Approaches To Valuation - Problem Set Solutions
Approaches To Valuation - Problem Set Solutions
APPROACHES TO VALUATION
Question 1
A. False. The reverse is generally true.
B. True. The value of an asset is an increasing function of its cash flows.
C. True. The value of an asset is an increasing function of its life.
D. False. Generally, the greater the uncertainty, the lower is the value of an asset.
E. False. The present value effect will translate the value of an asset from infinite to
finite terms.
Question 2
When equity is valued, the cash flows to equity investors are discounted at their cost
(the cost of equity) to arrive at a present value, which is the value of the equity stake
in the business.
When the firm is valued, the cash flows to all investors in the firm (including equity
investors, lenders and preferred stockholders) are discounted at the weighted average
cost of capital to arrive at a present value, which equals the value of the entire firm
(generally much higher than the value of just the equity stake.)
The distinction matters for two reasons:
(1) Mismatching cash flows and discount rates can cause significant errors in
valuation.
(2) Not recognizing what the present value of the cash flows measures can also lead to
misinterpretations. For instance, if the present value of cash flows to the firm is
treated as the value of equity, there is an obvious problem.
Question 3
(1) Paramount is similar to the average firm in the industry in terms of growth and
risk.
(2) The marker is valuing communications firms correctly, on average.
SOLUTIONS
** 5.50% is the geometric mean average premium earned by stocks over treasury
bonds between 1926 and 1990.
Question 4
An international portfolio manager would prefer a beta estimated relative to an
international index. Daimler Benz returns would be regressed against returns on such
an index to estimate its beta.
Question 5
A. Beta = 1.60 * 100/500 + 2.00 * 150/500 + 1.20 * 250/500 = 1.52
B. If they pay the cash out as a dividend: Beta = 1.60 * 100/350 + 1.20 * 250/350 =
1.31
If they keep the cash in the firm: Beta = 1.60*100/500 + 0*150/500 + 1.20*250/500 =
0.92
C. Use 2.00, the beta for the software division.
Question 6
A.
Unlevered
Beta
1.15 33.91% 0.95557808
Beta
Weyerhauser
Champion
International
Intenational Paper
Kimberly-Clark
D/E
The unlevered betas measure the business and operating leverage risk associated with
each of these firms.
B. New beta for Kimberly Clark = 0.85 * (1 + (1-0.4) (0.30)) = 1.00
C. The average unlevered beta of these comparable firms should be relevered using
the debt equity ratio of the initial public offering.
Average Unlevered Beta = 0.88
Beta of the Initial Public Offering = 0.88 (1 + (1-0.4) (0.40)) = 1.09
Question 7
A. CPC should have the highest beta (because of its high fixed costs) and Kellogg's
should have the lowest beta (because of its low fixed costs).
B. Old Debt/Equity Ratio = D/(D+E)/( 1 - D/(D+E)) = 0.3/ (1-0.3) = 0.4286
Unlevered Beta (using D/E ratio of 30%) = 0.88/(1 + (1 - 0.4) * 0.4286) = 0.70
New Debt/Equity Ratio = 0.7535/(1 - 0.7535) = 3.06
New Levered Beta = 0.70 (1 + (1 - 0.4) * (3.06)) = 1.985
Question 8
A.
Year
1988
1989
1990
1991
1992
1993
Earnings
$10.00
$15.00
$18.00
$18.50
$19.00
$22.00
Chg in Earnings =
_ Earnings
50.00%
20.00%
2.78%
2.70%
15.79%
7.00%
10.00%
5.00%
-10.00%
-8.00%
6.00%
[Use values of the firm (debt + equity) as the weights for unlevered betas]
QVC/Paramount Levered Beta = 1.12 * (1+ (1 - 0.35) (7417/2000)) = 3.82
(New Debt = 817 + 100 + 6500 = 7417; New Equity = 2000)
C. Viacom/Paramount Beta = 1.05 * 6500/14000 + 1.15 * 7500/14000 = 1.10
D. Viacom Unlevered Beta = 1.15/(1 + (1 - 0.35)(2500/7500)) = 0.95
Paramount Unlevered Beta = 1.05/(1 + (1 - 0.35)(817/6500)) = 0.97
Viacom/Paramount Unlevered Beta = 0.95 * 10000/(10000 + 7317) + 0.97 * 7317/
(10000 + 7317) = 0.958
Use values of the firm (debt + equity) as the weights for unlevered betas.
