Dr. P.V. Viswanath

pviswanath@pace.edu

Fall 2008 Exams, FIN 647

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

Midterm

Notes:

• If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
• 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.
• You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
• You must explain all your answers.
• You must answer questions 1, 4 and 5. Answer any one of questions 2 and 3.

1. Read the following extract from a WSJ article (August 5, 2008) and answer the questions below:

1. (12 points) Why did it take the arrival of Mr. Snyder to turn things around? Did previous stock-holders not realize what was necessary to improve the operations of the company?
2. (8 points) What lesson can you learn about corporate governance from the story described in this article?

No Fun for Six Flags As Parks Face Slump, by JEFFREY MCCRACKEN

AUSTELL, Ga. -- Six Flags Inc. Chief Executive Mark Shapiro looked up at Goliath, a 200-foot-tall roller coaster just outside of Atlanta, as riders roared downhill at 70 miles per hour. "Nice ride," he noted. "But we'll never get our return on investment with it."

Six Flags, one of the nation's largest amusement-park companies, is under serious financial strain. It hasn't posted an annual profit in years. It's weighed down by $2.4 billion of debt, and faces a $288 million payment to preferred stockholders next August.

Luring more customers to its 20 amusement parks during the peak summer months is essential to the New York-based company's turnaround effort. "This is the year we've got to put a number on the board that impresses," Jeffrey Speed, the company's chief financial officer, said last month. "It's a show-me story, and we've yet to perform. We know that."

Mr. Shapiro, the former head of programming at ESPN, has been trying to cut costs wherever he can. While competitors such as Ohio-based Cedar Fair try to lure more customers with ever bigger, more outrageous and expensive roller coasters, Six Flags is moving in an opposite, family-friendly direction. It has barred bikini tops and banned smoking everywhere but in small areas on the outskirts of the parks.

On Monday, Six Flags gave investors the first indication that its overhaul may be gaining traction. It posted a second-quarter profit of $94.6 million, in part due to a recent debt-restructuring deal.

But it's a terrible time for any company to try to pry more disposable income out of the wallets of beleaguered consumers. Consumer confidence is shaky, and sky-high gasoline prices are causing Americans to think twice about unnecessary driving. Already, several retailers and restaurant chains that cater to middle-market consumers have sought bankruptcy protection.

"Some theme parks held up in the last recession, but this is a different downturn, so you can't necessarily say they will hold up during this one," says John Puchella, a theme-park analyst for Moody's Investors Service. "This is a consumer-led downturn." Moody's estimates that attendance at amusement parks will drop about 5% this year.

At Six Flags, attendance declined 3% in the quarter, in part because Easter didn't fall during the second quarter this year. But revenue inched up 1%, thanks to management's efforts to squeeze more money from sponsorships and licensing fees.

Six Flags shares were down nine cents at $1.03 a share in 4 p.m. composite trading Monday on the New York Stock Exchange. They remain far below the $3.67 they were trading at one year ago.

That's bad news for two big Six Flags investors -- Washington Redskins owner Daniel Snyder, who won a proxy fight for control of the company in 2005, and Microsoft's Bill Gates, whose investment fund backed Mr. Snyder. As of March 31, Mr. Snyder, now the company's chairman, owned about 5.4% of Six Flags, and Mr. Gate's investment fund, Cascade Investments, owned 11%, the most recent securities filings indicate.

"We aren't where we want to be, but I think we are heading in the right direction," said Mr. Snyder in an interview in late June. Cascade declined to comment on its Six Flags investment.

Mr. Shapiro, who is 38 years old, says he wants to attract a family crowd with more modest roller coasters and kiddie rides. The new Dark Knight coaster at Six Flags Great Adventure in Jackson, N.J., tied to the latest Batman movie, cost about $7.5 million to build, compared with $20 million or so for giant coasters like the Goliath in Georgia. Its top speed is just 30 mph, less than half of Goliath's top speed. It's housed in a dark building, which makes it harder to notice how much smaller it is than its high-octane competitors.

"My strategy makes perfect sense," says Mr. Shapiro. "It's just whether we have enough money. So I need to make recognizable progress this year."

Six Flags was founded in Texas in 1961. Time Warner Inc. bought the company in 1991, then sold it in 1998 to Premier Parks, an Oklahoma-based park operator. Premier combined the two operations and took the company public later that year as Six Flags. The new company spent heavily on new rides, acquisitions and expansion into Canada, Mexico and Belgium. Its debt load ballooned.

Mr. Snyder, whose investment company was a large stockholder, began pushing in 2004 for Six Flags to bring in new management, sell off some parks, and begin going after families rather than thrill-seeking teenagers. "Stockholders would have been better off hiding their money under a mattress" than investing in the company under the existing management, Mr. Snyder wrote in a letter to Six Flag shareholders in October 2005, during the proxy battle. At the time, Six Flags shares were trading at about $7.25.

