LUBIN SCHOOL OF BUSINESS
Pace University
Fin 320 ADVANCED FINANCIAL ANALYSIS
Fall 1998
Prof. P.V. Viswanath

• Midterm
• Midterm Solution
• Additional Question prepared for Midterm
• Final
• Solution to Final

Midterm

• The exam is closed book.
• Time allowed is 1 hour and 30 minutes.
• 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.
• Write legibly; I cannot guarantee any credit for what I cannot read, even if it is correct.
• If an answer contains two contradictory statements, you may get no credit for the answer, even if one of the statements is correct.
• 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.
• Fill in the points allocations for questions 3 and 4. You may allocate 10 points or 20 points or 30 points to Q. 3 and the remainder to Q. 4. If your allocation is unclear or does not satisfy the above instructions, I will arbitrarily assign 20 points to each question.

1. (30 points) You have $50,000 saved up. However, your plans for the future are big! You want to take a vacation for the next 10 years, and spend $5,000 per month during those 10 years. Obviously, the $50,000 is not going to cover this. Fortunately, your friendly loan shark, sorry, banker is willing to lend you whatever additional funds you need, on condition that you repay the money in monthly installments in the 20 months following your splurge. If the going interest rate is 12% APR, how much will your eventual monthly payments be?

2. a. If the expected return on the stock market is 20% over the next year, and 1-year T-bills currently have a yield of 8%, what should a security with an expected value of $10,000 at the end of one year, and a beta of 1.5 sell for today? (15 points)

b. You invest $2000 in Wendy’s International (ticker symbol WEN) and $2500 in Merrill Lynch (ticker symbol MER). The standard deviation of returns on Wendy’s is 15% per year, while that on Merrill Lynch is 25% per year. If the two stocks are not correlated, what is the variance of annual returns on your portfolio? (15 points)

3. You have the following financial statements for CMP Media, Inc. for the years 1996 and 1997. Construct a statement of cash flows for 1997 that will allow you to reconcile the change in cash from end-of-year 1996 to end-of-year 1997.

Income Statement

Balance Sheet

Notes:

• Dividends paid in 1996 were $20,000, while dividends paid in 1997 were $25,944.30
• No common stock was repurchased during this period
• No plant and equipment was sold during this period

4. Read the following article and answer this question:

This article talks about the trend for companies offering stock options to their employees to reprice those options when the company’s stock price drops. (Repricing, in this context, simply means that the strike price is lowered.) As the article points out right at the beginning, stock options are a way of aligning interests of employees with those of shareholders. Obviously, repricing reduces the potential for such alignment. The article goes on to discuss such an option repricing scheme at Royal Gold. Discuss the effect of Royal Gold’s option repricing scheme from the point of view of aligning employee and shareholder interests.

The New, Unsinkable Stock Options
New York Times Internet Edition, November 1, 1998

Paying corporate employees with stock options is promoted as a way to align the interests of executives and other workers with those of shareholders. But while investors are encouraged to stick with a stock for the long term and to hold on tight if prices slide, many companies have developed a hair-trigger response to market dips when it comes to options pricing.

In October alone, more than 100 companies revealed options repricings, either in announcements or in filings with the Securities and Exchange Commission, a review of these documents found, and analysts expect many more companies to join the parade.

By moving quickly when the market was down temporarily, some of these companies gave employees a boost to their wealth when the market leaped back to life -- one that would be shared only by investors who bought new shares during the market dip.

Some companies that have announced repricings are tiny, like Interactive Flight Technologies of Phoenix, which makes in-flight entertainment systems for airlines. It went public in 1997 at $8 a share and gave employees options at that price. But when its stock plummeted this fall, Interactive repriced all its options down to 87 1/2 cents. The stock now trades at 62 1/2 cents.

A few better-known companies have also repriced options, including Ziff-Davis and CMP Media, the magazine publishers; Reebok, the shoemaker, and Republic Industries, H. Wayne Huizenga's network of car dealerships. Ziff-Davis repriced options for all employees; the other three excluded senior management.

