Dr. P.V. Viswanath

 

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Spring 2005

  
   
 

LUBIN SCHOOL OF BUSINESS
Pace University
Fin 647 Advanced Topics in Financial Management
Prof. P.V. Viswanath
Quiz 1

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. Define any five of the following terms (3 points each):

  1. Agency Costs
  2. Golden Parachute
  3. Bond covenants
  4. Greenmail
  5. Deferred Tax Asset
  6. Treasury Stock

2. Answer the following question in no more than one page: Why does the Board of Directors often fail in its efforts to monitor managers? (10 points)

3. Answer one of the following questions (10 points):

  1. When is an obligation recognized as a liability according to GAAP?
  2. Assume that all of the debt on your books was borrowed three years ago, when the treasury bond rate was 7% and you were borrowing at 7.5%. If the treasury bond rate today is 6%, and you are a riskier firm than you used to be, will the market value of your debt be greater than or less than your book value? Explain.

4. Read the following article, "Havas CEO Aims to Block Raider," in today's WSJ (February 10 2005, Page B5), and answer the question below. According to http://finance.yahoo.com, 2% of the shares were held by Institutional & Mutual Fund Owners, while 6% of shares were held by insiders. Almost all of its shares outstanding are available for trading in the market (float = 94% of shares outstanding).

Do you think that it would have been a good idea for Havas to have had poison pills approved by the management in just a case? Why or why not? (No more than one page.) (15 points)

Pouzilhac Attacks Bollore In Advance of May Meeting; Strong Growth Is Reported
By SIMON CLOW, DOW JONES NEWSWIRES, February 10, 2005; Page B5

PARIS -- In a sign of increasingly sour relations between the French advertising company Havas and its biggest shareholder, Chief Executive Officer Alain de Pouzilhac said he would be ready to face down any challenge from corporate raider Vincent Bollore at the company's potentially fractious shareholders meeting in May. Mr. Pouzilhac has been trying to put together a bloc of shareholders friendly to senior management ahead of the meeting, in an attempt to head off calls from Mr. Bollore for sweeping changes at the world's sixth-largest advertising holding company in terms of revenue.

Mr. Pouzilhac said yesterday that he would continue to oppose "a creeping takeover of Havas without paying the proper price."

The CEO said uncertainty over the company's future ownership structure was hampering his efforts to complete a deal in media-buying. Havas has been trying to bolster its MPG media-buying unit by seeking a strategic alliance with another media-buying concern, but talks earlier this year with Interpublic Group's Initiative failed to result in a pact.


"There is a very clear determination to say no to a creeping takeover if you are not going to pay the right price," Mr. Pouzilhac said. "If there is a confrontation at the shareholders meeting, we will be ready."

The last midsize player in a global ad industry increasingly dominated by larger rivals, Havas is seen as a possible takeover target because it failed in its recent attempt to buy Grey Global Group, a move some analysts believed would have bolstered its business. British rival WPP Group outbid Havas for Grey.

In recent months, Mr. Pouzilhac has been trying to persuade a number of investors to sign on with his shareholders bloc, including institutional buyers in the U.S. By the time of the shareholders meeting, Mr. Pouzilhac wants the bloc to hold a stake at least equal to Mr. Bollore's. Since starting to buy shares in Havas last year, Mr. Bollore has built up a holding of just over 20%. A spokesman for Mr. Bollore wasn't available for comment.

Mr. Pouzilhac's remarks came as Havas reported a 7% drop in its fourth-quarter revenue to €406 million ($518.7 million) from €436 million, but strong organic growth -- or growth excluding acquisitions -- sent the company's shares higher. Havas's American depositary shares were up 10 cents to $5.50 in 4 p.m. Nasdaq Stock Market composite trading.

Mr. Pouzilhac said a more-buoyant world-advertising market and a turnaround in Havas's U.S. and U.K. operations would spur revenue and profit this year. He added that a jump in new business would offset the loss of major accounts with chip maker Intel and Germany's Volkswagen.