Raising the Price

After he took over as chairman, he recruited film producer Harvey Weinstein to fill a seat on the company's board, for his marketing prowess. Mr. Snyder had met Mr. Shapiro when ESPN was trying to lure the National Football League's Monday night games to the network. Impressed by Mr. Shapiro's marketing background, Mr. Snyder persuaded him to run Six Flags, and to bring a team of ESPN veterans with him.

In 2006, after cleaning up its parks and adding some new rides, management raised admission prices by $5 to $10, driving the ticket price to as high as $40 in some markets. But attendance dropped below 25 million in 2006, from 28.7 million in 2005. "Our lack of pricing power was really a big surprise to me," says Mr. Shapiro.

In 2006 and 2007, Six Flags sold 10 parks and a 100-acre lot in Houston for about $400 million, hundreds of millions less than anticipated, according to Mr. Speed, the company's CFO. Mr. Snyder had set a goal of trimming debt to less than $2 billion. But with the real-estate proceeds going to fund operations, the debt remained at $2.4 billion. Rivals such as Cedar Fair and Universal City Development Partners, whose theme parks include Universal Studios Florida, carry much smaller debt loads relative to their cash flow.

Mr. Shapiro hasn't wavered from his view that the old amusement-park formula -- build bigger and better roller coasters as often as possible -- isn't a money-maker. He says he's not overly interested in the typical teenage fans of such rides, who were once Six Flags' best customers. He is courting parents, young children and corporate groups, and is emphasizing rides tied to movies and cartoon characters, which can generate T-shirt and sweatshirt sales.

Six Flags used to spend $200 million or more a year on capital expenditures, mostly on new roller coasters and other rides. It has cut that figure to about $100 million a year, an amount Mr. Speed calls "sustainable."

2. Navistar's 10-K filings for the fiscal year 2007 (year ending Oct. 31, 2007) inform us that operating leases are treated as follows:

We lease certain land, buildings, and equipment under non-cancelable operating leases and capital leases expiring at various dates through 2021. Operating leases generally have 5 to 25 year terms, with one or more renewal options, with terms to be negotiated at the time of renewal. Various leases include provisions for rent escalation to recognize increased operating costs or require us to pay certain maintenance and utility costs. Our rent expense for the years ended October 31, 2007, 2006, and 2005 was $50 million, $46 million, and $42 million, respectively. Rental income from subleases was $2 million for each of the years ended October 31, 2007, 2006, and 2005.

Future minimum lease payments at October 31, 2007, for those leases having an initial or remaining non-cancelable lease term in excess of one year and certain leases that are treated as finance lease obligations, are as follows:

The following additional information is available: Navistar carries $8m. worth of 9.95% Senior Notes, due 2011. Assume that the notes are trading at part. Operating lease payments for the year ending Oct. 31, 2007 were $50m.

1. (15 points) At what value should the operating leases be carried in Navistar's balance sheet, from the point of view of a financial analyst?
2. (10 points) Net Income for the year ended Oct. 31, 2007 was -$120m; interest expense was $502m. and taxes were -$47m. Hence Earnings before Income and Taxes were $335m. What is the adjusted operating income for the year ended Oct. 31, 2007?

3. Looking through various 10Ks, it is possible to collect the following information (in millions of dollars):

Net Capital for Navistar, as of 7/31/2008 and 10/31/2007 were $1603m. and $1633m. The latest data for 2008 that are available are as of July 31. (Net Capital was computed from available 10K data as the sum of Net Debt and Shareholder's Equity.)

1. (10 points) Compute Net Operating Profit After Taxes (NOPAT) for Navistar for the 3 months ended 7/31/2008 and for the year ended 10/31/2007.
2. (15 points) Has Navistar's operating performance improved in 2008 compared to 2007? Is this due to higher operating profit margins or due to better utilization of operating assets?

4. Use the information provided to you in Q.3 regarding Navistar's financial condition. In addition, the 10K for 2007 has the following information for the year ended 10/31/2007 (in millions of dollars) in the Consolidated Statement of Cashflows:

1. (10 points) Compute the Free Cashflow to Equity for Navistar for the year ended Oct. 31, 2007.
2. (5 points) Navistar's beta, according to Google (http://finance.google.com/finance?q=NYSE%3ANAV) is 1.81. If the yield on the 10-year T-note is 3.936% and your estimate of the market risk premium is 7%, what is the required rate of return on Navistar?
3. (10 points) Growth estimates for NAV (according to Yahoo) are 27% per annum. However, you believe that this is too optimistic; you think such a high growth rate can only be maintained for the next two years. Assuming a stable growth rate of 5% thereafter, what is your valuation of Navistar's stock price right now (Oct. 31, 2008)? (Estimate the price as of the end of 2007 and compound forward to Oct. 31, 2008 using a rate of return of 6% per annum.)

