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CF

© All Rights Reserved

- Chapter 12 IM 10th Ed
- Test 1
- 2012CFNCE207001.pdf
- Corporate Finance Valuation
- Gaines Boro
- Technical Analysis n Cost of Capital
- corporate_finance_chapter6.pptx
- Cost of Capital
- Beximco Pharma Valuation
- Course Outline - Financial Management
- F9FM-SQB-Conts_d07
- wells fargo company analysis
- MF0015.docx
- Case Quest
- Presentation Example 4
- Corporate Finance Report Analysis
- Motives of Stock Repurchases and Payout Policy
- Cost of Capital
- ACF_Dividends&Repurchase.pdf
- SS 11

You are on page 1of 121

Business

Sector Averages

Revenues (in $ millions)

Enterprise Value/Sales

Computer hardware

Computer services

Country

United States

China

$1,000

$600

0.80

2.00

currency

3.00%

4.00%

5.00%

7.00%

3.00%

To compute beta

Business

Computer hardware

Computer services

Estimated Value

Weight

$800.00

$1,200.00

$2,000.00

0.4

0.6

To compute ERP

Country

United States

China

ERP

Revenues

5.00%

7.00%

6.00%

9.2400%

Cost of equity in US $ =

$800.00

$800.00

$1,600.00

Part b

First, estimate the divestiture value

Hardware revenues in US =

Estimated value =

Debt raised =

Invested in China services=

Incremental revenue

Business

$500

$400.00

$400.00

$800.00

$400.00 ! Invested value/ EV to Sales of sector

Estimated value

Computer hardware

Computer services

New D/E ratio =

Levered Beta =

To compute ERP

Country

United States

China

Weight

$400.00

$2,000.00

16.67%

83.33%

1.0733 ! Use US marginal tax rate, since borrowing is

Tax benefits are also in US.

ERP

Revenues

5.00%

7.00%

6.60%

$300.00

$1,200.00

I gave full credit if you weighted the ERP by the values of the businesses in US (600) and C

Cost of equity in US $ =

10.08%

Problem 2

0

Storage facility investment

Inventory investment

Years 1-10

-2,250,000

-750000

Current

Revenues

EBITDA

$5,000,000.00

$900,000.00

After investment

$7,500,000.00

$1,500,000.00

Incremental EBITDA

- Depreciation

Incremental operating income

- Taxes

Incremental after-tax operating income

+ Depreciation

After-tax cash flow

NPV =

$600,000.00

$200,000.00

$400,000.00

$160,000.00

$240,000.00

$200,000.00

$440,000.00

$89,152.82

Part b

With a perpetual life, assume that capital maintenance = depreciation & no salvage value

Initial investment =

-3,000,000

NPV = -3000000 + X/.10 = 0

! No salvage value, if you have perpetual life

Solving for X

Annual after-tax cash flow =

$300,000.00

Incremental after-tax operating income

$300,000.00

Incremental pre-tax operating income

$500,000.00

+ Depreciation

$200,000.00

Breakeven Incremental EBITDA

$700,000.00

Breakeven EBITDA

$1,600,000.00

Breakeven EBITDA margin =

21.33%

Note: Including depreciation while ignoring capital maintenance is not an option, since de

Problem 3

Current beta =

Current cost of equity =

Current after-tax cost of debt =

Debt ratio =

Cost of capital =

New Debt/Equity ratio =

Unlevered beta =

New levered beta =

New cost of equity =

New after-tax cost of debt =

New debt ratio =

New cost of capital =

Old firm value =

Increase in firm value

New firm value =

- New Debt =

New equity value =

No of shares

Value per share =

3.06

18.300%

6%

80%

8.4600%

1.5

0.9

1.71

11.5500%

4.50%

0.6

7.32%

1000

214.2857142857

1214.2857142857

600 ! Don't forget to subtract debt

614.2857142857

40 ! Divide by total # shares

$15.36

(You will get the same answer, if you divide the increase in value by total number the shar

Problem 4

Revenues

Net Income

Depreciation

Cap Ex

$1,000

$100

$40

$50

$1,100

$110

$45

$60

Total Debt

$10

$10

$30

$15

0%

40%

Net Income

+ Depreciation

- Cap Ex

- Change in Working capital

+ Increase in debt

FCFE

Dividends paid

Change in cash balance

Cash Balance

$100.00

$40.00

$50.00

$10.00

$10.00

$90.00

$0.00

$90.00

$90.00

Next year

$110.00

$45.00

$60.00

$20.00

$5.00

$80.00

$44.00

$36.00

$126.00

Year +2

Revenues

Net Income

+ Depreciation

- Cap Ex

- Change in Working capital

- Debt repaid

FCFE

Dividends paid

Change in cash balance

Cash balance

$1,440.00

$144.00

55

77

$84.00

$25

$13.00

$72.00

-$59.00

$137.00

$1,728.00

$172.80

60.5

84.7

$28.80

$25

$94.80

86.4

$8.40

$145.40

Problem 5

After-tax operating income =

Invested capital =

Return on capital =

60

500

12%

High Growth

Reinvestment rate =

1

After-tax operating income

- Reinvestment

FCFF

Terminal value

Present value

Value of operating assets =

+ Cash

- Debt

Value of equity

Value per share =

Price per share =

Undervalued by

Stable growth

9.00%

75.00%

3%

25.00%

2

$65.40

$49.05

$16.35

$71.29

$53.46

$17.82

$14.86

$688.43

$50.00

$300.00

$438.43

$17.54

$16.00

-8.766%

$14.73

Sector Averages

Unlevered Beta

Grading template

1.25

0.9

40%

25%

Total Revenues

$800.00

$800.00

1. Wrong risk free rate: -1/2 point

Unlevered Beta

1.25

0.9

1.04

3. Wrong ERP: -1/2 point

4. Math errors: -1/2 point

Weights

0.5

0.5

1.

2.

3.

4.

Wrong levered beta: -1 to 1.5 points

ERP weighted incorrectly: -1 to 1.5 points

Math errors: -1/2 point each

Unlevered Beta

1.25

0.9

0.9583

are also in US.

Weghts

20%

80%

Salvage Value

250000

750000

Incremental

$2,500,000.00

$600,000.00

1.

2.

3.

4.

5.

After-tax cash flow incorrect: -1 point

Salvage value incorrect: -1 point

PV incorrect: -1/2 point

Math error: -1/2 point

2. Included salvage value: -1 point

3. Did not consider capital maintenance: -1 point

s not an option, since depreciation will run out after ten years.

2. Wrong weights: -1/2 point

3. Math error: -1/2 point

t to subtract debt

1.

2.

3.

4.

Did not after-tax cost of debt: -1/2 point

Wrong weights: -1/2 point

Math error: -1/2 point

1.

2.

3.

4.

Did not subtract out new debt: -1 point

Divided change in value by old shares: -1 point

Other math errors: -1/2 point each

otal # shares

by total number the shares and add to the value per share)

$1,200

$120

$50

$70

2. Did not compute change in debt: -1 point

3. Did not compute cash balance: -1/2 point

$60

$75

50%

Most recent year

$120.00

$50.00

$70.00

$30.00

$60.00

$130.00

$60.00

$70.00

$196.00

Year +3

$2,073.60

$207.36

66.55

93.17

34.56

$25

$121.18

103.68

$17.50

$162.90

2. Did not compute change in debt: -1 point

3. Did not compute cash balance: -1/2 point

1.

2.

3.

4.

5.

Did not compute reinvestment in years 1-3: -1 point

Did not recompute reinvestment in year 4: -1 point

Discounted at wrong discount rate: -1/2 point

Math error: -1/2 point

Terminal year

$77.70

$58.28

$19.43

$857.49

$658.84

$80.03

$20.01

$60.02

1.

2.

3.

4.

Did not subtract debt: -1 point

Did not compare to current market value: -1/2 point

Math error: -1/2 point

Problem 1

US

Steel

Technology

Total

Grading template

Brazil

Total

$800.00

$400.00

$1,200.00

$600.00

$300.00

$900.00

$1,400.00

$700.00

Part a

For beta

Steel

Technology

Value

Weight

Unlevered beta

$1,800.00

57.14%

0.9

$1,350.00

42.86%

1.2

$3,150.00

1.02857

For ERP

2. ERP weighted incorrectly: -1 point

3. Math errors: -1/2 point

Value

US

Brazil

Weight

$2,100.00

$1,050.00

$3,150.00

Cost of equity

ERP

66.67%

33.33%

6%

9%

7.00%

because it is not a risk free rate

Part b

US

Steel

Technology

Total

$1,200.00

$900.00

$2,100.00

Brazil

Total

$600.00

$1,800.00

$1,200.00

$2,100.00

$1,800.00

Debt =

2700

44.44%

For beta

Value

Weight

Unlevered beta

$1,800.00

46.15%

0.9

$2,100.00

53.85%

1.2

$3,900.00

1.06154

New levered b 1.344615385

Steel

Technology

For ERP

US

Brazil

Value

Weight

ERP

$2,100.00

53.85%

$1,800.00

46.15%

$3,900.00

Cost of equity

After-tax cost

Debt ratio =

Cost of capita

12.93%

3.00%

30.77%

9.87%

Problem 2

Part a

Initial invest

Annual cash flow

-$5,000.00

Betas not reweighted for business: -1 point

Betas not reweighted for country: -1 point

Did not relever beta: -1 point

Math errors: -1/2 point

company restructures. So, both

1200

Equity =

D/E ratio =

1.

2.

3.

4.

5.

6%

9%

7.38%

Revenue

EBITDA

- DA

EBIT

- Taxes

Aftertax EBIT

+ DA

After-tax Cash

NPV =

$4,000.00

$800.00

$500.00

$300.00

$120.00

$180.00

$500.00

$680.00

1.

2.

3.

4.

