Dr. P.V. Viswanath

pviswanath@pace.edu

Summer 2007 Exams, FIN 647

• Midterm
• Solution to Midterm
• Make-up Midterm
• Solution to Make-up 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.

1. Read the following WSJ article and answer the questions below:

1. (8 points) Would you expect real estate firms to have higher than average or lower than average betas? Explain.
2. (7 points) How would you take into account the concerns about corporate governance and DLF's treatment of minority shareholders?
3. (8 points) "According to the prospectus, the family and businesses connected to them will directly or indirectly control more than 87.43% of the shares after the IPO. At present, they own 97.42% of the company." If you assume that the stocks will be sold at the midpoint of the trading range mentioned in the article, what is the rupee value of the equity owned by existing minority shareholders in the company?
4. (7 points) "Edelweiss estimates that DLF's existing land bank has a net asset value of 512 to 517 rupees a share. It says the IPO also provides growth opportunities not included in that valuation, such as a tie-up with Hilton International -- already unveiled by DLF -- to develop hotels across India." If so, why are shares in the company being offered at between Rs. 500 and Rs. 550? Isn't this too low a number? Explain your answer.

DLF Rides India's Land Boom
Investors in Real-Estate IPO Could Feel Bumps
By JACKIE RANGE
June 8, 2007; Page C6

NEW DELHI, India -- Executives from Indian property giant DLF have been traveling the globe with a pitch likely to attract many investors: Ride India's real-estate boom via the nation's largest initial public offering.

By area of completed residential and commercial developments, New Delhi-based DLF is India's biggest property developer. It is offering 10% of the company in an IPO that at the top end of the range could raise $2.36 billion. Shares will be priced between 500 rupees and 550 rupees ($12.37 and $13.61), and will be on sale from Monday through Thursday. Trading on India's National Stock Exchange and Bombay Stock Exchange is set to start in the first week of July.

The offer will be roughly twice the size of India's biggest IPO to date, according to research firm Thomson Financial. That was by oil-and-gas company Cairn India, which raised $1.18 billion in December.

With India's economy ripping along, so is real estate. Moody's Investors Service and ICRA Ltd. have cited market participants as forecasting that Indian property development will be worth $90 billion in 2015, compared with $12 billion in 2005.

Given expectations like those, DLF's offer has generated significant attention and support.

"DLF is the best way to get exposure to Indian real estate, given its size, quality and credentials," Mumbai financial-services firm Edelweiss said in a research note.

The firm, which hasn't done any investment-banking work for DLF, says it believes the company is a growth story and its shares will become the standard way of playing Indian real estate.

But some analysts say investors in DLF might find ownership to be a bumpy ride. They say that in the past there have been concerns about corporate governance and DLF's treatment of minority shareholders. (Earlier, the Singh family that controls DLF had a listed company. When that company delisted in 2003, some retail shareholders continued to hold stakes.)

K.P. Singh, a property entrepreneur and head of the Singh family, has transformed DLF into a powerhouse of residential and commercial real estate with a massive portfolio of land. The company has almost single-handedly turned the once-sleepy Delhi suburb of Gurgaon into a popular residential and business district that has become a glass-and-steel icon of the new India. However, some analysts say the company's focus on Gurgaon is a negative for investors, because it effectively concentrates a large portion of risk in one spot.

Singh family members make up a third of the company's board, including the posts of chairman and vice chairman. According to the prospectus, the family and businesses connected to them will directly or indirectly control more than 87.43% of the shares after the IPO. At present, they own 97.42% of the company.

When DLF unveiled plans to list its shares last year, a number of minority shareholders came forward to say they had been treated poorly by the company, said people knowledgeable about the situation. In its listing prospectus, DLF said it and India's market regulator, SEBI, had received numerous complaints from shareholders saying they hadn't had the opportunity to participate in a previous debenture issue.

A government investigation exonerated the company of any wrongdoing but suggested it allow minority shareholders to participate in the debenture issue to settle their grievances, according to those people. DLF did so, and then reapplied for a listing in January this year.

Analysts at Macquarie Bank cited "poor management of conflict by DLF, evidenced by its minority shareholder debenture issue" as a one reason for caution. Macquarie hasn't done any investment-banking work for DLF.