5. (30 points) Answer any three of the following questions:

1. Here are two examples of risk faced by a firm:
   • Competitive Risk: the earnings and cash flows on a project can be affected by the actions of competitors.
   • Industry-specific Risk: covers factors that primarily impact the earnings and cash flows of a specific industry.
   • International Risk: arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced.
   Pick two of these risks and explain if it is mostly diversifiable or mostly not diversifiable. Explain.
2. What is the beta of a lottery ticket, according to the CAPM?
3. What is the beta of the market portfolio?
4. Your friend tells you: "The market risk premium never changes; it's only the asset risk premium that changes." Do you agree? If you agree, explain why your friend is right. If you disagree, explain why and give an example of when the market risk premium might change.

Solution to Midterm

1. a. There was a change in ownership in 2005. Mr. Snyder now owns about 5.4% of Six Flags, and Mr. Gate's investment fund, Cascade Investments, owns 11%. This gave Mr. Snyder a strong incentive to increase the stock price, and he was willing to incur any incidental costs on his own. Accordingly, he looked around for a talented CEO, and found him in the person of Mark Shapiro. Mr. Shapiro eventually turned things around. It wasn't that previous stockholders didn't realize that things had to change -- it was simply that nobody had the incentive to take actions that would be costly only to them, but that would benefit everybody equally. The motivation that Mr. Snyder had can be seen in the following paragraph in the article:

Mr. Snyder, whose investment company was a large stockholder, began pushing in 2004 for Six Flags to bring in new management, sell off some parks, and begin going after families rather than thrill-seeking teenagers. "Stockholders would have been better off hiding their money under a mattress" than investing in the company under the existing management, Mr. Snyder wrote in a letter to Six Flag shareholders in October 2005, during the proxy battle. At the time, Six Flags shares were trading at about $7.25.

b. Large block stockholders are good for effective oversight of management.

2. a. The discount rate to use in computing the present value of the operating lease payments is 9.95%, since that is the cost of debt for Navistar. Using this discount rate and making some assumptions regarding the pattern of operating lease payments after 2012, we get an operating lease liability value of $181.28m. as of October 31, 2007.

b. The adjusted operating income for the year ending Oct. 31, 2007 works out to $355.93m., as shown below:

3. a. NOPAT is defined as Net Income plus net after-tax interest expense; since we have no interest income, this works out to Net Income plus after-tax interest expense. To compute this, we need the tax rate. This can be estimated as Income Tax Expense divided by Income before Income tax, which works out to 8/280 or 2.86% for the 3 months ended 7/31/2008 and 47/-73 or -64.38% for the year ended 10/31/2007. NOPAT can then be computed as 272 +(1-0.0286)(88) = $357.49m. for the 3 months ended 7/31/2008 and -120+(1+0.6438)(502) = $705.21m. for the year ended 10/31/2007.

b. Annualized Operating ROA (NOPAT/Net Capital) for 2008 can be estimated as four times NOPAT for the three months ending 7/31/2008 divided by Net Capital as of 7/31/2008. This works out to 4(357.49)/1603, which works out to 89.20%. Breaking this down into NOPAT margin (NOPAT/Sales) and Net Asset Utilization (Sales/Net Assets), we find for 89.20% = (357.49/3954) x (4x3954/1603) = 9.21%x9.6794 (Note that Net Asset Utilization is also computed by annualizing Sales by multiplying by four).

For the year ended 10/31/2007, we have Operating ROA of 705.21/1633 or 43.18% equal to (NOPAT Margin)x(Net Asset Utilization) = (58.79/11910)x(11910/1633) = 0.59%x7.2933.

We see, therefore, that Operating ROA for Navistar has increased both due to superior NOPAT margin, as well as improved asset utilization.

Notes:

• The tax rate for the year ended Oct. 31, 2007 was computed above as 47/-73, which comes out to be a negative percentage. However, this doesn't make much sense. Taxes paid are positive, even though Income before taxes is negative; this is probably because of a discrepancy between reported income and income computed for tax purposes (perhaps due to items such as provisions for bad debt that cannot be deducted for tax purposes, but may be considered as an expense for reporting purposes). If this is the case, then the underlying tax rate is still positive, and we can't add back a number for after-tax interest expense that's actually greater than the amount of the interest expense, itself. This would lead to a lower number for ROA for 2007, thus accentuating the improvement from 2007 to 2008 that we see in the numbers presented above.
• NOPAT is computed by taking Net Income and adding back after-tax net interest, where net interest is defined as interest expense minus interest income. One might be tempted to make the argument that finance revenues should be considered interest income. However, in our case, part of Navistar's operations involves financing purchases of their equipment. Hence the finance revenues are actually "operating" revenues.

