points each.
• Question 10 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. 10 by email by midnight Wednesday, Oct. 27, 2010.

1. In July 2007, Apple had cash of \$7.06 billion, current assets of \$18.75 billion, current liabilitites of \$7.04 billion, and inventories of \$0.29 billion.

1. What is Apple's current ratio?
2. What is Apple's quick ratio?
3. In July 2007, Dell had a quick ratio of 1.26 and a current ratio of 1.31. What can you say about the asset liquidity of Apple relative to Dell?

2. In January 2009, American Airlines (AMR) had a market capitalization of \$1.7 billion, debt of \$11.1 billion, and cash of \$4.6 billion. American Airlines had revenues of \$23.8. British Airways (BABWF) had a market capitalization of \$2.2 billion, debt of \$4.7 billion, cash of \$2.6 billion, and revenues of \$13.1 billion.

1. What are the market capitalization-to-revenue ratios (also called the price-to-sales ratio) for AMR and BABWF?
2. What are the enterprise value-to-revenue ratios for American Airlines and British Airways?
3. Which of these comparisons is more meaningful and why?

3. You have an investment opportunity in Japan. It requires an investment of \$3 million today and will produce a cash flow of Y351 million in one year with no risk. Suppose the risk-free interest rate in the United States is 5%, the risk-free interest rate in Japan is 1%, and the current competitive exchange rate is Y113 per dollar. What is the NPV of this investment?

4. Suppose Bank One offers a risk-free interest rate of 6.0% on both savings and loans and Bank Enn offers a risk-free interest rate of 6.5% on both saving and loans.

1. What arbitrage opportunity is available?
2. Which bank would experience a surge in demand of loans? Which bank would receive a surge in deposits?
3. What would you expect to happen to the interest rates the two banks are offering?

5. You have just turned 30 years old, have just received your MBA, and have accepted your first job. Now you must decide how much money to put into your retirement plan. The plan works as follows: Every dollar in the plan earns 9% per year. You cannot make withdrawals until you retire on your 70th birthday. After that point, you can make withdrawals as you see fit. You decide that you will plan to live to 100 and work until you turn 70. You estimate that to live comfortably in retirement, you will need \$100,000 per year starting at the end of the first yar of retirement and ending on your one hundredth birthday. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

6. You are running a hot Internet company. Analysts predict that its earnings will grow at 40% per year for the next five years. After that, as competition increases, earnings growth is expected to slow to 6% per year and continue at the level forever. You company has just announced earnings of \$3 million. What is the present value of all future earnings if the interest rate is 10%? (Assume all cashflows occur at the end of the year.)

7. Suppose the current one-year interest rate is 5.7%. One year from now, you believe the economy will start to slow and the one-year interest rate will fall to 4.7%. In two years, you expect the one-year interest rate to fall to 1.7%. The one-year interest rate will then rise to 2.7% the following year, and continue to rise by 1% per year until it returns to 5.7%, where it will remain from then one.

1. If you were certain regarding these future interest rate changes, what two-year interest rate would be consistent with these expectations?
2. What is your forecast for the economy in the medium term? For the long term?

8. In the summer of 2008, at Heathrow airport in London, Bestofthebest (BB), a private company, offered a lottery to win a Ferrari or 70,530 British pounds, equivalent at the time to about \$141,060. Both the Ferrari and the money, in 100 pound notes, were on display. If the UK interest rate was 5% per year, and the dollar interest rate was 3% per year (EARs), how much did it cost the company in dollars each month to keep the cash on display? That is, what was the opportunity cost of keeping it on display rather than in a bank account?

9. Answer any five of the following questions:

1. Explain how the financial system facilitates the sharing and transfer of risk. Provide two different examples.
2. What is the relevance of the stock market to the concept of a corporation?
3. What is moral hazard? Give an example in the context of a business.
4. What happens to the control of the firm in bankruptcy?
5. How does the market ensure that the Law of One Price holds?
6. How does the financial system facilitate the pooling of resources? Provide two different examples.
7. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?

