Dr. P.V. Viswanath

pviswanath@pace.edu

Fall 2007 Exams

• Midterm
• Solution to Midterm
• Final Exam
• Solution to Final

Fin 647 Advanced Topics in Financial Management

Midterm

Notes:

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. Read the following WSJ article and answer any two of the questions below (10 points each):

1. Honeywell and 3M were down 4.6% and 6.5%, much more than Caterpillar, which dropped 3.5%. If this was the only information you had to go by, what would you say about their market betas?
2. Is there any other information in the article that would cause you to be cautious about the inference in part (a)? Explain.
3. Based on what you know of the businesses that McDonald's, 3M and Caterpillar are in, what can you say about their betas?
   3M Company (3M) is a diversified technology company with a global presence in various businesses, including industrial and transportation, healthcare, display and graphics, consumer and office, safety, security and protection services, and electro and communications.
   Caterpillar Inc. operates in three principal lines of business: Machinery, Engines and Financial Products. Machinery deals with the design, manufacture, marketing and sales of construction, mining and forestry machinery.
   McDonald's Corporation primarily franchises and operates McDonald's restaurants in the food service industry. These restaurants serve a varied, yet limited, value-priced menu in more than 100 countries around the world.

The Dow’s Three Stooges
Posted by David Gaffen, October 19, 2007, 10:55 am

It’s an earnings-driven breakdown on the Dow Jones Industrial Average today, as three of the four components that reported prior to today’s opening were responsible for a good chunk of the losses on the 30-stock average in the morning.
3M, Honeywell and Caterpillar are leading the charge lower.

Stocks are continuing to sink, reacting to the brief bump-up in oil over $90 a barrel and another bout of weakness in the U.S. dollar as investors continue to express concern over the possibility of sluggish economic growth, but with dollar-induced inflation from overseas. Industrials are leading the major indexes lower, as the Morgan Stanley Cyclicals Index is off 1.9%.

“Because the risks are not fully known as yet, a lot of attention is being paid to forward guidance that is murky, and I think if a company gives murky guidance the market is not giving it benefit of the doubt,” says Alan Gayle, director of asset allocation at Trusco Capital Management.

Among those issuing clouded guidance was industrial equipment giant Caterpillar, which was down 3.5% % after the company missed expectations and lowered forthcoming guidance. Fellow components Honeywell and 3M are worse, falling 4.6% and 6.5%, respectively, as the latter said it would be slowing its pace of stock buybacks.

Combined, the three stocks account for 96 points of negative drag on the Dow, with 3M’s massive drop making up 50 points of that fall-off. The lone earnings reporter to buck the trend was McDonald’s, which was off fractionally, contributing little to the Dow’s move.

2. I collected (using a program written by Michael Kishinevsky) price data on McDonald's (MCD) and the NYSE Composite Index for the period Oct. 2002 to Sept. 2007, and then computed returns on the MCD and the NYSE Index. I then regressed MCD returns on NYSE returns and obtained the following output.

Answer the following questions using the information above:

1. (5 points) What is McDonald's beta according to this regression?
2. (10 points) How closely does McDonald's move with the market? Are you surprised? What piece of information from the regression are you using to answer this question?
3. (10 points) Can you reject the hypothesis that McDonald's beta is one? Explain.
4. (10 points)

Subsequently, I ran another regression, this time using data for the second half of the period. The results are given below:

Regression Statistics
Multiple R	0.634874
R Square	0.403065
Adjusted R Square	0.380956
Standard Error	0.03953
Observations	29
ANOVA
	df	SS	MS	F	Significance F
Regression	1	0.028488	0.028488	18.23106	0.000216
Residual	27	0.04219	0.001563
Total	28	0.070678
	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	0.005243	0.008339	0.628723	0.534814	-0.01187	0.022353
0.01798	1.448386	0.339218	4.269784	0.000216	0.752369	2.144403


What is your estimate of McDonald's beta from the new results for the second-half of the subperiod? How different is it from your answer in (a)? Can you explain the size of the discrepancy (if it's large, explain why, and if it's not large, give the reason why it's not large).