An option is the right to buy shares in the future at a preset price. If the stock rises in value, the holder can profit from the difference between the preset -- or "strike" -- price and the market price when the option is exercised.

Options have become an increasingly important part of corporate compensation, sometimes creating hundreds of millions of dollars in wealth for executives. Many companies have begun extending options plans to lower-ranking managers and rank-and-file workers, as well.

Of course, if a stock's market price falls below the strike price, the options are "underwater" and cannot be exercised except at a loss. That is supposed to be the chance the holder takes.

But in this year's market turmoil, many companies have rewritten options terms to spare their holders from getting wet.

Robert G. Monks, a principal in Lens Inc., an investment firm that has long pressed to reign in executive pay, predicted that by next May, when the majority of companies will have filed proxy statements, "repricing options will be virtually universal."

That view is extreme, said David L. Yermack, an associate professor of finance at New York University's Stern School of Business. His research, published earlier this year, found that smaller companies repriced about 2 percent of executive options annually from 1992 to 1995. He expects 10 percent to 20 percent of companies to reprice options by next May.

"There are enough firms that know how much institutional investors object to repricing options and would not do it under any circumstances," Yermack said. "A clear third of the Fortune 500 would see it as morally reprehensible."

As for the filings in October, Yermack said that "you would think people would wait more than a month or two after the price drops before doing this."

The issue was addressed last Monday by John Bogle, the senior chairman and founder of the Vanguard Group of mutual funds, during a speech at a conference sponsored by the Investor Responsibility Research Center. Bogle urged colleagues to "take a firm stand" against repricings that are "grossly unfair" to shareholders.

Monks said options repricings, especially when extended to senior executives, showed that "the market in executive compensation has been contrived and is not an honest market." He denounced what he called "the fraud of options that are a one-way street -- I win when I win and I still win when my shareholders lose."

Robert Salwen of the Executive Compensation Corp., a consulting firm in New York, said two recent calls from clients suggested that companies were of two very different minds these days.

"My first call was from a company suffering underwater options that wanted advice on repricing," Salwen said, "and the next call was a company that wants to grant out-of-the-money underwater options as an incentive to executives to bring up the stock price. I've never experienced that juxtaposition before."

A review of the filings with the SEC also found two significant trends in options repricing. One is to award options that vest, or become eligible to be exercised, in monthly rather than annual increments. That gives employees at least some of their options much sooner.

The other trend has showed up at companies like Royal Gold, a Denver concern with royalty interests in Nevada gold-mining operations. Royal Gold repriced all its outstanding options, but reduced their number by 21 percent.

Employees were left with the same potential economic value they had before, based on an option-valuation technique known as the Black-Scholes method, said Stanley Dempsey, the company's chief executive. (Some 54 percent of the affected options belong to him.)

For options holders, there is an upside and downside to such a repricing: If the stock price rises to a level between the old and new strike prices, the holder will now profit. But if the stock price soars above the original strike price, the profit potential is limited by the reduced number of options.

Psychologically, however, many workers feel that they are better off with such a repricing: They stand to gain even if the company's prospects are not as rosy as they once might have seemed. Salwen said he expected many companies to adopt this approach, which is more palatable to institutional investors than a straight repricing.

But in highly competitive job markets, he said, "it will not be enough to calm the waters and keep people from walking" to a rival offering a bigger options package.

Solution to Midterm:

1. The present value of your spending needs can be computed using the annuity formula using a monthly rate of 1% and a monthly cashflow of $5,000 for 120 months. This works out to $348,502.61. Hence over the course of the 10 years, you will need to borrow money with a present value of $348,502.61 less $50,000 or $298,502.61. At the end of the 10 years, this will have a value of $298,502.61(1.01)¹²⁰ = $985,174.10. Spread out over the next 20 months, we can compute the monthly payment, again using the annuity formula (periodic rate = 1%, PV = $985,174.10 and number of periods = 20), to be $54,593.73.

2.a. The required rate of return on the security is .08 + 1.5(.20-.08) = 26%. Hence the present value of the security = 10000/1.26 = $7936.51

b. The portfolio weights are 20/45 and 25/45; hence the variance of returns = (20/45)²(15)² + (25/45)²(25)². Taking the square root, we find that the standard deviation of returns = 15.41%

3.

