Dr. P.V. Viswanath

pviswanath@pace.edu

• Midterm Practice 1
• Solutions to Midterm Practice 1
• Midterm Practice 2
• Solutions to Midterm Practice 2
• Midterm
• Solutions to Midterm
• Midterm 2
• Solutions to Midterm 2
• Practice Final
• Final
• Solutions to Final

Midterm Practice 1

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.
• Do any 7 of questions 2-10.
• Question 11 is a take-home question; you must turn it in by midnight tomorrow night.

1. Answer any four questions from those below:

1. Explain how the financial system facilitates the sharing and transfer of risk. Provide three different examples.
2. What is adverse selection? Give an example of adverse selection in the context of a corporation.
3. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?
4. How is the role of the stock market in stock value maximization?
5. Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate?
6. What are the determinants of expected rates of return on assets in an economy?

2. Are there any disadvantages to requiring by law that a certain proportion of all directors be independent, i.e. that they not have any direct connection with the firm's operations?

3. Problem 25, page 48, Chapter 2.

4. Problem 16, page 46, Chapter 2.

5. Problem 17, page 76, Chapter 3.

6. Problem 13, page 75, Chapter 3.

7. Problem 45, page 125, Chapter 4.

8. Problem 29, page 124, Chapter 4.

9. Problem 39, page 152, Chapter 5.

10. Problem 23, page 150, Chapter 5.

11. Read the article, "Is It Time to Scrap the Fusty Old P/E Ratio?" by Ben Levisohn, WSJ, Sept. 4, 2010 and answer the questions posed (Go to Media Articles and click on Interpreting Financial Statements).

Midterm Practice 2

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 will not receive full points.
• Answer any seven of questions 1-8. The first seven questions carry 10 points each.
• Question 10 is a take-home question. You may use any existing on-line resources to answer it, but you may not ask any individual on the web or off for help. I must receive your answer to Q. 10 by email by midnight Wednesday, Oct. 27, 2010.

1. In July 2007, Apple had cash of $7.06 billion, current assets of $18.75 billion, current liabilitites of $7.04 billion, and inventories of $0.29 billion.

1. What is Apple's current ratio?
2. What is Apple's quick ratio?
3. In July 2007, Dell had a quick ratio of 1.26 and a current ratio of 1.31. What can you say about the asset liquidity of Apple relative to Dell?

2. In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion.

1. What are the market capitalization-to-revenue ratios (also called the price-to-sales ratio) for AMR and BABWF?
2. What are the enterprise value-to-revenue ratios for American Airlines and British Airways?
3. Which of these comparisons is more meaningful and why?

3. You have an investment opportunity in Japan. It requires an investment of $3 million today and will produce a cash flow of Y351 million in one year with no risk. Suppose the risk-free interest rate in the United States is 5%, the risk-free interest rate in Japan is 1%, and the current competitive exchange rate is Y113 per dollar. What is the NPV of this investment?

4. Suppose Bank One offers a risk-free interest rate of 6.0% on both savings and loans and Bank Enn offers a risk-free interest rate of 6.5% on both saving and loans.

1. What arbitrage opportunity is available?
2. Which bank would experience a surge in demand of loans? Which bank would receive a surge in deposits?
3. What would you expect to happen to the interest rates the two banks are offering?

5. You have just turned 30 years old, have just received your MBA, and have accepted your first job. Now you must decide how much money to put into your retirement plan. The plan works as follows: Every dollar in the plan earns 9% per year. You cannot make withdrawals until you retire on your 70th birthday. After that point, you can make withdrawals as you see fit. You decide that you will plan to live to 100 and work until you turn 70. You estimate that to live comfortably in retirement, you will need $100,000 per year starting at the end of the first yar of retirement and ending on your one hundredth birthday. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

6. You are running a hot Internet company. Analysts predict that its earnings will grow at 40% per year for the next five years. After that, as competition increases, earnings growth is expected to slow to 6% per year and continue at the level forever. You company has just announced earnings of $3 million. What is the present value of all future earnings if the interest rate is 10%? (Assume all cashflows occur at the end of the year.)

7. Suppose the current one-year interest rate is 5.7%. One year from now, you believe the economy will start to slow and the one-year interest rate will fall to 4.7%. In two years, you expect the one-year interest rate to fall to 1.7%. The one-year interest rate will then rise to 2.7% the following year, and continue to rise by 1% per year until it returns to 5.7%, where it will remain from then one.

1. If you were certain regarding these future interest rate changes, what two-year interest rate would be consistent with these expectations?
2. What is your forecast for the economy in the medium term? For the long term?

8. In the summer of 2008, at Heathrow airport in London, Bestofthebest (BB), a private company, offered a lottery to win a Ferrari or 70,530 British pounds, equivalent at the time to about $141,060. Both the Ferrari and the money, in 100 pound notes, were on display. If the UK interest rate was 5% per year, and the dollar interest rate was 3% per year (EARs), how much did it cost the company in dollars each month to keep the cash on display? That is, what was the opportunity cost of keeping it on display rather than in a bank account?

9. Answer any five of the following questions:

1. Explain how the financial system facilitates the sharing and transfer of risk. Provide two different examples.
2. What is the relevance of the stock market to the concept of a corporation?
3. What is moral hazard? Give an example in the context of a business.
4. What happens to the control of the firm in bankruptcy?
5. How does the market ensure that the Law of One Price holds?
6. How does the financial system facilitate the pooling of resources? Provide two different examples.
7. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?

