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FINA3326A Assignment #1 with Solutions September 28 2015

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]

b. Use cost of capital to discount CF to Firm to find Firm Value:


= 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?

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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

Value = D1/(r g) = 4.5 / (.11 (-.1)) = 4.5/ .21 = $21.43 [1 point]

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
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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:

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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

After expanding the consumer business,


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.

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EXHIBIT ImageCo: Income Statement and Reorganized Balance Sheet
Amount in $ million

Income statement Reorganized balance sheet

Today Year 1 Today Year 1

Revenues 800.0 840.0 Operating working capital1 70.1 73.6

Operating costs (640.0) (672.0) Property and equipment 438.4 460.3

Depreciation (40.0) (42.0) Invested capital 508.5 533.9

Operating profit 120.0 126.0

Debt 200.0 210.0

Interest expense (16.0) (16.0) Shareholders equity 308.5 323.9

Earnings before taxes 104.0 110.0 Invested capital 508.5 533.9

Taxes (26.0) (27.5)

Net income 78.0 82.5

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]

b. FCFF for year 1 = 94.5 increase in WC Net increase in


property and equipment = Net Cap Ex
= 94.5 (73.6 70.1) (460.3 438.4) = 69.1 [1 point]

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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%

a. What is the Equity Risk Premium?



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?

Solution to Q8 not 0.90*(8%-3.3%)=4.23%


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

b. Cost of equity = Rf + beta * Equity Risk Premium = 3.3% + 0.9 * 4.7%


= 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

c. 3.56 * (1+g) / (.0753 g) = 85, solve for g


3.56 * ( 1 + g) = 85 * (.0753 g)
85g + 3.56g = 6.4 3.56
g = 3.21% [1 point]

[TOTAL: 14.5 points]

END

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

7b. Determine Free Cash Flow to Firm (FCFF) for year 1

Definition of FCFF:
FCFF = EBIT(1-t) - (Capital Expenditures - Depreciation) -
Change in non-cash Working Capital

EBIT (1 t) = 126 * (1 -.25) = 94.5

Property and Equipment (think BASE):

Beginning balance: 438.4


Add (Capital Expenditures): ?
Subtract (Depreciation and Disposal): 42.0
Ending balance: 460.3

438.4 + CAPEX 42.0 = 460.3


CAPEX = 460.3 438.4 +42.0 = 63.90
Therefore (Capital Expenditures - Depreciation) = Net CAPEX =
63.90 42.0 = 21.90

Alternatively, we can simply take the difference between the


beginning and ending balances of Property and Equipment to
calculate the Net CAPEX = 460.3 438.4 = 21.90

Change in non-cash Working Capital = 73.6 70.1 = 3.5


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

FCFF = 94.5 21.90 3.5 = 69.1

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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:

Beginning balance: 200.0


Add (New Debt Issued): ?
Subtract (Principal Repaid): ?
Ending balance: 210.0

New Debt Issued Principal Repaid = Net Increase in Debt

Ending balance Beginning balance = Net Debt Issued Principal


Repaid = 210.0 200.0 = 10.0

One way to think about this is that a net increase in debt is a


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

FCFE = 82.5 21.9 -3.5 (-10) = 67.1

Another approach is to assume a constant debt to capital structure,


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

Today: 200/508.5 = 0.3933


1 Year: 210/533.9 = 0.3933

Therefore, Reinvestment will be financed by debt (39.33%) and


equity (60.67%).

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FCFE can now be expressed as:
FCFE = Net Income - (1- d)(Net Capex) - (1- d) (Increase in WC)

where d = Debt/Capital Ratio

FCFE = 82.5 (1-0.3933)(460.3-438.4) (1-0.3933)(73.6-70.1)


= 67.09