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Index benchmark. [10 minutes]
d. Evaluate the appropriateness of using the Salomon Brothers World Government Bond Index as a
benchmark for purposes of monitoring PTC™s non-U.S. portfolio exposures in relation to its pen-
sion benefit liability exposures. [5 minutes]
3. CFA Examination Level II
CFA
®
As a new employee at Clayton Asset Management, Emma Bennett has been assigned to evaluate the
credit quality of BRT Corporation bonds. Clayton holds the bonds in its high-yield bond portfolio.
The following information is provided to assist in the analysis.
BRT Corporation is a rapidly growing company in the broadcast industry. It has grown primarily
through a series of aggressive acquisitions.
Early in 1996, BRT announced it was acquiring a competitor in a hostile takeover that would
double its assets but also increase debt burdens. The credit rating of BRT debt fell from BBB to BB.
The acquisition reduced the financial flexibility of BRT but increased its presence in the broadcast-
ing industry.
Now, mid-1997, BRT has announced its merging with another large entertainment company.
The merger will alter BRT™s capital structure and place it as a leader in the broadcast industry. The
early 1996 acquisition combined with this merger will increase the total assets of BRT by a factor
of four. A large portion of the total assets are intangible, representing franchise and distribution
rights.
Although the outlook for the broadcasting industry remains healthy, large telecommunication
companies attempting to enter the broadcasting industry are keeping competitive pressures high.
Laws and regulations also promote the competitiveness of the environment, but initial start-up
costs make it difficult for new companies to enter the industry. Large capital expenditures are re-
quired to maintain and improve existing systems as well as to expand current business.
For Bennett™s analysis, she has been provided with the financial data shown in Table 19.7 through
Table 19.10.
a. Calculate the following ratios using the projected 1997 financial information:
(1) Operating income to sales
(2) Earnings before interest and taxes to total assets
(3) Times interest earned
(4) Long-term debt to total assets [4 minutes]




Table 19.7 BRT Corporation Balance Sheet Data at Year End”December 31 (In Millions)


Projected
1993 1994 1995 1996 1997

Current assets $ 654 $ 718 $2,686 $ 2,241 $ 5,255
Net fixed assets 391 379 554 1,567 2,583
Other assets (Intangibles) 2,982 3,090 3,176 8,946 20,435
Total assets $ 4,027 $ 4,187 $6,416 $ 12,754 $ 28,273
Current liabilities $ 799 $ 876 $ 966 $ 1,476 $ 3,731
Long-term debt 2,537 2,321 2,378 7,142 15,701
Other liabilities 326 292 354 976 349
Total equity 365 698 2,718 3,160 8,492
Total liabilities and equity $ 4,027 $ 4,187 $6,416 $ 12,754 $ 28,273
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36 Web Problems




Table 19.8 BRT Corporation Income Statement Data”Years ending December 31
(In Millions Except Per-Share Data)


Projected
1993 1994 1995 1996 1997

Net sales $1,600 $1,712 $2,005 $4,103 $9,436
Operating expenses 1,376 1,400 1,620 3,683 8,603
Operating income $ 224 $ 312 $ 385 $ 420 $ 833
Interest expense 296 299 155 270 825
Income taxes 20 42 130 131 4
Net income $ (92) $ (29) $ 100 $ 19 $ 4
Earnings per share ($ 0.86) ($ 0.24) $ 0.83 $ 0.09 $ 0.01
Average price per share $26.30 $34.10 $ 4.90 $40.10 $40.80
Average shares outstanding 107 120 121 198 359




Table 19.9 BRT Corporation Selected Financial Ratios


Projected
1993 1994 1995 1996 1997

Operating income to sales (%) 14.0% 18.2% 19.2% 10.2% *
Sales to total assets 0.39 times 0.41 times 0.31 times 0.32 times 0.33 times
Earnings before interest
and taxes to total assets 5.5% 7.4% 6.0% 3.3% *
Times interest earned 0.76 times 1.04 times 2.48 times 1.55 times *
Long-term debt to total assets 63.0% 55.4% 37.0% 55.9% *




Table 19.10 Clayton Asset Management Credit Rating Standards


AVERAGE RATIOS BY RATING CATEGORY
AA A BBB BB B CCC CC
Financial Ratios
Operating income to sales (%) 16.2 13.4 12.1 10.3 8.5 6.4 5.2
Sales to total assets 2.50 times 2.00 times 1.50 times 1.00 times 0.75 times 0.50 times 0.25 times
Earnings before interest and
taxes to total assets 15.0% 10.0% 8.0% 6.0% 4.0% 3.0% 2.0%
Times interest earned 5.54 times 3.62 times 2.29 times 1.56 times 1.04 times 0.79 times 0.75 times
Long-term debt to total assets 19.5% 30.4% 40.2% 51.8% 71.8% 81.0% 85.4%
Bond Credit Spread Information
Current yield spread in basis points
over 10-year Treasuries 45 55 85 155 225 275 350
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Chapter 20




