Dr. P.V. Viswanath

pviswanath@pace.edu

• Midterm
• Solution to Midterm
• Final
• Solutions to Final

Midterm

• Show all your computations and formulae; even if you use a calculator or a spreadsheet to get the answers, you must show the formula that you are using.  No points will be given if I don't see the formula and how you got your answer.  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.
• Any cheating or plagiarism will result in your getting zero credit for the exam.
• No bonus points -- on question 6 -- will be awarded unless you have attempted all subsections of all the other questions. So you are better off concentrating on the non-bonus part of the exam, first!
• One 8.5 x 11 sheet will be allowed, which may contain formulas only!  No worked out examples, nothing else.  Violation of this rule will be considered cheating.

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

1. Come up with a way to justify Amazon's stock price of $59, as of the printing of the article. Explain where and why you disagree with Jack Hough. (10 points)
2. What is the benchmark rate that Jack Hough is using in his CAPM risk-adjusted discount rate calculation (using MoneyChimp's calculator)? ( 5 points)
3. Why is Jack Hough rejecting Media General Financial Services' estimated beta for Amazon, of 2.6? Do you agree with him? Why or why not? (10 points)

Price Check: Is Amazon Overvalued?
By Jack Hough, October 20, 2003 (http://www.smartmoney.com)

Before you move on to mallets or, dare we say, power tools, take comfort in knowing that if you didn't get in on the 900% gain shares have posted since that low, you're not alone. You're in the company of such Yahoo Message Board bears as businessbuddha, who lists his 10 reasons to dump shares now. Among them: price competition from Overstock.com (OSTK), sales-dampening power outages and "huge insider selling." (Three million insider-owned shares were sold within the past six months.)

Wondering whether it's too late to buy? So are a lot of other investors. That makes now the perfect time for a SmartMoney.com Price Check.

For those who missed our soup-to-nuts valuations of eBay (EBAY) in May and Intel (INTC) just last week, here's how the Price Check works. We take news items like Amazon's search-engine venture or its partnership with home-furnishing retailer Bombay (BBA), and we promptly ignore them. That's because we assume that analysts have already worked such information into their earnings estimates. For share-pricing purposes, we're concerned only with income and balance-sheet information, consensus growth projections and the like.

We'll run the numbers through several valuation methods, starting with the simplest and ending with the leading-edge. With each step we'll refine our assumptions and at the end you'll have our take on exactly what the stock is worth.

Ben Graham's Formula
Warren Buffet says Ben Graham's "The Intelligent Investor," published in 1940, taught him how to buy stocks. Graham developed a quick-draw formula that allows investors to sketch a stock's worth. It looks like this:

PE = 8.5 + 2G

where PE is the price/earnings ratio and G is the annual rate at which earnings are expected to increase, currently 25% for the next five years for Amazon, according to the Reuters Research's consensus. That gives us a P/E of 58.5. Since the 13 analysts who cover Amazon's shares are looking, on average, for earnings of 57 cents a share in 2003, that implies a current share price of $33.35. But that is, after all, just a sketch. For one thing, we're using pro-forma earnings projections, which ignore special charges. This method doesn't account separately for revenues and margins, something we'll be doing soon.

Discounted Cash Flow
Discounted-cash-flow analysis seeks to determine what a company's future payments — whether actual payments like dividends or theoretical reinvested payments like earnings — are worth today. The assumption (and it's a doozy) is that those earnings will be reinvested wisely.

We'll use the discounted-cash-flow calculator offered by the brainy tree-swingers at MoneyChimp.com. To start, we enter the 57-cent earnings consensus for 2003 and the 25% long-term earnings-growth projection. We'll also need a stable growth rate for when Amazon slows down in maturity, and a discount rate, or the rate available on alternative investments.

Since this calculator uses a two-stage growth model — a single high-growth period followed by a stable growth period — we'll extend the 25% earnings-growth assumption out 10 years (an admittedly aggressive assumption which we'll be fine-tuning soon), then fall back to a stable growth rate of 4%. The fact that a stable growth period of infinite length would produce a company of infinite size matters little, since the present value of cash flows, say, 20 years out, is tiny.

