Dr. P.V. Viswanath

pviswanath@pace.edu

• Midterm
• Solutions to Midterm
• Final
• Solutions to Final

Midterm

• 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. For the quantitative questions, you must show your formulas and your computation, else you may get no credit at all.

1. (15 points) Read the following article and answer the questions below:

1. What do you think will happen to Neiman Marcus's profit margin? What information in the article leads you to this conclusion?
2. What do you think will happen to NM's asset turnover ratio? What information in the article leads you to this conclusion?
3. What do you think of this strategy change? Is it a wise move? Why or why not?

Neiman Marcus Group Inc. swung to a fiscal third-quarter loss on a 24% sales decline and disclosed a merchandising strategy that calls for more lower-priced goods.

Until the new strategy kicks in, the Dallas luxury-goods retailer known for its lavish holiday gifts catalog and designer apparel expects to offer promotional and other events to boost sales.

The company, owned by private-equity funds TPG Capital and Warburg Pincus LLC., described the new strategy as "rebalancing" its merchandise to include less-pricier goods within its designer collections.

In addition to ongoing expense cuts, Neiman said it would reduce capital spending in its next fiscal year by about 25% from the between $105 million and $115 million it expects to spend this year.

Burt Tansky, the company's chief executive officer, said Wednesday that the retailer doesn't see the economic slide ending soon. "We believe that the recovery is tentative and any improvement will be gradual," he told investors in a conference call. As a result, it is pursuing what he called a "conservative" merchandise-buying plan for the fall.

He said that while customers hadn't questioned its prices in the past, "we are sensing a shift in our customer's mind-set."

Neiman's new merchandising strategy "will strengthen our position in mid-price" goods, he said. "This is not something that will occur overnight," Mr. Tansky cautioned, noting the larger impact wouldn't be seen in its stores until the spring.

For the quarter ended May 2, privately held Neiman reported a net loss of $3.1 million, compared with prior-year net earnings of $55.4 million. Higher markdowns and promotion costs pushed gross margin to 36.5% from 40% a year ago.

Last month, Neiman reported third quarter revenue fell to $810.1 million from $1.06 billion. The retailer operates 40 Neiman Marcus stores, the Bergdorf Goodman store in New York City, and six Cusp boutiques.

2. (20 points) Here is some information on Neiman-Marcus Group's income statement and balance sheets for the three years ending July 2005. (On May 2, 2005, Neiman Marcus Group was the subject of a leveraged buyout (LBO), selling itself to two private equity firms, Texas Pacific Group and Warburg Pincus. Hence we cannot get more recent data.)

1. For the years ending 7/30/2005 and 7/31/2004, compute the Net Profit Margin and the Asset Turnover Ratio.
2. For the two years, compute Return on Equity and Return on Assets. Which is larger and what strategic decision allows it to be larger?

3. (25 points) Answer any five of the following questions:

1. What is moral hazard? Give an example in the context of a business.
2. How might one argue against using stock prices as measures of stockholder wealth?
3. What are the advantages of payback as a investment criterion?
4. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?
5. How does the financial system facilitate the sharing of information? Give two different examples.
6. How can the existence of bid and ask prices that differ from each other be consistent with the notion of the law of one price?

4. (15 points) A rich aunt has bequeathed you some money. Under the terms of her will, you will get $1000/year for 10 years and then $20,000/year in perpetuity. If these cashflows have the same risk as another marketable security that yields a return of 12% per annum, what is the market value of your aunt's bequest?

5. (10 points) Suppose your bank is willing to lend you $93,850.74 in return for a promise to pay $10,000/month for one year. Show that the bank must be getting at least a 60% rate of return per annum!

6. (25 points) Neiman Machines currently rents a machine for $50,000 per year. It is considering buying a machine that will cost $150,000 and will involve yearly expenditures of $20,000. The life of the machine is 10 years and will be depreciated using the straight-line method for tax purposes as well as for reporting purposes; the machine is not expected to have a salvage value at the end of its life. The cost of capital for NM is 10% per year and the tax rate is 40%. Should the company buy the new machine or continue to rent?