4. The incentive alignment problem has to do with the fact that normally, managers who are paid a salary don’t have the same interest in maximizing share prices as stockholders. This might be partially remedied by requiring managers to hold some of the company’s stock in their portfolio. However, this is not a complete solution, because, while the disutility of the effort that the manager puts into his work is borne by him alone, the benefits of his efforts are shared by all shareholders. From this point of view, complete alignment will occur only when the manager is the sole owner of the firm. Furthermore, if the manager is paid partly in the form of a salary, that, too, reduces his incentive to take risks in an appropriate fashion.

A call option, however, has the potential to resolve this problem. The reason is that the call option is similar to a leveraged position in a stock. Hence, if the share price goes up by 1%, the value of a call option will go up by more than $1%. This can compensate for the fact that the manager does not own 100% of the shares of the firm.

Now, if the firm engages in repricing of options, this balance can be upset. Normally, when the share price drops by 1%, the value of a call option will drop by more than 1% by the same reasoning as above. However, if the firm resets the exercise price at a lower level, the value of the call option is restored to a partial or full extent. This shields the manager from downside risk on his options vis-à-vis his actions. At the same time, since the firm does not reprice his options when the stock price goes up, he maintains the upside potential of his options. This can lead to his being benefited by taking highly risky positions, since he is not affected on the downside, while benefiting on the upside.

Furthermore, to the extent that he has a reserve income level below which he would not like to go, i.e. to the extent that he engages in satisficing behavior, the repricing shields him from that possibility. This could also lead him to reduce the effort that he invests in raising the stock price.

Now, to the question of the particular repricing scheme used by Royal Gold, there is no redistribution of money to the employees through the repricing, since the value of the options is kept constant. However, this does not mean that the incentive effect is constant. The more the option is out-of-the-money, the greater the sensitivity of the option to changes in the stock price. The greater the sensitivity of the option to changes in the stock price, the greater the incentive for the employee/manager to take risks, since payoffs on the option are still asymmetric. The repricing of the option may, therefore, be a way of reducing perverse incentives for the manager to take excessive risk.

Additional Midterm question

Read the article from the WSJ of Dec. 2, 1998 that follows and answer these questions:

1. In your own words, explain why the Exxon-Mobil merger should affect corporate giving. (10 points)
2. Assume that corporations are motivated by maximizing the value of the firm in making philanthropic contributions. In the light of that assumption, explain the following statement from the article, "… (M)ajor corporate changes can mean big shifts in such giving, observers say." (15 points)

Cultural Groups Worry Mobil-Exxon Deal May Portend Drop in Charitable Giving

Competitors aren't the only ones quaking at the thought of the Exxon Corp.-Mobil Corp. megamerger. So are university presidents, cultural organizations and public-broadcasting entities that have come to rely upon the two oil giants for donations.

Ellen Grant, manager of the corporate fund at the John F. Kennedy Center for the Performing Arts in Washington, D.C., fears that, upon merging, the two oil companies probably will slice their combined donation in half. "We're all in depression here," she says. "I'm sure foundations around the country are tearing their hair out over this."

Similar fears have set in for Peter Hall, director of a Yale University program that monitors nonprofit giving by corporations. "You have Mobil, a major supporter of the arts, joining with Exxon, a company whose most imaginative giving is providing money for petrochemical education," he says. "It doesn't sound good."

According to the Taft Group, a Detroit concern that tracks corporate giving, Exxon made a total of $55.4 million in contributions in 1997, while Mobil donated a total of $31.2 million nationwide.

Mobil, known for its arts patronage, is the oldest and possibly largest corporate donor to the Public Broadcasting System. The company recently signed a four-year agreement with PBS to extend its 28-year support of "Masterpiece Theater." A Mobil spokeswoman says the company hasn't yet discussed with Exxon "Masterpiece Theater," or other charitable donations. Exxon couldn't be reached for comment.

