|
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.
- Assume a tax rate of 40% where not provided.
1. (10
points each) Read the following article and answer the questions below:
a.
How could Miguet force creditors to make concessions?
Don’t creditors have an iron-clad contract whereby the company
has to pay them a coupon and bond face value?
b.
We learnt in class how difficult it is for shareholders to control the
Board of Directors of a company.
How did shareholders managed to vote out Eurotunnel’s Board, according
to you? Use the information
in the article and any other information provided below.
According to the Eurotunnel
website, http://www.eurotunnel.com/ukcMain/ukcCompany/ukcInvestorRelations/ukcShareholderInfo/ukpShareholderAnalysis,
as of Dec. 31, 2003, 6% of Eurotunnel’s shares are hold by banks, 29%
are held by institutions and 65% are held by individuals.
According to the Eurotunnel
website, there was 6.4billion euros of debt, as of 12/31/03.
Of this, 0.4b was senior debt, 4.5 was junior debt, 1.5 billion
consisted of Participation Loan notes, while equity consisted of 1.1b
euros.
The share price, as of
March 13, 2005 was 0.24 euros.
Eurotunnel's Board Is Ousted by Shareholders
Jo
Wrighton and Greg Keller. Wall
Street Journal. (Eastern edition). New York, N.Y.: Apr
8, 2004. pg. A.6
PARIS -- Creditors of
Eurotunnel, the struggling operator of the underwater "Chunnel"
linking Britain and France, are bracing for tough negotiations with new
management after the unprecedented ouster of the European company's two
top executives and the rest of its board by a shareholders' revolt.
French politician and
publisher Nicolas Miguet rallied shareholders around his own team of directors,
promising to defend small investors and force creditors to make concessions
in the restructuring of Eurotunnel's debt of GBP 6.4 billion ($11.8 billion),
much of which is now held by hedge funds.
Mr. Miguet's campaign
struck a chord with Eurotunnel's 1.1 million, mainly French, small investors
whose shares have plummeted in value. At a shareholder meeting in Paris,
63% of investors voted to oust Chairman Charles Mackay, Chief Executive
Officer Richard Shirrefs and the rest of the Eurotunnel board. They also
voted for a new team of directors, including Jacques Maillot, former head
of travel agency Nouvelles Frontieres, who is expected to become Eurotunnel's
new chairman.
The move marked the first
time shareholders tossed out the management of a listed company in France.
But while shareholders
celebrated -- Eurotunnel shares rose 7% on the news in Paris -- creditors
warned they won't give much ground to stockholders. The company has a
market capitalization of GBP 1.4 billion, just one-fifth of debt outstanding.
While the new management
has yet to detail its restructuring plans, bondholders think part of the
rescue would involve swapping Eurotunnel debt for equity, a classic restructuring
step. However, instead of wiping out shareholders, as would normally happen,
they think the Eurotunnel rebels would like to save some equity for shareholders.
Whatever their stance,
a new Eurotunnel management is under pressure to reach an agreement with
creditors. The company will start to face a debt-repayment crisis at the
end of next year, when it has to make all of its interest payments in
cash, under the terms of the last debt- restructuring pact in 1997, said
Markus Niemeier, research analyst at Barclays Capital in London.
2. (30 points) You wish to
buy a car. Unfortunately,
you don’t have any ready cash. On
the other hand, you just recently invested $200,000 in a private equity
fund. The fund manager will not give you your money back right away,
unfortunately. However, according
to your calculations, your investment in the fund should grow at the average
rate of 15% a year for the next 5 years, at the end of which you can cash
out.
Of course, you still want
your car right now! What
to do? Luckily for you, your
friendly banker is willing to lend you some money using your investment
as collateral. Your banker
believes that your investment has a beta of 1.5, the market risk premium
is 6% and that the current five-year T-bond rate is 4.5%.
He is willing to lend you 80% of the estimated market value of
your investment so that you can buy your car.
The APR on the loan is 18% and the money is to be repaid in monthly
installments, starting 13 months from now.
If there are 48 payments in all, what is the size of each payment?
3. (5 points each) Read the article below and answer the following questions
with full explanations:
A stock with a beta of 0.5 is
- exactly half as volatile as the market portfolio
- less than half as volatile as the market portfolio
- more than half as volatile as the market portfolio
- Why would low-beta stocks outperform the market during market declines?
- Are the betas in the list of ten below historical betas, or are they
prospective betas?