10. Read the article below and answer the following questions:

### Companies may be forced to follow banks’ lead and tap their shareholders Economist, Jan 15th 2009, New York

IN 2008 battered banks scurried to raise fresh capital. As the recession bites, they will have to come back for more. Jostling with them for limited funds will be a fast-growing number of cash-strapped non-financial firms. Pain is spreading fast across the corporate world: analysts estimate that fourth-quarter profits across the S&P 500 fell by 15% year-on-year, the sixth decline in a row—the worst run on record. Days after laying off 13,500 and cutting production, Alcoa, a bellwether for earnings, announced a crushing \$1.2 billion loss. Even traditionally defensive industries, such as pharmaceuticals, are suffering: Pfizer plans to lay off up to 8% of its researchers.

With banks loth to lend and credit markets still in turmoil, a tsunami of defaults seems imminent, despite the fact that credit has thawed a little in recent weeks: junk-bond spreads have fallen from their dizzying peak of 22 percentage points over government debt, and firms are paying less to issue commercial paper, widely used to finance working capital. But they will still struggle to roll over much of the \$518 billion of corporate bonds and more than \$1 trillion in loan facilities that, according to Citigroup, must be refinanced this year—especially given increased competition from sovereign borrowers seeking to plug deficits. Worse, a growing band of investors is using a mix of short-selling and credit-default swaps (CDSs)*** to bet against firms with heavy refinancing exposures. As their CDS spreads widen, those companies find it ever harder to sell fresh debt.

This could leave a lot of companies having to cough up big chunks of principal on top of their regular interest payments when bonds mature, just as revenues plummet. The debt-service coverage ratios (free cashflow divided by repayment obligations) of highly geared* firms are falling below the critical level of one at a pace that seems to be unprecedented, says Barrie Wilkinson of Oliver Wyman, a consultancy. Cutting interest rates to the bone does little for firms that suddenly find themselves having to repay principal.

CDS spreads imply that around 10% of American firms will be forced into default. To avoid this, those that have trouble rolling over their debt have two main options. The first is to sell assets and use the proceeds to pay down debt. But losses booked from selling at fire-sale prices could quickly wipe through thin layers of equity. The second route is to raise capital, either through a debt-for-equity swap—as GMAC, a troubled vehicle-finance and mortgage lender, has done—or a discounted offering, such as a rights issue.

Some have already taken this last route to get lenders off their backs. Britain’s Premier Foods, for instance, is planning a rights issue in exchange for banks loosening the terms of its debt covenants.** Others are likely to follow. Andrew Smithers of Smithers & Co, a research firm, expects American companies to swing from being net buyers of their own equity (through buybacks) to net sellers. Mr Wilkinson predicts a “great dilution” of existing shareholders in 2009. This could drive another round of selling in stockmarkets, he argues, which have hitherto focused only on falling profits. Fear over the need for further capital-raising contributed to the decline of banks’ shares.

Cash-poor firms would do well to move quickly. Banks that needed equity but dithered last year discovered to their cost that the pool of available capital was not limitless; they had to pay far more for it later, if they could get it at all. And stronger firms are drinking at the pool, too: Scottish & Southern, a British energy group, has just raised £479m (\$704m), in part to bolster its ammunition for opportunistic deals.

As the problem grows, governments in America, Britain and Germany are starting to step in. But all this woe has a silver lining—at least for the investment bankers who have already been through it. The wave of corporate capital-raising will bring in underwriting fees that will help offset the slump in mergers and flotations. If they can find willing takers, that is.

*Note: "highly geared" means "highly levered
** Debt covenants are conditions that lenders often impose on borrowers that require them to maintain financial ratios at certain minimum levels, failing which, usually, the loan has to be repaid immediately.
*** A CDS is a contract between two parties where the buyer of the CDS makes periodic payments over the life of the contract to the seller in exchange for a commitment to a payoff if a third party defaults.

1. What is the difference between the debt-service coverage ratio described in the article and the interest coverage ratio?
2. After reading this article, could you sugggest some circumstances in which interest coverage ratios could be misleading?
3. Who might use credit default swaps?
4. "As their CDS spreads widen, those companies find it ever harder to sell fresh debt." Explain why. (Hint: this is an example of how the financial system provides information to economic agents to make optimal decisions.)