3. 3M Company operates as a diversified technology company. It operates in six segments: Industrial and Transportation; Health Care; Display and Graphics; Consumer and Office; Safety, Security, and Protection Services; and Electro and Communications. It's market capitalization is $62b. and its beta is 0.8, according to Yahoo. The table below gives the proportion of sales contributed by each segment, according to the 2006 10-Ks filed by the company in February 2007.

You have the additional information re other firms in the Security and Protection Services industry (Source: Yahoo):

1. (10 points) Compute the market value of assets for each of the firms in the table above.
2. (10 points) Use the numbers computed in (a) to estimate the asset beta for the Security and Protection Services sector (assuming these four firms are representative of the industry; assume also that the tax rate is 40% for all firms).
3. (10 points) Use this information to estimate the beta of the rest of 3M (other than the Security and Protection Services segment).
4. (10 points) Suppose you now believe that due to structural changes in the economy, the asset beta of the Security and Protection Services sector needs to be raised by 20%. Estimate the new beta of 3M.

4. (10 points) Answer any three of the following questions in no more than half a page each.

1. Is it good to make insider trading illegal? Can you think of reasons why insider trading should be made legal?
2. The uncertainty regarding a firm's returns that is unrelated to the market is called idiosyncratic risk. The uncertainty regarding a firm's returns that is related to the market is called systematic risk. The sum of idiosyncratic and systematic risks is called the total risk and is equal to the variance of the firm's return. Consider the proportion of the variance of a firm's returns that is accounted for by systematic risk. Would this proportion be higher for smaller firms or larger firms? Why?
3. Why does the Board of Directors not always function well to control the CEO's activities?
4. Would a geometric average of historical returns a better forecast of future returns if investors have a long-term horizon or would an arithmetic average be better?
5. Why is the beta the more appropriate measure of risk of an asset, rather than its return variance?
6. When is regression inapproriate to estimate a firm's beta?

Solutions to Midterm

1.

1. It looks like this is a market-wide slowdown. Hence, I would say that Caterpillar, Honeywell and 3M, all had large betas, with their magnitudes in that same order. If we can interpret the Morgan Stanley Cyclicals Index as a measure of what's happening to the market overall, we'd have betas of 3.5/1.9 (= 1.84), 4.6/1.9 (=2.42) and 6.5/1.0 (=6.5), overall.
2. There are some cautions in interpreting these numbers as betas. Since the slowdown, apparently, is due to the drop in the dollar and increase in oil prices, stock price declines would be related to how exposed the firms were to exchange rate risk and how dependent they were, directly or indirectly, on oil. Further, if the downturn is earnings driven, perhaps some of the firms with very steep declines are those that had unexpectedly low drops. For these firms, the beta, as measured above, might be too high.
3. Firms and industries producing capital goods and consumer durables are usually hard hit by recessions. Two factors explain this:
   * Postponability – Within limits, purchases of durable goods can be postponed. During recessions, producers frequently delay the purchase or more modern production facilities and the construction of new plants, whereas in good times, capital goods are often replaced before they completely depreciate. Similarly, during recessions, households often delay the purchase of big-ticket items, including automobiles, white goods, and so on.
   * Monopoly Power – Many industries producing capital goods and consumer durables are found in high concentration, i.e. a small number of large firms dominate the market. These firms can set above-competitive prices to increase their profit. When recession hits, these firms are reluctant to lower prices since this would upset the industry price structure, possibly sparking a price war. This reluctance means that the initial effects of a drop in demand are primarily a decline in production and an increase in employment.
   If we use this perspective, we see that Caterpillar's profits would fluctuate a lot more with the business cycle than McDonald's. 3M's products cater partly to businesses and partly to consumers and hence they would be in an intermediate position. Hence, we'd expect Caterpillar to have the highest beta, followed by 3M and then McDonald's. According to Yahoo, 3M has a beta of 0.8, while Caterpillar has a beta of 1.69, and McDonald's has a beta of 1.74. Of course, this analysis ignores the other characteristics of the goods, themselves, as well as the debt/equity ratios. McDonald's has a D/E ratio of 0.542, while Caterpillar and 3M have debt/equity ratios of and 3.189 and 0.477 respectively. This partly clarifies the picture, but the high beta of McDonald's is still unexpected, if we think of McDonald's product as a necessity. It is possible that competition for low-margin staple foods has transformed the fast-food industry into a primarily high-margin, non-necessity producing industry.