10. Read the article below and answer the following questions:

Companies may be forced to follow banks’ lead and tap their shareholders
Economist, Jan 15th 2009, New York

IN 2008 battered banks scurried to raise fresh capital. As the recession bites, they will have to come back for more. Jostling with them for limited funds will be a fast-growing number of cash-strapped non-financial firms. Pain is spreading fast across the corporate world: analysts estimate that fourth-quarter profits across the S&P 500 fell by 15% year-on-year, the sixth decline in a row—the worst run on record. Days after laying off 13,500 and cutting production, Alcoa, a bellwether for earnings, announced a crushing $1.2 billion loss. Even traditionally defensive industries, such as pharmaceuticals, are suffering: Pfizer plans to lay off up to 8% of its researchers.

With banks loth to lend and credit markets still in turmoil, a tsunami of defaults seems imminent, despite the fact that credit has thawed a little in recent weeks: junk-bond spreads have fallen from their dizzying peak of 22 percentage points over government debt, and firms are paying less to issue commercial paper, widely used to finance working capital. But they will still struggle to roll over much of the $518 billion of corporate bonds and more than $1 trillion in loan facilities that, according to Citigroup, must be refinanced this year—especially given increased competition from sovereign borrowers seeking to plug deficits. Worse, a growing band of investors is using a mix of short-selling and credit-default swaps (CDSs)*** to bet against firms with heavy refinancing exposures. As their CDS spreads widen, those companies find it ever harder to sell fresh debt.

This could leave a lot of companies having to cough up big chunks of principal on top of their regular interest payments when bonds mature, just as revenues plummet. The debt-service coverage ratios (free cashflow divided by repayment obligations) of highly geared* firms are falling below the critical level of one at a pace that seems to be unprecedented, says Barrie Wilkinson of Oliver Wyman, a consultancy. Cutting interest rates to the bone does little for firms that suddenly find themselves having to repay principal.

CDS spreads imply that around 10% of American firms will be forced into default. To avoid this, those that have trouble rolling over their debt have two main options. The first is to sell assets and use the proceeds to pay down debt. But losses booked from selling at fire-sale prices could quickly wipe through thin layers of equity. The second route is to raise capital, either through a debt-for-equity swap—as GMAC, a troubled vehicle-finance and mortgage lender, has done—or a discounted offering, such as a rights issue.

Some have already taken this last route to get lenders off their backs. Britain’s Premier Foods, for instance, is planning a rights issue in exchange for banks loosening the terms of its debt covenants.** Others are likely to follow. Andrew Smithers of Smithers & Co, a research firm, expects American companies to swing from being net buyers of their own equity (through buybacks) to net sellers. Mr Wilkinson predicts a “great dilution” of existing shareholders in 2009. This could drive another round of selling in stockmarkets, he argues, which have hitherto focused only on falling profits. Fear over the need for further capital-raising contributed to the decline of banks’ shares.

Cash-poor firms would do well to move quickly. Banks that needed equity but dithered last year discovered to their cost that the pool of available capital was not limitless; they had to pay far more for it later, if they could get it at all. And stronger firms are drinking at the pool, too: Scottish & Southern, a British energy group, has just raised £479m ($704m), in part to bolster its ammunition for opportunistic deals.

As the problem grows, governments in America, Britain and Germany are starting to step in. But all this woe has a silver lining—at least for the investment bankers who have already been through it. The wave of corporate capital-raising will bring in underwriting fees that will help offset the slump in mergers and flotations. If they can find willing takers, that is.

*Note: "highly geared" means "highly levered
** Debt covenants are conditions that lenders often impose on borrowers that require them to maintain financial ratios at certain minimum levels, failing which, usually, the loan has to be repaid immediately.
*** A CDS is a contract between two parties where the buyer of the CDS makes periodic payments over the life of the contract to the seller in exchange for a commitment to a payoff if a third party defaults.

1. What is the difference between the debt-service coverage ratio described in the article and the interest coverage ratio?
2. After reading this article, could you sugggest some circumstances in which interest coverage ratios could be misleading?
3. Who might use credit default swaps?
4. "As their CDS spreads widen, those companies find it ever harder to sell fresh debt." Explain why. (Hint: this is an example of how the financial system provides information to economic agents to make optimal decisions.)

Solution to Midterm Practice 2

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. Answers without explanations may not receive any points.
• Answer questions 1-5 in class. Question 6 should be sent to me by email by midnight of Wednesday, October 26, 2011.

1. What is the market debt-to-equity ratio of each firm?
2. What is the book debt-to-equity ratio of each firm?
3. What is the interest coverage ratio of each firm?
4. Which firm will have more difficulty meeting its debt obligation?

1. What is the no-arbitrage price of a security that pays cash flow of $1,700 in one year and $1,700 in two years?
2. What is the no-arbitrage price of a security that pays cash flow of $1,700 in one year and $11,900 in two years?
3. Suppose a security with cash flows of $850 in one year and $1,700 in two years is trading for a price of $2,210. What arbitrage opportunity is available?

3. (15 points) Marian Plunket owns her own business and is considering an investment. If she undertakes the investment, it will pay $32,000 at the end of each of the next 3 years. The opportunity requires an initial investment of $8,000 plus an additional investment at the end of the second year of $40,000. What is the NPV of this opportunity if the rate of return on investments of similar risk is 2% per year? Should Marian make the investment?

