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Question 1

Everest Limited has the following projected cash flows to equity and cash

flows to the firm over the next five years:

CF to Interest CF to

Year Equity (1 - tax) Firm

1 120.00 30.00 150.00

2 126.00 31.50 157.50

3 132.30 33.08 165.38

4 138.92 34.73 173.64

5 145.86 36.47 182.33

Terminal

Value 2,125.40 3,719.45

(The terminal value is the value of the equity or firm at the end of year 5.)

Everest Limited has a cost of equity of 11% and a cost of capital of 7.5%.

a. What is the value of the equity?

b. What is the value of the firm?

Solution to Q1

a. Use cost of equity to discount CF to Equity to determine the equity value:

= 120/(1+.11) + 126/(1+.11)^2 + 132.3/(1 +.11)^3 + 138.92/(1+.11)^4

+(145.86+2125.40)/(1+.11)^5 = 1,746.50 [1 point]

= 150/(1+.075)^1 + 157.5/(1.075)^2 + 165.38/(1.075)^3 +

173.64/(1.075)^4 + (182.33 + 3719.45)/ (1.075)^5 = 3,256.78 [1 point]

Question 2

Suppose risk free rate (Rf) = 8%. Expected market return (Rm) = 12%

Beta for Stock XYZ = 1.4

What is the required rate of return on Stock XYZ?

1

Solution to Q2

Apply CAPM

Required rate of return (Rxyz) = Rf + beta * (equity risk premium)

Equity risk premium = Rm Rf = 4%

Rxyz = 8% + 1.4 * 4% = 13.6% [1 point]

Question 3

Basin Mining Companys ore reserves are being depleted, and its costs of

recovering a declining quantity of ore are rising each year. As a result, the

companys earnings and dividends are declining at 10% per year. If D0 =

$5. R = 11%, what is the value of Basin Minings stock?

Solution to Q3

Use Gordon Constant Growth Model

D1 = D0 * (1 + g)

G = -10%

Therefore, D1 = 5 * (1 -.1) = 4.5

Question 4

Under what circumstances does growth destroy value?

Solution to Q4

If the ROIC is below the require rate of return, growth destroys value [1

point]

Question 5

You bought a share of Company ABC that paid a dividend of $2 last year.

You expect the dividend to grow at 5% per year for the next 3 years, and you

plan to hold the stock for 3 years, then to sell it.

a. What is the expected dividend for the next 3 years, i.e. D1, D2, and

D3, note that D0 = $2

b. If the appropriate discount rate is 10%, and the first dividend will

occur 1 year from now, what is the present value of the dividend stream?

only dividend

2

c. If the expected price of the stock is $48.62 three years from now (P3 =

$48.62), what is the present value of the expected stock price at a discount

rate of 10%? only stock price

d. If you plan to buy the stock, hold it for 3 years, and then sell it for

$48.62, what is the most you should pay for it?

e. Use the Gordon Growth Model to calculate the present value of the

stock. Assume that growth is at a constant of 5%.

Solution to Q5

a. D1 = $2 * 1.05 = $2.1 ; D2 = $2 * 1.05^2 = 2.21; D3 = $2 * 1.05^3

=2.32 [0.5 point]

b. PV = 2.1/1.1 + 2.21/1.1^2 + 2.32/1.1^3 = 1.91 + 1.82 + 1.74 = 5.47

c. PV = P3/(1.1)^3 = 48.62/1.1^3 = 36.53 [0.5 point]

d. PV of dividend stream and sale proceeds = 5.47 + 36.53 = $42; [0.5

point] therefore you should not pay more than $42 for the stock to

achieve a 10% required rate of return

e. PV = D1 / (r g) = 2.1 / (.10 -.05) = $42 [0.5 point]

Question 6

a. Suppose Sunset Chemical Companys management conducts a study and

concludes that, if Sunset expands its consumer products division (which is

less risky than its primary business, industrial chemicals), the firms beta

will decline from 1.1 o 0.9. However, consumer products have a somewhat

lower profit margin, and this will cause Sunsets growth rate in earnings and

dividends to fall from 7% to 6%. Should management make the change?

Assume the following:

Rm = 11%; Rf = 7.5%; D0 = $2

b. Assume all the facts as given in part a, except the one about changing beta

coefficient. By how much would the beta have to decline to justify the

expansion?

