Dr. P.V. Viswanath
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1. Keller Cosmetics maintains an operating profit margin of 5% and an asset turnover ratio of 3.
2. A couple will retire in 20 years; they plan to spend about $30,000 per year in retirement, which should last about 25 years. They believe that they can earn an 8 percent effective annual return on their retirement savings.
3. The Economist of February 8, 2001 had the following lead paragraph in an article about boards of directors. Can you explain CalPERS' point of view? That is, why is CalPERS saying what it's saying? (10 points; half a page, no more.)
A DECADE ago, 66% of all directors on American company boards were outsiders; last year that figure had risen to 78%. The California Public Employees Retirement System (CalPERS), the loudest voice in American corporate governance, argues that the only company executive on the board should be the chief executive—ie, given that the average size of the American company board is about 12, 92% of all company directors should be independent non-executives. In the past ten years, the demand for non-executives has increased by almost a fifth, and CalPERS is asking for another big increase.
4. Your brother-in-law is recommending a stock that is expected to pay dividends per share of $3, $3.15 and $3.30 for the next three years. It's earnings are expected to grow at the rate of 4% for the following years, and its dividend payout ratio is expected to remain constant from the third year and beyond. This stock has not been trading for very long, and very little information is available beyond what has been mentioned above. However, your brother-in-law has estimated that this stock is very similar in risk to another stock that has a beta of 1.2. The return on 10 year T-bonds, right now is about 4% and the market risk premium is estimated to be 6% (i.e. the expected return on the market portfolio less the risk-free rate). What is the maximum price that you should be willing to pay for this stock? (20 points)
5. Here are the balance sheets for Atrexia Corp.
Here are the Income Statements:
Dividends paid to shareholders for 1995 were $711; for 1996, they were $715; and for 1997, they were $670. Cost of Goods sold includes depreciation of $2231 in 1995, $2300 in 1996 and $2445 in 1997.
6. Compute the following ratios for Atrexia Inc. for 1996:
7. a. Several years ago, Castles in the Sand, Inc. issued bonds at face value at a yield to maturity of 7 percent. Now, with 8 years left to go until the bonds mature, the company has run into hard times and the yield to maturity on the bonds has increased to 15 percent. What is the price of the bond, at this moment? (8 points)
b. Suppose that investors believe that Castles can make good on the promised coupon payments, but that the company will go bankrupt when the bond matures and the principal comes due. The expectation is that investors will receive only 80 percent of face value at maturity. If they buy the bond today, what yield to maturity do they expect to receive? (You will need to use trial-and-error to get the precise answer, unless you use a financial calculator. You need to write down the formula that needs to be solved to get any credit. If you then use a financial calculator to get the answer, that would be OK. If you use trial-and-error and work out the answer by hand, provide two iterations; i.e. try one answer, then by looking at what the formula gives you, try to get a second and better answer.) Will this yield-to-maturity be greater or less than 15%? Why? (7 points)
1. a. ROA = Asset turnover/Operating profit margin = 3/0.05 = 0.15 = 15%
b. Net Income = EBIT - Interest - Taxes = 20000-8000-8000 = 4,000. Net Income
+ Interest = 12000. Now, if debt/equity = 1, then debt = equity, so total
assets are twice equity; note also that ROA = [(NI +Int)/ Sales]*(Sales/TA).
2. a. We need to find out what the present value of the money that the couple plans to spend in retirement is. This can be done by computing (30000/0.08)[1-(1.08)25]; this will be the value in year 20. This needs to be brought to the present by dividing by (1.08)20. This comes to $68707.62.
Now to compute how much needs to be saved each quarter, we compute the effective rate per quarter as (1.08)0.25-1 = 0.0194266 or 1.94266% per quarter. Using this in the annuity formula, we set up the equation 68707.62 = (C/0.0194266)[1-(1.0194266)80] and solve to get C = $1699.35.
b. The real rate of return will be 1.08/1.04 - 1 or 3.846%; this can be approximated as 8 - 4 or 4%.
c. At an inflation rate of 4% per annum, if the couple were going to be spending $30,000 in nominal dollars, 20 years from now, then in real dollars, it would be equal to 30,000/(1.04)20 = $13691.61. So, if we assume that the couple's expenditures in each of the 25 years in retirement will be $13691.61 (in real terms), the value at the beginning of retirement in real terms would be (13691.61/0.04)[1-(1.04)25] = 213,891.4. The present value of this, today works out to 213,891.4/(1.04)20, as before to get $97617.24.
