Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

  Home/ MBA 648/ Exams/  

Spring 2010




  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  • You must explain all your answers.

1. Read the following article and answer these questions:

  1. (8 points) Regarding the new small cars introduced by Audi and BMW, the article says: "They are designed to be true premium cars with preppy performances ... and premium prices to match." But the various next paragraph we are told that "making money with such vehicles will be tough." If the cars carry high price tags, why should they not make money?
  2. (9 points) We read in the article, "Some analysts have questioned whether BMW really makes money with the Mini. But Norbert Reithofer, chief executive of BMW, insisted that at the Munich-based carmaker, “we earn money with every car.”" How could both analysts and Mr. Reithofer be correct? Doesn't one of them have to be lying?
  3. (8 points) Suppose you can obtain the unpublished financial statements for the small car segements of different automakers. What difference do you expect to see between the financial statements of volume carmakers like Renault and Nissan Motor and those of the high premium brand producers like BMW?

Leather Seats and Computer Navigation Enhance Small Vehicles of Desire

By JACK EWING, New York Times, March 4, 2010

GENEVA — In 1959, Volkswagen helped make its Beetle into a best-seller in the United States with the advertising slogan “Think Small.”

Nowadays the motto could be “Think Small and Pricey.”

Under pressure to cut fuel consumption, and trying to appeal to younger buyers, carmakers are increasingly rolling out small, stylish cars with accoutrements normally found in high-end vehicles.

These new models from luxury carmakers like Audi or BMW, many of which were on view at the Geneva International Motor Show this week, are not the boring econoboxes of yore.

They are designed to be true premium cars with peppy performance and features like leather seats or turbocharged engines — and premium prices to match.

The cars aim to open a new market, but without the slim profit margins that are typical for small cars. Industry executives with long experience building small cars, though, warn that making money with such vehicles will be tough.

“It’s another market, another target group,” said Luca di Montezemolo, chairman of Fiat Group. “It’s a challenge.”

The most prominent new entry is Audi’s two-door A1, which the company’s Volkswagen unit introduced Tuesday in Geneva. Audi plans to start selling the car in Europe this summer at a price of about €16,000, or $21,600, for the base model, which includes a turbo-charged engine, power steering and an on-board computer with navigation.

“It’s the first real premium car in its segment,” Audi’s chief executive, Rupert Stadler, said during the introduction event.

Well, not quite. The pioneer in the segment was probably BMW’s Mini brand, though Daimler’s Smart car could also claim to be a trailblazer. BMW further expanded the Mini line this year with the four-wheel-drive Countryman, which the company introduced in Geneva at a display staffed by models in plaid farmer shirts and tight jeans.

But Audi is pursuing a different strategy than its two German rivals, and taking more risk, by selling the new small car under its own brand name.

The mass-market carmakers have also tried to push their small cars upscale. Examples include the Fiat 500, which the Italian auto plans to begin selling in the United States later this year, and Ford’s new Fiesta, a bestseller in Europe that the company is trying to market in the United States as a premium small car. The Fiesta has features like push-button starting and, like the 500, sportier handling and acceleration than is typical of economy cars.

Ford says it already has 8,000 orders in the United States for the new Fiesta, which the company will begin delivering in the summer.

“The future is in favor of small cars,” Mr. di Montezemolo said during an interview.

Whether it’s a profitable future for carmakers is a tougher call. Some analysts have questioned whether BMW really makes money with the Mini. But Norbert Reithofer, chief executive of BMW, insisted that at the Munich-based carmaker, “we earn money with every car.”

Still, Mr. di Montezemolo and others remain skeptical as to whether the high-end carmakers, accustomed to building roomy luxury rides, have the cost discipline necessary to make money with smaller vehicles.

In any case, the volume carmakers do not sound threatened. “They are creating a new segment,” said Carlos Ghosn, chief executive of both Renault and Nissan Motor, during a meeting with reporters Wednesday in Geneva. “I don’t think they are competing with the generalists.”

Nick Reilly, chief executive of Opel/Vauxhall, said small cars from the likes of Audi could actually help the mass-market brands. “If affluent people are willing to be seen in a car of that size, then it will increase the readiness of other people to be seen in cars of that size,” Mr. Reilly said.

Small, well-appointed cars are an easier sell in Europe, with its narrow roads and high fuel prices. But carmakers have long been skeptical that well-off U.S. buyers would downsize.

That attitude could be changing. “There is a general tendency toward small cars in the U.S.,” Daimler’s chief executive, Dieter Zetsch, said during a session with reporters Tuesday in Geneva.

However, Daimler’s own experience has been mixed. The two-seat Smart car is a common site on urban streets in Europe but has been a perennial money loser for Daimler since its introduction more than a decade ago.