Forgot to take taxes: -1 point

Wrong discount rate: -1 point

Math errors: -1/2 point each

-$635.99

Part b

Annual after-t

Revenues=

$107.99

$539.96 ! Divide by after-tax margin

Part c

Existing

Expensed

$0.00

Tax savin

$0.00

2. Error in getting back to revenues from annuit

3. Wrong discount rate: -1/2 point

New

$2,000.00

Depreciation

$500.00

$800.00

$600.00

3. Math errors: -1/2 point each

Depreciation t

$200.00

$240.00

10.00

5.00

PV of tax savi

$1,283.53

$933.52

Change in NP

$449.98

only the depreciation changes. I

cash flows will leave you with su

unlikely that you will get the rig

$250.00

1. All or nothing

Number of yea

Problem 3

Part a

Expected FCFF

$5,000.00

8.40%

Cost of equity

Value of the f

Solving for g

Expected grow

3.400%

Part b

New Debt$2,000.00

New Equit$3,000.00

66.67%

New D/E ratio

40.00%

New D/C ratio

1.26

New levered b

Cost of equity 10.5600%

7.0000%

Cost of debt

8.02%

Cost of capital

$415.94

Change in fir

Part c

3. Did not lever beta: -1 point

4. Other errors: -1/2 point

If the cash is paid out a as a special dividend, the number of shares remains unchanged at 80 million

$5,415.94

$2,000.00

- Debt

New Equity va $3,415.94

New firm valu

All or nothing

$34.16

Part c

$5,415.94

$2,000.00

- Debt

Value of equit $3,415.94

New firm valu

Check your answer

If buyback price =

33.02069528

Number of sha2000/X

Remaining shares

Remaining sha100-2000/X Price per share =

Value to buyb (X-50)*(2000/X)

(100 -2000/X)*51= 3415.94 Value of equity=

66.97930472

51

It is not. It is the price of the rem

$3,415.94

Solving for X

X=

$60.57

Problem 4

1

12%

30%

2

14%

25%

3

16%

15%

Revenues

$100.00

Net Income

$10.00

Capital expend

$40.00

Depreciation

$12.00

Non-cash Work

$36.00

Chg in noncash WC

FCFE

Cash balance

$45.00

1

$140.00

$16.80

$46.00

$15.00

$42.00

$6.00

-$20.20

$24.80

2

$196.00

$27.44

$52.90

$18.75

$49.00

$7.00

-$13.71

$11.09

3

$274.40

$43.90

$60.84

$23.44

$41.16

-$7.84

$14.35

$25.44

Revenues

$100.00

$140.00

Net Income

$10.00

$16.80

Capital expend

$40.00

$46.00

Depreciation

$12.00

$15.00

Non-cash Work

$36.00

$42.00

Chg in noncash WC

$6.00

New Debt

$4.00

FCFE

-$16.20

- Dividends paid

$3.36

Cash balance

$45.00

$25.44

Desired cash balance at end of year 3

Cash available for buybacks

$196.00

$27.44

$52.90

$18.75

$49.00

$7.00

$4.00

-$9.71

$5.49

$10.24

$43.90 2. Error on new debt: -1 point

$60.84 3. Error on cash balance: -1 point

$23.44

$41.16

-$7.84

$4.00

$18.35

$8.78

$19.81

$10.00

$9.81

Net Margin

Total non-cas

2. Change in non-cash WC wrong: -1 point

3. Other errors: -1/2 point

Part a

Base

Part b

Problem 5

After-tax oper

10

12.00%

Book value of

45

Book value of

15

Cash

10

Invested capit

50

Return on capi

20%

10%

Net Cap ex

Change in non

Normalized acq

Reinvestment

Expected grow

Expecedd grow

Reinvestment r

After-tax oper

Reinvestment

FCFF

Terminal value

PV @ 12.5%

Value of opera

$2.00

$1.00

$3.00

60%

12.00%

3.0%

15.00%

1

$11.20

$6.72

$4.48

2

$12.54

$7.53

$5.02

$4.00

$137.07

$4.00

+ Cash

$10.00

- Debt

$15.00

Value of equit

Value per sha

Terminal value

1. Did not recompute reinvestment rate: -1/2 po

2. Used wrong discount rate: -1/2 point

3. Math errors: -1/2 point each

$132.07

$26.41

Value today

1. Used wrong discount rate: -1/2 point

2. Used wrong discount rate just on terminal va

3 Term year

3. Cash not added: -1/2 point

$14.05

$14.47 4. Debt not subtracted out: -1/2 point

$8.43

$2.17

$5.62

$12.30

$175.72

! New reinvestment rate = 3%/20% = 15%

$129.07

You then have to add cash (sinc

debt.

ed incorrectly: -1 point

incorrectly: -1 point

is not a risk free rate in US$.

wrong: -1 point

eighted for business: -1 point

eighted for country: -1 point

er beta: -1 point

estructures. So, both numbers have to be resestimated.

taxes: -1 point

nt rate: -1 point

1/2 point each

g back to revenues from annuity: -1/2 point

nt rate: -1/2 point

1/2 point each

epreciation changes. In fact, doing all of the

will leave you with such a mess that it is very

at you will get the right answer.

beta: -1 point

at 80 million

is the price of the remaining shares.

n-cash WC wrong: -1 point

debt: -1 point

balance: -1 point

there is one acquisition every five years and gives you the am

The simplest solution is to average the amount and add it to

reinvestment. That pushes up the reinvestment rate and gro

rate.

Here is why you cannot ignore it. This is clearly part of the c

strategy to grow. If you ignore it, you will understate reinves

iscount rate: -1/2 point

1/2 point each

iscount rate just on terminal value: -1/2 point

ed: -1/2 point

racted out: -1/2 point

ave to add cash (since you have not counted it yet) and subtract out

s and gives you the amount

amount and add it to your

estment rate and growth

ill understate reinvestment

Problem 1

Part a.

Business

Estimated Val Weight

Storage Devic

400

Electronics

600

Social Media

800

Firm

1800

Equity

1200

Debt

600

D/E ratio =

0.5

Levered beta =

0.2

0.4

0.8

Unlevered beta

0.9

1.2

1.8

1.4

1.82

Part b

Business

Estimated Val Weight

Unlevered Beta

Electronics

600

0.375

1.2

Social Media

1000

0.625

1.8

Firm

1600

1.575

Equity

1200

Debt

400

D/E ratio

0.333333333

Levered beta =

1.89

Part c

Business

Estimated Val Weights

Unlevered beta

Electronics

600 0.428571429

1.2

Social Media

800 0.571428571

1.8

Firm

1400

1.542857143

Equity

800

Debt

600

D/E

0.75

Levered Beta =

2.24

Problem 2

0

-20

5

0

Incremental Revenue

Incremental EBITDA

Incremental Depreciation

Incremental EBIT

Incremental Tax

Incremental EBIT (1-t)

+ Incremental Depreciaton

- Incremental

-10

FCFF

-10

NPV =

-$0.32

$10.00

$2.00

4

-$2.00

-$0.80

-$1.20

4

$0.50

$2.30

$20.50

$4.10

4

$0.10

$0.04

$0.06

4

$0.53

$3.54

$31.53

$6.31

4

$2.31

$0.92

$1.38

4

$0.55

$4.83

$43.10

$8.62

4

$4.62

$1.85

$2.77

4

$0.58

$6.19

$55.26

$11.05

4

$7.05

$2.82

$4.23

4

$13.37

-$5.14

200

$210.00

$10.00

200

$220.50

$20.50

200

$231.53

$31.53

200

$243.10

$43.10

200

$255.26

$55.26

$10.50

$0.50

$11.03

$0.53

$11.58

$0.55

$12.16

$0.58

$25.53

$13.37

Investment

Revenue befor

Revenue after

Incremental revenue

Working capita

Working capita

Incremental

200

20

10

10

b. Effect of expensing

Tax benefit of

$8.00

Tax benefit of

Effect on NPV

New NPV =

c.

NPV with syst

Cost of syste

NPV of increm

Annual after-t

Pre-tax expen

$1.93 ! Initial investment * tax rate

$1.62

-$0.32

-$13.93

$13.62

$3.59 ! Annuity given NPV

$5.99 ! Pre-tax amount

Long way to do

0

Incremental EBITDA

Incremental EBIT

Incremental taxes

Incremental EBIT (1-t)

- Incremental

-$10.00

FCFF

$10.00

PV

$13.62

1

$2.00

$2.00

$0.80

$1.20

$0.50

$0.70

2

$4.10

$4.10

$1.64

$2.46

$0.53

$1.94

3

$6.31

$6.31

$2.52

$3.78

$0.55

$3.23

4

$8.62

$8.62

$3.45

$5.17

$0.58

$4.59

5

$11.05

$11.05

$4.42

$6.63

$13.37

-$6.74

Problem 3

Part a

Current lever

Cost of equity

After-tax cost

Market value o

Debt

Debt ratio =

Cost of capita

Unlevered bet

New D/E ratio

Levered beta

Cost of equity

After-tax cost

Debt ratio =

Cost of capita

Change in cost

Savings each

Increase in fi

New firm valu

New debt (to

Old debt

Increase in de

1.15

9.900%

2.40%

800

200

0.2

8.40%

1

9

6.4

41.400%

4.50%

90%

8.1900%

0.2100%

2.1

$25.64

$1,025.64

$923.08

$200.00

$723.08

Interest expe

$69.23 ! Two things can affect your cost of capital. The first is that your

Operating inc

$60.00 ! Interest coverage ratio will decrease increasing your default spread.

Tax rate for c

34.67% ! That may be difficult to compute and I did not look for it.

Levered beta

6.88 ! However, you can compute your interest expense and it gives you an

After-tax cost

4.90% ! Interest expense> EBIT, which affects your cost of capital

Cost of equity

44.28%

Cost of capita

8.84%

You did not have to work your way through. If you showed the tax rate effect, you got full credit

Problem 4

Last12months

Revenues

$1,000

EBITDA

$250

Depreciation

$60

NetIncome

$80

NoncashWorki

$75

TotalDebtouts

150

Parta

FCFEwihtoutc

NetIncome

+ Depreciatio

$88

$66

($5)

-5

$154

$52.80

Changeinn

+(NewDebt

FCFE(beforeca

Dividends

Changeincashbalance

Capitalexpenditures

1

$1,100

$275

$66

$88

$70

145

2

$1,200

$300

$72

$96

$65

140

3

$1,300

$325

$78

$104

$60

135

$96

$72

($5)

-5

$168

$57.60

$104

$78

($5)

-5

$182

$62.40

$112

$84

($10)

-5

$201

$67.20

4

$1,400

$350

$84

$112

$50

130

5

$1,500

$375

$90

$120

$40

125

5 Cumulative

$120

$90

($10)

-5

$215

$72.00

$520

$390

($35)

($25)

$920

$312

-100

$708

Partb,

Tokeepthecashbalanceconstant&paydowndebt

$312 ! You don't need cap ex to solve this part of the problem

Exisitngdivide

125 ! So, not credit for carry through of part a mistakes

Cashtopay

100

Cashflowto

$87

Remainingdivi

$520

Cumularivenet

Payout ratio

16.73%

Partc

Thecompanyexpectsitsearningsgrowthandreinvestmentneedstodecreaseinthefuture

Problem 5

Current

After year 5

EBIT (1-t)

10

Invested Capit

100

Net Cap Ex

7

Change in work

2

Return on capi

10%

10%

Reinvestment

90%

30%

Expected grow

9%

3%

Cost of capital

12%

8%

Year

1

2

EBIT (1-t)

$10.90

$11.88

- Reinvestme

$9.81

$10.69

FCFF

$1.09

$1.19

Terminal value

Present value

$0.97

$0.95

Value of opera

$130.51

+ Cash

$15.00

- Debt

$40.00

Value of equit

$105.51

/ Number of s

$8.00

3

$12.95

$11.66

$1.30

4

$14.12

$12.70

$1.41

$0.92

$0.90

5 Terminal year

$15.39

$15.85

$13.85

$4.75

$1.54

$11.09

$221.87

$126.77

$13.19

! Wrong D/E ratio: -1 point

! Wrong D/E ratio: -1 point

! Wrong D/E ratio: -1 point

!

