LUBIN SCHOOL OF BUSINESS
Pace
University
Fin
320 ADVANCED FINANCIAL ANALYSIS
Spring 1998
Prof. P.V. Viswanath
Midterm I
I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.
II. Tropica Corp. has the following data available to you:
Balance Sheets as of December 31, 1996 and 1997:
1996 | 1997 | |
Assets | ||
Current Assets | ||
Cash | 39,700 | 27,500 |
Marketable securities | 1,000 | 11,000 |
Accounts Receivable (net) | 81,500 | 72,700 |
Inventories | 181,300 | 242,000 |
Total current assets | 303,500 | 353,200 |
Fixed Assets: | ||
Land | 112,000 | 112,000 |
Plant and equipment (net) | 445,200 | 464,800 |
Total fixed assets | 557,200 | 576,800 |
Other assets | 13,300 | 21,500 |
Total assets | 874,000 | 951,500 |
Liabilities and net worth | ||
Current liabilities: | ||
Accounts payable | 71,200 | 83,000 |
Notes payable | 50,000 | 140,000 |
Accrued Expenses | 33,400 | 36,300 |
Total current liabilities | 154,600 | 259,300 |
Long-term debt: | ||
Mortgage payable | 106,000 | 90,800 |
Net worth: | ||
Common stock | 225,000 | 230,000 |
Retained earnings | 388,400 | 371,400 |
Total Net Worth | 613,400 | 601,400 |
Total Liabilities and Net Worth | 874,000 | 951,500 |
Note: Dividends paid were $30,000 for 1996 and $15,000 for 1997.
Income Statement:
1996 | 1997 | |
Net Sales | 1,133,400 | 1,147,700 |
Cost of Goods Sold (excluding depreciation) | 709,000 | 781,100 |
Depreciation | 31,500 | 32,200 |
Gross Margin | 392,900 | 334,400 |
Expenses | ||
|
172,500 | 227,000 |
|
65,500 | 71,800 |
|
22,200 | 25,000 |
|
9,700 | 14,300 |
Total Expenses | 269,900 | 338,100 |
Profit (loss) before taxes | 123,000 | (3,700) |
Federal Income Tax | 56,600 | (1,700) |
Net income (loss) | 66,400 | (2,000) |
Compute Cash flow from Operations for Tropica for the year 1997, and using this, compute Net Cash Flows provided by Operating Activities as represented in the Statement of Cash Flows. (25 points)
(Bonus question) For what purpose might you compute these two different cash flow numbers? (5 points)
III. a. (5 points) You are walking down the corridor with your
friend at work, Ms. Linda Tremple. Being very proud of yourself,
you show her the following numbers that youve calculated as
part of your duties as an investment analyst. She takes one look
at these numbers and exclaims: "Oh no! These numbers violate
the CAPM.!" What do you think shes talking about, and
why?
Stock | Estimate of Expected Return | Standard Deviation of Returns | Beta Estimate |
Bio-Gen | 20% | 35% | 1.50 |
Boeing | 12% | 40% | 1.03 |
Coca-Cola | 22% | 50% | 1.20 |
General Electric | 14% | 20% | 1.10 |
b. (20 points) You are a little shaken, but you continue with the report youre preparing for your client. You need to come up with the expected return and variance of returns on a portfolio consisting of $75,000 in Bio-Gen, and $25,000 each in Boeing and Coca-Cola. You have the following information regarding the correlations between their returns: Correlations between returns on different stocks in your portfolio
Bio-Gen | Boeing | Coca-Cola | General Electric | |
Bio-Gen | 0.2 | 0.1 | 0.25 | |
Boeing | 0.5 | 0.6 | ||
Coca-Cola | 0.7 |
(10 points) Assuming that your estimates are correct, what would the beta of your portfolio be?
(10 points) What would the weights of a portfolio consisting of Bio-Gen and Boeing alone be, if you wanted to minimize the variance of portfolio returns?
