Dr. P.V. Viswanath

pviswanath@pace.edu

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

Sample Midterm

1. Definitions:
Define the following terms -- agency costs, operating cash flow, profit margin, bid price, sinking fund.

2. a. Is an IPO a primary market transaction or a secondary market transaction?
b. How are auction markets like the NYSE different from dealer markets?
c. Under standard accounting rules, is it possible for a company's liabilities to exceed its assets? If this happens, is the company bankrupt?
d. What information does the capital intensity ratio provide about a firm?
e. How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required rate of return on a bond?

3. Chapter 3, problem 29 (p. 82); Chapter 5, problem no. 48 (p. 149); Chapter 7 problem 15 (p. 219).

Midterm

• Show all your computations and formulae; even if you use a calculator or a spreadsheet to get the answers, you must show the formula that you are using.  No points will be given if I don't see the formula and how you got your answer.  Make all your assumptions explicit.  If your approach is correct, you will get some credit, even if your arithmetic answer is wrong.  So concentrate on getting your logic right.
• If you answer a question, I have the discretion to award you some points, even if you are completely wrong.  If you don't attempt the question at all, I can give you no points!  So attempt every question.
• Any cheating or plagiarism will result in your getting zero credit for the exam.
• One 8.5 x 11 sheet will be allowed, which may contain formulas only!  No worked out examples, nothing else.  Violation of this rule will be considered cheating.
• Good Luck!

1. Provide brief definitions for the following terms (20 points):

1. primary markets
2. financial leverage
3. Receivables turnover
4. collar

2. Answer any two of the following questions briefly -- no more than one page (20 points).

1. What is the difference between th term structure of interest rates and the yield curve?
2. Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than the real return?
3. In recent years, Dixie Co. has greatly increased its current ratio. At the saem time, the quick ratio has fallen. What has happened? Has the liquidity of the company increased?
4. Would the goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country?

3. (25 points) AT&T's dividend for the last four quarters is as follows (http://finance.yahoo.com/q/hp?s=T&a=00&b=2&c=1992&d=10&e=3&f=2003&g=v) :

26-Sep-03 $ 0.24 Cash Dividend
26-Jun-03 $ 0.19 Cash Dividend
27-Mar-03 $ 0.19 Cash Dividend
27-Dec-02 $ 0.19 Cash Dividend

On Yahoo's website (http://finance.yahoo.com/q?s=T), the number for the annual dividend is $0.95. If you read the Key Statistics page (http://help.yahoo.com/help/us/fin/research/research-12.html), you find the following information on how the annual dividend number is computed:

Annual Dividend: This value is the total of the expected dividend payments over the next 12 months. It is generally the most recent cash dividend paid or declared multiplied by the dividend payment frequency, plus any recurring extra dividend.

If you believe that AT&T's dividends will grow at the rate of 10% per year for the coming year, and then at the rate of 3% per year, forever, what would you estimate the price of AT&T to be, assuming that the correct required rate of return for AT&T is 7% per annum. (You may assume that dividends from next year on, will be paid annually, and not quarterly.)

4. (20 points) You want to buy a new sports car from Muscle Motors for $68,000. The contract is in the form of a 60-month annuity due at a 9 percent APR. What will your monthly payment be?

5. (15 points) Y3K Inc. has sales of $3680, total assets of $800, and a debt-equity ratio of 1.20. If its return on equity is 12 percent, what is its net income?

Solutions to Midterm

1. a. Primary markets are markets where issuers of securities originally sell them to investors. This is in contrast to secondary markets, such as the NYSE, where investors trade amongst themselves (although issuers may also trade in secondary markets to buy back securities and/or to resell them).

b. Financial leverage refers to the use of debt by firms, in their capital structure. This allows them to increase the expected returns to their equityholders (although, usually, with a corresponding increase in risk).

c. Receivables turnover refers to a particular measure of how fast receivables are collected. This measure is defined as Sales/Accounts Receivable.

d. A collar refers to a maximum and a minimum limit on the interest rate charged on a loan, or on the coupon rate for a given bond.

2.a. The term structure refers to the relationship between yields on zero-coupon default-free bonds. The yield curve refers to the yield-to-maturity on actual bonds (often Treasuries), usually with coupons.

2b. If an investor has to have a certain number of dollars at some specific time in the future, say to make a mortgage payment, he would be more interested in ensuring that he has a given nominal return, than in the real return.

2c. The quick ratio is the ratio of (Current Receivables - Inventory) to Current Assets; hence if the quick ratio has fallen, but the current ratio has increased, it must be that inventory as a proportion of current assets has gone up. Since inventories are generally of lower liquidity, the firm's liquidity must have dropped.

