• Midterm 1
• Solutions to Midterm 1
• Midterm 2
• Solutions to Midterm 2
• Final
• Solutions to Final

Show all your computations and formulae.  Make all your assumptions explicit.  If your approach is correct, you will get some credit, even if your arithmetic answer is wrong.  So concentrate on getting your logic right.
If you answer a question, I have the discretion to award you some points, even if you are completely wrong.  If you don't attempt the question at all, I can give you no points!  So attempt every question.

Just as there could be a conflict of interests between bondholders and stockholders, and between stockholders and managers, there could also be a conflict of interests between the firm and its customers, especially when the products sold by the company are specialized durables, such as computers, that require post-sale servicing.  Once they have purchased the product, customers need the firm to obtain servicing for the product -- they are tied to the firm because the firm is the lowest cost service provider at that point.  However, the firm is now in the situation of a monopoly provider of those services, and can, in principle, either demand higher payments than previously contracted for, or, if it cannot extract better terms, provide a lower quality of service.  

One solution to this conundrum might be for the firm to acquire an equity interest in the customer.  Evaluate the validity of this argument, and when, if ever, it would work.  Could this be a justification for Cisco manager Deborah Traficante's relationship with her customer, MegsINet, Inc., and other similar relationships at Cisco?  What problems could arise from such relationships?  How would you restructure them to reduce the firm-customer conflict described above?

Web of Interests: At Cisco, Executives Accumulate Stakes In Clients, Suppliers
Firm Says This Is Legitimate But Has Revised Policy; FBI Probes One Deal
A `Disguised Compensation'?
By Glenn R. Simpson and Scott Thurm, 10/03/2000, The Wall Street Journal
(Copyright (c) 2000, Dow Jones & Company, Inc.)

In the spring of 1998, Deborah Traficante led a Cisco Systems Inc. team that sold $16 million worth of networking gear to a small Internet-service provider called MegsINet Inc. She also helped arrange for Cisco's financing arm to lend money to the start-up to pay for the purchase.

She earned a lot more than the standard commission. That July, closely held MegsINet arranged for the Cisco vice president to buy 85,714 of its shares for 56 cents each. Ten months later, MegsINet was taken over by another company for cash and stock, earning Ms. Traficante a paper profit of at least $200,000.

A conflict of interest? It wasn't at Cisco, where senior executives frequently invest in or accept stock options from customers, suppliers and partners.

At an airline, insurer or other Old Economy business, investment by an employee in a customer or supplier might trigger loud alarms, since it could give the employee an incentive to favor that company. But such relationships are common among high-tech businesses, including Cisco, the San Jose, Calif., maker of Internet switching equipment widely regarded as an archetype of Silicon Valley success.

Andreas Bechtolsheim, a Cisco vice president, holds stakes in at least seven Cisco suppliers or partners. Cisco's No. 2 official, Executive Vice President Gary Daichendt, was an early investor in Convergent Communications Inc., which is now a big Cisco customer and client of Cisco's finance arm. At least 11 other Cisco executives have invested in or received stock options from companies that do business with Cisco, on terms unavailable to most investors.

Ms. Traficante has been especially active. Last year, she was favored with an allocation of "friends and family" shares in the initial public offerings of three Cisco customers: Rhythms NetConnections Inc., Covad Communications Group Inc. and USinternetworking Inc. Such shares aren't available to most investors.

2. You need $25,000 five years from now.  You plan to make equal payments at the end of every month into an account that pays a stated annual interest rate of 12% (this is not the effective annual rate).  The bank compounds interest on a monthly basis. (30 points)

1. What are your monthly payments?
2. If you decide to make twenty equal quarterly payments (at the end of every quarter), rather than monthly payments, how much would you have to put away every quarter?
3. Suppose you decide to make equal quarterly payments, but make an additional payment of the same amount immediately (in addition to the twenty other payments), how much would you have to pay in every quarter?

3.  Here is some information on Alliant Techsystems, Inc. from http://biz.yahoo.com/p/a/atk.html (35 points):

Alliant Techsystems Inc. conducts its business into three operating segments: Aerospace, Conventional Munitions and Defense Systems. Alliant Aerospace designs and produces solid rocket propulsion systems for space launch vehicles and strategic missile systems and composite structures for space launch vehicles, reusable launch vehicles, aircraft, spacecraft, missiles and other applications. Conventional Munitions supplies, designs and develops small and medium caliber ammunition, tank ammunition, munition propellants, commercial gun powders, flares and solid tactical propulsion systems for the United States and allied governments as well as for commercial applications. Alliant Defense Systems designs, develops and supplies munitions, weapon systems, secure electronics, threat warning devices, warheads, fuses and batteries to the United States and allied governments.