At a recent news conference, Vice Chairman Rajiv Singh pledged that DLF would treat its shareholders well and said all retail investors should feel "safe and secure."

DLF had to adjust its prospectus for the IPO after SEBI tightened rules surrounding valuation of land banks and disclosure of asset ownership. After the new rules were unveiled, DLF incorporated the requirements, and its IPO was approved.

But the stop-go listing process has taken some of the edge off interest in the stock, in the view of Sharmila Joshi, vice president of institutional sales at Mumbai-based Asit C. Mehta Investment Intermediaries.

To be sure, the IPO has many supporters, in part because of DLF's size in a fast-growing market. The stock also is expected to become a core holding of many India-dedicated funds.

Edelweiss estimates that DLF's existing land bank has a net asset value of 512 to 517 rupees a share. It says the IPO also provides growth opportunities not included in that valuation, such as a tie-up with Hilton International -- already unveiled by DLF -- to develop hotels across India.

"It's an industry leader, so it will have a premium over normal players in the sector," says Jigar Shah, head of research at Mumbai-based K.R. Choksey Shares & Securities.

DLF plans to use the IPO proceeds to help pay for more land and development rights, construction and loan servicing.

The IPO is taking place at a time when listed Indian property companies have been experiencing tough times as a result of higher interest rates and government measures to cool the property market.

In a May 4 note that made no specific comment on DLF, Citigroup noted that India's property sector had "corrected sharply" from highs in December and had been "extremely volatile" in the past two to three months. Citigroup Global Markets India is a joint bookrunner for DLF's IPO.

Given the real-estate sector's negative sensitivity to higher interest rates, Citigroup said, "we see more downside than upside at current levels."

2. Answer any three of the following four questions (5 points each):

1. Does the validity of the objective of stock price maximization depend upon capital market efficiency? Explain your answer.
2. What is the required rate of return on a lottery ticket according to the Capital Asset Pricing model, and why? Do you agree with this statement? Explain your answer.
3. The R²of a regression of the monthly returns on HOLX stock on the S&P 500 portfolio returns over the period 2001-2006 is 0.7. What does this mean?
4. The regression in c. above produces a slope coefficient estimate of 1.95. The standard error of the estimate is 0.45. Provide a range for the beta value of HOLX's stock based on the regression, such that you are 95% certain that the true beta would fall within that range.

3. In looking at HOLX, you have come up with the following quantity forecasts (all numbers in millions):

1. (15 points) Compute Free Cash Flow to Equity for the fiscal year ending June 30, 2008.
2. (10 points) Assume that Free Cashflow to equity will increase by 15% for the year 2008-2009 and then will increase at the rate of 3% forever, thereafter. If the total amount of cash held by the company, now, is $25 million, what is your estimate of the market value of equity? Use a cost of equity capital of 15% per annum.

4. Hologic, Inc., together with its subsidiaries, develops, manufactures, and distributes diagnostic and medical imaging systems for serving the healthcare needs of women. It focuses on mammography and breast care, and osteoporosis assessment. (Source: http://finance.yahoo.com). Hologic (HOLX) identifies three different segments in reporting operating income: Mammography/Breast Care, Osteoporosis Assessment and Other. Since it is difficult to identify assets devoted entirely to one segment or another, you have decided to use revenue information to compute the relative importance of each segment for HOLX. Revenues (in thousands) for the year ending September 2006 are identified in the 10K filings as follows -- Mammography: 335,795, Osteoporosis: 80,162, Other: 46,723.

You have identified five other pure play companies (i.e. single-segment companies) with the following characteristics (the following information is not factual). All these firms are of relatively equal size.

Hologic, itself, has a debt-equity ratio of 0.05 (taking into account the capitalized value of its opeating leases).

1. (20 points) What is your estimate of the stock beta of HOLX, using the information above? (Assume a 40% tax rate for Hologic.)
2. (5 points) If I told you that Yahoo provides a value for HOLX's equity beta of 2.08, what would you say? (Assume for the purpose of this sub-question, that the information regarding the pure-play companies is factually correct.)

