| |
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.
- 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.
- (21 points) Read the article below and answer the following questions:
- You may already know that the vote at the Chattanooga plant went against the union. While the concept of a union to battle for workers rights fits in with the usual adversarial model of stockholders against employees, this particular union vote was supported by VW management as a necessary step to establish a works council. From one opint of view, this is very unusual. Stockholders contribute capital, in return for residual claims to firm cashflows and thus have an indirect say (through board of directors elections) in the employment of the firms' managers who have a fiduciary responsibility to shareholders; employees, on the other hand, have a contractual relationship with the firm - they provide labor and they get compensated for it. Managers, as shareholder representatives, decide how the firm is run. Why would a firm establish a council that would seem to usurp shareholder rights by allowing employee representatives to share in "managerial" decision-making prerogatives?
- You may or may not have been able to justify the concept of workers councils in part (a). Still, workers councils only discuss staffing schedules and working conditions. What would you say to allowing workers to elect representatives to the board of directors? Would this be going too far? Could this be justified?
- Propose and justify participation in the board of directors for another group, that does not legally have such representation, currently.
"Why Volkswagen is helping a union organize its own plant," by Lydia DePillis, Washington Post, February 10, 2014.
This week at Volkswagen's plant in Chattanooga, Tenn., 1,570 workers will vote on whether to join the United Auto Workers. It's a big deal: While the big three American carmakers are all unionized, so far the foreign companies have avoided it by locating in Southern states with strong Right to Work laws. From their perspective, unions usually just mean work stoppages, expensive benefit plans, and the inability to fire people at will.
That's what's weird about the VW vote: The German company is campaigning for the UAW, not against it, in a kind of employer-union partnership America has seldom seen. What gives?
Well, VW is kind of different, as automakers go. It understands how having a union can boost productivity and allow it greater flexibility in adjusting to downturns. It should know: The rest of its plants are unionized too.
This would also be something new for the United Auto Workers. They wouldn't have the same relationship with VW as they do with Chrysler, General Motors, and Ford. Rather, the idea is to create something called a "works council," which are widespread across Europe and enjoy tremendous influence over how plants are run. In America, that kind of body can't be established without a union vote -- but crucially, the works council would be independent of the union, meaning the UAW would give up some control as soon as it gained it.
While the details of the arrangement would be ironed out after the election, works councils -- which are elected by all workers in a factory, both blue and white collar, whether or not they belong to the union -- usually help decide things like staffing schedules and working conditions, while the union bargains on wages and benefits. They have the right to review certain types of information about how the company is doing financially, which often means that they're more sympathetic towards management's desire to make cutbacks when times are tough. During the recession, for example, German works councils helped the company reduce hours across the board rather than laying people off, containing unemployment until the economy recovered.
In the early 1990s, Harvard labor law expert Paul C. Weiler interviewed managers about why they valued works councils. One representative executive told him:
There are three major advantages of councils. You're forced to consider in your decision making process the effect on the employees in advance…this avoids costly mistakes. Second, works councils will in the final run support the company. They will take into account the pressing needs of the company more than a trade union can, on the outside. And third, works councils explain and defend certain decisions of the company towards the employees. Once decisions are made, they are easier to implement.
In that way, works councils can be an ally of management in keeping the business strong for the sake of keeping workers employed over the long term. Weiler was given this example:
[The parent company made] an agreement with the works council to introduce a flexible work-time system, around-the-clock operation through Saturday, starting again Sunday night. They were under tremendous pressure from the union not to do this, but let us go ahead. We couldn't have gotten that out of the union.… Our works council people are not hostile to rationalization of automation. On the contrary, they ask us to automate, to modernize our machinery so that our operations can be competitive. They say, 'We know that we lose jobs by this, but we agree that this is a good thing.'
Works councils are also typically not allowed to call strikes, but they also don't usually need to, because their authority is baked into their agreements with the company (and, in Europe, usually enforced by law). If the UAW wants to strike over wages and benefits, it's still able to do so, but the likelihood of arriving at a mutually agreeable solution without one is much higher.
That's why VW wants its plant to go union. According to VW's global works council leader, Bernard Osterloh, the company even sees its culture of worker codetermination as a "competitive advantage."
