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Answers Key for Midterm Exam - Equity Valuation | ECON 720, Exams of Economics

University of San Francisco (USF)Economics

Material Type: Exam; Class: Equity Valuation; Subject: Economics; University: University of San Francisco (CA); Term: Fall 2003;

Typology: Exams

Pre 2010

Uploaded on 07/30/2009

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ECON 720 – EQUITY VALUATION
TAKEHOME MIDTERM EXAM
Answer Key For Section 2
Good Luck!
QUESTION TOPICS TIME
1 Cash Flows 15 points
2 Ratio Analysis 10 points SECTION 1:
3 Margin Analysis 15 points COMCAST
4 Pro Forma Analysis 10 points
5 International Accounting 15 points
6 Miscellaneous Accounting 15 points SECTION 2:
7 World CAPM 15 points SELECTED TOPICS
8 Risk & Return 15 points
Total 110 points
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Download Answers Key for Midterm Exam - Equity Valuation | ECON 720 and more Exams Economics in PDF only on Docsity!

ECON 720 – EQUITY VALUATION

TAKEHOME MIDTERM EXAM

Answer Key For Section 2

Good Luck!

QUESTION TOPICS TIME

1 Cash Flows 15 points

2 Ratio Analysis 10 points SECTION 1:

3 Margin Analysis 15 points COMCAST

4 Pro Forma Analysis 10 points

5 International Accounting 15 points

6 Miscellaneous Accounting 15 points SECTION 2:

7 World CAPM 15 points SELECTED TOPICS

8 Risk & Return 15 points

Total 110 points

  1. INTERNATIONAL ACCOUNTING

Rogers Cable

2002 and 2003 Financial Statements

For Fiscal Years Ending December 31

All

Current

Temporal

Income Statement 2002 2003 2003 2003 Revenue $474 $598 1.25 $478.40 1.25 $478. Depreciation (20) (23) 1.25 (18.40) 1.38 (16.67) Other operating costs (368) (460) 1.25 (368.00) 1.25 (368.00) Admin costs (16) (19) 1.25 (15.20) 1.25 (15.20) Income before taxes 70 96 76.80 78. Taxes (26) (35) 1.25 (28.00) 1.25 (28.00) Net income $44 $61 $48.80 $50. Translation Gain/Loss CTA 36.75 (1.43) NI after Translation Gain/Loss 85.55 49. Dividends 18 24 1.25 19.20 1.25 19. Balance Sheet 2002 2003 2003 2003 Current assets 201 187 1.20 155.83 1.20 155. Net property, plant & equip. 474 569 1.20 474.17 1.38 412. Total Assets $675 $756 $630.00 $568. Current liabilities 127 210 1.20 175.00 1.20 175. Long-term debt 112 65 1.20 54.17 1.20 54. Total Liabilities 239 275 $229.17 $229. Shareholders Equity 436 481 Equity 327.82 Equity 327.  R/E 66.35 394.17R/E 29.90 357. Total liabilities and equity $675 $756 $623.33 $586.

Comcast has a wholly owned Canadian subsidiary, Rogers Cable, Ltd., whose functional currency is the local

currency (CDN$). The relevant exchange rates for Rogers cable are shown below.

Exchange Rates

Date CDN$/US$^ US$/CDN$^ US$/CDN$

At purchase of Fixed

Assets (historic rate) 1.38 0.

Ending - Average EXR 0.

1-Jan-03 1.33 0.752 Ending - Beginning EXR 0.

Average for 2003 1.25 0.

31-Dec-03 1.20 0.

A. (5 points) Calculate the Translation Gain/Loss for Rogers using the all-current method.

CTA is based on the CDN$ amount of Net Assets in Rogers. This is positive at beginning of

year and increases by R/E – Dividends over year. CDN$ increases in value over year so

Comcast gains on its exposure. Implies CTA must be a positive number.

B. (5 points) Calculate the Translation Gain/Loss for Rogers using the temporal method.

Translation Gain/Loss is based on the CDN$ amount of Net Monetary Assets in Rogers.

This is negative at beginning of year and decreases over year. CDN$ increases in value

over year so Comcast loses on its lack of exposure. Implies Translation adjustment must be

a negative number.

Year Rate Original Cost Dep'n Expense Accum Dep'n Net Book Value

SYD 55

Double Declining Balance

B. Provide a brief discussion of each of the following statements.

i. Earnings reported by firms with defined benefit plans are likely to be of higher quality

than earnings reported by firms with defined contribution plans.

False.

Defined contribution plans report as the pension expense the actual amount needed to fulfill

their obligation to the employees in the given year. In contrast, defined benefit plans report a

pension expense that is “smoothed” version of the actual expense. Both the smoothed

expense and the “actual” expense are subject to a variety of assumptions about future

interest rates, inflation rates, etc. Thus neither the reported nor actual pension expense is

necessarily a good measure of what the true cost will be.

Thus earnings reported by defined contribution plan companies are likely to be more

predictable and of higher quality because of the fewer assumptions involved in their

calculation.

ii. Advances in medical science, with a resulting increase average lifetimes, will not affect

accounting for either defined benefit or defined contribution plans.

Defined contribution plans will NOT be affected by this increase in average lifetimes as they

do not guarantee a pension payout in the future, they only set an amount contributed each

period.

In contrast, defined benefit plans promise a pension payout at some point in the future. If the

payout is a lump sum based on some combination of service-related variables, then the

change will NOT affect the pension accounting. If instead, the pension promises a fixed

payment per year for the rest of the retirees life, then the pension obligation has increased,

and the amount needed to be contributed each year will have increased..