Now the effective real quarterly rate works out to (1.04)0.25-1 = 0.0098534 or .98534% per quarter. Using this in the annuity formula, we set up the equation 97617.24 = (C/0.0098534)[1-(1.0098534)80] and solve to get C = $1769.39. This means that the actual amount that the couple should save in one quarter's time is 1769(1.04)0.25 =1786.82.
d. The last quarter of the 20 years, they would save (1769.39)(1.04)20 = $3876.95.
4. The required rate of return is 4 + 1.2(6) = 11.2%. The price of the stock three years from now will be (3.3)(1.04)/(0.112-0.04) = 47.67. The present value of this is 47.67/(1.112)3 = 34.67. The present values of hte next three dividends are 3/(1.112) = $2.70, 3.15/(1.112)2 = $2.55 and 3.30/(1.112)3 = $2.40. The current price of the stock is the sum of all these numbers, viz. 34.67 + 2.70 + 2.55 + 2.4 = $42.32.
5.a. Operating Cashflow = EBIT + Depreciation – Taxes = Net Income
+ Interest + Depreciation = 2681 + 706 +2231 = $5618
6.a. EBIT (computed as Net Income + Interest + Taxes) for 1995, 1996 and 1997 is $4968 (= 2681 + 706 + 1581), $5234 and $5695; Interest is $706, $888 and $845. Hence the interest coverage ratios are 7.04, 5.89 and 6.74. If the interest coverage ratio indicates the quality of hte debt, the bond prices should have dropped over the three years.
6.b. Current ratios are 1.505 (15009/9973), 1.478 (16925/11454) and 1.609 (17625/10957) for 1995, 1996 and 1997 respectively.
6c. The debt-to-equity ratio equals 0.96 (12320/12808), 0.875 (13203/15081) and 0.69 (12596/18263) for 1995, 1996 and 1997 respectively.
7.a. Note, first, that the coupon payment is $70. The price of the bond, right now, can be computed as (35/.075)[1-(1.075)-16] + 1000/1.07516 = 634.34.
7b. If investors expect to receive all coupon payments plus 80% of the face value, then we have the equation 634.34 = (35/k)[1-(1+k)-16] + 800/(1+k)16. Clearly, the answer here must be less than 15%, since 15% is the promised yield, i.e. the maximum possible yield. Let's try 14% per annum, i.e. 7% per six-months. If we do that, then the price works out to 709.54. Hence the answer must be even lower. If we try 13%, the price works out to 633.95, which is pretty close. The right answer must be just higher than 13%.
1. Read the article below from the Wall Street Journal of Feb. 14, 2004, and answer the following questions:
After months of uncertainty, Revlon Inc. unveiled a debt-for-equity swap and related agreements that will reduce its debt by about 50%, alleviating a cash crisis that has plagued the cosmetics giant.
The rescue package, which includes slashing the company's $1.9 billion debt load by at least $930 million, received the approval of one of Revlon's biggest bondholders, Fidelity Investments' Fidelity Management & Research Co., which will exchange $155 million in debt for equity in Revlon. Fidelity also gets two seats on Revlon's 10- member board. Securing Fidelity's commitment is a victory for Revlon in its battle to remove the specter of a bankruptcy filing that has haunted the company for more than a year.
The plan, which calls for issuance of a yet-to-be determined number of additional shares, will reduce the equity stake held by Ronald O. Perelman's MacAndrews & Forbes Holdings Inc., which currently has an 83% interest in Revlon. Even so, "we would anticipate and fully expect Ronald to remain the principal shareholder in the company," Revlon Chief Executive Jack Stahl said. Because it is still unclear if other investors will follow Fidelity's lead, it's too early to say how many additional shares Revlon may issue.
The plan will offer big bondholders 300 to 400 shares for every $1,000 in notes tendered for exchange. Revlon said it expects $780 million in debt to be swapped for equity in the first quarter. MacAndrews & Forbes, Mr. Perelman's main investment vehicle, has agreed to swap $475 million in debt it holds for equity..."This is extremely good news for bondholders," said Brendan White, senior portfolio manager at Touchstone High-Yield Bond Fund, which has about 1.2% of its assets, or $1 million, invested in Revlon debt. "This goes a long way to righting the capital structure. Previously, we had to focus on the balance sheet." Now, the company can "focus on improving the business."
Revlon, which has reported a string of quarterly losses, has been struggling to compete in a soft market for cosmetics sold through mass merchants and drug and grocery store chains against bigger and better- funded competitors such as L'Oreal SA and Procter & Gamble Co. In addition, consumers have been more willing to increase their spending on prestige cosmetics sold in department stores, where Revlon brands aren't distributed.