The Smart was initially a hit when Daimler started selling it in New York and other metropolitan areas last year, but sales fizzled when fuel prices fell from record highs. Audi does not plan to export the first generation of the A1 to the United States but may consider selling a future version there.

2. Here are the annual financial statements for Tata Motor Company (in thousands of dollars):

PERIOD ENDING 31-Mar-09 31-Mar-08 31-Mar-07
Current Assets
Cash And Cash Equivalents 458,200   373,800   246,100  
Short Term Investments 172,000   19,300   60,100  
Net Receivables 2,586,800   1,640,600   1,406,100  
Inventory 2,128,500   858,100   787,100  
Other Current Assets 506,800   219,700   144,100  
Total Current Assets 5,852,300   3,111,500   2,643,500  
Long Term Investments 2,127,800   2,563,100   1,799,700  
Property Plant and Equipment 4,354,400   2,489,700   1,476,800  
Goodwill 105,500   174,100   167,900  
Intangible Assets 2,452,100   77,800   69,400  
Other Assets 454,200   811,100   130,800  
Deferred Long Term Asset Charges 84,400   -   -  
Total Assets 15,430,700   9,227,300   6,288,100  
Current Liabilities
Accounts Payable 2,966,700   1,482,600   1,184,700  
Short/Current Long Term Debt 7,386,300   1,724,500   902,600  
Other Current Liabilities 1,125,200   1,390,500   715,100  
Total Current Liabilities 11,478,200   4,597,600   2,802,400  
Long Term Debt 2,507,000   1,469,100   933,500  
Other Liabilities 527,800   236,600   199,400  
Deferred Long Term Liability Charges 154,200   152,900   138,800  
Minority Interest -   140,800   94,100  
Total Liabilities 14,667,200   6,597,000   4,168,200  
Stockholders' Equity 
Common Stock 101,400   96,300   89,400  
Retained Earnings -552,200 977,600   746,800  
Treasury Stock -   -   -  
Capital Surplus 1,541,200   994,000   921,400  
Other Stockholder Equity -326,900 562,400   362,300  
Total Stockholder Equity 763,500   2,630,300   2,119,900  


Period Ending 31-Mar-09 31-Mar-08 31-Mar-07
Total Revenue 14,250,900 9,126,200 7,692,000
Cost of Revenue 13,206,300 7,193,800 6,112,500
Gross Profit 1,044,600 1,932,400 1,579,500
Research Development Exp
Selling General and Administrative Exp
Non Recurring Exp
Other Exps
Operating Income or Loss
Total Other Income/Expenses Net (449,100) 203,000   124,700  
Earnings Before Interest And Taxes (507,000) 795,100   738,000  
Interest Expense 674,700   262,500   125,600  
Income Before Tax (1,181,700) 532,600   612,400  
Income Tax Expense 16,600   147,400   188,200  
Minority Interest -   (28,700) (16,700)
Net Income (1,198,300) 355,100 420,300
  1. (10 points) Compute the long-term debt to equity ratio for the three years. What would you conclude from these numbers about the firm's leverage?
  2. (10 points) The stock prices at the end of March 2009, 2008 and 2007 respectively are 4.87, 14.99 and 15.25 respectively. Basic Weighted Average Shares Outstanding for the same dates are 440,482; 385,439 and 384,544 respectively. With this additional information, what would you say about the firm's leverage?
  3. (5 points) What additional information might you want to have before you concluded that Tata Motors was overleveraged or underleveraged?


  1. (5 points) You want to buy a house costing $200,000; you have approached a bank for a mortgage on monthly repayment terms. If the bank's alternative is to lend the money to a businessman who promises to pay interest at the rate of 12% a year, what APR should it charge you? (Note: I am asking you for the Annual Percentage Rate, not the EAR or the Equivalent Annual Rate.)
  2. (10 points) If it does charge you that rate, what would your monthly payment be, assuming that the duration of the loan is 10 years?
  3. (5 points) If you had to make the payments at the beginning of the period, what would your monthly payment be?

4. You are planning to retire in 10 years. Right now, you only have $200,000; you know that's not enough and are planning on saving additional money for your retirement in the coming ten years. After you retire, you will need to rely on your total savings to live another 20 years, after which you hope to come into an inheritance, and you won't have to worry about financial issues anymore!

You believe that the money that you save can be invested at 6% per annum. Frankly, you could get as much as 12% per annum, but you are not interested in taking the additional risk that that would entail -- you don't want to be on the streets because a Credit Default Swap you invested in suddenly lost all of its value!

