MIDTERM EXAM 1 BUS 497a: Company Valuation and Value Creation Spring 2011, AUBG NAME_______________________________________ Solution Guide

INSTRUCTIONS:
1.

2. 3. 4.
5. 6. 7.

You have 90 minutes to complete the exam. The exam is worth a total of 100 points. You may use a calculator and scratch paper sheets. You must hand in the sheets with your exam (put your name on it). Allocate your time wisely. Use the number of points assigned to each problem as your guide. In order to get full credit on the problems, you must show ALL your work! You can get partial credits if you show your calculations or provide arguments to support your answer. No credits will be warded if you fail to state your assumptions or conclusions explicitly.

Part A. Multiple choice questions (2 or 3 points each, 15 in total) Shareholders and wealth accumulation are most important in __________, while ___________ are the most important determinants of value for Continental Europe. A. Former communist courtiers, wealth and revenues growth. B. United States and United Kingdom, business continuity and inclusive shareholder governance. C. Asia and Latin America, tax and social policy. D. Capital goods sector, representative directors and legal government structures. E. Public Sector, tax and social policy Answer B.
1.

A.

D.

2. Shareholders can align managers with enterprise goals by: Require ring more frequent and detailed reporting of operations. B. Replacing debt with equity, thus, forcing managers to invest in high-yield operational assets. C. Issuing stock options and share grants to managers for achieving various levels of performance. Reviewing managements hiring choices. Answers B and C.

A. D.

Why should shareholder wealth be the most important metrics of corporate performance? Equity holders have the most decision-making authority in the firm. B. Most employees have funded pensions. C. It shouldnt be. Job growth is the most important social goal on its own. Managers will limit investment in outdated strategies. Answers A, B and D
3.

A. D.

4. Why is period-to-period economic profit insufficient to measure performance? It isnt inefficient since all elements of value creation are represented. B. It is inefficient because future performance is not impounded into the metric. C. It is inefficient because the cost of capital is not included in the calculations. It isnt inefficient because the cost of capital is included in the calculations. Answer B. 5. How are decisions in real and financial markets different? A. They really arent different because each depends on the maximization of future value. B. They really arent different because real market performance is mimicked and replicated in efficient financial markets. C. They are different because real markets discounted cash flow maximization must be augmented by financial market preferences for exceeding expectations of intrinsic value. D. They are different because real market value optimization does not take into account financial market systematic risk. Answer C.
6.

(3 points) Identify four process steps necessary to value equity (price per share) using the enterprise model? A. Value the companys operations by discounting FCF from operations at the
2

weighted average cost of capital (WACC). B. Value non-operating assets, such as excess marketable securities, nonconsolidated subsidiaries, and other equity investment. Combining the value of operating assets and non-operating assets leads to enterprise value. C. Identify and value all non-equity financial claims against the companys assets. Non-equity financial claims include (among others) fixed- and floatingrate debt, pension shortfalls, employee options, and preferred stocks. D. Subtract the value of non-equity financial claims from enterprise value to determine the value of common stock. To determine share price, divide equity value by the number of shares outstanding.
7.

What must a company do to increase its value? Outline three action plans that relate to ROIC, WACC, growth, capital and NOPLAT. A. Grow capital at an ROIC greater than the cost of capital. B. Decrease capital to lower the capital base, while maintaining NOPLAT at current levels. C. Lower the weighted average, risk-adjusted, cost of capital (WACC) by adjusting the companys financial structure.

B. Problem Solving (10 or 15 points each, 55 points in total)

8.

