Financial and Economic Analysis

Directions: Answer the following problems IN DETAIL. Your analysis must be typed and should be free of grammatical errors and “slang” terms.” Wherever appropriate, make sure you supplement your discussion with graphical analysis and equations. The graphs may be hand drawn, but please make sure they are neat. There are no restrictions or requirements on working in groups. The one exception is that each person must hand in his/her OWN work. In economic terms, there are no input restrictions; however, the output MUST be yours.

1. (15 points) The accommodative policies of the Federal Reserve System, the European Central Bank, and the Bank of Japan involve the purchase of fixed-income securities to infuse liquidity into their respective economies for the purpose of stimulating economic activity. Using the “money line-spending line” diagram and aggregate demand and supply curves, depict a situation in which monetary accommodation will not produce the intended outcome. Apart from the graphical analysis, what is a reason to doubt that the policies will work as intended?

2. (5 points) Returning to the first problem set, which of the five companies are most likely to be impacted by the increase in global liquidity? Why? Do their betas tell you anything?

3. (10 points) A popular financial newsletter called the Zweig Forecast states the following: "In a nutshell, easier money and lower interest rates are bullish; tighter money and higher interest rates are bearish" (Martin E. Zweig's italics, not mine). Is this really true? Let us test this assertion with the following model on stock prices:

SPt= b0 + b1iTt + b2Mt + et

whereSPt=annual stock price index -- the S&P 500; iTt = annual yield on long-term Treasury bonds; Mt=annual M2 in real (1982-84=100) dollars; and et = error term.

The results were generated from 40 years of data through 2008, and are listed below:

(Adjusted) R2 = 0.283 F (2, 38) = 8.904

SPt=12.554 - 13.357iTt - 0.122Mt (4.809) (-4.121) (-2.179)

The respective “t” values are in parentheses. Does the evidence support the quote? Why or why not?

4. (5 points) Four U.S. firms currently have debt rated as “Aaa,” two of which are headquartered in New Jersey, Automatic Data Processing and Johnson & Johnson. Based on the current term structure of interest and the current stance of monetary policy, what would be your strategy at this time as a member of the treasury department of either corporation? Why?

5. (10 points) After considerable negotiation with its owners, you have purchased a home for $545,700. After a 20 percent down payment, you finance the remainder under a twenty-year mortgage at the annual percentage rate (APR) of 3.32%)

a. (4 points) What are your monthly payments? Show ALL your work, including your use of the formula.

b. (6 points) Over time, what is the total cost of the home? After the third monthly payment, what is the total amount that you owe each in interest and principal? Show ALL your work, including your use of the formulas. (Note: In the intermediate steps of your calculations, take the decimal point to five places. At the final calculation, round off to two places.)

6. (5 points) Name the advantages a zero-coupon bond has over a coupon bond? What are the disadvantages?

7. (5 points) Demonstrate that you understand the difference among coupon yield, current yield, and yield to maturity with the following illustration for Morgan Stanley debt, par value of $1000: current price of $920, coupon rate of 4.2%, issue date of September 15, 2010, settlement date of October 10, 2010, and maturity date of January 15, 2015. (Note: To solve for the yield to maturity, please use the formula provided on Blackboard.)

8. (5 points) What is the maximum price that you would pay up for a series of Baa-rated debentures, each with a face value of $1000, that promise to pay 29 more semiannual coupons of $26.25 each at a yield to maturity of 5.06%? Please show how you arrive at your result.

9. (10 points) You are provided with the following monthly expected returns, each of which is represented by E(Ri), and betas for the following stocks. Please estimate the capital asset pricing model and draw conclusions about the significance and realism of the results. (Note: Please use conventional tests of the R-squared and coefficients.) On the basis of your results, please name at least three of the stocks that you would recommend as “buys.”

E(Ri) Beta |AA |0.8 |1.3 | |AXP |0.8 |1 | |BA |1 |0.80 | |C |0.8 |1.35 | |CAT |1.2 |1.7 | |CSCO |0.6 |0.95 | |KO |0.4 |0.6 | |DIS |0.6 | | |DD |0.6 |0.7 | |ED |0.4 |0.55 | |XOM | |0.6 | |GE |0.5 |0.9 | |GM |0.6 |0.8 | |HPQ |0.4 |1.3 | |HD |0.4 |0.9 | |HON |0.9 |1.15 | |INTC |0.8 |1.1 | |IBM | |1.4 | |IP |0.4 |0.80 | |JNJ |0.3 |0.35 | |MCD |0.6 |0.5 | |MSFT |0.8 |1.2 | |MMM |0.5 |0.9 | |JPM |0.9 |1.70 | |PG |0.4 |0.45 | |SYK |0.6 |0.4 | |T |0.6 | | |UTX |1.1 |1.1 | |WMT |1 |0.8 | |WPC |0.7 |1.2 | | | | |