That doesn't mean, however, that the vote is unopposed. National anti-union groups and the state's Republican leaders are campaigning against the UAW, saying unionization will spread like a contagion through Tennessee's other auto plants. “Then it’s BMW, then it’s Mercedes, then it’s Nissan, hurting the entire Southeast if they get the momentum," said Sen. Bob Corker (R.-Tenn.).
BMW likes its works councils too, though. Apparently, some politicians think they know what's good for auto makers better than the companies do themselves.
- (24 points) Answer any four of the following questions:
- What is adverse selection? Give an example of adverse selection in the context of a corporation.
- How is the role of the stock market in stock value maximization?
- What is the difference between the sustainable growth rate and the internal growth rate?
- What happens to the control of the firm in bankruptcy?
- Explain how the financial system facilitates the sharing and transfer of risk. Provide two examples; at least one of them should use derivatives and you should provide some context as to how risk is transferred or shared (i.e. don't just give the name of the derivative).
- You borrowed money to buy your $2.5m. house five years ago. At that time, you had to put down a 20% down payment and the bank lent you the rest of the money at an APR of 12.68% p.a. on a 25 year mortgage with monthly payments. You have just made your sixtieth payment. You now wish to refinance your mortgage at the now available APR of 11% p.a. The new loan will be a 20-year loan.
- (10 points) If you wanted to pay off your existing loan right now, how much will you have to pay the bank?
- (5 points) If a friend offered to lend you the money to pay off your existing loan, would you borrow from him or would you refinance the loan? Your friend is currently getting a return of 11.5% on his investments and while he doesn't want to make any more money off you, he also doesn't want to lose money by lending to you.
- (8 points) If you decide to go with the new mortgage, what will your new monthly payments be?
- (18 points) Using the information below, answer the following questions:
- What is the quick ratio for HD, as of February 13, 2013? Use the definition "Total Current Assets less Inventory less Other Current Assets" ÷ Current Liabilities. What is the quick ratio as of Jan. 30, 2011? What would you conclude from these two numbers?
- Suppose you were told that the items under "Other Current Assets" were more liquid than Inventories. Would you modify the definition of the quick ratio from part (a), keeping in mind the purpose of the quick ratio? If yes, how would you modify it?
- Compute the average collection period for the year ending February 3, 2013. Compute the same number for the year ended January 29, 2012. What do you conclude from a comparison of these two numbers?
- (Bonus, 5 points) Suppose you were told that 50% of the sales for the year ending January 29, 2012 were cash sales, whereas only 25% of the sales for the year ending Febuary 3, 2013 were cash sales and the rest were credit sales. How would this information affect your conclusion in part (c)?
Income Statement for The Home Depot, Inc. (HD)
| Period Ending |
Feb 3, 2013 |
Jan 29, 2012 |
Jan 30, 2011 |
| Total Revenue |
74,754,000 |
70,395,000 |
67,997,000 |
| Cost of Revenue |
48,912,000 |
46,133,000 |
44,693,000 |
|
| Gross Profit |
25,842,000 |
24,262,000 |
23,304,000 |
|
|
Operating Expenses |
|
Research Development |
- |
- |
- |
|
Selling General and Administrative |
16,508,000 |
16,028,000 |
15,849,000 |
|
Non Recurring |
- |
- |
- |
|
Others |
1,568,000 |
1,573,000 |
1,616,000 |
|
|
|
Total Operating Expenses |
- |
- |
- |
|
|
| Operating Income or Loss |
7,766,000 |
6,661,000 |
5,839,000 |
|
|
Income from Continuing Operations |
|
Total Other Income/Expenses Net |
87,000 |
13,000 |
(36,000) |
|
