Quiz I, F4365, Fall, 1994 Name



Quiz I, F5360, Spring, 1997

1. a. Using the attached financial statements, perform a Du Pont Analysis of Intel Inc.

b. What can we conclude about Intel from your answer in part “a”?

2. Why might ratios be of limited value in evaluating the performance of a company?

3. On the first day on your new job, you tell your boss that while at Baylor you have studied a simplified EVA system. Your boss responds that he has never heard of EVA and asks you what it is. Explain to your boss what EVA is and why the firm you have gone to work for might benefit from using EVA.

4. Using the following information and the attached financial statements, calculate the capital charge that would be used in calculating Intel’s 1995 EVA.

Additional information on Intel:

(1) The average yield to maturity on Intel’s short-term debt was 9% as of Dec. 31, 1994 and 7.5% as of Dec. 31, 1995.

(2) The average yield to maturity on Intel’s long-term debt was 11% as of Dec. 31, 1994 and 10% as of Dec. 31, 1996.

(3) The statutory income tax rate is 35%.

(4) The following summary numbers were given for the past 10 years:

(In millions--except per share amounts)

Research Operating Net Earnings Dividends

Net Cost of & devel- income income (loss) declared

revenues sales opment (loss) (loss) per share per share

- -------------------------------------------------------------------------------

1995 $16,202 $ 7,811 $ 1,296 $ 5,252 $ 3,566 $ 4.03 $ 0.15

1994 $11,521 $ 5,576 $ 1,111 $ 3,387 $ 2,288 $ 2.62 $ 0.115

1993 $ 8,782 $ 3,252 $ 970 $ 3,392 $ 2,295 $ 2.60 $ 0.10

1992 $ 5,844 $ 2,557 $ 780 $ 1,490 $ 1,067 $ 1.24 $ 0.05

1991 $ 4,779 $ 2,316 $ 618 $ 1,080 $ 819 $ 0.98 --

1990 $ 3,921 $ 1,930 $ 517 $ 858 $ 650 $ 0.80 --

1989 $ 3,127 $ 1,721 $ 365 $ 557 $ 391 $ 0.52 --

1988 $ 2,875 $ 1,506 $ 318 $ 594 $ 453 $ 0.63 --

1987 $ 1,907 $ 1,044 $ 260 $ 246 $ 248 $ 0.34 --

1986 $ 1,265 $ 861 $ 228 $ (195) $ (203) $ (0.29) --

(5) Intel’s beta is 1.15

(6) Intel’s stock price was [pic] as of 12/30/94 and was [pic] as of 12/30/95.

(7) The return on 30-year U.S. Treasury strips was 5.81% as of 12/30/94 and was 7.64% as of 12/30/95.

Check figures:

1. Main concepts: Intel appears to be operating more efficiently and profitably with less debt. Points for discussing following ratios (level in ’95 and change from ’94): tax burden ratio, profit margin, asset turnover, leverage ratio, ROE. Need industry ratios to compare to Intel’s.

2. Main concepts: based on accounting numbers (acct. method, cost vs. value, accrual vs. CF), seasonal businesses, diversified firms, poor industry performance, potential problems.

3. Main concepts: EVA is measure of economic profit. Benefits: better measure of profitability (discuss why), mgt. incentives, leads to wealth creation for stockholders (discuss why).

4. 1272.38

Consolidated Statements Of Income

Three years ended December 30, 1995

(In millions--except per share amounts)

1995 1994 1993

------- ------- -------

Net revenues $16,202 $11,521 $ 8,782

------- ------- -------

Cost of sales 7,811 5,576 3,252

Research and development 1,296 1,111 970

Marketing, general and

administrative 1,843 1,447 1,168

------- ------- -------

Operating costs and expenses 10,950 8,134 5,390

------- ------- -------

Operating income 5,252 3,387 3,392

Interest expense (29) (57) (50)

Interest income and other, net 415 273 188

------- ------- -------

Income before taxes 5,638 3,603 3,530

Provision for taxes 2,072 1,315 1,235

------- ------- -------

Net income $ 3,566 $ 2,288 $ 2,295

======= ======= =======

Earnings per common and

common equivalent share $ 4.03 $ 2.62 $ 2.60

======= ======= =======

Weighted average common and

common equivalent shares

outstanding 884 874 882

======= ======= =======

Consolidated Balance Sheets

December 30, 1995 and December 31, 1994

(In millions--except per share amounts)