- What is the implicit definition of the market portfolio in the estimation
of these betas?
- Pick any stock from the list of ten below and explain, based on its
industry membership, why it has a high beta.
- Many economists believe that the economy is in a recovery phase and
predict that the stock market will do much better than T-bills over
the next year. Assuming the truth of this forecast, explain which of
the ten stocks below you would buy.
SmartMoney Stock Screen / High-Beta Stocks
Jack Hough. Wall
Street Journal. (Eastern edition). New York, N.Y.: Jan
13, 2005. pg. D.2
DON'T LET A HIGH BETA dissuade you from buying an otherwise promising growth
stock.
Beta is a measure of volatility. It's based on a statistical comparison
of the fluctuations of a given company's share price versus the fluctuations
of an index -- usually the Standard & Poor's 500- stock index -- over
a certain time period. A stock with a beta of 0.5, for example, is said
to be only half as volatile as the S&P 500; a stock with a beta of
2.0 is doubly so. A stock with a negative beta zags when the S&P 500
zigs.
Bearish and safety-first investors usually look for low-beta stocks --
those with betas of, say, 0.5 and lower -- because these have shown a
tendency to outperform the S&P 500 during broad market declines. But
low-beta stocks also tend to underperform during surges. So bullish or
aggressive investors might wish to search specifically for high betas.
The 10 stocks on the list below have betas of 2.0 or higher; that is, they've
shown at least twice the volatility of the S&P 500 over the past three
years. All have posted share-price gains of at least 12% over the past
26 weeks (again, about double that of the S&P 500), and have had their
current-year and next-year earnings consensuses boosted within the past
four weeks. All have topped earnings expectations, on average, in their
past four quarterly reports, and have debt/capital ratios of 0.4 or lower.
Finally, all are projected to boost their earnings by at least 12% annually
over the next five years.
To get an idea of how expensive each stock is relative to its growth prospects,
give its price/earnings-to-growth, or PEG, ratio a look. The measure is
calculated by dividing a company's price/earnings multiple by its projected
long-term earnings growth rate. Stocks with PEGs near or below 1.0, in
particular, are considered possible bargains.
As always, please research thoroughly any stocks on our list before buying
them.
When
Volatility Is a Good Thing
These 10 stocks carry high betas as a result of
their rapid price gains.
Name |
Industry
|
Current
Price
|
Beta
|
1-year
Price Change |
PEG Ratio
|
American
Eagle Outfitters (AEOS)
|
Apparel Stores
|
$48.81
|
2.46
|
63%
|
1.2
|
Ameritrade
Holding (AMTD) |
Investment Brokerage
|
13.16
|
2.78
|
33
|
1.3
|
CarMax
(KMX) |
Auto Dealerships |
29.88
|
2.27
|
50
|
2
|
Children's
Place Retail Stores (PLCE)
|
Apparel Stores
|
37.14
|
2.35
|
94
|
1.4
|
F5
Networks (FFIV) |
Internet Software &
Services |
42.2
|
3.46
|
74
|
2.3
|
Intervoice
(INTV) |
Voice Recognition Technology |
13.33
|
2.58
|
40
|
1
|
Medco
Health Solutions (MHS)
|
Prescription Benefits Mgmt
|
42.74
|
2.43
|
25
|
1.3
|
Nvidia
(NVDA) |
Graphics Processors |
22.03
|
3.18
|
30
|
2.5
|
Sina
(SINA) |
Internet Software &
Services |
30.45
|
2.27
|
14
|
0.6
|
Tibco
Software (TIBX) |
Business Software &
Services |
12.61
|
2.7
|
71
|
1.5
|
4. Philip Morris is examining the costs of equity
and capital it uses to decide on investments in its two primary businesses
– food and tobacco. It has
collected the following information on each business:
·
The average beta of publicly traded stocks in the tobacco
business is 1.10 and the average debt/equity ratio of such firms is 20%.
·
The average beta of publicly traded firms in the food business
is 0.809, and the average debt/equity ratio of such firms is 40%.
Philip Morris has a beta of 0.95 and a debt ratio
of 25%; the pre-tax cost of debt is 8%.
The treasury bond rate is 7% and the corporate tax rate is 40%.
The market risk premium is estimated to be 5%.
a.
(10 points) Estimate the cost of capital for the tobacco
business; also estimate the cost of capital for the food business.
b.