Earnings Before Interest And Taxes |
7,853,000 |
6,674,000 |
5,803,000 |
|
Interest Expense |
632,000 |
606,000 |
530,000 |
|
Income Before Tax |
7,221,000 |
6,068,000 |
5,273,000 |
|
Income Tax Expense |
2,686,000 |
2,185,000 |
1,935,000 |
|
Minority Interest |
- |
- |
- |
|
|
|
Net Income From Continuing Ops |
4,535,000 |
3,883,000 |
3,338,000 |
|
|
Non-recurring Events |
|
Discontinued Operations |
- |
- |
- |
|
Extraordinary Items |
- |
- |
- |
|
Effect Of Accounting Changes |
- |
- |
- |
|
Other Items |
- |
- |
- |
|
|
| Net Income |
4,535,000 |
3,883,000 |
3,338,000 |
| Preferred Stock And Other Adjustments |
- |
- |
- |
|
| Net Income Applicable To Common Shares |
4,535,000 |
3,883,000 |
3,338,000 |
Balance Sheet for The Home Depot, Inc. (HD)
| Period Ending |
Feb 3, 2013 |
Jan 29, 2012 |
Jan 30, 2011 |
|
| Assets |
| Current Assets |
|
Cash And Cash Equivalents |
2,494,000 |
1,987,000 |
545,000 |
|
Short Term Investments |
- |
- |
- |
|
Net Receivables |
1,395,000 |
1,245,000 |
1,085,000 |
|
Inventory |
10,710,000 |
10,325,000 |
10,625,000 |
|
Other Current Assets |
773,000 |
963,000 |
1,224,000 |
|
| Total Current Assets |
15,372,000 |
14,520,000 |
13,479,000 |
| Long Term Investments |
140,000 |
135,000 |
139,000 |
| Property Plant and Equipment |
24,069,000 |
24,448,000 |
25,060,000 |
| Goodwill |
1,170,000 |
1,120,000 |
1,187,000 |
| Intangible Assets |
- |
- |
- |
| Accumulated Amortization |
- |
- |
- |
| Other Assets |
333,000 |
295,000 |
260,000 |
| Deferred Long Term Asset Charges |
- |
- |
- |
|
| Total Assets |
41,084,000 |
40,518,000 |
40,125,000 |
|
| Liabilities |
| Current Liabilities |
|
Accounts Payable |
8,871,000 |
8,199,000 |
7,903,000 |
|
Short/Current Long Term Debt |
1,321,000 |
30,000 |
1,042,000 |
|
Other Current Liabilities |
1,270,000 |
1,147,000 |
1,177,000 |
|
| Total Current Liabilities |
11,462,000 |
9,376,000 |
10,122,000 |
| Long Term Debt |
9,475,000 |
10,758,000 |
8,707,000 |
| Other Liabilities |
2,051,000 |
2,146,000 |
2,135,000 |
| Deferred Long Term Liability Charges |
319,000 |
340,000 |
272,000 |
| Minority Interest |
- |
- |
- |
| Negative Goodwill |
- |
- |
- |
|
| Total Liabilities |
23,307,000 |
22,620,000 |
21,236,000 |
|
| Stockholders' Equity |
| Misc Stocks Options Warrants |
- |
- |
- |
| Redeemable Preferred Stock |
- |
- |
- |
| Preferred Stock |
- |
- |
- |
| Common Stock |
88,000 |
87,000 |
86,000 |
| Retained Earnings |
20,038,000 |
17,246,000 |
14,995,000 |
| Treasury Stock |
(10,694,000) |
(6,694,000) |
(3,193,000) |
| Capital Surplus |
7,948,000 |
6,966,000 |
6,556,000 |
| Other Stockholder Equity |
397,000 |
293,000 |
445,000 |
|
| Total Stockholder Equity |
17,777,000 |
17,898,000 |
18,889,000 |
|
| Net Tangible Assets |
16,607,000 |
16,778,000 |
17,702,000 |
- Suppose you have just turned 25 and have just started working on your new job. You plan to retire when you will have completed 30 years working. You expect to live for another 35 years after your retirement and you would want to have at least $70000 (in current dollars) at the beginning of every year for every year of your retirment. You expect to be able to invest your savings in a mutual fund earning an 8% p.a. real rate of return.
- (10 points) How much would you need to have saved up when you stop working? (Note that the required $70,000 each year has to be available to you at the beginning of the year.)
- (10 points) How much should you save each year, in real dollars, during your working life, assuming you save the same amount each year?
- (Bonus, 8 points) You realize that you would find it easier to save more in the later years of your life when you would have fewer obligations and a higher income. Based on this realization, you decide to want to save twice as much every year from year 41 to year 55, as from year year 26 to year 40. How much should you save every year for the first 15 years of your working life?
Midterm Solutions
1.