(10 points) Watson Dunn is planning to value BHP Billion Ltd. (NYSE: BHP) using a single-stage FCFF approach. BHP Billion, headquartered in Melbourne, Australia, provides a variety of industrial metals and minerals. The financial information Dunn has assembled for his valuation is as follows: The company has 1,852 million shares outstanding. Market value of debt is $3.192 billion. FCFF is currently $1.1559 billion. Equity beta is 0.90, the equity risk premium is 5.5%, and the risk-free rate is 5.5%. The before tax cost of debt is 7.0%. The tax rate is 40%. To calculate WACC, assume the company is financed 25% with debt. FCFF growth rate is 4%. Find: using Dunn information, calculate: 1) WACC 2) Value of the firm 3) Total Market value of equity 4) Value per share

Solution: 1) The required return on equity is r = E(Ri) = Rf + i[E(Rm) Rf] = 5.5% + 0.90(5.5%) = 10.45% The weighted average cost of capital is: WACC = 0.25(7.0%)(1-0.40) + 0.75(10.45%) = 8.89% 2) Firm Value = FCFF0(1 + g)/(WACC - g) Firm Value = 1.1559(1.04)/0.0889 0.04) = $24.596 billion 3) Equity Value = Firm Value Market Value of debt Equity Value = 24.596 3.192 = $21.404 billion 4) Value per share = Equity Value/Number of shares outstanding Value per share = 21.404/1.852 = $11.56
9.

(15 points) Do Pham is evaluating Phaneuf Accelerating using FCFF and FCEE valuation approaches. Pham has collected the following information (currently in Euro): Phaneuf has net income of 250 million, depreciation of 90 million, capital expenditures of 170 million, and an increase in working capital of 40 million. Phaneuf will finance 40% of the increase in Net fixed assets (capital expenditures less depreciation) and 40% of the increase in working capital with debt financing. Interest expenses are 150 million. The current market value of Phaneufs outstanding debt is 1,800 million. FCFF is expected to grow at 6 percent indefinitely, and FCFEE is expected to grow at 7 percent. The tax rate is 30%.
4

Phaneuf is financed with 40 percent debt and 60 percent equity. The before-tax cost of debt is 9 percent, and the before-tax cost of equity is 13 percent. Phaneuf has 10 million outstanding shares.

Find: 1) Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the value per share. 2) Using the FCFE valuation approach, estimate the total market value of equity, and the value per share Solution: 1) The FCF to firm is computed as: FCFF = NI + NCC + Int(1 T) FCInv WCInv FCFF = 250 + 90 + 150(1 0.30) 170 40 FCFF = 235 million The weighted average cost of capital is: WACC = 0.40(9.0%)(1-0.30) + 0.60(13%) = 10.32% The value of the firm is: Firm Value = FCFF1/(WACC - g) = FCFF0(1 + g)/(WACC - g) Firm Value = 235(1.06)/0.1032 0.06) = 5,766.20 million Equity Value = Total Firm Value Market Value of Debt Equity Value = 5,766.20 1,800 = 3,966.20 million Value per share = Equity Value/Number of shares outstanding Value per share = 3,966.20/10.00 = $396.62 per share 2) The FCF to equity is computed as: FCFE = NI + NCC FCInv WCInv + Net borrowing FCFE = 250 + 90 170 40 + 0.40(170 90 + 40) FCFF = 178 million Note: because the company is borrowing 40 percent of the increase in net capital expenditures (= 170 90) and working capital (40), net borrowing is 48 million. The total value of equity is: Firm Value = FCFE1/(WACC - g) = FCFE0(1 + g)/(r - g) Firm Value = 178(1.07)/0.13 0.07) = 3,174.33 million Value per share = Equity Value/Number of shares outstanding
5

Value per share = 3,174.33/10.00 = $317.43 per share

10.