4. (15 points) You have decided to refinance your mortgage. You plan to borrow whatever is outstanding on your current mortgage. The current monthly payment is $1,850 and you have made every payment on time. The original term of the mortgage was 20 years, and the mortgage is exactly four years and eight months old. You have just made your monthly payment. The mortgage interest rate is 6.750% (APR). How much do you owe on the mortgage today?

5. (20 points) Answer any five of the following question:

1. What is adverse selection? Give an example of adverse selection in the context of a corporation.
2. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work as it is supposed to?
3. How does the financial system facilitate the pooling of resources? Provide two different examples.
4. Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate?
5. What information do we get from a yield curve?
6. How does the market ensure that the Law of One Price holds?

6. (20 points) Here is a post on Facebook by KJB Security Products on Monday, November 30, 2009 at 4:43pm titled "Profit Margin vs. Sales Volume."

When it comes to increasing your bottom line, there are two approaches retailers may take: Increase profit margin or increase sales volume. Ideally, a company would do both, but that’s usually not possible, especially during a recession. Taking a couple steps back, Profit Margin (PM) is the percentage of profit you make on a sale, after taking all of your costs into consideration. For example, if you bought a TV direct from the manufacturer for $100, and sold it for $200, your gross profit margin would be 50%.

Sales Volume (SV) refers to the total number of sales that you make. Some retailers are more focused on the total sales volume, and simply look to move as many products as they can, usually by focusing on a low-price strategy, thereby resulting in a lower profit margin. This allows them to make more sales, but at what cost? Say you took that TV you bought for $100, and sold it for $150 instead of $200. Your margin just dropped to 25%, and you made $50 less. The theory here is to realize more sales, in order to “make up” for the decreased margin. This strategy works extremely well for big retailers, such as Wal-Mart, that operates on a razor thin profit margin of barely 3%.

The reason that Wal-Mart is able to sell at such an unheard-of profit margin is because they make up for it in volume. This strategy works great for large retailers, but the same strategy can backfire for someone in the specialty electronics industry.

When you sell based on price instead of margin, you are inherently facing several problems. The first is when you realize what brought customers to you in the first place. They bought from you because you had the lowest price for the product they wanted. They didn’t come to you because of the relationship you had built with them, your customer service, the sales experience, technical support, or brand recognition. They bought from you because your price was simply a few dollars lower than your nearest competitor. So you may have got the sale this time, but next time that customer wants to buy a product…instead of going directly to you, they again start their search for the lowest price. By then, your competitor might have undercut you by a few dollars, and since you were simply selling on price, as soon as a competitor pops up that sells the product for less, you’ve lost your customer.

On the other hand, rather than focusing on the price, smart smaller retailers focus on the added-value they package with every sale: Great customer service; helpful technical support; a friendly a knowledgeable sales staff. These are the things that keep customers coming back to you every time they want to make a purchase. And when you do that, combined with a healthier profit margin, you will see that even if you make a few less sales, you can still make more money with higher profit margins.

For a more applicable example, let’s take KJB’s Sleuthgear Recluse. If your cost for the Recluse is $249, and you sell it for the MAP price of $449, you’d make an easy $200 per sale. At that price, let’s say you sell 5 per month…your total profit would be $1000. Maybe then you decide if you lower your price, and sell it for $349 instead, you can sell an additional 3 units per month…so now you’ve increased your sales to 8 units, but since you lowered your profit margin, you’re actually only making $800 in profit. So just because you made more sales, you’re actually making less money per sale. At the end of the day, which would you rather have, more total sales, or more money in your pocket?

For one other quick example, let’s take the D1400 Voice Recorder. Let’s say your cost is $19, and you are deciding whether to sell it for $49 or $29. At $29 you’re may sell 20, for a total profit of $200. At $49, you might sell a few less, maybe 15…but at a total profit of $450. By keeping your margin higher, not only will you make more money, but you will be able to more easily absorb incidental costs such as return and technical support costs.

The lesson to take from this margin vs. volume discussion is that lowering your price, while having the advantage of possibly increasing sales, does not necessarily translate to more profits (and in many cases, results in lower profits). By keeping your margins higher on your products, you can put more money in your pocket, which at the end of the day, is the goal of every business.

Now read this article called "Sales Volume vs. Profit Margin" at http://www.yournew.com/internet_marketing_myths.cfm

We find that a concern many companies express is that their Internet ventures may serve to improve the sales volume of their business at the cost of reduced profit margin. This is perhaps the biggest fear, with the very least supporting evidence. That is, indeed, a myth.

First, it is important to understand that it is common to achieve an even higher profit margin from your online sales than offline sales. This is for multiple reasons, but can include cost factors as basic as a lower cost of aquiring the sales lead, and lower cost of inventory, inventory management, and accounting. This is also largely because online shoppers are often far more motivated by company credibility and shopping convenience than by saving a couple dollars.

Second, let's say that you are in a highly competitive industry where you fear that if you advertise your pricing online you will never be able to see the same profits from your non-Internet customers. A good example of this is the automobile industry. The same example works for any industry, but for this purpose, let's use cars. Too many automobile dealers fear that because they have a car advertised online that they must sell each car at their advertised lowest price on the Internet. One really quick answer to this is in the form of a question ... "Does this happen when you advertise with your local newspaper or television?" Of course not. You probably do not even offer the same special pricing on television as you do in newspapers or yellow page advertisements. You offer a specific vehicle and you advertise that unit at that price. If you commoditize yourself and forget that every buyer and every sale is unique, you do so at your peril. Many people will pay more for the same things they have always sought ... service, convenience, company reputation, and presentation. The list goes on, but most importantly, you must understand that the Internet does not take away from the things that set your business apart. You simply have a new set of tools with which to promote those valuable benefits.