2.

1. McDonald's beta is 1.407973, according to the regression.
2. The R-squared tells us how closely McDonald's moves with the market. The R-squared here, is 38.84%; that is, 38.84% of the variance in the return on McDonald's can be explained by market movements. It is not particularly huge.
3. The standard error of the beta is 0.234014; hence the estimated beta is (1.407973-1)/0.234014 or 1.74 standard deviations larger than a beta of one. The chances of getting an estimated beta this large, if the true underlying beta were 1 is less than 10%; hence one could reject the null hypothesis of a unit beta. Under other assumptions, it would be even easier to reject a unit beta.
4. The beta in the second period is very similar to the beta in the overall period from Oct. 2002 to Sept. 2007. This suggests that McDonald's did not change its operations too much between the first period and the second period.

3.

1. Given the market value of equity and the debt/equity ratio, it's easy to compute the market value of assets. For example, for CKP, the debt/equity ratio is 0.032 and the market value of equity is $1.1b. Hence the market value of debt is 0.032 times this amount of 0.0352b. The market value of assets, thus is 1.1 + 0.0352 or 1.1352b. We can compute the market value of assets of the other firms, as well, in the same fashion. The market value of assets of all the firms is given in the table below.
2. We can now use the formula: Asset beta = (Equity beta)/(1+(1-tax rate)(D/E)) to compute the asset betas. These are also given in the table below. Finally, we take a weighted average of these betas, with the market values of assets as the weights to get an estimate of the industry asset beta, which turns out to be 1.531. This can be used as an estimate of the asset beta for the 3M's Safety and Security Protection Services (SSPS) segment of 3M.
   

   Company	MV Equity	Debt/Equity Ratio	MV assets	Equity Beta	Asset Beta
   CKP	$1.10	0.032	1.1352	1.06	1.040031
   ID	$1.30	0.175	1.5275	4.52	4.090498
   GEO	$1.50	0.955	2.9325	1.75	1.112524
   BCO	$2.90	0.164	3.3756	0.99	0.901311
   				Ind beta	1.530947

3. Now, the equity beta of 3M is 0.8 and its debt-equity ratio is 0.477; hence the asset beta of 3M can be worked out using the formulas above, as 0.8/(1+0.6(0.477)) = 0.622.
   Now this is a weighted average of the asset betas of 3M's Safety and Security Protection Services (SSPS) segment and of the rest of 3M, with weights equal to the percentage of sales for the SSPS segment (11.4) and the percentage of sales for the rest of the firm (100-11.4). Hence we can write: 0.622 = (0.114)(1.531) + (1-0.114)b, where b is the asset beta for the rest of 3M. Solving, we find b = 0.505; this is the asset beta of the rest of the firm. Although it's inappropriate to ascribe debt/equity ratios for parts of a single corporate entity, if we did want to use the D/E ratio of 0.477 for all segments, we could also compute an equity beta for the non-SSPS part of 3M. This would work out to 0.505(1+0.6(0.477)) = 0.65.
4. If the new asset beta of the SSPS segment were now (1.2)(1.531) = 1.8372. The new asset beta for 3M would then be (1.8372)(0.114) + (1-0.114)(0.505) = 0.6569. The new equity beta for 3M would then be 0.6569(1+0.6(0.477)) = 0.8449.

4.

