Dr. P.V. Viswanath

pviswanath@pace.edu

• Quiz 1
• Solution to Quiz 1
• Examples of questions for Quiz 2
• Quiz 2
• Solution to Quiz 2

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. Please define any (and only) five of the following terms briefly (4 points each):

1. liquidity
2. real assets
3. financial intermediary
4. agency costs
5. free cash flow
6. financial leverage

2. Please answer each of the following three questions in brief (5 points each):

1. What does the sustainable growth rate number tell us?
2. What sorts of firms are likely to pay out more of their earnings in the form of dividends?
3. If agency problems can be mitigated by tying the manager's compensation to the fortuntes of the firm, why don't firms compensate managers exclusively with shares in the firm?

3. Compute the following financial ratios for the Chicago Pizza & Brewery Inc (CHGO), using the information below. For your information, here's some general information on the company, as well.

Chicago Pizza & Brewery, Inc. (BJ's) owns and operates 30 restaurants located in California, Oregon, Colorado, Arizona and Texas, and receives fees from one licensed restaurant in Lahaina, Maui. Each of these restaurants is operated either as a BJ's Restaurant & Brewery, a BJ's Pizza & Grill, a BJ's Restaurant & Brewhouse or a Pietro's Pizza restaurant. The menu at the BJ's restaurants feature BJ's signature deep-dish pizza and BJ's own hand-crafted beers, as well as a selection of appetizers, entrees, pastas, sandwiches, specialty salads and desserts. The eight BJ's Restaurant & Brewery restaurants feature in-house brewing facilities where BJ's hand-crafted beers are produced. The three Pietro's Pizza restaurants serve primarily Pietro's thin-crust pizza in a very casual, counter-service environment.

a. (5 points each) Compute the following ratios for the firm, as of 28 Sept. 2003; where the ratios involve flow numbers, compute them for the quarter ending 28 Sept. 2003.

1. Current ratio
2. Total Debt ratio
3. Times Interest Earned
4. Average Tax Rate
5. Receivables Turnover
6. Return on Assets
7. Return on Equity

b. (5 points each) You have the following additional information -- depreciation for the quarter ended 28 September 2003 is $993,000; the company pays no dividends. Compute the following quantities:

1. Operating Cashflow
2. Changes in Working Capital
3. Net Capital Spending (include Other Assets in your definition of Fixed Assets, along with Property, Plant and Equipment)
4. Cashflow from assets
5. Cashflow to stockholders
6. Cashflow to Creditors (consider Other Liabilities and Deferred Long Term Liability Charges as Long-term Debt categories).

4. Bonus question (10 points): What is the Dupont Identity, and how is it useful?

Solution to Quiz 1

2.

1. The sustainable growth rate tells us how fast the firm can grow without relying on outside equity, i.e. using internal equity and external debt financing in more or less the same ratio to equity as heretofore.
2. Firms that have fewer growth opportunities are among those firms who are likely to pay out more of their earnings as dividends.
3. One reason that managers cannot be compensated exclusively with shares in the firm, is because that would make their portfolio excessively risk. As a result they would require very high expected compensation. This would, normally, not be worthwhile for a firm, especially one that is not the entrepreneurial venture capital stage.

3.a.

1. Current ratio = Current Assets/Current Liabilities = 29545/7530 = 3.92
2. Total Debt ratio = (Total Assets - Total Equity)/Total Assets = (79275-69994)/79275 = 0.117
3. Times Interest Earned = EBIT/Interest = 1491/6 = 248.5
4. Average Tax Rate = 517/1485 = 34.81%
5. Receivables Turnover = Sales/Av. AR = 26744/[(1171+1311)/2] = 21.55
6. Return on Assets = (Net Income + Interest)/Total Assets = (968 + 6)/[(79275+78558)/2] = 1.234%
7. Return on Equity = 968/[(69994+68,646)/2] = 1.40%

3.b. Note from the answers below, that Cashflow from assets = (Cashflows to stockholders + Cashflows to creditors) = -978

1. Operating Cash Flow is defined as EBIT + Depreciation - Taxes = 1491 + 993 - 517 = 1967
2. Change in Net Working Capital = (29545 - 7530) - (32002 - 8765) = -1222
3. Net Capital Spending = Change in Fixed Assets + Depreciation = (44479-41086) + (589-708) + 993 = 4267
4. Cashflow from assets = Operating Cash Flow + Change in Net Working Capital + Net Capital Spending = 1967 - (-1222) - 4267 = -978.
5. Cashflows to stockholders = -[(62375-62156) + (1909-1748)] = -380
6. Cashflows to creditors = Interest - New debt issued = 6 - [(1070-1112) + (681-35)] = -598

4. The DuPont identity decomposes the return on equity to show the contribution of different elements of the firm's decision-making to that return. It is therefore useful in helping the firm concentrate on its strengths or in figuring out what aspect of the firm's operations may need fixing.