If you do not reach out to the people who are shopping online, you are missing an exceedingly important part of your market. If you are in this position, what you will clearly need to address is the fact that if you do not market your business in every possible way, including a well presented Internet presence, you will become even less visible over time. Time is not on your side as your competition is gaining market share and polishing their online presentation, just as they have been in the years while you neglected yours.

Answer the following questions and send me your response in a Word file:

1. The second article seems to be contradicting the first article. Is this so? Can you reconcile the two messages? Or are they irreconcilable? And, if they are, which message is wrong? Write no more than 500 words.
2. The first article seems to suggest that the margin vs volume discussion is only relevant when comparing across industries. However, in a given industry, you have to go with either profit margin or sales volume. (And in the internet sales case, the first article seems to suggest that you have to go with profit margin if the goal is to increase profits.) Can one use the Dupont formula as a framework for product/marketing strategy even within a given industry? Write no more than 500 words.

Midterm Solutions

1. 1. Market debt-to-equity:
      The market debt-to equity ratio for Firm A = $504.1 million/$402.1 million = 1.25.
      The market debt-to equity ratio for Firm B = $81.3 million/$38.2 million = 2.13.
      
   2. Book debt-to-equity:
      The book debt-to-equity ratio of Firm A = $504.1 million/$303.8 million = 1.66.
      The book debt-to-equity ratio of Firm B = $81.3 million/$36.3 million = 2.24.
      
   3. Interest coverage ratio:
      The interest coverage ratio of Firm A = $98.1 million/$49.9 million = 1.97.
      The interest coverage ratio of Firm B = $7.8 million/$6.6 million = 1.18.
      
   4. From the leverage ratios, we see that Firm B has more leverage; it also has a lower interest coverage ratio. Hence, it will probably have more difficulty meeting its debt obligations than Firm A.
2. 1. The no arbitrage price of a security that pays cash flow of $1,700 in one year and $1,700 in two years is 1598 + 1428 = $3,026.
   2. This security can be thought of as a combination of one unit of security B1 and 7 units of security B2. Hence the no-arbitrage price of a security that pays cash flow of $1,700 in one year and $11,900 in two years is $1,598 + ($1,428 * ($11,900/$1,700)) = $11,594.
   3. Suppose we buy 2 units of the new security, then we can get $1700 in one year and $3400 in two years. Using those cashflows as security, we could then issue and sell one unit of B1 (secured by the $1700 in one year) and 2 units of security B2 (secured by the $3400 in year 2). The cost of the 2 units of the new security would be 2210x2 = $4420, while the sale of the units of B1 and B2 would yield 1598 + 2(1428) = $4454, for a net present cashflow of 4454-4420 = $34. The net cash flow in both years would be zero. Hence this strategy is profitable and self-financing. The investor woudl, therefore try to scale this strategy up manifold to make large profits; this will continue until the price of the new security stabilizes at [1598 + 2(1428)]/2 = 2227.
   
   
3. The NPV of this opportunity = -8,000 - $40,000/ (1+0.02)² + [($32,000/0.02)(1-(1/1.02³))] = $45,837.51.
   Yes, Marian should make the investment.
4. Since the mortgage payment is monthly, the monthly rate for mortgage will be 6.75%/12 = 0.5625% and the total period for remaining loan will be = 240 - 56 = 184 months. Therefore, the amount you owe on mortgage today = [($1,850/0.005625)(1-(1/1.005625¹⁸⁴))] = $211,719.57. The previous payments are essentially irrelevant; what you need to pay off the mortgage today is the present value of all promised future payments.

1. An adverse selection is when one of the parties to a transaction lacks information while negotiating. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints.
2. The purpose of the Board of Directors is to monitor the manager. However, the directors don't always have the proper incentives to monitor the manager, or the knowledge to evaluate him/her. Hence this monitoring doesn't always work out as expected.
3. The financial system facilitates the pooling of resources through the creation of securities as well as by the creation of specific financial institutions that offer pooling contracts. Thus, the stock exchange allows individuals to buy shares of stock that represent very small portions of the total amount of resources required to run a firm. Similarly, mutual funds, through contracts with their customer, pool funds and then buy large amounts of stocks of many different issuers, allowing the customers of the mutual fund to buy shares in diversified portfolios.
4. EAR is greater than APR because of the compounding effect. This effect is explicitly taken into account in the EAR, whereas it is implicit in the APR.
5. The yield curve shows the yield to maturity on bonds of different maturity. It helps to predict future interest rates and inflation rates. In addition, it helps to predict the future state of economy. For example, if there is a downward sloping yield curve, it usually predicts a downturn in the economy.
6. The market ensures that the Law of One Price holds by providing market participants an opportunity to engage in arbitrage. In equilibrium, as well, economic agents will act appropriately to adjust supply and demand for the different units of the product on sale so that the Law of One Price holds.

6. a. The first article suggests that it's possible to trade-off profit margin for volume, but that this depends very much on the industry. Although there is not a clear explanation as to when this can be done and when not, it would seem that in industries with low price elasticity of demand, it is not worth dropping price because sales are not going to react as much as would be necessary to increase profits. There is also the suggestion that in the latter kind of industry, using a low-price strategy can confuse customers because they will ignore features such as good service, convenience, etc. and only focus on price.