!

!

!

Change in working capital not computed each year: -1 point

Forgot to reverse working capital at end of period (when it reverts): -0.5 point

Other mistakes: -0.5 points each

! Your NPV will be higher and you should get full credit

! Did not compute lost PV from depreciation tax savings correctly: - 0.5 points

(If you did the entire problem the long way - with the cash flows - you should

get the same effect where your NPV increases by this amount)

! Used NPV from part 1 without correcting for investment & depreciation: -1 point

! Did not annualize: -1 point

! After-tax cost of debt incorrect: -0.5 point

! Did not after-tax cost of debt: -0.5 point

! Math errror: 0.5 point

! Did not use firm value change to get to debt: -1 point

! I did give half a point, if you explicitly computed an interest coverage ratio

! Paying down debt shown as cash inflow instead of outflow: -1 point

! Forgot depreciation add back: -1 point

! All of the other reasons may sound plausible, but they are not defensible. You don't want

to pay dividends just because everyone else is or to attract dividend-liking investors just

for the sake of expanding your investor base. You certainly don't want to pay dividends

if you expect your reinvestment needs to be high in the future.

! FCFF not consistent with growth: -1 point

! Wrong discount rate on termnal value: -0.5 point

! Subtracted cash (instead of adding it): -0.5 point

flow: -1 point

g investors just

pay dividends

Problem 1

a.

Market value of equity =

800

Market value of interest bearing d

400

PV of lease commitments =

406.0553654 ! PV of $ 80 million @5%

Firm value =

1606.055365

Debt ratio =

50.19%

Beta =

1.15

Cost of equity =

9.25%

Cost of debt (after-tax)

3.00%

Cost of capital =

6.11%

b.

Value of entertainment =

963.6332192

Value of electronics =

642.4221462

Current unlevered beta =

0.716715637 ! 1.15/(1+(1-.4)(806/800))

Unlevered beta = 0.7167 = 0.90 (.4) + X (.6)

Solving for new unlevered beta

Unlevered beta after divestiture = 0.594526061

Debt after transaction =

645.4498288 ! 806 - 0.25*642.42

Equity after transaction =

318.1833904 ! 800 - 0.75*642.42

D/E ratio after transaction =

2.028546581

Levered beta after transaction = 1.318140347

Cost of equity =

10.09%

After-tax cost of debt =

3.90%

Cost of capital =

5.94%

1.

2.

3.

4.

Used after-tax cost of debt to capitalize

Unlevered and relevered beta for leases

Did not after-tax cost of debt: - 0.5 poin

1.

2.

3.

4.

5.

Did

Did

Did

Did

Did

1.

2.

3.

4.

5.

Errors on computing annual after-tax ca

Did not salvage working capital or show

Did not salvage initial investment: -0.5

Used company's cost of capital : -1 poin

not

not

not

not

not

back out unelvered beta of ente

estimate new D/E ratio correctly

adjust cost of debt: -0.5 point

after-tax cost of debt: -0.5 point

Problem 2

Initial investment =

Initial investment in WC =

60

10

0 Yrs 1-10

-70

Initial investment

Salvage

Revenues

EBITDA

- Depreciation

EBIT

EBIT (1-t)

+ Depreciaton

Cash flow

NPV =

20

100

15

5

10

6

5

11

you will get in year 10 because you will be

tax benefit will be 0.4(10) = 4

9.042450851

Initial investment

Terminal value

Revenues

EBITDA

- Depreciation

EBIT

EBIT (1-t)

+ Depreciaton

- Cap maintainence exp

Cash flow

NPV =

Year 10

-70 Forever

will deplete your assets' earning power an

100

15

5

10

6

5

5

6

There will be nothing to depreciate after y

! Adjusted cash flow just for perpetuity in

is not mathematically impossible, but it is

! Other errors: -0.5 point each

! Salvaged working capital and initial inve

c.

PV of synergy =

! Error in PV = -0.5 point

Problem 3

a.

Current cost of equity =

After-tax cost of debt =

Debt ratio

Cost of capital

0.085

0.027

0.2

0.0734

b.

New debt ratio =

Unlevered beta =

New levered beta =

Cost of equity =

After-tax cost of debt =

Cost of capital =

0.6

0.869565217 ! 1/(1+(1-.4)(0.25))

1.652173913 ! 0.8686(1+(1-.4)(1.50))

0.117608696

0.039

0.070443478

c.

Increase in firm value =

52.46265893 ! (.0734-.0704)(1250)/.0704

2. Error on weights: 0.5 point

1.

2.

3.

4.

Errors in unlevering and relevering beta

Errors in pre-tax cost of debt: -0.5 point

Did not after-tax cost of debt: -0.5 point

!

!

!

!

11

Number of shares bought back = 45.45454545 ! 500/11

Portion of value to bought back s 45.45454545 ! 45.45 (11-10)

Error in computing change

Did not net out portion of

Did not adjust number of s

7.008113476 ! 52.46-45.45)

Remaining shares =

54.54545455 ! 100-45.45

Value increase per remaining shar 0.12848208 !7.008/54.54

Price per share =

10.12848208

d. The value per share will be higher than computed in part c, because stockholders

will get a bonus from being able to keep existing debt at lower rates on the books.

Problem 4

Revenues

Net income

+ Depreciation

- Cap Ex

- Change in WC

- (Debt repaid + Debt issued)

FCFE

Dividends

Change in cash balance

Cash balance at start of year

Cash balance at end of year

60

90

10

15

5

7.5

8

10

-1

3

-1

2.75

9

12.25

2

10.25

7

2

3

10

10

12

Total reinvestment =

Debt used =

Debt ratio =

2

1

0.5

Payout ratio =

c.

iii.NegativeJensensalpha,negativeEVA

I would not trust the managers of the company and want my cash back.

Part a

1. Error on dealing with change in working

2. Error on dealing with change in debt: -0

3. Other errors in computing FCFE: -0.5 po

4. Change in cash balance incorrect: -0.5 p

Part b

1. Did not compute change in working cap

2. Did not compute change in debt correct

3. Other errors: -0.5 point each

4. Divided dividend by revenues or some o

Problem 5

High growth

Return on capital =

Expected growth =

Reinvestment rate =

Cost of capital

Year

EBIT (1-t)

Reinvestment

FCFF

Terminal value

Present value (at 12%)

Value of operating assets =

+ Cash

- Debt

Value of equity

Value per share

25.00%

10%

0.4

12%

Current

$20.00

Stable growth

15% Return on capital = EBIT

3%

0.2 ! g/ ROC

10%

1

2

3

$22.00

$24.20

$26.62

$8.80

$9.68

$10.65

$13.20

$14.52

$15.97

$11.79

272.0068328

20

50

242.0068328

$12.10

$11.58

$11.37

4

$29.28

$11.71

$17.57

$11.17

x cost of debt to capitalize leases: - 0.5 point

d relevered beta for leases (why?): 0.5 point

tax cost of debt: - 0.5 point

out unelvered beta of entertainment business: -1 point

ate new D/E ratio correctly: -1 point

t cost of debt: -0.5 point

tax cost of debt: -0.5 point

puting annual after-tax cash flow: -1 point

ge working capital or show tax benefit from not salvaging: -0.5 point

ge initial investment: -0.5 point

y's cost of capital : -1 point

not to salvage working capital, you have to show the tax benefit

ear 10 because you will be writing off the investment. That

be 0.4(10) = 4

r assets' earning power and not be able to go on forever.

thing to depreciate after year 10)

flow just for perpetuity in year 10: -0.5 point (This is a lesser sin. It

tically impossible, but it is economically infeasible. Think Apple iTV)

0.5 point each

ing capital and initial investment: -0.5 point

hts: 0.5 point

t beta: -1 point

vering and relevering beta: - 0.5 point

ax cost of debt: -0.5 point

tax cost of debt: -0.5 point

Error in computing change in firm value: -0.5 point

Did not net out portion of value to buyback shares: -1 point

Did not adjust number of shares: -1 point

ng with change in debt: -0.5 point

n computing FCFE: -0.5 point

sh balance incorrect: -0.5 point

ute change in debt correctly: -1 point

-0.5 point each

end by revenues or some other variable: -0.5 point

a. Did not compute reinvestment: -1 point

b. Computed ROC incorrectly: -0.5 point

5 Terminal year

$32.21

$33.18

$12.88

$6.64

$19.33

$26.54

$379.16

$226.11

Part b

a. Did not compute reinvestment: -1 point

b. Did not use new cost of capital;: -0.5 point

c. Other errors in computation: -0.5 point

Part c

a. Used wrong discount rate for term value: -0.5

b. Did not compute PV of FCFF: -0.5 point

c. Forgot to add cash: -0.5 point

d. Forgot to subtract debt: -0.5 point

Problem 1

Book Value

$500

$500

$1,000

Cement

Steel

Total

a,

Market value of equity =

Market value of debt =

Debt/equity ratio =

Unlevered beta for firm =

Levered beta for firm =

Cost of equity =

After-tax cost of debt =

Debt Ratio =

Cost of capital =

b

Cement

Steel

$900

0.90

$600

1.20

$1,500

$1,000

! Used book value weights for unlevered beta: -0.5 point

$500

! Debt to equity ratio set to zero or ignored: -1 point

50.00%

! Did not use after-tax cost of debt: -0.5 point

! Math errors: -0.5 point

1.02

1.33 Computational notes

10.63%

The unlevered betas should always be weighted based upon the market value

3.60%

Since balance sheets have to balance, the market value of assets (businesses

33.33%

Thus even though the debt is not given, it can be backed out of the market va

8.29%

Book value

$75

$500

25

$500

ROC

15.00%

5.00%

1.17

9.8500%

1.56

11.8000%

Problem 2

Life Products

Pfizer

debt

cost of debt

Cost of equity Cost of capital

8.00%

4.80%

14.00%

12.50%

5.00%

3.00%

9.00%

7.50%

Initial investment =

$750.00

After-tax Operating inc

+ Depreciation =

Cash flow to firm=

90.00

$50.00

$140.00

Discount rate =

PV of cash flows =

NPV =

$928.61

$178.61

! Used wrong discount rate: -1 point

! Forgot to subtract out initial ivnestment: -1 point

b. PV of licensing fees has to be greater than the NPV of investing and ! Used wrong discount rate: -1 point

PV of cash flows =

$178.61

! PV formula not set up: -1 pont

Annual after-tax cash flow

$17.21

! Use pre-tax cost of debt fo (I gave full credit for both 15-year annuity and pe