If you were to retire today, you reckon you'd need about $80000 per year to support you in the style in which you have been accustomed to live. Of course when you retire (in ten years time), prices would generally be higher. You look at the US Department of Labor website (http://www.bls.gov/cpi/) and you see that the consumer price index for all urban consumers increased at the rate of 3.24% over 2009. You figure that that is a good estimate of what inflation is likely to be for the foreseeable future. Using this as a benchmark, you compute what your needs will be on the date that you retire. You also figure that the Republicans are going to be in power in another ten years and they are going to be so efficient in managing the economy that inflation will be pretty much zero from then on. (Of course, if this were the case, then interest rates would probably be lower as well, but we'll ignore that.)

Make the following additional assumptions:

  1. you will withdraw money at the beginning of each year, during your retirement and use it for your needs for the rest of the year.
  2. During the remaining time that you will be working, you plan to put aside some money from your paycheck, which is paid at the end of every month.

Answer the following questions:

  1. (15 points) How much do you need to save monthly for the next ten years to fund your retirement?
  2. (Bonus: 10 points) Suppose you have already followed your saving schedule (as computed by you) and you are now ready to retire. Suddenly, you decide to look at inflation forecasts, and you realize that inflation is going to be quite high -- more like 10% an annum and not zero as you originally assumed. Can you estimate how many years you can live on your savings? (Note: you don't have enough information to provide a numerical answer to this question; I want to see how you would proceed.)


  1. (10 points) Name two functions of the financial system and for each function, two specific examples of financial institutions or financial securities that accomplish this function, along with a two-line explanation of how that function is accomplished.
  2. (10 points) Answer any one of the following two questions:
    1. Why might you not believe that stock prices are good measures of shareholder wealth?
    2. What are agency costs and provide one example with one para of explanation.

Midterm Practice


  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  • You must explain all your answers.

1. Use the balance sheet and income statements for Atrexia Corp. (given below) and answer the following questions:

Balance Sheet at Year-end
Cash 20 45 83 883
Accounts Receivable 690 900 853 845
Inventories 11014 14064 15989 15897
Total Current Assets 11724 15009 16925 17625
Property, Plant, and Equipment (net of depreciation) 15675 18485 21497 22904
Other Assets 1151 1607 1316 1287
Total Assets 28550 35101 39738 41816
Liabilities and Shareholders' Equity
Accounts Payable 4104 5907 6442 7628
Notes Payable 1646 1882 2798 618
Other Current Liabilities 1656 2184 2214 2711
Total Current Liabilities 7406 9973 11454 10957
Long-Term Debt 10460 12320 13203 12596
Total Liabilities 17866 22293 24657 23553
Common Stock 697 851 1099 1895
Retained Earnings 9987 11957 13982 16368
Total Shareholders' Equity 10684 12808 15081 18263
Total Liabs and Shareholders' Equity 28550 35101 39738 41816

Here are the Income Statements:

Income Statements for Years ending
Sales 83412 94749 106146
Cost of Goods Sold 65586 74564 83663
Marketing and Administrative 12858 14951 16788
Interest 706 888 845
Income Taxes 1581 1606 1794
Total Expenses 80731 92009 103090
Net Income 2681 2740 3056

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.

  1. Compute the debt-to-equity ratio for 1994, 1995, 1996 and 1997. How has it been changing?
  2. Compute EBIT for 1995, 1996 and 1997 and then use it to compute the Cash Coverage Ratio for those years.
  3. Compute the Net Profit Margin and Asset Turnover for the three years, 1995, 1996 and 1997.
  4. Can you make a statement about the overall strategy of the firm, using the Dupont Identity?

2. You need $100,000 to make some much-needed improvements to your house. At the beginning, you think that you might be getting a large payment in six months time from your employer as back-pay. So you approach your bank for a bridge loan. Your bank is willing to lend you $100,000 for six months; at the end of the six months, you have to pay the bank back $105,380.05.

Unfortunately, you discover that, as a result of a recent court decision, the back-pay is not going to be forthcoming. You go back to your bank the same afternoon, and the bank agrees to extend the amount of time you will have to repay the loan to three years. However, the bank does not want to take the risk that you may not be solvent in three years time. Hence they ask you to repay the loan in equal monthly instalments over the three years, with the first payment to be made in one month. The bank is kind enough to keep the effective annual interest rate on the new longer-term loan the same as on the original bridge loan. What will be the amount of the monthly payment?

3. Today's date is 1/1/2011. A couple will retire in 10 years (i.e. on 12/31/2020); they plan to spend about $30,000 per year in retirement, which should last about 25 years, i.e. until 12/31/2045. (Don't worry about what will happen at that point -- just assume they don't have to worry about consuming anything from that point on, one way or the other :-)). They believe that they can earn an 8 percent nominal effective annual return on their retirement savings.