1995 1994

------- -------

Assets

Current assets:

Cash and cash equivalents $ 1,463 $ 1,180

Short-term investments 995 1,230

Accounts receivable, net of allowance for

doubtful accounts of $57 ($32 in 1994) 3,116 1,978

Inventories 2,004 1,169

Deferred tax assets 408 552

Other current assets 111 58

------- -------

Total current assets 8,097 6,167

------- -------

Property, plant and equipment:

Land and buildings 3,145 2,292

Machinery and equipment 7,099 5,374

Construction in progress 1,548 850

------- -------

11,792 8,516

Less accumulated depreciation 4,321 3,149

------- -------

Property, plant and equipment, net 7,471 5,367

------- -------

Long-term investments 1,653 2,127

Other assets 283 155

------- -------

Total assets $17,504 $13,816

======= =======

Liabilities and stockholders' equity

Current liabilities:

Short-term debt $ 346 $ 517

Accounts payable 864 575

Deferred income on shipments to distributors 304 269

Accrued compensation and benefits 758 588

Accrued advertising 218 108

Other accrued liabilities 328 538

Income taxes payable 801 429

------- -------

Total current liabilities 3,619 3,024

------- -------

Long-term debt 400 392

Deferred tax liabilities 620 389

Put warrants 725 744

Commitments and contingencies

Stockholders' equity:

Preferred Stock, $.001 par value, 50 shares

authorized; none issued -- --

Common Stock, $.001 par value, 1,400 shares

authorized; 821 issued and outstanding in

1995 (827 in 1994) and capital in excess

of par value 2,583 2,306

Retained earnings 9,557 6,961

------- -------

Total stockholders' equity 12,140 9,267

------- -------

Total liabilities and stockholders' equity $17,504 $13,816

======= =======

Quiz II, F5360, Spring, 1997

1. You have just taken out a loan that requires you to repay $250,000 three years from today (you make no payments between now and then). If the rate on the loan is 6.5% per year compounded quarterly, how much have you borrowed?

2. You have just purchased a new type of bond that pays a quarterly coupon of $95. This bond matures 6 years and 1 month from today but it pays no par value (only coupons). If the required return on the bond is 7.5% per year, what is the most you should have paid for the bond?

3. You have just checked the balance of your father’s retirement savings account and are pleased to find that he has a $500,000 balance in the account. However, you have estimated that he will need to have $750,000 in his account when he retires five years from today. You father plans to make an additional deposit later today and then make additional monthly deposits through 3 years from today. He also plans for each deposit to be 0.2% larger than the previous one. If your father’s retirement account earns 5.25% per year compounded continuously, how much must he deposit today in order to end up with $750,000 five years from today?

4. You have been thinking about investing in either Unamerican Airlines (motto: “Leave the striking to us”) or Subcontinental Airlines (motto: “Let your luggage see the world while you fly to Houston and back”). The expected return on Unamerican is 8% and the standard deviation of returns on Unamerican is 22%. The return on Subcontinental will depend on the state of the economy as follows:

Economic Conditions Probability Return

Great .25 35

Pretty Darn Good .55 8

Awful .20 -19

Which would be riskier if held by itself?

Check Figures:

1. 206,031.35

2. 1916.49

3. 2166.98

4. Unamerican since 22% > 18.06%

Quiz III, F5360, Spring, 1997

1. Suppose your aunt has just left you $250 million and has specified that you may invest only in the following three companies:

Company E(r) s

Starr FlipFlops Inc. 12 8

Whitewater House Inc. 14 15

Futures Profits Inc. 19 30

Your aunt has also allowed you to buy T-bills that earn 6% and to borrow money (assume that you can borrow at the T-bill rate).

a. Draw the 3 companies and label each on a risk/return graph.

b. Sketch a reasonable feasible set.

c. Identify (on your graph) and label the efficient set (given your answer in part a)

d. Identify (on your graph) and label the optimal combination of these 3 companies.

2. Based on the following information, what is you estimate of the return that Campaign Finance ReformNOT Inc’s. should earn (the required return) in 1997?