Annual licensing fee =

$28.68

! Tax rate implicit in pre-tax and after-tax cost of debt. No points off for not do

Problem 3

10.00%

Current cost of equity =

3.60%

Current after-tax cost of

$2,000.00

Current firm value =

25.00%

Debt Ratio =

8.40%

Current cost of capital =

8.00%

New cost of capital=

0.40%

Savings in cost of capital

$100.00

PV of savings =

Part a: Buy back stock at $10.25

48.78

# of shares bought back

Compuatational notes

The key part of this problem is recognizing that when investors

and those who do not will be a function of the buyback price. W

a buyback price is provides is an indication that they are not. A

Thus, you need to go through the following steps:

1. Estimate the change in firm value from the change in the co

2. Estimate how many shares you will buy back at the buyback

3. Estimate how much buyback stockholders get of the value c

4. Estimate how much remaining value change there is for thos

5. Divide by the remaining shares outstanding to get the value

Premium paid =

Value paid to buyback sh

Remaining value increas

Remaining shares =

increase in value for rem

Value per share =

$0.25

$12.20

$87.80

101.22

$0.87

$10.87

! Firm value change computed incorrectly: -1 point

! Did not allocate a portion of firm value change to buyback shares: -1 point

Let the price paid back be X

500/X

! Kept number of shares bought back fixed: 1.5 points

Number of shares bought

X-10

! Equation set up incorrectly for soluation: -1 point

Premium paid =

Value paid to buyback sh(500/X) (X-10)

For the value per share on remaining shares to be unchanged

Value paid to buyback sh $100.00

(500/X) (X-10) = 100

$12.50

X=

Problem 4

Revenues

Net Income

Depreciation

Non-cash Working capital

-3

$1,000

$100

$25

$100

Net Income

+ Depreciation

- Change in non-cash WC

FCFE (without cap ex

Dividends paid

-2

$1,200

$120

$40

$90

Last year

$1,500

$150

$50

$75

$120

$40

-$10

$170

$150

$50

-$15

$215

$48.0

$60.0

! Working capital change not dalt

1 Forgot dividends: -1 point

! Did not deal with change in cash

(120-100) = FCFE - 108 -0

FCFE = 128

FCFE without cap ex =

FCFE with cap ex =

Cap ex over two years =

$385

128

$257.00

Next year

Revenues

$1,725.0

Net Income

$172.5

Cap Ex

$86.25

Depreciation

$57.5

Chg Non cash Working Capit

11.25

New Debt issued

10.00

FCFE

$142.50

Dividends

$69.0

!

!

!

!

Change in working capital incorrect or ignored: -0.5 to -1 poin

Forgot to net out dividends: -0.5 to -1 point

Math errors: -0.5 point

(100-120) = 142.5 - 69 -X

Stock Buybacks =

$93.50

Problem 5

Loans

Current

$5,000.00

1

$5,500.00

2

$6,050.00

3

$6,655.00

4

$7,320.50

Capital Ratio

Capital invested

$400.00

8.00%

$451.00

8.20%

$51.00

$508.20

8.40%

$57.20

$572.33

8.60%

$64.13

$644.20

8.80%

$71.87

Net income

- Capital invested

FCFE

$100.00

$110.00

$51.00

$59.00

$121.00

$57.20

$63.80

$133.10

$64.13

$68.97

$146.41

$71.87

$74.54

b. Stable growth

ROE =

Expected growth rate =

Equity Reinvestment Rate

Net income in year 6 =

FCFE in year 6=

Cost og equity ;in year 6 =

Terminal value of equity in

c. Value today

Year

FCFE

Terminal value of equity

PV

Value of Equity

/ number of shares

Value per share

12.00%

4.00%

33.33%

! Used wrong discount rate: -0.5 point

! Used wrong growth rate: -0.5 point

$167.49 ! 161.05*1.04

$111.66

10.00%

$1,861.03

1

$59.00

2

$63.80

3

$68.97

4

$74.54

$52.68

$1,301.69

50

$26.03

$50.86

$49.09

$47.37

5

$80.53

$1,861.03

$1,101.69

ted based upon the market values of the businesses, not book values

arket value of assets (businesses) = market value of equity + debt

n be backed out of the market value of the assets

Cost of capitalEVA

7.77%

9.07%

! Did not compute costs of capital for businesses (used company cost of cap

! Multiplied return spread by market value: -0.5 point

$36.17

-$20.33

Computational notes

The key aspect of the licensing fee is that it is a fixed amount

and that the only risk you face is the default risk in Pfizer. Since it is a fixed amount (anld

not a function of operating income or risk), the discount rate is the pre-tax cost of debt

for Pfizer. It is not the cost of capital.

If the licensing fee had been a percentage of operating income on the product, it would have

been appropriate to use Pfizer's cost of capital to discount the cash flows.

Com

set up: -1 pont

t for both 15-year annuity and perpetuity answers)

t of debt. No points off for not doing this.

recognizing that when investors are not rational, the value allocation between those who sell back shares

function of the buyback price. While the problem does not specify that investors are not rational, the very fact that

an indication that they are not. After all, when investors are rational, the buyback price = price for the remainign shares.

the following steps:

value from the change in the cost of capital (as you always do)

you will buy back at the buyback price (Dollar debt taken/ Buyback price)

k stockholders get of the value change (Buyback price - Original price) (No of shares bought back)

ng value change there is for those who do not sell back their shares

res outstanding to get the value change for remaining stockholders

Working capital change not dalt with correctluy: - 0.5 point

Forgot dividends: -1 point

Did not deal with change in cash correctly: -1 point

correct or ignored: -0.5 to -1 point

0.5 to -1 point

5

$8,052.55

Compuational notes

For a bank, investment in regulatory capital becomes the equivalent of net cap ex and wor

$724.73

9.00%

$80.53

capital change. Thus, the amount you have to invest in regulatory capital has to be taken o

of net income each year to get to FCFE. I gave full credit, if you estimated the investment i

regulatory capital to be an absolute number ($64.95 million a year)

$161.05

$80.53

$80.53

! Did not treat it as reinvestment for FCFE: -1 point

! Subtracted out other items (like loans) to get to FCFE: -1 point

r 6 correctly: -1 point

! Forgot to PV terminal value: -0.5 point

! Subtracted out debt from PV: 0.5 point

alue: -1 point

sses (used company cost of capital): -2 points

e remainign shares.

you estimated the investment in

Problem 1

Levered Beta

Tax rate

Market value of equity

Book value of equity

Market & Book value of debt

a. Unlevered beta

Value of the firm =

Weights of the firms =

Unlevered beta for the firm =

b.

Levered beta after transaction =

To compute D/E ratio

1.05 ( 1+ (1-.4)* D/E) = 1.35

Solving for the D/E ratio

Debt to equity =

Value of combined firm =

Debt in combined firm =

Debt in existing firms =

New debt for deal =

c.

Cost of equity =

Cost of debt =

Debt ratio =

Cost of capital =

Trident (acquirer)

1.2

40%

12000

8000

3000

Achilles

(Target)

1.5

40%

6000

8000

4000

1.043478261 1.071428571

15000

10000

60.00%

40.00%

1.05

1.35

46.67%

$25,000.00

$7,955.23

$3,000.00

$4,955.23

Instead, you have to estimate th value of the com

and take the proportion that is debt.

12.100%

3.300%

31.821%

9.30%

Problem 2

a. Correct discount rate is cost of capital (since operating cashflows are being discounted)

Cost of capital =

8.80%

b. Computed NPV =

Discount rate used =

Initail investment =

PV of 10 years of earnings =

Annual after-tax OI =

c.

Assets

Non-cash WC

20

12%

600

620

$109.73 ! Annuity given r=12% and 10 years

Initail investm Salvage

600

50

0

50

EBIT (1-t)

+ Depreciation

- Change in WC

FCFF

$109.73

60

0

$169.73

NPV =

PV of tax benefits from 10-yr depr

Change in NPV from shift

New NPV =

$155.39 ! Deprecn=60; Tax savings=24; n=10

$32.29

$502.72

Problem 3

a. Current debt ratio =

Cost of equity =

Cost of capital =

b. Implied growth rate

Current value of firm =

Expected cash flow next year=

Value of firm = 1500 = 80/ (Cost of capital -g)

Solve for g,

Implied growth rate =

c. New cost of capital =

Annual savings =

PV of savings with implied growth =

Debt at the optimal debt ratio

Existing debt =

New Debt issued =

# Shares bought back =

Preimium to shares bought back =

Remaining premijm =

Remaining number of shares =

Increase in value per share =

0.2

0.094

8.24%

1500

80

2.91%

8.00%

3.6

$70.68

$600.00 ! 40% of firm value

$300.00

$300.00

29.27

$7.32

$63.36

90.73

$0.70

d. Only if new investments earn more than the new cost of capital. After you borrow the money,

the new cost of capital is the only one you care about.

Problem 4

Revenues =

Net Income =

Depreciation =

Cap Ex =

Non-cash Working capital =

Expected growth rate =

Debt ratio for funding new investments

Year

Revenues

Non-cash Working capital

Net Income

+ Depreciation

- Cap ex

- Change in WC

+ New debt issued

FCFE

Total FCFE =

Dividends to be paid =

Total Net income =

Payout ratio -=

100

25

10

15

12

20%

25%

1

120

14.4

30

12

18

2.4

2.1

23.7

86.268

76.268

109.2

69.84%

Net Income

30

+ Depreciation

12

- Cap ex

18

- Change in WC

2.4

- Debt repaid

10

FCFE

11.6

Total FCFE=

48.624

2

144

17.28

36

14.4

21.6

2.88

2.52

28.44

3

172.8

20.736

43.2

17.28

25.92

3.456

3.024

34.128

36

14.4

21.6

2.88

10

15.92

43.2

17.28

25.92

3.456

10

21.104

Dividends paid

Payout ratio

0

48.624

44.53%

c. Firms are less certain about future earnings (buybacks are flexible)

The other answers either do not make sense (more certain about earnings would increase dividends

or would have applied even more strongly prior to the last decade (dividends taxed at a higher rate

(I know we talked about mgmt compensation containing options, but more as a contributing factor

than the main factor. If you did circle other, and mentioned this, you did get 0.5 point)

Problem 5

EBIT (1-t)

- Net Cap Ex

- Chg in non-cash WC

FCFF

Book Capital invested =

Reinvestment rate =

Return on capital =

Expected growth rate =

a. FCFF for next 3 years

Year

EBIT (1-t)

- Net Cap Ex

- Chg in WC

FCFF

PV (at 12%)

b. Terminal value

Growth rate =

Return on capital =

Reinvestment rate =

EBIT (1-t) in year 4 =

- Reinvestment in year 4 =

FCFF in year 4

Terminal value =

4000

1000

200

2800

12000

30.00%

33.33%

10.00%

3%

33.33%

9.00%

$5,483.72

$493.53

$4,990.19

$71,288.36 ! Use stable period cost of capital

PV of FCFF for next 3 years =

PV of terminal value =

Value of operating assets =

- Debt

Value of equity

Per share value =

$8,103.56

$50,741.65 ! Discount at 12% for 3 years

$58,845.20

$4,000.00

$54,845.20

$10.97

1

$4,400.00

$1,100.00

$220.00

$3,080.00

$2,750.00

2

$4,840.00

$1,210.00

$242.00

$3,388.00

$2,700.89

3

$5,324.00

$1,331.00

$266.20

$3,726.80

$2,652.66

Wrong weights on companies: -1 point

Math errors: -0.5 point

Math errors: -0.5 point each

ve to estimate th value of the combined firm

portion that is debt.

