PART 3. HISTORICAL PERFORMANCE, RISK AND RETURN ANALYSIS FOR THE FIRM (45 marks)

Objective: To develop a historical performance, return and risk profile for your company.

Key Questions

1. Estimating Historical Return

a. Calculate the total return (including the capital gain and dividend yield) for the company stock over the last one year, five years and ten years.

b. Calculate the return on comparable market index for the same periods. Did the stock outperform or underperform the market?

c. What is the yield on existing bonds of the company? If the company has issued several bonds, calculate and compare the yield on various maturities.

d. Decompose the yield on longest maturity bond into the risk-free rate, default risk premium and maturity risk premium.FIN325/ Corporate Finance, Homework #1

2. Estimating Historical Risk Parameters

a. Calculate the standard deviation of the return, preferably using monthly data and five years of observations. What is the probability that the stock return is positive (assuming the normal distributions of the returns)?

b. Run a regression of returns on your firm's stock against returns on a market index, preferably using monthly data and five years of observations.

c. What is the intercept of the regression? What does it tell you about the performance of this company's stock during the period of the regression?

d. What is the slope of the regression? What does it tell you about the risk of the stock?

e. What portion of this firm's risk can be attributed to market factors? What portion to firm-specific factors? Why is this important?

3. Calculating the Free Cash Flows

a. Using the summary financial statements for the company, compile the five years of Income Statements and Balance Sheet for the company.

b. Complete a common-sized income statement and a common-sized balance sheet for the last two years. Interpret your results.

c. Compute the firm's free cash flows for the last two years and analyze the trend in operating and free cash flows.

d. What are were the major sources and uses of cash during the last two years? e. How liquid is the firm? f. Are its managers generating an adequate profit on sales and the firm's assets? g. How is the firm financing its assets?

h. Are its managers generating a good return on equity and capital?

Information Sources.

For the publicly traded firms the primary source of information would be the annual reports and corporate website (look for investor relations). For firms that are incorporated in the United States, the detailed information on the CEO and the board of directors could be found in the filings made by the firm with the SEC. In particular, the 14-DEF will list the directors in the firm, their relationship with the firm, and details on compensation for both directors and top managers. You can also get information on trading done by insiders from the SEC filings. For firms that are not listed this information is much more difficult to obtain. However, the absence of readily accessible information on directors and top management is more revealing about the power that resides with incumbent managers.

Information on a firm's relationships with bondholders usually resides in the firm's bond agreements and loan covenants. Although this information may not always be available to the public, the presence of constraints shows up indirectly in the firm's bond ratings and when the firm issues new bonds.

The relationship between firms and financial markets is tougher to gauge. The list of analysts following a firm can be obtained from publications such as the Nelson Directory of Securities Research. For larger and more heavily followed firms, the archives of financial publications (e.g., the Financial Times, The Wall Street Journal, Forbes, Barron's) can be useful sources of information.

Finally, the reputation of a firm as a corporate citizen is the most difficult area to obtain clear information on, because it is only the outliers (the worst and the best corporate citizens) that make the news. The

FIN325/ Corporate Finance, Homework #1

proliferation of socially responsible mutual funds, however, does give us a window on those firms that pass the tests (arbitrary though they sometimes are) imposed by these funds for a firm to be viewed as socially responsible.

Information about insider and institutional ownership of firms is widely available, since both groups have to file with the SEC. These SEC filings are used to develop rankings of the largest holders of stock in firms. Insider activity (buying and selling) is also recorded by the SEC, although the information is not available until a few weeks after the filing.

Summary financial statements for most of the companies could be found at http://finance.yahoo.com, http://www.morningstar.com/, http://uk.reuters.com/.