Return on:

Year Campaign S&P500 T-bills

1994 -8 -12 6.4

1995 32 45 4.2

1996 45 29 3.4

Return on T-bills for 1997 is 5.6%.

The market risk premium is expected to be 7.3% in 1997.

3. On February 25, the Wall Street Journal revealed the following:

Return on a 1-year Treasury strip = 5.55%

Return on a 2-year Treasury strip = 5.86%

Return on a 3-year Treasury strip = 6.02%

Return on a 4-year Treasury strip = 6.09%

a. Why do we use Treasury strips in estimating the term structure?

b. What is the forward rate during the fourth year?

c. Given our discussions in class, what is a reasonable estimate of the market’s forecast of the one-year rate that will exist during the fourth year?

d. How would you go about earning the rates in parts b and c?

e. On a time-line, graph and label each of the rates given above (the four T-strip rates) and the rates in parts b and c.

4. Assume that we can perfectly forecast future short-term interest rates. What does this imply about the relationships that should exist between interest rates (forward, spot, and short) and what does it imply about investment strategy?

Check Figures:

1. Main points: optimal = point of tangency. Feasible set is curve set to left of individual firms. Efficient set is set of portfolios with highest return for risk.

2. 11.575%

3. a. no default risk, pure rate; b. 0.063; c. anything less than 6.3%; d. (a) buy 4-year and hold all 4 years (b) wait until 3 years from today and invest for one year (estimate only)

4. LT rates = geo. average of expected future 1-period rates, fwd rates = expected future 1-period rates; strategy irrelevant.

Quiz IV, F5360, Spring, 1997

1. Answer the following using the attached page from the Wall Street Journal.

a. Suppose that on Friday, March 14, you sold five calls on Oracle that expires in June and which as a strike price of $45. What was your cash inflow(+)/outflow(-) on the 14th?

b. Assume that at the expiration of the option the price of Oracle has in increased by $6 per share. What is your cash inflow(+)/outflow(-) at expiration? Explain what has happened to cause this cash inflow/outflow.

c. What is your total profit(+)/loss(-) from having sold the options?

2. Again using the attached page from the Wall Street Journal, suppose that on Friday, March 14th, you had planned to purchase a put on Boeing that expires in April (one month from when you purchased the put) and which had an exercise price of $110. Unfortunately no puts with these characteristics were traded. You did note, however, that a call on Boeing was traded that expires in April and which had an exercise price of $110. You also noticed that the return on a T-bill maturing at the same time as the put and call was 4.98% per year compounded continuously.

a. What set of transactions could you have undertaken that would have provide you with the same payoff as if you had purchased the put on Boeing? Be specific.

b. What would have been your total cost of creating this “artificial put”?

3. For several years, Abbott Hammer and Nail Inc. has leased to a used bookstore space in a building that is attached to their store. However, this bookstore recently moved and Abbot is considering knocking out the common wall and using the space to sell computer software (the hardware store would be renamed Abbott Hardware and Software). Before this expansion, Ernst & Young’s Valuation Group has estimated that Abbott’s assets have a current market value of $10 million and that the market value of Abbott’s stock is $4.6 million. Abbott’s debt matures for $8.5 million 3 and a half years from today. The expansion would cost $1,000,000 (funded from cash) and would have a net present value of $10,000. However due to the greater risk involved with selling computer software, the standard deviation of returns on Abbott will increase to 52%. The return on a U.S. Treasury strip maturing 3 and a half years from today is 6.44% per year compounded continuously.

a. Will Abbott’s bondholders be in favor of this expansion? Why or why not?

b. What could Abbott’s bondholders have done to prevent this expansion?

4. InfoTek Inc. has begun to implement an EVA bonus system for its management. In 1996, InfoTek’s EVA was -$300,000, but has set a target of -$100,000 for 1997. However, after 1997, InfoTek’s target EVA will be established using the Harnischfeger self adjusting target approach discussed in class. InfoTek has set a target EVA bonus for its CEO of $50,000 with an EVA leverage factor of $150,000. In order to prevent short-run decision making, InfoTek plans to establish a bonus bank system where 1/3 of the balance in the bonus bank is paid out and where 1/3 of the current bonus is paid out and 2/3 is deposited in the bonus bank. InfoTek has set up a beginning balance in the bonus bank of $100,000. If InfoTek’s actual EVA is +$30,000 for 1997and is +$120,000 for 1998, what will be the bonus actually paid to InfoTek’s CEO in 1997 and 1998?