! Used 8.8% rate: -1 point

! I gave full credit, if you misread the problem and subtracted

depreciation from this number

! Forgot salvage value: -0.5 point

Did not add back depreciation: -1 point

Math errors: -0.5 point

8.8%,10) + 50/1.088^10

! Forgot the tax effect: -0.5

! Multipled by (1-t) instead of t: -0.5 point

Did not set up equation: -2 points

Used wrrong WACC in discounting: -0.5 point

! Did not estimate surplus paid to buyback shares: -0.5 point

Did not adjust number of shares for biuyback:-0.5 point

!

!

!

!

Did not adjust for debt : -0.5 point

No changei n non-cash WC: -0.5 point

Computed payout ratio incorrectly: -0.5 point

! When you are replaying debt, you cannot also multiply

your reinvestment by (1-Debt ratioj since that works only

if the debt raito is constant.

Consequently, you have to subtract out the debt repayment

to get to FCFE

! Counted the debt ratio adjustment: -1 point

Problem 1

a. Unlevered Beta =

b. Debt =

Equitty =

D/ E Ratio =

Levered Beta =

c. New unlevered beta =

New Debt =

New Equity =

D/E Ratio =

New levered beta =

Grading Guidelines

1.04

500

2000 ! Value of the firm - Debt

0.25

1.196

1

1500

1500

1

1.6

1.

1.

2.

3.

Used book value of equity: -1

Used effective tax rate: -.5

Math error: -0.5

2. Error on new business weights: -0

3. Error on new debt to equity ratio

4. Used book equity in D/E ratio: -1

twice but there were clues in the se

Problem 2

Investment in upgrade =

- Salvage of old plant

Initial investment

10

1. Computed PV of future cash flow

2.5 ! Depreciation of $500,000 for next 5 years2. I have no clue what you were doi

7.5

Existing

Upgraded

Incremental

EBIT

1

2.5

1.5

EBIT (1-t)

0.6

1.5

0.9

+ Depreciation

0.5

1

0.5

After-tax Cashflow

1.1

2.5

1.4

In yrs 6-10, the entire upgrade cash flow of $2.5 million is incremental

c. NPV =

2. Used total depreciatioin instead o

3. Other errors: -0.5 point to -1 poin

(I gave full credit if you treated EBIT

in incremental cash flows from year

+PV of 2.5 million from yrs 6-10

2. Ignored years 6-10 completely: -1

3. Ignored initial investment: -1 poi

Problem 3

a. Cost of equity today =

9.400%

Cost of debt today =

3.00%

Debt Ratio =

0.2

Cost of capital today -=

8.12%

b. Unlevered beta =

1.043478261

New levered beta =

1.460869565

New cost of equity =

10.57%

New cost of debt =

0.036

New debt ratio =

0.4

Cost of capital =

7.78%

c. Annual savings =

3.356521739 ! (.0812-.0778) (1000)

PV of savings =

88.69485294 ! 3.36/(.0778-.04)

Increase in value/share 1.108685662 ! Divide by 80 million

New share price =

11.10868566

Amount of buyback =

200

# of shares bought back 18.00393009

2. Wrong cost of equity: -0.5 point

3. Forgot after-tax cost of debt: -0.5

2. Errors on weights: -0.5 to -1 poin

3. Forgot to after-tax cost of debt: -

1.

2.

3.

4.

Did not compute PV of savings w

Did not divide by the total numbe

Other math errors: -0.5 point

Problem 4

Year

Revenues

Net Income

Deprecistion

Dividends paid

Decrease in cash balance

FCFE over 3-year period =

Net Reinvestment

Gross Reinvestiment

-3

1000

100

50

40

-2

1200

120

60

48

-1 Total

1500

150

75

60

3700

370

185

148

40

108

262 ! Net Income - Dividends + Chg in Cash

447 ! Add depreciation

1. Forgot cash balance change: -1 p

2. Subtracted change in cash baqla

Any mistake in this problem cost yo

simply because tracing out math er

Revenues

Net Income

Depreciation

Capital Expenditures

Change in working capital

Dvidends

Total dividends =

Increase in cash balance

Required FCFE =

Net Reinvestment

Total Reinvestment

Debt used =

As % of Reinvestment =

1

1650

165

82.5

165

37.5

66

2 Total

1815

3465

181.5

346.5

90.75

173.25

181.5

346.5

41.25

78.75

72.6

138.6

2. Error on FCFE computation: -1 po

3. Misplayed the change in cash ba

4. Other errors: -0.5 point each

138.6

40

178.6

167.9

252

84.1

33.37%

full credit even if your ratio did not

Problem 5

Year

EBIT(1-t)

FCFF

Reinvestment Rate =

Expected growth rate=

Return on capittal =

Current

$80.00

$20.00

75.00%

15.00%

20.0%

4%

Stable reinvestment rate= 0.333333333

EBIT (1-t) in year 4

$126.54

FCFF in year 4 =

84.35786667

Termnal value =

1405.964444

1

FCFF

$23.00

Terminal Value

PV @ 12%

$20.54

Value of operating assets

$1,064.01

+ Cash

50

- Debt

250

Value of equity

$864.01

/ Number of shares

100

Value of equity per share

$8.64

1

$92.00

$23.00

2

$105.80

$26.45

3

$121.67

$30.42

2. Did not compute growth rate righ

3. Error on ROC formula = -0.5 to -1

2. Used wrong cost of capital (12%

3. Grew operating income twice: -0

2

$26.45

3

$30.42

1405.964444

$21.09

$1,022.39

1.

2.

3.

4.

5.

Forgot to discount terminal value

Used wrong discount rate (10% i

Subtracted cash instead of addin

Added debt instead of subtractin

rading Guidelines

Error on weighting or used levered betas: -0.5 each

Used book value of equity: -1

Used effective tax rate: -.5

Math error: -0.5

Error on new business weights: -0.5 to -1 point

Error on new debt to equity ratio: -0.5 point

Used book equity in D/E ratio: -1 poiint (Feels like you are being punished

wice but there were clues in the second part that should have led to fixing the error)

I have no clue what you were doing: -0.5 point to -1 point

Used total depreciatioin instead of incremental: -1 point

Other errors: -0.5 point to -1 point

gave full credit if you treated EBIT as EBITF+DA. That would have given you $1.1 million

incremental cash flows from years 1-5 and $1.9 million from years 6-10.

Did not estimate higher cashflows from years 6-10: -1 to 1.5 points

Ignored years 6-10 completely: -1.5 point

Ignored initial investment: -1 point

Weights on debt and equity wrong: -0.5 point

Wrong cost of equity: -0.5 point

Forgot after-tax cost of debt: -0.5 point

Did not recompute beta: -1 point

Errors on weights: -0.5 to -1 point

Forgot to after-tax cost of debt: -0.5 point

Did not compute PV of savings with growth: -1 point

Did not divide by the total number of shares: -0.5 point

Other math errors: -0.5 point

1

gave full credit for both net and gross reinvestment

Forgot cash balance change: -1 point

Subtracted change in cash baqlance: -1 point

ny mistake in this problem cost you a point, even if it were a math error

mply because tracing out math errors was very messy.

Error on FCFE computation: -1 point

Misplayed the change in cash balance: -1 point

Other errors: -0.5 point each

you got the dollar debt used (84.1) correct, you got

ll credit even if your ratio did not match up.

Did not compute growth rate right: -1 point

Error on ROC formula = -0.5 to -1 point

Used wrong cost of capital (12% instead of 10%) -0.5 point

Grew operating income twice: -0.5 point

Forgot to discount terminal value: -0.5 point

Used wrong discount rate (10% instead of 12%) -0.5 point

Subtracted cash instead of adding: -0.5 point

Added debt instead of subtracting: -0.5 point

Problem 1

a. Market value of equity =

Debt value =

Debt to equity ratio =

200

50

0.25

Firm value =

Cash =

Operating ass

250

25

225

1.2

Levered beta for Vaudeville =

1.242 ! 1.08(1+(1-.4)(.25))

b. New debt =

Equity =

New Debt/Equity ratio =

200 ! Stays unchanged

0.75

Firm value =

1.486

Movie =

2.154

Software =

New levered beta =

350

225

125

Problem 2

a. NPV of project =

PV of cashflows over next 5 years =

Annual after-tax cashflow =

Annual after-tax operating income =

-1.2

8.8 ! Initial investment + NPV

$2.32 ! Five year annuity with r=10%

$0.32 ! Subtract out depreciation of $ 2 million

b. PV of tax benefits

From straight line depreciation =

From accelerated depreciation =

Year

1

2

3

4

5

c. After tax return on capital =

Cost of capital =

Economic Value Added=

Tax benefit

PV

$1.60

$1.20

$0.60

$0.40

$0.20

$1.45

$0.99

$0.45

$0.27

$0.12

$3.29

$0.26 ! Difference in present values

6.00% ! After-tax operating income/ BV of capital

10.00%

-16

Problem 3

a. Current cost of equity =

Cost of capital =

b. New Debt to Equity =

New beta =

New cost of equity =

New cost of capital =

Change in firm value =

Change in value per share =

c.