The second article does not explicitly contradict the first article but seems to suggest that the same strategy could work in any industry and with any product, at least on the Internet. The article suggests that Internet buyers are much more conscious of service, company credibility and shopping convenience -- all of which are factors that are not easily commoditizable. As such, it would be possible to earn a higher profit margin on the Internet by emphasizing these factors. Although one might conclude from the second article that all products are susceptible to the same strategy on the Internet, that's not necessarily what the article is saying. In fact, by looking at the example that it gives, viz. automobiles, one might infer that the article is indeed talking about brandable, non-commoditized goods only.

Rather, the article is making the point that Internet customers are different and are more susceptible to branded goods. The article is, thus, pushing a market segmentation approach, where internet customers are treated differently from non-internet customers.  The article also emphasizes that segmentation is possible, because if it were not possible, the lower costs in the internet market might force prices down in the bricks-and-mortar market, as well – although exactly how this would happen in equilibrium is not fully explained. But it's important to keep in mind that the lower operating costs in the Internet will not, in themselves, create higher profit margins because of competition.

b. If one defines a industry very narrowly, then it's probably true that a low-cost high-volume approach can only succeed in some industries and not in others. However, if an industry is defined not overly narrowly, then there might be space for both a high profit-margin approach and a high-volume approach. For example, in the outerwear market, there might be high-quality, stylish, branded jackets, where profit-margin would be emphasized, while at the same time leaving open the possibility of selling non-branded low-cost, functional outerwear with high volumes. The issue boils down to price elasticity of demand for different segments of the same industry. Where price elasticity is high, a low-price approach could work.

Midterm 2

1. What is the market debt-to-equity ratio of each firm?
2. What is the book debt-to-equity ratio of each firm?
3. What is the interest coverage ratio of each firm?
4. Which firm will have more difficulty meeting its debt obligation?

1. What is the no arbitrage price per share of the ETF in a normal market?
2. If the ETF currently trades for $225, what is the arbitrage opportunity available?
3. If the ETF currently trades for $255, what is the arbitrage opportunity available?

3. (15 points) Marian Plunket owns her own business and is considering an investment. If she undertakes the investment, it will pay $32,000 at the end of each of the next 3 years. The opportunity requires an initial investment of $8,000 plus an additional investment at the end of the second year of $40,000. What is the NPV of this opportunity if the rate of return on investments of similar risk is 2% per year? Should Marian make the investment?

4. (15 points) You have just sold your house for $1,100,000 in cash. Your mortgage was originally a 30-year mortgage with monthly payment and initial balance of $750,000. The mortgage is exactly 18.5 years old, and you have just made a payment. If the interest rate on the mortgage is 7.75% APR, how much cash will you have from the sale once you pay off the mortgage?

Questions 5 and 6 are the same as for the first Midterm.

Midterm 2 Solutions

1. 1. Market debt-to-equity:
      The market debt-to equity ratio for Firm A = $504.1 million/$402.1 million = 1.25.
      The market debt-to equity ratio for Firm B = $81.3 million/$38.2 million = 2.13.
      
      
   2. Book debt-to-equity:
      The book debt-to-equity ratio of Firm A = $504.1 million/$303.8 million = 1.66.
      The book debt-to-equity ratio of Firm B = $81.3 million/$36.3 million = 2.24.
      
      
   3. Interest coverage ratio:
      The interest coverage ratio of Firm A = $98.1 million/$49.9 million = 1.97.
      The interest coverage ratio of Firm B = $7.8 million/$6.6 million = 1.18.
      
      
   4. From the leverage ratios, we see that Firm B has more leverage; it also has a lower interest coverage ratio. Hence, it will probably have more difficulty meeting its debt obligations than Firm A.
2. 1. The no-arbitrage price per share of ETF in a normal market is $30*2 + $41*3 + $20*3 = $243.
   2. Buy one share of ETF, break it up into its components and sell 2 shares of HP, 3 shares of S, and 3 Shares of F to get total arbitrage profits of $243 - $225 = $18.
   3. Buy 2 shares of HP, 3 shares of S, and 3 Shares of F, combine them to form one share of ETF and sell it to get total arbitrage profits of $255 - $243 = $12.
   
   
3. The NPV of this opportunity = -8,000 - $40,000/ (1+0.02)² + [($32,000/0.02)(1-(1/1.02³))] = $45,837.51.
   Yes, Marian should make the investment.
   
   
4. The monthly rate for the mortgage will be 7.75%/12 = 0.6458%. Therefore, the monthly payment on the mortgage was = ($750,000*(0.006458)) / (1 - (1/1.006458³⁶⁰)) = $5,373. There are (12*(30-18.5)=) 138 payments remaining. The present value of the remaining mortgage = ($5,373 / 0.006458) * (1 - (1/1.006458¹³⁸)) = $489,751.57, which you must pay off. Hence the net cash from the sale after the mortgage pay-off = $1,100,000 - 489,751.57 = $610,248.43.

Final Practice

Read the article entitled "A Patient/Fan of GTx Buys More" below from the WSJ of Nov. 10, 2010 and answer the following questions:

1. Tony Marchese, CIO of Insiders Trend Fund LP said: "These are lottery tickets. The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low." Marchese simply meant that the uncertainty in both cases were high. Having studied asset pricing, explain how else GTx stock is be similar to a lottery ticket.
2. Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment. Explain what Mr. Moreland might mean.
3. The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. What are the implications of this fact for the Efficient Markets Hypothesis?