Check Figures:

1. a. +1093.75; b. -1000 (net); c. +93.75

2. a. (1) buy call on Boeing w/ 110 strike that expires in April, (2) short-sell 100 shares of Boeing, (3) buy T-bill w/ that matures in April with maturity value of $11,000

3. a. no since value of bonds drops by 381,794.37; b. when issued could have restricted expansions outside of hardware business or made debt convertible

4. EVA Bonus paid: 64,444.44 in 1997, 76,851.85 in 1998

Quiz V; F5360; Spring, 1997

1. Your neighbor is a stock broker and was very interested to hear that you have recently been studying whether markets are efficient. He tells you that the concept of efficient markets is a lot of academic drivel and that it results from the frustration of head-in-the-clouds academics that can’t beat the markets themselves. Wanting to show your neighbor that you are receiving a balanced education, what evidence might you discuss with your neighbor that shows that your neighbor might in fact be right and that markets are in fact inefficient?

2. Your boss at Old Line Industries Inc. has just asked you to calculate the discounted payback and the profitability index for a new factory that Old Line is considering building.

a. How would you go about calculating the factory’s discounted payback and profitability index.

b. Once you have calculated these numbers (the discounted payback and profitability index), how would you use them to make a recommendation about the factory?

c. After you have calculated these numbers and made your recommendations, your boss asks you if there are any better approaches to making capital budgeting decisions than discounted payback and profitability index and to justify your answer. How do you respond?

3. Your boss at Old Line Industries has asked you to help him review the work done by one of your colleagues (he didn’t tell you who) on identifying the incremental, after-tax cash flows for the new factory that Old Line is considering building. For each of the following, tell whether the analysis is correct. If there is an error tell what the error is and correct it. Your boss has asked you to only look at the analysis for years 0, 2, and 7. Throughout assume that Old Line’s marginal tax rate is 34%.

a. The land on which the factory will be built was purchased a year ago for $750,000. The current market value of this land is $800,000.

Colleagues analysis: CF0 = -$750,000(1-.34) = -$495,000; CF2 = CF7 = 0

b. The factory would cost $9 million to build and will fall into the 7-year depreciation (MACRS) class.

Colleagues analysis: CF0 = 0; CF2 = -9,000,000 * .20 = -$1,800,000;

CF7 = -9,000,000 * .0576 = -$518,400

c. An architect has finished blueprints for the new factory at a cost of $29,000. The architect was paid this morning.

Colleagues analysis: CF0 = -29,000; CF2 = CF7 = 0

d. Sales would equal $7 million per year beginning a year from today.

Colleagues analysis: CF0 = 0; CF2 = +$7,000,000 (1-.34) = +$2,380,000, CF7 = +$2,380,000

e. If the new factory is opened, labor costs at the new factory will be $1.25 million per year beginning a year from today. Opening the new factory will also allow the firm to eliminate the overtime being worked by employees at Old Line’s existing factories. Overtime pay this year is $1.875 million and would continue at that pace for the foreseeable future if the new factory were not built.

Colleagues analysis: CF2 = -$1,250,000(1-.34) = -$825,000; CF7 = -$825,000

4. Assume that the discount being used by Old Line Industries Inc. to analyze the new factory was calculated by plugging the average beta of the securities issued by Old Line into the Capital Asset Pricing Model. Might this approach cause any problems with the analysis? If so, why? If not, why not?

Check Figures:

1. main concepts: value vs. growth, small stocks, corporate insiders, earnings announcements

2. a. main concepts: need: incremental cash flows, required return; discounted payback: calculate PV of CF, years for PV of CF to equal investment; profitability index: calculate PV of CF, divide by outflow; b. DPB: if finite, PI: > 1; c. DPB ignores CF after payback; PI ignores scale; NPV has none of these problems & measures change in firm value

3. a. -783,000; b. CF0 = -9,000,000, CF2 = +749,394; CF7 = +272,952; c. CF0 = 0; d. CF2 = +4,620,000; e. CF2 =CF7 = +412,500

4. firm risk may have changed, sample may not reflect population, risk of new factory not same as firm; possible incorrect rejection if true beta < estimated beta; possible incorrect acceptance if true beta > estimated beta.