Debt to Equity =

New beta =

New cost of equity =

New cost of capital =

Change in firm value =

NPV from project =

Total increase in firm value =

Increase in value per share =

9.80%

9.80%

33.33%

1.44

10.76%

9.12%

$11.11

$2.78

0.25

1.38

10.52000%

9.26%

8.695652174

$5.00

$13.70

$3.42

! Unlevered beta (1+(1-t)(D/E))

! Cost of debt =7% (1-.4)

! (Change in cost of capital * 100)/(.0912-.03)

(This is an approximation. The NPV will add to equity valu

making the debt ratio even lower)

! Uses new weights for debt and equity

! (Change in cost of capital * 100)/(.0926-.03); note that even thou

Problem 4

Year

NetIncome

NetCapex

ChangeinnoncashWC

+Changeindebt

FCFE

Change in cash balance over 3

years=

TotalFCFEover3years=

$100.00

$120.00

$150.00

$180.00

$30.00

$50.00

$55.00

$66.00

$10.00

$20.00

$10.00

$4.00

$0.00

$40.00

$10.00

$0.00

$80.00

$90.00

$75.00

$110.00

30

$245.00

Totaldividendspaidover3years=

Dividendpayoutratio=

b.ExpectedFCFEnextyear

$110.00

Cashavailableforstockholders=

$110.00

58.11%

Problem5

EBIT (1-t)

- Net Cap Ex

- Change in non-cash WC

FCFF

PV (at current cost of capital of 12%)

Current

$20.00

$10.00

$5.00

$5.00

1

$23.00

$11.50

$5.75

$5.75

$5.13

2

$26.45

$13.23

$6.61

$6.61

$5.27

3

$30.42

$15.21

$7.60

$7.60

$5.41

Growth rate during firt 3 years =

Return on capital first 3 years =

Growth rate after year 3 =

Reinvestment rate =

EBIT (1-t) in year 4 =

FCFF in year 4 =

Terminal value of firm =

75%

15%

20.0%

0.04

0.2

$31.63

$25.31

$421.79

+ Cash

- Debt

Value of equity today =

Value per share today =

$25.00 (Terminal value gets discounted back at today's cost of ca

$80.00

$261.04

$26.10

!

!

!

!

EBIT (1-t) in year 3 (1.04)

Net of reinvestment

FCFF in year 4 / (New cost of capital -g)

n; Equity decreases

b. Did not consider cash: -1 point

c. Debt to Equity ratio wrong; -0.5 point

b. Wrong debt to equity ratio: -0.5 point

b. Did not consider depreciation: -1 point

c. Added back depreciation: -0.5 point

(Very difficult to do. You have to subtract out old depreciation_

b. Computed tax benefit incorrectly: -0.5 point

c. Other errors: -0.5 point each

b. Used market value instead of book value: -1 point

b. New cost of capital incorrect: -0.5 point

c. Adjusted number of shares for buyback: -1 point

(If investors are rational, this is not necessary)

00)/(.0912-.03)

n; Equity does not change a. Did not compute new debt ratio and cost of capital: -1 point

NPV will add to equity valub. Did not add back NPV of new invstment: -1 point

00)/(.0926-.03); note that even though firm value increases to 125, you save only on the old firm value which was invested at the old

b. Dividends computed incorrectly: -1 point

c. Mechanical errors: -0.5 point each

! The non-cash WC =30

Increase of 20% =6

a. Reduced FCFE by cash balance (this will double the cash balance): -0.5 to 1 point

b. change in WC incorrect: -1 point

c. Other error: -0.5 to -1 point

b. Mechanical errors; -0.5 point each

rs + Terminal value/1.12^3

d back at today's cost of cab. Did not subtract debt and add back cash: -0.5 each

Problem 1

Part a

Market value of equity =

Market value of debt =

Unlevered beta =

Levered beta =

Cost of equity =

Cost of capital =

700

300

0.96

1.206857143

0.093274286

7.43%

Part b

New business mix after acquisition

Hotels

Transportation

New value for Equity =

New value for debt =

Unlevered beta=

New debt to equity ratio =

Levered beta =

New cost of equity =

Cost of capital =

1000

400

800

600

0.914285714

0.75

1.325714286

0.098028571

7.02%

Problem 2

Iniital investment =

Reduction in Inventory =

Savings from storage facility

Net Initial Investment =

Annual Cash flow

Increased Revenue

Increase in EBIT

- Depreciation

Increase in EBIT

Increase in EBIT (1-t)

+ Depreciation

- Change in WC

Annual Incr CF

NPV =

-15

4

4 ! Investment in new facility - Capital Gains tax - Investment in old facilit

-7

Yr 1

yrs 2-10

15

1.8

1.5

0.3

0.18

1.5

1.2

0.48

15

1.8

1.5 ( No incremental depreciation from storage facility, since

0.3 the old and the new system have same book value)

0.18

1.5

1.68

$2.23

Problem 3

Cost of equity Cost of debt (after-tax)

Market value of equity =

Market value of debt

Cost of capital =

0.1074

0.03

150

46.13913254 ! You have to compute market value based upon interest expenses and

8.92%

Part b

Unlevered beta =

New market value of equity =

New market value of debt =

New levered beta =

New cost of equity =

New cost of debt =

Cost of capital =

1.316948546

100

96.13913254 ! I did give full credit if you assumed that refinancing would alter market

2.076610291

0.128064412

0.042

8.59%

Shares bought back =

Share of those sold back =

Remaining firm value =

Remaining shares =

Increase in value/share

Value per share =

$11.63

$4.65

$3.49 ! Don't forget to net out the share of the surplus given to those who sel

$8.14

$10.35

$0.79

$10.79

Problem 4

Year

Revenues

Non-cash WC

Net Income

+ Depreciation

- Cap ex

- Change in non-cash WC

FCFE

Dividends paid

Cash balance

$50.00

$10.00

$15.00

$10.00

$16.00

$15.00

1

$55.00

$11.00

2

$60.50

$12.10

3

$66.55

$13.31

4

$73.21

$14.64

$16.80

$11.00

$17.60

$1.00

$9.20

$8.40

$15.80

$18.82

$12.10

$19.36

$1.10

$10.46

$9.41

$16.85

$21.07

$13.31

$21.30

$1.21

$11.88

$10.54

$18.19

$23.60

$14.64

$23.43

$1.33

$13.49

$11.80

$19.87

b. To maintain its cash balance at $ 15 million, the firm can afford to pay out $ 4.87 million more in dividends over the e

Total dividends paid =

$45.02

! No need for elaborate mathematical equaltions. Just c

Total net income =

$80.29

! I did give full credit to those who used only year 4 numb

Payout Ratio =

56.07%

c. To get to a cash balance of $ 30 million, you would have to issue $ 10.13 million in debt

Total reinvestment

Debt Ratio =

1

$7.60

2

8.36

3

9.196

4

10.1156

28.72%

Problem 5

Expected dividends next year =

Cost of equity =

Growth rate =

Value of Equity =

b. Growth Rate =

Retention Ratio =

Return on equity =

60

8%

4%

1500

who did use it..

4%

40%

10.0%

New retention ratio =

Value of equity = 1500 = 100 (1-.3333)/(r - .04)

Solve for r

Cost of equity =

8.44%

12%

33.333%

d. When the return on equity is less than the cost of equity. As the payout ratio is increased, the expected growth rate (

! I did give you full credit if you showed the inventory reduction in year 1.

ave same book value)

! Depreciation on storage facility is not incremental since it is the same for

both old and new facility

! I was very, very generous on this problem. I did take off 1 point for using non-incremental revenue (operating income)

and 0.5 points for using non-incremental depreciation.

matical equaltions. Just compute the total FCFE/Total net income

who used only year 4 numbers..

Total

! Divide additional debt by total reinvestment

$35.27

given next year's income, you don't need (1+g), though I did not take off credit for those

recompute the new payout ratio (you cannot keep dividends fixed while raising ROE and holding g constant)

the expected growth rate (which is = (1- payout ratio) ROE) will decrease. If the ROE < COE, the second effect will dominate.

tion in year 1.

Problem 1

a. Unlevered beta prior to restructuring

Levered beta from regression =

Average debt to equity ratio =

Tax rate =

Unlevered beta from regression=

1.2

25%

40%

1.0435

b.

.30 (.80) + .70 (X) = 1.0435

Solving for X,

Unlevered beta of remaining business =

1.147826087

Cash of 30% of firm value is used to retire debt (10%) and buy back stock (20%)

Debt to Equity after =

0.166666667 ! The easiest way to do this is to set up a balance sheet.

D =20 and E =80 before the restructuring; D=10 and E = 60 after

Levered beta after =

1.262608696

Problem 2

As set up by the analyst,

NPV = 1.5 = -10 + Annual Cashflow (PV of annuity, 10 years, 12%)

Solving for the annual cashflow

Annual Cashflow estimated by analys

$2.04

b. Corrections for errors

The cashflows are pre-debt cashflows. The analyst should have used the cost of capital

Cost of capital =`

0.096

Depreciation correction

Depreciation used =

Correct depreciation =

Reduciton in depreciation =

Reduction in tax savings (CF) -

1

0.8

0.2

0.08

Salvage value =

Working capital salvage =

Correct Cashflows

Cashflow to firNet present value =

1.5 ! Salvage value in year 10

Year 0

-11.5

Years 1-10

Year 10

$1.96

3.5

$2.12

b. The other and more complicated solution is to estimate cashflows to equity and discount at the cost

of equity

Investment

Salvage

Debt

After-tax interest expenses

Cashflow to Equity

Net present value at 12% =

0 1-9

-$11.50

$3.45

-$8.05

$2.23

Problem 3

a.

Market value of debt =

10

$471.27

$0.14

$1.82

3.5

-$3.45 (Debt creates cash inflow

when borrowed, and has

to be repaid at end)

$0.05

Debt to capital ratio =

Cost of equity =

Cost of debt =

Cost of capital =

$300.00

61.10%

14.84500%

4.80%

8.71%

b.

If the value of the firm does not change, the cost of capital after the change should be the same as before.

Cost of capital after =

8.71%

Unlevered Beta =

1.158281117

New Debt ot capital ratio =

0.305514773

New levered beta =

1.464008563

New cost of equity=

11.06%

After-tax Cost of debt after =

3.37%

Pre-tax Cost of debt =

5.61%

Problem 4

NetIncome

CapitalExpenditures

Depreciation

IncreaseinNoncashWorking

DebttoCapitalRatio

Dividends

FCFE

a.

Cashbalanceatbeginning

+ FCFE

Dividends

EndingCashBalance

b.

NetIncome

(CapExDepreciation)(1

ChginWC(1DR)

FCFE

Dividendsthatcouldhavebe

c.Expectednetincomenext

(CapExDeprecn)*(1DR

ChginWC(1DR)

FCFE

Increaseincashbalance=

Amountavailablefordividen

Increaseovercurrentyear

Problem5

a.NetCapEx=

Halifax

$100

$150

$60

$10

0%

$0

$0

$10.00

$0

Donnell

$80

$60

$30

$10

20%

$40

$48

$10.00

$48

Rutland

$50

$30

$15

$5

20%

$30

$34

$10.00

$34

$0

$40

$30

$10

$18

$14

$100

72

8

$20

$20

$100

18

12

$70

20

$50

$20

50

ChangeinWorkingcapital=

TotalReinvestment=

ReinvestmentRate=

Retunoncapital=

Expectedgrowthrate=

10

60

60.00%

10.00%

6.00%

current

EBIT(1t)

Reinvestment

FCFF

$100.00

106

112.36

119.1016

60.00

63.6

67.416

71.46096

$40.00

42.4

44.944

47.64064

$42.40

$44.94

$47.64

b.Retunoncapitalinperpetui

9%

Expectedgrowthinperpetuit

3%

Reinvestmentrateinperpetuit

33.33%

FCFFinyear4=

81.78309867

Terminalvalueatendofyear 1635.661973

c.