Solution to Midterm Exam

1.

1. Apple's current ratio is computed as CA/CL = 18.75/7.04 = 2.66.
2. Apple's quick ratio is (CA-Inventories)/CL = (18.75 - 0.29)/7.04 = 2.62.
3. Apple has more net liquidity in the short run.

2.

1. The market capitalization-to-revenue ratios for AMR and BABWF are: 1.7/23.8 = 0.07143 and 2.20/13.1 = 0.1679
2. The enterprise-value-to- revenue ratios are (1.7+11.1-4.6)/23.8 = and (2.2+4.7-2.6)/13.1 = 0.3445 and 0.3282.
3. The enterprise-value-to-revenue ratios are more meaningful since AMR and BABWF have different leverage ratios (AMR's is much higher). Hence the market-value-to-revenue ratios are not meaningful.

3. Discounting the Y351m. to the present, using the yen interest rate of 1%, we get Y347.52; converting this to dollars at the current exchange rate, we find that this equals 347.52/113 or \$3.0754m. Hence the NPV is \$0.0754m. or \$75,440. Keep in mind that the current exchange rate cannot be used to convert future dollars!

4.

1. One could borrow from Bank One at 6% and lend to Bank Enn at 6.5%.
2. Bank Enn would experience a surge in deposits and a Bank One, a surge in demand for loans.
3. Bank Enn would drop its interest rate for deposits and Bank One would increase its interest rate for loans so that the rate would be ultimately the same for both banks.

5. Withdrawals of \$100k. per year would start in year 71 and continue to year 100. The value of that amount at the time of retirement would be (100/.09)(1-(1.09)-30) = \$1027.365k. The value of that today would be 1027.365/(1.09)40 = \$32.7088k.

If you save \$x per year (in '000s) starting at the end of the current year until your retirement at age 70, the present value of that would be (x/.09)(1-(1.09)-40) = 10.75x. Equating 10.75x to 32.7088k, we see that x = 3.04006; i.e. you need to save \$3040.06 per year for 40 years.

6. The present value of earnings, for the next 5 years is 3(1.4)[1-(1.4)/(1.1)]5/(0.1-0.4)= 32.75249. The present value as of the end of year 5 of future earnings is 3(1.4)5(1.06)/(.10-.06); discounting this to the present, we get [3(1.4)5(1.06)/(.10-.06)]/(1.1)5 = 265.49. Hence the present value of all future earnings is 32.75249 + 265.49 or \$298.24 million.

7.

1. The two year interest rate would be [(1.057)(1.047)]0.5= 1.052 or 5.2% per annum.
2. The yield curve suggests that the economy will not do well in the short-term and in teh medium term, but will pick up eventually, perhaps in about three or four years.

8. The opportunity cost was 3% per year in dollars, i.e. (1.03)1/12-1=0.0024663; in dollar terms, it's 0.0024663 x \$141,060 or \$347.89. Remember that you can't convert future dollars at the current exchange rate!

9.