1. One advantage of making insider trading legal is that information possessed by insiders would be incorporated faster into prices because insiders would trade on their information. On the other hand, this might cause other traders to be more cautious in trading because the person they might be trading with could be an insider with superior information. If this fear is widespread, it might reduce liquidity.
2. The proportion of the variance of a firm's returns that is accounted for by systematic risk would probably be higher for larger firms. The reason is that larger firms are like portfolios of smaller firms. The idiosyncratic component of the returns of these "smaller" component firms would cancel out and hence most of the movement of the return of the larger firm would be related to the market. Another way of thinking of this is that the larger firms is more akin to the entire market than the smaller firm, since it comprises a larger proportion of the market.
3. The Board of Directors doesn't always function well in controlling the CEO because their compensation is not always tied to the fortunes of the firm; and even if it is, it wouldn't comprise as large a portion of their wealth. Furthermore, the CEO often has a say in the composition of the Board.
4. A geometric average of historical returns a better forecast of future returns if investors have a long-term horizon because it more accurately mimics the return that an investor would get over a long interval.
5. The beta is the more appropriate measure, because it ignores idiosyncratic risk, which can be diversified away, and hence does not need to be compensated for.
6. Regression is appropriate if the historical returns of the firm are a good indication of the future -- for example, if the firm has not changed its operating pattern vis-a-vis the rest of the economy.

Notes:

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.
4. You must explain all your answers.
5. You have 2 hours to complete the exam; please make sure to attempt all the questions, so I can give you partial credit, if necessary.

1. ( 30 points) Please read the following article and answer any three of the questions below (parts a-c were taken from the Wall Street Journal Weekly Review of Aug. 31, 2007):

1. Why would banks be more willing to give Boston Scientific concessions on the terms of their existing loan after Boston Scientific prepaid $1 billion of their debt?
2. In order to make the prepayment, Boston Scientific is using $750 million of cash and is drawing on a line of credit secured by accounts receivable. From Boston Scientific's perspective, what is the difference between using cash and drawing on the line of credit to make the prepayment? What is the difference from the lenders' perspective?
3. How does specifying a maximum total debt to EBITDA protect Boston Scientific's lenders?
4. In class, we discussed one of the sources of agency costs of debt, viz. that equity holders have an incentive to take on additional debt. Here we see that Boston Scientific is doing exactly the opposite. Do investors think that paying down the debt in this fashion is good for shareholder value? Explain.

Boston Scientific Gets Debt Breathing Room
By KEITH J. WINSTEIN, August 24, 2007

Boston Scientific Corp. paid down $750 million of its $8.9 billion debt, winning concessions from its banks as it works to reduce costs and get out from under the debt it took on to buy Guidant Corp. last year.

The Natick, Mass., medical-device maker agreed to prepay $1 billion on a $5 billion loan from a syndicate of banks led by Merrill Lynch & Co. Three-quarters of the payment was made from Boston Scientific's cash on hand, and the rest, $250 million, from draws on a line of credit secured by accounts receivable. In exchange, the banks agreed to relax certain covenants on the loan and on a $2 billion revolving line of credit, which Boston Scientific hasn't touched.

Although the prepayment gives Boston Scientific more breathing room in the short term, it doesn't significantly alter its long-term cash-flow trajectory. At last quarter's rate of operating cash flow -- $211 million -- and factoring in required payments and likely capital expenditures, Boston Scientific would need to dip into the revolving line of credit to make an April 2009 loan payment.

But operating cash flow could improve if sales pick up. Boston Scientific's defibrillator sales are off 20% from two years ago, when a series of recalls hurt the company's reputation. Sales of stents, which prop open clogged arteries, have been hurt by critical medical studies and are down 27% from a year ago. But a Japan launch in May could provide a boost to stent sales. Restructuring charges, which have weighed on cash flow, could also be lower over the long term.

Overall, the payment reduces Boston Scientific's total debt to about $8.2 billion and lowers its continuing interest payments. The next payment of principal on the loan won't be due until April 2009, for $300 million. The company had $1.5 billion in cash at the end of June, and after the $750 million payment it has "nearly $1 billion," the company said.

The loan agreement requires Boston Scientific to keep its total debt below 4.5 times its annual earnings before interest, taxes, depreciation and amortization, or Ebitda. At the end of June, that ratio was 4.0. Previously, Boston Scientific had been required to reduce it to 3.5 by April 2008. Under the relaxed covenants, the company will have until April 2009 before the limit goes to 4.0, and not until October 2009 will it need to achieve a 3.5 ratio.

The banks also agreed that some of the company's litigation settlements and restructuring charges won't be counted as reducing its Ebitda.

