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
• 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 will not receive full points.
• Answer any seven of questions 1-8. The first seven questions carry 10 points each. Questions 9 and 10 carry 15 points each.
• Question 9 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. 9 by email by midnight Sunday, March 13, 2011.

1. In March 2005, General Holdings (GH) had book value of equity of $ 116 billion, 10.2 billion shares outstanding, and a market price of $36.02 per share. GH also had cash of $10 billion, and total debt of $363 billion. Four years later, in early 2009, GH had book value of equity of $108 billion, 10.9 billion shares outstanding with market price of $11.35 per share, cash of $52 billion, and total debt of $508 billion.  Over  this period, what was the change in GH’s

1. market capitalization?
2. market-to-book ratio?
3. book debt-equity ratio?
4. market debt-equity ratio?
5. enterprise value?

2. Suppose the firm receives a $5.7 million order on the last day of the year.  You fill the order with $3.9 million worth of inventory. The customer picks up the entire order the same day and pays $2.6 million upfront in cash; you also issue a bill for the customer to pay the remaining balance of $3.1 million in 30 days. Suppose the firm’s tax rate is 0.0 %( i.e. ignore taxes). Determine the consequences of this transaction on each of the following:

1. revenues
2. receivables
3. earnings
4. inventory
5. cash

3. Consider a portfolio of two securities: one share of Citigroup stock and a bond that pays $100 in one year. Suppose this portfolio is currently trading with a bid price of $133.60 and ask price of $134.20, and the bond is trading with a bid price of $96.30 and ask price of $96.50. In this case, what is the no-arbitrage price range for Citigroup stock?

4. You have an investment opportunity in Japan. It requires an investment of $3 million today and will produce a cash flow of ¥348 million in one year with no risk. Suppose the risk free rate in the United States is 7%, the risk free rate is Japan is 4%, and the current competitive exchange rate is ¥110 per dollar. What is the NPV of the investment? Is it a good opportunity?

5. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year and will be $1000. Each year after that, you will receive a payment on the anniversary of the last payment that is 4% larger than the last payment. This pattern of payments will go forever. If the interest rate is 14% per year,

1. What is today’s book value of bequest?
2. What is the value of the bequest immediately after the first payment is made?

6. Your grandmother bought an annuity from Rock Solid Life Insurance Company for $260,000 when she retired. In exchange for the $260,000, Rock Solid will pay her $30,000 per year until she dies. The interest rate is 6%. How long must she live after the day she retired to come out ahead (that is, to get more in value than what she paid in)? Show the formulas and provide an approximate answer.

7. The mortgage on your house is five years old. It required monthly payments of $1450, had an original term of 30 years and had an interest rate of 10 % (APR). In the intervening five years, interest rates have fallen. So, you have decided to refinance - that is, you will roll over the outstanding balance into a new mortgage. The new mortgage has 30 years term, requires monthly paymenta, and  has an interest rate of 6.125%(APR)

1. What monthly payments will be required with the new loan?
2. If you want to pay off the mortgage in 25 years, what monthly payments should you make after refinancing?
3. (bonus) Suppose you continue to make monthly payments of 1450. How long will it take for you to pay off the mortgage after refinancing?

8. Your uncle Fred just purchased a new boat. He brags to you about the low 7.1 % interest rate. (APR, monthly compounding) he obtained from the dealer. The rate is even lower than the rate he could have obtained on his home equity loan (8.15% APR, monthly compounding). But if his tax rate is 26% and interest on home equity is tax deductible, which loan is truly cheaper? What is the after tax cost on the home equity loan?

9. (15 points) The following description is taken in a slightly paraphrased form from Jonathan Berk and Peter DeMarzo's textbook, "Corporate Finance" 2nd edition, page 513:

In Chapter 7 bankruptcy, a trustee is appointed to oversee the liquidation of the firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist. In Chapter 11 bankruptcy, all pending collection attempts of creditors are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan. While developing the plan, management continues to operate the business. ... The creditors must vote to accept the plan, and it must be approved by the bankruptcy court. If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm.