Exxon, in contrast, is better known for its support of educational programs, to which it contributed $24.4 million last year. Among other things, it sponsors the largest matching-gift fund program in the country, donating $3 for every $1 its employees donate for educational purposes.

And major corporate changes can mean big shifts in such giving, observers say. In 1990, when Exxon left New York for Texas, the city lost about $4.1 million in charitable donations; Texas received an increase of about the same amount, according to Mr. Hall. "When Exxon moved out of New York City," he says, "the imagination and adventure went out of its gift-giving."

Ed Davis, president of the foundation for gifts and endowments at Texas A&M University, in College Station, said he looks forward to the merger because it could draw more money to his school. Exxon says it gave more than $500,000 to the university last year.

"Both companies are from Texas, and if they merge they will probably make their presence in Texas stronger," he said. "Places like A&M will reap the benefits."

Peter Frumkin, a professor of public policy at Harvard University, fears that programs such as a Mobil-sponsored exhibit of Vietnamese art, now at Washington's Meridian International Center, won't be as lucky.

"After a merger, corporations want to save money and cut costs, and unfortunately in today's corporate climate, there is less room for good-intention giving," Mr. Frumkin says.

"They want to donate to something that is going to further the company name or create a viable work force," he adds. "Unfortunately, an exhibit on Vietnamese art isn't profitable."

Final

• The exam is closed book.
• Time allowed is 2 hours.
• 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.
• Write legibly; I cannot guarantee any credit for what I cannot read, even if it is correct.
• If an answer contains two contradictory statements, you may get no credit for the answer, even if one of the statements is correct.
• 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.

1. Stephanie Waters, an equity analyst specializing in the waste management industry thinks that the recent upgrade in AWIN’s debt rating will be followed by a move by the company to increase its debt-equity ratio. According to her analysis, the firm’s improving coverage levels have increased AWIN’s debt capacity. Consequently, she feels, a move towards higher leverage is bound to increase firm value.

The following additional information is available:

• Yahoo’s Market Guide website reports a beta of 1.79 for Allied Waste Industries.
• The thirty year Treasury bond is currently trading around 5%.
• For the three-month period ending 9/30/98, Allied Waste had an interest expense of $19.893 million. Since the long-term portion of Allied Waste’s debt is $1,534.5 million, this works out to approximately 5.28% on an annual basis. However, Stephanie believes that this is due to an inflated historical book value for Allied Waste’s bonds. She believes that Allied’s true marginal cost of debt is closer to 7%, similar to the coupon rate on the subordinated junior debenture issue that Allied had issued at close to par in 1996.
• Allied Waste’s statutory tax rate is 40%.
• Yahoo also provided the following stock price information for Allied Waste (updated Dec 9, 1998):
  • 52-Week Low $16.125
  • Recent Price $20.688
  • 52-Week High $31.625

1. Compute Allied Waste’s weighted average cost of capital. Ignore current liabilities. Treat deferred taxes; accrued closure, post-closure and environmental costs; and other long-term obligations as debt. (15 points)
2. Suppose Stephanie is correct. Assume that Allied will issue $200 million of new debt to be used to buy back equity. Assume that the increased leverage would lead Duff & Phelps Credit Rating to downgrade Allied’s debt by one notch leading to an increase in cost of debt from 7% to 7.5%. Compute the new weighted average cost-of-capital. (20 points)
3. Estimate the change in Allied’s value from the swap. Would you recommend that Allied go through with the swap? (15 points)

2. Can you explain why Allied Waste’s beta is at the level of 1.79 (source: Yahoo)? In other words, is this beta level consistent with the information that you have on the company and its operations? Use no more than two pages in your exam book to answer this question. Be very legible. (30 points)
3. Allied Waste pays no dividends. How do you explain this? Use no more than two pages in your exam book to answer this question. Be very legible. (20 points)

Attachments:

1. Wall Street Journal article of December 9, 1998 from http://interactive.wsj.com
2. Company Profile from http://biz.yahoo.com
3. Information on Allied Waste’s company profile from http://www.alliedwaste.com/corp.htm.
4. Financial information from http://www.disclosure.com

Attachment A:

Allied Waste North America Sr Sub Notes Raised To BB-: DCR

December 9, 1998, Dow Jones Newswires

NEW YORK -- Duff & Phelps Credit Rating Co. (DCR) said it upgraded the senior secured rating of Allied Waste North America Inc. (Allied Waste) to double-B-plus from double-B, which applies to the company's $1.1 billion revolving credit agreement.