5. (10 points) You believe that the market risk premium is about 6% and that HOLX's beta is 2.08. The yield on 10 year Treasuries is 5.116% (WSJ, June 8, 2007). Further, for the latest quarter (ending March 31, 2007) the company reported income tax expense (in thousands) of $12,650 on taxable income of $34,284. (http://finance.yahoo.com). If the firm reports an average coupon rate, for its outstanding debt, of 6.14%, what is its weighted average cost of capital (WACC)? Assume that its debt-equity ratio is about 0.05.

Solution to Midterm

1.a. Real estate stocks probably have betas greater than one. This is because they represent land, which is a capital good. The demand for land is a demand derived from the demand for other goods. There is also a real option component to the value of land; this causes land to fluctuate more relative to the market compared to other assets.

b. According to the article, "When DLF unveiled plans to list its shares last year, a number of minority shareholders came forward to say they had been treated poorly by the company, said people knowledgeable about the situation. In its listing prospectus, DLF said it and India's market regulator, SEBI, had received numerous complaints from shareholders saying they hadn't had the opportunity to participate in a previous debenture issue." It sounds like minority shareholders have not had a routine way to express their opinion of the way the firm is being run. Allowing them to choose a director to represent their interests might be one way to give them a voice.

c. The family current owns 97.42% of the company. Hence the minority interest is 2.58%. The article estimates that the new equity issue could raise $2.36b. at the top range of $13.61. Hence the new equity issue is 2.36b/13.61 or 173,401,900 shares. We also know that after the IPO, the family's interest will drop to 87.43%.

Suppose X is the number of shares outstanding right now. Then, the number of shares with the family now is 0.9742X. The number of total shares after the IPO will be X+173401900. Hence 0.9742X/(X+173401900)=0.8743. Solving, we find 0.9742X = 0.8743X +(0.8743*173401900) or X = 1,517,570,382 shares, assuming that the family does not buy any of the newly issued shares. The expected trading range is 500 to 550 rupees. The market value of the current minority shareholders, therefore, is (0.0258)*1,517,570,382*525 or Rs. 20,555,490,824 or about Rs. 20.5b.

d. One answer to this question is simply that the Rs. 517 estimate for the existing properties is too high. Another is that the other growth prospects are not as large as they are made out to be. There may also be a minority discount because of the governance problems this company has had. Finally, the very fact of equity issuance is often a signal that the existing shares are overvalued.

2. a. The objective of share price maximization is valid only if markets are efficient. This is because the ultimate objective is either shareholder wealth maximization or firm value maximation. If markets are not efficient, then maximizing share prices may not maximize firm or equity wealth because market prices do not reflect true values.

b. The required rate of return on a lottery ticket is zero because the return on a lottery ticket is uncorrelated with market returns. As a result, all the uncertainty is diversifiable.

c. This means that 70% of the variation in HOLX's equity returns over that time period can be explained by movements in the value of the market.

d. The 95% confidence interval is 1.95 + (1.96)(0.45) and 1.95 - (1.96)(0.45) or 2.832 and 1.068.

3. The Free Cash Flow to Equity for the year ending June 2008 is:

Net Income	65
+ Depreciation	10
- Increase in Non-Cash Working Capital	5
+ Increase in Debt	2

or $72m. However, the numbers provided here do not include capital expenditures. We assume this is zero; however, if this is not so, we need to subtract capital expenditures, as well, to get the Free Cash Flow to Equity. (An alternate assumption might be that Net Capital Expenditures are zero -- that is capital expenditures equal depreciation.)

b. Assuming an increase of FCFE of 15% for the next year (2008-2009), we get 72(1.15) or $82.8m. Growth thereafter is at 3% p.a. Hence the value, as of June 2008, of future FCFE is 82.8/(0.15-0.03) = $690m. Discounting this back to the present, we get 690/1.15 or 600. The FCFE for the year ending June 2008, itself is 72; discounting this back to June 2007 gives us 72/1.15 or 62.6087. Adding the two, we get 662.6087. Adding the value of cash to this, we end up with 662.6087+25 = $687.6087m.

4. a. HOLX consists of three segments. We will find HOLX's beta by looking at the betas of the pure-plays in the three segments. Testing Inc. has a stock beta of 2; we use the information provided to compute its unlevered or asset beta as 2/(1+(1-0.2)0.5) = 1.428571. Similarly, Women Care's asset beta works out to 1.469388. Not having information on the sizes of the two companies, we weight them equally to get an asset beta for the Mammograph segment of 1.44898.