When discussing corporate governance, we noted that it was the entirety of a corporation's organization and structure as well as the contracts, implied and explicit between the firm and its stakeholders and we suggested that the goal of the firm's governance structure was to maximize firm value, i.e. the sum of the values accruing to all its stakeholders. If this is true, then the choice of Chapter 7 or 11 in bankruptcy should be guided by which one maximizes firm value. The bankruptcy petition of Borders Group, Inc. in the United States Bankruptcy Court of the Southern District of New York, was filed on Feb. 16, 2011 by Scott Henry, the CFO of the Borders Group and is available online at http://www.bordersreorganization.com/pdflib/20_10614.pdf.

Read the introductory paragraphs 1-6 and specific portions of the General Background, viz. sections A-B and D-H (i.e. paragraphs 7-14 and 21-34 , which are to be found between pages 3 and 11, skipping section C) and section J ("Restructuring Goals" paragraphs 47-49, page 16). Then answer the following questions:

1. Do you think Chapter 7 or Chapter 11 is most appropriate for Borders, Inc., assuming that the objective is firm value maximization? Use the information provided and any other information you may wish to obtain on the Internet. You don't have to accept management's conclusions or opinions.
2. According to the 10-Q statement filed by the company on 12/9/2010, the number of shares outstanding were about 72 million. Michael Edwards (557,000 shares), the CEO of the company and Scott Henry, the CFO (200,000 shares) were the largest direct shareholders of the company (shareholding data from http://finance.yahoo.com/q/mh?s=BGP+Major+Holders). Do you think that the current bankruptcy law, which allows existing management to propose a reorganization plan is conducive to the presumed goal of firm value maximization? Explain your answer, with reference to the Borders case. If you don't think that the current rules are optimal, how would you change them?

10. (15 points) Answer any five of the following questions:

1. What is the role of the stock market in stockholder wealth maximization?
2. Firm stakeholders are not going to participate in a firm if it does not create value for them. Hence, one could conclude that maximization of firm value is the ultimate objective of a firm. But if firm value is paramount, why is stockholder value relevant?
3. Explain how the financial system facilitates the sharing and transfer of risk. Provide two different examples.
4. How can the existence of different bid and ask prices be consistent with the notion of the law of one price?
5. What information do we get from a yield curve?
6. What is moral hazard? Give an example in the context of a business.

Midterm Solutions

1. a. Market Capitalization:
2005 market capitalization: 10.2 billion shares*$36.02 per share=$367.4 billion
2009 market capitalization: 10.9 billion shares*$11.35 per share=$123.7 billion
So, the change over the period is $123.7 billion- $367.4 billion= -$243.7 billion.

b. Market-to-book ratio:
2005 Market-to-Book = $367.4 billion/$116 billion= 3.17
2009 Market-to-Book= $123.7 billion/$108 billion= 1.15
The change over this period is 1.15-3.17= -2.02

c. Book debt-equity ratio
2005 Book debt to equity: $363 billion/$116 billion=3.13
2009 Book debt to equity: $508 billion/$108 billion=4.70
The change over the period is 1.57.

d. Market debt-equity ratio:
2005 Market debt to equity: $363 billion/=$367.4 billion=0.99
2009 Market debt to equity:$508 billion/$123.7 billion=4.11
The change over the period is 4.11-0.99=3.12

e. Enterprise value = Equity + Debt - Cash:
2005 enterprise value: $367.4 billion-$10 billion+$363 billion=$720.4 billion
2009 enterprise value: $123.7 billion-$52 billion+$508 billion=$579.7 billion
The change over the period is -140.7 billion.

2.

1. Revenues increases by $5.7 million.
2. Receivables increases by $5.7 million-$2.6 million=$3.1 million.
3. Earnings increases by $5.7 million-$3.9 million=$1.8 million.
4. Inventory decreases by $3.9 million.
5. Cash increases by $2.6 million.

3. To answer this question, we have to ask ourselves -- how can we obtain arbitrage profits? We can buy Citigroup stock by buying the portfolio and selling the bond. The cost of buying Citigroup stock is this: -134.20(buy portfolio at ask price) +$96.30(sell bond at bid price)=  -$37.9. So, if we can sell Citigroup stock for more than $37.9, we can earn an arbitrage profit by buying the portfolio and selling Citigroup stock.
We can also sell Citigroup stock by selling the portfolio and buying the bond. We can earn +$133.60(sell portfolio at bid price)-$96.50(buy bond at ask price)= $37.1. If we can buy Citigroup for less than $37.1, there is an arbitrage opportunity. Thus, no arbitrage implies that the competitive price of Citigroup stock can be between $37.10 and $37.90.