- It is commonly understood that shareholders, as "owners," get the right through their vote for a Board of Directors, to appoint managers, who have a fiduciary duty to represent shareholder interests; all other parties have contractual relationships with the firm. However, once we realize that such an arrangement exists only because it is expected to lead to the best utilization of the resources under the control of the firm. Under some circumstances, one might well argue that a cooperative organization is preferable. In a social environment where a collaborative framework is feasible and more efficient, workers may be included in firm management, particular in matters that have to do with the factory floor. Workers may be naturallly suspicious of management as working against their interests and refuse to work with them, and vice-versa. However, in the case of Volkswagen, which has acquired a reputation as a worker-friendly firm, such a collaborative arrangement, as envisaged in Chattanooga, might well be more efficient.
- Giving workers the right to a representative on the Board of Directors is, indeed, more difficult to justify than allowing them a say in the determination of working conditions. However, workers, especially in a firm like Volkswagen, are long-term participants in the enterprise; as such, they may be willing to contribute to the long-term viability and profitability of the firm, to the extent of perhaps even giving up raises when the firm is in difficult circumstances or by making a loan to the firm from pension fund assets. But such behavior would require their acceptance as full-fledged partners of management, for example by giving them a seat on the Board of Directors. Hence even such a step could be justified, though it would not necessarily be indicated in all circumstances.
- Customer representatives may arguably be given a voice on the Board of Directors, provided this does can be done in a manner consistent with protecting the firm's proprietary information. This may create brand loyalty for the firm especially in a competitive environment.
2.
- Adverse selection occurs 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. This might happen if 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. This causes a problem because the presence of a disproportionately large number of high risk individuals raises the premium even for low-risk individuals who desire to be insured.
- The stock market has two functions from the point of view of stock value maximization. One, it provides an objective measurement of stock or stockholder value; two, it allows the firm to use the stock price as an input into incentive mechanisms. This promotes stock value maximizing behavior on the part of managers and other firm employees.
- The sustainable growth rate is the rate at which the firm can grow if it uses no additional equity other than its retained earnings for reinvestment purposes, while keeping the debt-equity ratio constant. That is, there is an assumption that the firm will raise additional debt. The internal growth rate is the rate at which the firm can grow if it uses its retained earnings alone for reinvestment purposes, with no additional outside capital; hence the internal growth rate will be lower than the sustainable growth rate, since the leverage ratio will drop.
- In bankruptcy, management continues to have control of the firm for a limited period of time, usually 120 days; however, they are no longer working on behalf of shareholders, but rather on behalf of all of the firm's security holders. Bondholders and other creditors of the firm have a say in any proposed reorganization of the firm's capital structure.
- 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! When an investor owns a share of stock but wants to limit his losses, he can buy a put option on the stock that would give him the right (but not the obligation) to sell the stock at his lower limit price.
3.
- Your original mortgage 0f $2m. (0.8x$2.5m) has an APR of 12.68%; hence the monthly rate would have been 12.68/12 or 1.0567%. Using that rate, we could solve for the monthly payment using the equation $2m. = (C/0.010657)[1-(1.010657)-300]. This gives us C = 22076.16. Now, you have 240 monthly payments left. The present value of 240 monthly payments of $22076.16 works out to $1,921,580.60.
- Your friend is getting a 11.5% return on his money. You can refinance at 11% APR, which translates to an EAR of (1+0.11/12)12-1 or 11.57%. Hence you would prefer to borrow from your friend, since his EAR of 11.5% < 11.57%. Alternatively, your friend would lend you the money at an APR of 12x[(1.11)(1/12)-1] = 10.4815% p.a.
- If you went ahead with the refinancing at the bank's 11% APR, your new monthly payments would be obtained by solving the equation $1,921,580.60 = (C/0.009167)[1-(1.009167)-240]. We find C = $19,834.33.
4.
- The quick ratio as of Feb. 13, 2013, defined as "Total Current Assets less Inventory less Other Current Assets" ÷ Current Liabilities works out to (15372-10710-773)/11462 or 33.93%. The same quick ratio, two years earlier was (13479-10625-1224)/10122 = 16.1%. This indicates that the short-term liquidity position of the firm, relative to its liabilities, has improved dramatically over the two years, taking a conservative view of the liquidity of its current assets.
- If we were told that "Other Current Assets" were more liquid, we might redefine the quick ratio as "Total Current Assets less Inventory" ÷ Current Liabilities, since the objective of the quick ratio is to obtain a conservative measure of the firm's current assets. Now that we know that Other Current Assets are much more liquid, even a conservative approach may allow us to include it in the category of liquid current assets.