(15 points) Kenneth McCoin has earning per share of $3.00 in 2002 and expects earnings per share to increase by 21% in 2003. Earnings per share are expected to grow at a decreasing rate for the following five years, as shown in the table below. In 2008, the growth rate will be 6% and is expected to stay at that rate thereafter. Net capital expenditures (capital expenditures minus depreciation) will be $ 5.00 per share in 2002 and then follow the pattern predicted in the table. In 2008, net capital expenditures are expected to be $1.50 and will then grow at 6% annually. The investment in working capital parallels the increase in net capital expenditures each year. In 2008, investment in working capital will be $0.375 and is predicted to grow at 6% thereafter. Kenneth McCoin will use debt financing to fund 40% of net capital expenditures and 40% of the investment in working capital. Year Growth rate for earnings per share Net capital expenditure per share 2003 21% $5.00 2004 18% $5.00 2005 15% $4.50 2006 12% $4.00 2007 9% $3.50 2008 6% $1.50

The required rate of return for Kenneth McCoin is 12%. Find the value per share using a two-stage FCFE valuation approach. Solution: Year Growth rate for EPS EPS CAPEX per share Inv. in WC per share New debt financing = 40% of (CAPEX WC inv.) FCFE = NI CAPEX WCinv. + New debt financing PV of FCFE discounted at 12% 2003 21% 3.630 5.000 1.250 2.500 -0.120 -0.107 2004 18% 4.283 5.000 1.250 2.500 0.533 0.425 2005 15% 4.926 4.500 1.125 2.250 1.551 1.104 2006 12% 5.517 4.000 1.000 2.000 2.517 1.600 2007 9% 6.014 3.500 0.875 1.750 2008 6% 6.374 1.500 0.375 0.750

3.389 5.249 1.923

The present values of FCFE from 2003 through 2007 (see the bottom row of the table above) sum up to $4.944. Using the constant growth model (FCEE will grow from 2008 onward at a constant 6 percent), we can find the value of these cash flows as: V2007 = FCFE2008/(r - g) = 5.249/(0.12 0.06) = $87.483 The PV of this stream is $87.483/1.12^5 = $49.640. The value per share is the value of the first five FCFE (2003-2007) plus the PV of the FCFE after 2007, or $4.944 + $49.483 = $54.588 11. (15 points) Jorge Zaldys, CFA, is researching the relative valuation of two companies
6

in the aerospace/defense industry: NCI Heavy Industry (NCI) and Relay Group International (RGI). He has gathered relevant information (in Million of Euros) on the companies in the following table.
Company Price per share Shares outstanding Market value of debt Book value of debt Cash and investment Net income Net income from continuing operations Interest expense Depreciation and amortization Taxes RGI 150 5 million 50 52 5 49.5 49.5 3 8 2 NCI 100 2 million 100 112 2 12 8 5 4 3

Using the information in the above table, answer the following questions: 1) Calculate P/EBITDA for NCI and RGI. 2) Calculate EV/EBITDA for NCI and RGI. 3) Select NCI or RGI for recommendation as relatively undervalued. Justify your selection. Solution: 1) EBITDA = Net income from continuing operations + Interest expense + Taxes + Depreciation and Amortization EBITDA for RGI = 49.5 + 3 + 2 + 8 = 62.5 million Per share EBITDA = 62.5/5 = 12.5 P/EBITDA for RGI = 150/12.5 = 12 EBITDA for NCI = 8 + 5 + 3 + 4 = 20 million Per share EBITDA = 20/2 = 10 P/EBITDA for NCI = 100/10 = 10 2) Market value of equity for RGI = 150 x 5 = 750 million Market value of debt for RGI = 50 million Total market value for RGI = 750 + 50 = 800 million Enterprise value (EV) = 800 5 = 795 million No we divide EV by total (as opposed to per-share) EBITDA: EV/EBITDA for RGI = 795/62.5 = 12.72 Market value of equity for NCI = 100 x 2 = 200 million Market value of debt for NCI = 100 million Total market value for NIC = 200 + 100 = 300 million Enterprise value (EV) = 300 2 = 298 million No we divide EV by total (as opposed to per-share) EBITDA:
7

EV/EBITDA for NCI = 298/20 = 14.9 3) Zaldys should select RGI as relatively undervalued because: First, it is correct that NCI appears to be relatively undervalued based on P/EBITDA, because it has a lower P/EBITDA multiple: P/EBITDA = 12 for RGI P/EBITDA = 10 for NCI RGI is relatively undervalued based on EV/EBITDA however, because RGI has the lower EV/EBITDA multiple: EV/EBITDA = 12.72 for RGI EV/EBITDA = 14.9 for NCI EBITDA is a pre-interest flow, therefore, it is a flow to both debt and equity, and the EV/EBITDA multiple is more appropriate than P/EBITDA multiple. Zaldys would rely on EV/EBITDA to reach his decision when the two ratios contradict.