4.

1. The FCFE for the year ended Oct. 31, 2007 can be computed as Net Income - (Capex - Depreciation) - (Increase in Short-term Operating Assets - Increase in Short-term Operating Liabilities) = Net Income - (Capex - Depreciation) - (Decrease in Short-term Operating Liabilities - Decrease in Short-term Operating Assets) + Net Increase in Debt = -120 - (312-371) - (402-212) + 779 = $528m.
2. The required rate of return, using the CAPM formula, is: 3.936 + 1.81(7) = 16.606%
3. Using the FCFE number of $528 for the year ending Oct. 2007, we get estimated FCFE for the year ending Oct. 2008 as $670.56 (=528(1.27)) and $851.61 (= 528(1.27)²) for the year ending Oct. 2009. Thenceforth, FCFE is assumed to grow at 5%. Hence the discounted value, as of 10/2009 of future FCFE is computed as 851.61(1.05)/(0.1661-0.05) = $7704.565, for a total value of 851.61 + 7704.565 = 8556.176 at 10/2009 and 670.56 at 10/2008. Discounting these numbers to 10/2007, we get a value of $6867.777. Compounding this forward ten months to Oct. 31, 2008 at a rate of 6%, we get $7279.844.
   Now, we know from the fact that for the three months ending 7/31/2008, Net Income was 272m. and EPS was $3.85, that the number of shares outstanding at that time was 272/3.85 = 70.649m.
   Dividing our NAV euiqty value by the number of shares outstanding, we get a price per share of 7279.844/70.649 = $103.04.
   (Note that as of July 2008, the stock price was around $80, although on Oct. 28, 2008, it closed at $24.90).

5.

1. Here's what one could say about these three risks:
   1. Competitive: Mostly diversifiable; not very different from firm specific risk.  However, if the industry is very large, may be less diversifiable
   2. Industry-specific: Same as Competitive.
   3. International: Mostly diversifiable, even if looked at from the perspective of an investor who basically only invests in domestic stocks, because exchange rate changes affect different stocks differently. But, to the extent that there is some global macro-event that affects all domestic stocks similarly, this would be less diversifiable.
2. Zero, because all of the uncertainty is diversifiable and unrelated to the market.
3. One, because a regression of the market return on the market return would give us a slope coefficient of one.
4. No; market risk premiums can also change, if overall uncertainty changes or if investors become more or less risk averse.

Final

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. Read the following excerpt from an article in the Wall Street Journal, November 23, 2008 (http://online.wsj.com/article/SB122748733837451899.html?mg=com-wsj) and answer the questions below:

1. (15 points) How could the investors in Mervyn have made money when the store chain is in liquidation? Explain in sufficient detail, using your own words.
2. (10 points) As the article makes clear, Mervyn's has defaulted on its debt. For the purposes of this question, assume that the date is prior to 2004, when Cerberus and Son took over Mervyn's. Suppose now that you are an investor in Mervyn's debt. What would you do to minimize the likelihood of a default on the debt? Explain all the pros and cons of your suggested strategy.

Making a Bundle on Mervyn's
Buyout Firms Profited, but Chain Ended Up in Liquidation and Thousands Lost Jobs

Charlene Glafke began her career 35 years ago in the toy section of a Mervyn's department store in Daly City, Calif. From that $2.50-an-hour job, she rose to an $80,000-a-year marketing post at company headquarters in nearby Hayward.

On Oct. 17, Mervyn's LLC Chief Executive John Goodman summoned Ms. Glafke and her colleagues into a meeting room, and said the company -- already operating under bankruptcy-court protection -- was shutting down, the victim of an economic slump and a fiercely competitive retail environment.

The 53-year-old Ms. Glafke lost her job, along with about 18,000 other employees at the 177-store chain.

"I gave my life to Mervyn's," says Ms. Glafke, of Castro Valley, Calif., who now spends her day surfing the Internet to look for work, calling recruiters and meeting with job-placement agencies. "It's heartbreaking."

The company's owners have fared considerably better. Cerberus Capital Management LP and a group of private-equity investors bought Mervyn's from Target Corp. in 2004 for $1.25 billion. The investor group, which structured the buyout as two separate purchases -- one for the retail operations, and one for the chain's valuable real-estate holdings -- has earned more than $250 million in profits, say people familiar with the deal. The Mervyn's store chain, by contrast, is in liquidation.