While many on Madison Avenue see Havas as vulnerable for more account turnover, some have been surprised by the company's ability to keep landing new business. It recently landed work from Charles Schwab, Pfizer and Vonage.

If Mr. Pouzilhac manages to put together his bloc, it could pave the way for a rancorous shareholders meeting as Mr. Bollore uses his stake to push for changes to Havas's management structure. As part of his campaign, Mr. Bollore has demanded two seats on Havas's board, as well as the appointment of separate management and supervisory boards.

Mr. Bollore made his name in a series of daring corporate raids in France in the 1990s, and his building up of a 20% stake in Havas has triggered speculation that he soon could sell the holding to a bigger advertising company, such as WPP or France's Publicis Groupe. Mr. Pouzilhac initially welcomed Mr. Bollore's share-buying, but relations between the two men have become tense lately. The Havas CEO has accused Mr. Bollore of not making his intentions with regard to the company sufficiently clear.

Shortly after Christmas, Mr. Bollore said he would use his shares to borrow €200 million from Societe Generale, giving the businessman more firepower to increase his stake. So far, his holding has remained unchanged at just over 20%.

Answers to Quiz 1

1.

  1. Agency Costs: The term agency costs is often used to refer to the costs incurred by the firm due to the conflicts between management and shareholders, conflicts between shareholders and bondholders, etc. These may be out-of-pocket costs, as well as opportunity costs.
  2. Golden Parachute: a provisoin in an employment contract that allows for the payment of a lump sum or cash flows over a period of time if the manager covered by the contract loses his/her job in a takeover.
  3. Bond covenants: conditions in bond indentures that are designed to protect bondholders.
  4. Greenmail: the practice of paying-off intending acquirers to avoid hostile takeovers.
  5. Deferred Tax Asset: Companies that pay more in taxes than the taxes they report in the financial statements create an asset called a deferred tax asset. This may happen because the firm uses a different basis for computing income for reporting purposes than for tax purposes. The deferred tax asset reflects the fact that the firm’s reported earnings in future periods will be greater as the firm is given "credit" for the deferred taxes.
  6. Treasury Stock: Stock that the corporation has issued and then has acquired back.

2. There are several reasons why the Board of Directors often fails in its role as a monitor of management performance. Here are some:

  1. The CEO often hand-picks most of the directors of the Board, and hence they are beholden to him
  2. Directors often hold only token stakes in their companies. Hence they do not have a real interest in how well the firm is run.
  3. Many directors are themselves CEOs of other firms, and hence they do not have the time to invest in another company.
  4. Directors lack the expertise to ask the necessary tough questions, because they may not be experts -- or, alternatively, because they are not involved in the day-to-day affairs of the company, they may not have the information.
  5. The CEO sets the agenda, chairs the meeting and controls the information.
  6. The search for consensus overwhelms any attempts at confrontation -- it's always more difficult to confront the CEO than to go along with him.

3.

  1. When is an obligation recognized as a liability according to GAAP?
    For an obligation to be recognized as a liability, it must meet three requirements:
    i . It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date.
    ii . The firm cannot avoid the obligation.
    iii . The transaction giving rise to the obligation has to have happened.
  2. Assume that all of the debt on your books was borrowed three years ago, when the treasury bond rate was 7% and you were borrowing at 7.5%. If the treasury bond rate today is 6%, and you are a riskier firm than you used to be, will the market value of your debt be greater than or less than your book value? Explain.
    The market value of the bond today, compared to its book value will depend on the correct discount rate to be used to value the bond's cashflows. On the one hand, interest rates, in general, are lower today, but on the other, the firm is riskier and hence the spread over the Treasuries will be higher. Whether the market value is greater or not will depend on whether the increase in the spread is greater than the decrease in the riskfree rate (if so, mkt value will be lower) or if the increase in the spread will be less than the decrease in the riskfree rate (in which case, the bond's market value will be greater than the book value).