Quiz VI; F5360; Spring, 1997

1. Provide a short answer to each of the following (sometimes even one word):

a. What advantages do term loans provide as a source of funding?

b. What is a trustee?

c. After purchasing a coupon bond, interest rates fall. Will this cause your return to be greater or less than the yield to maturity that existed when you purchased the bond?

d. What are two disadvantages of being publicly owned?

e. What regulatory body oversees the activities on exchanges, insider trades, and proxies?

2. The CFO at your firm is trying to decide whether a planned stock offering should be done through a cash offering or a rights offering. He has asked you to prepare a report laying out the advantages of each. What do you write?

3. Assume that we have perfect capital markets and that you own 5000 shares of a firm that is funded with 50% debt and 50% equity (there are 500,000 total shares are outstanding trading for $35 each). The firm has just announced that it intends to issue enough stock to repurchase all of its outstanding bonds.

a. If the firm proceeds with its plans, what will happen to your risk? Why?

b. If the firm proceeds with its plans, what will happen to your expected return? Why?

c. If the firm proceeds with its plans, what will you need to do in order to undo the impact of the firm’s change in capital structure. Be as specific as possible.

4. Assume that the firm in which you own stock has just announced that it intends to decrease the amount of debt in its capital structure. At the announcement of its plans, the firm’s stock price immediately jumped higher. What have we studied in this class that might explain this reaction?

Check Figures:

1. a. speed, flexibility, low issue costs, no SEC registration; b. 3rd party [2] responsible for enforcing the indenture; c. unclear due to opposite affects on price and reinvestment income; d. increased regulation which is costly, creates conflict between owners and managers, hostile takeovers become possible, information reporting requirements; e. SEC

2. main points: advantages of cash offering: sold to general public, cash all at once; advantages of rights offering: no dilution, no underwriting spread, no underpricing problem.

3. a. decreased, least risky CF going to b/h or mathematically; b. decreased, no longer earn spread between asset and borrowing rates or mathematically; c. borrow $175,000 and invest proceeds in firm’s stock

4. main point: financial distress costs exceeds benefits of debt => too much debt. Additional points for linking to probability of bankruptcy, potential lost tax shields, loss of confidence in firm (and related problems), diversion of resources, agency costs from s/h-b/h conflict.

Quiz VII, F5360, Spring, 1997

1. How do the ex-dividend date, declaration date, payment date, and date of record relate to dividends and in which order to they fall on a time line?

2. Assume that Final Blues Inc. has 3 stockholders. Josh owns 2000 shares, Eddie owns 3000 shares, and Rob owns 4000 shares. All purchased their shares when originally issued at $25 per share. These shares are estimated to have a current market value of $65 per share. Because Final Blues has begun to generate more cash flow than is needed for positive NPV projects, Final Blues intends to repurchase 300 shares at $75 per share. Assume that none of the 3 pay income taxes.

a. Show that even if each stockholder behaves rationally and in their own best interest that wealth will be redistributed between the 3 stockholders if Final Blues repurchases the shares via a tender offer.

b. Assume that rather than a tender offer, the firm plans to repurchase the shares via issuance of transferable put rights. Assume also that each stockholder behaves rationally and in their own best interest and that Rob sells his put rights to Josh for what the puts are worth. Show that in this case there is no wealth redistribution between the 3 stockholders. (Assume that the puts expire immediately).

3. Assume that markets are perfect, that investors have homogeneous expectations, that investment is optimally fixed, and that any surplus cash has been paid out to stockholders. Why is it that under these conditions stockholders will be indifferent about whether or not the firm pays out an additional dividend? Note: provide as much justification for your answer as is possible.

4. Suppose that in order to balance the budget by 2002, the federal government increases the marginal tax rates for all individuals by five percentage points (for example, all those with a marginal tax rate for 1996 of 28% will have a 33% marginal tax rate in 1997). Note that corporate taxes are not changed. What would you expect to happen to the amount of dividends that American companies pay? Justify your answer.