4. The cash inflow is ¥348 million in one year; this is worth ¥348/1.04 = ¥334.615 million today. In dollar terms, this is equal to ¥334.615/110 =$3.042 million today. The NPV=$3.042 million-$3 million= 0.042 million > 0; so, this is a good opportunity.
One thing to keep in mind is that when we make a capital budgeting decision, all we are asking is -- is this a good investment today, given what we know? If it is, then we invest. We don't want to ask the question -- can I ever lose money on this? You could, if you were a)extremely risk averse and b)couldn't find anybody to take the risk off your hands at the market price of risk.
However, in the case of our problem, the only uncertainty is the exchange rate; but you can always use a combination of borrowing/lending and moving from yen to dollar in spot exchange markets to get a certain profit of $0.42m or the equivalent in yen.

5.a. To find the value, use the formula present value of the growing perpetuity, PV=C/(r-g), where C is the first payment, r is interest rate and g is the growth rate. We find that PV=$1000/(0.14-0.04) =$10000.

b. To find the value of bequest immediately after the first payment is made, use the formula present value of the growing perpetuity, once more:
PV=C/(r-g), where C is the first payment, r is interest rate and g is growth rate. We find PV=$1000*1.04/(0.14-0.04)=$10400.

6. Suppose N is the year when your grandmother dies and her cash flow stops. Your grandmother breaks even when the NPV of the cash flow is zero. That is, let NPV= -$260000+ [(30000/0.06)(1-(1/1.06^N))]= 0. Solving for N, we find (1-(1/1.06^N)) = 260000*0.06/$30000, i.e. (1-(1/1.06^N))=0.52, which becomes 1.06^N=1/0.48. Using logs, we can solve to find N= 12.6 years. So if she lives for 13 years, she will come out ahead.
(Note that, we round up because she does not receive partial mid-year payments.)

7. a. To calculate the outstanding balance of original mortgage today, we first note that there are 25x12 months=300 months remaining on the loan. The monthly discount rate is 10%/12=0.8333%. So, the outstanding balance can be computed using the present value formula, PV = [(1450/0.008333)(1-(1/1.008333³⁰⁰))]=$159568.
The next step would be to find the loan payment on the new mortgage. The monthly discount rate on the new loan is the new loan rate of 6.125%/12=0.5104%. Solving the equation [(C/0.005104)(1-(1/1.005104³⁶⁰))]=$159568, we find C=$969.53.

b. Solving the equation [(C/0.005104)(1-(1/1.005104³⁰⁰))]=$159568, we find C=$1040.28.

c. We have to solve the equation [(1450/0.005104)(1-(1/1.005104ⁿ))]=$159568. We get 0.5617 = (1-(1/1.005104ⁿ); or (1/1.005104ⁿ) = 0.4383; or 1.005104ⁿ = 1/0.4383 = 2.28153. Taking logs, we find that n = log(2.28153)/log(1.00514) = 162; i.e. the loan would be paid off in 13 years and 6 months.

8. Because the taxes are usually paid annually, we first convert the home equity loan to an EAR to determine the actual amount of interest during that year. The after tax cost of home equity loan, which is tax-deductible, is [(1+0.0815/12)¹²-1](1-0.26) or 6.26%. The dealer's boat loan has a cost of [(1+0.071/12)¹²-1]=7.34%. Hence the after tax cost of home equity loan is cheaper at 6.26% than the dealer’s boat loan at 7.34%.

9.