Shares in Boston Scientific rose 1.9% to $12.71 at 4 p.m. in New York Stock Exchange composite trading.

2. (10 points) Here is a description of Boston Scientific (NYSE: BSX) from http://finance.yahoo.com. Please describe the relevant factors that would be important in determining Boston Scientific's long-term debt-to-capital ratio.

Boston Scientific Corporation engages in the development, manufacture, and marketing of medical devices that are used in interventional medical specialties worldwide. The company offers its products in three groups: Cardiovascular, Endosurgery, and Neuromodulation. The Cardiovascular group focuses on products and technologies for use in interventional cardiology, cardiac rhythm management, peripheral interventions, cardiac surgery, vascular surgery, electrophysiology, and neurovascular procedures. The Endosurgery group offers products that are used in helping patients with malignant and benign tumors, gastrointestinal cancers, incontinence, abscesses, end stage renal disease, benign prostatic hyperplasia, gallstones, and urinary stone disease, as well as uterine fibroids and menorrhagia. The Neuromodulation group provides auditory solutions to treat permanent deafness through the use of cochlear implants; and pain management devices that use neurostimulation to mask chronic pain signals with electrical impulses.

The company's medical products are used for enlarging narrowed blood vessels to prevent heart attack and stroke; clearing passages blocked by plaque to restore blood flow; detecting and managing fast, slow, or irregular heart rhythms; mapping electrical problems in the heart; opening obstructions and bringing relief to patients suffering from various forms of cancer; performing biopsies and intravascular ultrasounds; placing filters to prevent blood clots from reaching the lungs, heart, or brain; treating urological, gynecological, renal, pulmonary, neurovascular, and gastrointestinal diseases; and modulating nerve activity to treat deafness and chronic pain. It markets its products through direct sales force, and a network of distributors and dealers. Boston Scientific Corporation has a strategic collaboration with CryoCor, Inc. for the treatment of cardiac arrhythmias. The company was founded in 1979 and is headquartered in Natick, Massachusetts.

3. Ford Motor Company (NYSE: F) has 2.11 billion shares outstanding (according to Yahoo), and the closing price on Friday, Dec. 7, 2007 was $7.06. It's Yahoo stock beta is 2.07. According the 10-K filings for 2006, it had $172,049 million worth of debt (book value). Short-term liabilities (of various kinds) amounted to $108,811 million for a total of $280,860 million. A representative interest (coupon) rate for the most recently issued debt is 7.2% per annum. However, it should be kept in mind that much of this debt is convertible; hence, adjusted for the convertibility feature, the cost of debt is probably closer to 8%. According to the 10-K statements, S&P gives Ford a B credit rating. Of course, Ford has a variety of debt, some of them convertible and some not, some of them secured and some not, some of them long term and some short-term. However, assume that the overall credit rating of B fairly represents Ford's credit rating. Because of accrued tax-loss carryforwards, Ford's marginal tax rate is only about 17% (taking local jurisdiction taxes into account as well), even though the fiduciary federal tax rate is 35%.

As already mentioned, Ford's debt has not all been recently issued, and so it is difficult to figure out its market value. However, considering its weakening position since the beginning of January 2004, it seems reasonable to assume, on average, that the ratio of market value to book value for its debt is about 0.8.

1. Ford does not seem to have any intentions currently of changing its capital structure. Suppose, however, that it planned to sell $30b. worth of additional equity, in order to buy back some of its debt. Such an action would definitely raise its bond rating, perhaps to BB; if so, it's borrowing rates would drop by 50 basis points. Assuming that such a move would not have major implications for Ford's operating cashflows, and assuming as well that it would then be able to renegotiate all of its debt to more favorable terms, indicate whether this is a good move? Assume a market risk premium of 6% and a riskfree rate of 6%. (20 points)
2. What would be the impact on the share price of the announcement of such a move (assuming that it's unexpected)? (10 points)

4. (15 points) The traditional formula for recovering the unlevered beta from the levered beta is by assuming a debt beta of zero. That is, using the fact that the beta of a portfolio is the weighted average of the betas of the assets making up the portfolio, we have the relationship, b(assets) = DE^tab(debt) + (1-DE^ta)b(equity), where DE^ta, the tax-adjusted debt-assets ratio = D(1-tax rate)/(D(1-tax rate)+E)). If we now set b(debt) = 0 and rewrite the equation, we get the standard formula that b(equity) = b(assets)[1+(1-tax rate)(D/E)]. Is this a reasonable assumption to make in this context? Suppose you assumed that the beta of debt is 0.3 at the old capital structure and that it drops to 0.15 after the leverage is lowered. What is the weighted average cost of capital after the leverage reduction?