Check Figures:

1. correct order: declaration date, ex-divided date, date of record, payment date; points for discussing each

2. a. Josh gains 344.83 from Rob; b. price per put = .3448, no wealth redistribution

3. main points: show that wealth unchanged, that can undo dividend and that can create own dividend

4. firms with excess cash will pay less dividends since other uses of excess cash become relatively better for stockholders (points for discussing these other options and how now more attractive).

Final Exam, F5360, Spring, 1997; page 1 of 2

1. In an interview for a job at Compaq Computers Inc., the interviewer tosses you the latest 10-k (hint: this is the annual report) for Compaq and asks you how you would use it to figure out whether or not Compaq is well managed. What would you tell her?

2. Next, the interviewer tosses you a DEF 14A (in addition to the 10-k) which lays out management compensation and asks you whether or not top management is compensated in a way that will lead them think and act in the best interests of stockholders. What would you look for and how would you answer her question?

3. Later, you are talking to the head of Compaq’s cash management department and he states that the firm is thinking about putting a significant amount of money into “riding the yield curve” where the firm buys longer term securities than it needs for its short-term investment needs and then sells them prior to maturity in order to capture the premium that is usually built into longer-term rates. How would you respond when he asks your opinion about such a strategy?

4. When talking to the Corporate Treasurer, he states that Compaq’s growth has begun to slow and that it is beginning to generate high profits and cash flow in excess of what is needed to fund new investment opportunities. He states that Compaq has never used much debt in its funding and has no real plans to do so in the future. How would you respond to his statement when he asks your opinion?

5. The Corporate Treasurer goes on to state that the firm is somewhat unsure of what to do with all of the cash it is beginning to generate (remember that he previously told you that Compaq was beginning to generate more cash than was needed to fund new investment opportunities). How would you respond when he asks your opinion?

6. The Corporate Treasurer states that when he was hired, he was granted an option to buy 10,000 shares of Compaq stock at $75 per share. These options expire 2 years and 3 months from last Friday (May 2nd). He asks you what these options are worth. Using information from the Wall Street Journal lying on his desk, what would you tell him? (Note: In the Wall Street Journal you also find that the return on a Treasury Strip that matures 2 years and 3 months from today is 6.28% per year and when you ask, the corporate treasurer tells you that the standard deviation of returns on Compaq is 48%).

7. The Corporate Treasurer states that Compaq is considering whether or not to build a new manufacturing facility in Houston. He states $35 million has already been spent in the building process but that he has had an offer from Dell Computer to buy their partially completed facility for $43 million. The cost to complete the facility would be $60 million (This additional cost will be paid one month from today if Compaq decides to proceed). Net cash inflows are estimated to be $2.1 million per month beginning 4 months from today and are expected to grow by 1% per month. Net cash inflows are expected to continue through 5 years from today. The beta of the new plant is estimated to be 1.4 and the beta for Compaq as a whole is 1.2. The return on short-term T-bills is 4.8% and the market risk premium is 8.2%. Should Compaq proceed?

8. As you are getting ready to leave your interview, you mention that Compaq stock has done really well lately and that this provides a strong sign that Compaq’s future looks bright. Several people standing around laugh and state that the market price of Compaq doesn’t seem to have any relationship to what Compaq is really worth or what is going on at Compaq. How do you respond?

Check figures:

1. Basic types of analysis: ratio analysis, EVA analysis (points for discussing how would calculate and interpret each)

2. Main concept: look for compensation in form other than paycheck or accounting based bonuses like options, stock EVA bonus

Final Exam, F5360, Spring, 1997; page 2 of 2

3. Main points: should earn higher return due to evidence that premium exists on LT rates, but higher risk since must sell prior to maturity at unknown rate. The higher return and risk offset.

4. Main points: advantages of debt: tax deductibility, mgt-s/h conflict resolution

5. Options: dividends, repurchases, NPV projects, acquisitions, purchase financial securities, issue debt and repurchase stock

6. 373,391.79

7. Yes, 3.63 > 0

8. Evidence that markets are fairly efficient and prices quickly adjust to new information; possible exceptions: Compaq not releasing all information, Compaq is growth firm and thus overvalued.

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