1. How would the beta of Imperial Tobacco change after its acquisition of Reemstma?  Explain how you came up with your answer. (10 points)
2. Would it have more or less diversifiable risk?  Explain. (10 points)
3. Is it ethical for Imperial Tobacco to diversify into markets where cigarettes are not subject to the same sorts of restrictions and regulations that its own home markets are?  Or is it, perhaps, a fiduciary duty of management to its stockholders? (10 points)
4. If you were a financial analyst at Imperial Tobacco, trying to use the CAPM to come up with a required rate of return for the Reemstma acquisition, what would you choose as the market portfolio? I don't need to know the name of the actual portfolio or index -- just explain what the characteristics of such a portfolio would be, and why.(10 points)

Imperial Tobacco Nears Deal to Buy Big German Maker
By Sarah Ellison, 03/06/2002, The Wall Street Journal

LONDON -- Imperial Tobacco PLC, maker of Embassy and Superking cigarettes, is close to completing a deal to buy Germany's Reemtsma Cigarettenfabriken GmbH, the world's fourth-largest tobacco company, for about six billion euros ($5.2 billion), people familiar with the talks said.

The fate of Reemtsma, which is 75%-owned by Tchibo Holding AG, a German coffee and tea company, is expected to be formally decided today during a meeting of Tchibo's supervisory board.

The acquisition would give Imperial a significant foothold in emerging markets in Eastern Europe, where Reemtsma sells 75% of its cigarettes, unhindered by the litigation risks that plague tobacco companies in the U.S.

The deal would roughly double the size of Imperial, which reported sales of GBP 5.9 billion ($8.4 billion) last year. The company would become the world's fourth-largest tobacco company after Philip Morris Co., British American Tobacco PLC and Japan Tobacco; it is now ranked No. 11. Japan Tobacco explored a purchase of Reemtsma but ultimately said it wasn't interested.

Imperial confirmed yesterday it is in talks with Reemtsma. Other companies that have submitted proposals include French-Spanish tobacco concern Altadis SA, and Britain's Gallaher Group PLC.

Imperial is expected to announce that it will fund a portion of its bid by issuing new shares. The company is expected to take on a hefty debt burden, roughly 4.3 billion euros, to finance the purchase.

The auction process, which has gone on for months, has been slowed by faltering stock markets and the need to win approval of the Herz family, which controls Tchibo. The company had revenue of 5.4 billion euros in 2000. Tchibo is being advised by Merrill Lynch & Co. on the auction of Reemtsma.

Q. 2. (Source: StockVal) Net Income per share for Thor Industries, Inc. (THO) for 2001 was $2.23, with 11.963 million shares outstanding.  The firm had capital expenditures of $17.2 million last year, and depreciation of $4.9 million.  Current liabilities were $87.3 million, current assets were $238 million, and cash was $107.2 million.  Interest expense was 0.8 million.  Thor Industries has a beta of 0.76 based on the last 60 months of data . Assume that noncash working capital, net income, depreciation and capital expenditures will all increase by 10% for the next five years, and then by 5% for ever.  Thor Industries does not have any long-term debt or current debt, and there is no expectation that debt will be used in the future.

 The current yield on 10-year T-bonds is 5.31% (source: http://www.bloomberg.com/markets/C13.html?sidenav=front).  Assume that the market risk premium is 6% per annum.

1. What is the required rate of return on Thor stock? (10 points)
2. Estimate the free cash flow to equity in 2001.  (Assume that non-cash working capital increased 10% in 2001 over 2000.) (10 points)
3. Estimate the price of Thor stock at the end of 2005. (10 points)
4. Estimate the per share price for THO as of the end of 2001.  (10 points)
5. Estimate the price of THO as of March 31, 2002, assuming that Thor pays no dividends between Dec. 31, 2001 and March 31, 2002.   (10 points)
6. If I told you that Thor stock traded at $46.31 on March 18, 2002, what would you say regarding market efficiency?   (10 points)

Solutions:

1.