Though few businesses have been spared by the current financial crisis, those owned by private-equity firms are in especially dire straits. Several private-equity executives have fretted privately that the Mervyn's deal highlights a longstanding criticism of buyout funds: that they "strip" companies, loading them with debt and carting away good assets, with little regard for employees.

Forty private-equity-owned companies have sought bankruptcy-court protection this year, according to data compiled by Thomson Reuters. And of the 86 Standard & Poor's-rated companies that have defaulted on their debt this year, 53 were involved in private-equity transactions, according to S&P.

S&P expects the default rate to increase sharply over the next year, probably leading to more private-equity-backed companies filing for bankruptcy protection. Creditors, employment lawyers and bankruptcy are expected to step up legal scrutiny of those buyout transactions, which typically involved large amounts of borrowed money.

The Mervyn's deal "was done when money was cheap and private-equity firms could pay themselves a dividend or do any number of clever exit strategies to profit from an investment," says Diane Vazza, head of global fixed-income research at S&P. "These firms are in the business of making money for their investors, but there can be consequences to that."

In September, Mervyn's sued its private-equity owners, seeking monetary damages. The 57-page lawsuit alleges that the structure of the acquisition pushed the company into bankruptcy by stripping the retailer of its real estate. Spokesmen for the private-equity owners said the lawsuit is without merit.

"I don't know the first thing about the financial world and have no idea how the owners were able to do that while the company went bankrupt and we all lost our jobs," says Deborah Fleming, 46, of San Leandro, Calif., who worked in a variety roles at Mervyn's for 23 years, and now is struggling to make mortgage payments on her two-story home and meet medical bills for her daughter. "But they apparently did," she adds.

Cerberus and its partners engineered the Mervyn's deal to split the retailer into a retail operating company and a property company, a strategy known in Wall Street slang as an "opco-propco" structure.

The private-equity owners contributed about $455 million of equity and raised $800 million in debt to fund the Mervyn's purchase. Then, they assigned 98% of the deal's value to the property company, which they funded with about $430 million of the equity and all the debt.

The deal assigned only $25 million of equity to the retail operating company. The private-equity owners also shared $58 million in deal fees upon closing the transaction, according to the Mervyn's lawsuit.

The property company, as owner of the Mervyn's stores, leased them back to the retailer. It also sold certain properties to mall owners and other retailers. As real-estate values increased, these and other transactions earned more than $250 million for the buyout group, which included Sun Capital Partners Inc. and real-estate specialist Lubert-Adler. The property company, still an operating business, is one of the creditors of the Mervyn's store chain.

With "the amputation of the real-estate legs from the body of the retail operations," says the company's lawsuit, the private-equity owners "made sure that any residual value or upside in the real-estate assets were reserved for themselves, and not for Mervyn's."

The owners, however, believe the deal's structure had nothing to do with the retailer's collapse, according to people familiar with their thinking.

The private-equity owners made back their investment on the retail operations, too. Mervyn's, which was founded in 1949 by Merv Morris, sold clothes, housewares and jewelry to low- and middle-income consumers. The company sold shares to the public in 1971 and was acquired seven years later by Dayton Hudson Corp., which later changed its name to Target Corp. In 2004, Target put the lagging chain up for sale to focus on its flagship brand.

Turnaround experts Cerberus and Sun sought to improve Mervyn's fortunes, bringing in a top executive from J.C. Penney Co. to run the chain. Mervyn's retail operations reaped more than $50 million in earnings before interest, taxes, depreciation and amortization, or Ebitda, in the first year under its new owners. This allowed the owners to pay themselves a one-time dividend from the retail operation's cash flow.

But the retailer's sales began to drop as the real-estate market suffered in California, where most of its stores are located. Mervyn's also tried to cater to Hispanic consumers, many of whom have been hurt by the economic downturn and job losses in the mortgage and home-building industries.

Late last year Cerberus, which is struggling with its high-profile investments in auto maker Chrysler LLC and lender GMAC, sold its stake in the retailer to its partners.

In July, Mervyn's filed for protection from creditors under Chapter 11 of the federal Bankruptcy Code and attempted to restructure, before deciding in October to liquidate.

