FINA3326A Assignment #2 Questions and Solutions

Question 1
a. The Indonesian Government has rupiah-denominated bonds
outstanding, with an interest rate of 14%. S&P has a rating of
BB on these bonds, and the typical spread for a BB-rated
country is 5% over riskless rate. Estimate the rupiah riskless rate.

b. You are trying to estimate a country risk premium for Poland.

You find that S&P has assigned an A rating to Poland and that
Poland has issued euro-denominated bonds that yield 6% in the
market currently. Germany, an AAA-rated country, has euro-
denominated bonds outstanding that yield 3.5%, and France, an
AA rated country, has euro denominated bonds outstanding
yielding 3.89%.

Solutions to Q1
a. Rupiah riskless rate = 14% - 5% = 9% [0.5 point]
b. Risk Premium for Poland = default spread against Germany =
6% - 3.5% = 2.5% [0.5 point]

Question 2
The Hang Seng Index is at 21,920. The dividend yield of the
stocks in the index was 4.2% last year. The dividend stream is
expected to grow at 6% per annum for the next three years, and
thereafter at 3% in perpetuity. The riskless rate for HK dollar is
2.5%. Estimate the implied equity risk premium.

Solutions to Q2
D0 = 21920 x 4.2% = 920.64
D1 = 920.64 x (1 + .06) = 975.88

D2 = 920.64 x (1.06)^2= 1034.31

D3 = 920.64 x (1.06)^3 = 1096.50

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D4 = 920.64 x (1.06)^3 x (1.03) for the calculation of terminal
value = 1129.39

Terminal Value at the end of year 3 = D4/(r perpetual g)

= D4 / (r - .03) = 1129.39/(r -0.03)
Terminal Value is at the end of year 3, not year 4.

PV = D1/(1+r)+D2/(1+r)^2+D3/(1+r)^3+(D4/(r - .03))/(1 + r)^3

Solve for r using Excel What If function
r = 7.698%
Implied equity risk premium = expected return riskless rate
= 7.7% - 2.5% = 5.20% [1 point]

Question 3
The standard deviation of the Mexican Equity Index is 48%, and
the standard deviation of the S&P 500 is 20%. You use an equity
risk premium of 5.5% for the U.S.

a. Estimate the country equity risk premium for Mexico using the
relative equity standard deviations.
b. Now assume that Mexico is rated BBB by S&P and that it has
US dollar denominated bonds outstanding that trade at a spread of
about 3% above the US Treasury bond rate. If the standard
deviation of these bonds is 24%, estimate the country risk premium
for Mexico.

Solutions to Q3
a. CERP for Mexico = 5.5% x .48/.20 = 13.2% OR
7.7% (being 13.2% - 5.5%) [0.5 point]
Both answers are recognized as correct as it is revealed that the
term CERP is not consistently defined in the context of Lecture
Note Packet 1.

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b. CRP for Mexico based on default spread scaling up based on
relative volatility of equities vs. bonds
= 3% x .48/.24 = 6% [0.5 point]

Question 4
You are valuing a PRC incorporated company in HK dollars.

a. What would you use as a riskless rate?

b. What is the rate you would use today? Please cite your
information sources.

Solutions to Q4
a. Hong Kong dollar riskless rate [0.5 point]
b. 10-year HK government Bond yield = 1.57%
Source : Bloomberg
http://www.bloomberg.com/markets/rates-bonds
Hong Kong is rated AAA by S&P, and AA1 by Moodys.