The following financial statement information has been obtained from Disclosure:

Annual Liabilities (in '000s)

Income Statement

 Answer the following questions:

1. If you were a financial analyst, desirous of evaluating the firm's financial condition, would you capitalize research and development expenditures?  Why or why not?
2. Assuming that your answer to the earlier question is yes, how would you come up with a figure for the amortizable life of the R&D asset?
3. Assuming that the amortizable life of the R&D asset is 8 years, estimate the value of the asset as of March 31, 2000.
4. The stock price of ATK stock as of the close of trading on Oct. 4, 2000 was 81 3/8.  Is the book value of the firm's equity higher or lower than the market value?
5. If you were constructing a balance sheet for the firm, using the market value of the firm's equity, what other entries would you make?  (Remember, Total Assets have to equal Total Liabilities and Net Worth.)

Solution to Midterm 1

 1. The argument does have some validity because now Cisco managers will not take advantage of their position.  On the other hand, maybe individual Cisco managers will neglect other clients.  An alternative would be for Cisco to take the position, rather than the managers.  Also, perhaps, contracts could be structured so that payments are conditional on service.

2. a. .  Solving, we find 13761.24 = 44.955C, or C = $306.11/month. 

b. First we need to find out the interest rate per quarter; this equals (1.01)³ – 1 = 0.030301 or 3.0301%.  We then use this in the annuity formula:

.  Solving, we find 14.83616 C = 13761.24, or C = $927.5475 per quarter.

c. 15.83616C = 13761.24, or C = $868.98 per quarter.

3.

1. Yes, it is important to include R&D as an asset because the company's future cashflows depend on R&D outlays.

2. I'd look at the nature of the product.  More specifically, I would look at how long it took for a company's research efforts to come to fruition. I would try to do this analysis for several products in the industry, and then use the average as an estimate of the amortizable life.

 Note:  You could also choose to amortize none of the company's R&D outlays in the current year.  This is also a reasonable assumption.

4. The book value is clearly lower.  If you compute the book value of equity per share, it works out to $114,947/9074 = $12.67 per share.

5. Since market value is much higher, I would have to find some way to mark up the assets.  The obvious way is to revalue intangibles, such as R&D. 

Midterm II

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

1. The article reports: "And over the long term, Alliance's strategy is to keep its business diversified."  Does diversification make sense for Alliance Capital?  Explain your answer in about one page. (25 points)
2. "The stock is changing hands at about 48.69, about 14.5 times Zack's Investment Research 2001 earnings estimates of $3.35 per share -- a slight premium to its 13% long-term growth rate."  Use this information to estimate the required rate of return on Alliance.  If the return on the S&P 500 over the last three years was 16.5% (according to Yahoo), and the rate of return on 1 year T-bills is 6.19% according to http://www.bloomberg.com/markets/C13.html.), estimate Alliance's beta. (20 points)

Is It Time to Align with Alliance?

By ALLISON KRAMPF, Barron's Online, Nov. 6, 2000

In their heyday, mutual funds were the way to invest, before technology stocks and online trading seized the limelight.

Now, with the tech stock selloff, shares of mutual fund companies have taken off as investors have come to value asset managers -- and their takeover potential. The stocks have come so far that some analysts and fund managers say that too many funds are chasing too little money (see Weekday Trader, "Fund Stocks May Lose Street's Mutual Admiration," June 19).

But others say some asset managers could be good investments over the long term.

One favorite: New York City-based Alliance Capital Management.

Alliance, which has a market capitalization of $8.52 billion, acquired Sanford C. Bernstein, the renowned money manager for institutions and wealthy individuals, for $3.5 billion (approximately $1.5 billion in cash and 40.8 million newly issued shares). The deal closed last month.

But even before the Bernstein acquisition, Alliance was "an early player in the private, high-net-worth area," says John Riazzi, president and chief investment officer of Dean Investments.

And now, with nearly half a billion dollars under management, Alliance has the scale to be one of the major players among asset managers. It also gets fee income comprising almost 95% of the company's revenue.

"Alliance is seeing net inflows [of funds]," Riazzi says.

Riazzi, who holds 100,000 shares of Alliance, says he would add more at current levels of 48.69, about 14.5 times Zack's Investment Research 2001 earnings estimates of 3.35 per share. Currently, the stock is trading about 15% off its 52-week high of 56.688 hit in September. (It hit a low of 29.313 in January.)