  1. If they make quarterly payments into a savings plan, how much will they need to save each quarter? Assume the first payment comes in one quarter (i.e. 4/1/2011)? (Hint: figure out the effective rate per quarter; this is what you need to use in the annuity formula.)
  2. If the rate of inflation over the period is expected to be 4 percent per annum, what is the annual real rate of return that the couple will get on their savings?
  3. If there is going to be inflation, then it doesn't make sense to assume that the couple will continue to live on the same $30,000 per year, since this will buy progressively less and less as time goes by. Hence, let us compute the value of $30,000 ten years from now in terms of today's dollars. Since inflation is 4% per annum, in ten years time, a person will need 30,000(1.04)10 or $44,407.33 to buy the same amount of goods that s/he could buy today. Assume, therefore, the couple will be withdrawing $44,407.33 at the beginning of their retirement at the beginning of the very first year of their retirement (i.e. on 1/1/2021, which money they will spend over the coming year). At the beginning of each year subsequent to that, for another 24 years, they will withdraw a nominal amount, which will equal the purchasing power of the $44,407.33 (the last withdrawal will be on 1/1/2045). How much will the couple have to save each quarter, in real terms, assuming that they choose to save the same amount in real terms each quarter for the next 20 years? (Hint: this is essentially the same thing as part a., except in real terms.)
  4. What will the couple have to save in nominal terms the last quarter of the 10 years?

Solution to Midterm Exam

1. a. The cars may have premium prices, but this doesn't mean that the profit margin is sufficiently high. This viewpoint is somewhat supported by the article's comment regarding the Smart car, regarding which it says that the car is a "common sight on urban streets in Europe," suggesting that many Smart cars have been sold; if despite this high volume of sales, it has been a "perennial money loser," it must be that the profit margin is not sufficiently high. Alternatively, it might be that even though the profit margin per car is high, still not enough of them are sold to cover fixed costs, particuarly unallocated fixed costs. Consequently, the new premium small cars could have premium prices and still not make money.

b. They could both be correct in the following sense. It might very well be that, as Mr. Reithofer says, that the company earsn money with every car. That is, the profit margin on every car is positive. However, in spite of this, it could be that not enough cars are sold to cover fixed costs, so that the company might be losing money, overall, on the entire project.

c. We'd expect to find the profit margin, i.e. the ratio of Net Income to Revenue, to be high for BMW, which makes premium small cars, while we'd expect to find the ratio of Sales to Assets to be much higher for Renault or Nissan Motors which makes low-cost small cars

2. a. Using data from Tata's financial statements, we see that the ratio of long-term debt to the book-value of stock holder has increased sharply in the year ending March 31, 2009. Whereas it increased a bit from 0.44 to 0.559 from 2007 to 2008, it's gone up from that level to all of 3.284, revealing that the firm probably took on a lot of debt in that year. Another factor is the fact that the firm had losses, which reduced the book value of equity. As a consequence of both factors, the ratio has increased roughly six-fold.

b. If we use the share prices on those dates, as well as the number of shares outstanding, we can compute the market value of equity. Assuming that the book value of debt is not too far from its market value, as is more likely to be the case with debt than with equity, we can compute the same ratio in more-or-less market value terms by dividing the book value of debt (from the balance sheet) by the market value of the shares outstading. This ratio also increases relatively modestly from 2007 (0.159) to 2008 (0.254), but then, it more than quadruples (increases by a factor of 4.6 approx) to 1.169. This is a somewhat smaller jump. Furthermore, the firm's leverage looks a lot less alarming than if we used book values of debt and equity. Book value of equity, in this case, is much more sensitive to the loss in 2009; the market value has not changed as much. As a result, the impact shows up more starkly when book value numbers are used. (This is not always the case; often market value numbers are more volatile.)

  31-03-09 31-03-08 31-03-07
LT Debt 2507000 1469100 933500
Stockholder Equity 763,500 2,630,300 2119900
LT Debt/Stockholder Eq 3.284 0.559 0.440
Total Assets 15430700 9227300 6288100
LT Debt/Tot Assets 0.162468326 0.1592123 0.148455
Stock Price 4.87 14.99 15.25
Shares Outstanding 440482 385439 384544
Mkt Val of Equity 2,145,147.34 5,777,730.6 5864296
LT Debt/Mkt Val of Equity 1.169 0.254 0.159

.c. We'd want to, at the very least, look at the leverage ratios of other companies in the industry. We'd also look to see if the firm had other long-term liabililites, which are equivalent to long-term debt. We would want to look at the tax advantages of debt for Tata in the Indian context, and we'd also want to know how stable its cashflows are.

