30 points
The exam consists of 15 questions pertaining to a fictitious situation and spans the different topics in the course. Each question/answer is worth 2 points based on the following criteria:
• Clarity in meaning. Correct grammar and syntax should certainly help. (You are welcome to use the services of WPI’s writing center at http://www.wpi.edu/academics/cxc/writing-center.html before your final submission).
• Documentation (the discussion references data sources and verifiable facts)
• Credibility (the discussion is articulated based on appropriate qualitative and/or quantitative methods)
• Critical thinking (the discussion considers multiple facets of a given issue, highlighting the pros and cons)
• Completeness (the discussion covers many possible points)
As you provide your answer to each question, please limit to no more than 400 words per question, except for the last question (conclusion) which may be of any length.
IMPORTANT: All answers must be included in one single pdf file posted to the designated submission link on the course page, with your name printed in the document AND as the file name (or your work will probably not be located successfully and thus you cannot receive a grade). Each question and the corresponding answer should appear on one same page.
For this exam, you are to select a public company in the same industry as your group partner’s, so that both partners can share industry knowledge with each other. Keep in mind the exam questions below in making your selection, since the selected company needs to have enough available information for you to work on the questions. If you consider a company that does not disclose enough information to answer the questions, you should not select it. Your selection must be approved by the instructor only to ensure that no two people in the class work on a same company.
Assume that you are being recruited by a company for one of its managerial positions. The position is in a field of your professional expertise, and involves some financial responsibilities. Naturally, you feel undecided at first. On the one hand, you are not familiar with the company. You do not wish to be part of a “bad” company. On the other hand, you can research about the company to familiarize yourself with it. The offer is generous and you are eager to contribute to and grow with a “good” company. You have to do some research and analysis before deciding to join the company or not. The following are some questions addressing governance and financial concerns that you consider before making up your mind. Answer each of the following questions, to reach a conclusion at the end.
1) GOVERNANCE ENVIRONMENT
Assess the governance environment of the firm by considering its governance and management structure. Your discussion could incorporate board directors’ information, including the competence, and independence of board directors. Your discussion could also incorporate auditors’ information and analysts’ reports. Additional information may be obtained from the firm’s Annual Report (for example the MD&A Section, or the CEO’s message, or the Chairman’s message).
2) AGENCY CONFLICTS
Continue to assess the governance environment of the firm by considering conflicts of interest (or agency conflicts).What are agency conflicts? Provide two examples of conflicts of interest in the company (agency theory can be used as supporting theory) and analyze the conflicts situation. Explain how the company can use incentives and financial reporting to mitigate the conflicts of interest you described.
3) AUDITORS
Continue to assess the governance environment of the firm by examining its auditors. What is the role of external auditors in corporate governance? Are they responsible for the firm’s financial statements and internal controls? Discuss examples of independence issues with external auditors? If there are independence issues, what are some mechanisms or procedures to mitigate them? Who are the external auditors of your company and does there seem to be independent issues with these auditors?
4) INTERNAL CONTROLS
Continue to assess the governance environment of the company by examining its internal controls. What are internal controls in the context of a business organization? Under the Sarbanes Oxley Act of 2002, who (the board directors, management, or auditors) is responsible for designing and maintaining the company’s internal controls? Does there seem to be any internal controls issue within the company? Your answer should incorporate the management’s report on internal controls in the company’s Annual Report and the auditors’ attestation on internal controls.
5) INDUSTRY
What sector or industry does this company belong to? Using resources (such as industry database IBISWORLD at http://ezproxy.wpi.edu/login?url=http://clients1.ibisworld.com, or S&P Industry Survey at WPI Library), please describe some overall trends in this sector, its risks, opportunities and financial outlook in the long and short future.