1. Management is trying to argue that it should be given an opportunity to reorganize, i.e that Chapter 11 is most appropriate. However, given the information provided in the bankruptcy petition, it could be argued that Chapter 7 is more appropriate than Chapter 11. It would seem that the Borders stores are not doing well because of strong competition that Borders has not been able to counter because it did not take timely measures to fight them. As the petition itself says in Section H29 on page 10, "A variety of external economic and competitive factors have led to a substantial decline in the Debtors' profitability and liquidity. Foremost among those external factors are the economic factors which have led to a decline in consumer discretionary spending, and the rise of competitive forces in the marketplace."
   What we see here is not a company in financial difficulties because it has overextended itself in terms of financial obligations and hence needs a chance to reorganize them. Rather, it seems to be a case of the business itself being in bad shape. The management could be construed as simply asking the creditors for a free option on the assets of the firm in the form of delaying payment on the debt. If management's strategy works out, then creditors get paid and stockholder retain value and management gets to keep their job. If not, then bondholders lose even more value than if they were given control of the assets of the firm immediately.
2. Since management is going to be more interested in ensuring that their jobs are kept intact, they might have an incentive to push for Chapter 11, rather than Chapter 7, even when it's in the interests of firm value maximization to liquidate the firm. For example, in the case of Borders, not only would management lose their jobs if the company were liquidated, but in addition, the CEO and the CFO are large shareholders of the firm; the CEO holds about 0.75% of the shares outstanding. While this is not a large number, in terms of the proportion of total shares outstanding, it's still a large number of shares. For example, the stock price on May 21, 2010 was $2.24, so the value of the CEO's shares would have been about $1.12m. The present value of continuing employment at Borders, compared to second best employment elsewhere might be even more.
   Hence this might be an argument against allowing management to provide a reorganization plan. On the other hand, management is probably best suited to draw up a reorganization plan, so this argument is certainly not conclusive. It's also not clear what a better alternative would be.

10.

1. If the stock market is efficient, then the stock price measures the true value of the stock and the manager can use it as a guide to evaluate the optimality of his/her actions.
2. Maximization of firm value might make overall sense. However, by giving managers the goal of maximizing firm value, we set up a system of multiple monitors. This could lead to inefficient monitoring, since what provides value for one stakeholder is not necessarily desirable for another stakeholder. Since stockholders are residual claimants and thus having the most to gain by firm value maximization, it makes sense, therefore, to make them the ultimate monitors of management. But this can only work if management is beholden to stockholders alone, i.e. if the managerial objective is the maximization of stockholder wealth. What do we do, then, about the objectives of other stakeholders? The (second-best) solution is for other stakeholders to resort to contractual stipulations -- to the extent that managerial actions are observable, this would allow stakeholders to force management to take their well-being into account, as well.
3. The financial system facilitates the sharing and transfer of risk by creating securities or contracts with payoffs of differing risk. Buying and selling these securities then allows investors to change their risk profile. Furthermore, buy buying derivative securities such as options and futures, investors can actually take on new risk or reduce their existing risk. Examples are the sale of insurance policies and call options on stock or credit-default swaps. Keep in mind that selling shares transfers everything -- expected cashflows as well as risk -- so it's not really a way of transferring risk alone!
4. The law of one price does not require all prices to be the same, if the procedure of buying and selling is costly. Thus, if the maintenance of inventories or the process of searching for willing buyers/sellers is costly, then in equilibrium, the price at which dealers (of a good or security) are willing to buy the good will be lower than the price at which they are willing to sell it. The difference is simply compensation to the dealer for his out-of-pocket costs or for taking on risk.
5. The shape of a yield curve provides us with information about future economic activity; for example, a downward sloping yield curve usually implies that the economy is expected to go into a downturn. The slope of the yield curve also provides us with estimates of future interest rates.
6. Moral hazard refers to a problem of information asymmetry that manifests itself in distorted incentives after two parties enter into a contract that initiates a relationship. Thus, after a firm issues debt, managers acting on behalf of stockholders have an incentive to take excessive debt or pay excessive dividends that actually reduce the value of the firm as a whole, but hurt only bondholders, while benefiting stockholders. Another example is the incentive for an insured person to take excessive risks or to take insufficient precautions to avoid risk.

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. The final decision as to what is acceptable on your formula sheet will be mine.
• You must explain all your answers. Answers without explanations may not receive any points.
• Answer any five of questions 1-6. Questions 7 and 8 are compulsory.

1. What is the IRR of this investment? You don't have to compute the actual IRR. Simply provide a range that is no more than 10% points wide, within which the true IRR must lie. However, make sure that you show your iterations. Simply using your financial calculator to obtain the IRR and then constructing a range will not suffice.
2. If you are choosing between this investment and putting your money in a safe bank account that pays an EAR of 5% a year for any horizon, can you make the decision simply by comparing this EAR with the IRR of the investment? Explain.