3.a. The deal with the businessman is the opportunity cost of the bank; hence that should be the rate of return that it demands from you (assuming that the risk is the same). Since the businessman is offering 12%, the bank should also charge you 12%. Since the payment schedule is monthly, the corresponding APR works out to ((1.12)1/12-1)*12 = 11.3866%. The equivalent monthly rate is simply (1.12)1/12-1 = 0.9489%

b. Assuming a loan term of 10 years, the annual payment, C, satisfies the equation: 200000 = (C/.0094888)[1-(1.0094888)-120]. Solving, we find that C = $2798.94

c. If the payments were to be made at the beginning of the year, the equation would be 200000 = C + (C/.0094888)[1-(1.0094888)-119], which resolves into 200000 = 72.4555C, or C = $2760.31, which as one would expect is less than the answer in part (b).

4. a. Suppose you save $C a month. You're going to save the same amount at the end of each month for 10 years. The money can be invested at the rate of 6%, which works out to an equivalent monthly rate of (1.06)(1/12) -1 = .0048676. Hence, the present value of your savings is (C/0.0048676)[1-(1.0048676)-120] = 90.724325C.

You will need to start consuming after 10 years. If you retired right now, you'd require $80,000. Since prices are increasing at the rate of 3.24% per year (according to your estimate), in 10 years, this amount would be equivalent to 80000(1.0324)10 = $110044.91. You will need to withdraw that amount at the beginning of your retirement and the same amount (since you estimate inflation thereafter to be zero) for the next 20 years. The value of all those withdrawals at the beginning of your retirement will be 110044.91 + (110044.91/.06)[1-(1.06)-19] = $1,337,938.80. The present value of that money is 1337938.8/(1.06)10=$747,098.03. Of this, $200,00 is already saved. So $547,098.03 is required; equating this to (C/0.0048676)[1-(1.0048676)-120] and solving for C, we get $6030.34.

b. You have just retired and, as per your calculations in the previous question, you are sitting on a nest egg of $1,337,938.80. (You don't need to calculate this amount separately, since if there were to be no inflation, then we know that you'd have enough money for the future.) The inflation rate has jumped from 0% to 10%. You assumed that the real interest rate would be (a very high) 6% (nominal rate of 6% less the inflation rate of zero percent). We need to know how the real interest rate would change. If the real interest rate remained unchanged, i.e. the nominal interest jumped to (6%+10%=) 16%, then nothing should change. We could reinterpret the calculation of 110044.91 + (110044.91/.06)[1-(1.06)-19] = $1,337,938.80 in terms of the real interest rate and hence what you have now is exactly what you need.

The problem is if interest rates don't rise enough, so that the real interest rate is lower. In that case, the money that you have now would not earn enough interest and you'd run out of money before the twenty years were up! For example, if the real rate were 3% (i.e. the nominal rate were 13%), the number of years, n, that you'd be able to live in the style that you had originally planned would satisfy 110044.91 + (110044.91/.03)[1-(1.03)-(n-1)] = 1,337,938.80. Solving this, we get an answer of n=16.35 years.

5. a. Six functions of the financial system are:

  1. To transfer economic resources across time, borders and among industries
  2. To provide ways of managing risk
  3. To provide ways of clearing and settling payments to facilitate trade
  4. To provide a mechanism for the pooling of resources and for the subdividing of ownership in various enterprises
  5. To provide price information to help coordinate decentralized decision making in various sectors of the economy
  6. To provide ways of dealing with the incentive problems created when one party to a transaction has information that the other party does not or when one party acts as an agent for another

Look at the first two functions. Banks transfer economic resources across time by allowing individuals to deposit funds, lending them to businesses and repaying depositors with interest in a later period. Money transfer organizations like Western Union allow people to send money across borders and across currencies.

Futures markets allow participants to hedge the risk of changes in prices. Thus, wheat farmers can take short positions in wheat futures to offset the risk that the price that they might get for their wheat would drop. This risk is transferred to those who take the opposite side of the trade. Similarly municipal bond insurers take on the risk of bondholders that the municipalities might default on their bonds.


  1. Stock prices might not be good measures of stockholder wealth to the extent that stock markets are not informationally efficient and do not incorporate all available information about the stock's value. Also, if the markets are not liquid, stock prices might be stale and reflect out-of-date values.
  2. Agency costs are out-of-pocket and deadweight costs incurred due to divergence of interests between a principal and his/her agent. For example, when a firm issues debt, agency costs are engendered because the firm, acting on behalf of stockholders might take on excessive risk even at the cost of value destruction in order to transfer wealth from bondholders to stockholders. Bondholders rationally foreseeing this will impose restrictions on what firms can do and also require firms to keep records of their activities and make those records available. Such record-keeping is costly, and so are restrictions on firm activities potentially costly by not allowing the firm to take on certain value-enhancing investments.