For the discount rate, we'll use the 10% annual return the Standard & Poor's 500 has achieved over the past 50 years. That gives a preliminary value for shares of $47.78, but that doesn't figure in the risk inherent in Amazon stock.

To account for risk, we'll use the capital asset pricing model, or CAPM, developed by Nobel Laureate William Sharpe. It looks like this:

Risk-adjusted discount rate = risk-free rate + b (benchmark rate - risk-free rate)

where b is beta, the measure of a stock's volatility relative to an index like the S&P 500. Media General Financial Services lists Amazon's beta as 2.6.

Its beta calculation, though, uses a 36-month price regression, which would be a poor figure to use in Amazon's case. The company would appear riskier than it actually is thanks to the helter-skelter tech market of recent years. We'll instead use the Barra Risk Factor found using SmartMoney.com's risk map. It incorporates not just past volatility but also things like earnings stability and balance-sheet strength.

Amazon's risk factor is a 59, meaning that it's "forecasted to have more price volatility than 59% of the stocks in the broad market." We'll call that a "beta" of 1.2. Plugging that plus a risk-free rate of 4.4%, the current 10-year Treasury yield into MoneyChimp's CAPM calculator, we get a risk-adjusted discount rate of 11.12%. Applying that figure to the discounted-cash-flow calculation yields a current value of $38.54 for shares. Here's a table of values produced with different growth assumptions.

Discounted Cash Flow (Risk-Adjusted)
High-Growth Rate (Next 10 Years)	Implied Price Today
15%	$18.65
20%	$26.87
25%	$38.54
30%	$54.91
35%	$77.64

We're getting there, but the basic math we've used up until now to value shares has been like swinging our aforementioned foam baseball bat at a Mariano Rivera fastball. It's time to call in a big-leaguer.

The Damodaran Method
Many of the securities analysts whose projections we all follow learned valuation techniques from finance professor Aswath Damodaran. Either they attended one of his classes at New York University's Stern School of Business, or they studied his highly regarded book on the subject, "Investment Valuation."

Damodaran makes available on his Web site several advanced tools for pricing all types of companies. For our purposes, he recommended his high-growth calculator, which lets you manually input sales data for companies that don't yet have consistently positive net profits. "It allows you to adjust the operating margin over time, which is really the engine behind earnings growth," he says.

Hearing that we were looking at Amazon, Damodaran decided to join in. He's published several previous valuations for the company. In 2000 he said shares were worth $34 when they were trading at $84, and in 2001 he priced them at $19 when they had dropped to $11. Last year, he figured they were worth $25. Investors who've listened to him have made a killing.

This time, we looked at everything from operating leases to future dilution from outstanding stock options. And while we assumed some impressive revenue growth — 30% annually for the next five years, then gradually declining to a stable growth rate of 4% after 10 years (for a compounded average of 21.81% per year) — we adjusted operating margins toward a stable rate each step of the way. As Damodaran puts it, "Amazon cannot have Wal-Mart's (WMT) growth and Ann Taylor's (ANN) margins."

In the end, the analysis produced a value of $36.42, and that's our call for what Amazon's shares are worth today. That's a far cry from the $59 shares fetched on Friday. And it implies that Amazon will rake in $33 billion in sales in 2013, compared with the $5.1 billion projected for 2003 — a huge sales increase. We could make even more aggressive revenue assumptions, but to do so we'd have to change our operating margins accordingly, and the two would offset each other. If you're dying for a table of different revenue inputs with everything else the same, though, see below.

Is Amazon overvalued? We're afraid so. And rather significantly, it seems.