Viacom/Paramount Levered Beta = 0.958 * (1 + (1 - 0.35)(3317/14000)) = 1.11
(New Debt = 817 + 2500 = 3317)
Question 10
A. It measures the riskless rate during the period of the analysis.
B. There were four common economic factors driving stock returns over the
estimation period.
C. The factor coefficients measure the risk premium relative to each factor, and the
betas measure sensitivity to the factor.
D. Expected Return = 0.062 - 1.855 (-0.07) + 1.4450 (0.01) - 0.124 (0.02) - 2.744
(0.01) = 0.17638 or 17.638%
E. Expected Return = 6.25% + 1.05 * 5.50% = 12.025%
The CAPM assumes that the market factor captures all systematic risk. The APM
allows for multiple sources of systematic risk.
Question 11
A. See second-to-last column below.
$32.00 $1.06
Ogden Co.
Honda
(ADR)
Microsoft
$25.00 $1.25
$25.00 $0.27
$84.00 $0.00
g
15.00
%
4.00%
10.00
%
NMF
Book
Value
Weights
$1918
25.86%
$5500
74.14%
1994 projection
$137.80
$144.16
-$6.36
D. (Also in millions)
Net Income =
- (1 - 0.75) * (850 - 580) * 1.06 =
FCFE =
$137.80
$71.55
$66.25
Question 6
1991
Revenues
1994
(no
debt)
$8,494 $9,000 $9,360 $9,360
- Operating Expenses
- Depreciation
1992
$872
= EBIT
1993
1994
$860
$894
$894
- Interest Expenses
$510
$515
$536
$536
- Taxes
$362
$420
$437
$437
= Net Income
$326
$235
$244
$244
+ Depreciation
- Capital
Expenditures
- Working Capital
$872
$860
$894
$894
($235)
($350) ($400)
($0)
$63
$0
$98
$242
$202
$202
$63
$0
$301
$300
($50)
=FCFE
+ Interest Expenses
(1-t)
- Net Debt Issues
$185
($350) ($400)
=FCFF
$725
Working Capital
Total Debt
($5)
Debt Ratio
$285
43.84%
Tax Rate
To get the new debt issues in 1994, take 43.84% of the net capital expenditures in that year (1040 - 894)
Question 7
FCFE/shar
e
$1.12
$1.25
$1.18
$1.40
$1.29
4
5
$1.57
$1.76
Year
Terminal
Value
Real CF
$1.09
$23.32
$1.40
$21.63
Year
1
Before Taxes
Expected
Terminal
DPS
Price
$0.67
After Taxes
Expected
Terminal
DPS
Price
$0.43
$0.75
$0.48
$0.84
$0.54
4
5
$0.94
$1.06
$0.60
$0.68
$62.79
$56.34
EPS
1987
1988
1989
1990
1991
1992
$0.67
$0.77
$0.90
$1.10
$1.31
$1.51
A. Arithmetic Average
=
B. Geometric Average
=
Growth
rate
14.93%
16.88%
22.22%
19.09%
15.27%
17.68%
17.65%
C. The geometric average considers the compounded effects of growth. The arithmetic
average does not.
Question 2
EPS = 0.4413 + 0.172
(t)
Growth rate from this regression
$0.172 a year.
model equals
A. Linear Regression =
Question 3
Year
1987
1988
1989
1990
1991
1992
1993
EPS
7.27
7.91
-0.97
-2.64
8.42
-0.06
10.75
Corrected g
8.09%
-112.26%
172.16%
131.35%
-100.71%
100.56%
t
1
2
3
4
5
6
7
33.20%
3.17%
Question 4
A. Retention Ratio = 64%
Return on Equity = 1625/5171 = 31.4%
Expected Growth Rate = 0.64 * 31.4% = 20.10%
B. Growth Rate in 1993 = ( $5,171 * (.25 -.314)/ $1,625) + 0.64 * 0.25 = -4.37%
C. Growth Rate After 1993 = 0.64 * 0.25 = 16%
Question 5
A. Retention Ratio = 1 - $660/$1080 = 0.3889
Return on Assets = ($1080 + $550 * (1 - 0.4))/($6000 + $6880) = 10.95%
Debt/Equity Ratio = (6880/6000) = 1.14
Expected Growth Rate: = 0.3889 (10.95% + 1.14 (10.95% - (550/6880) * (1 - 0.4)) =
7.00%
B. Retention Ratio = 50%
Total Assets = $6000 + $6880 - $2500 = $10.380.