Valueofthefirmtoday

FCFF

TerminalValue

PresentValue

Valueofthefirmtoday=

ValueofDebt=

ValueofEquity

Valuepershare

$1,635.66

$38.55

$1,340.38

$400.00

$940.38

$9.40

$37.14

$1,264.69

structuring; D=10 and E = 60 after)

hen borrowed, and has

be repaid at end)

Problem 1

a.

Business

Unlevered beta Sales

Value/Sales Estimated Value of Business

House Furnishings

1.3

400

1.6

640

Construction Services

0.9

600

0.6

360

Unlevered beta = 1.3(640/1000) + 0.9 (360/1000) =

1.156

Debt/ Equity ratio =

0.666666667

Levered Beta =

1.6184

b.

Cost of equity =

11.473600%

Cost of capital = 11.4736 (.6) + 6.8 (1-.4) (.4) =

c. After expansion plan

New value of construction business =

Value of house furnishings =

Unlevered beta =

Debt to Equity ratio =

New levered beta =

8.52%

560

640

1.11333333

1

1.7813

Problem 2

Revenues

- Printing & production

- Payroll costs

- Depreciation

EBIT

- Taxes

EBIT (1-t)

+ Depreciation

CF to firm

Yrs 1-10

$8,400,000

$2,400,000

$2,000,000

$1,500,000

$2,500,000

$1,000,000

$1,500,000

$1,500,000

$3,000,000

Check

7903703.15

2258200.9

2000000

1500000

2145502.25

858200.899

1287301.35

1500000

2787301.35

NPV = -20,000,000+ 3,000,000 (Pv of annuity for 10 years at 9%) + PV of 5,000,000 at end fo year 10 =

$1,365,027.14

! Forget salvage value: To get a NPV of zero,

Annual cash flow has to be =

Difference in after-tax cash flow =

Difference in pre-tax cashflow =

Difference in number of papers/year =

Difference in number of papers/month =

Breakeven number of papers =

$212,699

$354,498

$141,799 ! Divide by $ 2.50 (difference betwee

$11,817

188183.41

Problem 3

Market value of debt =

PV of Operating leases =

Total Debt=

$22.30

$19.45

$41.75

Cost of equity =

Cost of capital =

$20.00

0.162

8.90%

! Other math errors: -0

Cost of equity at optimal debt ratio

Debt/Equity Ratio =

1

Unlevered beta =

1.243111822

New levered beta =

1.988978915

Cost of equity =

12.96%

Cost of capital = 8.25% = 12.96% (.5) + Pre-tax cost of debt (1-.4) (.5)

Pre-tax cost of debt =

5.91%

Problem 4

Year

Revenues

EBIT

- Interest expenses

Taxable income

- Taxes

Net Income

+ Depreciation

- Cap Ex

- Chg in WC

- Debt repayment

- Acquisition

FCFE

Base

500

150

10

140

42

98

40

50

1

550

165

10

155

62

93

44

50

10

50

27

Cash Balance

80

107

Target cash balance

Cash that can be paid out over next 3 years =

Total net income over next 3 years =

Maximum dividend payout ratio over next 3 years=

Problem 5

Return on capital for the firm =

Reinvestment rate for first 3 years =

1

EBIT (1-t)

$66.00

- Reinvestment

$44.00

FCFF

$22.00

Terminal value

PV of cashflows

$19.64

Reinvestment rate in stable growth =

Terminal value =

Value of firm today =

+ Cash

- Debt

Value of Equity =

Value per share =

2

$72.60

$48.40

$24.20

$19.29

2

605

181.5

10

171.5

68.6

102.9

48.4

50

11

100

-9.7

97.3

3

665.5

199.65

0 ! Did you

199.65

79.86 ! Did you

119.79

53.24

50

12.1 ! Did you

! Did you

remember to t

switch to a 40

compute the c

show repayme

110.93

208.23

50

158.23 ! Did you consider the st

315.69

50.12% ! I did give you full cred

0.66666667

3

$79.86

$53.24

! Forget reinvestment ($26.62

$940.07

! 79.86 (1.03) ( 1 - 0.2

$688.07

0.2

$940.07

$727.00

100

150

$677.00

$67.70

! You have to add back c

ue of Business

If you use revenue weights: -1

00 at end fo year 10 =

Forget salvage value: -1

,000/1.09^10 + X(PVA,

Other math errors: -0.

Did you show repayment

79.86 (1.03) ( 1 - 0.20

You have to add back ca

688.068204

Problem 1

a. Unlevered beta for the firm =0.9 (.6) + 1.4 (.4) =

Debt to equity ratio =

Levered beta = 1.1 (1 + (1-0) (9)) =

1.1

900.00%

11

Cost of capital = 49% (.1) + .17 (1-0) (.9) =

c. If 1/2 of the internet business is divested,

Unlevered beta = 0.9 *.75 + 1.4 *.25 =

New Debt to equity ratio =

New levered beta =

49.00%

20.20%

1.025

7

8.2

a levered beta and a cost of capit

would be determined by the marg

the problem asked for next year's

debt. Thus, harsh though it might

If you did not recompute the unle

Problem 2

The maximum amount of initial investment will be the amount that makes the net present value zero.

First compute the PV of the cashflows ignoring depreciation

EBIT on Dried Flowers =

$2.00

EBIT on Traditional offerings =

$1.80

! I was gentle here and allowed for multipl

- Over time Salary

$1.00

in overtime is already considered in the op

EBIT w/o depreciation

$2.80

still got full credit.

Taxes

$1.12

$1.68

Incremental EBIT =

$10.32 ! If there was no depreciation, this would be your breakeven in

PV of EBIT for 10 years =

A second best solution for those who abhor algebra

Assume you invest $10.32 million and compute depreciation on that basis

Depreciation tax benefit each year =

PV of depreciation tax benefits for 10 year

Initial investment with depreciation tax ben

$2.54

0

$12.86 ! I have added the depreciation tax benefit to the PV of EBIT. I

will now change to 1.286 million and you will be in iterating fo

If your initial investment is $1, your depreciation each year would be $.10 and the tax benefit would be $0.04

PV of tax benefit on $ 1 iniitial investment = PV of $0.04 for 10 years = 0.245782684

If your initial investment was X, your tax benefits would be $0.2458

X = 10.32 + .2458 X

Solving for the initial investment, Initial investment =

$13.69

Problem 3

a. Current cost of equity =

0.086

Current cost of capital =

7.72%

b. Unlevered beta =

0.782608696

New levered beta =

1.486956522

New cost of equity =

0.109478261

New cost of capital =

7.26%

c. Increase in firm value =

75

Annual Savings =

2.880434783

Annual savings/ (WACC - g) = 2.88/(.0726 -g) = 75

Solve for g,

Expected growth rate=

3.42%

! Wrong weights for debt and equity also cost a point

! (.0772 - .0726) (625) Don't use market value of equity alon

! If you set the problem up right but got the wrong answer, yo

Problem 4

Earnings

Dividends

Cash Balance

110

100

44

40

100

78

Dividends paid by the firm =

22

44

Net cap ex in most recent year =

66

44

Earnings

- Net Cap Ex

FCFE

Dividends

Cash balance

1

$121.00

$52.80

$68.20

$0.00

$168.20

2

$133.10

$63.36

$69.74

$0.00

$237.94

3

$146.41

$76.03

$70.38

$0.00

$308.32

.85 = (1- ord tax rate)/ (1-.2)

Ordinary tax rate =

32.00%

! Add the FCFE every year to the previous year'

Problem 5

Reinvestment last year =

50

EBIT (1-t) last year =

60

Reinvestment rate =

83.33%

Return on capital =

12.00%

Expected growth for next 3 years =

b. Terminal value calculation

Stable period reinvestment rate =

Expected EBIT (1-t) in 4 years =

Terminal value =

10.00%

0.333333333

83.0544

1107.392

! A minor error is pulling this out an extra year.

c. Value today

EBIT (1-t)

Reinvestment

FCFF

Terminal value

Present value

Value of firm

1

$66.00

$55.00

$11.00

2

$72.60

$60.50

$12.10

$10.00

$862.00

$10.00

3

$79.86

$66.55

$13.31

$1,107.39

$842.00

a. discounted EBIT (1-t) instead of FCFF

b. discounted the terminal value back at 10% in

c. discounted the terminal value back 4 years in

n part a and b, the key question was whether to consider the marginal tax rate. If the problem had asked for

levered beta and a cost of capital without specifying a time period, a reasonable case can be made that the eventual beta

ould be determined by the marginal tax rate of 40% (giving you a beta of 7.04) and the cost of debt would be 10.2%. However

e problem asked for next year's beta and cost of capital. Next year, there is no way the firm will be getting any tax benefits of

ebt. Thus, harsh though it might seem, you lost a point on each if you did consider taxes.

gave full credit even if you did consider a tax rate. I felt you had borne enough punishment

you did not recompute the unlevered beta or used the wrong one, you did lose a point.

here and allowed for multiple interpretations. For instance, if you assume that the $ 1 million

already considered in the operating margin, your incremental EBIT would be $2.28 million. You

this would be your breakeven initial investment. If you go to this point, you got 4 points

on and you will be in iterating forever. If you go this far, you got 5 points.

equity also cost a point

ave to multiply by the total number of shares outstanding. If you used remaining shares, you lost a point

use market value of equity alone which is 500

ht but got the wrong answer, you lost only 1/2 point.

every year to the previous year's balance to get to final cash balance. Start at 100

on, if you inserted a dollar dividend or put the wrong sign on price change, you would have lost a point

age return on capital, you would have got a lower return on capital but still should have got full credit.

s pulling this out an extra year. It would have cost you 1/2 point

credit if you took your FCFF and terminal value and discounted back at 10%. However, you would have lost credit if you

BIT (1-t) instead of FCFF

e terminal value back at 10% instead of 9%

e terminal value back 4 years instead of 3 years

would be 10.2%. However

getting any tax benefits of

Problem 1

Market value of equity =

Market value of debt =

Debt/Equity ratio

2000

2000 ! Value of firm (4000) - Value of equity

1

Bottom-up levered beta

Cost of equity =

Cost of capital =

0.9625

1.54

12.1600%

9.08% ! Debt to capital ratio = 50%; Cost of debt = 10%

New D/E ratio =

New levered beta =

New cost of equity =

New cost of capital =

1.08

0.5 ! Debt drops to $ 1 billion

1.41

11.63%

9.26%

Problem 2

Stated NPV =

100 !