And over the long term, Alliance's strategy is to keep its business diversified. The fund company is looking to broaden its product lines (it recently launched a global and international index management business) and to expand its fixed-income capabilities.

"Investors have focused on equities, but we want to make sure if the pendulum swings that we have a diverse and broad product line," Alliance CFO Robert Joseph tells Barron's Online.

Derek Izuel, portfolio manager with the Aim Global Trends Fund, likes several aspects of Alliance's business. "It is growing earnings steadily (in the mid-teens over the last few years) and it has a higher return on equity," estimated at 89.3% this year (three percentage points above its average of about 86.3% for the last four years), Izuel says.

Alliance has benefited from its emphasis on growth mutual funds over the last decade. But though growth funds have cooled in this year's market, that should not cause too much concern.

"Value funds have done better in this year's market, but that is only one year in the last eight," Izuel says. And, "if you look at demographic trends, the demand is for growth funds," Izuel adds.

(Sanford Bernstein is a value shop, so Alliance is not putting all its eggs in the growth basket.)

And Alliance does not seem to be suffering. With $9.2 billion in net inflows for the third quarter, "Alliance remains a leader across the mutual fund industry in attracting new money," says Prudential Securities' analyst John Hall.

Alliance's Joseph says that international expansion is still in the cards. Alliance has had a presence in Europe since the 1970s, and currently Alliance has 27 offices and affiliates and joint ventures in 20 different countries.

Meanwhile, the shares look attractively valued. "It is cheaper now [than at the beginning of the year, when it was trading at about 20x earnings] due to the choppiness of the equity markets, which have hurt most fund groups," says Jeff Hopson, an analyst at A.G. Edwards & Sons.

The stock is changing hands at about 48.69, about 14.5 times Zack's Investment Research 2001 earnings estimates of $3.35 per share -- a slight premium to its 13% long-term growth rate.

Earnings are expected to grow by 20% in 2000 and by 15% in 2001, according to Goldman Sachs.

Goldman analyst Richard Strauss rates Alliance Market Perform, with a price target at 60, a 25% premium over the current price. Strauss says more industry consolidation and continued fund flows into Alliance could boost its stock price.

Of course, since Alliance is 57% owned by AXA Group, the stock does not have the same takeover premium as many of its independent peers do.  "If there was the decision to buy the rest, AXA would pay some premium but it is not the same open bidding process," Riazzi points out. A.G. Edwards' Hopson speculates that parent AXA could acquire Alliance for around 58, a 20% premium to the current price.

But unlike other fund companies, Alliance's diversified earnings stream and solid fee income should help it prosper no matter what the market is doing. And investors who ally themselves with the company should benefit as well.

2. Here are the top ten holdings of Van Wagoner Emerging Growth Fund (VWEGX), as reported at http://www.stockpoint.com.

a. Assuming that the average beta for the stocks for which betas are not provided is equal to the average beta for the stocks for which betas have been provided above, estimate the beta of the Van Wagoner Emerging Growth Fund. (20 points)

b. Stockpoint also reports the beta for the fund (using data from the last three years) as 1.36.  If your answer is different from this reported beta, provide three reasons why the two estimates could differ. (10 points)

c. Using the CAPM, compute the required rate of return for the fund.  (Use the following information: The return on the S&P 500 over the last three years is  16.5%.  The rate of return on 1 year T-bills is 6.19% according to http://www.bloomberg.com/markets/C13.html.)  The actual rate of return on the fund over the last year was 128.36%.  Explain the discrepancy. (10 points)

d. Here is some financial statement information about JDSU from http://www.hoovers.com, as of June 2000.  Use this to estimate JDSU's unlevered beta. Assume a tax rate of 40%. (15 points)

Solution to Midterm II

It is, however, possible to make an argument for product line diversification.  If the firm believes that its clients are looking for a one-stop shop for all their investment needs, then the firm should offer a complete line of funds, i.e. product diversification.  Also, if its costs per fund would be lower, the greater the number of funds it offers.  This could be, for example, if there are economies of scale in managing funds.

b. Using a growth rate (of earnigns) of 13%, if 3.35 is the earnings per share estimate for the next year, the stock price formula (for a growing perpetuity) gives us: 48.69 = 3.35/(r-0.13), where r is the required rate of return.  Solving, we find r = `9.88%.

If we now use the CAPM [Required ROR = R_f + b(E(R_m) - R_f)], we have the relation 20.77 = 6.19 + b(16.5-6.19). Solving, b = 1.415.