The Damodaran Method
High-Growth Rate (Next 10 Years)	Implied Price Today
15%	$21.53
20%	$31.04
25%	$44.73
30%	$64.19

Summary of Implied Values
Graham	DCF	DCF Risk-Adj.	Damodaran
$33.35	$47.48	$38.54	$36.42

2. (15 points) Provide brief definitions for any three of the following terms:

1. synthetic rating
2. operating leverage
3. fundamental beta
4. treasury stock
5. assets-in-place
6. super-majority amendment
7. greenmail

3. (20 points) Answer any two of these in no more than one page, each:

1. How might societal objectives conflict with stockholder objectives? How are these conflicts handled?
2. Would you want to have stockholders who are institutional investors on a board of directors? Why or why not?
3. As a financial analyst, how would you value assets in place?
4. If you knew that the last three years had been a period when stocks lost value, overall, what is the likelihood that low beta stocks would have done better during that period than high beta stocks?
5. You have the following information from Yahoo (as of November 4, 2003) for two firms in the Oil Well Services & Equipment industry:
   

   Company	Equity Beta	Market Cap	Total Debt/Equity
   Helmerich & Payne Inc (HP)	0.49	$1.31b	0.23
   GlobalSantaFe Corp (GSF)	1.209	$5.10B	0.284

   
   Which firm, do you think would have a higher return volatility? Why?

4. (20 points) Use the information from problem 3.e. for this question. Suppose you have a new firm in the Oil Well Services & Equipment industry, which has a debt-to-total assets ratio of 0.23. Estimate its equity beta, if the marginal tax rate for all firms is 40%. You also know that Yahoo computes Market Cap as the total dollar value of all outstanding shares (shares times current market price).

5. (20 points) Lear Corporation, a manufacturer of automotive supplies, generated $650 million in free cash flow to the firm (prior to debt payments, but after reinvestment needs and taxes) last year. The firm has a cost of capital of 8.5% and debt outstanding of $3.88 billion. The firm has 66.5 million shares outstanding. The cash flows are expected to grow at the rate of 4.5% a year in perpetuity. Estimate the value of Lear Corporation (as a firm).

6. (Bonus) Use the data from problem 3.e for this question:

1. (5 points) What is the expected rate of return on Helmerich and Payne (HP), if the yield on the 10-year T-bond is currently at 4.31% (http://www.bloomberg.com/markets/index.html) and you estimate the market risk premium to be 5%?
2. (5 points) If the volatility (standard deviation) of returns on HP is 12% per annum, and the volatility of returns on the market portfolio is 15%, what is the correlation between the returns on HP and that on the market portfolio?

Solutions to Midterm

1.

1. There are two essential points in Jack Hough's computations that could be attacked -- one, his cashflow estimates, and two, his discount rate estimates.
   Regarding his cashflow estimates, one could assume a higher permanent growth rate, greater than 4%; given that the current 10-year rate is 4.4%, this is not unreasonable. We might also assume a higher initial growth for a longer period, but given that Hough is already assuming a 10-year initial growth rate of 30%, this is unreasonable, since analysts are forecasting a 25% initial growth rate.
   As far as discount rates go, a beta less than 1.2 for a technology stock is probably difficult to justify, but it might be justifiable with more data on sales patterns, etc. On the other hand, a market rate of return of less than 10% may be justifiable, if we look at an implied risk premium model and add on the 4.4% riskfree rate.
2. Jack Hough has come up with a required rate of return of 11.12%; this means that 11.12 = 4.4 + 1.2(benchmark rate - 4.4), which yields a benchmark rate of 10%.
3. The 2.6 beta estimated by Media General Financial Services is a regression beta based on the last three years. Since Jack Hough states, "The company would appear riskier than it actually is thanks to the helter-skelter tech market of recent years, he must believe either that individual companies have not necessarily changed over the last few years, but that stock movements were artificially magnified by investors, or that stocks, like technology stocks, that were high-beta over the last 3 years are now different from what they are, and actually lower beta.

2.