2. (12 points) You decide HomeNet has the following assumptions: Sales of 50,000 units in year 1 increasing by 47,000 units per year over the life of hte project, a year 1 sales price of $260/unit, decreasing by 10% annually and a year 1 cost of $120/unit decreasing by 21% annually In addition, new tax laws allow you to depreciate the equipment, costing $7.5 million, over three years using straight-line depreciation. R&D expenses total $15 million in year 0 and selling, general, and administrative expenses (SGA) are $2.8 million per year (assuming there is no cannibalization). Under these assumptions the unlevered net income is shown below in hte table:

Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to custromers). Furthermore, assume that HomeNet will have no working capital requirements.

1. Calculate HomeNet's FCF for each year.
2. If the discount rate is 10%, is the project worth investing in?

3. (12 points) The Isabelle Corporation rents prom dresses in its stores across the southern US. It has just issued a five-year zero coupon corporate bond at a price of $73 (assume $100 face value). You have purchased this bond and intend to hold it until maturity.

1. What is the yield-to-maturity of this bond?
2. What is the expected return on your investment (expressed as an EAR) if there is no chance of default?
3. What is the expected return (expressed as an EAR) if the probability of default is 50% and, in the case of default, you will recover 90% of the face value?
4. What can you say about the five-year risk-free rate of return?

4. (12 points) Halliford Corporation expects to have earnings this coming year of $2.67 per share. Halliford plans to retain all of its earnings for the next two years. It will then retain 19% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 22% per annum. Any earnings that are not retained will be paid as dividends. Assume Halliford's share count remains constant and all earnings growth comes from the investment of retained earnings. If Halliford's equity cost of capital is 8.8%, what price would you estimate for Halliford's stock?

5. (12 points) Consider two worlds. The expected return and volatility of all stocks in both worlds is the same. In the first worlds, all stocks move together -- in good times, all prices go up together, and in bad times they all fall together. In the second world, stock returns are independent -- one stock increasing in price has no effect on the prices of other stocks.

1. Suppose you are a risk-averse investor. Suppose, further, that because of a miracle, you actually have the option of choosing once of the worlds to invest in. Which world would you choose to invest in?
2. Suppose the investors in both worlds were risk-averse like you (but, of course, unlike you they do not have the option of choosing their world -- they have to invest in whatever world they happen to find themselves in), would it be possible for the expected return and volatility of all stocks in both worlds to be the same? Explain.

6. (12 points) Global Pistons (GP) has common stock with a market value of $600 million and debt with a value of $100 million. Investors expect a 17% return on the stock and a 7% return on the debt. Assume perfect capital markets.

1. Suppose GP issues $100 million of new stock to buy back the debt. What is the expected return of the stock after this transaction?
2. Suppose GP instead issues $139.62 million of new debt to repurchase stock.
   1. If the risk of the debt does not change, what is the expected return of the stock after this transaction?
   2. If the risk of the debt increases, would the expected return of the stock be higher or lower than when debt is issued to repurchase stock in the last question? Explain.

7. Read the following excerpt from an article in the Economist of March 3, 2011 and answer the following questions:

1. (10 points) There are two basic arguments for efficient markets. One, investors have no reason to pay more for assets than they are worth; the flip side of this point is that sellers of assets will not sell them for less than their true worth. Two, even if some investors pay too much for an asset, other investors who are more savvy will short-sell them and make money when the assets drop down to their true value. This action by arbitrageurs will, itself, force market prices to correct; again, the flip side of this argument is that if some investors don't pay enough for specific assets and they are undervalued, other more savvy investors will buy them and force their prices to rise. In the light of this information, explain why property markets are inefficient.
2. (10 points) Volatility in property markets is obviously bad for the economy, witness the recent crash of the US financial system. How would you fix this problem? Answer only with respect to the issues raised in the excerpt.

Bricks and Slaughter: Property is widely seen as a safe asset. It is arguably the most dangerous of all, says Andrew Palmer

...