DCR also said it raised its ratings on the company's senior subordinated notes to double-B-minus from single-B-plus and on the senior discount notes of Allied Waste Industries to single-B-plus from single-B.

Also, DCR said Allied Waste's prospective issuance of $1.5 billion in senior unsecured notes were assigned an initial rating of double-B.

DCR said the ratings were raised based on Allied Waste's operating margin performance and coverage levels, growth in geographic diversity and increased capital resources, "balanced by the company's use of leverage in pursuing an aggressive pace of acquisitions.

"The company`s success in capturing waste volumes through tuck in acquisitions, in order to feed its capital-intensive landfills, has recently led to the generation of positive free cash flow.

"This has resulted in increased financial flexibility in the event of adverse economic events, as well as the capacity to utilize internally generated funds to partially finance continuing growth through acquisition.

"Industry fundamentals remain positive over the near term, and free cash flow generation is expected to grow. Coverages are expected to improve meaningfully over the near term due to the addition of recent equity-financed acquisitions," DCR said.

Attachment B: Company Profile from Yahoo

Allied Waste Industries, a solid waste management company in the US, is near the top of the heap. The company, which has 69 landfills, provides solid waste management and handling services, including non-hazardous waste collection, transfer, recycling, and disposal services to residential, municipal, and commercial customers in 28 states in the Midwest, Northeast, Northwest, Southeast, and Southwest. Allied Waste Industries has grown rapidly through more than 120 acquisitions. In addition to expanding into West Coast markets, Allied Waste Industries has made a bid to merge with industry giant Browning-Ferris Industries.

Attachment C: Company Profile from company website:

OPERATIONS

Allied Waste Industries, Inc., headquartered in Scottsdale, Arizona, is a vertically integrated solid waste management company providing non-hazardous waste collection, transfer, recycling and disposal services to approximately 1.4 million residential, municipal and commercial customers located in 18 states. The Company conducts its operations through 81 collection companies, 43 transfer stations, 21 recycling facilities and 56 landfills. All information is as of 12/31/97.

TOTAL REVENUE MIX

• Revenue by Category
• Collection 59%
• Disposal 25%
• Transfer 7%
• Recycling 3%
• Other 6%

COLLECTION REVENUE MIX

Collection Revenue by Customer Type

• Commercial 70%
• Residential 30%

STRATEGY

Allied's business strategy is a simple one -- vertical integration. This dictates that Allied must constantly be aware of opportunities for consolidation of operations in existing markets and for entry opportunities in new markets that fit our vertical integration model. Our business model also requires that Allied's collection operations seek to dispose of all the waste they collect at Allied disposal facilities. Allied rigorously applies this strategy, even if it means divesting where integration is not feasible.

THE INDUSTRY

Based on data available from the Environmental Protection Agency (the "EPA") and industry trade journals, Allied estimates that the total 1996 revenues of the non-hazardous solid waste industry in the United States were approximately $36 billion. The non-hazardous solid waste industry is highly fragmented. Approximately 41%, 32% and 27% of the revenue is generated by publicly traded companies, municipalities and privately held companies, respectively. The five largest publicly traded companies represent a substantial majority of the publicly traded company revenues.

The non-hazardous solid waste industry is characterized by consolidation. Allied believes that several factors will lead to continuing acquisitions and consolidation in the industry. Rising costs, regulatory complexities and increased capital expenditures will create opportunities for large integrated public companies that have the requisite management expertise and ready access to capital.

These developments, as well as more stringent financial assurance requirements being imposed on solid waste management companies by various municipalities, have increased the amount of capital generally required for solid waste management operations, causing smaller companies that lack the requisite capital to sell their operations to better-capitalized companies.

