Topic 1 Tutorial Questions

Business Valuation II
Discussed in Tutorials in Week 2

1. M&M Corp. currently has assets with book value of 1000 and is financed entirely with
equity. The company is expected to have a return on equity (ROE) equal to 10% in
perpetuity. The required rate of return by shareholders of M&M Corp. is equal to 10%.
(a) Beginning next year, M&M Corp. is expected to reinvest half (i.e., 1/2) of its net
income and continue with that reinvestment policy in perpetuity. The company is
expected to pay the remainder of its next income in dividends. What is today’s
intrinsic value of equity equal to?
Solution: Given the supplied data, the expected net income next year, N I1 , will be equal to
ROE × BV E0 = 0.1 × 1000 = 100 and the expected dividend next year, D1 , will
be one-half of N I1 or D1 = 0.5 × 100 = 50. At the same time, given the forecasted
reinvestment rate, b, of 0.5, the expected growth in future net income and dividends
will be equal to g = b × ROE or 0.5 × 0.1 = 0.05 or 5%. Finally, the shareholders’
required rate of return on equity is already provided as 10%. Now we have all the
necessary information we need in order to apply the dividend discount model to find
the present intrinsic value of equity as follows V0e = reD−g
1 50
= 0.1−0.05 or V0e = 1000.
(b) Is it possible to vary the forecasted reinvestment rate in such a way as to increase
today’s intrinsic value of equity?
Solution: Let us try to reduce the forecasted reinvestment rate to b = 0.25. In this case the
starting dividend next year will be D1 = 0.75 × 100 = 75 but the forecasted future
growth rate in earnings and dividends will decline to g = 0.25 × 0.10 = 0.025. The
75
present intrinsic value of equity will, in this case, be equal to V0e = 0.1−0.025 = 1000
and nothing changed from the baseline set of forecasts. Similarly, increasing the
forecasted reinvestment rate to, say, b = 0.75 will reduce the starting dividend next
year to D1 = 25 but will increase the forecasted growth rate in earnings and dividends
to g = 0.75 × 0.1 = 0.075. The present intrinsic value of equity under these forecasts
25
is equal to V0e = 0.1−0.075 = 1000 or, once again, no change. A more formal proof
that does not depend on specific values for b in the special case when ROE = re is
left as an exercise but can be shown to lead to the following present intrinsic value:
N I1
V0e = ROE . Notice that the latter is completely independent of the forecast/choice for
a reinvestment policy and as a consequence it is independent of the forecast/choice of
dividend payout policy. This is one of the celebrated two “independence” results by
Modigliani and Miller showing that a company cannot change its intrinsic value by
changing its reinvestment/dividend payout policy. Note that the fact that ROE = re
is critical for that to be true.
(c) What do you conclude from this?
Solution: When an all-equity financed firm is expected to break even on its shareholders’ re-
quired return on equity (i.e., ROE = re ) and earn zero economic profits (which is
the technical term from economic theory), the present intrinsic value of equity is
unchanged for various sustainable reinvestment/dividend payout policies. Note that
this is a knife-edge case as a low reinvestment rate will lead to a high starting divi-
dend and a low expected growth rate. At the opposite extreme, a high reinvestment

1
 rate will lead to a very low starting dividend but a higher expected growth rate. If
ROE = re , both of these dividend streams have the same present value.

2. Robust Growth, Inc. currently has assets with book value of 1000 and is financed entirely
with equity. The company is expected to have a return on equity (ROE) of 20% in
perpetuity. The required rate of return by shareholders of Robust Growth, Inc. is equal
to 10%.