Part C. Mini case problem (25 points) As a financial analyst demonstrate your client the equivalence between free cash flow and economic profit representations of value with a model similar to the three-year horizon model. Discuss the similarities, differences and usefulness of each representation. Use the following template and assumptions:
Assumptions ROIC Growth WACC Year 1-3 (%) 18% 20% 14% Year 4+(%) 15.75% 5% 12%

Note 1: Beginning invested capital equals $55.56 Note 2: Net Investment is (gt/ROICt)(NOPLATt), and NOPLATt+1 = NOPLATt(1 + g). Beginning invested capital plus net investment equal the new capital.

Solution:
3-year horizon NOPLAT Net Investment Free Cash Flow Beginning IC Net Investment New IC NOPLAT Capital Charge Economic Profit Discount Factor Present Value FCF Present Value EP PV FCF 1-3 PV CV FCF Total Value PV EP 1-3 PV CV IC Total Value 1 10.00 (11.11) (1.11) 55.56 11.11 66.67 10.00 (7.78) 2.22 0.8772 (0.97) 1.95 (3.08) 99.51 96.43 6.16 34.71 55.56 96.43 2 12.00 (13.33) (1.33) 66.67 13.33 80.00 12.00 (9.33) 2.67 0.7695 (1.03) 2.05 3 14.40 (16.00) (1.60) 80.00 16.00 96.00 14.40 (11.20) 3.20 0.6750 (1.08) 2.16 CV Base 15.12

Note: use the formula on p.217 in the textbook

In this example, economic profit is positive while free cash flow is negative during the explicit forecast period. The firm is adding value while at the same time is requiring net investment in excess of operating earnings (NOPLAT). A critical assumption for the operation of the model is that the ROIC (15.75%) for the continuing base period must be consistent with continuing base period NOPLAT and the level of capital at the end of the explicit forecast period (equivalently the beginning of the continuing base period). 1. The free cash flow model shows the firm how much funding is generating or is needed during the forecast periods. This representation would be certainty useful to the corporate treasurer and the maintenance of long-term goals for the firms money desk and bank cash management relationships. 2. The economic profit valuations show the firm how much value is gained or lost during the forecast periods. The primary audience for this representation would be banks, and other contractual claimants on the firms ability to generate earning.

10

Part D. Essay question (5 points) (There is a limit of up to 5 sentences. Be short and on the spot.) Define the role of value-based management systems and give examples of performance metrics that can be used in a financial management system. Extract from a student work: The key role of the value-based management (VBM) system is to create and use performance metrics that are related to shareholder value. The most popular performance metrics consider how much a companys return exceeds its cost of capital. VBM encompasses corporate strategy, shareholder value, internal control, and management compensation. It provides employees and managers with a set of rules that helps them evaluate what creates and destroys shareholder value and gives them the incentive to make appropriate decisions. The most popular performance metrics used in financial management systems are: 1. Economic Value Added (EVA) - measures by how much the earnings exceed the expected minimum return shareholders could get by investing in other similar-risk companies. 2. Cash Flow Return in Investment (CFROI) shows which percentage of the cash invested was generated by the companys cash flow in a certain period. 3. Discounted Cash Flow (DCF) express the market value of a company as a present value of its future expected cash flows. 4. Return on Invested Capital (ROIC) NOPLAT/Invested Capital, it is later compared to companys cost of capital.

11