Solutions

1.a, b. There are several ways to answer this question. One is as an accounting exercise. If you do it like this, you can use historical information about the first part of NM's fiscal year to compute what NM's ratios will look like in their annual financial statements. Then you can say that, given the drop in sales, the asset turnover is going to be low because asset turnover is sales/assets and sales has been low. Regarding profit margin, you can point to the promotions and conclude that the profit margin is going to end up being low (as in fact the article itself says). The second way is to talk about the future, but still focus on realized values of NM's ratios. Thus, you could look at the very low sales and thus low asset turnover ratio and conclude that as sales improve, which they will at some point most likely, the asset turnover ratio will improve as well; even though this is seemingly future-oriented, you are really making a statement about the low asset turnover ratio for the past year.

Finally, you could talk about the impact of strategy on expected future values of the profit margin and asset turnover ratios in comparison with the same ratios in past years. As financial analysts, this is the only meaningful kind of statement to make about future ratios. If you do this, you can note that NM's marketing strategy has changed -- it is going to use lower-priced goods. Lower-priced goods typically have lower profit margins. Lower-profit margins can deliver high ROA and ROE only if sales volume and asset turnover ratio go up. You can see this is in the works by noting the drop in capital spending of 25%; it is not entirely clear if this reflects a strategic change or simply a short-term cost-cutting measure because of the lack of funds. However, considering the change in merchandising strategy, it might very well reflect a strategic move.

c. Is this strategic move a good one? Perhaps. Maybe the market for high-ticket, high-margin items is over-crowded; or maybe the industry demand itself is declining secularly. If so, NM would still be at the higher-end of the industry. On the other hand, it looks like NM is repositioning itself. Given that it has a brand name as a quality retailer, this move to reposition itself at a lower level might not be wise.

2. a. We can use the information given to compute the following numbers:

b. Return on Equity is consistently larger than Return on Assets -- this is because of a strategic decision to take on debt.
(If you read the question to mean why is Return on Equity (and ROA) in 2005 greater than in 2004, the answer clearly is that the Net Profit Margin in 2005 is much higher -- and is not outweighed by the lower asset turnover ratio or the drop in the Assets/Equity ratio from 1.857 to 1.69 (in the case of ROA).)

3.

1. 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.
2. To the extent that stock markets are not informationally efficient or are excessively volatile, stock prices will not properly reflect stockholder wealth.
3. The payback criterion is very simple to apply and requires very little information -- this is its main advantage.
4. The Board of Directors is supposed to represent the shareholders who elect them and advance their interests. This does not always happen because they are usually nominated by the CEO and work closely with him -- as a result, they might work to the benefit of the CEO or other officers. Furthermore, directors may be on several boards and rarely take enough time to look closely at the affairs of the company, whose stockholders they are supposed to represent. Their compensation is also, often, not sufficient to provide the right incentives.
5. The financial system facilitates the sharing of information primarily through the operation of financial markets. For example, changes in the price of stocks are the result of aggregation of market information regarding the value of the assets represented by those stocks. This allows investors to decide whether to channel their investments to this sector or to that sector, to this firm or to that firm. The financial system also includes firms, such as ratings firms and financial analysis firms that provide information directly or indirectly to their customers and to market investors.
6. 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.

4. The present value of an annuity of $1000 for 10 years is (1000/0.12)[1-(1.12)^-10 = $5650.22. The present value of the perpetuity as of the end of year 10 is simply 20000/.12; discounting that to the present gives us $53662.21. Adding the two, we have $59,312.43.

5. A 60% p.a. return equals (1.6)^1/12 -1 = .03994 or 3.994% per month. Discounting the 10000 per month for 12 months at this rate gets us (1000/0.03994)[1-(1.03994)^-12 = $93881.18. Since the bank only gives you $93,850.74, which is less, they are getting more than 60% p.a.

6. The after-tax savings per year from the direct expenditures is 0.6(50000-20000) or $18,000. In addition, the tax benefit from depreciation is (150,000/10)(0.4) or $6000 for a total benefit of $24,000 from buying the machine. The present value of this works out to (24000/0.1)[1-(1.1)^-10 = $147,469.61. The cost of the machine is higher, at $150,000. Hence it is not worth buying.

Final

Notes:

• If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
• If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
• You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
• You must explain all your answers.