2. a. We have the beta values for seven of the firm's holdings.  If w_i is the fund's percentage portfolio holdings for stock i, and b_i is the beta of stock i, the value-weighted average of the betas of the seven stocks is obtained as Sw_ib_i/Sw_i.  Sw_i = 22.56; hence the value-weighted average works out to [(2.8)(12.61) + (3.1)(2.48) + (0.7)(2.12) + (1.0)(1.79) + (6.7)(1.78) + (1.85)(0.91) + (1.3)(0.87)]/22.56 = 2.006.  If we can assume that the average beta for the stocks for which betas are not provided is equal to the average beta for the stocks for which betas have been provided, then 2.006 is also the estimated beta of the fund.

b. Here are three reasons:

1. Our assumption that the average beta for the stocks for which betas are not provided is equal to the average beta for the stocks for which betas have been provided could be wrong.
2. The betas in the table are from two different sources, Yahoo and Hoovers, both of which are different from Stockpoint.  The estimation methodology could differ between the three sources, e.g. the index that they use could differ and the sample period could differ.
3. The composition of the portfolio is not constant over time.  Stockpoint's beta could have used a different portfolio composition compared to Yahoo and Hoovers.

c. The expected rate of return using the CAPM is 6.19 + 1.36(16.5-6.19) = 20.21%; this is much lower than the actual return over the last year of 128.36%.  This is probably because the stocks chosen by the firm did better over the year than expected by the market.

d. The debt-equity ratio is 41/24778.6 = 0.00165.  Using the formula, the unlevered beta = levered beta/[1+(1-t)D/E] = 1.85/[1+(1-0.4)(0.00165)] = 1.848.

Final Exam

• Show all your computations and formulae.  Make all your assumptions explicit.  If your approach is correct, you will get some credit, even if your arithmetic answer is wrong.  So concentrate on getting your logic right.  And explain all your answers as much as possible.

•  If you answer a question, I have the discretion to award you some points, even if you are completely wrong.  If you don't attempt the question at all, I can give you no points!  So attempt every question.

•  Although to answer some questions correctly, you will need the answers to previous questions, I will evaluate each question independently.  Hence, even if you have not been able to answer a previous question, do not skip the following questions.  Make an arbitrary assumption about the answer to the previous question and proceed with the following questions.

1. (30 points) Read the article below from Inc. and answer the following question:

List the factors to be taken into account in determining the right amount of debt for an entrepreneurial operation, according to the article.  Comment briefly on the validity of the arguments given, for each factor.  I will only read five lines per point.

Giving credit to debt
Inc; Boston; Nov 2000; Vol. 22, no. 16, pp. 125 ff. Jill Andresky Fraser;

TO LEVERAGE, OR NOT TO LEVERAGE: THAT IS THE QUESTION for many entrepreneurs-at least the ones who have the option of borrowing funds to finance their company's growth. In today's environment of rising interest rates, debt has started to look less appealing than it looked throughout much of the 1990s. But for some business owners, it always was undesirable, no matter what the cost of borrowing was. "I'm doing $2 million in sales with only a $20,000 credit line outstanding," says Jerry Edwards, co-- owner and president of Chefs Expressions, a catering company in Timonium, Md. "With the exception of a single two-year period when we borrowed $50,000 to pay for some expensive equipment tied to an expansion effort, we've always funded our growth out of cash flow. I had a credit line that I didn't dip into for 10 years!"

Edwards is scarcely alone in his aversion to borrowing. "We see many mature, privately held companies that are debt free by choice, as well as many service companies that are debt free by necessity because they don't have the assets to support a long-term borrowing arrangemen it," reports Z. Christopher Mercer, the CEO of Mercer Capital Management Inc., based in Memphis.

Although many company owners consider their lack of indebtedness a strong selling point, does having no debt on the books really enhance a company's value when its owner is seeking an outright sale or a public or private stock offering? "The quick answer is no," say Jeffrey D. Jones, president of Certified Appraisers Inc., in Houston. "From a marketing standpoint, a buyer is purchasing gross value, which is a function of its earnings and what the marketplace will pay for them."

At times, Jones acknowledges, debt can affect a business's appraised value. "If I were hired to assess a company's value for a divorce settlement," he explains, "the key number to determine would be its net equity, which is calculated by subtracting liabilities from gross value. The more debt, the lower the net equity." But that number would not have an impact on the company's sale price in the open market.