(10 points) Estimate the cost of capital for Philip Morris,
as a firm
c.
(10 points) Having looked at your estimates of the cost
of capital for the tobacco and food divisions at Philip Morris, the financial
managers have come back with a question.
Where, they want to know, does the substantial risk posed by tobacco
lawsuits show up in the costs of capital that you have estimated?
Respond.
Solutions to Midterm
1. a. Creditors do have a contract whereby the company has to pay them
a coupon and bond face value. However, there are often provisions in bankruptcy
law, whereby a company may be allowed to suspend payments to its creditors
if doing so is necessary for the company to maintain itself as a going
concern. The key word, here, is suspend. Once a company enters into bankruptcy
there is a procedure in place, whereby the company has to be reorganized
or liquidated. In principle, the creditors are not supposed to lose out
at all; and the purpose of the suspension of payments is only supposed
to prevent an unwarranted scramble for repayment on the part of creditors
that might force an otherwise healthy company into bankruptcy -- this
would be akin to a trading halt on an exchange, in a company's stock,
if the price starts dropping precipitously because of investor panic.
However, where the bankruptcy law gives existing shareholders or existing
management, discretion as to how to file the reorganization plans, bondholders
might be willing to forego some of their rights or payments, in order
to ensure a speedy conclusion to the bankruptcy proceedings. This is particularly
important because the ability to wait is, in itself, a sort of call option
that can only be beneficial to stockholders. European Law is, in general,
not as debtor-friendly as US law; still the law there is also getting
more debtor-friendly over time.
Finally, management can often take actions that expropriate bondholder
value because no contract, least of all, a bond indenture, is complete.
b. In this case, even though a large percentage of the shares were diffusely
held -- 65% -- still, 35% were held by banks and institutions, and so,
only 16% more was needed from the shares held by individuals, in order
to vote against the managemetn slate of candidates for the Board of Directors.
It is also possible that even though 65% of shares were held by individuals,
this percentage may not have been held diffusely -- in other words, there
might have been some large blocks amongst the 65%.
2. The expected value of your investment in the private equity fund,
after five years is 200,000(1.15)5 = $402,271.44. This investment
has a beta of 1.5; hence the required rate of return on this investment
is 4.5 + 1.5(6) = 13.5%, using the CAPM. Hence the market value of this
investment is 402271.44/(1.135)5=$213,569.82. The banker will
lend 80% of this, or $170,855.86. The APR on the loan is 18%; hence the
effective monthly rate is 18/12 or 1.5%.
Payments, however, don't start until 13 months from now; so it is as
if we have a loan that will be made in a year's time with monthly payments
starting the next month. If we look at it, this way, the value of the
loan, in 12 months time, rises to 170,855.86(1.015)12 = $204,278.37.
We can, now, use the annuity formula to find the value of each of the
48 monthly payments, by solving 204,278.37 = (C/0.015)[1-(1/1.015))48]
or C = $6000.68.
3. a. A stock with a beta of 0.5 is more than half as volatile as the
market portfolio, because in addition to market related uncertainty stocks
also have idiosyncratic volatility. Of course, this idiosyncratic volatility
does not "count" in terms of being priced by the market, but
it contributes to the volatility, nevertheless, if not to risk.
b. A low-beta stock is a stock that moves less than the market, in whatever
direction the market is moving. Hence, in times of market declines, a
low-beta stock would tend to decline less than the market -- and hence
outperform the market.
c. The betas in the list below are historical betas, as it says: "they've
shown at least twice the volatility of the S&P 500 over the past three
years."
d. By referring to beta as the comparison of a companys' share price relative
to the fluctuations of the Standard & Poor's 500, the article is implicitly
defining the S&P 500 as the market.
e. Tibco Software, which is in the Business Software and Services industry
would, obviously, see its sales rise when the rest of the economy is doing
well, since it sells to other business. This would imply a positive beta.
However, more than that, business would buy software, i.e. invest in new
productive assets only if they saw the economy continuing to do well.
If the economy were predicted to do moderately well in the future, businesses
would not buy new software. Hence, Nvidia's stock would reflect amplified
market movements in the case of a robust market, while in the case of
a sour economy, Nvidia's stock would plummet as businesses would immediately
cut their purchases of business software, which would be seen as contra-indicated
"investments." In economic terms, demand for business software
is a derived demand.
f. If the report is true, then the stock with the highest beta would be
best, which in this case, is FFIV.