New Return on Assets = (1020 + 550 * (1 - 0.4))/10380 = 13.01%
(The earnings before interest and taxes goes down by $100. The earnings after taxes
will drop by $60. Note that interest expenses will be lower after debt is paid off, but
the net income will go up by an equivalent amount.)
New Debt Equity Ratio = (4380/6000) = 0.73
New Expected Growth Rate = 0.50 (13.01% + 0.73 (13.01% - 7%*(1 - 0.4))) = 9.72%
(The growth rate next year will be much higher as a result of the shift in the return on
equity, but the long term growth rate will now be 9.72%)
C. Beta Before Change = 1.10
Unlevered Beta = 1.10/(1 + (6880/(330 * $63)) * (1 - 0.4)) = 0.9178
(Use market value of equity for this calculation)
Beta After Change = 0.9178 * (1 + (4380/(330 * $63)) * (1 - 0.4)) = 1.04
Question 6
A. Pre-Interest, After-Tax Profit Margin = EBIT (1-T)/Sales = 10 * (1 - 0.36)/ 60 =
10.67%
Asset Turnover = Sales/Total Assets = 60/30 = 2
Return On Assets = 0.1067 * 2 = 0.2134 Or 21.34%
Retention Ratio = 35%
Expected Growth Rate = 0.35 (0.2134 + 1 (0.2134 - 0.065 * 0.64)) = 13.48%
B. Pre-Interest, After-Tax Profit Margin = 9.00%
Return on Assets = 0.09 * 2 = 18%
New Growth Rate = 0.35 (0.18 + 1 (0.18 - 0.065 * 0.64))= 11.14%
C. Break-Even Asset Turnover = 0.2134/0.09 = 2.37
Question 7
A. Expected Growth Rate = 0.93 (25% + 0.10 (25% - 8.50% * (1 - 0.4)) = 25.10%
D. True. Portfolios of stocks that are undervalued using the dividend discount model
seem to earn excess returns over long time periods.
E. True. The model is biased towards these stocks because of its emphasis on
dividends.
Question 2
A. A stock that pays no dividends is not a stable stock. The Gordon Growth model is
not designed to value such a stock. If a company with stable growth insists on not
paying dividends, but retains the FCFE, this FCFE can be used in the Gordon Growth
model as the dividend.
B. A stable stock cannot have a growth rate greater than the discount rate, because no
company can grow much faster than the economy in which it operates in the Gordon
Growth Model. This upper limit on how high growth rates can go operates as a
constraint in the model.
C. This should not happen for a stable stock, for the same reasons stated above.
D. It is true that the model smooths out growth rates in dividends. In present value
terms, though, this smoothing effect cannot have a large effect on the value estimate
obtained from the model.
E. The model requires that, in the long term, the growth rate for a firm is stable (close
to the growth rate in the economy). Thus, cyclical firms, which maintain an average
growth rate close to a stable rate, cyclical ups and downs notwithstanding, can be
valued using this model.
Question 3
A. Cost of Equity = 6.25% + 0.90 * 5.5% = 11.20%
Value Per Share = $3.56 * 1.055/(.1120 - .055) = $65.89
B. $3.56 (1 + g)/(.1120 - g) = $80
Solving for g,
g = (80 * .112 - 3.56)/(80 + 3.56) = 6.46%
Question 4
A. This should increase both the cost of equity (by raising interest rates) and the
nominal growth rate. Whether the increase will be the same in both variables will
depend in large part on whether an increase in inflation will adversely impact real
economic growth.
B. This should affect the estimation of a stable growth rate. A much higher stable
growth rate can be used for firms in economies which are growing rapidly.
C. An analyst has very limited flexibility when it comes to using the Gordon Growth
model in estimating growth. If the growth potential of the industry in which the firm
operates is very high, a growth rate slightly higher (1 to 2%) than the growth rate in
the economy can be used as a stable growth rate. Alternatively, a two-stage or threestage growth model can be used to value the stock.