(10 points) If you wanted to create a portfolio consisting of only two stocks, which pair of stocks would you pick, if you wanted to minimize the variance of returns on the portfolio? Why?
Partial Solutions to Midterm I
II. Even though the question asked for a computation of Cash flows from Operations and then to compute Net Cash Flows from Operating Activities, this solution provides a direct computation of Net Cash Flows from Operating Activities:
1996 | 1997 | Increase from 1996 to 1997 | Outflows | |
Assets | ||||
Current Assets | ||||
Cash | 39,700 | 27,500 | -12,200 | |
Marketable securities | 1,000 | 11,000 | 10,000 | included in investing activity |
Accounts Receivable (net) | 81,500 | 72,700 | -8,800 | -8,800 |
Inventories | 181,300 | 242,000 | 60,700 | 60,700 |
Total current assets | 303,500 | 353,200 | 49,700 | |
Fixed Assets: | ||||
Land | 112,000 | 112,000 | 0 | |
Plant and equipment (net) | 445,200 | 464,800 | 19,600 | -32,200 (Depreciation from Income Statement; difference between this number and 19,600 presumed to be purchase of assets) |
Total fixed assets | 557,200 | 576,800 | 19,600 | |
Other assets | 13,300 | 21,500 | 8,200 | assumed to be investments |
Total assets | 874,000 | 951,500 | ||
Liabilities and net worth | ||||
Current liabilities: | ||||
Accounts payable | 71,200 | 83,000 | 11,800 | -11,800 |
Notes payable | 50,000 | 140,000 | 90,000 | -90,000 (If this is interpreted as financing, then it would not be included in operating cash flows.) |
Accrued Expenses | 33,400 | 36,300 | 2,900 | -2,900 |
Total current liabilities | 154,600 | 259,300 | 104,700 | |
Long-term debt: | ||||
Mortgage payable | 106,000 | 90,800 | -15,200 | Financing activity |
Net worth: | ||||
Common stock | 225,000 | 230,000 | 5,000 | |
Retained earnings | 388,400 | 371,400 | -17000 | 2000 (Loss as show in Income Statement; the difference between Net Income and -17,000 is dividends paid) |
Total Net Worth | 613,400 | 601,400 | ||
Total Liabilities and Net Worth | 874,000 | 951,500 | ||
Net Cash (in)flows from Operations | $83,000 |
Midterm II
I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.
- Diversification
- Markowitz portfolios
- Intangible Assets
II. Here are the financial statements for TRW, Inc. for 1994 and 1995
Income Statement
1995 | 1994 | |
Sales | 10172 | 9087 |
Cost of goods sold | 8190 | 7270 |
Administrative and Selling expenses | 1169 | 1168 |
Interest expense | 95 | 105 |
Other expenses | 10 | 9 |
Earnings before income tax | 708 | 535 |
Income taxes | 262 | 202 |
Net earnings (loss) | 446 | 333 |
Dividends paid were $134 in 1995 and $126 in 1994.
Included in Cost of Goods Sold and Administrative and Selling
expenses is Depreciation of property, plant and equipment, which
amounted to $433 in 1995 and $402 in 1994.
1995 | 1994 | |
Assets | ||
Current Assets: | ||
Cash | 59 | 109 |
Accounts Receivable | 1428 | 1338 |
Inventories | 534 | 470 |
Prepaid expenses | 78 | 59 |
Deferred Income taxes | 237 | 239 |
Total Current Assets | 2336 | 2215 |
Property, Plant and equipment | 2563 | 2489 |
Intangible Assets | 658 | 656 |
Other Assets | 333 | 276 |
Total Assets | 5890 | 5636 |
Liabilities and Shareholders Investment | ||
Current liabilities: | ||
Short-term debt | 133 | 122 |
Accrued compensation | 385 | 346 |
Accounts payable | 1388 | 1311 |
Notes payable | 106 | 207 |
Total Current liabilities | 2012 | 1986 |
Long-term liabilities | 1165 | 1134 |
Long-term debt | 541 | 694 |
Shareholders Investment: | ||
Common Stock | 484 | 439 |
Retained Earnings | 1688 | 1383 |
Total Shareholders Investment | 2172 | 1822 |
Total Liabilities and Shareholders Investment | 5890 | 5636 |
III. You have the following information:
Asset | Expected Return | Standard Deviation of Returns | Correlation with the market return |
A | 12% | 20% | 0.4 |
B | 25% | 35% | 0.5 |
C | 30% | 25% | 0.3 |
Solutions:
II.