Yesterday, Revlon released better-than-expected fourth-quarter results, surprising some company watchers. In the quarter, Revlon narrowed its loss to $12.6 million, or 18 cents a share, compared with a year-earlier loss of $179.4 million, or $3.36 a share. Sales climbed 73% to $368.5 million from $212.6 million a year earlier. Excluding the company's growth-plan-related returns and allowances, net sales were up 26%, the company said. Revlon attributed the stronger results to sharply lower costs to cover returns from retailers of unsold merchandise, strong consumer response to new products such as its ColorStay Overtime lipstick, licensing revenue and favorable foreign-currency translation.
Deutsche Bank Securities analyst George S. Chalhoub questioned whether the improved results reflected any delays or cuts in discounts, allowances or other brand-support expenses, such as advertising. In an interview, Mr. Stahl said the results "reflect all the things we are doing to grow the business, which are indeed sustainable."
A spokeswoman for Fidelity, Sarah Friedell, said the firm agreed to the debt-for equity offer because "we believe this is in the best interest of all Revlon shareholders long-term, and our own shareholders."
It remains to be seen whether investors will embrace the offer. Revlon has not yet begun "formal conversations" with other investors, Mr. Stahl said. He added that while the company expects more debtholders to convert their holdings to equity, "the important thing is that the plan is not dependent on additional debt being exchanged by other public owners."
Mr. White said he hadn't decided whether his fund would participate in the debt-for-equity exchange or the other offerings Revlon announced yesterday. Revlon's 8.125% notes due 2006 were trading at 101 1/2 cents yesterday afternoon, up from 75 cents on the dollar on Wednesday, according to Merrill Lynch. Revlon's 8.625% notes, due in 2008, surged even more -- to 93 cents from 57 cents on the dollar.
Stock investors were less enthusiastic, sending the shares sharply lower in heavy trading. The stock fell 35 cents, or 9.9%, to $3.19 in 4 p.m. New York Stock Exchange composite trading. "A lot of new shares are coming out," reducing the value of existing shareholders' stakes, said Mr. White. He added, however, that the restructuring "is good for the company," because "it gives them flexibility."
2. Define and briefly explain any four of the following terms (5 points each):
3. According to the article, "Revlon's 8.125% notes due 2006 were trading at 101 1/2 cents yesterday afternoon, up from 75 cents on the dollar on Wednesday, according to Merrill Lynch. Revlon's 8.625% notes, due in 2008, surged even more -- to 93 cents from 57 cents on the dollar." Answer the following questions:
4. Revlon's equity beta, according to Yahoo (http://finance.yahoo.com/q/ks?s=REV) is 1.546. The current yield on 10-year Treasuries (as of 1 p.m., May 11, 2004, http://www.bloomberg.com/markets/index.html) is 4.78%. Assume that the market risk premium is 5.5% (this is a fair estimate based on historical data for the last fifty or so years).
5. You had the following data for Revlon's stock prices:
6. You are holding a large portion of your portfolio in Revlon stock and want to diversify your holdings. Your stock broker has suggested three different stocks for you to consider -- Estee Lauder (ticker EL), Clorox Company (ticker ) and Delta Airlines. Since it would cost money to sell Revlon stock and buy another stock, you don't want to invest in companies that will not offer a reasonably good amount of diversification. Keeping the transactions cost element in mind, which of the the three stocks would you not pick for this purpose? Explain. (Hint: You may read the business profiles for the four companies, which can be found below.) (10 points; no credit without explanation.)
Following are the Reuters' abridged summaries for selected companies, as given in Yahoo:
Revlon: Revlon, Inc. manufactures and sells an array of cosmetics and skin care, fragrances and personal care products. The Company's products are sold worldwide and marketed under such brand names as Revlon, ColorStay, Revlon Age Defying and Skinlights, as well as Almay in cosmetics; Almay Kinetin, Vitamin C Absolutes, Eterna 27, Ultima II and Jeanne Gatineau in skin care; Charlie in fragrances, and High Dimension, Flex, Mitchum, Colorsilk, Jean Nate and Bozzano in personal care products. The Company conducts its business exclusively through its direct subsidiary, Revlon Consumer Products Corporation and its subsidiaries. Its principal customers include large mass volume retailers and chain drug stores, as well as certain department stores and other specialty stores, such as perfumeries. The Company also sells consumer products to United States military exchanges and commissaries, and has a licensing group.