- The average collection period (also known in the text as "receivables in days") is measured as "accounts receivables/average daily sales" or 1395/(74754/365) = 6.8113 days for the year ending February 3, 2013. For the year ending January 29, 2012, this ratio would be 1245/(70395/365) = 6.455 days. This shows that the efficiency in collection has dropped off a bit from a year before.
- Truly speaking, we should only be including credit sales in our computation of the average collection period, since only credit sales need to be collected; hence the ratios would be 1395/(74754x0.75/365) and 1245/(0.5x70395/365) or 9.081 days and 12.91 days. Now we would conclude that efficiency in collection of receivables has gone up dramatically.
5. You have just turned 25,you plan to retire at age 55 and you expected to live until age 90. Keep in mind that all computations are in real dollars and the required rate of return is also a real rate; hence we ignore the issue of inflation to compute our required annual saving. This would be the amount that we would save the first year; thereafter, we would increase our savings amount by the rate of inflation.
- You want $70k at the beginning of every year for 35 years. The present value of this on the date of your retirement would be 70 + (70/0.08)[1-(1.08)-34] = $881,085.36.
- The present value of this today is $881,085.36/(1.08)30 = $87,559.91. Hence the yearly amount to save in real dollars at the end of every year for the next 30 years is given by $87,559.91 = (C/0.08)[1-(1.08)-30] = $7777.72.
- Suppose you decide to save $C/year for the first 15 years; then you'd save $2C per year for the next 15 years. The present value of your savings for the first 15 years would be (C/0.08)[1-(1.08)-15] or 8.5595C. The present value of your savings for the last 15 years would be (2C/0.08)[1-(1.08)-15]/(1.08)15 or 5.3966C. Hence the equation to solve is $87,559.91 = 8.5595C + 5.3966C. Solving for C, we get $6273.95. Not surprisingly, this amount is lower than the $7777.72 which we got in part (c).
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.
- (21 points) Read the article below and answer the following questions:
- Can you explain why equity analysts' investment advice should be bad? Competition, in other sectors of capitalist economies, leads to better products; why not here?
- Why should investment advice be worse in bad times than in good times?
- Suppose you are a finance correspondent at the Economist. Now imagine that Loh and Stulz discovered that equity analysts' investment advice is better in bad times than in good times. How would you explain this in your hypothetical Economist article?
The accuracy of equity research Consistently wrong Bear market or bull, analysts give bad advice, Economist, Jan 18th 2014
It is no secret that equity analysts at banks do not always give the best investment advice. In 2001 Eliot Spitzer, the attorney-general of New York state, exposed their habit of heaping praise on undeserving firms with which their colleagues hoped to do business. Some had advised clients to buy stocks they had referred to in private as “junk”, “crap” and “shit”.
But it is hard to talk up dud firms when markets are falling, and anyway, there is little business to be won at such times. So it might have been reasonable to assume that analysts’ recommendations are better in bearish markets than bullish ones. New research, alas, suggests this is not so: the advice analysts give in bad times seems to be even worse than the boosterism they peddle in good.*
Roger Loh of Singapore Management University and René Stulz of Ohio State University looked at analysts’ forecasts of profits and the buy or sell recommendations they issued for the period 1983-2011. Their predictions, it turned out, were less reliable in falling markets than in rising ones, even after making allowances for increased volatility in such times. Analysts’ forecasts of profits for the next quarter were out by 46% more during periods of financial crisis than at other times, for instance.
The drop in accuracy may be linked to cuts in research budgets. During downturns banks spend less on research. For instance, in the most recent crisis budgets were cut by around 40%, according to Neil Scarth at Frost Consulting, largely by replacing more experienced (and more expensive) analysts with younger, greener ones. The fear of being fired may also befuddle rather than focus minds.
Ironically enough, Messrs Loh and Stulz also found that investors pay more attention to analysts’ opinions when times are tough. Normally only one change in ten in analysts’ stock recommendations moves the price of the share in question. But the proportion increases to one in seven in falling markets, even though there are more changes during market routs. Just as drivers value maps more when it is foggy, investors pay more heed to research during periods of increased uncertainty, reckons Mr Stulz. Unfortunately for them, that is also when their maps are most likely to be wrong.