5. (12 points) Ford's 10-K also has the following information. Of the questions posed below, answer part a. and either of parts b. or c.

The Credit Agreement requires ongoing compliance with a borrowing base covenant and contains other restrictive covenants, including a restriction on our ability to pay dividends. The Credit Agreement prohibits the payment of dividends (other than dividends payable solely in stock) on our Common and Class B Stock, subject to certain limited exceptions. In addition, the Credit Agreement contains a liquidity covenant requiring us to maintain a minimum of $4 billion in the aggregate of domestic cash, cash equivalents, loaned and marketable securities and short-term Voluntary Employee Benefit Association (“VEBA”) assets and/or availability under the revolving credit facility.
With respect to the borrowing base covenant, we are required to limit the outstanding amount of debt under the Credit Agreement as well as certain permitted additional indebtedness secured by the collateral described above such that the total debt outstanding does not exceed the value of the collateral as calculated in accordance with the Credit Agreement (the “Borrowing Base value”).

Elsewhere, we are told that the Voluntary Employee Beneficiary Association trust (“VEBA”) is a trust which may be used to pre-fund certain types of company-paid benefits for U.S. employees and retirees.

1. Explain the restriction on the payment of dividends in the credit agreement..
2. Explain the purpose of the liquidity covenant in the credit agreement. Would you expect to find a similar covenant in the bond indenture, as well? Why or why not?
3. Why is there a restriction on additional indebtedness in the credit agreement? Would you expect to find a similar covenant in the bond indenture, as well? Why or why not?

6. (8 points) In 2005, Ford Motor Company paid dividends of 40 cents per share to common stockholders (10 cents per quarter). However, in the third quarter of 2006, this was reduced to 5 cents, and in the last quarter, the dividends were eliminated altogether. A footnote in the firm's 10-K has the following information:

On December 15, 2006, we entered into a new secured credit facility which contains a covenant prohibiting us from paying any dividends (other than dividends payable solely in stock) on our Common and Class B Stock, subject to certain limited exceptions. As a result, it is unlikely that we will pay any dividends in the foreseeable future.

If Ford Motor Company does not expect to pay any dividends in the foreseeable future, would it be right to conclude that the stock is worthless? Why or why not?

Solution to Final Exam

1. a. Less of their money is at risk; furthermore, the payment is a signal from management that things are expected to look better in the future. Also, reducing free cashflow might mean greater discipline for the managers – more pressure on them.
b. Using cash reduces the company’s flexibility in case things go unexpectedly bad; this is from the company’s perspective, primarily. From the lenders’ perspective, being paid with cash is better – this way, the accounts receivable are available for collection by the lenders. Furthermore, being paid with cash is like being given priority over other debtholders on payment, at least with respect to the use of the cash.
c. Such a covenant would reduce the possibility that the current lenders would have to compete with other creditors for the same amount of assets.
d. The company is being able to relax the covenants – furthermore, it now has more breathing room to pay back the debt. Hence it could very well increase shareholder value. Also, it’s possible that the debt that’s being paid back has too high an interest rate given the improvement in Boston Scientific’s situation.

2. BSX has three different aspects -- manufacture, development and marketing (of medical devices). As far as development is concerned, its assets are intellectual and intangible and cannot support much debt. Investment projects are unlikely to generate cashflows in the short-run and hence debt is not the optimal source of capital. Agency problems are also rife, and again, debt is contra-indicated. As far as the marketing is concerned, the asset of value is probably reputation and a distribution network, neither of which can support much debt. They are probably not assets that can be transferred to other entities. On the manufacturing side, however, there are probably factories and other tangible assets that can be sold in the event of bankruptcy and that can hence support debt. However, the product is such that quality is not immediately apparent to the buyer, and hence reputation is important here as well. Assets, though tangible, might well be specialized again suggesting that a lot of debt is not good.