Memphis businessman and philanthropist Joseph "Pitt" Hyde III has been funding Mitchell Steiner's research since Dr. Steiner successfully treated him for prostate cancer 14 years ago. Mr. Hyde, chairman of Dr. Steiner's biopharmaceutical company, GTx Inc., made his latest investment last week, buying more than $15 million in shares in the company's stock offering.

Mr. Hyde, founder of AutoZone Inc., bought the shares at $2.80, and now owns about 35% of the company. He said he was taking advantage of a "unique opportunity to buy a large block of shares at a favorable price."

The offering, which raised a net $37.6 million to fund the company's clinical development projects, increases outstanding shares by about 39%. GTx shares traded at $2.80 Tuesday.

Tony Marchese, general partner and chief investment officer of Insiders Trend Fund LP, questioned why Mr. Hyde was the only insider to purchase shares in the latest offering and said small biotech companies, such as GTx, are a high-risk, high-reward investment.

"These are lottery tickets," he said. "The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low, he said.

Mr. Marchese said such stocks are not for the average investor, and should take up no more than 1% to 2% of a large, well-diversified portfolio.

Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment.

The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. He advised selling at least half of a position as speculators push the price higher, rather than waiting for the news to be released.

GTx has seen its stock fall after recent news events, such as the FDA's order last fall that it conduct more studies on its prostate-cancer drug candidate Toremifene. Disappointing results from a study of Toremifene in May sent the stock price to its all-time low of $1.90.

Before markets opened Tuesday, the company reported its third-quarter loss narrowed to $8.6 million from a year-earlier loss of $12 million on a 40% decrease in expenses. Revenue dropped 64% to $1.3 million on lower payments by developmental partners Ipsen Biopharm Ltd. and Merck & Co., but sales of Fareston, a breast-cancer drug that GTX bought from Orion Corp. in 2005, climbed 34% to $960,000.

In a phone interview, Dr. Steiner, the company's chief executive officer, called the FDA's decision last fall a major setback, and said it will probably take four years to do the work necessary to submit the drug for FDA approval.

He said, however, that the company and the agency have agreed on a plan that he expects to lead to approval for the drug, which is being developed to reduce bone fractures in men with prostate cancer.

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.
• For all quantitative questions, you must provide the formula and show the numerical equivalents of the variables in the formula. You may then use your scientific or financial calculator to compute the answer and put it down on your answer sheet.
• You must explain all your answers. Answers without explanations may not receive any points.

1. (15 points) HMK Enterprise would like to raise $12 million to invest in capital expenditures. The company plans to issue five-year bonds with a face value of $1,000 and a coupon rate of 8.8% (annual payments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon rate bonds of various ratings:



Rating	AAA	AA	A	BB	B
YTM (%)	8.3	8.4	8.8	9.3	9.8



1. (9 points) Assume the bond will be rated AA, what will be the price of the AA-rated bonds be?
2. (3 points) How much total principal amount of these bonds must HMK issue to raise $12 million today, assuming the bonds are AA rated?
3. (3 points) What must be the rating of the bonds for them to sell at PAR?


2. (8 points) You are considering opening a new plant. The plant will cost $104.6 million upfront. After that, it is expected to produce profits of $28.8 million at the end of every year. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8.2%. Should you make the investment?


3. (10 points) Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in million dollars):



	Year 1	Year 2
Revenues	127.8	157.5
COGS and Operating expenses	47.1	47.5
Depreciation	27.1	38.2
Increase in working capital	5.7	7.5
Capital expenditures	28.9	42.1
Marginal corporate tax rate	35%	35%



1. (5 points) What are the incremental earnings for this project for years 1 and 2?
2. (5 points) What are the free cash flows for this project for the first two years?
4. (15 points) DFB Inc., expects earnings this year of $5.89 per share, and it plans to pay a $3.71 dividend to shareholders. DFB will retain $2.18 per share of its earnings to reinvest in new projects with an expected return of 15.3% per year. Assume that DFB will maintain the same dividend payout ratio, retention rate, and return on new investment in the future and will not change the number of its outstanding shares.
1. (5 points) What growth rate of earning you would forecast for DFB?
2. (5 points) If DFB's equity cost of capital is 11.9%, what price would you estimate for DFB stock?
3. (5 points) Suppose DFB instead paid a dividend of $4.71 per share this year and retained only $1.18 per share in the earnings. If DFB maintains this higher payout rate in the future, what stock price would you estimate now?
5. (5 points) Suppose that market risk premium is 6% and the risk-free interest rate is 3%. Using the data in the table below, calculate the expected return of investing in Starbucks's stock and Hershey's stock.



	Starbucks	Hershey
Beta	1.04	0.19



6. (12 points) In June 2009, Pear Computer had no debt, total equity capitalization of $102 billion, and a (equity) beta of 1.63. Included in Pear's assets was $22 billion in cash and risk-free securities. Assume that the risk free rate of interest is 5% and the market risk premium is 4%.
1. (4 points) What is Pear's enterprise value?
2. (4 points) What is the beta of Pear's business assets (i.e. those assets, other than cash and risk-free securities)?
3. (4 points) What is Pear's WACC?


7. (15 points) Answer any three of the following questions:
1. Working Capital requirements need not be taken into account in evaluating a new project -- after all, working capital is not consumed; it can be recovered once the project is completed. True or False? Explain.
2. How is beta different from standard deviation of returns as a measure of risk?
3. "Issuance of new equity dilutes earnings. Hence it's bad." Is true or false? Explain.
4. What is the most important source of capital for firms? Can you explain why this might be so?
5. What are the determinants of the rate of growth of a firm's earnings?
   