We use a similar technique to get the asset beta estimate for the Osteoporosis segment, which works out to 2.257378. Since the sole firm in the "Other" segment has no debt, its asset beta is the same as its equity beta, which is 0.6.

We must now find a weighted average of these three asset betas. Unfortunately, we don't have the relative asset sizes of the three segments in HOLX. We therefore use the relative revenues of 335,795 for Mammograph, 80,162 for Osteoporosis and 46,723 for Other. With these weights, we get a composite asset beta of (335795*1.44898 + 80162*2.257378 + 46723*0.6)/(335795 + 80,162 + 46,723) or 1.503307.

Company Name	Industry Segment	Stock Beta	Marginal Tax Rate	Debt/Equity Ratio	Unlevered beta	Weights		HOLX weights
Testing Inc.	Mammograph	2	0.2	0.5	1.428571	0.5	1.44898	335,795
Women Care	Mammograph	1.8	0.25	0.3	1.469388	0.5
Bone Density	Osteoporosis	2.8	0.25	0.23	2.38806	0.5	2.257378	80,162
Osteo Health	Osteoporosis	2.35	0.3	0.15	2.126697	0.5
Medical Welfare	Other	0.6	0.34	0	0.6	1	0.6	46,723
							1.503307

We then find HOLX's equity beta as 1.503307*(1+(1-0.4)*(0.05)) = 1.548406.

b. The Yahoo estimate is computed simply by running a regression of the returns on HOLX over the last five years on the market return. HOLX's exposure to the different segments could have changed from then to now. If so, a bottom-up beta would provide a better estimate.

5. The average tax rate is 12650/34284 = 0.368977.

The WACC is (.05/1.05)(6.14)(1-0.368977) + (1/1.05)(5.116+2.08*6) = 16.94259%

Make-up Midterm

1. Walgreen's Net Income for the year ended August 2006 was $1,750,600,000. Here are other numbers for the same time period (unless otherwise indicated) (in millions of dollars):

1. (10 points) Compute the Free Cash Flow to Equity for the year ended August 2006.
2. (5 points) Walgreen's beta is estimated to be close to zero, by Yahoo. However, you think that this is a biased estimate. Considering that the average beta is 1, you raise your estimate of WAG's beta to 0.33. You estimate the market risk premium to be 5.5%, and the long-term Treasury rate to be 5.5%, as well. What is the required rate of return on equity for WAG?
3. (5 points) Walgreen's cost of debt is estimated to be 6.25% based on a S&P rating of A+. The marginal tax rate for WAG can be assumed to be the rate on the highest slab of corporate income, viz. 35%. The long-term debt to equity ratio for WAG for the last year was 0.1246. Compute the WACC for WAG.
4. (10 points) Analysts estimate a growth rate in earnings (assume this will also apply to FCFE) for the next five years of 15.66 percent (i.e. from Aug. 2006 to Aug. 2011). If you believe a perpetual growth rate thereafter of 3%, what would your estimate of Walgreen's equity value be (as of Aug. 2011).
5. (10 points) What do you estimate Walgreen's share price to be, as of Aug. 2006 (shares outstanding as of Aug. 2006 = 997.44m.)?

Solution to Make-up Midterm

1. In order to compute the Free Cash Flow to Equity, we first need to compute change in Non-cash working capital. This equals non-cash current assets less current liabilities for 2006 less the same number for 2005. This is computed as (9705.4 - 5755.3 - 919.9) - (8316.5 - 4481 - 576.8) = -$228.5. Now Free Cash Flow to Equity for the year ending August 2006 equals Net Income Plus Depreciation less change in non-Cash Working Capital less Capital Expenditures less Change in Long-term Debt. This works out to 1750.6 + 572.2 +228.5 - 1338 + 21.9 = $1235.
2. The required rate of return on equity is 0.055 + 0.33(0.055) = 0.07315 or 7.315%
3. The long-term debt to equity ratio is 0.1246. Hence the weights for debt and equity are (0.1246/1.1246) = 0.11076 and 1/1.1246 = 0.88924. Hence the WACC = (0.11076)(0.0625)(1-0.35) + (0.88924)(0.07315) = 0.06955 or 6.955%
4. The FCFE for the year ended August 2011 would be 1235(1.1566)⁵= 2556.544, assuming the given growth rate of 15.66%. For the year after that, growth is at 3%. Hence the FCFE for the year ending August 2012 is 2556.544(1.03) = 2633.24. The FCFE from this point on is expected to grow at a constant 3% p.a. Therefore, the terminal value would be 2633.24/(.06955 - 0.03) = $61025.26m plus the future value of cash. If we allow cash to grow at the cost of equity capital as well, that would give us 919.9(1.07315)⁵= 1309.311. Summing up the two values, we get 61025.26 + 1309.311 = $62334.57m.