1. (10 points) Read the following article titled "Wendy's/Arby's Gets Cooking With New Management Team " from the July 4 issue of Barron's Insight and answer the following question:

Towards the end of the article, we read:
As for the bond offering, some investors say the company didn't need the money, as it will generate more than $100 million of free cash flow this year. But "our philosophy is that when money is available, you take it, and take the risk out of your balance sheet," says Mr. Peltz. Wendy's will use $132.5 million of the offering proceeds to repay some of its bank debt. The company says the remainder will be used for general corporate purposes, which could mean working capital, acquisitions, dividends or stock buybacks. Mr. Peltz says it would be foolish to pay a special dividend. But he doesn't rule out a buyback as he, too, thinks the shares are cheap.
Here are some viewpoints; comment on any two of them:

1. Tiffany says: "According to Modigliani-Miller, the value of the firm is independent of the capital structure of the firm. Hence this bond issue only decreased the value of the firm because of issuance costs."
2. Maria says: "Mr. Peltz clearly doesn't know what he's talking about! Increasing leverage increases the risk of the equity! How could taking on debt decrease risk?"
3. Tsung-Wei says: "Bank debt is always better than corporate bonds! The firm has a long-term relationship with its bank. It doesn't have to worry about information asymmetry -- the firm can reveal information without having to worry about the information getting to its competitors. This allows the bank to offer better terms than outside bond investors. Furthermore, if things are going bad, it's easier to negotiate better terms with a bank. On the other hand, with corporate bonds, the only alternative is bankruptcy and all its attendant legal costs!"
4. Junfeng says: "I can understand using corporate debt, which is long-term capital to fund acquisitions, which are long-term investments. But to use corporate debt to fund working capital, which is short term? I think Mr. Peltz needs to take MBA 648, 'Introduction to Finance,' once again!"

Shares of Wendy's/Arby's Group (NYSE: WEN) have slid more than 30%, to around $4, since April, amid worries about declining sales at Arby's and management's reluctance to reveal how it will use the proceeds from the company's recent $565 million bond offering.

But the prospects for greater operating efficiencies and rapid growth in the restaurant chain's cash flow suggest the shares could be worth at least $6 apiece -- and maybe as much as $9 in the next few years.

Founded 40 years ago by the late Dave Thomas, Wendy's is the third-largest fast-food chain in the U.S., behind McDonald's and Burger King. The company has long prided itself on serving hamburger patties that weren't previously frozen. And it was way ahead of the pack in featuring salads. Mr. Thomas, who starred in Wendy's commercials and became its public face, died in 2002.

Today, the company is controlled by Nelson Peltz and Peter May, who have built a substantial record as investors in the food-services industry.

Messrs. Peltz and May were investors in Wendy's, and their investment company, Triarc, owned Arby's. The two chains merged last September, giving the pair a 22% stake in the combined entity.

Arby's, which specializes in roast-beef sandwiches, contributed one-third of the company's 2008 revenue of $3.7 billion, and about 35% of operating income. Last year, Wendy's/Arby's lost $3.05 a share, largely due to merger-related costs. The company is expected to earn 19 cents a share this year, and 28 cents in 2010.

Roland Smith, Wendy's/Arby's CEO, is aiming to save $60 million through post-merger cost-cutting, and another $100 million by boosting Wendy's operating margins, now just 12%. Last year, he hired David Karam, the head of one of Wendy's largest and most-successful franchisees, as Wendy's president, a move praised by Pamela Thomas Farber, Mr. Thomas's daughter.

Mr. Smith sees Arby's expanding to 5,000 outlets from today's 3,500, and Wendy's adding another 1,000 stores to its current 6,000. A new store can provide a 20% return on invested capital.

As for the bond offering, some investors say the company didn't need the money, as it will generate more than $100 million of free cash flow this year. But "our philosophy is that when money is available, you take it, and take the risk out of your balance sheet," says Mr. Peltz.

Wendy's will use $132.5 million of the offering proceeds to repay some of its bank debt. The company says the remainder will be used for general corporate purposes, which could mean working capital, acquisitions, dividends or stock buybacks.

Mr. Peltz says it would be foolish to pay a special dividend. But he doesn't rule out a buyback as he, too, thinks the shares are cheap.