C. On December 31, 2003, Motorola established a restructuring charge of $200 million,

of which $80 million was for severance pay for workers who will be terminated in the

year 2004 and $120 million was for the write down of assets on December 31, 2003.

i. What is the impact of this accounting change on the following ratios for 2003 –

Operating Cash Flows/Sales, Net Income/Sales, and Sales/Net Fixed Assets

ii. What is the impact of this accounting change on the same ratios for 2004 – Operating

Cash Flows/Sales, Net Income/Sales, and Sales/Net Fixed Assets

Ratio

Effect on 2003 Ratio

(Circle One)

Effect on 2004 Ratio

Compared to Adjusted

Ratio (Circle One)

Restructuring

Operating Cash Flow / Sales No Effect Decrease

Net Income / Sales Decrease Increase

Sales / Net Fixed Assets Increase No Effect

Restructuring

Operating Cash Flow / Sales : In 2003, the restructuring charge is a non-cash item, therefore

there is no effect on operating cash flow or the ratio. In 2004, the $80 million in

severance is paid, reducing operating cash flow and therefore reducing the ratio. The

fixed asset write-down has no effect on operating cash flow in year 2004.

Net income / Sales : In 2003, net income, and hence the ratio, is decreased because of the

charge. In year 2000, depreciation declines because of the write-down of assets in 2003.

This increases net income and the ratio for 2004.

Sales / Fixed Assets : In 2003, writing down $120 million of fixed assets increases the ratio by

reducing the denominator. In 2004, there is no additional effect from this write-down. The

ratio is not affected by the charge for severance pay.

Decision Rule: If ˆ 57 ˆ57,1%

c

t   t then REJECT Null Hypothesis.

Clearly this condition holds and we reject the Null Hypothesis that the risk of Duratex is

greater than or equal to the Brazilian market, in favor of the Alternative Hypothesis

that the risk of Duratex is less than the Brazilian market at the 1% level of significance.

C. (3 points) Are you surprised by the estimate of the intercept term in the Brazilian

CAPM regression? Why or why not?

You should be surprised. This is a slightly different version of the CAPM, involving rates of return

rather than risk premia. Thus the intercept should be an estimate of the risk-free return in Brazil.

It is clear that the intercept (i.e. the risk-free rate) is NOT significantly different from zero. Test of

intercept = 0 is a t-stat of (-0.0012/.0076) = -0.16. A very small number that does not allow us to reject

the Null that the intercept is not significantly different from zero.

8. RISK AND RETURN AROUND THE WORLD

The following are summary statistics for daily returns on the overall market indexes for Brazil,

Germany, the NASDAQ 100 (US), and Russia between July 3, 1997 and August 3, 1998 (

daily observations). Assume that the mean return and variance for the NASDAQ index are

known without error.

RBrazil RGermany RNASDAQ RRUSSIA

Mean Returns -0.00087 0.00136 0.00083 -0. Std. Deviation 0.03044 0.01457 0.01185 0. Sample Mean Std. Deviation 0.00177 0.00085 0.00069 0. Coef. Of Variation -34.86560 10.70948 14.23792 -14.

Coefficient of Variation = (Std. Deviation of the Returns)/(Mean Return). It is a measure

of the risk vs. return tradeoff of investing in a particular market index.

A. (6 points) Test the hypothesis that the return on the German Stock Market index is

greater than the mean return on the NASDAQ Market Index. Provide the Null and

Alternative Hypotheses, the appropriate test statistic and its distribution, and the

Decision Rule for the test.

Procedure General Germany vs NASDAQ

Null Hypothesis, H 0 :   Mkt GER  NAS

Alternative Hypothesis, H 1 :  > Mkt GER > NAS

Test Statistic: ˆ 1

GER GER NAS n r

r

t

s

 ˆ^1 .00136^ .00083 0.

n.

t 

Distribution of Test Statistic: tn-1 t297-

Critical Value for Test

Statistic: tn-1,^ ^ 5%-level =1.

Decision Rule: Reject H 0 if t^ ˆ n  1  tn 1, 

Result: Cannot Reject^ Null Hypothesis

Note that this means that we cannot reject the hypothesis that the mean return on the German

market index and the mean return on the NASDAQ market index are the same. While the German

index mean return is higher as measured, it is not sufficiently higher given the error with which we

are measuring it, for us to conclude that its mean return is greater than the NASDAQ’s mean return.

B. (6 points) Test the hypothesis that the variance of the German Stock Market’s return

is greater than the variance of the return on the NASDAQ Market Index. Provide the

Null and Alternative Hypotheses, the appropriate test statistic and its distribution,

and the test’s Decision Rule.

Procedure General IBM

Null Hypothesis, H 0 : ^  Mkt GER  NAS

Alternative Hypothesis,

H 1 : 

 > Mkt GER > NAS

Test Statistic: (^)   2 2

ˆ n 1

s

 n

 ^ ^ ^ ^     2 2 1 2

 n    

Distribution of Test

Statistic:

^2 n-1 ^2 297-

Critical Value for Test

Statistic: 

2 n -1,  337.

Decision Rule: Reject H 0 if

2 2

ˆ n  1  n 1,5%

Result: Reject Null Hypothesis at the 5% level

Note that this means that we reject the hypothesis that the variance of the returns on the

German market index and the variance of the returns on the NASDAQ market index are the same.

The variance of the German index return are sufficiently higher than the NASDAQ’s return variance

for us to conclude that the German returns are significantly riskier at the 5% level of confidence.

C. ( 3points) Which market provides the best risk versus return trade-off? Why?

Sort of a trick question. Given what you know – the coefficients of variation for the indexes – you

should have chosen the German index as having the best risk/return trade-off since it has a smaller

number than the NASDAQ.

Given the results of the two tests, however, you should choose the NASDAQ because while the

mean returns are not statistically significantly different the variance on the German market is

significantly higher – hence its coefficient of variation is likely to be significantly higher than that of

NASDAQ.