Final ExamFNCE-455

June 13, 2012

Student Name

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Breakdown of Points

• Page 2 – Equity Analysis, 9 points

• Page 3 – Equity Analysis, 20 points

• Page 4 – Equity Analysis, 6 points / Options, 5 points

• Page 5 – Options, 20 points

• Page 6 – Fixed Income, 20 points

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You’re trying to study when the phone rings. It’s your friend Lena – who is very rich - calling from London. “Are you almost done with finals? Great – my family needs financial help, and we need you to come over right away! My Dad said you’re the only one of my friends he’d trust.” Glad to have made the grade, you jet off, and meet her in the Palm Court at the Langham Hotel.

“Not that I mind,” you say, but “why did you fly me over?”

“Well,” she says, “my Dad asked me to work with you on some financial questions. He wants to double-check the advice he’s getting. Our first problem is that our advisors say we need to sell Dell. My Dad has a million shares of it.” She shows you a chart on her iPad. “Performance has been terrible!”

1. Scanning the news on your iPhone you see that Dell has just announced plans to pay a quarterly dividend of $0.08 per share. The latest quote on the stock is $11.97.

a) (3 points) Assuming the company does not grow dividends beyond the current level in the future, and using a required rate of return of 8%, what would be a reasonable estimate of the value of Dell?

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b) (3 points) Based on the above calculation, what is your estimate of the PVGO of Dell?

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c) (3 points) Now assume that Dell can grow dividends at a 6% rate to perpetuity – using a simple dividend discount calculation, what would the stock be worth?

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2. (6 points) You run Greenblatt’s ‘Magic Formula’ list and notice that Dell is on it. Please answer the following questions about this model:

The ‘Magic Formula’ list zooms in on companies with (circle one)a) Low Long-Term Debt and high P/E ratiob) High Return on Capital and low Enterprise Value / Operating Earningsc) High Gross Margin and low EV/EBITDAd) High Dividend Yield and high growth rate

Greenblatt recommends that you sell stocks purchased using his system (circle one)a) When they no longer appear on the listb) When they have appreciated by 20% or morec) One year after purchased) Never

The ‘Magic Formula’ approach assumes that (circle one)a) Stocks tend to over-react to new informationb) Stocks tend to under-react to new informationc) Stocks tend to react appropriately to new informationd) The ‘Magic Formula’ makes no assumption about stocks’ reaction to new

information

3. Intrigued by the idea that Dell is a ‘Magic Formula’ stock, you decide to dig a little deeper into the fundamentals, and are surprised to see that the company has such a high return on equity. You run the numbers for the past five years (Table 1).

Cal Year Sales EBITPretax Profit Net Profit Assets Equity

2007 61,133 3,523 3,827 2,947 25,635 4,328 2008 61,101 3,192 3,324 2,478 27,561 3,735 2009 52,902 2,172 2,024 1,433 26,500 4,271 2010 61,494 3,433 3,350 2,635 33,652 5,641 2011 62,071 4,431 4,240 3,492 38,599 7,766

a) (10 points) Please complete the five-factor Dupont analysis below, supplying the missing values (don’t forget to label the columns).

Cal YearNet/

Pretax = ROE2007 0.77 68%2008 0.75 66%2009 0.71 34%2010 0.79 47%2011 0.82 45%

b) (4 points) Based on your analysis above, please circle all of the following statements which are true:

- The company has benefited from a lower tax rate in recent years- The company has increased its dependence on financial leverage since 2008- Asset efficiency is deteriorating- Operating margins improved significantly in 2011

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4. (2 points) You decide to do some work to sort out what kind of growth rate you could reasonably expect from Dell. Although the company will be paying a dividend, you estimate that it will still be retaining 80% of its earnings for investment in future growth. Given its recent return on equity, what rate of growth might the company be capable of?

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5. (4 points) Lena’s family has good connections with London brokerage firms, and while you are doing your math, she is arranging a visit with an analyst who has good knowledge of Dell. “There’s no doubt it’s a cheap stock,” he says. “In fact, the Price/Earnings ratio is just 6.1x…a level that is fairly unprecedented, as only 19 S&P stocks with a market cap of greater than $20 billion have traded at less than 7.0x between 1990 and the end of 2011. In any case, I think the company is turning the corner now, and should be able to grow earnings 10% a year for the next five years.” Please give three reasons why you should not rely entirely on the analyst’s forecasts.

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6. (5 points) The analyst seems to think the stock is unlikely to go lower, but Lena says the position would need to generate more income to justify its place in the portfolio. Please recommend an option strategy that will meet this objective, and diagram its profit profile in the space provided below.

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0 S TX

Recommended Strategy

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7. (10 points) Please circle the choice that best describes how the following events would affect the value of a call option on Dell using the Black-Scholes option pricing model:

Event Impact on Call Valuation

A decline in Dell’s stock price Increase Decrease No Effect

The passage of time Increase Decrease No Effect

An increase in the risk-free rate Increase Decrease No Effect

A change in investor risk preferences Increase Decrease No Effect

A decrease in the dividend payout Increase Decrease No Effect

8. (4 points) You look at Dell options and see that a January 2013 call option with a strike price of $10.00 is trading at $2.60. With the stock trading at $11.97, what is the intrinsic value of this option?

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9. (6 points) Under what conditions will the Black-Scholes value of a stock option exceed the intrinsic value? Please explain your answer. (feel free to draw a diagram) in the space below).

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10. (5 points) “If you want to make money from Dell with less risk, maybe you should consider buying their bonds,” the analyst suggests. “The company is very credit-worthy. The bond rating agencies give the company’s debt an A rating.” Please give one reason why this might be a useful insight, and one reason why you might want to be careful using this information

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11. (10 points) You review the terms of the bond and see that it is a straight bond (i.e., there is no call feature) with a 4.6% annual coupon, due to mature in five years. Please complete the worksheet below to estimate both the value and duration of the bond.

Time (Years) Payment

PV of Cash Flow @ 4% Weight

1 46 2 46 3 46 4 46 5 1046

Value of the Bond: _______________ Duration of the Bond: _____________________

12. (5 points) Assume now that the Dell bond had a feature allowing the company to call the bond if interest rates fell below 2%. All else equal, would you expect such a bond to sell at a higher or lower price than the bond above? Please explain your answer.

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...and we’re done here. Have a great summer!