Another reason for momentum in property markets is the fact that there are no short-sellers. If you think property is overpriced, it is difficult to profit from that view. As Adam Levitin of Georgetown University Law Centre and Susan Wachter of the University of Pennsylvania pointed out in a recent paper on the causes of the housing bubble in America, it is impossible to borrow the Empire State Building in order to sell New York real estate short. HSBC probably came closest by selling its Canary Wharf tower in London for £1.1 billion ($2.18 billion) in 2007 and buying it back from its debt-laden Spanish owners for £250m less in late 2008—the greatest short sale in the history of property, says one observer. Some investors infamously did make money from betting against American subprime mortgages, but their real achievement was to find a way of doing so, by buying up credit-default swaps that paid out when mortgage-backed securities soured.

There have been attempts to create instruments that allow property to be hedged or shorted. Mr Shiller himself has been involved in launching derivatives linked to home-price indices for both large and small investors, but with limited success to date. Commercial-property derivatives, however, are gaining ground.

Such products are conceptually appealing but face several obstacles. Some are common to all financial innovations: new products lack enough liquidity to lure buyers in, for example. Others are more specific to property. Individual properties and neighbourhoods differ, which makes it hard to construct accurate hedges. Government interventions to shore up the housing market add an extra element of unpredictability. And since house-price cycles tend to last for a long time, says Mike Poulos of Oliver Wyman, a consultancy, it can be expensive to sustain a short position.

Up, up and away with the fairies

The effects of buying a home when prices are rising are insidious. A 2008 paper by Hugo Benitez-Silva, Selcuk Eren, Frank Heiland and Sergi Jiménez-Martín used the Health and Retirement Study, a biennial survey of Americans over the age of 50, to compare people’s estimates of the value of their homes with actual values when a sale took place. The authors found that homeowners overestimate the value of their homes by an average of 5-10%. Those who had bought during good times tended to be more optimistic in their valuations, whereas those who had bought during a downturn were more realistic. Expectations of higher prices explain why bubble-era buyers were more willing to buy risky mortgage products and take on ever greater quantities of debt. The amount of mortgage debt in America almost doubled between 2001 and 2007, to $10.5 trillion.

The rich-world buyers of today ought to be more realistic about the future value of their homes, but attitudes are deeply entrenched. When asked to rate the safety of various investments, two-thirds of the respondents in the Fannie Mae survey classed homeownership as a safe investment, compared with just 15% for buying shares. Only savings accounts and money-market funds, both of which enjoyed an explicit government guarantee during the financial crisis, scored higher than homes. Homeowners who were “under water” on their mortgages (ie, they owed more than their properties were worth) were just as sure as everyone else that housing was a safe investment.

8. (20 points) Answer any four of the following questions:

1. Interest payments are deductible for computation of corporate tax. This would suggest that all firms would want to maximize their interest rate deductions. Still, the average ratio of amount of interest paid to EBIT was rarely above 50% for S&P 500 firms from 1975 to 2005. How would you explain this?
2. What factors other than the beta of a stock estimated with respect to a large diversified equity portfolio seem to be empirically important in predicting the average return on stocks?
3. Stock prices typically rise when the firm makes an announcement of a new product. Is this consistent with the Efficient Market Hypothesis? Explain.
4. 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.
5. Which prices are more volatile -- those of long-term bonds or those of short-term bonds? Why?

Solutions to Final Exam

1. a. Suppose all the money were available only in five years, the IRR would be [(960+810)/630]^1/5 -1 = 22.95%. Hence the true IRR is greater than this. Suppose we try 32.95%. In this case, the NPV would be -630 + 960/1.3395⁵+ 810/1.3295² = $59.37. Hence the true IRR is even higher. Now, if we try 42.95, the NPV is -72.79. Hence the true IRR is between 32.95% and 42.95%.

b. Since the two opportunities are both safe and since we're comparing flat term structures in both cases, we know that the two investments can be compared by discounting the cashflows from the investment opportunity using the 5% opportunity cost of capital. We also know that since the cashflows of the investment opportunity, do not switch sign, the NPV profile is downward sloping. Hence the NPV of the investment opportunity using the 5% discount rate will be positive. In this way, we see that the investment opportunity and the bank deposit can be compared without any logical problem.

2.