Based on S&Ps AAA rating, there is no need to adjust for

default spread, and the riskless rate for HK dollar = 1.57% [0.5
point]

Alternatively, based on Moodys AA1 rating, the default spread

between AAA and AA1 = 0.54% - 0.42% = 0.12%
Therefor, the riskless rate = 1.57% - 0.12% = 1.45%

Answers based on other data sources are also recognized as

correct.

http://www.bondsonline.com/Todays_Market/Corporate_Bond_Sp
reads.php
Reuters Corporate Spreads for Industrials

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Note that (i) the information is as of March 2014 (somewhat
outdated) and (ii) the spreads are expressed in basis points, where 1
basis point = .01%

Question 5
K2 Railroad, a U.S. company, reported net income of $770 million
in 2014 after interest expenses of $320 million. The corporate tax
rate was 36%. It reported depreciation of $960 million in that year,
and capital expenditure was $1.2 billion. The firm also had $4
billion of debt outstanding on the books, rated AA (carrying a yield
to maturity of 4.0%) and trading at par (up from $3.8 billion at the
end of 2013). The beta of the stock was 1.02, and there were 200
million shares outstanding (trading at $60 per share), with a book
value of $5 billion. K2s working capital requirements were
negligible. (The Treasury bond rate was 3%, and the equity risk
premium was 5.5%). The company is a mature company and can
be expected to grow at a constant rate equal to the riskless rate,
which is a proxy for economic growth.

a. Estimate the free cash flow to the firm in 2014.

b. Estimate the value of the firm at the end of 2014.
c. Estimate the value of equity at the end of 2014, and the value per
share, using the FCFF approach.

Solutions to Q5
a. FCFF = EBIT(1-t) - (Capital Expenditures - Depreciation) -
Change in non-cash Working Capital
Net Income Before Tax = 770 / (1 t) = 770/ (1 0.36) = 1,203.13
it is wrong to write EBIT*(1-t) = 770+320
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EBIT = Net before Tax + Interest Expense = 1,203.13 + 320 =
1,523.13
EBIT (1 t) = 974.80
Net Capex = (Capex Depreciation ) = 1,200 960 = 240
Change in non-cash Working Capital = negligible = 0
FCFF = 974.80 240 0 = 734.80 [0.5 point] It should be noted
that Net Income is after tax.
b. Value of the firm = FCFF1 / (WACC g)
Cost of equity = 3% +1.02 x 5.5% = 8.61%
After tax Cost of debt = (1 - .36) x 4% = 2.56%
Market value of debt = 4,000 (as the debt is trading at par, the
market value = the book value)
Market value of equity = 200 x 60 =12,000
Market Value of Invested Capital = 4000 + 12,000 = 16,000
WACC = 12,000/16,000 x 8.61% + 4,000/16,000 x 2.56%
= 7.10%
Firm value = (734.80 x 1.03) / (0.071 - .03) = 18,459.61 [0.5
point] Answers where the only error was due to the use of a wrong
input (from a. above) are also given full credit.
c. Value of equity = firm value market value of debt = 18,459.61
4,000 = 14,459.61
Intrinsic value per share = 14,459.61/200 = 72.30 [0.5point] same
as the comment in b above.

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Question 6
Time Warner Inc., had a beta of 1.61 in 1995. Part of the reason
for the high beta was the debt left over from the leveraged buyout
of Time by Warner in 1989, which amounted to $10 billion in
1995. The market value of equity at Time Warner in 1995 was
also $10 billion. The marginal tax rate was 40%.

a. Estimate the unlevered beta for Time Warner.

b. Estimate the effect of reducing the debt ratio by 10% next year
on the beta of the stock.

Solutions to Q6
a. Unlevered Beta = Levered Beta / ( 1 + (1- tax rate) (D/E Ratio))
= 1.61 / (1 + (1 - .40) (1/1)) = 1.006 [0.5 point]
b. D/E to be reduced by 10% next year = 1 x 0.9 = 0.9
Levered beta next year = 1.006 x (1 + (1-.4) X 0.9) = 1.55 [0.5
point] Full credit is also given to answers which were based on a
different interpretation of the wording reducing the debt ratio by
10%.

Question 7
You try to estimate the cost of capital for Mont Rose Telecom.
The firm has the following characteristics:

100 million shares outstanding, trading at $250 per share.

Book value of debt of $10 billion, with an average maturity
of 6 years, and interest expense of $600 million on the debt.
The firm is not rated, but it had operating income (EBIT) of
$2.5 billion last year. (Firms with an interest coverage ratio
of 3.5 to 4.5 were rated BBB, and the average default spread
was 1%).
The tax rate for the firm is 35%. Equity risk premium is
5.5%.