4. One could make a case either way: i.e. that having a poison pill would have helped Management fend off the attempted takeover by Mr. Bollore, and that this would be good for the company, or that the poison pill would prevent Mr. Bollore from getting the management to institute change at Havas.

From Mr. Pouzilhac's comments ("There is a very clear determination to say no to a creeping takeover if you are not going to pay the right price."), it looks like he is willing to consider a buyout, but that the price is the sticking point. This of course, suggests that having a poison pill would have helped Mr. Pouzilhac in extracting a good price from Mr. Bollore for the stock.

On the other hand, looking at what Mr. Bollore is looking for (Mr. Bollore uses his stake to push for changes to Havas's management structure. As part of his campaign, Mr. Bollore has demanded two seats on Havas's board, as well as the appointment of separate management and supervisory boards.), one could argue that he is interested, not so much in buying the company for cheap, but rather in ensuring that the company is well run.

Looking at the company's float, it looks like there would be a serious problem with shareholders trying to act collectively. It could be argued that takeovers are the only practical way to force recalcitrant management to behave properly; hence poson pills that make takeovers more difficult would be detrimental to the interests of shareholders. Given the size of the company and the restructuring that seems to be going on in the industry, it would be difficult to argue that any outsider (Mr. Bollore, for example) could buy the company at less than market value without a competitor entering the picture.

Quiz 2

1. (25 points) Here is some data on Syms Coporation (NYSE: SYM; http://finance.yahoo.com/):

Data in thousands
Year ending 28-Feb-04 1-Mar-03 2-Mar-02
Net Income -4688 -9035 -2319
Cash 21386 19197 19485
Total Current Assets 104907 107771 118880
Total Current Liabilities 28702 30429 32919
Depreciation 10896 10908 11520
Capital Expenditures -2,392 -3,116 -7,990
  1. What is the Free Cash Flow to Equity for the years ending Feb. 2004 and Feb. 2003? What is the growth rate in Free Cash Flow from 2003 to 2004?
  2. Yahoo provides a beta for Syms of 0.035. The 10-year T-bond rate at the close of trading on Feb. 28, 2004 was (source: finance.yahoo.com) 4.39%. Assume a market risk premium of 5.5%. What is the required rate of return for Syms equity?
  3. Assuming that the growth rate in free cashflow to equity will continue for the next five years, i.e. from Feb. '04 to Feb. '09, and then taper off to an annual perpetual rate of 2% p.a., what is your estimated price of SYMS stock, as of the end of February 2004? The number of shares outstanding, currently, is 15.15m, and the actual stock price at close of trading on February 2004 was $13.55/share.

2. (25 points) You are interested in lending some of the money you have saved up because of your low Pace tuition. If you invested it in the stock market, you estimate that you would, on average, earn about 10% from a diversified portfolio. (This follows from the information given in 1.b. above.) You believe that if you lent the money instead, you would need to earn at least 18% per annum because of a. the higher amount of beta risk, and b. the less diversified nature of your investments.

One of your clients wishes to borrow $100,000 from you today (Feb. 28, 2004). He wishes to repay it in the following manner: he will pay an equal amount every quarter for 12 quarters, with the first payment to start six months from now; on each of the two dates, August 31, 2008 and August 31, 2009, he will pay $10,000. What should the amount of each of his equal quarterly payments be?

Solutions to Quiz 2

1. a.
Data in thousands
Year ending 28-Feb-04 1-Mar-03 2-Mar-02
Net Income -4688 -9035 -2319
Cash 21386 19197 19485
Total Current Assets 104907 107771 118880
Total Current Liabilities 28702 30429 32919
Depreciation 10896 10908 11520
Capital Expenditures
-2,392
-3,116
-7,990
Working Capital 76205 77342 85961
Noncash WC 54819 58145 66476
Change in noncash WC -3326 -8331
FCF 11926 13320

Working Capital is computed as Current Assets minus Current Liabilities. NonCash Working Capital excludes cash. FCF is computed as Net Income + Depreciation - Capital Expenditures - Change in Noncash Working Capital.