8. Read the excerpts from the following article "Around the World in One Movie: Film Financing's Global Future" by Nicholas Kulish and Michael Cieply from the Dec. 5, 2011 issue of the New York Times and answer these questions:
1. (10 points) The Wachowskis brought in about $1.5 billion at the worldwide box office for Warner Brothers with the Matrix series. But their “Speed Racer,” also for Warner, was a high-budget flop in 2008. This time, Warner agreed to distribute the film in the United States but was not a large contributor to its production budget.  “To have taken the whole movie, given the expense, would have been a very risky proposition for us,” said Warner’s top film executive, Jeff Robinov.
   This sounds like Warner Brothers is using volatility of cashflows as a risk measure.  According to the CAPM, volatility is not the right risk measure.  Only that portion of volatility that is correlated with market movements, i.e. beta, is relevant for asset pricing.  In other words, it’s only systematic portion of volatility that is relevant for investors, not idiosyncratic volatility.  Why is Mr. Robinov worried about total volatility, i.e. systematic volatility as well as idiosyncratic volatility?
2. (10 points) One advantage of having disparate financing, said Peter J. Dekom, a veteran entertainment lawyer, is that it gives filmmakers greater creative freedom. “The more investors you have, the less control you feel from any one investor,” he said.  
   Compare this situation to what we learnt in corporate governance.  When there are many, many shareholders, each shareholder has no incentive to invest resources in ensuring that management acts appropriately in maximizing shareholder wealth.  On the other hand, if there is a large shareholder (like Warren Buffet or the California state pension system Calpers), then that entity will have a vested interest in keeping an eye on management.  In this context, however, Mr. Dekom suggests that having a large number of investors is good.  Do you agree with him?  Is it possible to justify Mr. Dekom’s point of view from the viewpoint of maximizing firm wealth?

POTSDAM, Germany — The German craftsmen on Stage 15 in the Babelsberg studio were hard at work on a recent afternoon building a dystopian Korean slum, the thud of a nail gun and a whiff of sawdust in the air. Next door, Andy and Lana Wachowski, the American-born team behind the “Matrix” movies, were filming black-clad storm troopers from an imagined future for their latest feature, “Cloud Atlas.”

From its truly global parentage to its time-bending story told by three directors using two separate production crews, the movie is unabashedly strange. The narrative, which starts near New Zealand and circles the globe, is bewildering in its complexity, featuring characters in six eras who might share a soul migrating through time. And the project’s primary backers are from China, Korea and Singapore.

But “Cloud Atlas,” in all its glorious confusion, also serves as a guidepost to the future of the film business. Increasingly, sophisticated filmmakers who once relied on American studios for backing are turning to a globe-straddling independent finance system for their most expensive projects.
“Cloud Atlas,” with its $100 million budget and high-wattage cast, including the Academy Award winners Tom Hanks and Halle Berry, was an epic independent film too complicated, too expensive and perhaps too risky for any conventional studio to have backed.

To move forward, the project broke free of national boundaries. The investors from Asia and beyond contributed roughly $35 million, without which the film could not have been made. German subsidies account for $18 million more. In the United States, “Cloud Atlas” will be distributed, probably next fall, by Warner Brothers, which has made only a modest investment to date. In many ways, the producers are drawing a blueprint for a new era of genuinely international filmmaking.

……

Money came from the Singapore container ship magnate Tony Teo; the Hong Kong film distributor the Media Asia Group, which made what its chief executive, John Chong, called the company’s “largest ever investment in a Western production”; and Dreams of the Dragon, a Beijing film company that had not previously invested in a major film. One of its owners, Wilson Qiu, in an e-mail, cited his “fascination with the source material.”

Others also claim pride of authorship. “From our perspective, ‘Cloud Atlas’ is a German film,” said Christine Berg, project manager for the German Federal Film Fund. Not only are the country’s subsidies substantial, but Mr. Tykwer, who achieved fame with his Berlin film, “Run Lola Run,” is in charge of the second crew.
One advantage of having disparate financing, said Peter J. Dekom, a veteran entertainment lawyer, is that it gives filmmakers greater creative freedom. “The more investors you have, the less control you feel from any one investor,” he said.

The idea of shooting on parallel tracks, with the Wachowskis directing one unit and Mr. Tykwer the other, grew from a realization that the stars were more likely to work for a steep discount if the shoot could be finished in half the time. Actors also play different roles in different time periods, keeping them busy and, on certain days, turning stars into extras.
“It’s sort of like guerrilla filmmaking in a way,” Ms. Berry said. “Even though there seems like there’s a lot of money, it’s not opulent. All the money’s going into the screen.”
Still, such an unusual project presents hurdles in capturing a mainstream audience.

The Wachowskis brought in about $1.5 billion at the worldwide box office for Warner Brothers with the Matrix series. But their “Speed Racer,” also for Warner, was a high-budget flop in 2008. This time, Warner agreed to distribute the film in the United States but was not a large contributor to its production budget.
“To have taken the whole movie, given the expense, would have been a very risky proposition for us,” said Warner’s top film executive, Jeff Robinov. Whether it was smart business to jump in only part way, Mr. Robinov said, “I can’t tell you until we’ve seen more.”

