Econ 156
Gary Smith
Fall 2003

Second Test (75 minutes)

You need not do tedious calculations; if calculations are needed, you must write down the explicit equation(s)
identifying the variables. Do not write “Y = aX; solve for X.” You can write “100 = 10X; solve for X.”

1

Carnegie is going to acquire a new copier. They can either buy the machine for $15,427 or lease it for $6,000 cash plus $188.00/month for 60 months. Either way, they will have to pay $248.33/month for a service contract that covers all maintenance and repairs and the machine will be discarded after 5 years. What would you advise them?
2
 When a nationwide firm, like Century 21 or Coldwell Banker, acquires a local real estate company, it typically pays 5 times EBIDTA (Earnings Before Interest, Taxes, Depreciation and Amortization), which is a measure of the company’s cash flow. Suppose that reported EBIDTA is the correct and accurate measure of cash flow; specifically, EBIDTA hasn’t been affected by accounting tricks or unusual events. Identify the two most important reasons why it isn’t reasonable to use a constant multiple.
3
 Explain this analysis of pension fund and life insurance companies holding assets with an average duration of 8 years: “[I]nvestment horizons of 40 years are not uncommon for pension funds or life insurance companies....such portfolios will surely suffer when interest rates decline, even though the associated temporary increase in market value...may create the illusion of investment success.”
4
 The economic value added (EVA) model says that firms create value for their stockholders by earning profits that exceed the cost of capital. EVA “is the dollar amount by which profits in any given period exceed or fall short of the cost of capital used to produce these profits.” (Al Ehrbar, EVA: The Real Key to Creating Wealth, Wiley, 1998, p. 3.) Suppose that a firm has no debt and that all earnings are paid out as dividends. It has assets K that earn an annual rate of return r, and shareholder’s required rate of return is R. Which of these equations for the value of the firm is most consistent with EVA analysis? Explain your reasoning.
a. P = (rK - RK)/R
b. P = K + (rK - RK)/R
c. P = K
d. P = sum of (rK - RK)
5
 The Federal Home Loan Bank System says that one advantage of Freddie Mac to S&Ls is that, “When interest rates are rising, lenders [S&Ls] can sell off their older, low-interest loans [to Freddie Mac ] and reinvest in mortgages at higher interest rates.” What is the implicit assumption? [“A Guide to the Federal Home Loan Bank System,” FHLB System Publication Corporation, March 1987, p. 59.]
6
 In 1992 Congress changed the tax rules so that companies could only deduct from their taxable income the first million dollars of any executive’s salary. Many companies began paying their executives with stock options (which don’t reduce the profits reported to shareholders, but do reduce taxable income when the options are exercised). It was also thought that paying executives with options would focus their attention on the company’s stock price, which certainly matters to investors. Explain, based on your knowledge of the value of call options, whether a CEO who wants to maximize the value of these options would
  a. take actions that increase or decrease the volatility of the company’s stock price?
b. increase or reduce the firm’s dividends during the period before the options’ expiration date?
7
 TCW used monthly data for the period January 1986 through June 1994 to estimate the correlation coefficients among the returns from three different types of assets: S&P 500 stock index, Lehman Brothers Treasury bond index, and TCW’s high-yield bond index. The correlation coefficient between stocks and Treasury bonds was 0.2; the correlation coefficient between stocks and high-yield bonds was 0.5; and the correlation coefficient between Treasuries and high-yield bonds was 0.4. Explain the following:
a. why Treasuries and high-yields are positively correlated.
b. why Treasuries and stocks are positively correlated.
c. why the correlation between Treasuries and stocks is far from perfect.
d. why high-yield bonds are more closely correlated with stocks than with Treasury bonds.
8
 Many savings and loan associations have short-term deposits and long-term mortgages. Explain which of the following actions are appropriate and which are inappropriate if S&Ls want to reduce the extent to which their net worth is affected by changes in interest rates:
a. buy 30-year zero-coupon bonds
b. buy bond futures
c. buy call options on Treasury bonds
d. buy put options on Treasury bonds
e. swap their fixed-rate debts for variable-rate ones
9

On Monday, October 27, 2003, Bank of America agreed to buy FleetBoston Financial in an all-stock merger, with Fleet shareholders receiving 0.5553 Bank of America common shares for each of their shares. At the time, Fleet had 1.05 billion shares outstanding and Bank of America had 1.49 billion shares outstanding. The preceding Friday, FleetBoston stock closed at $31.80 and BankAmerica stock closed at $81.86. On the day the merger was announced, FleetBoston stock closed at $39.2 and BankAmerica stock closed at $73.57.

Bank of America said it expected the merger to save $1.1 billion, or 6 percent of the combined companies’ expenses. The merger also offers FleetBoston a partner to help it expand beyond its regional base in an industry that is increasingly trying to achieve economies of scale, and gives Bank of America a presence in the wealthy Northeastern region of the country. Estimate the increased market value created by this merger.
10
 Suppose a loan has these characteristics: P = amount borrowed; R = monthly interest rate; X = monthly payments; n = number of monthly payments. A professor asked his class what formula would equate the present value of the monthly payments to the amount borrowed. A student answered P = nX. In what special case is this answer correct?