1. The yield-to-maturity is [100/73]^1/5 -1 = 6.5%.
2. The EAR is also 6.5%.
3. The expected cashflow is 100(0.5)+0.5(90) = 95. Hence the expected yield-to-maturity is [95/73]^1/5 -1 = 5.41%.
4. You would expect the five-year risk-free rate of return to be less than 5.4%.

3.

The NPV, thus, works out to $10,188.71 (in '000s). Hence the project is worth taking.

4. Since the retention rate is 100% for the next two years, earnings will grow at the rate of 22% (retention rate x ROE). Hence at the end of year 3, the earnings will be 2.67(1.22)² = $3.974. The dividend that period will be 3.974(1-0.81) = $3.219. The growth rate in dividends from then on, will be 0.19(0.22) = 0.0418 or 4.18%. Hence the price of the stock at the end of period 2 will be 3.219/(0.088-0.0418) = $69.67. For the first two periods, there will be no dividends, since the retention ratio is 100%. The price of the stock today, therefore, is simply 69.67/(1.088)² = $58.86

5.

1. The second world would be preferable because of diversification. Hence the volatility of my portfolio returns would lower.
2. The expected returns in the second world should be lower because the investor risk is lower.

6.

1. The weighted average cost of capital is 17(600/700) + 7(100/700) = 15.57%. If GP issues $100 million of new stock to buy back the debt, there will be no debt at all; in that case, since the WACC will remain the same, it will also be the required rate of return on the equity, viz. 15.57%.
2. 1. If GP issues $139.62 million of new debt to repurchase stock, the required rate of return on the debt would remain 7%. However, the required rate of return on the stock, y, would have to satisfy y((600-139.62)/700)+((100+139.62)/700)(7) = 15.57. Solving, we find y = 20.03%.
   2. If the risk of the debt increases, the expected return on the stock would be lower, because the expected return on the debt would be higher, but the WACC would still remain the same. Another way of thinking of this is as follows: since the operations of the firm are not changing, the required rate of return on the firm as a whole is not going to change -- it will remain at 15.57%; hence, if the risk of the debt increases, this means that debt-holders are taking more of the risk and correspondingly equity holders are taking less of the risk.

7.

1. According to the argument made in the article, investors make irrational decisions because they tend to be excessively optimistic. This causes house-buyers to pay too much for real estate. However, more rational investors are not able to capitalize on this overpricing because they would need to short sell, and short-selling is expensive.
2. The solution is to address the two problems. One is to educate home-buyers. The other is to develop a liquid real estate derivatives market. Of course, the real question is -- how can this be done. Here's what one student said (in my words and augmented by my ideas): set up a transparent valuation system that would be based on several objective factors, such as number of bedrooms, transactions prices of nearby houses, proximity to transportation, acreage etc. Then use existing housing data to allow home buyers to value houses based on the factor scores of the houses that they are interested in. Of course buyers can still choose to pay more. But this would create more transparency and objectivity. This is somewhat similar to the requirement that securities exchanges report transactions prices on a timely basis, with an added model to account for the heterogeneity of the housing market.
   Another method might be to tax housing transactions, similar to the proposed securities transactions tax. This might reduce the value of a house in the sight of intending buyers. Of course, this might cause more fraud through buyers and sellers masking the true price.

8.

1. The average ratio of amount of interest paid to EBIT cannot go too high for two reasons. One, bond investors have to pay tax on interest income, even if corporations don't. Second, there are agency costs of debt, as well as bankruptcy costs which have to be incurred when a firm goes bankrupt due to excessive debt.
2. Empirically, at least three other factors seem to be important in explaining average stock returns. One, the movement of the prices of stocks with high book-to-market ratio, the prices of stocks with low market capitalization, and stock return momentum.
3. Yes, this consistent with the Efficient Market Hypothesis because firms usually introduce new products only if they are profitable and the NPV is positive. Hence a new product announcement is good news.
4. Even though 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.
5. Long-term bonds are more volatile. This is because changes in interest rates affect cash flows (coupon payments) over many periods. Furthermore, the discount factor for farther cash flows is affected much more in percentage terms for a given change in interest rates because the discounting function is nonlinear. However, the lower volatility of longer-term yields causes longer-term bond price volatility to be less than it would be otherwise. Nevertheless, longer-term bonds are, indeed, more volatile than shorter-term bonds.

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