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Quiz 1
A. Explain the following terms briefly:
1. Marking to Market
2. Agency Costs
3. Capital Market Efficiency
4. Deferred Tax Asset
B. Answer any two of the following three questions briefly – no
more than half a page each.
What is the role of stock analysts in corporate governance?
When is an obligation recognized as a liability according to GAAP?
What is the difference between purchase accounting and pooling accounting?
Solutions to Quiz 1
1. Marking to Market: The valuation of trading investments in balance
sheets is required to be done at market value, according to GAAP rules.
This is called marking-to-market. This ensures that firms such as investment
banks, whose assets are primarily securities held in other firms for purposes
of trading, revalue the bulk of these assets at market levels each period.
2. Agency Costs: The costs incurred due to agency problems, i.e. conflicts
of interest between different stakeholders in the firm, such as management
and stockholders, or stockholders and bondholders. These costs could be
out-of-pocket costs due to monitoring or compliance with contractual requirements,
or they could be opportunity costs, such as the cost of suboptimal actions
taken due to inadequate monitoring or due to excessively stringent contractual
requirements.
3. Capital Market Efficiency: This refers to the extent to which information
is incorporated in market prices of securities, as well as the speed of
incorporation of such information.
4. Deferred Tax Asset: Companies that pay more in taxes than the taxes
they report in the financial statements create an asset called a deferred
tax asset. This reflects the fact that the firm’s earnings in future
periods will be greater as the firm is given credit for the deferred taxes.
B. What is the role of stock analysts in corporate governance?
Ans: Stock analysts investigate all characteristics of a stock and all
information about it that are relevant for pricing. Even though they may,
themselves, not trade in it, for legal reasons, making this information
available has two effects – one, it makes the market more efficient;
and two, which is more relevant for corporate governance, it brings to
light, what may be hidden by management, and what management could do,
in order to increase the stock price.
When is an obligation recognized as a liability according to GAAP?
Ans. For an obligation to be recognized as a liability, it must meet three
requirements:
a. It must be expected to lead to a future cash outflow or the loss of
a future cash inflow at some specified or determinable date.
b. The firm cannot avoid the obligation.
c. The transaction giving rise to the obligation has to have happened.
What is the difference between purchase accounting and pooling accounting?
Ans. In purchase accounting, the purchase price is allocated to tangible
assets first, and the excess is then allocated to intangible assets; the
residual is allocated to goodwill. Goodwill must, then, be amortized over
time. In pooling accounting, the book values of the assets of the acquiring
and acquired firms are aggregated to create a consolidated balance sheet
of the firm. This is no longer a permissible method of accounting for
mergers under GAAP rules.
Quiz 2
1. You are trying to value CVS Corporation, a leading chain of drugstores.
You have estimate the free cash flows to equity for the firm this year
to be $400 million. You anticipate that these cash flows will grow at
the rate of 15% a year for the next five years, 10% a year for the succeeding
five years, and thereafter at the rate of 5% a year. The firm has a cost
of equity of 11% and 400 million shares outstanding.
a. Estimate the total value of equity in CVS.
b. If the stock is trading at $36 today, and you are confident about your
free cash flow estimates, where could you have gone wrong, assuming you
believe that the current stock price is correct? Explain how you would
bring your computations into line with the current stock price.
2. A local finance company quotes a 15% interest rate on one-year loans.
So, if you borrow $20,000, the interest for the year will be $3000 with
annual interest payments. Because you must repay a total of $23,000 in
one year, the finance company requires you to pay $23,000/12 or $1,916.67
per month for the next 12 months. Assume that the payments would be made
at the end of each month. What is the effective annual rate? Legally,
what rate would have to be quoted (APR)? (Hint: Computing the EAR for
this problem will require a trial-and-error procedure; so if you set up
the problem and attempt to come up with an answer, I will give you full
points for the EAR part.)
Solutions to Quiz 2
1. a. The total value of equity is simply the present value of the free
cash flows to equity. The current FCFE is $400 m. Since this is growing
at the rate of 15% per annum for the next 5 years, the FCFE at the end
of the 5th year is $400(1.15)5. The FCFE at the end of the
6th year is $400(1.15)5(1.1), since the growth rate for the
6th year is 10% per annum. Arguing similarly, we find that the FCFE at
the end of the 10th year is $400(1.15)5(1.1)5(1.05).
Using the PV of an annuity formula, we can use these figures to find the
PV of the FCFE from year 1 to year 5 to be  =
2226.89. The PV of the FCFE from year 6 to year 10 works out to  =
2323.53. Note that the last factor in this expression accomplishes the
discounting to time zero. The PV of the FCFE from year 11 onwards works
out to  =
7985.85. Summing all these values gives us $12536.27 m. This yields a
per share value of $31.34.
b. If the stock is trading at $36 today, and we are confident about your
free cash flow estimates, then the only way that the stock price could
be right is if the required rate of return were actually lower than the
posited 11%. (Remember that estimated growth rates of FCFE are really
estimates regarding future FCFE.)