(a) Beginning next year, Robust Growth, Inc. is expected to reinvest a quarter (i.e.,
1/4) of its net income and continue with that reinvestment policy in perpetuity. The
company is expected to pay out the rest of its net income in dividends. What is
today’s intrinsic value of equity equal to?
Solution: Given the supplied data, the expected net income next year, N I1 , will be equal to
ROE × BV E0 = 0.2 × 1000 = 200 and the expected dividend next year, D1 , will
be three-quarters of N I1 or D1 = 0.75 × 200 = 150. At the same time, given the
forecasted reinvestment rate, b, of 0.25, the expected growth in future net income
and dividends will be equal to g = b × ROE or 0.25 × 0.2 = 0.05 or 5%. Finally, the
shareholders’ required rate of return on equity is already provided as 10%. Now we
have all the necessary information we need in order to apply the dividend discount
model to find the present intrinsic value of equity as follows V0e = rD 1
e −g
150
= 0.1−0.05 or
V0e = 3000.
(b) Is it possible to vary the forecasted reinvestment rate in such a way as to increase
today’s intrinsic value of equity? Be careful not to make the present value of equity
infinite.
Solution: Let us try to reduce the forecasted reinvestment rate to b = 0.2. In this case the
starting dividend next year will be D1 = 0.8 × 200 = 160 but the forecasted future
growth rate in earnings and dividends will decline to g = 0.2 × 0.20 = 0.04. The
160
present intrinsic value of equity will, in this case, be equal to V0e = 0.1−0.04 = 2666.67
and so the value declined. On the other hand, increasing the forecasted reinvestment
rate to, say, b = 0.3 will reduce the starting dividend next year to D1 = 140 but will
increase the forecasted growth rate in earnings and dividends to g = 0.3 × 0.2 = 0.06.
140
The present intrinsic value of equity under these forecasts is equal to V0e = 0.1−0.06 =
3500 or, in this case, the value of equity/firm increases.
(c) What do you conclude from this?
Solution: When an all-equity financed firm is forecasted to earn positive economic profits, i.e.,
ROE > re , then it is possible to increase the present intrinsic value of the firm
by increasing the forecasted reinvestment rate. Note that the higher growth rate is
more than enough to compensate for the discount effect and we end up with a higher
present intrinsic value of equity when b increases. Note however that there are limits
to growth. There is point beyond which the present intrinsic value becomes infinite.
re
This critical value for b is given by bcritical = ROE < 1.

3. Underperformer, Inc. currently has assets with book value of 1000 and is financed entirely
with equity. The company is expected to have a return on equity (ROE) of 8% in per-
petuity. The required rate of return by shareholders of Underperformer, Inc. is equal to
10%.

2
 (a) Beginning next year, Underperformer Inc. is expected to reinvest five eighths (i.e.,
5/8) of its net income and continue with that reinvestment policy in perpetuity. The
company will pay out the rest of its income in dividends. What is today’s intrinsic
value of equity equal to?
Solution: The expected net income next year, N I1 , will be equal to ROE × BV E0 = 0.08 ×
1000 = 80 and the expected dividend next year, D1 , will be three-eighths of N I1 or
D1 = (1 − 0.625) × 80 = 0.375 × 80 = 30. At the same time, given the forecasted
reinvestment rate, b, of 0.625, the expected growth in future net income and dividends
will be equal to g = b × ROE or 0.625 × 0.08 = 0.05 or 5%. Finally, the shareholders’
required rate of return on equity is already provided as 10%. Now we have all the
necessary information we need in order to apply the dividend discount model to find
the present intrinsic value of equity as follows V0e = reD−g
1 30
= 0.1−0.05 or V0e = 600.
(b) Is it possible to vary the forecasted reinvestment rate in such a way as to increase
today’s intrinsic value of equity?
Solution: Let us try to reduce the forecasted reinvestment rate to b = 0.5. In this case the
starting dividend next year will be D1 = 0.5 × 80 = 40 but the forecasted future
growth rate in earnings and dividends will decline to g = 0.5 × 0.08 = 0.04. The
40
present intrinsic value of equity will, in this case, be equal to V0e = 0.1−0.04 = 666.67
and so the value of equity increased. On the other hand, increasing the forecasted
reinvestment rate to, say, b = 0.75 will reduce the starting dividend next year to
D1 = 20 but will increase the forecasted growth rate in earnings and dividends to
g = 0.75 × 0.08 = 0.06. The present intrinsic value of equity under these forecasts is
20
equal to V0e = 0.1−0.06 = 500 or, in this case, the value of equity/firm decreases.
(c) What do you conclude from this?
Solution: When an all-equity financed firm is forecasted to earn negative economic profits, i.e.,
ROE < re , then it is possible to increase the present intrinsic value of the firm by
reducing the forecasted reinvestment rate. Note that the resulting lower growth rate
effectively reduces capital waste (i.e., relative to shareholders’ required rate of return)
and we end up with a higher present intrinsic value of equity when b decreases. Note
however that in all three scenarios for Underperformer, Inc., both the earnings and
the dividends are forecasted to grow at a positive rate. Unfortunately, this growth is
detrimental to value. Ideally, we would reduce b all the way to zero, i.e., start paying
out all of our net income as dividends to shareholders or, even better, liquidate the
firm and return the capital to shareholders for deployment elsewhere.