Business owners who are proud of keeping their companies free of debt may wonder whether they'll get at least an intangible benefit: some kind of recognition for their ability to resist financial temptation and run a tight ship. However, an investment banker, a professional investor, or a potential buyer will evaluate the situation differently from the owner. "Professionals are not going to be making those kinds of judgments or worrying about whether you deserve personal credit or not," says John J. Egan III, a partner at law firm McDermott, Will & Emery in Boston. "Instead, their focus will be on where the company is today, which is what's going to determine whether it will be sellable and, if so, for how much."

Jones agrees. "Some owners may have been able to avoid borrowing because they inherited a large amount of money that they could put into the business, or they left their last jobs with a big early-- retirement package. Those are the kinds of things that are completely irrelevant to the value and marketability of a company. So why should anyone care about them?"

Meanwhile, some experts argue that choosing a debt-free approach to entrepreneurship actually may have a negative influence on a company's value at sale time. Says Conor Reilly, a partner in the New York City law firm Gibson, Dunn & Crutcher LLP, "Sophisticated buyers and investors will look for an overall capital structure that is intelligently constructed. Having some debt is a good thing if it allows your company to increase its revenues and return on equity. If you don't have any debt, and an outsider suspects that its absence has hindered growth, that's a detriment."

That's not to say, however, that it makes sense to load up on debt just to convey the right impression to the outside world. Depending on the dynamics of your industry, as well as the type of growth that you are pursuing, borrowing may be unnecessary, costly, and constricting. "I can completely understand why some entrepreneurs don't want to get involved with it," says Egan. "In many cases, they'll have to sign a personal guarantee for the loan and accept all kinds of covenants, which may even restrict growth if they need to obtain waivers all the time from their bankers."

From Edwards's vantage point, there just never seemed to be any compelling reason to take on more than a minimal level of debt. "I don't believe it's possible to maintain the kind of high-quality catering operation that I've got while pushing growth any faster than 15% each year," he says. "And that's what we've always been able to do without any help from a loan. Anyone looking at my company can see that it can sustain steady growth without my running to the bank three or four times each year for more cash." He adds, "I'd only think about selling it for a great offer. But if I did, I wouldn't want to use a big chunk of the proceeds to pay off debt."

An internally funded growth model might impress a potential buyer who shared the seller's objectives and assumptions about the industry. But for people with much faster growth on their minds, warns Reilly, "someone who boasts about running a debt-free business will seem out of touch, maybe even antiquated. The business world has evolved in such a different direction from that. I can't recall, for example, the last time I saw a company with a $100-million capitalization that didn't at least have some credit-line facility. How could you support that kind of growth without it?"

Ultimately, debt offers an advantage that may indirectly improve a company's prospects for a lucrative sale. As Egan points out, "Potential buyers do reference checks. If they can talk to a banker who has a good history of working with the company and its owner, that's only going to help. It even helps if the banker tells the prospective buyer that the company has had some tough times along the way but has always managed to live up to the terms of the loan and has always provided reliable financial information." For owners who can't yet qualify for a bank loan (or who really don't want one), that type of validation can also come from nonbank lenders, suppliers, or strategic partners who may provide financing while the company grows.

The right debt mix

The question of whether debt increases or decreases a company's value has no one-size-- fits-all answer, but here are some guidelines as you think about your own company.

Do you anticipate doing an initial public offering or selling your company within the next three to five years?

If so, then you've little choice but to ratchet up the company's growth rapidly-which means that a credit line probably is essential. If your company is too new or too small to qualify for a credit line on its own, look for ways to pair an equity financing deal with a bank loan. (That strategy is increasingly possible, especially for companies who land investments from established venture capitalists, private-equity funds, or repeat angel investors with contacts in the banking community.)

Is debt justifiable?

If your company's lack of funds stems from cash-flow problems that require corrective measures (perhaps in your accounts-receivable or -payable systems), don't expect an outsider to applaud your unnecessary borrowing.

Are you running a fast-growing service company or a company with few assets that can serve as collateral?

Then you're in a bind. You probably could use some debt, but unless your personal financial position is very strong, it's unlikely that you'll be able to persuade a banker to give you a loan. Instead of relying entirely on equity deals to bring capital into the business, pursue other sources of financing, with the goal of moving to a traditional credit line as soon as you establish a track record and a cash-flow stream. (Consider starting with a credit line from your credit-card company or with a contract-financing deal from a non-bank lender.)

Can you control your company's hunger for capital?

That should be a major concern for any growth-oriented company. Although some debt is good, too much can be catastrophic. "If you owe too much, or if it's coming due sometime soon and a prospective buyer would have reason to worry, then debt can be a big strike against your company," says John J. Egan III, a partner at law firm McDermott, Will & Emery in Boston. So walk the line between abstinence and self-- destruction-ideally by layering both debt and equity arrangements into your growing company's capital structure.