1. The financial system facilitates the sharing and transfer of risk by creating securities or contracts with payoffs of differing risk. Buying and selling these securities then allows investors to change their risk profile. Furthermore, buy buying derivative securities such as options and futures, investors can actually take on new risk or reduce their existing risk. Examples are the sale of insurance policies and call options on stock or credit-default swaps. Keep in mind that selling shares transfers everything -- expected cashflows as well as risk -- so it's not really a way of transferring risk alone!
2. The essential aspect of a corporation is the separation of management and ownership. The existence of a stock market facilitates the purchase and sale of these ownership rights independent of the management.
3. Moral hazard refers to the incentives for economic agents who are parties to a contract to take inefficient actions that differ from the actions that they would have taken if they had not been party to the contract. Thus moral hazard leads to a potential waste of resources. For example, persons who have insured their car are likely to worry less about the maintenance of the car knowing well that if there is an accident, they will be at least partially reimbursed by the insurance company.
4. In bankruptcy, control of the firm changes to the bondholders, in theory. In practice, management has a limited amount of time to put together a plan that would satisfy the firm's obligations to them.
5. The market ensures that the Law of One Price holds by providing market participants to engage in arbitrage. In equilibrium, as well, economic agents will act appropriately to adjust supply and demand for the different units of the product on sale so that the Law of One Price is attained.
6. The financial system facilitates the pooling of resources through the creation of securities as well as by the creation of specific financial institutions that offer pooling contracts. Thus, the stock exchange allows individuals to buy shares of stock that represent very small portions of the total amount of resources required to run a firm. Similarly, mutual funds, through contracts with their customer, pool funds and then buy large amounts of stocks of many different issuers, allowing the customers of the mutual fund to buy shares in diversified portfolios.
7. The purpose of the Board of Directors is to monitor the manager. However, the directors don't always have the proper incentives to monitor the manager, or the knowledge to evaluate him/her. Hence this monitoring doesn't always work out as expected.

10.

1. Interest coverage ratios only take into account the ability of a firm to make interest payments on the debt, and not on the obligation to make principal payments.
2. Normally, there would be no reason to take the obligation to pay principal in evaluating a firm's liquidity because the principal can always be rolled over. However, if credit markets are tight or if the circumstances of the firm, itself, have changed so that new financing is either impossible or would require a much higher interest rate, then the use of the interest coverage ratio could be misleading.
3. A firm or a person who is owed money by a second corporation could buy a credit-default swap issued by a third party that would pay off in the event of default by the second party. Hence a firm who is owed large sums of money by another corporation might find it useful to buy a credit-default swap. Similarly, somebody expecting investment of a certain sum of money by a second party might by a credit-default swap to protect against non-investment by that party due to bankruptcy. This might be, for example, a non-profit organization promised funding by a potential donor.
4. If the CDS spread widens, it must be that the underlying party's ability to make the payment on the security has worsened. Hence those companies' cost of raising funds would go up. There is an interesting comment made by an individual on a public website that seems to address exactly this point (http://seekingalpha.com/article/138047-how-cds-spreads-affect-equity). A Wikipedia article (http://en.wikipedia.org/wiki/Credit_default_swap) provides more information on what CDSs are.

Final Practice

Read the article entitled "A Patient/Fan of GTx Buys More" below from the WSJ of Nov. 10, 2010 and answer the following questions:

1. Tony Marchese, CIO of Insiders Trend Fund LP said: "These are lottery tickets. The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low." Marchese simply meant that the uncertainty in both cases were high. Having studied asset pricing, explain how else GTx stock is be similar to a lottery ticket.
2. Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment. Explain what Mr. Moreland might mean.
3. The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. What are the implications of this fact for the Efficient Markets Hypothesis?

Memphis businessman and philanthropist Joseph "Pitt" Hyde III has been funding Mitchell Steiner's research since Dr. Steiner successfully treated him for prostate cancer 14 years ago. Mr. Hyde, chairman of Dr. Steiner's biopharmaceutical company, GTx Inc., made his latest investment last week, buying more than \$15 million in shares in the company's stock offering.

Mr. Hyde, founder of AutoZone Inc., bought the shares at \$2.80, and now owns about 35% of the company. He said he was taking advantage of a "unique opportunity to buy a large block of shares at a favorable price."

The offering, which raised a net \$37.6 million to fund the company's clinical development projects, increases outstanding shares by about 39%. GTx shares traded at \$2.80 Tuesday.

Tony Marchese, general partner and chief investment officer of Insiders Trend Fund LP, questioned why Mr. Hyde was the only insider to purchase shares in the latest offering and said small biotech companies, such as GTx, are a high-risk, high-reward investment.

"These are lottery tickets," he said. "The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low, he said.

Mr. Marchese said such stocks are not for the average investor, and should take up no more than 1% to 2% of a large, well-diversified portfolio.

Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment.

The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. He advised selling at least half of a position as speculators push the price higher, rather than waiting for the news to be released.