Final Exam


  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • For all quantitative problems, first write out the formula; then write out the numbers corresponding to the formula. Then compute the answer.
  • 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, definitions, or anything else.
  • You must explain all your answers.

1. Read the following article "SAIC's Balance Sheet Is Too Clean for Its Own Good," by Robert Armstrong in the WSJ of April 19, 2010 and answer these questions, using no more than one side of your examination booklet for each question. Make your answer straightforward, clear and concise. A rambling answer will be penalized:

  1. (10 points) According to the Modigliani-Miller hypothesis, the value of a firm is independent of its capital structure. If this is so, how could any firm have "too little" debt as the article indicates SAIC does? What's wrong about low levels of debt?
  2. (10 points) Explain in the case of SAIC, why increasing debt would raise the value of its shares.

Debt has a bad reputation. In the financial crisis, an excess of it brought down some great companies. Post-crisis, CFOs like to describe their balance sheets as "clean" or "pristine," as if they were selling detergent. But firms with little debt pay a high cost for capital and deliver unnecessarily low returns for shareholders.

SAIC Inc., which provides information-technology services and support to the U.S. military and the federal government, is a perfect example of an under-levered and inefficient capital structure.

The company has very strong cash flow, stable working capital and low capital expenditure requirements. The stock sells at a moderate multiple (12 times earnings), indicating that the equity cost of capital is not low. Organic revenue growth is steady and comes from a customer that pays on time. The company is focused on areas of the federal budget -- such as military information systems, data analysis, and cyber security -- that are likely to keep growing even in a budget crunch.

In short, SAIC is well positioned to use some leverage. Yet there is only $216 million in net debt on its balance sheet, 3% of total capitalization. The net debt/Ebitda (earnings before interest, taxes, depreciation and amortization) ratio is 0.2 times.

Several of SAIC's competitors, notably SRA International Inc. and ManTech International Corp., also have balance sheets that are too good for their own good. ManTech took a step in the right direction this month by issuing $200 million in senior notes.

Of the big government IT suppliers, only CACI International Inc. has incorporated a reasonable amount of debt, and its debt/Ebitda ratio is an unthreatening 2.6x.

The simplest way to adjust the capital structure is to issue debt and buy back shares. SAIC has made significant repurchases ($1.2 billion over the last three years), but the company would benefit immediately if it did so on a much more aggressive scale.

The company could easily handle a $2 billion share buyback over the next year, funded with $500 million in cash flow and $1.5 billion in debt, and still have a debt/Ebitda ratio under 2x. There would still be plenty of cash available for acquisitions.

Done right, the result could be a 20% boost to EPS two years down the road.

SAIC and other companies in the industry tend to prefer acquisitions to buybacks as a use of cash. SAIC has spent $600 million on acquisitions since 2008. This makes sense as far as it goes: When a contractor adds capacities through acquisition, it can sell a broader set of services to the government, reducing dependence on any one federal budget line and making the contractor more difficult to fire. But barring the appearance of very large acquisition opportunities, SAIC needs to get serious about levering up and buying back stock.

An SAIC representative declined to comment.

2. Birchdale Inc. is deciding whether to expand into department stores.  Although long-term cashflows are not easy to estimate, management has projected the following numbers for the first two years (in millions of dollars):

  Year 1 Year 2
Revenues 125 160
Cost of goods sold and operating expenses other than depreciation 40 60
Depreciation 25 36
Increase in Working Capital 5 8
Capital Expenditures 30 40
Marginal Corporate Tax rate 35% 35%
  1. (5 points) Compute the free cashflows for the first two years.
  2. (5 points) Although Birchdale Inc. is not traded on the stock exchange, you have determined that is sufficiently similar to AnnTaylor Stores Corp., which is traded on the NYSE under the ticker ANN.  According to Yahoo Finance (http://finance.yahoo.com/q?s=ANN), ANN’s beta is 1.99.
    The yield on the US 10 year T-note is 3.605%, as of May 4, 2010 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_h_dtabnk&symb=UST10Y&page=bond).  Assume that the market risk premium is 5.5% What is the required rate of return on Ann Taylor Stores Corp. stock?
  3. (5 points) Assume that the new Birchdale Inc. project will be financed in a manner similar to that of the ANN firm.  According to Finance Yahoo, ANN has total debt of $1.6m, while its market capitalization is $1.47billion. According to the terms that ANN has with its lenders, it borrows at LIBOR plus about 1.5%.  The 3-mth LIBOR rate is currently at 0.35%.  Using this information, compute the WACC.
  4. (10 points) Assume that free cashflows will grow at a rate of 3% per annum for ever after year 2.  An initial investment of $200 million is required. What is the NPV of Birchdale’s new department store venture?