4. a. If Philip Morris desires to use its own debt ratio of 25% for all
its business, then the computation of the levered beta to be used for
its tobacco business is as follows:
- compute the unlevered beta for firms in the tobacco business. This
can be computed as 1.1/[1+(1-0.4)(0.2)] = 0.982
- lever up this using Philip Morris' debt ratio of 25% to get 1.1784.
Hence the cost of equity is 7 + 1.1784(5) = 12.892. The cost of capital
is (0.75)(12.892) + (0.25)8(1-0.4) = 10.869%.
The cost of capital for the food business is computed similarly. The
unlevered beta for firms in the food business is 0.645; lever up this
using Philip Morris' debt ratio of 25% to get 0.774. The cost of equity
is 7 + 0.774(5) = 10.87%. The cost of capital is (0.75)(10.87) + (0.25)8(1-0.4)
= 9.353%
b. The average cost of equity for Philip Morris can be computed as 7
+ 0.95(5) = 11.75, and the cost of capital as (0.25)(8)(1-0.4) + (0.75)(11.75)
= 10.0125%
c. One might argue that litigation risk is diversifiable, and should
not be included in the costs of capital. If litigation risk is not diversifiable,
then the cost of that has to be added on, perhaps by an increase in the
estimated beta, assuming that the beta is a historical beta. If the betas
are, indeed, historical betas, then it may be difficult to argue that
the beta estimate already includes the effect of litigation risk because
the nature of litigation risk in the past is probably different from that
in the future.
Final Exam
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. Answers without explanations may
get no points or be heavily penalized.
- There are ten questions below. You must attempt the six questions
for which point values have been assigned, ranging from 5 points to
20 points. Four other questions are marked "optional." Do
any two of these optional questions for 15 points each. Any additional
optional question that you attempt will be graded out of 10 points.
Hence you can obtain a maximum of 120 points if you attempt all questions
and all your answers are perfect.
Using the information in items A-F (except where indicated
to the contrary) to answer the questions below:
- (15 points) What sort of capital structure would you expect Lennar
Corporation to have? High on debt or low? Use only the
information in "Key facts about Lennar from WSJ Online" to
make your case.
- (optional) Why (in the Dow Jones article) does Fitch include the debt
and equity from Lennar's off balance-sheet operations (partnerships
and joint ventures) to compute an overall debt-to-capitalization ratio
of 46.9%? If Lennar doesn't have to consolidate those operations for
reporting purposes, why should they be incorporated in the computation
of its debt ratios?
- (optional) Why does Lennar used off balance-sheet financing for those
joint ventures (see Dow Jones article)?
- (5 points) The net debt to capitalization ratio is defined as "Net
debt in relation to total shareholders' equity (including minority)
and net debt;" and net debt is defined as "Short- and long-term
interest bearing liabilities and related derivatives, less cash and
cash equivalents," according to http://www.autoliv.com. Compute
the net debt to capitalization ratio as of February 28, 2005, using
the data from Yahoo (item B). Is this number the same as the one in
the Dow Jones article?
- (5 points) The WSJ.com website has the following information regarding
Lennar Corportation's balance sheet for Feb. 28, 2005, which differs
somewhat from the information in Yahoo. Long term debt is given as $2,002,867,
while "cash and cash-equivalents" are $509,068. Using this
information, compute the net debt to capitalization ratio, once more.
Which number is more correct, do you think? Why?
- (10 points) Define the debt-equity ratio as the ratio of the market
value of long-term debt to the market value of equity. Correspondingly,
define the debt-to-assets ratio as the ratio of long-term debt to the
sum of long-term debt and the market value of equity. Using these definitions,
and using the February 28, 2005 balance sheet, compute the unlevered
beta for Lennar. Note that Yahoo.com reports Lennar's beta as 0.544.
Use any other information provided, as needed. (Ignore the off-balance
sheet ventures for the purpose of this question.)
- (optional) According to Yahoo, Lennar's beta is 0.544; that is, it
reacts in a dampened fashion to market moves. Your friend, Jane, argues
that this beta is probably an underestimate. "If the economy improves,
demand for housing will probably go up quite a bit because homeowners
will expect the improvement to continue and spend more on homes in anticipation
of that improvement. On the other hand, if the economy tanks, homeowners
will probably get worried and cut their home purchase plans sharply.
I think Lennar's true beta is probably about 1.8," says Jane. Comment.