1. synthetic rating:a rating assigned to a firm based on its financial ratios.
2. operating leverage: the ratio of fixed costs to total costs of a firm; the higher this ratio, the higher the operating leverage. This also measures the sensitivity of the firms' operating earnings to changes in output levels.
3. fundamental beta: a beta estimated by looking at the fundamental characteristics of the firm, such as the type of business, operating leverage and financial leverage.
4. treasury stock: the stock of a firm that it has bought back.
5. assets-in-place: these refer to investments already made.
6. super-majority amendment: an amendment to a firm's charter, requiring an acquirer to acquire more than 51% of a firm's stock.
7. greenmail: this refers to when a firm buys back a potential acquirer's stock at a much higher price than that paid by the raIder (and than the market price).

3.

1. If there are social costs to the firm's actions that are not borne by stockholders, stockholders might want the firm to engage in those actions because they would increase firm value, although social wealth might decrease. Such an example might be environmental pollution. This can be handled in various ways -- one is to the require the firm to purchase the social asset that is affected by the company's actions; another is to pass legislation that restricts the actions of the firm; yet another might be to bring social pressure, through consumer boycotts on the firm.
2. Institutional investors, particularly if they are large would have more clout than small stockholders. Furthermore, larger institutional stockholders cannot easily get out of a stock position without incurring high transaction costs (because their trades would move the market); also, if they are large, they cannot really stay out of large segments of the market. The upshot of all of this is that they would have an incentive to make sure that management improved its performance. On the other hand, to the extent that institutional investors were small, and tended to move in and out of a stock, they would probably not care very much about the long-term value of a stock.
3. You would use market value, wherever available to value assets-in-place. If market values were not available, you would estimate the cashflows generated by the asset, and find the discounted present value to get a market value estimate.
4. If stocks, overall, had lost value, this means that the market portfolio lost value. Higher beta stocks would have dropped more than lower beta stocks.
5. For two firms in the same industry, all other things being the same, if one had higher leverage, it would have a higher equity beta, and hence, probably a higher return variance. In this case, we already have the equity betas; hence the financial leverage information is irrelevant, and we would simply use the equity beta information. We would conclude, therefore, GSF would have higher return variance.

4. The asset beta of HP is 0.49/(1+(1-0.4)0.23) = 0.43058; the asset beta of GSF is 1.209/(1+(1-0.4)0.284) = 1.033. The market value of the assets of HP is D+E = (1+D/E)*E = (1.23)(1.31) = 1.6113; similarly the market value of the assets of GSF is (1.284)(5.10) = 6.5484. Hence our estimate of the asset beta of the new company would be an average of 0.43058 and 1.033, weighted by the value of the assets of the two companies, i.e. [(0.43058)*(1.6113)+(1.0330)*(6.5484)]/(1.6113+6.5484) = 0.91404. We can then obtain the equity beta of the new firm as 0.91404[1+(1-0.4)(1.7493/6.41)] = 1.063706.

5. The value of the firm would be 650(1.045)/(.085-.045) using the growing perpetuity formula, which gives us 16981.25 million or 16.981 billion. Hence the D/E ratio is 0.2285.

6. a. The expected rate of return is 4.31 + 0.49(5) = 6.76%

b. The correlation(R_HP,R_m)=Cov(R_HP,R_m)/[std. dev.(R_HP)*std. dev.(R_m)] = beta(R_HP)*[std. dev.(R_m)/std. dev.(R_HP)] = 0.49(15/12)= 0.6125.

Final Exam

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

1. The following article entitled, "Risky Business: Can the Capital Markets Solve the Problem of Terrorism Insurance," appeared in the Dec. 4th 2003 issue of the Economist. Please read it (and the additional financial information below the article) and answer the following questions, regarding the capital structure of FIFA:

1. (10 points) Should the cancellation bonds be considered debt or equity? Answer from the viewpoint of a financial analyst.
2. (10 points) Your friend, Hal, has already taken FIN 647 from the renowned (denounced?) professor, P.V. Viswanath. So he knows all about agency costs, and the incentive for equity holders of firms with debt to increase their financial leverage. He thinks that FIFA has issued these CAT bonds simply to transfer wealth from bondholders to equityholders. Do you agree with him? Explain.
3. (10 points) Your other friend, Daniel, a football enthusiast is up in arms against the FIFA. "Everybody knows that increasing financial leverage increases bankruptcy risk. Issuing these bonds will simply raise the probability of the firm going bankrupt," he says. Do you agree with him? Explain.