3. (10 points) You may have noticed that ANN has almost no debt, compared to its market valuation?  Why is ANN’s debt-assets ratio so low, in your opinion?  Use no more than one page for your response. Here is some information to help you in your analysis:
Business Summary from Yahoo finance: AnnTaylor Stores Corporation, through its subsidiaries, operates as a specialty retailer of women's apparel, shoes, and accessories primarily in the United States. The company’s stores offer a range of career and casual separates, dresses, tops, weekend wear, shoes, and accessories under the Ann Taylor, LOFT, Ann Taylor Factory, and LOFT Outlet brands. It serves customers through its traditional retail stores and on the Internet at anntaylor.com and LOFTonline.com, as well as by phone. As of January 30, 2010, it operated 907 retail stores, including 291 Ann Taylor stores, 506 LOFT stores, 92 Ann Taylor Factory stores, and 18 LOFT Outlet stores in 46 states, the District of Columbia, and Puerto Rico. The company was founded in 1986 and is headquartered in New York, New York.


  1. (10 points) Ann Taylor has not paid any cash dividends.  However, based on the information that you have, suppose that you have determined that the company will start paying dividends of $2.00 per share on June 30, 2015 and that the dividends will increase at the rate of 5% per annum for ever.  What would you estimate the stock price of ANN to be today?  (Ignore the time difference between today and June 30, 2010 for the purpose of this question.) You can use information from problem 2 to answer this question.
  2. (5 points) The stock was actually trading at $25.01, as of close of trading on May 4, 2010.  What does this say about the Efficient Markets Hypothesis?

5. (10 points) Another firm in the apparel industry, Nordstrom (NYSE: JWN) does have senior unsecured debt, rated BBB+ by Standard and Poor’s (according to Nordstrom’s 10K for the fiscal year ended January 30, 2010).  The average coupon rate on Nordstrom’s long-term debt is 6.5%.  Suppose the maturity of a particular Nordstrom bond issue is 10 years and the yield-to-maturity demanded by the market, based on Nordstrom’s relatively low debt rating is 10%, what would this bond sell for.  (You may assume that the face value of the bond is $1000.)

6. You have examined the stock "The Limited Brands, Inc." trading on the NYSE. The following table lays out the results of your evaluation of the stock's prospects over the next year:

Scenario LTD S&P 500
Strong Economy 8% 20%
Moderate Economy 10% 15%
Weak Economy 6% 10%

Each of these three scenarios, you believe are equally likely.

  1. (5 points) What is the expected return on LTD over the next year?
  2. (5 points) Compute the variance of returns on the S&P 500.
  3. (5 points) How would you go about computing LTD's beta with this information?


7. (10 points) Answer any one of the following questions in brief (no more than one page):

  1. Evaluate the following argument: Manufacturing firms usually have proportionately more debt than service firms because they need to raise a lot of capital.
  2. Evaluate the following argument: Markets are efficient; therefore there cannot be patterns in bond prices.
  3. The growth rate in earnings is equal to the product of the retention ratio and the return on equity -- the less a firm pays out of its earnings, the greater the growth rate of earnings. Retaining more of the earnings is therefore a surefire method for a CEO to increase the price of his firm's stock.
  4. The higher the P/E ratio, the more expensive a stock. Hence the way to pick stocks is to make sure that the P/E ratios are low

Solutions to Final Exam

1. a. A firm can, indeed, have too little debt in the real world, because the assumptions of the Modigliani-Miller hypothesis do not apply. In the real world, interest payments, but not dividend payments, are tax deductible; hence capital structure affects the after-tax payments made to the contributors of capital to the firm. A firm with little debt cannot take advantage of interest deductions and the consequent tax shelters. A firm with little debt can also not benefit from the positive impact of debt on managerial incentives.

b. If a firm goes into bankruptcy, the nature of the firm's assets will determine how quickly their value can be realized. Since the firm has to pay off its creditors right away, in bankruptcy, illiquid assets will lose value. Hence firms will illiquid assets should not have too much debt. SAIC may, indeed, be characterized as a firm with illiquid assets because a lot of its value probably depend on its ability to obtain contracts with the Federal Government. This ability cannot be sold if the firm needs money quickly. The firm, probably, also has intellectual property being in the information-technology area. These assets, too, are difficult to sell. All of these considerations, however, suggest that SAIC should _not_ have too much debt.

On the other hand, the point made by the author of the article is that SAIC has stable cashflows. This being the case, the likelihood that unexpectedly bad circumstances will land SAIC in bankruptcy court are low. Furthermore, since the firm has low working capital requirements and capital expenditure requirements, operating cashflow is high and this would provide enough of a cushion even in bad circumstances, even if the firm did issue debt. As a result, the probability of bankruptcy with larger levels of debt would still be manageable. This is the opinion of the writer of the article.