Examples of Questions for Quiz 2

1. Check out Problem 3 from the Fall 2003 Midterm at http://webpage.pace.edu/pviswanath/class/632/exam/fal03exa.html.

2. Here is another example. Suppose your firm's dividend payout ratio is 50%, and its return on equity is 12%. If comparable securities yield 12%, what should your firm's shares sell at if the dividend paid yesterday was $12 per share, and 10 year T-bonds yield 4%?

3. Your firm has the opportunity to co-invest with a partner in a project that will require an initial investment of $680,000. The returns from the project will take the form of 5 equal annual payments with the first payment beginning one year from now. You have determined that the risk of the project is similar to the risk of a stock with the ticker LPN. Over the last 5 years, LPN has earned an annual return of 12% per annum. One of the analysts in your firm estimates that the current cost of capital of LPN is 15% per annum. Another analyst believes that the correct opportunity cost for investors who invest in LPN is 17% per annum. You firm has to negotiate with the partner regarding the size of the annual payments. What would you recommend as the minimum annual payment that your firm should receive for investing in the project?

Quiz 2

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. You are trying to price a stock (KPC) that has just paid a dividend of $3 per share (March 9, 2004). It's current dividend payout ratio is 60% and its return on equity is 20%, whereas its return on assets is 15%. The firm expects to maintain the dividend payout ratio for the next ten years (the last dividend payment will be on March 9, 2014). The firm currently has a firm contract to sell all of its assets on March 10, 2014; the purchasing firm, at that time will pay every shareholder the amount of $75. You have identified a set of two firms that are comparable to yours in terms of investor risk; one of those firms is expected to provide investors with a return of 16% according to analysts, while the other firm is expected to provide a return of 17.5%. What would your estimate be of the value of one share of KPC today.

Solution to Quiz 2

The dividend yesterday was $3. Since the payout ratio is 60%, the retention ratio is 40% and the return on equity is 20%. Hence the growth rate in dividends if these statistics remain constant, will be (0.4)(0.2) =0.08 or 8% per annum. Hence the dividend next year will be 3(1.08) or $3.24.

The required rate of return, which is the opportunity cost for investors is 16% if we use firm 1 as our comparable and 17.5%, if we use firm 2 as the comparable. If we have no other information as to which firm is more similar to our firm, then we might just take a simple average of these two numbers, and use 16.75% as the required rate of return. Now, according to the information given to us, shareholders can expect dividends growing at the rate of 8% per annum, for the next 10 years, with the first dividend next year being $3.24. At that time, shareholders can also expect a payment of $75 per share.

Let us first figure out what the firm would be worth today, if it were not to be sold in ten years. In that case, we can simply use the Dividend Growth model and compute the present value as (3.24)/(0.1675 - 0.08) = $37.03. Under these circumstances, the value of the stock in ten years time could be computed in the same way, as (3.24)(1.08)¹⁰/(0.1675 - 0.08) = $37.03(1.08)¹⁰=$79.94. Note that we use (3.24)(1.08)¹⁰ in the numerator because, at the end of 10 years, the dividend for the following year would be (3.24)(1.08)¹⁰, i.e. the (expected) dividend that will be paid next year growing at the computed dividend growth rate of 8% per annum for ten years.

However, this assumes that dividend growth would continue at the same rate forever. If this assumption were valid, then we would not want to accept the deal providing for a $75 purchase price for the stock, in 10 years. And, in this case, the price today would continue to be $37.03. However, if we say that the assumption of an 8% growth rate forever is unrealistic, and we find the $75 price a good deal, we would have to reduce the original price estimate of $37.03 by the discounted present value of $79.94 - $75 = $4.94. The present value of the discount works out to 4.94/(1.1675)¹⁰=1.05. Hence the current price would be $37.03 - 1.05 = $35.98.