Symbols: Alcoa (AA), American Express (AXP), AT&T (T), Boeing (BA), Citigroup (C), Caterpillar (CAT), Cisco Systems (CSCO), Coca Cola (KO), Consolidated Edison (ED). Disney (DIS), Dupont (DD), Exxon Mobil (XOM), General Electric (GE), General Motors (GM), Hewlett-Packard (HPQ), Home Depot (HD), Honeywell (HON), Intel (INTC), International Business Machines (IBM), International Paper (IP), Johnson and Johnson (JNJ), McDonalds (MCD), Microsoft (MSFT), 3M (MMM), J.P. Morgan Chase (JPM), Procter and Gamble (PG), Stryker (SYK), United Technologies (UTX), Wal-Mart (WMT), and W.P. Cary (WPC)

10. (20 points)

a. (15 points) According to the CFO of Kansas City Southern (KSU), the railroad spent $175 million in 2009 to rebuild an abandoned rail line in order to provide the railroad with ready access to growing markets in Mexico. The railroad predicts a free cash flow of $21 million per year from the project. From the standpoint of net present value, do you think this is a good investment? To guide your analysis, please see the railroad’s Value Line summary page on Blackboard under KSU.PDF, which includes KSU’s (financial) capital structure and estimated beta.

lthough the company’s bond rating is “BB,” as rated by Standard & Poor, the project is re-financed at an interest rate of 7.2%. For ease of estimation, assume a corporate tax rate of 35%. Please show all your work. (Hint: Estimate the WACC, the equity cost of which you will obtain from the estimates of the capital asset pricing model in problem 9.)

b. (5 points) In what year does the internal rate of return exceed the WACC? What do you conclude by comparing the internal rate of return to a less formal means of estimating the cost of capital, such as the current interest rate on the bonds plus three percentage points? What do you conclude about the profitability of the project now? Please show your work.

11. (10 points) I recently had dinner with a stock analyst who has a “buy” recommendation on Tractor Supply (symbol, TSCO), stating that the company is well positioned in the sector of retail farm supplies and equipment and poised for further growth. In forming his recommendation, he performed his own analysis and talked directly with upper management. In terms of the rapidity and breadth with which financial markets incorporate new information into security prices, should I believe that TSCO’s future performance is likely to surprise investors positively? Please be specific and thorough.

12. (30 points)

a. (25 points) You are 28 years of age (very young and very wise). Your birthday is in December. Using a series of monthly contributions, you are determined to build an investment portfolio that will enable you to reach an inflation-adjusted, after-tax sum of at least $1.5 million by the time you reach the ripe young age of 60. Please assume the present tax structure remains in place for the length of your investment horizon and that the long-run inflation rate is approximated by the 10-year increase in the Consumer Price Index, from February of 2003 through February of 2013 (as obtained from www.chicagofed.org).

However, in being moderately risk-averse, you are not willing to take unnecessary risks (e.g., portfolios dominated by large-beta stocks, speculating with options, selling short, etc.), and you prefer a buy-and-hold strategy, as opposed to one based on frequent trading. To get started, assume that you begin with $10,000 -- accumulated since paying off your Seton Hall MBA loan -- and will choose from the securities listed below, eight of which are individual stocks, with their respective expected twelve-month returns and betas. Which ones will you choose? Why? As part of your analysis, assume you will make your first payment in May of 2013 and your last payment when you turn 60.

As part of your estimates, you will have to compute the correlation between each pair of security returns. The data from which to do so will be posted on Blackboard. They run from August of 2007 through August of 2012, 60 data points. Please be sure to show ALL your work and describe how you have arrived at the results. For the foreseeable future, if the maximum amount that you can save per month is $1,000.00, how likely is it that you will reach your goal? Please explain and show how you have arrived at your conclusion.

Symbols: Apple (AAPL), Chevron (CVX), Coca Cola (KO), Cummins (CMI), Express Scripts (ESRX), Google (GOOG), Johnson & Johnson (JNJ), and McDonald’s (MCD), six-month U.S. Treasury bill, ten-year Treasury note, and the S&P 500 (SP500)

Expected StockAnnual Return Beta Apple (AAPL)13%1.00 Chevron (CVX)7%0.80 Coca Cola (KO)8%0.55 Cummins (CMI)15%1.70 Express Scripts (ESRX)20%0.90 Google (GOOG)11%1.00 Johnson & Johnson (JNJ)6%0.50 McDonald’s (MCD)7%0.40 20-year “A” corporate bonds4.0%0.20 Six-month U.S. Treasury bills0.20%0 Ten-year Treasury note2.00%0 S&P 500 8%1

Mutual funds: The Vanguard 500 Index, which approximates the S&P 500 and other broad index mutual funds, has an expected long-term annual return of 8%.

b. (5 points) If the price of one of the stocks you have selected rises faster than you had expected, but you still want to hold the stock for the long term, how will you hedge your risk? Please be thorough and specific.