2. Yahoo in its summary of Home Depot's financial statements represents Home Depot as saying (http://biz.yahoo.com/e/080403/hd10-k.html): "We use capital and operating leases to finance a portion of our real estate, including our stores, distribution centers and store support centers. The net present value of capital lease obligations is reflected in our Consolidated Balance Sheets in Long-Term Debt. In accordance with generally accepted accounting principles, the operating leases are not reflected in our Consolidated Balance Sheets. As of the end of fiscal 2007, our long-term debt-to-equity ratio was 64.3% compared to 46.5% at the end of fiscal 2006. This increase reflects the net increase in Long-Term Debt as a result of the December 2006 Issuance of $750 million of floating rate Senior Notes, $1.25 billion of 5.25% Senior Notes and $3.0 billion of 5.875% Senior Notes. " As explained elsewhere in the document, fiscal 2007 is the year ending February 3, 2008. This 64.3% number is can be reconstructed by taking Long-term Debt in Home Depot's balance sheet, $11.383b and dividing it by $17.714b, which is Total Stockholder Equity. However, if you add the $1.833b in Other Long-Term Liabilities to Long-term debt and then recompute the debt-to-equity ratio, the ratio works out to 0.746.

Home Depot's 10-K has this to say about "Other Long-Term Liabilities:"
Also in connection with the sale (of HD Supply on August 30, 2007), the Company guaranteed a $1.0 billion senior secured loan ("guaranteed loan") of HD Supply. The fair value of the guarantee, which was determined to be approximately $16 million, is recorded as a liability of the Company and included in Other Long-Term Liabilities. The guaranteed loan has a term of five years and the Company would be responsible for up to $1.0 billion and any unpaid interest in the event of non-payment by HD Supply. The guaranteed loan is collateralized by certain assets of HD Supply.

Also under the heading "Leases," we read:
Certain lease agreements include escalating rents over the lease terms. The Company expenses rent on a straight-line basis over the life of the lease which commences on the date the Company has the right to control the property. The cumulative expense recognized on a straight-line basis in excess of the cumulative payments is included in Other Accrued Expenses and Other Long-Term Liabilities in the accompanying Consolidated Balance Sheets.

1. (5 points) Comment on the appropriateness of using the 64.3% debt-to-equity ratio as a measure of Home Depot's financial leverage.
2. (10 points) Also from the company's 10K for fiscal 2007:
   In December 2006, the Company issued $750 million of floating rate Senior Notes due December 16, 2009 at par value, $1.25 billion of 5.25% Senior Notes due December 16, 2013 at a discount of $7 million and $3.0 billion of 5.875% Senior Notes due December 16, 2036 at a discount of $42 million, together the "December 2006 Issuance." In addition, the company had 3.75% Senior Notes face value $998m due September 15, 2009; 4.625% Senior Notes with a face value of $998m. due August 15, 2010; 5.40% Senior Notes with a face value of $3.017b. due March 1, 2016; and 5.20% Senior Notes with a face value of $1b. due March 1, 2011, in addition to $750m. face value floating-rate notes due Dec. 16, 2009.
   What rate would you use as the cost of debt to compute the company's weighted-average cost of capital?
3. (10 points) Right now, according to Moody's, Home Depot's credit rating is Baa1. Home Depot's beta is 0.5 according to Yahoo (http://finance.yahoo.com/q/ks?s=HD). The rate on 10-year T-bonds according to WSJ is 2.715%. Home Depot has 1.7b shares outstanding. It's current market price (December 10, 2008) is $24.09. According to Home Depot's recent 10K filing, "Our combined federal and state effective income tax rate for continuing operations decreased to 36.4% for fiscal 2007 from 38.1% for fiscal 2006." Compute the WACC for Home Depot.
4. (10 points) Suppose that Home Depot issues an additional $5b. in debt and buys back and equal amount of equity. Assume that the cost of debt would go up by 200 basis points. The stock price has dropped from a value on Feb. 1, 2008 of $30.45. What would be the firm's new weighted average cost of capital?
5. (5 points) How would the value of Home Depot's equity change after the announcement?
   

3. (20 points) Look at the following two firm profiles (from Yahoo) and explain how they should approach the question of their financial leverage.