4. M&M Redux Corp. currently has assets with book value of 1000 and is financed entirely
with equity. The company is expected to have a return on equity (ROE) equal to 10% in
perpetuity. The required rate of return by shareholders of M&M Redux Corp. is equal
to 10%. The beta of the equity is equal to 1. The risk-free rate is equal to 5% while the
expected market risk premium is also equal to 5%.

(a) Beginning next year, M&M Redux Corp. is expected to swap half (i.e., 1/2) of its
equity for debt and continue with that capital structure policy in perpetuity. The
company pays no corporate income tax (i.e., Tc = 0) and is expected to have to pay
an interest rate of 5% on its newly issued debt (i.e., rd = 0.05). The company is
expected to pay all of its next income in dividends. What is today’s intrinsic value
of equity equal to? What about the intrinsic value of the firm?

3
Solution: The unlevered beta of equity is supplied as β unlev = 1 and the new levered beta is
β lev = β unlev × (1 + (D/E)) = 1 × (1 + 1) = 2. Using the CAPM, the new required
rate of return on equity is renew = rf + β lev × (E(rm ) − rf ) = 0.05 + 2 × 0.05 = 0.15
or 15%. Note that before the capital structure change the company was expected to
earn ROE × BV E0 = 0.10 × 1000 = 100. After borrowing 500, the company will have
to pay back 0.05 × 500 = 25 in interest which leaves only 100 − 25 = 75 in net income
under the new capital structure. Note that since the company is not reinvesting
anything it will experience zero growth in its new income. Hence, the intrinsic value
N I1 75
of equity is equal to V0e = rnew −g = 0.15−0 = 500. Note that the intrinsic value of the
e
firm stays the same, i.e., 500 + 500 = 1000.
(b) Suppose instead M&M Redux decides to swap three quarters (i.e., 3/4) of its equity
for debt and continue with this new capital structure policy forever. Every other
detail is the same as in the previous part of this question. What is the new intrinsic
value of equity equal to? How about the intrinsic value of the firm?
Solution: The new levered beta is β lev = β unlev × (1 + (D/E)) = 1 × (1 + 3) = 4. Using the
CAPM, the new required rate of return on equity is renew = rf +β lev ×(E(rm ) − rf ) =
0.05 + 4 × 0.05 = 0.25 or 25%. Note that before the capital structure change the
company was expected to earn ROE × BV E0 = 0.10 × 1000 = 100. After borrowing
750, the company will have to pay back 0.05×750 = 37.50 in interest which leaves only
100−37.50 = 62.50 in net income under the new capital structure. Note that since the
company is not reinvesting anything again it will experience zero growth in its new
N I1 62.50
income. Hence, the intrinsic value of equity is equal to V0e = rnew −g = 0.25−0 = 250.
e
Note that the intrinsic value of the firm stays the same, i.e., 750 + 250 = 1000.
(c) What do you conclude from this?
Solution: Since the beta of equity under the new capital structure changes proportionately with
the leverage ratio (at book values) then the higher risk of the levered beta offsets the
reduced after-interest net income in such a way that the total intrinsic value of the
firm is unchanged compared to the value of the firm before the capital structure
change.

5. M&M Taxable Corp. currently has assets with book value of 1000 and is financed entirely
with equity. The company is expected to have a return on equity (ROE) equal to 10% in
perpetuity. The required rate of return by shareholders of M&M Taxable Corp. is equal
to 10%. The beta of the equity is equal to 1. The risk-free rate is equal to 5% while
the expected market risk premium is also equal to 5%. However, now assume that the
company can deduct its interest expense for tax purposes. The corporate income tax rate
is equal to 50%. Assume that this only impacts the after-tax cost of debt.