Table 19.11 Financial Information


Ratio 1997 1998 1999
Sturdy Machines
Cash flow/total debt (%) 37.3 31.0 33.0
Total debt/capital (%) 38.2 40.1 41.3
Pretax interest coverage (3) 4.2 2.3 1.1
Patriot Manufacturing
Cash flow/total debt (%) 34.6 38.0 43.1
Total debt/capital (%) 40.0 37.3 34.9
Pretax interest coverage (3) 2.7 4.5 6.1




b. Discuss the effect of the 1997 merger on the creditworthiness of BRT through an analysis of each
of the ratios in Part a. [8 minutes]
BRT Corporation 10-year bonds are currently rated BB and are trading at a yield to maturity of 7.70
percent. The current 10-year Treasury note is yielding 6.15 percent.
c. State and justify, based on your work in Parts a and b, the information in Tables 19.9 and 19.10,
and the introduction, whether Clayton should hold or sell the BRT Corporation bonds in its port-
folio. Include a discussion of two qualitative factors. [10 minutes]


CHAPTER 20

1. CFA Examination Level II
CFA
®
Current equity call prices for Furniture City are contained in the following table. In reviewing these
prices, Jim Smith, CFA, notices discrepancies between several option prices and basic option pric-
ing relationships.

CLOSING PRICES
FURNITURE CITY EQUITY CALL OPTIONS
MAY 31, 1997
EXPIRATION MONTH

Stock Close Strike June July August September

1191„2 110 87„8 12 1„2 15 18
1191„2 120 11„2 33„4 3 41„4
1191„2 130 1 21„4 27„8 5




Identify three different apparent pricing discrepancies in the table. Identify which of the basic op-
tion-pricing relationships each discrepancy violates. (Note: The fact that option contracts do not al-
ways trade at the same time as the underlying stock should not be identified as a discrepancy.)
2. CFA Examination Level III
CFA
®
On June 1, 1987, an institutional portfolio manager is managing a $1 million portfolio consisting of
U.S. government bonds. Currently, the portfolio is fully invested in one bond issue”Government
8% Bonds due June 1, 2002, selling at a market price of 100.
The manager is concerned about the outlook for interest rates over the next six months. The man-
ager believes interest rates will move significantly with probabilities favoring a strong rise in rates,
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38 Web Problems



but a strong decline is also possible. For the next six-month holding period, the manager™s goal is to
structure a portfolio that will be substantially protected from a rate rise but that will also participate
in any market advances.
Other available investment instruments are the following:
(1) Futures Contract on Government 8 percent Bonds, due 6/l/02

Futures expiration 12/1/87
Futures current price $101
Contract size $100,000

(2) Option Contracts on Government 8 Percent Bonds, due 6/l/02 expiring 12/1/87


Option Strike Price Market Price Contract Size

Calls 100 4.00 $100,000
Puts 100 2.00 $100,000



(3) Treasury bills maturing 12/1/87, yielding 3 percent for six months.
a. Assume that the manager wishes to maintain the current bond holding. Design an option strategy
that will achieve the manager™s goal of protecting against an interest rate rise while also partici-
pating in any market advances.
b. Assume that the manager is willing to maintain or sell the current bond holding. With available
instruments already listed, design two alternative portfolio structures that accomplish the same
goal.
c. Based on the following put-call parity relationship, calculate which of the two strategies designed
in Part b should be implemented:
Put Price 5 Call Price 2 Bond Price 1 (Present Value of Exercise Price)
3. CFA Examination Level III
CFA
®
Janice Delsing, a U.S.-based portfolio manager, manages an $800 million portfolio ($600 million in
stocks and $200 million in bonds). In reaction to anticipated short-term market events, Delsing
wishes to adjust the allocation to 50 percent stock and 50 percent bonds through the use of futures.
Her position will be held only until “the time is right to restore the original asset allocation.” Delsing
determines a financial futures-based asset allocation strategy is appropriate. The stock futures index
multiplier is 250, and the denomination of the bond futures contract is $100,000. Other information
relevant to a futures-based strategy is given in the following exhibit.


Information for Futures-Based Strategy

Bond portfolio modified duration 5 years
Bond portfolio yield to maturity 7%
Basis point value (BPV) of bond futures $97.85
Stock index futures price $1,378
Stock portfolio beta 1.0



a. Describe the financial futures-based strategy needed and explain how the strategy allows Delsing
to implement her allocation adjustment. No calculations are necessary.
b. Compute the number of each of the following needed to implement Delsing™s asset allocation
strategy:
(1) Bond futures contracts
(2) Stock index futures contracts
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Chapter 21



c. Discuss one advantage and one disadvantage of using each of the following for asset allocation:
(1) Financial futures
(2) Index put options
One month later, the yield to maturity on comparable bond portfolios has increased by 10 ba-
sis points and the stock index has risen by $28.
d. Calculate the percentage return (from price changes only) for the past month, assuming:
(1) Delsing executed the 50/50 asset allocation strategy using futures.
(2) Delsing did not execute the strategy but instead preserved her original long-term asset allocation.
4. a. Use combinations of payoff diagrams similar to those shown in Exhibits 21.10“21.12 to demon-
strate why the “synthetic put” version of the put-call-spot parity condition must hold in an arbi-

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