1. Foster Wheeler, Ltd. (FWLT) and its subsidiaries provide construction and engineering services to the oil and gas, oil refining, chemical/petrochemical, pharmaceutical, environmental, power generation, and power plant operation and maintenance sectors worldwide. It operates through two groups, Global Engineering and Construction Group (Global E&C Group), and Global Power Group. The Global E&C Group designs, engineers, and constructs onshore and offshore upstream oil and gas processing facilities; natural gas liquefaction facilities and receiving terminals; gas-to-liquids facilities; oil refining; and chemical, petrochemical, pharmaceutical, biotechnology, healthcare, and related infrastructure facilities. It also owns refinery residue upgrading technologies and a hydrogen production process used in oil refineries and petrochemical plants. In addition, this group also performs environmental remediation services, and engages in the development, engineering, construction, and ownership of power generation and waste-to-energy facilities in Europe. The Global Power Group designs, manufactures, and erects steam generating and auxiliary equipment for electric power generating stations and industrial facilities. It also provides a range of site services, including construction and erection services, maintenance engineering, and plant upgrading and life extension. In addition, this group provides research analysis and experimental work in fluid dynamics, heat transfer, combustion and fuel technology, materials engineering, and solids mechanics. Further, it owns and operates cogeneration, independent power production, and waste-to-energy facilities, as well as power generation facilities for the process and petrochemical industries. The company was founded in 1894 and is based in Clinton, New Jersey.
2. Baidu.com, Inc. (BIDU), through its subsidiaries, provides Chinese language Internet search services primarily in the People's Republic of China. The company offers a Chinese language search platform, which consists of Web sites and online application software; and Baidu Union, a network of third-party Web sites and software applications. Its products include Baidu Web Search that allows users to locate information, products, and services using Chinese language search terms; Baidu Post Bar and Baidu Knows, which provides users with a query-based searchable community; and Baidu News that provides links to local, national, and international news. The company also offers Baidu MP3 Search that provides algorithm-generated links to songs and other multimedia files; Baidu Image Search, which enables users to search various images on the Internet; Baidu Space to create personalized homepages in a query-based searchable community; Baidu Encyclopedia; and various online search products. In addition, it provides Baidu Desktop Search that enables users to search files without a Web browser; Baidu Sobar, which makes search function available on every Web page that a user browses; and Baidu Anti-Virus that provides anti-virus software products and computer virus-related news. Further, the company offers Japanese search services, including Web search, image search, video search, and blog search capabilities. Its services enable users to find relevant information online, including Web pages, news, images, and multimedia files. The company also offers online marketing services to its P4P and tailored solutions customers directly, as well as through its distribution network. It serves small and medium enterprises; corporations; and e-commerce, information technology services, consumer products, manufacturing, health care, entertainment, education, financial services, and real estate industries. The company was founded in 2000 and is based in Beijing, the People's Republic of China.

4. (15 points) Answer any three of the following four questions in brief:

1. Why would a firm want to issue floating rate debt?
2. If a firm wants to have greater flexibility in the future, should it use debt financing or equity financing today?
3. 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 this statement is not necessarily true.  
4. How would you estimate the beta for a firm that has just been established?

Solution to Final Exam

1.

1. Cerberus and a group of private-equity investors bought Mervyn from Target. However, rather than simply buying it outright, the purchase was structured in a particular manner. It was structured as two different purchases -- one for retail operations and one for the chain's valuable real-estate property holdings. They then had the property company lease the stores back to the retail company. Furthermore the owners paid themselves a large on-time dividend from the retail operations. Since the private-equity owners bought the entire firm, they could only have made money from the purchase in two ways -- one, if they ran the company more efficiently than the existing owners or two, if they dispossessed some other stakeholders in the firm. Who could these stakeholders have been?
   One, they could have dispossed Mervyn's debtholders. They could have done this in several ways -- one, by splitting the firm in two and assigning all of the debt to only one of the companies, the asset/debt ratio goes down; two, buy paying themselves a large dividend, they once again reduce the asset/debt ratio -- however, in this case, it was the retail division that paid the dividend and this division didn't have any of the debt. More importantly, the debtholders knew what they were getting themselves into.
   Two, they could have made money from the investors that they sold the money to, ultimately. However, nobody forced the new owners to buy the firm.
   Three, they could have been employees of the retailing division. This is suggested by the article, which highlights the fact that the employees are losing. Employees are similar to debtholders of the firm since they are paid fixed wages. However, if they thought they weren't getting a good deal, they could have walked away -- but to the extent that they had human capital tied up in the firm, they were unlikely to walk away from the firm and the new investors could dispossess them by extracting wealth from the firm and by making it riskier. The investors did both -- one they paid themselves a large dividend and they saddled the retail division with a lot of leases, which is akin to debt and made it riskier.
   So it looks like the only group they could have dispossesed would be the employees.
   On consideration of all the alternatives, it doesn't look like Cerberus and the other private equity investors were out to expropriate any other investors -- the potential benefits are too low. If so, what was the objective of the private investors in creating the financing structure for the purchase of Mervyns? This structure is often referred to as an OpCo-PropCo structure, where one company contains the real estate, while the other company contains the operating segment (the retail segment in the case of Mervyns) which will lease the real estate owned by the PropCo. The advantage of this structure is that the PropCo contains only real estate. Lenders to this company do not have to worry about the information asymmetry involved in lending to the OpCo. Hence interest rates would be lower. Presumably the same could be achieved by having a single corporation, but with debt that's secured by the real estate; however, the OpCo-PropCo structure is less expensive, since the debt can be structured as an unsecured one. Furthermore, firms that only lend on the basis of real estate would be willing to lend to the PropCo, while they might not be willing to consider lending to another corporation (see http://www.dechert.com/library/Structured_Finance_Report_05-06.pdf, page 4).
   The final answer to the question, therefore, is simply that the owners made money on the company when times were good, but ultimately when times were bad, Mervyns went bankrupt! A simple story, after all.
   