Also, what information is there in the article that supports the idea
of a lower beta?
- (15 points) Compute the cost of long-term capital for Lennar Corporation.
(Think carefully about what number you use for the cost of debt capital.)
Justify all the rates that you use. Assume a market risk premium of
5.5%. (Ignore the off-balance sheet ventures for the purpose of this
question.) The US Treasury 10-year bond rate is 4.18% (as of May 5,
2005).
- (20 points) If Lennar announces plans to issue new debt of $1billion
and use it to pay a special dividend of $1 billion to stockholders,
estimate the increase or decrease in the value of Lennar's equity. Assume
that the before-tax required rate of return on Lennar's debt would jump
by 100 basis points.
- (optional) Justify the use of the debt-to-assets ratio, as defined
in part 6., to compute the weighted average cost of capital instead
of the net debt to capitalization ratio used in parts 4. and 5.? Why
does the Dow Jones article use the net debt to capitalization ratio?
- Article from Dow Jones Newswires, April 22, 2005
- Balance Sheet Information from Yahoo (in '000s) (http://www.yahoo.com)
- Key facts about Lennar from WSJ Online
- Income and Loss Statement (from http://www.yahoo.com)
- Senior Notes and Other Debts Payable
- Excerpt from Press Release filed with the SEC
A. Article from Dow Jones Newswires, April 22, 2005
Fitch Assigns 'BBB+' To Lennar Corp.'s $300MM Debt
Issue
DOW JONES NEWSWIRES, April 22, 2005 4:53 p.m.
The following is a press release from Fitch Ratings:
Fitch Ratings-New York-April 22, 2005: Fitch Ratings has assigned a 'BBB+'
rating to Lennar Corp.'s (NYSE: LEN) $300 million 5.60% senior notes due
May 31, 2015. The Rating Outlook is Stable. The issue will be ranked on
a pari passu basis with all other senior unsecured debt. Proceeds from
the new debt issue are expected to be used for general corporate purposes.
The ratings and Outlook reflect the company's continuing solid financial
performance and the expectation that Lennar's credit profile will be maintained
as it executes its business model and continues to grow. The ratings also
reflect the company's very strong track record over the past 30 years
and through many past homebuilding cycles, management's sound operating
and financial policies, the company's well positioned, low-basis landholdings
in attractive growth markets, and its capacity to withstand a meaningful
housing downturn. Lennar's extensive balance sheet liquidity and external
liquidity sources position the company to weather a meaningful cyclical
downturn and to absorb acquisitions, consistent with its diversified growth
strategy. Under a severe housing contraction scenario, the company is
expected to generate sufficient cash relative to its financial obligations,
allowing the company to manage its capital structure easily within its
investment-grade rating.
The rating incorporates the expectations that leverage may periodically
spike outside of management's targeted range of 35%-45% as a result of
opportunistic acquisitions and that it will be prudently and quickly managed
down within that range thereafter (as was the case with the large U.S.
Home acquisition in May 2000). The rating also considers the off balance
sheet financing of its longer dated land supply and the concentration
of deliveries in Florida, Texas, and California (the three largest and
among the most supply-constrained state markets in the country). Fitch
views Lennar's partnerships and joint ventures (JVs) to be strategically
and financially material to the company's operations. However, the manageable
leverage levels and the extensive supply of land in attractive markets
held in the partnerships mitigate this risk to some extent. In addition,
pulling the off balance sheet debt back on balance sheet does not materially
alter Lennar's consolidated capital structure. Nevertheless, as these
unconsolidated entities grow further and provide an increasing source
of Lennar's land needs, it may prove more difficult for Lennar to distance
itself from them should they become financially distressed. Although the
company derives approximately 68% of deliveries from California, Florida,
and Texas, the many significant metropolitan markets within those states
with their own unique economic and demographic characteristics and the
company's product and price point diversity reduce the state geographic
risk.
Lennar has been active in improving homebuilding margins and return on
capital during much of this upcycle for housing and especially during
the past half dozen years, ranking near the top of its industry peer group
with regard to most financial and operating metrics. The company's predominantly
build-to-order strategy minimizes speculative inventory and allows management
the opportunity to adapt its land reinvestment decisions relative to fluctuation
in demand levels in its markets.