D. Same as the answer to 3.
Question 5
A. Expected Earnings Per Share in 1999 = $2.10 * 1.155 * 1.06 = $4.48
Expected Dividends Per Share in 1999 = $4.48 * 0.65 = $2.91
Cost Of Equity After 1999 = 6.25% + 1.1 * 5.5% = 12.30%
Expected Price at the End of 1998 = Expected DPS in 1999/(ke, 1999 - g)
= $2.91/(.1230 - .06) = $46.19
B.
Year
EPS
DPS
1994
$2.42
$0.79
1995
$2.78
$0.91
1996
$3.19
$1.05
1997
1998
Cost of Equity = 6.25% + 1.40 * 5.5% =
PV of Dividends and Terminal Price (@ 13.95%) =
$3.67
$4.22
$1.21
$1.39
Question 6
A. Retention Ratio = 1 - Payout Ratio = 1 - 0.42/1.50 = 72%
$46.19
13.95%
$27.59
Return on Assets
= (Net Income + Int Exp (1-t))/(BV of Debt + BV of Equity)
= (30 + 0.8 * (1 - 0.385))/(7.6 + 160) = 18.19%
Debt/Equity Ratio = 7.6/160 = .0475
Interest Rate on Debt = 0.8/7.6 = 10.53%
Expected Growth Rate
= 0.72 [.1819 + .0475 (.1819 - .1053 * (1 - 0.385))] = 13.5%
Alternatively, and much more simply,
Return on Equity = 30/160 = .1875
Expected Growth Rate = 0.72 * .1875 = 13.5%
B. Expected payout ratio after 1998:
= 1 - g/[ROC + D/E (ROC - i (1-t))]
= 1 - .06/(.125+.25(.125 - .07(1-.385))
= 0.5876
C. Beta in 1993 = 0.85
Unlevered Beta = 0.85/(1 + (1 - 0.385) * 0.05) = 0.8246
Beta After 1998 = 0.8246 * (1 + (1 - 0.385) * 0.25) = 0.95
D. Cost of Equity in 1999 = 7% + 0.95 * 5.5% = 12.23%
Expected Dividend in 1999
= ( $1.50 * 1.1355 * 1.06) * 0.5876 = $1.76
Expected Price at End of 1998 = $1.76/(.1223 - .06) = $28.25
E.
Year
EPS
DPS
1994
$1.70
$0.48
1995
$1.93
$0.54
1996
$2.19
$0.61
1997
1998
Cost of Equity = 7% + 0.85 * 5.5% =
PV of Dividends and Terminal Price (@ 11.68%) =
$2.49
$2.83
$0.70
$0.79
$28.25
11.68%
$18.47
EPS
$4.58
$5.32
$6.17
$7.15
$8.30
$9.46
DPS
$0.79
$0.92
$1.07
$1.21
$1.43
$2.35
7
8
9
10
$10.59
$11.65
$12.58
$13.34
$3.56
$4.94
$6.44
$8.00
$3.67
PV of Dividends - Transition =
$9.10
PV of Terminal Price =
Value Per Share =
$44.59
$57.36
SOLUTIONS
B.
Current Earnings per share =
- (1 - Desired Debt Fraction)
*
(Capital Spending - Depreciation) =
83.61%*
- (1 - Desired Debt Fraction)
*
Working Capital
$3.20
$1.00 =
$0.84
= 83.61%
*
$0.00 =
$0.00
$2.36
Cap
Term
Depr WC FCFE
Exp
Price
$2.71 $2.60 $1.30 $0.05 $1.64
4
5
6
Year EPS
$84.74
The net capital expenditures (Cap Ex - Depreciation) and working capital change is
offset partially by debt (20%). The balance comes from equity. For instance, in year 1:
FCFE = $2.71 - ($2.60 - $1.30) * (1 - 0.20) - $0.05 * (1 - 0.20) = $1.64)
Cost of Equity = 6.5% + 1 * 5.5% = 12%
Terminal Value Per Share = $5.08/(.12 - .06) = $84.74
Cap
Term
Depr WC FCFE
Exp
Price
$2.71 $2.60 $1.30 $0.05 $1.64
4
5
6
Year EPS
$52.09
Cap
Term
Depr WC FCFE
Exp
Price
$2.71 $2.60 $1.30 $0.05 $1.43
4
5
6
Year EPS
$45.85
$2.30 $0.68
$2.63 $0.78
$2.99 $0.89
4
5
6
$3.41 $1.01
$3.89 $1.16
$4.16 $0.88
$52.69
The net capital expenditures (Cap Ex - Depreciation) and working capital change is
offset partially by debt (10%). The balance comes from equity. For instance, in year 1
FCFE = $2.30 - ($0.68 - $0.33) * (1 - 0.10) - $0.45 * (1 - 0.10) = $1.57)
B. Terminal Price = $3.71/ (.1305 - .07) = $52.69
C. Present Value Per Share = 1.57/1.136 + 1.82/1.136^2 + 2.11/1.136^3 +
2.45/1.136^4 + (2.83 + 52.69)/1.136^5 = $35.05
Question 5
A.
