LUBIN SCHOOL OF BUSINESS
Pace University
MBA 648: Managerial Finance
Prof. P.V. Viswanath
Spring 2014
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.

  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.
  1. (21 points) Read the article below and answer the following questions:
     1. 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?
     2. Why should investment advice be worse in bad times than in good times?
     3. 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?”

  2. (24 points) Answer any four of the following questions:
     1. What is the most important source of capital for firms? Can you explain why this might be so?
     2. 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?
     3. 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.
     4. Which prices are more volatile -- those of long-term bonds or those of short-term bonds? Why?
     5. Which of these are idiosyncratic risks and which are systematic risks?
        1. The risk that your main production plan is shut down due to a tornado.
        2. The risk that there will be a strike at the Tennessee plant of your company.
        3. The risk that the economy slows, decreasing demand for your firm's products.
        4. The risk that your best employees will be hired away.
        5. The risk that your firm's expansion into the Chinese market will not materialize.
        6. The risk that the Chinese yuan will depreciate over the next year.
        
        
  3. 1. (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.
     2. (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?
        
        
  4. (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?
     
     
  5. (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?
     
     
  6. 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

     1. (10 points) How would you take advantage of the arbitrage opportunity?
     2. (5 points) How is the yield curve different from normally observed yield curves?