GTx has seen its stock fall after recent news events, such as the FDA's order last fall that it conduct more studies on its prostate-cancer drug candidate Toremifene. Disappointing results from a study of Toremifene in May sent the stock price to its all-time low of \$1.90.

Before markets opened Tuesday, the company reported its third-quarter loss narrowed to \$8.6 million from a year-earlier loss of \$12 million on a 40% decrease in expenses. Revenue dropped 64% to \$1.3 million on lower payments by developmental partners Ipsen Biopharm Ltd. and Merck & Co., but sales of Fareston, a breast-cancer drug that GTX bought from Orion Corp. in 2005, climbed 34% to \$960,000.

In a phone interview, Dr. Steiner, the company's chief executive officer, called the FDA's decision last fall a major setback, and said it will probably take four years to do the work necessary to submit the drug for FDA approval.

He said, however, that the company and the agency have agreed on a plan that he expects to lead to approval for the drug, which is being developed to reduce bone fractures in men with prostate cancer.

Final Exam

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. (20 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.

1. Why are the banks investing in slates of films rather than in individual films?
2. Does the Modigliani-Miller hypothesis holds with respect to financing in the motion picture industry? Why or why not?
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. You own a coal mining company and are considering opening a new mine. The mine itself will cost \$118 million to open. If this money is spent immediately, the mine will generate \$19 million for the next 10 years. After that, the coal will run out and the site must be cleaned and maintained according to environmental standads. The cleaning and maintenance are expected to cost \$1.8 million per year in perpetuity.

1. (6 points) What does the IRR rule say about whetheher you should accept this opportunity? What is the IRR of this investment? Use a trial and error method to provide a range of no more than 5 percentage points within which the IRR must lie.
2. (4 points) If the cost of capital is 8.2%, what does the NPV rule say?

3. (15 points) A bicycle manufacturer currently produces 387,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of \$1.90 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only \$1.50 per chain. The necessary machinery would cost \$292,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year sttraight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of \$49,000 but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are \$21,900. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

4. Suppose you purchase a 30-year Treasury bond with a 4% semi-annual coupon, initially trading at par. In 10 years' time, the bond's yield to maturity has risen to 7% (EAR). (Assume a \$100 face value bond.)

1. (3 points) If you sell the bond now, what internal rate of return (EAR) will you have earned on your investment in the bond?
2. (3 points) If instead you hold the bond to maturity, what internal rate of return (EAR) will you earn on your investment in the bond?
3. (3 points) Is comparing the IRRs in (a) versus (b) a useful way to evaluate the decision to sell the bond? Explain.

5. Suppose that in mid-2006, Coca-Cola Company had a share price of \$42.46. Its dividend was \$1.11, and you expect Coca-Cola to raise this dividend by approximately 6.7% per year in perpetuity.

1. (5 points) If Coca-Cola's equity cost of capital is 8.2%, what share price would you expect based on your estimate of the dividend growth rate?
2. (3 points) Given Coca-Cola's share price, what would you conclude about your assessment of Coca-Cola's future dividend growth?

6. (5 points) You turn on the news and find out the stock market has gone up 10%. Based on the data in the table below, by how much do you expect each of the following stocks to have gone up or down? (1) Starbucks, (2) Tiffany & Co., (3), Hershey, and (4) Exxon Mobil.

Starbucks Tiffany & Co. Hershey Exxon Mobil
Beta
1.04
1.64
0.19
0.56

7. The last four years of returns of a stock are as follows:

1 2 3 4
-4.4%
-28.1%
12.1%
4.2%

1. (3 points) Assuming that the future is likely to be similar to the past four years, what is your estimate of the stock's expected return?
2. (5 points) What is your estimate of the stock's variance of returns?
3. (3 points) What is your estimate of the standard deviation of returns for the stock?

8. Hardmon Enterprises is currently an all-equity firm with an expected return of 18%. It is considering a leverage recapitalization in which it would borrow and repurchase existing shares. Assume perfect capital markets.

1. (6 points) Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction?
2. (6 points) Suppose Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be 8%. What will the expected return of equity be in this case?