2. (20 points) Read the following company overview for Danaher Corporation (NYSE: DHR) from Market Guide (http://www.marketguide.com) and estimate the company's long-term-debt to equity ratio, where both debt and equity are measured in market-value terms.  Explain the reason for your conclusion. The average long-term-debt to equity ratio for the S&P 500 is 0.60, in book-market terms. 

Danaher Corporation conducts its operations through two business segments: Process/Environmental Controls and Tools and Components. The Process/Environmental Controls segment produces and sells compact, professional electronic test tools, underground storage tank leak detection systems and motion, position, speed, temperature, level and position instruments and sensing devices, power switches and controls, communication line products, power protection products, liquid flow and quality measuring devices, quality assurance products and systems, safety devices and electronic and mechanical counting and controlling devices. The Tools and Components segment produce and distribute general-purpose mechanics' hand tools and automotive specialty tools. In July 2000, Danaher completed the acquisition of Colfax Corp.'s Warner Electric motion control business for $144 million.

3. (20 points) Use the information below on Escalade, Inc. (ESCA) to estimate its dividend payout ratio.

Company Overview: Escalade, Inc. is a diversified company engaged in the manufacture and sale of sporting goods products and office and graphic arts products. Escalade manufactures and sells a variety of sporting goods such as table tennis tables and accessories, archery equipment, home pool tables and accessories, combination bumper pool and card tables, game tables, basketball backboards, goals, poles and portables, darts, and dart cabinets. The Company's office and graphic arts products include paper trimmers, paper folding machines, paper drills, collators, decollators, bursting machines, letter openers, paper joggers, checksigners, stamp affixers, paper shredders, paper punches, paper cutters, catalog rack systems, bindery carts, business card slitters, thermography machines, keyboard drawers, computer storage, copyholders, media retention systems, posting trays and related accessories.

The table below compares ESCA's performance with its industry (Recreational Products) and its sector (Consumer Cyclical).

 4. (30 points) Compute the weighted average cost of capital for the Newport Corporation (NASD: NEWP) as of 12/31/99.  You have the following information on the company:

• The company beta as reported by Marketguide is 1.28. 
• The average dividend yield on the S&P 500 over the last three years is around 1.5%.
• Footnote 8 to the Financial Statements provided in the firm's 10-K filing, filed with the SEC on March 29, 2000 (Source: http://www.10kwizard.com) tells us that most of the firm's debt is in the form of 8.25% senior notes.  You may assume that the bonds are trading at par.

In addition, you have access to the firm's balance sheet, data on historical S&P 500 Index month-end closing, and data on historical Treasury bill yields.

B: Data on S&P 500 Index month-end closing (Source: http://finance.yahoo.com)

Date	Open	High	Low	Close
Dec 99	1388.91	1473.10	1387.38	1469.25
Nov 99	1362.93	1425.31	1346.41	1389.07
Oct 99	1282.71	1373.17	1233.70	1362.93
Sep 99	1320.41	1361.39	1256.26	1282.71
Aug 99	1328.72	1382.84	1267.73	1320.41
Jul 99	1372.71	1420.33	1328.49	1328.72
Jun 99	1301.84	1372.93	1277.47	1372.71
May 99	1335.18	1375.98	1277.31	1301.84
Apr 99	1286.37	1371.56	1282.56	1335.18
Mar 99	1238.33	1323.82	1216.03	1286.37
Feb 99	1279.64	1283.84	1211.89	1238.33
Jan 99	1229.23	1280.37	1205.46	1279.64
Dec 98	1163.63	1244.93	1136.89	1229.23
Nov 98	1098.67	1192.97	1098.67	1163.63
Oct 98	1017.01	1103.78	923.32	1098.67
Sep 98	1018.87	1066.11	993.82	1017.01

C: Data on Treasury bill yields (http://www.economagic.com)

Solutions to Final Exam

1. There are several points brought out in the article regarding the optimal amount of debt for an entrepreneurial firm (not all in the last section).  The answer below has the following structure.  The main point is first set out with underling.  The citation from the article is then provided, in italics.  Following this are my comments, for each point.

1. Debt is useful to finance growth and to increase return on equity
   
   Says Conor Reilly, a partner in the New York City law firm Gibson, Dunn & Crutcher LLP, "Sophisticated buyers and investors will look for an overall capital structure that is intelligently constructed. Having some debt is a good thing if it allows your company to increase its revenues and return on equity. If you don't have any debt, and an outsider suspects that its absence has hindered growth, that's a detriment."
   