As this relatively robust housing cycle continues, creditors benefit
from Lennar's financial flexibility supported by $1.89 billion in liquidity
as of Feb. 28, 2005 (zero outstanding on its $1.4 billion revolving credit
facilities and $495.57 million in unrestricted cash and equivalents),
less $250.7 million of letters of credit collateralized against certain
borrowings available under the credit facilities. Homebuilding debt to
capitalization was 32.5% at the end of the fiscal 2005 first-quarter,
while net debt to capitalization was 26.4%. The balance sheet of Lennar's
unconsolidated entities (partnerships and JVs) had a debt to capitalization
ratio of 51.1% and net debt to capitalization ratio of 46.9% as of Feb.
28, 2005. Assigning Lennar's share of the off balance sheet debt and equity
to Lennar's consolidated numbers would only raise its leverage ratio to
36.9%. Under the most extreme (and unlikely) scenario, that of Lennar
absorbing all of the partnerships/JVs debt, its consolidated leverage
ratio would rise to 49.9%.
B. Balance Sheet Information from Yahoo (in '000s) (http://www.yahoo.com)
PERIOD ENDING |
28-Feb-05 |
30-Nov-04 |
30-Nov-03 |
30-Nov-02 |
Assets |
|
Current Assets |
|
Cash And Cash Equivalents |
616,139 |
1,427,941 |
1,502,806 |
971,056 |
Short Term Investments |
- |
- |
390,334 |
- |
Net Receivables |
500,678 |
666,374 |
60,392 |
48,432 |
Inventory |
- |
5,142,070 |
3,656,101 |
3,237,577 |
Other Current Assets |
|
- |
450,619 |
- |
Total Current Assets |
1,116,817 |
7,236,385 |
6,060,252 |
4,257,065 |
Long Term Investments |
1,342,214 |
1,364,851 |
600,980 |
1,033,441 |
Property, Plant and Equipment |
5,732,821 |
|
|
|
Goodwill |
55,970 |
56,019 |
43,503 |
34,002 |
Intangible Assets |
18,361 |
18,361 |
18,215 |
15,586 |
Other Assets |
487,311 |
489,664 |
52,482 |
415,539 |
Total Assets |
8,753,494 |
9,165,280 |
6,775,432 |
5,755,633 |
|
|
Liabilities |
|
Current Liabilities |
|
Accounts Payable |
1,629,224 |
1,830,047 |
1,040,961 |
969,779 |
Total Current Liabilities |
1,629,224 |
1,830,047 |
1,040,961 |
969,779 |
Long Term Debt |
2,626,308 |
2,917,948 |
2,286,874 |
2,447,927 |
Other Liabilities |
336,454 |
364,313 |
178,011 |
108,770 |
Minority Interest |
- |
- |
5,812 |
- |
Total Liabilities |
4,591,986 |
5,112,308 |
3,511,658 |
3,526,476 |
|
|
Stockholders' Equity |
|
Common Stock |
15,744 |
15,632 |
15,784 |
7,476 |
Retained Earnings |
2,952,503 |
2,780,637 |
1,914,963 |
1,538,945 |
Treasury Stock |
(109535.00) |
(3938.00) |
- |
(158992.00) |
Capital
Surplus |
1,315,867 |
1,277,780 |
1,358,304 |
873,502 |
Other Stockholder Equity |
(13071.00) |
(17139.00) |
(25277.00) |
(31774.00) |
Total Stockholder Equity |
4,161,508 |
4,052,972 |
3,263,774 |
2,229,157 |
Net Tangible Assets |
$4,087,177 |
$3,978,592 |
$3,202,056 |
2179569.00 |
C. Key facts about Lennar from WSJ Online
Lennar Corporation (Lennar) operates as a homebuilder and a provider
of financial services in the United States. The Company's homebuilding
operations include the sale and construction of single-family attached
and detached homes, as well as the purchase, development and sale of residential
land directly and through unconsolidated partnerships. The Company's financial
services subsidiaries provide mortgage financing, title insurance, closing
services and insurance agency services for both buyers of Lennar's homes
and other buyers, and sell the loans they originate in the secondary mortgage
market. Through these financial services operations, the Company also
provides high-speed Internet access, cable television and alarm installation
and monitoring services to residents of communities the Company develops,
as well as other communities.