9. (15 points) Answer any three of the following questions:

1. What are the advantages of payback as a investment criterion?
2. How is beta different from standard deviation of returns as a measure of risk?
3. What are the determinants of the rate of growth of a firm's earnings?
4. The holding period return is always greater than the yield-to-maturity. True or False? Explain.
5. "Issuance of new equity dilutes earnings. Hence it's bad." Is this true or false? Explain.

Solutions to Final Exam

1.a. There could be two reasons why banks would invest in slates of films. The most obvious reason is diversification. Of course, we do say that diversification at the firm level is not value-additive since individual investors can create diversified portfolios on their own. While this is true, bankruptcy can be costly. Hence banks and other firms would like to decrease the volatility of their investments, all other things being the same. This is particularly an issue with banks, since they have a lot of demand deposits and having insufficient capital can destroy them through a run.
The second reason is that there is a lot of information asymmetry in the film industry. The producer of a film has access to a lot of information that investors don't. Hence producers could manipulate the profitability of a film by assigning costs of other films to a particular film where there are outside investors, in order to reduce the payout to outside investors. If the outside investor has investments in several films made by a single studio, the potential for such cross-subsidy is less.
Also, banks are normally not experienced in determining the quality of individual films (which don't have a financial history for banks to look at), but they have more information about studios. Hence financing a slate of films reduces the need to be knowledgeable about individual films.

b. Modigiliani-Miller does not hold in the movie industry. For one, M&M assumes that taxes don't matter. However, n the motion picture industry studios have to deal with taxes.  Debt financing, often, has tax benefits. For example, (from Noel Simsiman's answer):

Paramount qualified for Section 48 tax relief in Great Britain in order to generate an extra \$12 million for Lara Croft: Tomb Raider.  In order to qualify, Paramount entered into a complex sale-leaseback transaction with Britain’s Lombard Bank, shot some scenes in Great Britain, and employed some British actors (Epstein, 2005).

Bank's lack of expertise in evaluating films may be an argument as to why banks should not finance films, but it doesn't show why one short of financing is better than another. There is nothing in a bank's lack of expertise that argues that other parties shouldn't finance films with debt financing. Hence, this, by itself, is not a good argument against M&M.

We do know, however, that there's a lot of information asymmetry -- insiders know more than outsiders. Furthermore, insiders could manipulate accounting of profits. As a result, all other things being the same, there would be a preference for debt financing. However, insiders could also increase the risk of a film; hence we have debt financing, collateralized as far as possible by specific assets such as DVD rights etc., with the remainder being equity financing. Such equity financing, particularly by studios, also comes with close monitoring, which proves the point.

c. According to Clark, "Films tend to do well in both good and bad economic situations." If this is true, then films have very low betas. Even though people are willing to spend more money on movies in good times, they do watch movies at all times. Hence the beta is probably low.

2.a. Note that at time 0, there is an outflow, then there are net inflows for the next ten years followed by net outflows forever after that. Since the sign of the cashflows changes twice, we know that there will be at least one inflection point. Normally, this would mean two different IRRs.

To obtain one of the IRRs, we need to pick a trial discount rate. If we used a trial rate of 5%, we see that the NPV is \$6.612m. With a discount rate of 8.2%, we have an NPV of -\$1.63m. Hence the correct IRR is within the following range: (5%, 8.2%).

In fact, as discussed above, there are two IRRs -- one, about 7.73%, and the other around 3.05%.

b. If the cost of capital is 8.2%, the NPV is given by -118 + (19/.082)(1-(1.082)-10) -(1.8/.082)*(1.082)-10 = -\$1.63 million; hence we would not invest in the project.