Year
Earnings
(CapEx-Deprec'n) *
(1-_)
Working Capital *
(1-_)
FCFE
Present Value
1
2
3
$0.66 $0.77 $0.90
4
$1.05
5
$1.23
$0.08
$0.10
$0.43
$0.50
$0.54
$0.31
$0.63
$0.31
Growth Rate
14.60%
12.20%
9.80%
7.40%
5.00%
Cumulated Growth
14.60%
28.58%
41.18%
51.63%
59.21%
Earnings
$1.41
$1.58
$1.73
$1.86
$1.95
(CapEx-Deprec'n) * (1-_)
$0.11
$0.13
$0.14
$0.15
$0.16
$0.45
$0.39
$0.30
$0.22
$0.13
FCFE
$0.84
$1.07
$1.29
$1.50
$1.67
Beta
Cost of Equity
10
1.38
1.31
1.24
1.17
1.10
14.59%
14.21%
13.82%
13.44%
13.05%
Present Value
$0.37
$0.41
$0.43
$0.44
$0.43
End-of-Life Index
5.00%
$1.92
13.05%
$23.79
$1.51
$2.08
$6.20
$9.79
B.
Year
Earnings
(CapEx-Deprec'n)*
(1-_)
Working Capital *
(1-_)
FCFE
Present Value
1
2
3
$0.66 $0.77 $0.90
4
$1.05
5
$1.23
$0.08
$0.10
$0.43
$0.50
$0.54
$0.31
$0.63
$0.31
5.00%
$1.78
13.05%
$22.09
$1.51
$1.90
$5.76
$9.17
C.
Year
Earnings
(CapEx-Deprec'n) *
(1-_)
Working Capital *
(1-_)
FCFE
Present Value
1
2
3
$0.66 $0.77 $0.90
4
$1.05
5
$1.23
$0.08
$0.10
$0.43
$0.50
$0.54
$0.31
$0.63
$0.31
6
7
8
9
10
14.60% 12.20% 9.80% 7.40% 5.00%
14.60% 28.58% 41.18% 51.63% 59.21%
$1.41 $1.58 $1.73 $1.86 $1.95
$0.11 $0.13 $0.14
$0.15
$0.16
$0.45
$0.22
$0.13
$0.39 $0.30
5.00%
$1.92
14.98%
$19.19
$1.51
$2.03
$4.75
$8.29
Question 6
A.
Year
Earnings
(CapEx-Deprec'n)*
(1-_)
Working Capital *
(1-_)
FCFE
Present Value
1
2
3
$1.02 $1.22 $1.47
4
$1.76
5
$2.12
$0.00
$0.00
$1.47
$1.76
$0.29
$0.18
$0.35
$0.19
Growth Rate
15.00%
10.00%
5.00%
Cumulated Growth
15.00%
26.50%
32.83%
Earnings
$2.43
$2.68
$2.81
(CapEx-Deprec'n)*(1-_)
$0.00
$0.00
$0.00
$1.59
$1.22
$0.67
FCFE
$0.85
$1.46
$2.14
Beta
1.1
1.1
1.1
Cost of Equity
13.05%
13.05%
13.05%
Present Value
$0.41
$0.62
$0.80
End-of-Life Index
5.00%
$2.25
13.05%
$27.92
$0.85
$1.83
$10.46
$13.14
Working Capital as % of
Revenues
60%
50%
40
30%
20%
A.
Yr
EBITDA
Deprec'n
EBIT
EBIT
Cap
_ WC
FCFF
(1-t)
Exp.