*Roger Loh and René Stulz, “Is sell-side research more valuable in bad times?”
- (24 points) Answer any four of the following questions:
- What is the most important source of capital for firms? Can you explain why this might be so?
- Interest payments are deductible for corporate tax purposes. Hence, one would think that debt should increase the value of a firm. However, your friend is convinced that if all taxes are taken into account, debt could actually decrease the value of a firm. How could this be?
- Stock prices typically rise when the firm makes an announcement of a joint venture. Why should this be so, according to the Efficient Market Hypothesis? Can you imagine a world where the reverse is true? Explain.
- Which prices are more volatile -- those of long-term bonds or those of short-term bonds? Why?
- Which of these are idiosyncratic risks and which are systematic risks?
- The risk that your main production plan is shut down due to a tornado.
- The risk that there will be a strike at the Tennessee plant of your company.
- The risk that the economy slows, decreasing demand for your firm's products.
- The risk that your best employees will be hired away.
- The risk that your firm's expansion into the Chinese market will not materialize.
- The risk that the Chinese yuan will depreciate over the next year.
-
- (10 points) You have discovered that returns on Climax stock for the last four years were 10%, -20%, 15% and 15%. Based on this information, what is your best estimate of a) the expected return on Climax stock and b) the standard deviation of returns on Climax stock.
- (10 points) Your equity analysis division has figured out that there is a 50% chance of a 20% runup in stockmarket prices (adjusted for dividends) over the next year, and an equal chance of a drop in prices of 10%. Under the same circumstances, your equity analysts figure the return on Climax stock would be 30% and -20%. You don't really trust your equity analysis department as to the precise level of estimated returns on Climax stock or the market portfolio; however you think that their estimation of the relative movements of Climax and the market are pretty much on target. If the risk-free rate of interest is 3% and your personal estimate of the expected return on the market over the next year is 8%, what is your estimate of the expected return on Climax stock over the next year?
- (15 points) A bicycle manufacturer currently produces 394,000 units a year and expects output levels to remain constant in the future. It buys chains from an outside supplier at a price of $1.9 a chain. The plant manageer believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.5 per chain. The necessary machinery would cost $287,000 and would be obsolete after 10 years. This investment could be dpreciated to zero for tax purposes using a 10 year straight-line depreciation schedule. The plant manager estimatedss that the operation would require additional $60,000 of inventory and other working capital upfront, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,525. If the company pays tax at a rate of 35%, and the opportunity cost of capital is 15%, what is the NPV of the decision to produce the chains in-house intstead of purchasing them from the supplier?
- (15 points) Huarong Pharmaceuticals just announced that it will cut its dividend from $3.73 to 2.03 per share and use the extra funds to expand. Prior to the announcement, Huarong's dividends were expected to grow at a 2.8% rate, and its share price was $50.11. With the new expansion, Huarong's dividends are expected to grow at a 5.1% rate. What share price would you expect after the announcement? (Assume Huarong's risk is unchanged by the new expansion.) What is the NPV of the increased investment?
- Assume there are three default-free bonds with the following prices and future cash flows:
| |
|
Cashflows |
| Bond |
Price Today |
Year 1 |
Year 2 |
| A |
90.9 |
0 |
100 |
| B |
100 |
120 |
0 |
| C |
105 |
10 |
110 |
- (10 points) How would you take advantage of the arbitrage opportunity?
- (5 points) How is the yield curve different from normally observed yield curves?
Final Solutions
1.
- The reason competition might not work here is that there may be incentives to convince investors to buy, rather than sell. If investors sell, they are likely to take the proceeds and invest them in other sectors, not necessarily in other equities, which is not so good for equity analysts. If all equity analysts have similar incentives, there's no reason why competition should produce better equity research that is unbiased.
- The reason given in the article is that in bad times, money may be scarce, research budgets may be lower and hence the quality of the advice might be worse. Another possibility is that the returns from convincing investors to make stock purchases, which may help the brokerage side of the equity analysts' investment banks, could be higher in bad times.
- Suppose there were no ties between the equity research side of investment banks and the brokerage side or that these ties were counterbalanced by pay schemes. Then competition to provide better equity research could be more intense in bad times than in good times. This could explain the hypothetical results that analyst advice is better in bad times.