BETA
6) Identify and discuss the risks of your firm, focusing on its market risk. Explain about beta as a measure of firm market risk. How is beta measured, and interpreted? As beta is the correlation between firm and market returns, you may compute beta based on a series of firm returns and market returns, which may be retrieved from a popular finance web site. Retrieve data to perform the computation of beta and report your work. Based on its beta measure, how do you assess your firm’s risk?
CAPM
7) Estimate your firm’s cost of capital, focusing on cost of equity. Use CAPM to estimate the company’s cost of capital (the required rate of return by investors of the company), given the company’s beta as determined above, the risk free rate of return (assumed to be from zero-coupon government bonds for US firms), and the market rate of return (assumed to be the SP500 index for US firms). Describe your data source, perform your estimation, and comment on the result.
CAPITAL BUDGETING
8) You have in mind an initiative (for example, a new product) that you want to spearhead at the company if you join it. Assume that you know the cash inflows that initiative would pay the company in the future, and you also know the cash outflows that initiative would require the company to pay up front and over time. Describe and tabulate all cash flows (using Excel). Based on such cash flow information, can you calculate the internal rate of return of your initiative? Comparing this internal rate of return to the company’s cost of capital, would it make sense for you to pitch the initiative and for the company to pursue it?
In support of your answer to this question, explain how quantitative modeling tools such as Net Present Value (NPV) and Internal Rate of Return (IRR) are used to make key business decisions related to deployment of capital and sources and uses of financial resources. Please detail the assumptions needed and how firms use the results of those analyses to inform their decisions.
9) PEER
Identify a peer company, defined as another company in the same industry or sector as the selected company and with approximately the same market value. Describe your data sources, screening, and selection. Are you aware of any major issues facing this company? Now that you have identified a peer, apply the financial analysis questions below to both the selected company and its peer for comparison where it is required.
FINANCIAL STATEMENTS
10) You want to examine the company’s financial information. Include the 3 financial statements in the most recent annual period as attachment to your submission (in the appendix). Describe and explain the purpose of the three major financial statements (balance sheet, income statement, and statement of cash flows). Explain how the information conveyed in those statements helps tell the story of the business activities, performance, and strategy of an organization in financial terms.
FINANCIAL ANALYSIS – LIFE CYCLE ANALYSIS
11) Discuss life cycle. Explain why a life cycle analysis is important for your decision. Perform a life cycle analysis based on the company’s patterns of cash flows to determine its life stage. Based on this analysis, does the company’s life cycle seem to match your life or career stage and aspiration?
FINANCIAL ANALYSIS – LIQUIDITY and SOLVENCY RISK
12) Discuss liquidity and solvency. Explain why a liquidity/solvency analysis is important for your decision. Perform analyses to comment on the company’s liquidity risk or solvency risk. What are the potentials for the company to fail soon? Does the company see to be appropriately leveraged and are there long-term solvency risks? The analyses should incorporate the company, its peer, and industry financial and non-financial data if available.
FINANCIAL ANALYSIS – PROFITABILITY
13) Discuss profitability and earnings persistence. Explain why the company’s profitability is important for your consideration. Perform analyses to comment on the company’s current and future profitability. Also analyze using both financial data and industry trends to analyze the company’s earnings persistence. The analyses should incorporate the firm, its peer, and industry financial and nonfinancial data if available.
FINANCIAL ANALYSIS – VALUATION
14) You want to perform basic valuation exercises to estimate the company’s valuation. You know that valuation depends on information on fundamentals (from financial analysis) and cost of capital or required rate of return (from CAPM), which you already have estimated. The analyses should incorporate the firm, its peer, and industry financial and nonfinancial data if available. Discuss your valuation of the company, and compare yours with the company current market valuation. Does the company appear overvalued or undervalued? Explain why valuation is important for your consideration.
SUMMARY OF CONSIDERATIONS AND CONCLUSION (FINAL DECISION)
15) Provide a summary of your considerations above. Assuming no other factors are relevant, assess all the pros and cons, and describe your decision whether to join the company.