$890
$534
$450
$82
$402
Value
$1,290
$400
$1,413
$438
$975
$585
$493
$90
$440
$1,547
$480
$1,067
$640
$540
$98
$482
$1,694
$525
$1,169
$701
$591
$108
$528
$1,855
$575
$1,280
$768
$647
$118
$578
$2,031
$630
$1,401
$841
$708
$129
$633
'93-97
After 1998
Cost of Equity =
13.05%
12.30%
AT Cost of Debt =
4.80%
4.50%
Cost of Capital =
9.37%
9.69%
Term
$14,326
Terminal Value
= {EBIT (1-t)(1+g) - (Rev1998 - Rev1997) * WC as % of Rev}/(WACC-g)
= (841 * 1.04) - (13500 * 1.0955 * 1.04 - 13500 * 1.0955)
* 0.07 /(.0969-.04) = $14,326
Value of the Firm
= 440/1.0937 + 482/1.09372 + 528/1.09373 + 578/1.09374 + (633 + 14941)/1.09375 =
$11,172
B. Value of Equity in the Firm = ($11566 - Market Value of Debt) = 11172 - 3200 =
$7,972
Value Per Share = $7,972/62 = $128.57
Question 5
Deprec'n
$350
EBIT
$560
EBIT(1-t)
$336
Cap Ex
$420
FCFF
$266
$364
$594
$356
$437
$283
$379
$629
$378
$454
$302
$394
$667
$400
$472
$321
4
5
$409
$426
$707
$749
$424
$450
$491
$511
$342
$364
Now
Term Val
$5,014
After 5 years
Cost of Equity =
13.33%
13.33%
Cost of Debt =
4.50%
4.50%
Cost of Capital =
11.56%
11.56%
Old
Value
$1,978
$2,358
$2,905
New
Value
$2,046
$2,453
$3,050
Change
$67
$95
$145
EPS
1984
$0.69
1985
$0.71
1986
$0.90
1987
$1.00
1988
$0.76
1989
$0.68
1990
$0.09
1991
$0.16
1992
($0.07)
1993
($0.15)
Question 2
A.
Total Assets in 1993 =
Normalized Return on Assets =
Normalized Return on Assets (pre-tax) =
$25,000
12%
(in millions)
20%
5000
Interest Expenses =
1400
3600
1440
Net Income =
2160
500
FCFE =
1660
13.05%
5%
$0.06
Question 3
A.
Earnings Per Share Next Year =
- (Cap Ex - Deprec'n) *(1- Debt ratio) =
- ( _ Working Capital) * (1 - Debt ratio) =
FCFE Next Year =
Cost of Equity = 7% + 1.1 * 5.5% =
Expected Growth Rate =
$5.52
$0.63
$0.045
$4.845
13.05%
5.00%
$52.70
- Interest Expense =
$17.00
$35.70
- Taxes (40%) =
$14.28
$21.42
$3.75
$4.76
FCFE =
$12.91
Question 5
A.
Year
1987
1988
1989
1990
1991
1992
Average =
Net Income =
- (Cap Ex - Deprec'n) * (1 - Debt ratio) =
= FCFE =
Net
Income
(Cap. Ex Deprec'n) *
(1 - Debt Ratio)
FCFE
1993
$1.78
$1.37
$0.42
1994
$1.89
$1.43
$0.45
1995
1996
Term Year
$2.00
$2.12
$2.23
$1.50
$1.58
$0.00
$0.50
$0.54
$2.23
Terminal
Value
$29.73
$1,440
$340
$1,100
$440
$660
13.33%
6.00%
$9,010
Equity
61.61%
13.33%
Debt
38.39%
5.10%
1996
$0.00
Terminal
Year
$11.42
$0.00
$0.00
$11.42
Terminal
year
$5.23
$3.14
$0.00
$3.14
Terminal
year
$1.98
$0.75
$0.94
$1.17
$1.46
$1.83
$0.45
$0.30
$0.54
$0.40
$0.65
$0.52
$0.78
$0.69
$0.93
$0.90
$29.71
$0.00
$1.98
EBIT (1-t)
Cap Ex Deprec'n
FCFF
EBIT (1-t)
Cap Ex Deprec'n
FCFF
Terminal Value
$0.00
$0.00
$51.56