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 The Treasury bond rate is 6%, and the unlevered beta of other
telecom firm is 0.80

a. Based on the synthetic rating, estimate the cost of debt for this
firm
b Estimate the market value of debt for this firm

c. Estimate the cost of capital for this firm.

Solutions to Q7
a. Current borrowing cost = Riskless rate + default spread of BBB
interest coverage ratio = 2500/600 = 4.17
rated debt (BBB)
= 6% + 1% = 7% [0.5 point] Half credit is given to the answer of
4.55% (which is the after tax cost of debt).

b. Market value of debt

Times Interest Earned = EBIT/ Interest Expense = 2,500/600 =
4.17 times; therefore it is likely to be rated BBB.
To estimate the market value (i.e. present value) of debt:
coupon Payment = interest expense = 600
N = Life of debt = 6 years
Future Value = book value of debt = 10,000 cost
I/Y Yield to Maturity = current borrowing cost = 7% of
PV = 9,523.35 [0.5 point] debt

c. The cost of capital = WACC

Mont Roses beta = unlevered beta of industry adjusted for Mont
Roses leverage = 0.80 x (1 + (1-t) D/E)
Mont Roses market value of equity = 250 x 100 = 25,000
Mont Roses D/E = 9,523.35/ 25,000 = 0.381
Levered beta = 0.80 x (1 + 0.65 X 0.381) = 0.998

After tax cost of debt = 7% x (1 t) = 7% x 0.65 = 4.55%

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Cost of equity = 6% + 0.998 x 5.5% = 11.489%
WACC = 25,000/ (25,000 + 9523.35) x 11.489% +
9523.35/(25,000 + 9523.35) x 4.55% = 0.724 x 11.489% + 0.276
x 4.55% = 9.574% [0.5 point]

Question 8
Derra Food is a specialty food retailer. On the most recent balance
sheet, the firm had $1 billion of equity and no debt, but it had
operating leases on all its stores. In the most recent year, the firm
made $85 million in operating lease payments, and its
commitments to make lease payments for the next 5 years and
beyond are:

Year Operating Lease Expense

1 $90 million
2 $90 million
3 $85 million
4 $80 million
5 $80 million
6 10 $75 million per annum

The firms current cost of borrowing is 7%.

a. Estimate the capitalized debt value of operating leases.

b. Estimate the book value debt to equity ratio.
c. Derra Food reported EBIT (after operating leases expensed) of
$200 million. Estimate the adjusted operating income.

Solutions to Q8
a. PV of operating lease expenses from year 1 to year 10,
discounted at 7% = $569.43 mm [0.5 point]
b. book value of debt to equity = 569.43/ 1,000 = 0.568 [0.5
point]

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c. Adjusted operating income = EBIT + Operating lease expensed
Deprecation of leased asset
= 200 + 85 56.94 = 228.06 [0.5 point]
Assume a life of 10 years for leased asset.

Question 9
Zif Software is a firm with significant R&D expenses. In the most
recent year, the firm had $100 million of R&D expenses. R&D
expenses are amortizable over 5 years, and over the past 5 years
they are:
Year%% % R&D%Expenses%($mm)%
25% % 50% (a) %60*1/5 + 70*2/5 + 80*3/5 +
24% % 60% 90*4/5
% + 100 = 260
23% % 70% (b) %50*1/5 + 60*1/5 +70*1/5
+80*1/5 +90*1/5 = 70
22% % 80% %
21% % 90% %
Current% % 100% %
Year%
% % % %

Assuming a linear amortization schedule over 5 years, estimate:

a. The value of the R&D asset.
b. The amount of R& D amortization this year.
c. The adjustment to operating income.