Growth in FCF from 2003 to 2004 is -10.47%

b. The required rate of return is 4.39% + 0.035(5.5) or 4.58%

c. Using FCF of 11926 for 2004 as a base, we can compute FCF for the years 2005 to 2009, with a growth rate of -10.47%, as well as the corresponding present values, using a discount rate of 4.58%. The terminal value at end fiscal year 2009 can be computed as 6862(1.02)/(.0438-0.02) = $271023.9. This can be discounted to the end of fiscal year 2004 to obtain 216626. Summing up all the present values, we get a total of $254,952.3 in thousands. Dividing by the number of shares outstanding, we get a price of $16.83
Year FCF Present Value
2005 10677.9 10210.0
2006 9560.4 8740.9
2007 8559.9 7483.2
2008 7664.0 6406.5
2009 6862.0 5484.7
Terminal Value 271023.9 216626.9
254952.3

2. There will be two payments of $10,000 each in 4.5 and 5.5 years. The present value of these can be computed as 10000/(1.18)4.5 and 10000/(1.18)5.5, which can be summed up to obtain $8772.14.

If the loan were to be repaid immediately, it would require 100000; subtracting out the present values of the two $10000 payments, the payoff amount today would be $91,227.86. If not paid today, in 3 months, this accumulates to $91,227.86(1.18)0.25 = $95.081.93. This is to be paid back in 12 periodic installments at a periodic rate of (1.18)0.25-1 or 4.2247%. Solving 91227.86 = (C/0.042247)[1-(1.042247)-12], we find C = $10,263.69.

 

  
 

Quiz 3

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.

A. Define any four of the following terms (20 points):

  1. Negative Pledge clause
  2. internal equity
  3. tracking stock
  4. puttable bonds
  5. subordinated debt
  6. conversion ratio

B. Answer any two of the following questions in brief (no more than half a page) (20 points):

  1. What does the Modigliani-Miller Theorem say?
  2. Would a firm with high variance of operating cash flows tend to have high or low debt/equity ratios? Why?
  3. Why would a firm want to issue floating rate debt?
  4. Here is an April 13, 2005 announcement from Dow Jones: “Shares of Broadwing Corp. (BWNG) soared 28% Wednesday after the telecommunications company said it will make a quarterly note payment in cash instead of issuing new stock.” Why do you think this happened?

C. Read the article below and answer question 1 and, either question 2 or 3 (20 points):
1. Why should a stock repurchase cause bond prices to drop?
2. “The value of existing bonds is diminished (in a LBO) because of the resulting risky, debt-heavy capital structure.” Do creditors have any protection against the firm taking such actions, which are detrimental to bondholders?
3. Your friend, John, who has purchased Sungard bonds feels that he should be compensated for the drop in the bond’s price. Your other friend, Sally, thinks that bondholders had already discounted the price that they paid for their bonds, initially when they bought their bonds, and if they hadn’t, they should have. “That’s just the luck of the draw,” she says. “Grin and bear it!” Who’s right, do you think?

Shades of the 'Eighties: Bondholders bemoan the return of LBOs
Barron’s, April 18, 2005; By JENNIFER ABLAN
THE CREDIT CYCLE has made a major turn. After years of assiduously strengthening balance sheets, Corporate America has increasingly been using its cash for the benefit of shareholders, buying back stock and increasing dividends.

Now, creditors have an additional worry -- leveraged buyouts. In an LBO, a group of investors borrow heavily to buy a company with little equity. The value of existing bonds is diminished because of the resulting risky, debt-heavy capital structure.
Several weeks ago, a group of seven private-equity investment firms agreed to buy SunGard Data Systems (SDS), a maker of financial software based in Wayne, Pa., for nearly $12 billion. Sungard's 4 7/8% notes due 2014 fell to 82 cents on the dollar. Most bonds are quoted in terms of their yield premium above benchmark Treasuries, which reflects the market's assessment of the credit. Distressed issues are quoted on a price basis because their payment of interest and principal are uncertain, making a yield calculation problematic. Before the LBO news, Sungard's investment-grade bonds traded at a yield spread of 100 basis points (one percentage point) over comparable Treasuries.

