BA 440

Midterm 1 Solutions

Multiple Choice:

  1. A
  2. C
  3. D
  4. C
  5. A
  6. C
  7. A or E
  8. C
  9. D
  10. E

Short Answer:

1.

Independence: The members of the board of directors have no relationship with the company or senior management.

Accountability: How accountable are directors and managers are to shareholders and how well does the board manage and evaluate its own performance.

Disclosure: To what extent and how timely is information about directors, compensation and the firm.

Questions that you can ask related to each dimension:

Independence:

What is the composition of the board and committees? Is there sufficient independent director representation?

What is the share structure? (Are there multiple voting classes?)

Is there a split between the CEO and Chairman of the Board?

Do directors meet independently of management?

Does the board have the authority to hire outside consultants without management approval?

Does the company meet or surpass exchange guidelines

Accountability

Does the company have a formal code of ethics?

How is management’s compensation structured?

How are the directors compensated?

Are the board elections staggered?

Is there a formal evaluation process for directors?

Disclosure

Are there complete biographies of the directors?

Does the company provide a full breakdown of executive compensation?

If compensation is performance based, does the company describe the performance metrics?

Has the firm been subject to regulatory or criminal investigation?

Does the company engage in outside business relationships (related-party transactions) with management or Board members and relations?

2.

a. To calculate the implied market risk premium, we need to first solve for ‘r’ in the equation below:

1370 = (20 * (1.04)) / (r – 0.04)

r = 5.67%

Based on the current market level, and assuming the constant dividend growth model is appropriate to value the market, this is the return (implied return) that is expected of the market by investors.

To get the risk premium, we subtract the risk free rate:

Implied risk premium = 5.67% - 4.37% = 1.3%

b. An increase in the S&P to 1400 would mean that the annual return would be:

(1400 – 1370) / 1370 = 2.19%.

This is less than even the risk-free rate and definitely does not compensate investors for the riskiness of the market. You would invest in the risk-free asset.

c. The historical risk premium approach assumes that investors’ risk aversion has not changed in a systematic way during the period in which the premium is estimated. Based on the information provided, it appears that investors are now less risk averse (more willing to invest in stocks) and therefore would demand a smaller risk premium than they would have in the early to mid 1900s. So using an average risk premium that includes that period to calculate a risk premium for today would overstate the current risk premium.

3.

Calculate an average unlevered beta for the competitiors:

Average levered beta = (1.5 + 1.8 + 2.2) / 3 = 1.83

Average D/E ratio = (35% + 50% + 60%)/3 = 48%

Average unlevered beta = 1.83 / (1 + (1-0.35)(0.48)) = 1.39

Adjust this unlevered beta for competitor cash:

Average cash = (10 + 25 + 30) / 3 = 21.67

Firm value = Equity + Debt,

We are given equity values (market cap), we need to calculate debt values:

Debt for competitor 1 = 0.35 * 500 = 175

Competitor 2 = 0.5 * 700 = 350

Competitor 3 = 0.6 * 900 = 540

Firm value for:

Competitor 1 = 175 + 500 = 675

Competitor 2 = 350 + 700 = 1050

Competitor 3 = 900 + 540 = 1440

Average firm value = 1055

Unlevered beta adjusted for cash: 1.39 / (1 – (21.67 / 1055)) = 1.42

This is the unlevered beta we assume is appropriate for the operating risk of Temper.

Adjust the unlevered beta for Temper’s cash:

Temper firm value: Debt = 0.25 * 800 = 200

Firm value = 200 + 800 = 1000

Unlevered beta adjusted for Temper’s cash: 1.42 * 1000/(1000 + 12) = 1.403

Temper’s levered beta:

1.403 * (1 + (1-0.35)(0.25) = 1.631

(a)Jensen’s alpha = 0.15% – 0.5% * (1 – 1.3) = 0.3% per month

General Forge outperformed expectations by 0.3% per month during the regression period.

(b)Since the beta for both firms are the same (1.3), a diversified investor would be indifferent between the two if the choice was based solely on risk.

(c)For an undiversified investor, the appropriate measure of risk is total beta.

For General Forge, this is:1.3 / (0.28)^0.5= 2.456

The annual risk free rate is 0.5% * 12 = 6%

So the required rate of return (using CAPM) is:

6% + 2.456 * 4.5% = 17.05%

4.

a. Firm performance can be measured using Jensen’s alpha:

0.9448 – 6/12 * (1 – 1.67) = 1.28%.

The firm overperformed expectations by 1.28% per month.

b. The regression beta = 1.672

c. A bottom up beta is generally more appropriate if you can find a set of companies that are similar in size to the company you are evaluating. It will also be more appropriate if the firm has changed substantially recently which would make the regression beta less meaningful. The regression beta would be more appropriate if there are no comparable companies and the firm has not changed significantly in recent years.