2. a. Free cashflow can be computed as Net Income + Depreciation less changes in Working Capital less Capital Expenditures. Net Income equal (Revenues less COGS less Depreciation)(1-tax rate). Hence NI for year 1 is (125-40-25)(1-0.35) = 39 and NI for year 2 is (160-60-36)(1-0.35) = 41.6. Hence free cashflow for year 1 is 39+25-5-30 = 29; free cashflow for year 2 is 41.6+36-8-40 = 29.6

b. The required rate of return is 3.605+1.99(5.5) = 14.945%

c. Total assets are $1.47b (equity) + $0.0016b (debt) or $1.4716b. The weight for debt is .0016/1.4716 = 0.001087 and the weight for equity is 1.47/1.4716 = 0.998913. The cost of debt is 0.35 + 1.5 = 1.85%. The WACC is computed as (0.001087)(1.85)(1-0.35) + (0.998913)(14.945) = 14.93%

d. If the free cashflows will grow at the rate of 3% after year 2, then the present value as of the end of year 2 of cashflows from year 3 onwards is (29.6)(1.03)/(0.1493-0.03) = $255.5562m. The present value (as of now) of this is 255.5562/1.14932 = 193.4221. The present value of the free cashflow from year 1 is 29/1.1493 = 25.2327, while the present value of the free cashflow from year 2 is 29.6/1.14932 = 22.4033. Adding all three values, we get the present value of the Birchdale venture, 241.11428. Subtracting out the initial investment of $200m, we get the NPV of $41.11428m.

3. It's not clear why ANN would have so little debt. It looks like they would have real estate as assets, which is very good as collateral. There is a possibility that, indeed, the real estate is leased. Hence, in principle, they may very well have leases, which are very similar to debt. Since they probably don't have manufacturing operations, the wouldn't have factories. In terms of warehousing and inventory, changes are with the internet, they probably have much less of their own inventory than they would otherwise have had. And inventory would be financed with trade credit, which wouldn't show up as debt.

4.a. The present value of the firm as of June 30, 2014 is 2/(0.14945-0.05) =20.110608. (Remember, here, we use the cost of equity capital, i.e. 14.95% and not the WACC, 14.93%.) The value of this today is 20.110608/1.149454 = $11.52.

b. We can't say for sure that the EMH is incorrect because our price of $11.52 depends on the assumptions that _we_ have made. All we can say is that we disagree with the forecasts of the marginal traders in the market. However, if we have used publicly avaiable information and our forecasts are optimal, then the EMH doesn't hold.

5. The YTM is 10%; hence the six-monthly yield is 5%. The coupons are 6.5%(1000)/2 = 32.5 every 6 months. Hence the present value of the coupon payments is (32.5/0.05)(1-(1.05)-20)= $405.02. The present value of the face value is 1000/(1.05)20 = $376.89. Adding the two together, we get the price of the bond as $781.91.


Scenario R(LTD) R(S&P 500) Prob. R(SP500)-ER(SP500) [R(SP500)-ER(SP500)]2
Strong Economy 8% 20% 0.333 5% 0.0025
Moderate Economy 10% 15% 0.333 0% 0
Weak Economy 6% 10% 0.333 -5% 0.0025
Mean Return 8% 15% Var 0.001667
std. dev 4.08%
  1. The expected return on LTD is 8%, while that on the S&P 500 is 15%.
  2. The variance of returns on the S&P 500 is 0.001667, which means that the standard deviation is 0.0016670.5 or 0.040825 or 4.0825%.
  3. The beta can be computed simply using the returns in a strong and a weak economy as (8-6)/(20-10) = 2/10 or 0.2; if we use the moderate and weak economy, we get (10-6)/(15-10) = 0.8. The true beta using all information works out to 0.6 (computed as Cov(R(LTD), R(S&P 500))/Var(R(S&P 500)). (This computation is not shown here.)


  1. False; capital can be either debt or equity. Manufacturing firms use more debt normally because they have a lot of fixed assets that are relatively more liquid and can be used as collateral for debt.
  2. While this is true generally of assets, this is not true of bonds. Since bonds have a fixed life, the price has to tend over time to the face value. Hence this will, perforce, create patterns in prices, though not patterns that can be used to generate abnormal profits.
  3. This is true only if the retained earnings are reinvested in positive NPV projects; else the value of the firm will drop. Earnings can grow, but growth in earnings, per se, is not valuable unless the value of the growth offsets the foregone immediate payouts.
  4. P/E ratios can be low, not necessarily because the stock is undervalued. A P/E ratio can be high because of expected future growth. Similar P/E ratios can be low because no growth in earnings is expected.





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