3. We first have to compute the cashflow.

After-tax Production Costs 1.5x387000(1-0.35) 377,325
Present Value of Production Costs 377,325xPV(\$1,15%,10 years) \$1893706.87
Annual Depreciation 292000/10 29,200
Tax Savings from Depreciation 29200x0.35 10220
Present Value of Tax Savings from Depreciation 10,220xPV(\$1,15%,10 years) -\$51,291.82
PV of NWC needs +49,500-49500/(1.15)10 \$37,264.36
PV(Scrapped Machinery) -21900/(1.15)10 -5,413.35
PV (Scrapped Machinery) after Cap Gains Tax 5413.35(1-0.35) -\$3518.68
Cost of Machinery   \$292000

The total after-tax present value of the costs of producing in-house are \$1,893,706.9-\$51,291.82+\$37,264.36-\$3518.68+\$292,000 = \$2,168,161. The total after-tax present value of the costs of buying are 387000(1.9)xPV(\$1,15%,10 years) = \$2,398,695.4.

Hence it is cheaper to produce in-house. The NPV of producing in-house is 2,398,695.4 - 2,168,161 = \$230,535.

4.a. When you bought the bond, its price was \$100. Its EAR now is 7%; hence its 6-monthly yield is (1.07)0.5 -1 = 0.0344 or 3.44%. Its price now is 100x0.02xPV(\$1,3.44%,40 periods) + 100/(1.07)20= 43.11 + 25.84 = 68.95. Meanwhile, you have been getting your semi-annual \$4 of coupon. If the price today were \$100, the IRR would be exactly 4%. However, since the price today is less than par, the IRR is less than 4% per six months or 8.16% EAR. The actual IRR works out to 2.82% per 6 months or 5.72% EAR. However, it's difficult to get this precise answer without a calculator. Trial and error would give an approximate answer.

b. If you hold the bond to maturity, then the EAR you will earn will be the promised EAR, i.e. 8.16% (which is 1.042 - 1).

c. Comparing the IRRs is not a useful way to evaluate the decision to sell the bond because the time periods are not the same.

5. a. Assuming dividends are paid annually, and the last dividend was 1.11, the next dividend, based on teh assumed growth rate would be 1.11(1.067) or \$1.1844. Based on continuing dividend growth at the same rate, Coca-Cola's share price estimate as of the beginning of the year would have been 1.1844/(0.082-0.067) or 78.96. Now that it's 6 months later, the price should have risen at the rate of the required rate of return; hence the price should be 78.96(1.082)0.5 = \$82.13.

b. Since the actual stock price is much lower, clearly the market's assessment of Coca-Cola's growth rate is much lower.

6. According to the CAPM, the expected change in a stock's price, given the change in the market portfolio is simply the change in the market times the beta. Hence the expected change in Starbucks is 10.4%, that in Tiffany's 16.4%, that of Hershey's 1.9% and that of Exxon Mobil, 5.6%.

7.a. The estimate of the expected return is simply the average, which is -4.05%. However, it is important to keep in mind that a stock's expected return is rarely negative, unless it's a strong hedge against market movements. Else nobody would buy the stock expecting to lose money!

b. The estimate of the variance is the sum of the squared deviations from the mean divided by the number of observations less than (3 in our case), which works out to 301.47 percent squared.

c. The estimate of the standard deviation is simply the square root of the estimate standard deviation, which is 17.39%

 Year Return Deviation Squared 1 -4.4 0.1225 2 -28.1 578.4025 3 12.1 260.8225 4 4.2 68.0625 Mean -4.05% Variance Est 302.47 Std Dev 17.39%

8.a. We know that in perfect capital markets, the WACC does not change. Hence we can solve 18% = (.5/1.5)6% + (1/1.5)req to find req = 24%.

b. Using the same formula, we get 18% = (1.5/2.5)8% + (1/2.5)req to find req = 33%.

9.

1. It is simple to calculate and doesn't require a precise estimate of the cost of capital.
2. Standard deviation measures total risk, whereas beta only measures non-diversifiable risk.
3. The two major determinants are the return on equity and the plowback rate.
4. This is false. It depends on what happens to interest rates in the interim.
5. Issuance of new equity need not dilute equity; it depends on whether the return on equity on the new funds is greater or less than the return on existing equity. In any case, whether the issuance of new equity is good or not depends on what is done with the funds raised -- if the return on the funds is greater than the required rate of return, then it will be beneficial to existing shareholders, assuming that the firm has not promised more than the required rate of return to the new equity holders.