(a) Beginning next year, M&M Taxable Corp. is expected to swap half (i.e., 1/2) of its
equity for debt and continue with that capital structure policy in perpetuity. The
company pays 50% corporate income tax (i.e., Tc = 0.50) and is expected to have
to pay a before-tax interest rate of 5% on its newly issued debt (i.e., rd = 0.05).
The company is expected to pay all of its next income in dividends. What is today’s
intrinsic value of equity equal to? What about the intrinsic value of the firm?
Solution: In this case, the new levered beta is β lev = β unlev × (1 + (D/E) × (1 − Tc )) = 1 ×
(1 + 1 × (1 − 0.5)) = 1.5. Using the CAPM, the new required rate of return on equity
is renew = rf + β lev × (E(rm ) − rf ) = 0.05 + 1.5 × 0.05 = 0.125 or 12.5%. Note

4
 that before the capital structure change the company was expected to earn ROE ×
BV E0 = 0.10 × 1000 = 100. After borrowing 500, the company will have to pay
back in after-tax terms 0.05 × 500 × (1 − 0.5) = 12.50 in interest which leaves only
100 − 12.50 = 87.50 in net income under the new capital structure. Note that since
the company is not reinvesting anything it will experience zero growth in its new
N I1 87.5
income. Hence, the intrinsic value of equity is equal to V0e = rnew −g = 0.125−0 = 700.
e
Note that the intrinsic value of the firm increases in this case to 500 + 700 = 1200.
(b) Suppose instead M&M Taxable decides to swap three quarters (i.e., 3/4) of its equity
for debt and continue with this new capital structure policy forever. Every other
detail is the same as in the previous part of this question. What is the new intrinsic
value of equity equal to? How about the intrinsic value of the firm?
Solution: The new levered beta is equal to β lev = β unlev × (1 + (D/E) × (1 − Tc )) = 1 ×
(1 + 3 × (1 − 0.5)) = 2.5. Using the CAPM, the new required rate of return on equity
is renew = rf + β lev × (E(rm ) − rf ) = 0.05 + 2.5 × 0.05 = 0.175 or 17.5%. Note
that before the capital structure change the company was expected to earn ROE ×
BV E0 = 0.10 × 1000 = 100. After borrowing 500, the company will have to pay
back in after-tax terms 0.05 × 750 × (1 − 0.5) = 18.75 in interest which leaves only
100−18.75 = 81.25 in net income under the new capital structure. Note that since the
company is not reinvesting anything it will experience zero growth in its new income.
N I1 81.25
Hence, the intrinsic value of equity is equal to V0e = rnew −g = 0.175−0 = 464.29. Note
e
that the intrinsic value of the firm increases in this case to 750 + 464.29 = 1214.29.
Note that a much higher level of borrowing only managed to increase the intrinsic
value of the firm by a little over $14 or just over 1% relative to the more conservative
debt-equity ratio in 5.(a) above.
(c) According to this model, the more debt a company issues the higher the total value
of the firm is going to be. Would it make sense replace all of the company’s equity
with debt? What do you expect will happen in that case?
Solution: In this case with Tc > 0 the beta of equity under the new capital structure changes
dis-proportionately with the leverage ratio (at book values) then the higher risk of
the levered beta is not enough to offset the reduced after-interest net income. In this
case, the net effect is to result in an intrinsic value of equity that exceeds the book
value of equity. This means that the total intrinsic value of the firm is increased when
compared to the value of the firm before the capital structure change.
Implication: One may conclude from this that in order to maximize the value of the firm, manage-
ment should borrow as much as possible, in fact it is optimal in this model to replace
all of the firm’s equity with debt. The problem with that, of course, is that this model
completely disregards the possibility of bankruptcy and any bankruptcy-related costs
(direct or indirect). Later in the class we will look at other firm valuation models that
explicitly take into account the likelihood of bankruptcy and the costs of financial
distress in trying to determine the optimal capital structure policy that maximizes
the value of the firm.