   Equity is much better than debt to finance growth because most growing firms are not likely to have the necessary cashflow in the short-run to pay interest on debt.  Debt might increase return on equity but it does so at the cost of greater risk.
   

2. Debt reduces flexibility
   
   That's not to say, however, that it makes sense to load up on debt just to convey the right impression to the outside world. Depending on the dynamics of your industry, as well as the type of growth that you are pursuing, borrowing may be unnecessary, costly, and constricting. "I can completely understand why some entrepreneurs don't want to get involved with it," says Egan. "In many cases, they'll have to sign a personal guarantee for the loan and accept all kinds of covenants, which may even restrict growth if they need to obtain waivers all the time from their bankers."
   
   This is quite true.
   

3. Using debt financing forces a short-run outlook and makes it difficult to run a high-quality operation
   
   From Edwards's vantage point, there just never seemed to be any compelling reason to take on more than a minimal level of debt. "I don't believe it's possible to maintain the kind of high-quality catering operation that I've got while pushing growth any faster than 15% each year," he says.
   
   Beyond the fact that creditors need to paid interest regularly, there is no fundamental reason why debt is incompatible with a high-quality operation.  If the operations are really high-quality, it should be possible to obtain enough equity to make interest payments, with the principal on the debt to be repaid with future cashflows from operations.
   

4. The existence of debt means that other people, particularly bankers have investigated the company, i.e. have monitored it in the past, and are monitoring it currently.
   
   Ultimately, debt offers an advantage that may indirectly improve a company's prospects for a lucrative sale. As Egan points out, "Potential buyers do reference checks. If they can talk to a banker who has a good history of working with the company and its owner, that's only going to help. It even helps if the banker tells the prospective buyer that the company has had some tough times along the way but has always managed to live up to the terms of the loan and has always provided reliable financial information."
   
   Debt has this advantage.
   

5. If an IPO is envisaged, then debt may be necessary because the focus of the firm is necessarily short-term; however if the company is too new, venture capital may be the only way to go.
   
   Do you anticipate doing an initial public offering or selling your company within the next three to five years?  If so, then you've little choice but to ratchet up the company's growth rapidly-which means that a credit line probably is essential.
   
   The text of the article does not make it clear why exactly debt is preferred and under what conditions, if an IPO is envisaged.  You've little choice is not a reason.
   

6. A company with few assets that can be used as collateral can't have much debt.

   Are you running a fast-growing service company or a company with few assets that can serve as collateral? Then you're in a bind. You probably could use some debt, but unless your personal financial position is very strong, it's unlikely that you'll be able to persuade a banker to give you a loan. Instead of relying entirely on equity deals to bring capital into the business, pursue other sources of financing, with the goal of moving to a traditional credit line as soon as you establish a track record and a cash-flow stream.

    This is quite true as we discussed in class.

7. Debt cannot be used to resolve a firm's profitability problems.
   
   Is debt justifiable?  If your company's lack of funds stems from cash-flow problems that require corrective measures (perhaps in your accounts-receivable or -payable systems), don't expect an outsider to applaud your unnecessary borrowing.

Neither debt nor equity would seem to be sensible in this case; perhaps it would make more sense to either sell the company or liquidate it.  However, if steps are being to turn the company around, equity might be preferable because more time would be available before any payments are made. 

2. We can use the information from the Company Overview in several ways:

1. Danaher sells specialty tools, whose quality probably can be seen only after several periods of use.  Hence it values its reputation.  As such, Danaher would want to keep a low debt ratio. 

2. Given its products, Danaher probably has a lot of intangible assets, like patents.  These would be more difficult to get rid of, if the company needs to be liquidated; the consequent high cost of bankruptcy would imply the need to have a low debt ratio.

3. The firm's earnings volatility is probably high, given the nature of its products, which likely have a high demand elasticity.  This points to a low level of leverage.

Given the S&P average long-term-debt to equity ratio for the S&P 500 is 0.60, in book-market terms, and given the spurt in the market for most companies, the long-term-debt to equity ratio in market-value terms is probably lower.  Hence, given the nature of Danaher, I would predict a lower debt ratio, say, 15%.

3. Several pieces of information from the Company Overview and the Financial Ratios are useful to estimate the dividend ratio. 