a. Cash flow from Operations = EBIT + Depreciation - Taxes =
708 + 95 + 433 - 262 = 974
Change in Working Capital = (2336-2012) - (2215-1986) = 95
b. Net Cash flow from Operating Activities = Cash flow from Operations - Interest - Change in Working Capital + Change in Cash = 974 - 95 - 95 + (-50) = 734.
III. a. It is not possible to say which stock is riskier, because we dont have their betas.
b. The weights are 0.5, 0.25 and 0.25. Hence the expected portfolio return = 0.5(12) + 0.25(25) + 0.25(30) = 19.75%
c. The variance = (0.5)2(20)2 + (0.25)2(35)2 + (0.25)2(25)2 + 2(0.5)(0.25)(0.2)(20)(35) + 2(0.5)(0.25)(0.3)(20)(25) + 2(0.25)(0.25)(0.6)(35)(25) = 353.75; hence the standard deviation of returns on the portfolio = 18.8%
d. The beta is computed using the formula, Beta = Corr(Ri,
Rm)[Std. dev(Ri)/Std. dev.(Rm)]
Asset | Expected Return | Standard Deviation of Returns | Correlation with the market return | Covariance with market returns | Beta |
A | 12% | 20% | 0.4 | 280 | 0.23 |
B | 25% | 35% | 0.5 | 612.5 | 0.5 |
C | 30% | 25% | 0.3 | 262.5 | 0.21 |
e. No, because the expected returns do not increase with the
betas.
Midterm III
I. Define the following terms and discuss in four or five sentences. Give examples, wherever relevant.
II. Here are the financial statements for TRW, Inc. for 1994 and 1995.
Income Statement
1995 | 1994 | |
Sales | 10172 | 9087 |
Cost of goods sold | 8190 | 7270 |
Administrative and Selling expenses | 1169 | 1168 |
Interest expense | 95 | 105 |
Other expenses | 10 | 9 |
Earnings before income tax | 708 | 535 |
Income taxes | 262 | 202 |
Net earnings (loss) | 446 | 333 |
Dividends paid were $134 in 1995 and $126 in 1994.
Included in Cost of Goods Sold and Administrative and Selling
expenses is Depreciation of property, plant and equipment, which
amounted to $433 in 1995 and $402 in 1994.
1995 | 1994 | |
Assets | ||
Current Assets: | ||
Cash | 59 | 109 |
Accounts Receivable | 1428 | 1338 |
Inventories | 534 | 470 |
Prepaid expenses | 78 | 59 |
Deferred Income taxes | 237 | 239 |
Total Current Assets | 2336 | 2215 |
Property, Plant and equipment | 2563 | 2489 |
Intangible Assets | 658 | 656 |
Other Assets | 333 | 276 |
Total Assets | 5890 | 5636 |
Liabilities and Shareholders Investment | ||
Current liabilities: | ||
Short-term debt | 133 | 122 |
Accrued compensation | 385 | 346 |
Accounts payable | 1388 | 1311 |
Notes payable | 106 | 207 |
Total Current liabilities | 2012 | 1986 |
Long-term liabilities | 1165 | 1134 |
Long-term debt | 541 | 694 |
Shareholders Investment: | ||
Common Stock | 484 | 439 |
Retained Earnings | 1688 | 1383 |
Total Shareholders Investment | 2172 | 1822 |
Total Liabilities and Shareholders Investment | 5890 | 5636 |
III. You have the following information:
Asset | Expected Return | Standard Deviation of Returns | Correlation with the market return |
A | 12% | 20% | 0.4 |
B | 25% | 35% | 0.5 |
C | 30% | 25% | 0.3 |
Solutions:
II. a. Cash flow from Operations = EBIT + Depreciation - Taxes = 708+95 + 433 - 262 = 974
b. Change in Working Capital = (2336-2012) - (2215-1986) = 95; Net Cash flow from Operating Activities = Cash flow from Operations - Interest - Change in Working Capital + Change in Cash = 974 - 95 - 95 + (-50) = 734.