1. The beta should not change much after the acquisition.  Both companies are in similar lines of business.  Betas for large companies are often lower; so Imperial being a smaller company, might see its beta go down, given that Reemtsma is larger.  Note that Reemstma's market is in emerging countries primarily.  The question is, how sensitive are Reemstma's sales in those countries to the economic environment.  If we believe that cigarettes are treated as staples, as food substitutes by poorer people, the sensitivity will be low, and the beta of the company's assets and the stock will be low.  Hence, Imperial's asset beta may be expected to drop after the acquisition.  On the other hand, Imperial's debt-equity ratio is going to go up; this will lead to a higher stock beta.  If the debt burden is very large, as is implied, it is likely that the second factor will overwhelm the first factor, thus leading to a larger beta for Imperial after the acquisition of Reemtsma.
2. Diversifiable risk may not go down much, since both companies are in similar industries.  Hence the same factors that affect Imperial's returns would affect Reemtsma's returns as well.  On the other hand, their markets are different; so, all in all, there probably will be some diversification.
3. From a narrow legal point of view, the fiduciary responsibility to stockholders predominates.  However, it may be argued that there is an implicit contract with society for the entire company; from this point of view, the ethical concerns would take on more importance.
4. The question is -- what definition of the market portfolio should one use in defining the beta for a stock. In principle, you should use the definition that corresponds to the investors who hold that stock. In other words, if a certain stock is held by investors in the domestic country only, then the pricing is done without respect to other stocks in that country, and the beta would be measured with respect to that country's index.  If a stock is held by investors globally, then a global index would be appropriate to measure its beta.
   
   This approach is particularly correct for the CFO of that company. However, if an individual investor who owns stocks globally is looking to invest in a stock that is really only held locally, he would evaluate his required rate of return on the stock using a beta defined with respect to a global index, and he would probably end up with a lower required rate of return and a higher valuation than the current holders of the stock -- this would be because those owners don't have the advantage of international diversification that he does.
   
   In our case, if Imperial's shareholders are primarily British, and British shareholders primarily hold portfolios heavy in British stocks, then a British index would be appropriate to evaluate the Reemtsma acquisition.

2.

1. The required rate of return, according to the CAPM is computed as the risk free rate plus the beta times the market risk premium.  Here, that works out to 5.31% + 0.76(6) or 9.87%
2. The free cash flow to equity is defined as net income plus depreciation less change in noncash working capital less capital expenditures less payments less net flows to debtholders.  In the case of Thor Industries, for 2001, we have, on a firm basis (not per share)
   

   Net Income	2.23 x 11.963 = $26.677 m.
   Noncash Working Capital = Current Assets - Current Liabilities - Cash	238 - 87.3 - 107.2 = $43.5 m.
   Change in Noncash Working Capital	43.5 x 0.1 = $4.35 m.*
   Depreciation	$4.9 m.
   Capital Expenditures	$17.2 m.
   Free Cash Flow	$10.02749 m.

Interest payments don't have to be separately taken into account, since they are already included in Net income.

*Strictly speaking, the change in noncash working capital should be (1-1/1.1)43.5 = $3.955m.

3. Free Cash flow is assumed to increase at the rate of 10% (since all the components increase at the same rate); hence, we get Free Cash Flow to Equity in succeeding years, as:
   

   2002	10.02749 (1.1) = $11.0302 m.
   2003	11.0302 (1.1) = $12.1333 m.
   2004	12.1333 (1.1) = $13.3466 m.
   2005	13.3466  (1.1) = $14.6812 m.
   2006	14.6812 (1.1) = $16.1494 m.
   2007	$16.1494 (1.05) = $16.9569 m.

From 2006 onwards, FCFE is expected to increase at the rate of 5%; so to price Thor as of the end of 2006, we can use a growing perpetuity formula.  This gives us the value of Thor at the end of 2006 as 16.9569/(0.0987 - 0.05) = $348.1898.  At the end of 2005, the value of Thor would be (348.1898 + 16.1494)/(1.0987) = $331.67; on a per share basis, that works out to 331.67/11.963 = $27.72

4. The value of Thor's equity as of the end of 2001 is simply the present value of the FCFE in 2002, 2003, 2004 and 2005 plus the present value of the value of Thor's equity as of the end of 2005.  This works out to 11.0302/(1.0987) + 12.1333/(1.0987)² + 13.3466/(1.0987)³ +  14.6812/(1.0987)⁴ + 331.67/(1.0987)⁴.  Dividing this by the number of shares outstanding gives us $22.385
5. The price at the end of March 2002 is simply 22.385(1.0987)^0.25 = $22.92.
6. If all our assumptions are correct, then we would have to say that the market is not efficient.  However, since we are simply working with assumptions, it is very possible that some of our assumptions are incorrect.  Hence we cannot automatically conclude that markets are inefficient.

Final Exam

• Show the formula you are using to answer the quantitative questions.  Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary.  You do not have to show computations beyond this.  However, make sure that the numerical value of your answer makes sense in the context of the question. 

• 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.

• Excessively verbose and irrelevant answers will be penalized.  