2d. In order for stock price maximization to make sense, the valuation mechanism must be trustworthy and produce good valuations. In the US, capital markets are fairly efficient, in the sense that they incorporate publicly available information. This may not be true in foreign countries. If so, stock price maximization may not be as appropriate.

3. The main issue, here, is that you use expected future dividends. Hence, if you believe Yahoo's statement that 95 cents is the expected dividend for next year, and you believe that dividend growth will be 3% a year, thereafter, the price would be 0.95/(0.07 - 0.03) = $23.75.

If you believe that the dividend growth rate is 10% for this year, then you could take last year's dividends, and use that. In that case, the stock price would be (0.81)(1.1)/(0.07 - 0.03) = $22.28.

4. If you treat this as an annuity with payments to be made at the end of the period, you would solve the equation for C, . This gives a value of C = $1411.57. The discount rate that is used is 0.09/12 = 0.0075. If you treat this as an annuity due, then, you would solve the same equation, except that instead of using $68,000 on the LHS, you would put 68000/(1.0075) or 67493.80. This gives a value of C=$1401.06.

5. If the debt-equity ratio is 1.2, then the debt-to-total assets ratio is 1.2/2.2, and the equity-to-total assets ratio is 1/2.2. Hence with the size of assets being 800, the size of equity is 800/2.2. If the return on equity is 12%, then net income = 0.12*800/2.2 = $43.64.

Final Exam

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.
5. The total number of points (maximum) adds up to 110. Any extra points you get will be treated as bonus.
6. Note that only the first question has any choice (however, I will only grade the first five definitions -- all others will be ignored). All other questions are obligatory.

1. Please define any (and only) five of the following terms briefly (3 points each):

1. cost of capital
2. diversification
3. portfolio
4. normal distribution
5. standard deviation
6. real options
7. capital rationing

2. Please answer each of the following three questions in brief:

1. (20 points) For each of the following news items, explain if it reflects systematic risk or unsystematic risk. The news item may sometimes not fit exactly into either category; if this is the case, say so, and explain why. Explain also how you think prices would react -- either the stock price of the particular company, or stock prices in general, or any other security prices that are relevant.
1. Baghdad, Iraq, Dec. 14 — Saddam Hussein, the deposed Iraqi leader, was captured in a raid on a farm near Tikrit on Saturday night, American officials confirmed today.
2. Los Angeles, Dec. 12 (Reuters) - The Walt Disney Company expects its cash contributions to its pension plan to increase more than fivefold this fiscal year, the company said in a filing with securities regulators Friday.
3. Washington, Dec. 12 (Reuters) - Consumer confidence weakened unexpectedly as the holiday shopping season swung into gear.
4. Saturday December 13, 7:20 pm ET, London (Reuters) - Investors led by Terry Smith, head of stockbroker Collins Stewart, have made a cash offer for the Telegraph newspaper titles, part of the troubled Hollinger International Inc (NYSE:HLR - News) group, the Sunday Times reported.
2. Catastrophe bonds are securities through which investors assume the financial risk of big natural disasters. For example, the International Football Federation, FIFA recently issued bonds, under the terms of which, investors are to be paid a specified coupon, every six months. At the end of 2006, investors will get the face value of the bonds, if the forthcoming 2006 World Cup takes place, as scheduled. However, if the games are cancelled, investors will only get a quarter of the bonds' face value. The Economist of December 4th, 2003, comments regarding investor attitudes towards such catastrophe bonds -- "investors have bought them because Treasury and corporate bond yields are skimpy and because natural disasters are uncorrelated with market swings."
   1. (5 points) What is the beta of these catastrophe bonds, according to the analysis of the Economist?
   2. (5 points) What is the required rate of return on these bonds?
3. A company has several projects with perpetual cash flows. For the i-th project, let C_i denote its periodic cash flows, and I_i the necessary initial investment. Suppose the required rate of return is 15% per period.
   1. (5 points) Express the present value of a project in terms of the variables, C_i, I_i and r.
   2. (5 points) Express the payback period for a project in terms of C_i, I_i and r.
   3. (5 points) The CFO of the company believes in the payback method of evaluating investments and knows nothing about the NPV rule. You, however, know that the NPV rule always leads to the correct investment decision. The CFO asks you what cut-off value he should use for the payback method, in order to evaluate the different projects. What would you tell him?
4. (10 points) Here is some information from an article by Mark Hulbert on the New York Times website, on December 14, reporting on some research done by two finance professors - Brad M. Barber of the University of California at Davis and Terrance Odean of the University of California at Berkeley.
   