III. a. It is not possible to say which stock is riskier, because we dont have their betas.
b. The weights are 0.5, 0.25 and 0.25. Hence the expected portfolio return = 0.5(12) + 0.25(25) + 0.25(30) = 19.75%
The variance = (0.5)2(20)2 + (0.25)2(35)2 + (0.25)2(25)2 + 2(0.5)(0.25)(0.2)(20)(35) + 2(0.5)(0.25)(0.3)(20)(25) + 2(0.25)(0.25)(0.6)(35)(25) = 353.75; hence the standard deviation of returns on the portfolio = 18.8%
Asset | Expected Return | Standard Deviation of Returns | Correlation with the market return | Covariance with market returns | Beta |
A | 12% | 20% | 0.4 | 280 | 0.23 |
B | 25% | 35% | 0.5 | 612.5 | 0.5 |
C | 30% | 25% | 0.3 | 262.5 | 0.21 |
e. No, because the expected returns do not increase with the
betas.
Final Exam
1. (20 points) Here is an excerpt from a February 7, 1997 New York Times article: Encore for '96 Plan to Hike Taxes on Business
The budget plan also tries to clarify a long-standing dispute over the distinction between debt and equity, which the tax code treats differently but which have become increasingly blurred with the large volumes of bonds with maturities of more than 40 years and zero-coupon convertible debt. If the proposals are adopted, the law would treat those products as equities, rather than bonds, eliminating favorable tax treatment.
Why might bonds with maturities of more than 40 years and zero-coupon convertible debt blur the distinction between debt and equity?
2. (20 points) The New York Times ran the following article on May 14, 1997 (partially reproduced below) that describes the dividend policies of four firms, IBM, Digital, Intel and Microsoft. On the face of it, it seems strange that all these firms are in the same industry, yet have differing dividend policies. Can you explain the difference? 10 Years Later, IBM Sets New High in Changed Market
An aside on Digital: It was an early adherent to the theory, which it did well in selling to Wall Street, that dividends do not matter because it is better for a company to plow its profits back into the business. As a result, owners of that stock in the last decade have not only lost money -- Digital's price is down 81 percent from August 1987 -- they have not gotten any dividends that would cushion the blow.
IBM has always paid a dividend, which it has just raised to 40 cents a quarter, up from 35 cents but well below the $1.10 quarterly it was paying when the stock last was hitting new highs. Since August 1987, a holder who stuck with IBM has collected $31.08 in dividends for each share.
The new technology leaders are closer to Digital, at least in dividend philosophy. Microsoft has never paid a dividend; while Intel has been making payouts since 1992, they are not exactly generous. It now pays 5 cents a quarter, or 20 cents a year -- a dividend yield on the current stock price of $152.375 of one-tenth of 1 percent a year.
3. (40 points) CSI Corporation is a mid-sized transportation firm with 10 million shares outstanding, trading at $25 per share and debt outstanding of $50 million, yielding 10%. The beta of the equity is 1.20, and the yield on the 30 year Treasury bond is 6%. It is estimated that if the firm borrows $100 million and buys back stock, the cost of debt will rise to 11%. Estimate the expected change in the stock price if the expected growth rate in operating earnings over time is 5%. The company is in the 40% tax bracket.