GOOAAAL! On December 5th Michael Schumacher, six times champion of Formula One motor racing, and other glitterati are due to make the draw for qualifying tournaments for the 2006 World Cup in Germany. That the show goes on is thanks, in large part, to a group of bankers led by Credit Suisse First Boston, a Swiss investment bank, which helped FIFA, the world football federation, insure the world's most popular sporting event against terrorism and other risks.

Such coverage has been hard and expensive to come by since September 11th 2001. AXA, a French insurer, backed out of insuring the 2002 tournament in Asia after that day's attacks. So this time FIFA turned to the capital markets: in September it issued $260m of “cancellation bonds”, the first transfer of terrorist risk to public investors. These will receive a handsome yield in return for underwriting the risk of cancellation. If the tournament is called off, they will lose three-quarters of their principal.

The offering is the latest twist on catastrophe bonds (“cat bonds”), through which investors have in the past assumed the financial risk of big natural disasters. Since cat bonds were first issued in 1997, after Hurricane Andrew in Florida and a huge earthquake in San Francisco caused reinsurance premiums to rocket, over $6.3 billion has been issued, according to Swiss Re, a reinsurer. So far this year, $900m of catastrophe risk has been transferred in this way.

But the explosion in the issuance of cat bonds expected by some has failed to materialise. On the plus side, investors have bought them because Treasury and corporate bond yields are skimpy and because natural disasters are uncorrelated with market swings. Helpfully, there have been few payouts. The bonds' defenders also say they offer secure coverage for many years, as opposed to annual negotiations with flighty insurers. However, the bonds are time-consuming to structure and are usually pricier than reinsurance.

Is the FIFA bond the new face of terrorism insurance? Probably not. FIFA's issue worked because football matches can be relocated and rescheduled relatively easily, making the risk of cancellation low: the World Cup will take place in 12 different stadiums in Germany. And like the bondholders, FIFA, which receives over 90% of its revenues from the tournament, has an enormous interest in the tournament's going ahead. This makes the insuring of the World Cup different from insuring against terrorism-related property damage. Cat bonds may be the way ahead, though, for other big-ticket events.

Here is FIFA's balance sheet for the last four years (http://images.fifa.com/events/congress/2003/FIFA_Financial_Report_E_2002.pdf). Note numbers are in millions of Swiss Francs (CHF).

The financial report (http://www.fifa.com/en/organisation/index.html) states the following:

FIFA ’s balance sheet total has increased by CHF 545 million to CHF 647 million since 1999. At the end of 2002,FIFA ’s current assets totalled CHF 442 million,with liquid assets of CHF 328 mil- lion,accounts receivables of CHF 61 million and deferred assets of CHF 53 million.FIFA ’s non- current assets had reached a value of CHF 205 million,mainly consisting of financial investments of CHF 157 million and tangible assets (i.e.real estate)of CHF 38 million.

The non-current assets of CHF 205 million are en- tirely financed through long-term capital of CHF 373 million (equity and provisions).FIFA ’s liabi- lities of CHF 274 million are fully covered by cur- rent assets of CHF 442 million.The equity ratio amounts to 23%(=CHF 151/647 million). Overall,this shows that FIFA is in a financially comfortable and sound position.

2. (15 points) Define any three of the following terms:

1. venture capital
2. negative pledge clause
3. sinking fund
4. rights offering
5. private placement

3. (10 points) You have the following information regarding Medtronic, Inc. (MED). Explain what you think its debt-equity ratio is. Use no more than one page.
Medtronic, Inc. is a medical technology company that provides lifelong solutions for people with chronic disease. The Company offers products and therapies for use by medical professionals to meet the healthcare needs of their patients. Primary products include those for bradycardia pacing, tachy-arrhythmia management, heart failure, atrial fibrillation, coronary vascular disease, endovascular disease, peripheral vascular disease, heart valve replacement, extra-corporeal cardiac support, minimally invasive cardiac surgery, malignant and non-malignant pain, diabetes, urological disorders, gastroenterological ailments, movement disorders, spinal surgery, neurosurgery, neurodegenerative disorders and ear, nose and throat surgery.