D. Income and Loss Statement (from http://www.yahoo.com)
PERIOD ENDING |
30-Nov-04 |
30-Nov-03 |
30-Nov-02 |
Total Revenue |
10,504,899 |
8,907,619 |
7,319,802 |
Cost of Revenue |
8,993,304 |
7,692,877 |
6,212,568 |
Gross Profit |
1,511,595 |
1,214,742 |
1,107,234 |
Operating
Expenses |
|
|
|
Selling General and Administrative |
141,722 |
111,488 |
85,958 |
Operating
Income or Loss |
1,369,873 |
1,103,254 |
1,021,276 |
Income
from Continuing Operations |
|
|
|
Total
Other Income/Expenses Net |
58,455 |
21,863 |
-
|
Earnings
Before Interest And Taxes |
1,519,067 |
1,207,054 |
1,021,276 |
Interest
Expense |
-
|
-
|
145,567 |
Income
Before Tax |
1,519,067 |
1,207,054 |
875,709 |
Income
Tax Expense |
573,448 |
455,663 |
330,580 |
Net
Income From Continuing Ops |
945,619 |
751,391 |
545,129 |
Net Income |
945,619 |
751,391 |
545,129 |
E. Senior Notes and Other Debts Payable (From Notes to Financial
Statements in the 10-K filed with the SEC on Feb. 14, 2005.
(Dollars in thousands) |
November
30, 2004 |
November
30, 2003 |
5.125% zero-coupon convertible senior subordinated
notes due 2021 |
274,623 |
261,012 |
5.95% senior notes due 2013 |
344,717 |
344,260 |
7 5/8%
senior notes due 2009 |
274,890 |
273,593 |
9.95% senior notes due 2010 |
304,009 |
301,995 |
5.50% senior notes due 2014 |
247,105 |
— |
Senior floating-rate notes due 2009 |
300,000 |
— |
Senior floating-rate notes due 2007 |
200,000 |
— |
Term loan B |
— |
296,000 |
U.S. Home senior notes |
— |
2,367 |
Mortgage notes on land and other debt |
75,670 |
72,990 |
|
2,021,014 |
1,552,217 |
F. Excerpt from Press Release filed with the SEC:
LENNAR COMPLETES $300 MILLION 5.60% 10-YEAR SENIOR NOTES OFFERING
MIAMI, April 28, 2005 — Lennar Corporation (NYSE: LEN and LEN.B)
announced that it has completed an offering of $300 million of 5.60% Senior
Notes due 2015. The Senior Notes were priced to yield 5.629%. Lennar expects
to use the proceeds from this offering for general corporate purposes.
Answers to Final
- Lennar Corporation is really a combination of two businesses -- one,
a homebuilder, that holds land; and two, a provider of financial services.
The homebuilding operation, since it holds land and constructed homes
in its asset portfolio, can take on debt. The provider of financial
services, since it does not have any assets, as such to support its
operations would not be able to take on much debt. In addition, the
cashflows from its operations are probably volatile, in keeping with
overall economy movements.
- It makes sense for Fitch to include Lennar's off balance-sheet operations
in its computation of an overall debt-to-capitalization ratio. This
is because these operations are really part of Fitch's overall business,
and Fitch's shareholders would be able to take advantage of the debt
supported by Lennar's off-balance operations. To the extent that Fitch
has responsibility for the debt issued by the joint ventures, etc.,
again, those operations should be taken into account in computing ratios
that reflect Lennar's liabilities. GAAP may not require consolidation
of off-balance sheet operations for various reasons -- one, it may desire
some sort of comparability across companies, and while off-balance sheet
operations may be intrinsic to some companies' operations, such as Lennar,
this may not be true for other companies; two, GAAP is subject to political
pressures, and while it may very well be moving in the direction of
requiring consolidation of currently off-balance operations, it may
not require that at the moment because of conflicting pressures from
different constituencies. Fitch and other rating agencies don't have
those same issues.
- There are several reasons why Lennar might use off-balance sheet finacing
-- one, for window-dressing purposes; since GAAP rules do not currently
require inclusion of those numbers, the ratios computed without them
might look better; two, it may be easier for Lennar to meet its requirements
vis-a-vis ratios for satisfaction of debt covenants, since again, debt
covenant ratios are based on GAAP numbers; three, it may want to issue
non-recourse debt, supported only by the assets of the joint ventures,
etc. Isolating certain streams of cashflow in this fashion may allow
it to raise funds overall in the cheapest manner.
- Interest bearing liabilities, in this case, simply includes the long
term debt. So, using the Yahoo numbers, we get net debt equal to 2626308-616139
or 2010169; hence net debt to capitalization works out to 2010169/(2010169+4161508)
or 32.57%, since stockholders' equity equals 4161508.