2. (25 points) Answer any five of the following questions:

1. Expected yields-to-maturity have to be lower than promised yields-to-maturity for corporate bonds and treasury bonds. Is this true or false? Explain.
2. What is the most important source of capital for firms? Can you explain why this might be so?
3. What should happen, according to the Efficient Markets Hypothesis, when a firm announces a dividend cut? Explain.
4. If you regress expected returns of portfolios of large asset classes against their standard deviations of returns, they tend to line up. However, if you do the same for individual stocks, they don't. Why? Explain.
5. Name two industries that use a lot of debt relative to equity? Explain why these firms use so much debt.
6. Your friend has spotted the following pattern -- if a stock goes down on a given day, it tends to go down on the following day, as well. This happens to be particularly true of small stocks. Explain how this might be possible, even if investors are on the lookout for mispricings?

3. You have the following information on WEN stock; these are prices for the four months upto July 2, 2009:

1. (2 points) What is the mean return on WEN stock for the four months?
2. (4 points) What is the standard deviation of returns?
3. (5 points) The values of the S&P 500 index for the first of the months of May, June and July were 919.14, 919.32 and 896.42. Use this information and all other information available to you to compute the beta of WEN stock.
4. (4 points) What is your forecast for the price of WEN stock for the beginning of August 2009?
5. (5 points) Provide a range for your August 2009 forecast such that you are 95% confident of the beginning of August 2009 price falling within that range.

4. Wendy's provided the following information in its 8-K filing on June 24, 2009. Answer the questions below:

On June 23, 2009, Wendy’s/Arby’s Restaurants LLC (which was formerly named Wendy’s International Holdings, LLC) (“Wendy’s/Arby’s Restaurants”), a direct wholly owned subsidiary of Wendy’s/Arby’s Group, Inc. (“Wendy’s/Arby’s Group”), completed its previously announced offering of $565.0 million aggregate principal amount of 10.00% Senior Notes due 2016 (the “Notes”).  The Notes were priced on June 18, 2009.
...
The Notes will mature on July 15, 2016.  Interest on the Notes will accrue at 10.00% per annum, paid every six months on January 15 and July 15, with the first payment on January 15, 2010, to holders of record on the January 1 or July 1 immediately preceding the interest payment date.  The Notes were priced at 97.533% of the principal amount, representing a yield to maturity of 10.50%.
...
The Notes are senior unsecured obligations and rank equally with all of Wendy’s/Arby’s Restaurants’ existing and future senior debt, rank senior to all of Wendy’s/Arby’s Restaurants’ future subordinated debt and effectively rank junior to all secured debt to the extent of the value of the collateral and to all liabilities of non-guarantor subsidiaries.  

1. (5 points) Assuming a face value of $1000 per note, the price of the note would be $975.33, since we are told that the notes were priced at 97.533% of the principal amount. How else could you have figured out the price from the information provided above (assuming you didn't have the 97.533% number available to you)?
2. (7 points) Compute the price of the bond, using the coupon rate and yield-to-maturity given above, but assuming a maturity of six years instead of seven years. Use this information to predict the price of the bond if it had a maturity of eight years.
3. (8 points) The form 8K provides the following addiitonal information:
   The Indenture includes certain customary covenants that, subject to a number of important exceptions and qualifications, limit the ability of Wendy’s/Arby’s Restaurants and its restricted subsidiaries to, among other things, incur debt or issue preferred or disqualified stock, pay dividends on equity interests, redeem or repurchase equity interests or prepay or repurchase subordinated debt, make some types of investments and sell assets, incur certain liens, engage in transactions with affiliates (except on an arms-length basis), and consolidate, merge or sell all or substantially all of their assets.  
   This part lists restrictions on: a)incurring further debt; b)issuing preferred debt; c)paying dividends on equity; d) redeeming or repurchasing equity interests; e) prepaying or repurchasing subordinated debts; f)making some types of investments; g)selling assets etc. Explain any two of these restrictions.

5. Wendy's beta (http://finance.yahoo.com/q/ks?s=WEN) is 0.81. Assume a risk-free rate of 3.55% (this was the rate on the 10-year Treasury note on July 1, 2009). Also assume a market risk premium of 6%.