Estee Lauder: The Estee Lauder Companies Inc. manufactures and markets skin care, makeup, fragrance and hair care products. Its products are sold in over 130 countries and territories under the following brand names: Estee Lauder, Clinique, Aramis, Prescriptives, Origins, M.A.C, Bobbi Brown, La Mer, Aveda, Stila, Jo Malone, Bumble and bumble, Darphin and Rodan & Fields. The Company is the global licensee for fragrances and cosmetics sold under the Tommy Hilfiger, Donna Karan, kate spade and Michael Kors brands. Estee Lauder sells principally through limited distribution channels to complement the images associated with its brands. These channels consist primarily of upscale department stores, specialty retailers, upscale perfumeries and pharmacies and, to a lesser extent, freestanding Company-owned stores and spas, its own and authorized retailer Websites, stores on cruise ships and in-flight and duty-free shops. It also sells products at prestige salons. In February 2004, it sold its jane brand.
Clorox: Clorox Company, incorporated as the Electro-Alkaline Company, has three business segments: Household Products - North America, Specialty Products and Household Products - Latin America/Other. The Company's business operations include the production and marketing of non-durable consumer products sold primarily through grocery and other retail stores. Principal products include bleach, household cleaners and salad dressings and other flavorings.
Delta Airlines: Delta Air Lines, Inc. is an air carrier that provides scheduled air transportation for passengers and cargo throughout the United States and around the world. As of February 1, 2003, Delta, including its wholly owned subsidiaries Atlantic Southeast Airlines, Inc. (ASA) and Comair, Inc., served 219 domestic cities in 47 states, the District of Columbia, Puerto Rico and the United States Virgin Islands, as well as 48 cities in 32 countries. Delta owns 40% of WORLDSPAN, L.P., a limited partnership that operates and markets a computer reservation system (CRS) and related systems for the travel industry. CRS services are used primarily by travel agents to book airline, hotel, car rental and other travel reservations and issue airline tickets. Delta also owns approximately 18% of Orbitz, LLC, a limited liability company that operates an online travel agency that offers travel services to consumers and business customers via the Internet.
1. a. Since dividends donít have to be mandatorily paid, the debt-for-equity swap will reduce the chances that Revlon might not have cash needed to make interest payments. Not having money to make interest payments would force the company into bankruptcy.
b. The restructuring will provide flexibility for two reasons: one, the company will not be forced to use available cash to pay out to bondholders Ė it can use it for reinvestment or other purposes; two, if necessary, in the future, the company will find it easier to issue debt to raise money in a hurry, since its financial leverage wonít be so high after the restructuring.
c. As pointed out in the answer to part a., the money will not need to come up with as much cash every six months to pay off interest due; this will alleviate the cash crisis.
d. The stock price usually drops when firms issue equity, instead of debt. This is because the market figures that the stock must be overpriced, for the company to choose to sell equity rather than debt.
2. a. rights offering: this is an issue of new stock, but one which is limited to existing shareholders of the company. The existing shareholders can trade these rights.
b. treasury stock: this refers to shares that the company has repurchased and is holding in its treasury.
c. warrant: a security which gives the holder the right to buy a share of the stock, which the company will issue, at a specified price within a specified period of time. This is similar to an option, except that when an option is exercised, the number of shares outstanding do not go up, as in the case of a warrant.
d. venture capital: this is the money invested to finance a new firm.
e. firm commitment: an underwriting arrangement, where the underwriter buys the securities from the firm and then resells them to the public. The underwriter takes on the risk that it might not be able to sell the stocks at the agreed offering price.
3.a. The 8.625% note due in 2008 was trading at a discount (93 cents on the dollar). The 8.125% note due in 2006 was trading at a premium.
b. We are dealing with a bond that has 4 years to maturity, with semi-annual coupons. Hence we have the price equaling = 27.2676 + 64.9331 = $92.20
4.a. Using the CAPM, we find that the required rate of return is 4.78 + 1.546(5.5) = 13.283%.
b. The price must, on average grow at the required rate of return. Hence the expected price in one yearís time = 3.44 (1.13283) = $3.897.
c. The growth rate in dividends = retention ratio x return on equity. Hence, for EL, this works out to (1-0.3/1.517)(0.2301), which works out to 18.46%.
d. According to the Dividend Growth model, P = D1/(r-g), where D1 = Div next period. In our case, g = 18.46/4 = 4.615%, r = 13.283%. Hence, we have 3.44 = D1/(0.13283-0.04615). Solving, we find D1 = 29.82 cents.
e. The impact on Revlon will be equal to 10%(beta) or 10(1.546) = 15.46%.
6. You certainly wouldnít want to invest in Estee Lauder, because itís in the very same industry, and competes with Revlon. However, you probably also donít want to buy Clorox because even though itís not in the cosmetics business, itís in the non-cyclical consumer products sector and hence would probably have returns that are highly correlated with those of Revlon.