Posted: June 23rd, 2023

BUS 172A (Investment Analysis) Assignment 2016

1Introduction to Cases and Suggested QuestionsBUS 172A (Investment Analysis)Table&of&Contents1. BETA MANAGEMENT CO. 22. MARRIOTT CORP.: THE COST OF CAPITAL 33. MERCURY ATHLETIC: VALUING THE OPPORTUNITY 7Submit reports in soft copies on Canvas and hard copies in class.21. Beta Management Co.Product number: 292122-PDF-ENGDescriptionA manager of a small investment company has been successfully using indexfunds for limited market timing. Growth has allowed her to move into pickingstocks. She is considering two small and highly variable listed stocks, but isconcerned about the risk that these investments might add to her "portfolio."Provides a lead-in to the CAPM. Students learn about total risk, non-diversifiableor portfolio risk, and (CAPM) beta, and calculate variability of the stocksseparately, and portfolio variance with and without the stocks, to see how anextremely risky (but low-beta) stock actually reduces risk; and calculate stockbetas.Assignment Questions1. Calculate the variability (standard deviation) of the stock returns ofCalifornia REIT and Brown Group during the past 2 years. How variableare they compared with Vanguard Index 500 Trust? Which stock appearsto be riskiest?2. Suppose Beta’s position had been 99% of equity funds invested in theindex fund, and 1% in the individual stock. Calculate the variability (bystandard deviation) of this portfolio using each stock. How does each stockaffect the variability of the equity investment, and which stock is riskiest?Explain how this makes sense in view of your answer to Question #1above.3. Perform a regression of each stock’s monthly returns on the Index returnsto compute the “beta” for each stock. How does this relate to the situationdescribed in Question #2 above?4. If Ms. Wolfe’s sole purpose is to minimize the portfolio risk, then whichstock is her choice?Caution• Vanguard index fund is the same as market portfolio.• When executing regression procedure do not the excess returns (rawreturn – riskfree rate) but use the raw returns due to the lack of risk-freereturn data.32. Marriott Corp.: The Cost of CapitalProduct number: 289047-PDF-ENGDescriptionGives students the opportunity to explore how a company uses the Capital AssetPricing Model (CAPM) to compute the cost of capital for each of its divisions. Theuse of Weighted Average Cost of Capital (WACC) formula and the mechanics ofapplying it are stressed.Assignment Questions1.What is the weighted average cost of capital for Marriott Corporation?a) What risk-free rate and risk premium did you use to calculate the costof equity?b) How did you measure Marriott’s cost of debt?2.What type of investments would you value using Marriott’s WACC?3.If Marriott used a single corporate hurdle rate for evaluating investmentopportunities in each of its lines of business, what would happen to thecompany over time?4.What is the cost of capital for the lodging and restaurant divisions of Marriott?a) What risk-free rate and risk premium did you use in calculating thecost of equity for each division? Why did you choose thesenumbers?b) How did you measure the cost of debt for each division? Should thedebt cost differ across divisions? Why?c) How did you measure the beta of each division?5.What is the cost of capital for Marriott’s contract services division? How canyou estimate its equity costs without publicly traded comparablecompanies? 4Hints and Directions for Marriot Inc. Case**You must follow this direction and hints.A. Risk free rate to compute the cost of debtCost of debt ! !! = !! + !"#$%& *Entire Marriott firm’s !! and Lodging division ! Long-term (30yr) risk-free rate *Restaurant and Contract services divisions ! Short-term (1yr) risk-free rateThe values are given in Table B on page 4.B. The after-tax cost of debt = ! ? ! ×!!Use t = 34%. During 1986 – 1992 The Highest average corporate tax rate was 34%.C. The weights in the WACC equationThe weights to compute the WACC should be the “target” weights shown in Table A.D. CAPMTo compute the cost of equity, you need the value of !! ? !! (market risk premium). Usethe spread using 1926 – 1987 period as the market risk premium in Exhibit 5.Caution: which spread to use for each divisional cost of equity (CAPM)? You determinebased on the match of whether the division is short-term or long-term. If you make anymistakes in this step, then the ultimate values of WACC will be misleading.E. Unlevering / Re-levering beta• Background:If an equity beta is unlevered, then the result is an asset beta.If and asset bta is levered (or, re-levered), then the result is an equity beta.• Caution:Unlevered beta = levered beta * (1/(1 + (D/E)*(1 – t)))Levered (or, relevered) beta = unlevered beta*(1 + (D/E)*(1 – t))**Use t = 0 for the Unlevering/re-levering process for this case. The reason is thatwhen you apply this to get unlevered beta for the divisions of Marriott, there is noinformation of tax rates for other firms. Hence, consistently t = 0 for this process.Caution:• The leverage given in the case is named “market leverage” in Exhibit 3 is Debt/(Debt+ Equity) as specified in its Footnote C. You have to covert this value into D/E for thelevering and unlevering prodecures.