To this, we add the amount of cash currently at hand, 919.9, to get a grand present value of $51570.37. Dividing by the number of shares outstanding, we get $51570.37m./997.44m. or $51.70 per share. (Interestingly enough, the closing stock price as of June 26, 2008 was $43.73!)

Final Exam

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 1.5 hours to complete the exam; please make sure to attempt all the questions, so I can give you partial credit, if necessary.

1) (Note that the information in this question is not factually complete) You are trying to evaluate whether United Airlines has any excess debt capacity. UAL has 12.2 million shares outstanding at $210 per share and debt outstanding of approximately $3 billion (book as well as market value). The debt has a rating of B and carries a market interest rate of 10.12%. The beta of the stock is 1.26, and the firm faces a tax rate of 35%. The treasury bond rate is 6.12%. Assume a market risk premium of 5.5%.

1. (15 points) Estimate the current cost of capital.
2. (15 points) You compute the optimal debt-to capital ratio to be 30%, at which point the rating will be BBB, and the market interest rate on the debt will be 8.12%. Estimate the change in firm value from going to the optimal.

2) (40 points) Please read the following article in the New York Times of June 29, 2007 and answer any two of the questions below:

1. Tyco International, as it stands currently, is a conglomerate. It consists of segments that operate in the electronics, healthcare and home security industries. Mr. Breen wants to split off the businesses. Presumably this would allow the board of directors and management of each business to focus on a single segment in a single industry. This should increase the combined value of the three business by reducing inefficiency. So why are the bondholders upset?
2. According to the article, "Nobody ever promises to ''maximize bondholder value.'' " Does this mean that it will always be optimal for firms to try and take advantage of loopholes in bond contracts to reduce the value of existing debt?
3. If Tyco wins its argument in court, what would you expect to happen to the cost of debt capital? Do you think it would go up or down? Explain your answer.
4. In the earlier case of Sharon Steel in 1982, the Second Circuit court held that despite the successor obligor clause, no assignment of debt to another party was possible unless all or substantially all assets at the time of the plan of liquidation are sold to a single purchaser. Does that decision support Tyco's position or the bondholders' position?

   Bondholders Scream Foul As Tyco Splits, by Floyd Norris

   Bondholders can be the forgotten investors in corporate America. Nobody ever promises to ''maximize bondholder value.'' Nor should they. Bond investors do not own the company, as shareholders do. They merely have a contractual relationship with it.

   But what happens if the company decides to run roughshod over the contract? Will the courts protect the bondholders?

   That is the issue being fought in federal court in Manhattan over the actions of a company known to every aficionado of corporate scandals, Tyco International.

   At issue is what Tyco's contract with its bondholders provides. The bondholders thought that bond indentures provided protection against having most of the company's assets moved to other companies, where they will no longer be available to secure the debt.

   Tyco's bond indentures used language that is identical to the wording in many other investment-grade bonds. Glenn Reynolds, a bond analyst at CreditSights, argues that a Tyco victory would make it much easier for leveraged buyout firms to break up companies, perhaps helping shareholders but leaving bondholders stuck with notes that are worth far less than they were. Companies could be cut in two or three, with the bonds securing the less desirable part of the company.

   ''The entire high-grade market is standing by, wondering how much new structural risk will be injected into their markets by the de facto gutting'' of indentures, he wrote.

   Tyco grew under the leadership of L. Dennis Kozlowski, whose current residence, the Mid-State Correctional Facility, is about a four-hour drive from his old Fifth Avenue apartment that included such necessities, paid for by Tyco, as a $6,000 shower curtain and a $2,960 set of coat hangers.