The Wachowskis are notorious for their secrecy, but they showed six minutes of footage at the American Film Market in Santa Monica last month.
“It looks phantasmagorical,” said Victor Loewy, a seasoned international film distributor who bid on the United Kingdom rights after watching the clip. “It’s so unlike anything I’ve seen in 40 years in this business.”

Solutions to Final Exam

1. 1. AA rated bond will have yield of 8.4%. The Price of AA rated bond is given by P = ($88 / 0.084) * (1 - 1 / (1+0.084)⁵) + $1,000 / (1+0.084)⁵ = $1015.8.
   2. Each bond will raise $1015.8. So the firm must issue total bonds = Amount firm wants to raise / Selling price of bond = $12 million / $1015.8 = 11,813.3. Therefore, the firm will need atleast 11,814 bonds. This will correspond to a principal amount of = 11,814 * $1000 = $11,814,000.
   3. To sell bonds at par, it must have a coupon value the same as the yield. Therefore, only A rated bonds can be sold at par.
   
   
2. The upfront cost is $104.6 million. The cost of capital is 8.2%. Now, since the plant will produce a profit of $28.8 million forever, the NPV of this investment opportunity is given by NPV = ($28.8 million / 0.082) - $104.6 million = $246.6 million. Since the NPV is greater than zero you should make the investment.


3. 1. The incremental earning for this project for years 1 and 2 are as follows:
   
   

   Incremental Earnings Forecast ($ millions)	Year 1	Year 2
   Revenues	127.8	157.5
   Less: COGS and Operating expenses	47.1	47.5
   Less: Depreciation	27.1	38.2
   EBIT	53.6	71.8
   Less: Income Tax at 35%	18.8	25.1
   Net Income	34.8	46.7

   
   
   2. Free Cash Flow for years 1 and 2 are as follows:
   
   

   Free Cash Flow ($ millions)	Year 1	Year 2
   Net Income	34.8	46.7
   Plus: Depreciation	27.1	38.2
   Less: Capital expenditure	28.9	42.1
   Less: Increase in NWC	5.7	7.5
   Free Cash Flow	27.3	35.3

   
   
   
   
4. 1. DFB's growth rate of earnings = Retention rate * Return on new investment = ($2.18 / $5.89) * 15.3% = 5.66%.
   2. According to constant dividend growth model, P₀ = Div₁ / (R_e - g) = $3.71 / (0.119 - 0.05663) = $59.48
   3. Repeating the process from a) and b), we have Earning growth rate = ($1.18 / $5.89) * 15.3% = 3.065%. and the stock price will be P₀ = $4.71 / (0.119 - 0.03065) = $53.31
   
   
5. The expected return on investment is: R_i = R_f + Beta_i * ( E[R_Mkt] - R_f )
   
   1. The expected return of starbucks stock = 3% + 1.04 * 6% = 9.24%.
   2. The expected return of Hershey stock = 3% + 0.19 * 6% = 4.14%.
   
   
6. 1. Pear's enterprise value is = $102 billion = $22 billion = $80 billion.
   2. The beta of the firm = 1.63 = Bus/ (Bus + Nonbus) * Beta_Bus + Nonbus/ (Bus + Nonbus) * Beta_Nonbus, where Nonbus refers to the non-business assets of the firm, viz. the cash and the marketable securities. Because the non-business assets are risk free, their beta is zero. Hence, solving, we find that the beta of Pear's business assets = ($102 billion / $80 billion) * 1.63 = 2.078.
   3. Pear's WACC is given by R_WACC = R_f + Beta * (E[R_Mkt] - R_f) = 5% + (2.078 * 4%) = 13.3%.
   
   
7. 1. Even though the working capital is not consumed and it can be recovered once the project is completed, still the time value of the working capital is lost. Hence working capital requirements must be taken into account in evaluating a project.
   2. The standard deviation measures total risk, whereas beta only measures non-diversifiable risk.
   3. Issuance of new equity need not dilute equity; it depends on whether the return on equity on the new funds is greater or less than the return on existing equity. In any case, whether the issuance of new equity is good or not depends on what is done with the funds raised -- if the return on the funds is greater than the required rate of return, then it will be beneficial to existing shareholders, assuming that the firm has not promised more than the required rate of return to the new equity holders.
   4. When firms raise new capital, they do so primarily by issuing debt; however, external capital accounts only for a small proportion of capital invested. A large proportion of capital needs are met from retained earnings. The reason that retained earnings features so prominently in how capital is raised is because there are no information asymmetry problems and there are no transac tions costs associated with using retained earnings.
   5. The two major determinants are the return on equity and the plowback rate.


8. 1. One reason a manager might worry about volatility of cashflows, i.e. total risk instead of just non-diversifiable risk is that total risk affects the probability of bankruptcy. An investor doesn't need to worry about the diversifiable risk component of asset returns, but a manager does need to worry about the probabilty of bankruptcy, since bankruptcy costs are non-zero and can reduce firm value.
   2. If one puts creative freedom first, of course, it's possible to agree with Mr. Dekom. However, can one agree with him about having many investors and have an investor wealth maximization point of view? There are several ways one could look at this issue. One, since each film, in general, is a new "project" and a new "firm," the producer will have to constantly go back to investors for new funding. Hence the agency problem might not be that bad. Second, perhaps the producer and the other creative talent are paid partly with non-pecuniary "creative freedom." If so, then it might be important to structure the investor contract in such a way that creative freedom is not stifled. Having many investors might be one way to get this done simply.

Go to MBA 648 Home Page