4. (10 points) Answer any one of the following two questions (no more than half a page each):

1. Why do firms issue convertible debt?
2. What sorts of firms would want to issue floating rate debt?

5. You have the following information for Culpepper, Inc., a toy retail firm. All information, unless specified is in thousands of dollars. Answer the questions below. (Your computations have to be clear to me. If they are muddled, and I cannot figure out what you are doing, I reserve the right not to give you any points.)

Balance Sheet

The firm's income statement is as follows:

The firm currently has 50,000 shares outstanding. The price of each share is $10. The bonds are selling at par. The firm's current beta is 1.5. The 10-year Treasury bond rate is 4.5%. The average market risk premium over the last 10 years has been 13% computed as the arithmetic average of the difference between the return on equities and the T-bill rate. If the market risk premium is computed as the geometric mean of the difference between the return on equities and the yield on 10-year Treasuries, it works out to 10%. On the other hand, over a 40 year period, these same numbers work out to 7% and 5% respectively.

1. (5 points) Estimate the market risk premium that you would use to compute the firm's cost of capital. Justify your choice.
2. (5 points) What is the firm's current cost of equity?
3. (5 points) Estimate the firms' current cost of debt, assuming that it is straight debt (i.e. not convertible, or hybrid in any way).
4. (5 points) What is the firm's weighted average cost of capital?
5. Suppose the management of Culpepper, Inc. borrowed enough money to buy back half of its equity (at the current market price).
   1. (5 points) What would its cost of equity be?
   2. (5 points) What would its cost of debt be, if the swap lowers the firm's rating to C, which increases its spread over comparable treasuries by 2 percentage points?
   3. (5 points) What is the firm's new cost of capital?

Solutions to Final

1.

1. Debt is different from equity in several ways --
   1. payments to debtholders are tax deductible -- on this count, the catastrophe bonds should be counted as debt.
   2. debtholders do not vote for the board of directors -- again, cat bonds should be counted as debt.
   3. debtholders get first claim on the assets of the firm in bankruptcy -- cat bonds qualify as debt.
   4. equity holders are residual claimants -- reduces in firm value are usually first borne by equityholders -- in this case, cat bond holders would bear the brunt of any losses due to cancellation of the 2006 World Cup; this makes the cat bonds more equity-like.

   On the whole, however, cat bonds are more like debt than equity.

2. Although it is true that firms that are leveraged have an incentive to issue more debt to dispossess bondholders, and though it is true that FIFA is currently somewhat leveraged -- it has at least 40 million CHF of long-term debt, cat bonds would not be the best way for FIFA to dispossess its existing bondholders. Since cat bondholders would bear the brunt of any losses due to World Cup cancellation, existing bondholders would be protected from losses on this count. Furthermore, since cat bondholders would be paid only a quarter of their principal in the case of World Cup cancellation, their issue probably reduces the likelihood of FIFA going bankrupt and having to incur bankruptcy costs. This should be good for all existing bondholders. Consquently, Hal is probably not correct in his assertion.

3. As explained above, Daniel is probably not right. In this case, the protection that cat bondholders provide to the firm by absorbing most of the ill-effects of World Cup cancellation could, conceivably decrease FIFA's bankruptcy probability. This is supported by the fact that the total value of the bonds is $260 million, or something on the order of 65 CHF, which is not insignificant considering that FIFA's total assets add up to 647 CHF. Additionally, the cat bonds can be thought of as insurance plus straight debt, which bears out the point that is being made here. Of course, exactly what is done with the funds that are raised with the debt is also important, but if they are simply ploughed into FIFA's operations, the net result would probably be a lower risk of bankruptcy.

1. venture capital: equity financing provided to small and often risky businesses in return for a share in ownership of the firm.