"Credit quality has peaked," says Mark Kiesel, head of the investment-grade corporate desk at Pimco. "Managements are turning their attention now to shareholders, and bondholders are taking a backseat, as evidenced by the recent trend of increased LBO activity, leveraged recaps, higher dividends and share buybacks."

Other companies whose bonds have been whipsawed on LBO speculation include retail giant J.C. Penney (JCP) and technology outfit Computer Sciences (CSC).

LBOs aren't the only risk facing bondholders. Last week, Kerr-McGee (KMG), the Oklahoma City-based oil and gas producer, announced a stock repurchase of up to $4 billion to fend off a proxy fight with investor Carl Icahn. While the shares soared on the news, the company's long bonds widened over 50 basis points to 265 basis points over Treasuries. Kerr-McGee's credit default swaps also jumped by about 100 basis points to 190 over Treasuries.

Standard & Poor's, Moody's Investors Service and Fitch Ratings slash Kerr-McGee's all lowered their long-term credit ratings to junk. S&P credit analyst Andrew Watt said in a press release that the use of debt "materially harms the company's credit profile." Fitch added Kerr-McGee's plan "substantially increases" its leverage to $7.2 billion from $3.2 billion currently.
All told, Pimco's Kiesel says "We're adding selectively where there are specific-name opportunities." Right now, says Kiesel, the "main opportunity" is the short maturities of Ford Motor Credit and General Motors Acceptance Corp. "We're favoring the finance entities of the autos, but we're staying two years and in," he adds.

D. (McDonald's Corporation has 1.27b shares outstanding, according to finance.yahoo.com. The same source pegs its debt at $9.22b. It's stock price, as of 12:53 p.m. ET, was $29.71. The stock's beta is 0.789. The 10-year T-bond is currently trading at a yield of 4.26% (morning trading on 4/21/05). Assume a market risk premium of 5%. McDonald's recently issued some senior debt securities at a yield of 6.375%. It's marginal tax rate is 38%.

Suppose McDonald's issues another $1b. worth of debt, it is estimated that its cost of debt would jump 1 percentage point.

  1. (10 points) Using these numbers, compute the firm's debt-to-equity ratio.
  2. (10 points) What is the firm's weighted average cost of capital?
  3. (10 points) What would be McDonald's equity beta if it issued the new debt?
  4. (10 points) What would be the value of McDonald's equity if it issued the new debt. Assume that the issuance of new debt would cause an additional expected bankruptcy costs of $100m.

Solutions to Quiz 3

A.

  1. negative pledge clause: a covenant included in the bond indenture that prevents bondholders' claim on the assets from being superseded by future debt that the firm might issue.
  2. internal equity: financing obtained from cashflows generated from the existing assets of a firm -- in contrast to funds raised from private sources or from financial markets.
  3. tracking stock: shares issued against specific assets or portions of a firm; they entitle their owners to a share of the assets and cash flows of that portion of the business.
  4. puttable bonds: bonds, whose buyers can put (sell) their bonds back to the firm and receive face value in the even of an occurrence such as a leveraged buyout.
  5. subordinated debt: debt, that is subordinated to other debt, whose holders have priority in claim over the holders of the subordinated debt.
  6. conversion ratio: the number of shares of stock for which each convertible bond may be exchanged.

B.