Solution to Zif

Year%% % R&D%Expenses%($mm)% Amortized%this%year% Unamortized%Value%

25% % 50% % 10% % 0% %
24% % 60% % 12% % 12% %
23% % 70% % 14% % 28% %
22% % 80% % 16% % 48% %
21% % 90% % 18% % 72% %
Current% % 100% not amortized
% !this % 100% %
Year% year-----------------------
% % % % % % ! %
% % % % % % % %

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 % % % % % % % %
% % % amortizati % % % %
on%
% % % this%year%% % % % %
% % % total% 70! % % %
% % % % % % % %
% % % % % Unamortized%% %
% % % % % value% 260! %
%
Solutions to Q9
a. The value of the R&D asset = unamortized value = 260 [0.5
point]
b. The amount of R& D amortization this year = 1/5 of the R&D
expense of each of the preceding five years (total of the third
column in the table above) = 70 [0.5 point]
c. The adjustment to operating income = add back this years R&D
expense and subtract the amortization of R&D asset = + 100 70 =
+30 [0.5 point]

Question 10
Want Want China (HK stock code: 151) released its interim report
on September 10, 2015.

You can find the most recent interim report (2015 Interim) and
annual report (2014) through the website of the Hong Kong stock
exchange:
ww.hkexnews.hk/listedco/listconews/advancedsearch/search_activ
e_main.aspx

a. Estimate the trailing 12-month operating income of Want Want

b. estimate the firms Return on Invested Capital (ROIC, or ROC).
Assume a tax rate of 25%. [Hint: for a precise definition of the
ratio, please refer to Supplementary Note Useful Financial
Ratios and Formulas on Moodle.]

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Solutions to Q10
a. EBIT trailing 12 months = EBIT for 2014 full year + EBIT for
2015 first half EBIT for 2014 first half

Want Want

EBIT US$mm
First half 2015 370.94
First half 2014 394.74
Full year 2014 776.79

EBIT TTM 752.99 [0.5 point]

b. ROIC = EBIT (1-t) / (BV of Debt + BV of Equity-Cash)

EBIT (1- t) = 752.99 x (1 0.25) = 564.74

Invested capital = BV of Debt + BV of Equity - Cash

to non-interest-
As of June 30, 2015 bearing liabilities. In addition, non-
cash 1531.29 interest-bearing liabilities
generally do not mean the definition of
"debt":
STD 245.9 - interest payments are tax deductible
LTD 998.22 - there is a contractual agreement
total debt 1244.12 - there are adverse consequences in the
event of non-payment
Equity* 2123,04 Just to be clear, for "BV of debt" we
Invested Capital 1835.87
will include only interest-
bearing debt (i.e.
ROIC = 30.76% (based on invested capital as of June 30, 2015).

The more accurate answer should be 33.21% (based on Invested

Capital at the beginning of the period, i.e. June 30, 2014) OR
31.94% (based on the average of Jun 30, 2014 and Jun 30, 2015).
[0.5 point]

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Full credit is given to any of the three alternative answers. My
personal preference is to use the beginning Invested Capital. The
Trailing-12-month figure should be used in the numerator.

*Equity includes Non-controlling Interests of $7.41

!
WantWant!
EBIT% % % % US$mm%
%
First%half%2015% % 370.94%
First%half%2014% % 394.74%
Full%year%2014% % 776.79%
%
%
EBIT%TTM% % % % 752.99%
% %
% %
After%tax%EBIT% % % 564.74%
tax%% % 25%%
% %
% %
As!of!June!30,!2015! % %
cash% % % 1531.29%
STD% % % 245.9%
LTD% % % 998.22%
total%debt% % % 1244.12%
Equity% % % 2123.04%
%
Invested%Capital% % 1835.87%
ROIC%% % 30.76%%
% %
% %
As!of!June!30,!2014! % %
cash% % % 1575.74%
STD% % % 629.24%
LTD% % % 747.62%
total%debt% % % 1376.86%
Equity% % % 1899.38%
%
Invested%Capital% % 1700.5%
%
% %
ROIC%based%on%IC%Jun%2014%% % 33.21%!

% %
ROIC%based%on%Avg%Inv%Cap%% % 31.94%!
Average%Inv%Cap% 1768.19%
Jun%30%14%and%Jun%30,%15% %
END % %

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