2. negative pledge clause: a covenant included in the bond indenture that prevents bondholders' claim on the assets from being superseded by future debt that the firm might issue.

3. sinking fund: this refers to a sum of money that is set aside each year to repay a portion of the bonds in a particular bond issue. Usually the bonds that are retired are chosen at random.

4. rights offering: right given to the existing investors in a firm to buy additional shares, in proportion to their current holdings, usually at a price much lower than the current market price.

5. private placement: a sale of securities to one or a few investors, where the terms are negotiated between the firm and the investors.

1. Medtronic is a medical technology company -- it would seem that most of its assets are patents and human capital. Since generation of medical technology solutions does not require a lot of investment in tangible capital goods, MED's assets are probably intangible. This would mean that it could not support much debt. Debtholders would much rather buy debt from companies that have assets that could be easily liquidated in the event of bankruptcy.

2. Medtronic probably does not have stable cashflows -- this would make it difficult for the company to make coupon payments regularly.

3. Medtronic probably needs flexibility -- it might have new projects or follow-up projects that may require new capital in an unpredicatable fashion. Debt would not provide this flexibility, since coupons have to be paid and the debt has to be repaid after a specified number of years.

4.

1. Firms, whose managers feel that the firm is undervalued, might not want to issue equity currently. Debt is less affected by undervaluation problems. At the same time, if the manager wants the flexibility of equity, a compromise can often be found in convertible debt.
   Other firms believe that investors over-estimate the value of the conversion option that convertible bond holders get. If this is true, then convertible bond issues would reduce the cost of obtaining funds.
   Also, high growth companies who currently do not have high cashflows might be able to issue convertible debt with lower coupons. Investors may be willing to accept the lower coupon in return for the potential share in the firm's good fortunes.
   Convertible debt also reduces agency costs. As we know, it is attractive for equity holders of leveraged firms to increase the firm's riskiness, because while ordinary bondholders are affected by the firm's ill-fortunes, they do not share in the firm's good fortunes. Obviously, this is not true of convertible bondholders, who do share in the firm's good fortunes.

2. Firms whose operating cashflows are positively correlated with interest rates could profitably issue floating rate debt because this would reduce the volatility of the firm's net income. Firms who felt that they could predict future interest rates (and expected them to be lower) would also want to issue floating rate debt.

5.

1. If we believed that the firm's horizon was a long one, the market risk premium should be estimated as the geometric average of the difference between the return on equities and the T-bond rate, i.e. 10%, or 5%. Which of these we choose depends on whether we believe that the current situation is better represented by the average of the last 10 years or the last 40 years. Inasmuch as the last ten years seem to be (at least ex-post) somewhat anomalous, I would use the average of the last 40 years, i.e. 5%.

2. The firm's cost of equity is 4.5% + 1.5(5) = 12%

3. The only estimate of the firm's cost of debt, that we have, is Interest on Long Term Debt/Face Value of debt, which works out to 10/100 or 10%, given that the debt was issued at par (hence the book value = face value). The tax rate would seem to be 16/40 or 40%; hence the after-tax cost of debt is (1-0.4)10 or 6%.

4. The market value of equity is 50000 x 10 or $500m.; the market value of debt is $100m. Hence the firm's weighted average cost of capital is 12(5/6) + 6(1/6) = 11%.

5. 1. The original asset beta of Culpepper would equal 1.5/[1+0.6(1/5)] = 1.34; the new asset beta would be 1.34*[1+0.6(3.5/2.5)] = 2.4656, since the new debt-equity ratio is (1+2.5)/(5-2.5) or 3.5/2.5. Its cost of equity would be 4.5 + 2.4656(5) = 16.828%
   2. The spread increases from what it had been previously, by 2%. Hence the cost of debt also goes up by 2%, since the Treasury rate is not changing. It's new after-tax cost of debt would be (10+2)(1-0.4) = 7.2%
   3. It's cost of capital would be [(3.5)(7.2) + (2.5)(16.828)]/6 = 11.212