Solution to Q6

Equity Risk Premium = Rm Rf = 3.5%

Before expanding the consumer products division:

3

Cost of equity = Rf + beta * ERP = 7.5% + 1.1 * 3.5% = 11.35%

Value per share before change = D1 /(r g) = 2.14 / (.1135 - .07) = 49.20

Where D1 = D0 * (1 +g) = 2.14

Cost of equity = 7.5% + 0.9 * 3.5% = 10.65%

New D1 = d0 * (1 + .06) = 2.12

Value after expansion = 2.12 / (.1065 - .06) = 45.59

Management should not make the change as it would lead to a decline in

value, from 49.20 to 45.59 [1 point]

To justify the expansion, the beta has to decline further so that it will lead to

a lowering of the required rate of return, resulting in a price of $49.20 or

higher.

First calculate the cost of equity to result in a value of 49.20

D1 = 2.12

49.20 = 2.12 / (r - .06) solve for r

r = 2.12/49.20 + .06 = 10.31%

cost of equity should not exceed 10.31%

then calculate the beta that will result in a cost of equity of 10.31%

10.31% = 7.5% + Beta * 3.5%

Solve for Beta

Maximum beta = (.1031 - .075)/. 035 = 0.8029

Beta has to fall to 0.8029 or lower in order to justify the expansion

[1 point]

Question 7

The Exhibit below presents the income statement and reorganized

balance sheet for Image Co, an $800 million consumer products

company.

a. Determine the operating profit after tax for year 1. Assume a

tax rate of 25 percent.

b. Determine Free Cash Flow to Firm (FCFF) for year 1.

c. Determine Free Cash Flow to Equity (FCFE) for year 1.

4

EXHIBIT ImageCo: Income Statement and Reorganized Balance Sheet

Amount in $ million

1 Accounts payable has been netted against inventory to determine operating working

capital.

Solution to Q7

a. Operating profit after tax for year 1 = 126 * (1 -.25) = 94.5 [0.5

point]

property and equipment = Net Cap Ex

= 94.5 (73.6 70.1) (460.3 438.4) = 69.1 [1 point]

5

c. FCFE for year 1= Net income increase in WC net increase

in P&E + net increase in Debt = 82.5 3.5 21.9 + 10 = 67.1

[1 point]

Question 8

Summit Company paid dividends per share of $3.56 last year, and dividends

are expected to grow 2.5% a year forever. The stock has a beta of 0.90, the

Treasury bond rate is 3.3%, and the expected return of the market is 8%

b. What is the value per share, using the Gordon Growth Model?

c. The stock is trading for $85 per share. What would the growth rate in

dividends have to be to justify this price?

a. Equity Risk Premium = 8% - 3.3% = 4.7% [0.5 point] not talking about a single equity

= 7.53%

Value per share = D1/ (r g) = 3.649 / (.0753 - .025) = 72.54 [1 point]

Where D1 = D0 * (1 + g) = 3.56 * (1 + .025) = 3.649

3.56 * ( 1 + g) = 85 * (.0753 g)

85g + 3.56g = 6.4 3.56

g = 3.21% [1 point]

END

6

Assignment #1 Detailed Explanation of Question 7b and 7c

Definition of FCFF:

FCFF = EBIT(1-t) - (Capital Expenditures - Depreciation) -

Change in non-cash Working Capital

Add (Capital Expenditures): ?

Subtract (Depreciation and Disposal): 42.0

Ending balance: 460.3

CAPEX = 460.3 438.4 +42.0 = 63.90

Therefore (Capital Expenditures - Depreciation) = Net CAPEX =

63.90 42.0 = 21.90

beginning and ending balances of Property and Equipment to

calculate the Net CAPEX = 460.3 438.4 = 21.90

Increase in non-cash Working Capital will tie up cash.

1

7c. Determine Free Cash Flow to Equity (FCFE) for year 1

Definition of FCFE

FCFE = Net Income - (Capital Expenditures - Depreciation) -

Change in non-cash Working Capital - (Principal Repaid - New

Debt Issued)

Debt:

Add (New Debt Issued): ?

Subtract (Principal Repaid): ?

Ending balance: 210.0

Repaid = 210.0 200.0 = 10.0

positive cashflow to Equity. Conversely, a net decrease in debt is a

negative cashflow to Equity.

as is the case in our example. Debt to Invested Capital:

1 Year: 210/533.9 = 0.3933

equity (60.67%).

2

FCFE can now be expressed as:

FCFE = Net Income - (1- d)(Net Capex) - (1- d) (Increase in WC)

= 67.09

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