4. (20 points) Gaulois, Inc. is a publicly traded tobacco company that is expecting to experience a 10% annual decrease in revenues, expenses, working capital and depreciation for each of the next three years. The company paid off all outstanding debt at the beginning of last year and had net income of $48m. in the year just ended. Management has decided to dramatically change the focus of the company to specialize in the telecommunications industry. Toward that end, the managers have decided to forego any additional capital expenditures in the tobacco business for the next three years in order to build a "war chest" to be used to acquire a presence in the target industry. Using the information shown below, determine how large the war chest will be at the end of three years if management keeps the payout ratio at its current level. (You may assume that Gaulois will invest any retained earnings in a money market account that will earn 10% per year. Furthermore, the current balance of the cash account is earmarked for maintaining the existing lines of business, so it shouldnt be included in your calculations.)
Income Statement for Year Just Ended
Revenues | $500,000,000 |
- Expenses | $350,000,000 |
- Depreciation | $ 70,000,000 |
EBIT | $80,000,000 |
- Taxes | $32,000,000 |
Net Income | $48,000,000 |
Dividends Paid | $24,000,000 |
Non-cash working capital = $70,000,000.
1. Zero-coupon convertible debt has a high probability of being converted; hence it is closer to equity than to debt. Long maturity bonds are more sensitive to the fortunes of the firm as a whole since payouts on these bonds continue for a long time. This also makes them closer to equity. The key point to be made is that the IRS assigns tax deductibility based on the equity-ness of a security, which, in turn, is essentially a question of how sensitive the securitys value is, to changes in the value of the firm.
2. You need to take into account several factors. The industry is, in general, high growth, and, as such, has a low payout ratio, as characterized by the zero payout policies of Microsoft and Digital. However, IBM, being an established firm, might already have established a clientele that likes the higher payout ratio that it initiated when it was behaving like a more mature firm in its monopolistic guise. Its funds raising costs might also be lower. Intels minimal payout ratio might be also due to its being somewhat older than Microsoft, and also its relatively less innovative profile.
3. The cost of equity capital before the debt-equity swap = 6% + 1.2(5.5%) = 12.6%. The after-tax cost of debt = 10%(1-0.4) = 6%. The market value of equity = $250m., and the market value of debt is assumed to be $50m. The WACC = (250/300)(12.60%) + (50/300)6%) = 11.51%
The unlevered beta = 1.2/[1+(1-0.4)0.2] = 1.071
The debt ratio after the swap is approximately 150/300 = 0.5; hence the beta after the swap = 1.071[1+(1-0.4)1] = 1.714. The cost of equity capital = 6% + 1.714(5.5%) = 15.43%; the after-tax cost of debt = 6.6%; the WACC is approximately (0.5)6.6% + (0.5)15.43% = 11.01%
The change in the value of the firm = $300m.(0.115 - 0.1101)/(0.1101-0.05) = $24.23m.; hence the stock price rises $24.23m./10m. = $2.42 at the announcement of the capital restructuring.
4.
Current | Next year | in 2 yrs | in 3 yrs | |
EBIT | 80 | 72 | 64.8 | 58.32 |
Depreciation | 70 | 63 | 56.7 | 51.03 |
Working Capital | 70 | 63 | 56.7 | 51.03 |
Change in WC | -7 | -6.3 | -5.67 | |
Net Income | 48 | 43.2 | 38.88 | 34.992 |
Dividends | 24 | 21.6 | 19.44 | 17.496 |
Increase in Cash | 91.6 | 82.44 | 74.196 |
If these funds are invested at 10%, the size of the war chest
will be 91.6(1.1)2 + 82.44(1.1) + 74.20 = $275.72m.
Go
to Prof. P.V. Viswanath's Home Page
Go
to FIN 320 Home Page