   
2. Mervyn's had no debt prior to 2004, actually. It was a division of Target, which sold the firm to Cerberus and Sun. These private equity investors raised new debt to finance the purchase. But suppose Target had had debt which Cerberus and Sun had purchased along with the equity and then saddled with new debt. In that case, the existing debtholders would have been affected negatively by the new debt. The only way they could have protected themselves would have been to have covenants in the debt requiring the entire debt to be repaid in the event of a change of control. However, this would reduce the attractiveness of the company and may, therefore, not have been in the interests of the debtholders themselves. Change of control is one of the ways in which bad management can be forced out or compelled to clean up their act.

2.

1. The 64.3% long-term debt-to-equity might not be a good measure of the firm's financial leverage for two reasons -- one, it does not include the operating leases; and two, it is based on book values not on market values.
2. The largest amount of debt has a coupon rate of 5.875%; it is also relatively recent. The rest of the debt has lower coupons and lower maturities. So one should probably use a weighted average which would be somewhat lower than 5.875%. On the other hand, rates probably have gone up since that debt was issued. So on balance, I would use 5.875% as the pre-tax cost of debt.
3. The market value of equity is 1.7b*24.09 = $40.953b; the value of debt is constructed as follows. Long-term debt is $11.383b; other long-term liabilities are 1.833b for a total of $13.216b; since we have no information on market values, and since the debt was issued not so long ago, the book value is an acceptable second best measure of the value of debt. This gives us an equity weight of 40.953/(40.953+13.216) = 0.756 and a debt weight of 0.244. The required rate of return on equity is 2.715+0.5(7) = 6.215% (assuming a risk premium of 7% -- a little on the high side, historically, but perhaps appropriate for todays' environment). The WACC is (0.756)(6.215) + (0.244)(5.875)(1-0.364) = 5.61%
4. If HD issues an additional $5b. in debt and buys back an equal amount of equity, the amounts of debt and equity would become $18.216b. and $35.953 for a D/E ratio of 0.50666. The original D/E ratio was 40.953/13.216 = 0.323. Using this, we can compute the beta of assets as 0.5/(1+(1-0.364)0.323) = 0.4154 and the new equity beta as 0.5485. The new cost of equity capital is 2.715% + 0.5485(7) = 6.55%. The new cost of deb is 7.875%. Hence the new weighted average cost of capital is ((1/1.50666)(6.55) + (0.50666/(1.50666)(1-0.364)(7.875) = 6.03%.
5. The change in the value of Home Depot would be a decrease of (40.953+13.216)(0.0603-0.0561)/0.0603 = $3.8b. Assuming that the entire drop is reflected in the price of the equity, this translates into a price drop of 3.8/1.7 = $2.24.

3.

1. FWLT designs, engineers and constructs facilities -- according to this, it is a service firm and would not be able to support debt. On the other hand, it also owns refinery residue upgrading technologies and production processes -- even though these are intangible assets, to the extent that they don't have equally good alternatives, they would ensure a stream of cashflows from their exploitation and hence could support debt. Finally, the Gobal Power group also owns and operates power generation facilities -- these are fixed assets that would support debt. Hence the optimal amount of leverage for FWLT would depend upon the relative value of the fixed assets to the rest of the firm, as well as the monopolistic power granted by the rights to technologies that the firm owns.
2. Baidu is entirely a service firm with very few hard assets, seemingly. Revenues in such a business could be very volatile and the firm's assets wouldn't be worth much in case of liquidation. As such, we would not expect it to have much debt.

4.

1. If a firm had cashflows that were positively correlated with the level of interest rates, floating rate debt would reduce the volatility of the firm's profits. Otherwise there is no reason to issue floating rate debt unless markets are inefficient and the floating rate debt can be issued at excessively high prices.
2. If the firm wants flexibility, it should use equity rather than debt because debt has to be serviced and repaid according to a schedule. Furthermore, debt often carries covenants which reduce the firm's flexibility.
3. This is not true because the proportion of debt in the firm's capital structure goes down simultaneously. Hence, given that the required rate of return for debt is lower than the required rate of return for equity, the weighted average of the two required rates of return could drop even if the increase in financial leverage caused both debt and equity to become more expensive.
4. You'd have to either compute regression betas of other firms in the industry and use them as a proxy for the new firm's beta, or alternatively, you'd have to generate the joint distribution of the firm's returns and the market return in different scenarios and then use that joint distribution to compute the beta.