• Note that the entire exam is about Bell Canada International; use all available information in answering all the questions.

a. (15 points) Presented at the end is the balance sheet of Bell Canada International, as of Dec. 31, 2001, in millions of U.S. dollars (Source: http://www.marketguide.com).  Compute the debt-equity ratio of Bell Canada International, using the book value of equity.  Assuming that we're using the debt/equity ratio to compute the weighted average cost of capital, and considering that this is used as a discount rate for all cashflows, you should use all debt, current as well as long-term, in the computation of the debt/equity ratio.  Deferred income tax is not really a liability at all, and simply has the effect of reducing retained earnings.  Hence, if you wish to use book value of equity, deferred income tax should be included as equity, rather than being included in "debt."  Also, minority interest represents an outside ownership interest in a subsidiary that is consolidated with the parent for financial reporting purposes.  However, it is more akin to equity than to debt because there is no obligation to make specific payments on minority interest; hence it should be included in equity.

b. (15 points) The price of Bell Canada International stock as of May 1, 2002 (Source: http://www.marketguide.com) is 5 cents.  What would be the debt-equity ratio, if you used the market value of equity?  (Think of what you should do with minority interest.)  Do you think this is a better measure of the debt/equity ratio if you planned to use it to compute the weighted average cost of capital?  Explain.

c. (15 points) The beta of Bell Canada International is 2.51 (Source: http://www.marketguide.com).  Compute the asset beta of the company.  The debt-to-equity ratio for Airgate PCS, Inc., which is in the same industry is 0.83 (Source: http://biz.yahoo.com/p/_servic-comsrv.html).  Estimate Airgate PCS's equity beta.

d. (15 points) On September 29, 1999 the Corporation issued $160,000,000 of Senior Unsecured Notes. These Notes mature on September 29, 2004 and bear interest at 11% payable semi-annually.  You don't have any other information on the cost of debt.  Compute the weighted average cost of capital for Bell Canada International.  Assume a riskfree rate of 5% and a market risk premium of 5.5%.

e. (20 points) What factors would you take into account in determining the dividend payout ratio for a firm?  Evaluate those factors in the case of Bell Canada International and suggest an optimal dividend payout ratio for them.

f. Read the following article from http://www.marketguide.com (4/29/2002 - 12:13:00 PM) and answer the questions below:

BCE INC: BELL CANADA INTERNATIONAL INC - Class Action Suit Launched Against BCE, Bell Canada International - And Its Directors, And BMO Nesbitt Burns

Toronto, Ontario, Apr 29, 2002 (Market News Publishing via COMTEX) --A $250 million class action has been launched on behalf of all persons who, on December 3, 2001, owned a least one unit of the 6.75% debentures issued by Bell Canada International ("BCI").

The defendants are BCE, BCI and individual directors of BCI, including former chairman and CEO Jean Monty and new CEO Michael Sabia. BMO Nesbitt Burns is also named in the action.

The plaintiffs, Kenneth Field, K. Field Resources, Brian T. Clark and Cooper M. Spence are represented by Harvey T. Strosberg of Sutts, Strosberg LLP.

The class action alleges that BCE, BCI and BCI's directors acted oppressively, were unfairly prejudicial to and unfairly disregarded the interests of the holders of the 6.75% debentures. On February 15, 2002, BCI retired the debentures by issuing approximately 911,211,546 BCI common shares it valued at approximately $0.27 per share. Yet, on the same day, BCI issued and sold approximately 3 billion BCI common shares to existing shareholders, under the recapitalization transactions, at approximately $0.14 per share, thereby raising approximately $441 million.

The class action also alleges that the recapitalization plan, announced on December 3, 2001 and implemented on February 15, 2002, was designed to permit BCE to maintain control of BCI at the least cost.

Under a rights offering included in the recapitalization plan, BCE purchased from BCI approximately 2.654 billion common shares at a cost of approximately $391 million. As a result, BCE holds 62.2% of BCI's issued common shares and continues to control BCI. Had BCI retired the debentures with BCI common shares valued at approximately $0.14 per share, BCE would have been required to pay to BCI a further $115 million to maintain its 62.2% controlling interest.

Class action counsel, Mr. Strosberg, said:

"The decision by BCE, and by BCI and its directors to sell common shares to BCE and others at $0.14 each while retiring the debentures by issuing and valuing the same common shares at $0.27 each, was, in my opinion, unfair, unreasonable, unwarranted and unjustifiable. And I believe this conduct was all the more egregious because BCI announced that it was essentially unable to meet its financial obligations as they fell due.

BCI then went on to prejudice holders of the debentures by converting them from creditors to shareholders."

"The court may be required to decide whether BCE, BCI and BCI's directors misused the capital markets," Strosberg added.

The plaintiffs allege that BMO Nesbitt Burns was negligent in the performance of services and in the expression of its opinions. For example, BCI has stated that it valued the common shares at approximately $0.27 per share for the purposes of retiring the debentures based upon advice it received from Nesbitt Burns.