- Using the WSJ information, we get net debt equal to 2002867-509068
or 1493799; hence net debt to capitalization works out to 1493799/(1493799+4161508)
or 26.41%. The WSJ.com site may be more trustworthy, since it sells
its data by subscription, and would have more competitive pressure to
provide correct numbers.
- The levered beta for Lennar is 0.544. The marginal tax rate can be
computed from the Income Statement for the fiscal year ended 30 Nov.
2004 as Income Tax Expense / Income Before Tax, i.e 573448/1519067 as
37.75%. The debt-equity ratio works out to 2626308/4161508 or 0.63.
(Although the definition calls for market values, there is no information
on that available to us, hence we are forced to use book value numbers.).
Using these data, the unlevered beta works out to 0.544/[1+(1-0.3775)0.63]
= 0.391
- I wouldn't agree with Jane for several reasons -- first of all, it's
not clear that her evaluation of the sharp movements in demand for homes
is correct; second, Lennar's has a lot of liquidity, as pointed out
in the article. The article also points out that even on the homebuilding
side, Lennar is geographically diversified and the busines cycle in
different states is not perfectly correlated; this reduces the volatility
of cashflows from Lennar's homebuilding operations.
- The cost of debt should be 5.629%, given the information in the recent
press release filed with the SEC. After tax, this works out to 5.629(1-0.3775)
or 3.504%. The cost of equity works out to 4.18 + 0.544(5.5) = 7.172%.
Since we're compute the cost of long-term capital, it would be appropriate
to use the D/E ratio computed in part 6, i.e. 0.63 to compute the debt
and equity weights; this would be 0.63/1.63 or 0.3865 for debt and 1/1.63
or 0.6135 for equity. The cost of capital, therefore is (0.3865)(3.504)
+ (0.6135)(7.172) = 5.754% (Note: to be absolutely correct, one should
really factor the new debt into the computation of the firm's stock
beta, as well as on the correct debt-equity ratio. However, I have not
taken that into account, here, in order to simplify the calculations
-- also, it will not affect the results greatly.)
- With the capital structure modifications, the debt-to-equity ratio
would become (2626308+1000000)/(4161508-1000000) or 3626308/3161508
= 1.147. Hence the new levered beta becomes 0.391[1+(1-0.3775)(1.147)]
= 0.67. The new cost of equity is 4.18 + 0.67(5.5) = 7.866%. The new
after-tax cost of debt is 6.629(1-0.3775) = 4.127%. The new debt and
equity weights are 1.147/2.147 = 0.534 and 0.466. The new weighted average
cost of capital equals (0.534)(4.127) + (0.466)(7.866) or 5.869%. Hence
the cost of capital has increased by 0.00115 (i.e. 0.05869-0.05754).
If we use the total value of the firm as 8,753,494 in thousands of dollars
from the latest balance sheet, the decrease in firm value, and hence
the decrease in equity value becomes (0.00115)(8753494)/0.05869 = $171,520,000.
- One might argue for the use of the debt-to-assets ratio, rather than
the net debt-to-capitalization ratio to compute the WACC, since cash
has to be financed as well. The issue really is what would happen to
cash if the firm's operations were to be scaled up; if the firm would
need to scale up its cash as well, then the weights used to compute
WACC would need to reflect that, and it would not be appropriate to
use the net debt-to-capitalization ratio. However, if the cash would
not need to be scaled up, then it would be appropriate to simply subtract
that from the debt to get a net debt figure; this could then be used
to compute the weights for the WACC. To get a better picture of this,
suppose debt were equal to cash in the company's balance sheet, then
net debt would be zero, and the net debt-to-capitalization number would
work out to zero. If the company were financing a new project, should
we only use the cost of equity capital to compute the hurdle rate? If
there were going to be no need to add to cash, that would make sense;
if the new project would need additional cash for working capital purposes,
then it would not make sense to talk of the hurdle rate for the new
project as simply being the cost of equity capital.
The Dow Jones article uses the net debt to capitalization ratio because
they want to capture the probability of bankruptcy and the extent of
flexibility that the firm has. Obviously, the greater the amount of
cash the less the impact of debt on the likelihood of bankruptcy; therefore,
this measure reduces debt by the amount of cash. Also, for the same
reason, only interest bearing debt is included.
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