BSX is invovled in a lot of different pharmaceutical products; while this is likely to produce some diversification, it is unlikely to generate the kind of diversification that would lead to stable cashflows. Its long-standing direct sales force adn distributor-dealer network on the other hand, may imply stable cashflows and hence the desirability of debt.

3.a. The debt/equity ratio currently is 280860(0.8)/2110(7.06) = 224688/14896.6 = 15.083. Total firm value = 224688 + 14896.6 = 239584.6 millions. The cost of equity is 6 + 2.07(6) = 18.42.
If the firm sold $30b. worth of additional equity, it’s debt-equity ratio would decrease to (224688–30000)/( 14896.6+30000) = 4.336.
The unlevered beta is 2.07/(1+(1-0.17)15.083) = 0.1531
The new levered beta would be 0.1531(1+(1-0.17)4.366) = 0.7079
The old WACC = (15.083/16.083)(8)(1-0.17) + (1/16.083)(18.42) = 7.3725%.

If the leverage is decreased, its cost of equity would drop to 6 + 0.7079 (6) = 10.2474. The cost of debt would be 7.5(1-0.17) or 6.225 after tax. Hence the WACC would drop to (4.336/5.336)6.225 + (1/5.336)10.2474 = 6.9788%

Since the new WACC is lower, and cashflows are not expected to be affected, this is a good move.

b. Assuming no growth, the increase in market value would be 239584.6(0.073725-0.069788)/0.069788 = 13515.86 million dollars. This would cause the stock price to rise by 13.51586/2.11 = $6.4056. Hence the new stock price would be 7.06 + 6.41 or $13.47.

4. Considering that Ford is so highly leveraged, it doesn't make sense to assume that the debt has a beta of zero. Using the new formula, DE^ta = 224688(1-0.17)/[14896.6+224688(1-0.17)] = 0.926; the unlevered beta = 0.926(0.3) + (1-0.926)2.07 = 0.431.

After the restructuring, the value of DE^ta = 194688(1-0.17)/[44896.6+194688(1-0.17)] = 0.7826. The levered beta, after the restructuring would be equal to whatever value b satisfies 0.431 = (0.7826)(0.15) + (1-0.7826)b. Solving, we find b = 1.4425. The new cost of equity equals 6 + 1.4425 (6) = 14.655. The WACC then equals (4.336/5.336)6.225 + (1/5.336)14.655 = 7.8048%. Now, we find that the restructuring is not worthwhile.

5. a. The main reason for the restriction on dividends is to prevent stockholders from reducing the asset base supporting debt. Of course, keeping dividends low means availability of more cash for investment and greater flexibility, all of which might well be good for bondholders, but they are also good for stockholders, and there is not need for bondholders to insert the dividend restriction into the credit agreement for that reason.

b. Since the credit agreement has to do with short-term debt, its payment depends crucially on short-term availability of funds, i.e. liquidity. There is less reason to have a similar covenant for longer-term bonds since bonds are not paid typically from short-term funds. Their repayment depends on longer-term cashflows.

c. The restriction on additional indebtedness is so that existing debtholders are not forced to share assets with new debtholders. This is something that bondholders are also likely to be interested in, for obvious reasons. This is an unlikely restriction in a credit agreement; however, Ford being in a precarious situation, financially might be the reason for the appearance of this restriction, here.

6. If the firm were not expected to pay any dividends at all in the future, the stock would, of course, be worthless. However, what is meant is that the firm is not expecting to pay dividends for the foreseeable future -- that is, the future that can be forecast with some degree of accuracy. This might be, say, three or four or five years. However, the firm by not paying dividends right now and keeping cash on hand instead would have more flexibility and more funds available to reinvest in the firm. Consequently, it would be more likely to reach profitability eventually, at which time, it would, indeed, pay dividends. Hence the firm's shares would not be worthless in spite of the footnote in the 10-K.