   The new management, led by Edward Breen, a former president of Motorola, decided last year that the company should be split in three, spinning off one company with Tyco's electronic businesses and another with its health care assets. The separation is effective today.

   Tyco will be left with its other businesses, including the home security business, and it is that company that will secure the bonds in question. The market thinks that company is worth about 40 percent of the total.

   The bondholders fear the new Tyco will be a prime candidate for a leveraged buyout, which could saddle the company with more debt and reduce the value of existing bonds.

   Is the split allowed by the bond indentures? They provide that if ''all or substantially all'' of Tyco's assets are transferred to another company, then that company must assume the debt as well. To the bondholders, the fact that most of the businesses that backed the bonds will be gone is clear evidence that the indenture is being violated.

   Tyco argues that it has every right to do that. After all, the assets being transferred out do not represent ''nearly all'' of the company's assets. But just to be safe, it tried to buy back the bonds -- for more than they were trading for but for less than it would have to pay if it redeemed them.

   That plan failed when many bondholders refused to sell. But now the company plans to go ahead with the split, and fight it out in court. If it loses, it could be forced to redeem $3.7 billion in bonds under terms specified when the bonds were issued. The company will not say how much that would cost it over what it offered to pay for the bonds, but the bondholders estimated the figure at $95 million.

   In their suit, the leading bondholders -- the Knights of Columbus and several insurance companies -- get in some reminders of the bad old days at Tyco, calling it one of the ''more infamous exemplars of corporate dishonesty, lawlessness and unaccountability'' in American history.

   The most prominent court ruling on the rights of bondholders, on which the pending suit relies, is a 1982 decision by the United States Court of Appeals for the Second Circuit on the liquidation of Sharon Steel by Victor Posner, one of the most colorful, and least scrupulous, corporate raiders of the era. Sharon bondholders managed to stop Mr. Posner from stripping the assets that backed their bonds.

   That was not Mr. Posner's only visit to federal court. One judge denounced him for being ''contemptuous of the interests of public shareholders,'' a phrase that could later have been applied to Mr. Kozlowski.

   Mr. Breen has strived mightily to repair Tyco's reputation. A Tyco mission statement, quoted by the bondholders, promises ''processes and practices that promote integrity, compliance and accountability.''

   The bondholders claim the company's treatment of them ''belies this worthy aspiration,'' but that is not the issue. The issue is simply whether Tyco is violating the contract it signed with the bondholders.

   But this case could end up setting a precedent that will be long remembered by investors. Mr. Breen's Tyco could end up being linked to Mr. Posner's Sharon Steel whenever bondholders go to court to complain they are being abused.

   That is, presumably, not the kind of legacy Mr. Breen most desires.

3) (10 points each) Answer any three of the following questions:

1. What are some of the agency costs of debt?
2. For what kinds of firms would you expect indirect bankruptcy costs to be high?
3. Here's what http://finance.yahoo.com says about Sento Corporation (Ticker: SNTO),
   Sento Corporation, through its subsidiaries, provides call and contact solution center services for customer acquisition, customer service, service intervention, and technical support for various organizations. Its services include self-help, live chat, Web collaboration, email, and telephone. The company specializes in Right Channeling offering, a mix of communications channels, which enables the client to channel its customers to particular communications channels, or give the customer the option to choose from various channels, including free phone, voice self-service, Web self-service, chat, forums, and email. Sento Corp., through its proprietary Customer Choice Platform, also offers professional services and customer interaction tools for customer acquisition, customer service, and technical support. In addition, the company offers Service Intervention a program that allows clients to avoid no-fault found service claims and product returns. Further, it provides licenses to certain clients for the use of its customer contact software tools that the company hosts. Sento Corp. principally operates in the United States, the Netherlands, France, and New Mexico. The company, through contractual relationships, also operates in India, Brazil, and Sweden. Sento Corp. was founded in 1986 and is based in Salt Lake City, Utah.
   Sento's debt-equity ratio is 0.878; are you surprised? Explain why or why not?
4. It is well-known that a firm has no fiduciary obligation to its bondholders. The only protection that bondholders have from being dispossessed is through the bond indenture. This being the case, you would expect detailed covenants prohibiting the firm from taking various actions and requiring it to take other actions. Can you explain why, in general, this is not the case, beyond some standard covenants?
5. What does the Modigliani-Miller hypothesis say?