2. The payments are equal to $1916.67 per month for 12 months, while
the amount borrowed equals $20,000. Using these numbers and figuring out
the implicit discount rate, we find that it is equal to 2.218% a month
or an APR of 26.62%. You have to solve the equation 20000 = PV(annuity
of 1916.67, no. of periods = 12) to get the 2.218%. The EAR = (1.02218)12
- 1 = 0.3012 or 30.12%
Quiz 3
FIN 647 Advanced Topics in Management Fall 2003
Quiz 3
A. Explain the following terms briefly:
1. implied market risk premium
2. market portfolio
3. marginal investor
4. beta
B. Answer any two of the following three questions briefly – no
more than half a page each. Make sure you explain everything.
- A stock with a high return variance will have a higher beta than
one with lower return variance. True or False?
- John holds all his money in manufacturing stocks. A good measure
of the risk of his portfolio is the beta of his portfolio. True or False?
- Why is beta the right measure of risk in a CAPM world?
Solutions to Quiz 3
A: Definitions
1. Implied market premium: the premium implicit in the pricing of the
market portfolio of risky assets today is called the implied market premium.
2. The market portfolio refers to the portfolio of all assets in the
economy.
3. The marginal investor: the marginal investor in a stock at a given
point in time is the investor that is most likely to be trading the stock
at that point in time. This is also the investor whose trading determines
the price of that stock at that time.
4. The beta of an asset is the measure of the non-diversifiable risk
of that asset. It measures the sensitivity of that asset's returns to
changes in the return on the market portfolio.
B.1. A stock with a high return variance need not have a higher beta
than one with a lower return variance because a lot of the variance on
the first stock could be due to diversifiable risk.
B. 2. John's portfolio beta is not a good measure of the risk of John's
portfolio, because John is actually bearing a lot of diversifiable risk,
while the beta only measures the non-diversifiable risk of the portfolio.
In other words, John's portfolio beta would be a downward biased measure
of his portfolio's true risk.
B.3. The beta, which measures the market or non-diversifiable risk of
a security is the correct measure of risk in a CAPM world because all
rational investors would diversify as much of their portfolio risk as
possible (Remember there are no transactions costs.) Hence only non-diversifiable
risk is borne by investors.
Quiz 4
Notes: Each question carries 10 points. Do not use more
than half a page for each question.
- Verizon Communications is engaged in the following business, according
to Yahoo:
Verizon Communications Inc. is engaged in the provision of communications
services. Verizon companies are providers of wireline and wireless communications
in the United States, with 135.8 million access line equivalents and
32.5 million wireless customers. The Company is also a directory publisher.
Its global presence extends to 32 countries in the Americas, Europe,
Asia and the Pacific through four segments: domestic telecom, which
serves a territory consisting of 135.8 million access line equivalents
in 29 states and the District of Columbia; domestic wireless, which
provides wireless voice and data services, paging services and equipment
sales in the United States; international, which includes international
wireline and wireless communications operations and investments in the
Americas, Europe, Asia and the Pacific, and information services, which
is engaged in print and online directory publishing and is a content
provider for electronic communications products and services
Explain, in no more than a couple of paragraphs, if Verizon should,
optimally, have a high debt-to-equity ratio or a low debt-to-equity
ratio. Give your reasons. Use bullet points to the extent you can.
- Your friend is the logical type. He argues as follows: "Both
the debt and the equity of a firm would be riskier, the higher its debt-equity
ratio. Since the cost of capital for the entire firm is a weighted average
of the costs of debt and equity, it is clear that a firm with a higher
leverage ratio will have a higher cost of capital than a firm with a
lower leverage ratio." Show why your friend is not necessarily
correct.
- Why might a bank impose more covenants on a firm than would bondholders
on a corporate bond issue?
Solutions to Quiz 4
- Verizon Communications is a multi-segment company. Certain of its
segments are in mature industries. For example, its domestic telecom
industry. The company has a lot of fixed assets across all lines of
business, but especially in its land-line service. The high level of
fixed assets would allow it to have a high leverage ratio. Furthermore,
given the mature and partially regulated nature of this segment, cashflows
are relatively secure. Some of its customers also have fixed-term contracts,
whereby they pay ahead of time for a month or more; this, too, provides
more certainty of cashflows. The worldwide nature of the business also
means additional diversification, which in turn means lower cashflow
volatility.
On the other hand, Verizon's cell-phone business is less regulated,
and it's a rapidly growing business with new technology that goes obsolete
fairly quickly; it's assets, therefore, have a short life, relatively.
- Even though the cost of debt and the cost of equity go up with higher
leverage, the cost of debt is still less than the cost of equity, and
a higher leverage ratio means that the weight placed on the lower cost
debt is also going up; hence a higher leverage ratio does not have to
mean a higher weighted average cost of capital, in spite of the fact
that both the cost of equity and the cost of debt are
rising.
- A bank can impose more covenants on a firm because the cost of renegotiating
covenants is lower. With a bond, the trustee cannot unilaterally negotiate
with the firm; he needs approval from bondholders, which can be costly.
So even if bondholders want more covenants, they would trade-off the
potential wealth expropriation against higher renegotiation costs and
lower flexibility.
It is also possible that newer firms tend to go to banks, rather than
to the capital markets. These firms may have higher agency costs, and
hence the optimal level of covenants would be higher. According to this
reason, there is self-selection of firms who go to banks.
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