2.
- The most important source of capital for firms is internally generated funds. This is so because there are no information asymmetry issues involved in using internal funds for projects. Information asymmetries would tend to raise the required return on externally generated funds and the baseline rate of return required on new projects.
- If personal taxes on debt interest payments were much larger than personal taxes on dividend and other equity returns so that the corporate tax advantage on debt issuance were not enough to offset it, debt could actually decrease the value of a firm.
- If firms in general made bad decisions in entering into joint ventures, perhaps because of the institutional issues involved in hooking up with another firm, the market would tend to view joint ventures askance.
- The prices of long-term bonds are mnore volatile than those of short-term bonds, even though short-term interest rates are more volatile than long-term rates. The reason is that the sensitivity of long-term bonds to interest rate changes is much greater.
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- idiosyncratic because firms in the economy at large are unlikely to be affected by the tornado.
- idiosyncratic; a strike in a firm is a local phenomenon.
- systematic; this will affect all firms in the economy to a greater or less extent.
- most likely idiosyncratic; this will affect your firm negatively and the hiring firms positively, but this is still not an economy-wide issue.
- idiosyncratic; sounds like a problem with your firm, although if it is because the Chinese economy overall is in the doldrums, it could affect all firms in the US and then it would be a systematic effect.
- systematic; this will affect all US firms -- exporters to China and elsewhere negatively and importers from China positively.
3.
- The expected return is (10-20+15+15)/4 = 5% p.a. The variance is [(10-5)2+(-20-5)2+(15-5)2+(15-5)2]/3 = (25+375+100+100)/3 = 200; the standard deviation is (200)0.5=14.14% p.a.
- According to the relative movement information ofr Climax and the market, the beta of climax is ((30-(-20)/(20-(-10)) = 5/3 = 1.67. Hence according to the CAPM, the expected return on Climax would be 3+1.67(8-3) = 11.33%
4.
The annual production costs are 394000(1.5) = 591,000. After tax, this works out to 384,150. From this we subtract (287000/10)(0.35) or 10045 of annual depreciation tax benefit. This works out to an annual net cash outflow of 384150-10045 or 374105. The present value of this computed as a 10-year annuity -- with a discount rate of 15% -- works out to 5.0188(374105) = $1,877,546.40. The present value of the scrapped machinery after paying tax at 35% is 21525(0.65)/(1.15)10=3458.42. On the other hand, the present value of working capital costs is 60000-60000/(1.15)10=$45168.92. The net present value, therefore, of in-house production for a ten-year period is $1,877,546.40 + $45168.92 - $3458.42 plus the $287,000 for the original purchase of the machinery, for a total of $2,206,166.90.
On the other hand, the present value of paying out after-tax dollars to the tune of 394000(1.9)(0.65) yearly over ten years is 394000(1.9)(0.65) times the annuity factor of 5.0188 previously obtained, or $3,757,050.20(0.65) = $2,442,082.60. Clearly, it is better to make the chains in-house.
5.
Assuming the dividend payment is to be made immediately after the announcement, and knowing that the growth rate of Huarong's dividends prior to the announcement is 2.8%, its share price of $50.11 would be equal to 3.73(1+g)/(r-g) = 3.83/(r-0.028). Solving, we find that the required rate of return, r, equals 10.452%.
After the announcement, the share price would be 2.03(1.051)/(0.10452-0.051) = $39.86. Hence the NPV of the new investment is 39.86-50.11-(3.73-2.03) = -$11.95 per share.
6.
- If we assume bonds A and B are properly priced, the one year interest rate is 20% p.a. (120/100-1). The two year interest rate is [100/90.9]0.5-1=0.04886 or 4.886% p.a. Assuming these rates are correct, the third bond should be priced at 10/1.2 + 110/1.1 or 108.33. Hence it is underpriced relative to the two other bonds. Hence I would buy bond C at $105 and sell/issue (1/12)th of bond B and (11/10)th of bond A; this would give me a cash flow of 10 in year 1 for my portfolio and 110 in year 2, which would be just sufficient to make the payments due on bond C. This strategy would cost me (11/10)(90.9) + 100/12 = 100 + 8.33 -105 = $3.33.
- The yield curve is unusual in that it is downward sloping, since yield curves are usually upward sloping.
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