   (The professors) focused on stocks mentioned in articles by the Dow Jones News Service and on stocks with large daily changes in price or jumps in volume, assuming that even when there were no wire service reports about such stocks, individuals still paid particular attention to them. Fundamentally, the researchers found that it didn't matter whether the articles were positive or negative, or whether the stocks' prices went up or down. As long as there were attention-grabbing events of any kind, investors were much more likely to buy these stocks than to sell.
   
   Would you say that this research supports the Efficient Markets Hypothesis? Explain.

3. Emisphere Technologies (EMIS) has a beta of 1.14, according to Yahoo (http://finance.yahoo.com/q/ks?s=emis), while AeroGen Inc (AEGN) has a beta of 2.391 (http://finance.yahoo.com/q/ks?s=aegn). The yield on a 10-year Treasury bond is 4.24% (http://www.bloomberg.com/markets/index.html). Suppose the market risk premium is 6% per annum.

1. (10 points) If the estimated expected rate of return over the next year on EMIS is 12%, is EMIS overpriced, underpriced or correctly priced?
2. (10 points) What is the required rate of return on AEGN?

4. Suppose a project has the following cashflows?

1. (10 points) What is the net present value of the two projects if the firm's required rate of return on such projects is 10%. (Hint: Project B is more profitable than project A.)
2. (10 points) Without computing the answer, make a reasonable guess as to which project will be more profitable if the required rate of return were to go up to 20%. Provide your reasoning. (No points without your reasoning.)

Solutions to Final

1.

1. The Cost of Capital for a firm is the return that investors in that firm require for investing in its projects. This is usually computed as the weighted average of the required return for the different classes of securities issued by the firm.
2. Diversification is the averaging out of independent risks in a large portfolio.
3. A portfolio is a mix of or collection of investments held by an institution or a private individual. It is also represented by a set of portfolio weights, corresponding to each asset in a set of investments.
4. The normal Distribution is a probability distribution that plots all of its values in a symmetrical fashion and most of the results are situated around the probability’s mean. Values are equally likely to plot either above or below the mean. Grouping takes place at values that are close to the mean and then tails off symmetrically away from the mean. It is also known as  “Gaussian distribution” or “bell curve.”
5. The standard deviation is a measure of dispersion of data about a mean value. A low standard deviation indicates that the data is clustered around the mean, whereas a high standard deviation indicates that the data is widely spread with significantly higher/lower figures than the mean.
6. A real option is an option that a firm has to take a particular decision to commit or commit resources to a particular project. Often, the conditions that would be favorable to a positive decision to commit resources can be tied to the price of a traded asset. To this extent, a real option can be valued using option pricing techniques.
7. Capital Rationing refers to restrictions on the amount of capital available within the firm for investment. In a world of capital rationing, it may not be possible to invest in all projects with positive NPV. Furthermore, if projects are not divisible, then it may be optimal to choose some smaller lower NPV projects over a higher NPV project that requires the use of a large amount of capital.

2.

1. 1. This would be considered systematic risk because it is likely to affect the entire political and economic climate, affecting most firms.
   2. This is an example of unsystematic risk because it will primarily affect the Walt Disney Company and not other companies.
   3. This is systematic risk because it would affect most firms.
   4. This is unsystematic risk; it would raise the price of Hollinger Securities and maybe affect the price of other firms in the industry, but not much more than that.
2. 1. If "natural disasters are uncorrelated with market swings," this implies that the beta of these catastrophe bonds is zero.
   2. The required rate of return would, therefore, be the risk-free rate according to the CAPM.
3. 1. C_i/r - I_i
   2. I_i/ C_i
   3. According to the NPV method, a project should be accepted if C_i/r - I_i, i.e. if C_i/r > I_i; i.e. if I_i/ C_i < 1/r. Hence the optimal cut-off value to use with the payback period is 1/r, which works out to 6.67 in our case.
4. This research does not support the Efficient Markets Hypothesis because according to the findings of this research, people would tend to buy attention-grabbing stocks even if the article had negative information about these stocks. In this case, the stock price should drop, but the increased demand is likely to raise the price of the stock, instead.

3.

1. According to the CAPM, the required rate of return for EMIS should be 4.24 + 1.14(6) = 11.08%; if the estimated expected return is 12%, instead, chances are that the stock is underpriced. This assumes that the stock price at the end of the coming year is expected to be correct.
2. The required rate of return on AEGN is 4.24 + 2.391(6) = 18.586%

4.

1. At a discount rate of 10%, the NPVs of the two projects are $9186.67 and $21154.98 respectively; clearly project B is more profitable.
2. If the discount rate of 20%, the NPV of project B would drop more drastically than that of project A because a large portion of project B's cashflows occur later in time. (In fact, at 20%, the NPVs become $1355.71 and -$1095.68 respectively.