1. The firm has a low beta (0.21), even compared to the industry (0.9) and sector (1.05).  This is indirect evidence that earnings volatility is low, and hence the firm can afford to have a high dividend payout ratio.
2. Institutional Ownership is low, less than 3%, compared to an average of 44% for the industry.  If one accepts the argument that institutional investors monitor on behalf of other shareholders, this firm would need other means of assuring sufficient monitoring.  Since the payment of dividends reduces free cash flow and means that the manager needs to go back to the financial markets to get additional financing for new projects, this firm should pay a higher proportion of its earnings in dividends, according to this theory.
3. The firm's growth rate is high (the EPS growth rate is 108%, compared to an industry average of 15%).  Hence the firm probably needs a lot of financing.  Since external financing is more expensive, ceteris paribus, than internal financing, it would be appropriate for the firm to retain more of its earnings to finance growth.  In this context, it's interesting to note that the capital spending growth rate is a negative 23.66%!  This seems to go contrary to all the other pieces of information, that we have available to us, in terms of the company's growth.  One possibility, pointed out to me by one of the students, Paul Maksys, is that the company happened to sell off one of its divisions, perhaps preparatory to buying another business.  (However, I have not been able to locate any information about such a sell-off.  Another possibility is that it had a big acquisition five years ago, which would then skew this statistic.  However, a look at ESCA's balance sheets for the last five years doesn't provide much evidence of this either.)
4. ESCA also has pretty good return on assets, equity and investment compared to the industry.  Hence, it makes sense to continue to grow.

On balance, therefore, ESCA should go with growth, and retain its earnings so as to be able to finance growth.  Perhaps a payout ratio of 5% - 10% would be appropriate.  In fact, its current payout ratio is 0%.  Part of the reason might be that its insider ownership is 58% (not given in exam), which would allow the company to resist calls for more dividends.

Note on Institutional Ownership and Dividend Payments: Many students seem to believe that institutional owners require a high dividend yield.  In order to do a quick test of that hypothesis, I went to http://www.marketguide.com/mgi/screen/AScreen.asp and starting with a universe of 9851 companies, I required my sample to have institutional ownership of at least 20%; this reduced the sample to 3863 companies.  If it is true that institutional investors like high dividends, then imposing an additional screen that the companies in the sample have a high dividend payout ratio should not have reduced my sample much.  And, in fact, I found that imposing a requirement that the payout ratio be 20% reduced my sample to only 807!

The number of firms in the total sample with a payout ratio > 20% is 1099, or 1099/9851 = 11.15%; the number of firms with an institutional ownership > 20% is 3863, or a proportion of 39.21%.  If the two criteria were independent, imposing both should give us 11.15 x 39.21 or 4.37%; if firms with high institutional ownership tend to have high payout ratios, the proportion of firms satisfying both criteria should be higher.  In fact, the actual proportion is 8.19%, which suggests that high institutional ownership and high payout ratios do go together.  However, it is not clear why this should be so.

As a robustness check, I looked at the proportion of firms among the 9851 that had institutional ownership less than 3% (as with Escalade); I found this to be 24.07%.  Now, I imposed the requirement that the payout ratio be at least 20%, and I got a total of 60 firms, which works out to 0.6%.  If the two conditions tended to go together, I should have found more than 24.07 x 11.15 or 2.68%.  This again confirms the theory that institutional investors look for high dividends.  It should be noted, however, that this is at best, an empirical regularity, and could fail in any particular case.  Hence, it is important to work out the reason why this should be so, for companies in general, and then to see if it applies to our case.

4.  The first step is to compute the debt-to-assets ratio.

Using 1999 data, if we use book value numbers, and we define debt as Total Long Term Debt, then the debt-to-assets ratio is 12.7/122.3 or 10.38%.  If we define debt as current liabilities plus long term debt, we get (31.0+12.7)/122.3 or 35.73%.  If we use short-term debt and long-term debt, we get (10+4.6+12.7)/122.3 or 22.32%.  Which measure is to be used depends on the purpose for which we are using.  See more on this at my website.

The cost of equity can be computed using the CAPM.  The expected rate of return on the market is computed as the expected capital gain on the "market" portfolio plus the dividend yield.  The expected capital gain on the market portfolio can be estimated as the return over the Dec. 1998-Dec. 1999 period on the S&P 500.  This yields 1469.25/1229.23 - 1 = 19.5%.  Using this information, and the fact that the beta of the company's stock is 1.28, the required rate of return on equity capital equals 5.84 + 1.28(19.5 + 1.5 - 5.84) = 25.24%, where 5.84, the one-year T-bill rate is taken to be the riskfree rate.

Hence the weighted average cost of capital (using the debt-to-assets ratio of 10.38%) works out to (1-0.4)(0.1038)(8.25) + (0.8962)(25.24) = 23.13%