1. (5 points) What is the required rate of return on WEN stock?
2. (8 points) Why is the beta so low, particulary compared to another restaurant chain, The Cheesecake Factory (Nasdaq: CAKE), which has a beta of 2.1. Yahoo has this to say of CAKE: "The Cheesecake Factory Incorporated operates upscale, full-service casual dining restaurants in the United States." Regarding WEN, it says: "Wendy's/Arby's Group, Inc., through its subsidiaries, operates as a franchisor of the Wendy's and Arby's restaurant systems in the United States and Canada. Wendy's is the restaurant franchising system specializing in the hamburger sandwich segment of the quick service restaurant industry; and Arby's is the restaurant franchising system specializing in the roast beef sandwich segment of the quick service restaurant industry.

6. (7 points) Tempered Cuisine plans to pay a dividend of $3.5 this year. The company has an expected earnings growth rate of 5% per year and an equity cost of capital of 11%. Assuming Maynard's dividend payout rate and expected growth rate remains constant, and Maynard does not issue ore repurchase shares, estimate Maynard's share price.

7. (10 points) Here are some recent news items that are relevant for WEN. Indicate whether these involve diversifiable or non-diversifiable uncertainty.

1. (July 2, Mergent Online) As things heat up this July, Arby's is introducing its new BBQ Bacon Cheddar Roastburger - a sandwich that truly captures the taste of the season. The latest addition to the Roastburger family of sandwiches, the BBQ Bacon Cheddar Roastburger features oven roasted, thinly sliced roast beef, topped with cheddar cheese, pepper bacon, crispy onions, tomato, pickle slices, and a finger-licking BBQ sauce on a specialty roll.
2. (June 9, Mergent Online) Wendy's is the winner in Zagat survey.
3. (July 6, WSJ) The U.S. nonmanufacturing sector showed some improvement in June, helped by export order activity, according to data released Monday by the Institute for Supply Management, a private research group.
4. (July 2, Investopedia) A recent report from a trade group in the restaurant industry indicates that tough times are still continuing as Americans are still reluctant to open their wallets and indulge in a night out on the town. 

Final Solution

1.

1. Tiffany would be correct if the firm could do all that it is proposing to do without the bond issue. In other words, MM says that, keeping investment policy constant, the value of the firm cannot be changed by changes in capital structure. However, in this case, Wendy's might be able to use the money profitably in new acquisitions and investments. Furthermore, the assumptions of MM don't really apply in this case because there are frictions present. Thus, if the firm's current bank debt has too high an interest rate and the new debt represents cheaper debt financing, the firm would be better off paying off the bank with the proceeds of the new debt.
2. Maria is right; it's not clear how borrowing money could reduce risk. On the other hand, if much of the money is kept as cash or reinvested in less risky investments, that would reduce the risk of the equity. It's not clear that this would raise equity values.
3. What Tsung-Wei says is often true. However, not always. If a firm has been around for a while and has established a reputation as a repayer of loans, it has a high level of cashflows and there is not that much information asymmetry, public debt could very well be cheaper.
4. Taken in isolation, Junfeng's comments are correct. However, it is possible that Wendy's was underleveraged to begin with; that is, it's possible that the maturity of Wendy's assets was previously too high compared to the maturity of Wendy's liabilities. Furthermore, the money is not going to be used for working capital alone but for long-term investments as well.

2.