Solution to Final Exam

1. a. The cost of equity capital is 6.12% + 1.26(5.5) = 13.05%; the cost of debt capital, after-tax is 10.12(1-0.35) = 6.578. The firm's equity is valued at 12.2(210) = $2562m. or $2.562 billion. It's debt is worth $3 billion. Hence the debt/equity ratio is 3/2.562 or 1.171, and the debt-capital ratio is 3/5.562, while the equity-capital ratio is 2.562/5.562. The WACC, then, equals (3/5.562)(6.578) + (2.562/5.562)(13.05) = 9.559%.

b. If we go to a 30% debt-capital ratio or a 3/7 debt/equity ratio, we have to recompute the WACC. The current beta = 1.26; the unlevered beta = 1.26/[1+(1-0.35)1.171] = 0.71545.  Hence the levered beta at a debt ratio of 30% = 0.71545(1+(1-0.35)(0.3/0.7) = 0.9148; the cost of equity = .0612 + 0.9148(.055) = 0.1115.  The WACC = (0.3)(1-0.35)(.0812) + (0.7)(.1115) = 9.39%. 

The value of the firm will go up by (5.562)(0.09559 - 0.0939)/(0.0939) = $100.471 million.

2. a. Bondholders are upset because the amount of collateral that they will be able to rely on will decrease drastically. This would, of course, reduce the value of their bonds. Even though the total value of the three segments might increase -- although this is not certain -- this gain will be enjoyed only by the stockholders; the bondholders will end up losing.
b. No, it will not be optimal for stockholders to always try and dispossess bondholders. The reason is that this will give the firm a bad reputation and if it wanted to raise debt funds in the future, it would have to pay a high rate of interest.
c. The cost of debt capital in the market, in general, will go up because investors will worry about being subject to the kind of dispossession that Tyco would have gotten away with. At the very least, bondholders will have to use very restrictive language in bond indentures to reduce the probability of being dispossessed.
d. On the face of it, it looks like the decision supports the bondholders. On the other hand, what we have here is not a liquidation; in fact, the original parent, Tyco International, will continue to exist, in contrast to the case of Sharon Steel. Consequently, it might be argued that the Sharon Steel case doesn't apply here.

3. a. The three main agency costs of debt are due to: i) taking of excessive risk by the stockholders of a leveraged firm, ii) payment of excessive dividends to stockholders and iii) taking on of excessive debt. All of these actions could reduce the value of the firm. This loss of value would be the agency cost of debt.

3. b. Indirect bankruptcy costs should be highest for:

• Firms that sell durable products with long lives that require replacement parts and service
• Firms that provide goods or services for which quality is an important attribute but where quality difficult to determine in advance
• Firms producing products whose value to customers depends on the services and complementary products supplied by independent companies:
• Firms that sell products requiring continuous service and support from the manufacturer

3. c. From the description of Sento Corporation, it looks like it is primarily a service firm with not a lot of tangible assets -- consequently, one might have expected to find that it had much lower leverage. On the other hand, according to Yahoo, the industry debt/equity ratio is 0.55, where the industry is defined as Information Technology Services. On of the largest firms in the industry, EDS has a ratio of 0.393, while a smaller firm, Stanley, Inc. (SXE) has a ratio of 0.281. Perhaps the explanation is that we're not dealing with a technology firm, which might be involved in cutting edge technological developments; rather this is a firm and an industry that is using, now relatively standard, tools to service other firms. Hence cashflows are much more stable and these firms can, therefore, support more debt than an average technology firm. Also, it's possible that this particular firm has more debt because it might not have done well in the recent past causing it's equity to drop in value thus pushing up its debt/equity ratio.

3.d. Detailed covenants might protect bondholders; on the other hand, they would reduce the flexiblity of the firm and cause it to lose out on promising positive NPV investments -- consequently, it might be worth it for bondholders not to strangle the firm too much with covenants, but rather rely on the firm's desire to establish a good reputation in the market.

3.e. The Modigliani-Miller hypothesis says that the market value of a firm is independent of its capital structure.