  1. What does the Modigliani-Miller Theorem say?
    The Modigliani-Miller theorem states that, if there are no leakages from cashflow in the form of payment to individuals other than security holders of the firm (and other than payments for operating purposes), then the value of the firm is independent of its capital structure.
    According to Merton Miller, himself in "Financial Innovations and Market Volatility" you can understand the idea, thus:
    "Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk."
  2. Would a firm with high variance of operating cash flows tend to have high or low debt/equity ratios? Why?
    Such a firm would probably have low debt/equity ratios. If the firm did issue a lot of debt, then the probability of bankruptcy and hence the expected bankruptcy costs would be high because of the the high variance of operating cashflows.
  3. Why would a firm want to issue floating rate debt?
    A firm might use floating rate debt to match inflows from operations with outflows to debtholders. This would reduce the probability of bankruptcy.
  4. Here is an April 13, 2005 announcement from Dow Jones: “Shares of Broadwing Corp. (BWNG) soared 28% Wednesday after the telecommunications company said it will make a quarterly note payment in cash instead of issuing new stock.” Why do you think this happened?
    This could be because the market might have interpreted the payment as evidence that the firm felt comfortable about its future cashflows to risk making the payment in cash.

C.

  1. As the article points out, " In an LBO, a group of investors borrow heavily to buy a company with little equity. The value of existing bonds is diminished because of the resulting risky, debt-heavy capital structure."
  2. As long as the firm is not violating any covenants, bondholders cannot prevent the firm from issuing more debt. However, at the time that the debt is issued, creditors can insist on better covenants, they can insist on puttable debt, and they can insist on debt with lower maturity.
    However, even after the debt is issued, debtholders may be able to do something. Not all of the loss suffered by bondholders is recouped by stockholders. Hence, if bondholders can buy up the stock, they can prevent management actions that would decrease the value of the firm, and thus be able to arbitrage the difference between the value of the firm implied by optimal capital structure and that implied by the firm's leveraged buyout.
  3. Sally has a good point. Bondholders, presumably, evaluated the risk of such an event when they bought the bonds and discounted the price of the bonds at that time to ensure that they would have sufficient compensation. At this time, however, they cannot claim that their rights are violated. However, if bondholders can make an argument that there was an implicit covenant that the firm would not issue new bonds, then they might be able to prevent the firm from issuing the bonds.

D.

  1. The firm's equity is worth 29.71x1.27b or 37.73b. Its debt, according to Yahoo is $9.22b. Using these numbers, its debt-equity ratio would be 0.244. However, it must be noted that the $9.22b is a book value, whereas the equity valuation is market value; therefore, one must be careful in using this ratio. One way of getting at the market value is to use the yield on the firm's current issued debt to value its existing debt. However, this cannot be done without information on the coupon rate and face value of the current debt.
  2. The total value of the debt and the equity is 9.22b + 37.73b or 46.95b. The cost of equity is 4.26+0.789(5) = 8.205%; the cost of debt can be estimated at 6.375%. Hence the weighted average cost of capital is (9.22/ 46.95)(1-0.38)(6.375) + (37.73/46.95)(8.205) = 7.37%
  3. It's asset beta is 0.789/[1+(1-0.38)(0.244)] = 0.685. If McDonald's issued the new debt, its new debt-equity ratio would become 10.22/37.73 or 0.2708. Hence, relevering its asset beta, we get 0.685[1+(1-0.38)(0.2708)] or 0.80.
  4. The new cost of equity for McDonald would be 4.26+0.8(5) = 8.26%%. The ratio of debt to the sum of debt and equity would be 10.22/(10.22+37.73) or 0.2131, while the corresponding ratio for equity would be 1-0.2131 or 0.7869. Hence the weighted average cost of capital would be (0.2131)(1-0.38)(7.375) + (0.7869)(8.26) = 7.47%. Hence, an estimate of the increase in McDonald's equity value would be (0.001)(46.95)/0.0747 or $0.6285b. If we take into account the increased expected bankruptcy costs, this figure would drop to $0.5285b. However, not all of the increased costs would probably be borne by the equityholders. The value of bondholders' share of the firm would also drop, since they would be less likely to be paid, and when they were paid, they would be paid less.