1. Because of the possibility of default, promised yields-to-maturity must be lower than expected yields-to-maturity. In some states of the world, the promised coupons or principal payments will not be made.
2. The most important source of capital is retained earnings; all other sources of capital have to deal with the problem of information asymmetry.
3. According to the Efficient Markets Hypothesis, when a firm announces a dividend cut, several things could happen. The price could drop because the market could interpret the dividend cut as throwing negative light on the future prospects of the firm. Furthermore, reducing dividends could increase the amount of free cash that is controlled by managers to use in investments that may be financially advantageous to them, but not to shareholders in general.
   On the other hand, if the firm is in an industry where there are a lot of investment opportunities, the market may interpret the dividend cut as information that the firm is planning to increase investment in these profitable opportunities.
   On balance, though, the news will probably be received negatively.
4. The reason is that for individual stocks, the standard deviation of returns includes the standard deviation of idiosyncratic, asset-specific shocks, which the market does not compensate for. This works like random noise in the regression. For diversified portfolios, on the other hand, there is no idiosyncratic risk and the expected returns reflect compensation for all of the uncertainty of their returns.
5. Engineering firms that have a lot of fixed assets have high financial leverage. One reason is that these assets can be easily disposed of in case of bankruptcy; hence bondholders value them as collateral. Another industry is the utility industry, whose cashflows are relatively stable due to the prices for their services being regulated and less subject to competition. As a result, the probability of bankruptcy and hence expected bankruptcy costs are low.
6. This may be possible with small stocks because small stocks have less liquidity. Hence bad news will cause the prices to drop much more than for large stocks. Usually, this will attract market makers who will spot a profit opportunity and come in to buy up shares from investors looking to sell because of the bad news; but with these illiquid stocks, it might take much more time and a greater drop in prices for this to happen.

3.

1. Taking the average of the numbers in the Price Move column, we see that the mean return is -4.4025%.
2. The standard deviation can be computed by taking the deviation of the four observations from the mean, squaring them, adding up the squared deviations and dividing by 3 (one less than the number of observations); this gives us an estimated standard deviation of 8.476%.
   

   Date	Price Move (%)	Deviation	Sq. Dev
   7/2/2009	3.75	8.1525	66.46326
   6/30/2009	-4.76	-0.3575	0.127806
   5/29/2009	-16	-11.5975	134.502
   4/30/2009	-0.6	3.8025	14.45901
   Mean	-4.4025	Est Var	71.85069
   		Est S. dev.	8.476479

3. Using the values for the index, we can compute the returns for the months of June and May as -2.491 % (896.42/919.32-1) and 0.0196% (919.32/919.14 -1). The corresponding values for the stock are 3.75% and -4.76%. We can use this information to compute the beta as (3.75-4.76)/(-2.491-0.0196) = -3.39.
4. The forecast for the beginning of the month of August would be the price at the beginning of July times the expected return per month, i.e. 4.15(1-0.044025) = $3.967.
5. We have the standard deviation of returns as 8.476%. Hence, the 95% confidence interval for the return would be [-4.4025 - 1.96(8.476), -4.4025 + 1.96(8.476)], or (-21.0155, +12.2105). The corresponding price range for the beginning of August would be [4.15(1-0.210155), 4.15(1+0.122105)] = (3.2778, 4.6567).

4.

1. The price can be computed by using the yield-to-maturity information of 10.5%.
2. Assuming a time to maturity of 6 years, a yield-to-maturity of 10.5% and a coupon rate of 10%, the coupon per half-year is $50 and the effective half-yearly rate of return is 5.25%. Then the price can be computed as (50/.0525)[1-(1.0525)^-6]+1000/(1.0525)⁶ =$978.151. Assuming that the impact of yield changes on the price is the same in both directions, we canpreidct the price of a similar bond with a maturity of 8 years and a similar yield-to-maturity and coupon as 975.33-(978.151-975.33) = $972.509.
3. 1. the company is restricted from incurring further debt because that would dilute the seniority of the current debt.
   2. preferred debt would be senior to the current debt and reduce its value.
   3. paying dividends would reduce the amount of assets available to pay bondholders.
   4. redeeming or repurchasing equity interests would also reduce the amount available to pay bondholders.
   5. risky investments would reduce the value of current debt.
   6. selling assets would reduce the amount available to pay bondholders if that money is used in riskier ventures or is paid out as a dividend.

5.

1. The required rate of return is 3.55 + 0.81(6) = 8.41%.
2. The reason is probably that Wendy's sells downscale burgers the demand for which will not change drastically even if the economy improves or deteriorates.

6. The price would be 3.5(1.05)/(0.11-0.05) = $61.25.

7.

1. This is diversifiable risk because it's specific to WEN.
2. This is also diversifiable because it's specific to WEN.
3. This is non-diversifiable because it affects the overall economy.
4. This is partially diversifiable because investors can shield themselves from movements in the restaurant industry by investing in many other industries. However, to the extent that this is a reflection of what's happening in the overall economy, it's not diversifiable.

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