• Also, the footnote in Exhibit 3 states that “market value leverage is the book value of 5debt divided by the sum of the book value of debt and the market value of equity.”The Unlevering-/levering- procedure uses the market value of D/E ratio. The reasonwhy the debt is just book value while the equity is market value is that the relevantdata to find out their market value of debts were not available. Let a = D/(D+E).Then, 1-a = E/(D+E). Hence, D/E = a/(1-a).• In the case:If the equity beta (each of lodging, restaurant, contract services and entire Marriott) isnot directly available, then you have to go though this un-/re-levering steps.For the entire Marriott, you cannot use the equity beta shown in Exhibit 3. You have tounlever it, and get the asset beta, using the then-current leverage (41%) and re-leverthe asset beta using the target leverage shown in Table A.For the lodging and restaurant divisions, there is no information on their own equitybetas or asset betas as of 1987. You have to compute the asset beta of each of thesetwo divisions using other firms’ equity betas given in Exhibit 3. Unlever each of theequity beta of other firms in the same division. When unlevering, use the leverage as of1987. Recall the unlevered betas are asset betas. Simple average the asset betas anduse it as the asset beta and re-lever the averaged asset beta to get the re-levered(equity) betas. When you re-lever, use the target leverage shown in Table A.For the contract services division, there is even no information on the equity betas ofother firms. Therefore, you have infer the asset beta first and re-lever it using:The asset betas of the entire Marriott, lodging division, restaurant division are calculatedin the previous steps (by you). The weights need to be calculated using their assets asof 1987 shown in Exhibit 2 for each division (for example, 2,777.4 for Lodging division,and so on) Consequently, the parts in (*) are calculated in the previous steps by youwith the only unknown asset beta of contract services division. You can now solve for itand then re-lever to get the equity beta for this division using the target leverage shownin Table A.F. HintsIf you follow the directions described above, then you will get the values as follows.Caution that there can be rounding errors in the values. Hence, your solutions would notbe exactly the same as those shown below.6WACC Asset beta Equity betaMarriott 12.50%Lodging 1.624RestaurantContract services 1.03873. Mercury Athletic: Valuing the OpportunityProduct number: 4050-PDF-ENGDescriptionIn January 2007, West Coast Fashions, Inc., a large designer and marketer of brandedapparel, announced a strategic reorganization that would result in the divestiture of theirwholly owned footwear subsidiary, Mercury Athletic. John Liedtke, the head of businessdevelopment for Active Gear, a mid-sized athletic and casual footwear company, sawthe potential acquisition of Mercury as a unique opportunity to roughly double the size ofhis business. The case uses the potential acquisition of Mercury Athletic as a vehicle toteach students basic DCF (discounted cash flow) valuation using the weighted averagecost of capital (WACC).Purpose of this caseFrom the second case you experienced the estimation of the weighted average cost ofcapital (WACC) for the entire firm and for divisions. Now you forecast the free cashflows to the firm (FCFFs) and estimate the value of enterprise with the WACC. Ofcourse, you will use the WACC from this case.Assignment QuestionsEstimate the value of Mercury using a discounted cash flow approach and Liedtke’sbase case projections.[Assume that the market risk premium is 5% and the risk-free rate of 4.93%][To calculate the WACC use the target debt to asset ratio of 0.2]**Use t = 0 for the Unlevering/re-levering process for this case.** Use t=0.4 (40%) for WACC. WACC = w!× 1 ? t ×r! + !!×!![The cash in Mercury’s balance sheet is considered all operational. Recall thatenterprise value + non-operating cash = firm value. Hence, in this case,enterprise value = firm value. ][Use the two tables in the next page to answer the question.]8Hints and Directions for Mercury Athletic Case**You must follow this direction and hints.Report the following two tables for this case.Caution:• To calculate FCFFs, you use NOPAT rather than EBIT.• Terminal year = 2011• NOPAT (Net operating profit after taxes) = EBIT*(1 – tax rate)• The number (9,805) is a hint. Your number may be different due to roundingerrors that is acceptable.HintAbout the amount of “invested capital”,In the Balance sheet, left side = Excess cash + operating assetsRight side = Debts (D) + Equity (E)Invested capital = D + E – Excess cash = operating assets.For Mercury case, the list of operating assets in 2011 is available from Exhibit 7.Grading-relatedPut middle step equations and numbers in the report.

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