A class action is a method for persons with common issues to join in a single court proceeding rather than each bringing an individual lawsuit.

______________

( i ) (15 points) Agency costs can be defined as follows:

The costs incurred because the objectives of the agent are not the same as those of the principal.  These can be of various kinds -- a) the costs of suboptimal actions taken by the agent, b) the explicit costs incurred by the principal in monitoring the agent, and c) the implicit costs incurred because of restrictions imposed by the principal on the agent's actions, which may lead to suboptimal actions taken by the agent.  Note that the agent might sometimes take actions to divert to himself/herself, part of the payoff that might have otherwise gone to the principal; however, if this does not reduce the total payoff to the two of them, there are no agency costs involved.

Keeping this in mind, would you say that there is an agency cost involved here?  If so, what is the nature of that agency cost?

( ii )  (5 points) Bell Canada International could have extracted this value from bondholders at any time.  Can you think of a reason why Bell Canada International might be doing this now?

______________________

Balance sheet of Bell Canada International, as of Dec. 31, 2001, in millions of U.S. dollars

Solutions

a. The debt-equity ratio is 2340.8/(288.6+51.0+62.5) = 5.821.

b. The market value of equity is 0.05(79.02) = 3.951.  However, minority interest is not included in these 79.02 shares; hence we add in the book value of minority interest, which raises the value of equity to 65.95.  The debt-equity ratio therefore becomes 35.49.  However, this is probably too high.  The book value of debt probably overstates the market value of debt in the same way that the book value of equity overstates the market value of equity.  If it were possible to get the market value of debt and equity, that debt-equity ratio would make more sense.  However, under the circumstances, 5.821 might not be a bad approximation of the market-value based debt-equity ratio.

c. Using a D/E ratio of 5.821, we can compute the asset beta as 2.51/(1+5.821).  Normally, we would multiply the D/E ratio in this formula by 1-t, where t is the tax rate.  However, given the losses that Bell Canada International has (see the high level of accumulated deficits), the marginal tax rate is probably zero.  This yields an asset beta of 0.368.  If we assume that Airgate PCS has the same asset beta, we can lever up its asset beta to get an equity beta of 0.368[1+(1-0.4)0.83] 0.551, where a tax rate of 0.4 is used, based on statutory conditions, since there is no reason to believe that Airgate PCS is not making money.  Airgate PCS's estimated equity beta is 0.55.

d. The cost of equity for Bell Canada, using the beta number is 0.05 + 2.51(0.055) = 0.1881.  If we assume that Bell Canada International's average cost of debt is 11% (this is the only piece of evidence we have on debt securities issued by Bell Canada, so we use it), the WACC would be (2340.1/3113)(18.81) + (1 - 2340.8/3113)(0.11), again leaving out the tax rate for the same reason as in the previous question.  This gives us 14.17%. 

e. In determining the dividend payout ratio, we'd look at the following factors:

• Investment Opportunities: A firm with more investment opportunities should pay a lower fraction of its earnings.
• Stability of earnings: A firm with more volatile earnings should pay, on average, a lower proportion of its earnings, so that it will not have to cut dividends.
• Alternative sources of capital: To the extent that a firm can raise alternative capital at low cost, it can afford to pay higher dividends
• Degree of financial leverage: If a firm has high leverage, it will probably also have covenants restricting the payment of dividends. Furthermore, to a certain extent, dividends and debt can be considered substitutes for the purpose of manager discipline.
• Signalling incentives: To the extent that a firm can signal using other less costly means, for example debt, it should pay lower dividends.
• Stockholder Characteristics: If a firm's stockholders want higher dividends, it should provide them.

Bell Canada should have a low payout ratio because it probably cannot raise funds easily, its earnings are probably very uncertain right now, and it has high financial leverage.  However, all this is moot because the firm has no earnings and is close to going bankrupt -- so, it should pay no dividends, right now.

f. ( i ) On first blush, there are no agency costs because it looks like this is a transfer from bondholders to stockholders.  The issue really is what the true price of the shares are.  The fact that the company issued shares to stockholders at 14 cents under the rights offering is no proof that that is the true value of the shares.  Firms routinely use a lower-than-market subscription price for shares under a rights offering, because otherwise existing shareholders might find the value of their current share-holdings diluted.  But if it is true that the true value is less than 27 cents, then, the company might find that it would have to pay a higher yield for its bonds, in future.

( ii )  The company might have been more willing to do this at this time because it is doing so badly that the probability of bankruptcy is substantial.  Hence the value of its reputation is not so high.