GROWTH

Allied achieves growth in two ways, through acquisitions and through internal development. Since 1992, the company has completed over 130 acquisitions which provided average annual revenue growth of 140% in reported revenues. During this period the company also added 410 million gate yards of landfill capacity by developing new landfills and obtaining permit expansions at existing landfills.

In December 1996, Allied completed the acquisition of Laidlaw's solid waste operations. Laidlaw provided collection, transfer, recycling and disposal services to about 260,000 commercial and 4.8 million residential customers. Laidlaw conducted its operations through 81 collection companies, 33 transfer stations, 23 recycling facilities and 46 landfills in 15 states and six Canadian provinces. In March 1997, Allied sold the Canadian operations (41 collection companies, 8 transfer stations, 10 recycling facilities and 7 landfills) to a subsidiary of USA Waste Services for $518 million.

In 1997, Allied completed 35 acquisitions, representing $369 million in annual revenues, and sold operations representing approximately $128 million in annual revenue. These companies added 22 collection operations and two transfer stations in ten states. These acquisitions, some of which were tucked into existing operations, enhanced our existing collection and disposal operations as well as providing growth opportunities in new markets.

Attachment D: Financial Information from Disclosure.

Consolidated Balance Sheet (In Thousands)

Income Statement (In Thousands Except Per Share Amounts For 3-month Period Ended Sep 30, 1998)

Solution to final:

1. Using market values for equity, we get a market value of 20.688/share x 139,522,000 shares = $2,886,431 (in thousands). This would yield a debt portion of 1827210/(1827210+2886431) = 38.76% and an equity portion of 61.24%. Although it is correct to use market value, for convenience, I will be illustrating the computations for the rest of this solution, using book value numbers. Ignoring current assets and liabilities, the debt portion of the capital structure works out to $1,827,210 and the equity portion, to $685,157 (in thousands). This works out to 72.73% and 27.27% respectively.

The required rate of return on equity = 5% + 1.79(5.5) = 14.845%.

The WACC = (0.2727)(14.845) + (0.7273)(1-0.4)(7) = 7.10%.

After the swap, the equity amount drops to $485,157 (or 19.31%) and the debt portion rises to $2,027,210 or 80.69%. The current equity beta is 1.79; the unlevered equity beta (asset beta) equals =0.69. The levered equity beta after the swap = = 2.42

The required rate of return on equity = 5 + 2.42(5.5) = 18.31%

The WACC = (0.1931)(18.31) + (0.8069)(1-0.4)(7.5) = 7.1667%

Hence the swap should not be undertaken. Assuming a growth rate of 0%, the impact (reduction) on firm value = (2,815,463)(0.071667-0.071)/0.071667 = $26,203.33 in thousands, or $26.2 million, approximately.

If we use the current cashflow to the firm of [EBIT(1-tax rate) + Depreciation - Capital Expenditures] = 47661(1-0.4), assuming that Capital Expenditures = Depreciation, then we get 2815463= [47661(1-0.4) (1+g)]/(.071 - g); thus, g = 5.5%.

Using this, the reduction in firm value is [(2,815,463)(0.071667-0.071)(1+0.055)]/(0.071667 - 0.055) = $118,869.5 in thousands or $118.87 million, approximately.

2. The main explanation for the high beta is the high financial leverage. The unlevered beta of 0.69 is consistent with the business that Allied Waste is in, that is, waste removal, which is, in all likelihood non-cyclical, implying a low beta.

However, if we look at the market value of equity to compute the unlevered beta, the picture is easier to explain. There is, indeed, some financial leverage, which explains a relatively higher beta. The average industry beta is 1.22, which is probably because of the high operating leverage necessary in this business. The high degree of regulation also demands high investment in fixed assets. In addition, the waste management business sector that AWIN has targeted is mainly commercial, which is likely to be very sensitive to changes in market conditions.

3. The reason that Allied Waste is paying a low dividend is because of its strategy of acquisitions, implying a need for funds. Also, it is a high growth firm, which means that a large portion of its assets are not capable of supporting debt. Finally, since it has a high level of debt relative to the industry, it does not need to pay dividends for the purpose of enforcing market discipline.

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