- 700 + CF (PVA, 10 years, 10%) = 100

! The analyst expensed the entire investment in computing NPV

Solve for the CF,

Annual operating cashflow (prior to depreciation)

$130.20

Correct initial investment =

1000

Correct after-tax annual cashflow =

$160.20 ! Add the tax benefit from depreciation to each year's

Correct NPV = -1000 + 160.20 (PVA, 10 years, 12%) =

-$94.86

Problem 3

Cost of equity before =

9.600%

Cost of capital before =

9.0600%

Increase in firm value = (Cost of capital before - Cost of capital after) * Firm value/ (Cost of capital after - Expected grow

150 = (.0906 - X) (1000)/(X - .05)

Solving for X,

Cost of capital after =

8.53%

Unlevered beta =

0.84375

New levered beta =

1.0607142857

New cost of equity =

10.24%

Cost of capital = 8.55% = 10.24%(.7) + After-tax cost of debt (.3)

After-tax cost of debt =

4.61%

Pre-tax cost of debt =

7.68%

Problem 4

Current year

Net Income

- Reinvestment

+ Net debt issued

FCFE

Payout ratio

Next year

100

70

0

30

30.00%

b.

Dividends paid

Stock buyback

Cash returned to stockholders

Effect on cash balance = FCFE - Cash returned =

Cash balance at end of year =

Problem 5

Firm value =

1500

110

77

15.4

48.4

44.00%

44

50

94

-45.6

54.4 ! 100 - 45.6

Solve for the reinvestment rate

Reinvestment rate =

25%

Return on capital = g/ Reinvestment rate =

20.00%

If the ROC = Cost of capital = 10%

Reinvestment rate =

Firm value = 100 (1-.5)/ (.10 - .05) =

Value of equity =

0.5

1000

700

Spring 2000

Problem 1

Unlevered beta for AT&T =

Unlevered beta for Media One =

Unlevered beta for combined firm =

0.86

1.22

0.95

Equity for AT&T after merger=

! =1.40/(1+(1-.4)(.25))

! Weighted average = 0.86 (300/400) + 1.22 (100/400)

125

275

1.21

Problem 2

Net present value estimated by analyst

- PV of Working capital investments =

($750.00)

$264.99 ! I also gave you full credit if you counted only the se

(I counted 200 right away and 100 in five years)

$844.82

$1,631.56 Comment: You were incredibly creative in trying to co

each year for the 10 years. Given the information in t

$513.41

$800.00 ! It is only the difference in tax benefits that matters.

- PV of Salvage =

+ PV of Terminal Value =

- PV of depreciation tax benefits

+ PV of expensing tax benefit

Corrected net present value

$58.33

Problem 3

Current Cost of Equity =

Current after-tax cost of debt =

Current Cost of Capital =

9.96%

3.72%

9.07% ! Current cost of capital'

Unlevered Beta =

New Levered beta =

New Cost of Equity =

New After-tax cost of debt =

Cost of Capital =

0.9

1.26

11.04%

0.045

8.42% ! New cost of capital

Change per share =

$21.62 ! In billions

$5.40

b.

Current interest expense on debt =

Book Value of Debt outstanding =

Market value of debt at 7.5% =

Drop in value of debt =

Total Change in firm value =

Change per share =

2.48

40

$36.43

$3.57

$25.19

$6.30

!

!

!

!

When you borrow more and make yourself riskier, th

This is the drop in value in debt, but it goes to stockh

I added the drop in bond value to the answer of the

the old debt and new debt. You then used the lower cost

which provides you with an increase in the stock price

While you are on the right track, doing this will lock i

fact, you will be able to get this benefit for only 10 ye

Problem 4

a. Change in cash balance =

Dividends Paid =

Stock Bought back =

FCFE

Using the statement of cash flows,

Net Income

1000

2500 +.2 X

Check

1500

950

1000

3450

4750

1500

.2 X

+

+

+

+

=

Depreciation

Capital Expenditures

Change in non-cash working capital

Net Debt Issued

FCFE

Solve for X

Net Income in 1998 =

2000

-3000

500

-800

2500 +.2X

2000

-3000

500

-800

3450

4750

Problem 5

Exp. Growth

EBIT (1-t)

ROC

Cost of Capital

Reinvestment Rate

EBIT(1-t)

- Reinvestment

FCFF

Terminal Value

Cumulated Cost of Capital

Present Value

Value of Firm =

- Value of Debt outstanding =

Value of Equity =

Value per share =

1

15%

115

20%

12%

2

15%

132.25

20%

11%

75.00%

75.00%

$115.00

$86.25

$28.75

1.12

$25.67

$2,026.29

800

$1,226.29

$12.26

$132.25

$99.19

$33.06

1.2432

$26.59

15%

5%

152.09

159.69

20%

15%

10%

9%

75.00%

$152.09

$114.07

$38.02

$2,661.50

1.36752

$1,974.03

1974.025974

33.33%

$159.69

$53.23

$106.46

nd 100 in five years)

Given the information in t

nd make yourself riskier, th

n debt, but it goes to stockh

value to the answer of the

he problem by reestimatin

You then used the lower cost

increase in the stock price

rack, doing this will lock i

this benefit for only 10 ye

! When costs of capital change each period, remember to

take the cumulated cost. We had to do this for Disney in

the valuation we had in the lecture notes.

Spring 1999

Problem 1

Unlevered Beta for Pepsi = 1.2 / (1 + 0.6*(0.1)) =

Current Levered Beta = 1.13 (1 + 0.6*(10/40)) =

1.13

1.30

New Debt = 10 + 2 = 12

New Equity = 40 - 12 = 28

Levered Beta = 1.075(1 + 0.6*(12/28)) =

1.35

1.0750

Problem 2

Cost of Equity = 5% + 1.25 (6.3%) =

12.875%

PV of Cash Flows = 15/.12875 =

$

116.50 ! Net cap ex and working capital are both zero

Equity Invested in Project = 0.6*150 =

90 ! Only equity investment considered

NPV of Project = 116.5 - 90 = $ 26.5 million

If you want to do this analysis on a firm basis, you have to compute the EBIT (1-t)

EbIT (1-t) = FCFF = 15 + 60*.08*(1-..4) =

17.88

Cost of Capital = 12.875% (0.6) + 4.8% (.4) =

0.09645

NPV = 17.88/.09645 - 150 =

$

35.38

Problem 3

Current Cost of Equity = 5% + 0.9 (6.3%) =

Current Cost of Capital = 10.67% (.9) + 6% (1-.4) (.1)=

10.67%

9.963%

New Levered Beta = 0.84375 (1 + (1-.4)(40/60)) =

Cost of Equity = 5% + 1.18 (6.3%) =

Cost of Capital = 12.43% (0.6) + 7% (1-.4)(.4) =

0.84375

1.18125

12.43%

9.138%

Change in value per share = 1994/300 =

$

6.65

Number of shares bought back = 3000/30 =

Shares remaining = 300 - 100 =

Change in value per share = 2093/200 =

1,994

100 ! New Debt taken = Debt at optimal - Current debt = 4000 - 1000 = 3000

200

$

9.97

Effect of overpaying on value per share = 500/300 =

$

(1.67) ! Value per share will be $ 1.67 lower than whatever your optimal value

Thus, your move to the optimal, and whether you use debt is independent of this assessment. Any answer that incorporated this drop in the

stock price got full credit.

Problem 4

Net Income

1996

$150

1997

$225

1998

$315

1999

$394

2000

$492

Capital Expenditures

Depreciation

$200

$125

$250

$190

$300

$250

$375

$313

$469

$391

$300

$330

$375

$469

$586

Net Income

- Net Cap Ex (1- Debt ratio)

- Chg in WC (1-DR)

FCFE

Dividends

Cash Balance

Non-cash WC

$150

67.5

22.5

$60

$30

$130

$225

54

27

$144

$45

$229

$315

45

40.5

$230

$63

$396

$375

$393.75

$56.25

$84.38

$253

$79

468.75

$174

$492.19

$70.31

$105.47 ! Change in 1999 computed from total WC

$316 below

$98

Total

585.9375

$218

$392

Problem 5

Return on Capital in 1998 =

600 (1-.4)/2000 =

18.00%

Reinvestment Rate in 1998 = (360-300+50)/360 =

0.305555556

Expected Growth Rate = 18% (.3056) =

5.50%

Cost of Equity = 5% + 1.1 (6.3%) =

0.1193

Cost of Capital = 11.93% (.7) + 7.5% (1-.4) (.3) =

9.70%

FCFF = EBIT (1-t) - (Cap Ex - Depreciation) - Chg in WC = 360 - (360-300) - 50 = 250

Firm Value = 250*1.055/(.097-.055) =

$

6,280 ! Getting the right answer is not enough. You have to justify the growth rate.

- 1000 = 3000

ptimal value

Spring 1998

Problem 1

a. Cost of Equity = 6% + 0.67 (5.5%) =

9.69%

b. Bottom-up Beta

Pharmaceutical Business = 1.15/(1+0.6*0.1) =

1.08

Specialty Chemical Business = 0.70/(1+0.6*0.35) =

0.58

Unlevered Beta for Mallinckrodt = 1.08 (255.4/306.9)+ 0.58 (51.5/306.9) =

c.

Current Debt/Equity Ratio = 556.9/(32*73) =

23.84%

Levered Beta for Mallinckrodt = 1.00 (1 + 0.6*(.2384)) =

1.00

1.14

Problem 2

a. Return on Equity = $ 190.10/1231.20 =

15.44% ! I used the beginning of the year book value of

b. Equity EVA = (.1544 - .0969) (1231.20) =

$

70.80

c. Divisional EVAs

Division

EBIT

Capital Inves ROC

Levered Beta Cost of Equity Cost of Capita

Pharma

$

255.40 $ 1,298.00

11.81%

1.24 $

0.1282

11.14%

Spec Chem

$

51.10 $

601.00 $

0.05

0.66

9.64%

8.57%

Problem 3

Pre-tax Cost of Debt for Mallinckrodt = 6.80% (Based upon interest coverage ratio and rating of A+)

Cost of Capital = 9.69% (32*73/(32*73+556.9)) + 6.80% (1-.4) (556.9/(556.9/(32*73+556.9)) =

b. Optimal Cost of Capital

Pre-tax Cost of Debt at Optimal =

7.25% (Based on interest coverage ratio at optimal)

Unlevered Beta = 0.67/(1+0.6*0.2384) =

0.586156215

New Beta = 0.60 (1+0.6*(40/60)) =

0.820618701

New Cost of Equity = 6% +0.84*5.5% =

10.51%

New Cost of Capital = 10.62% (.6) + .0725*.6*.4 =

8.05%

c. Value of Firm = 32*73+556.9 =

2892.9

New Dollar Debt at 40% Debt Ratio = 0.4*2892.9 =

1157.16

Additional Debt to be taken = 1157 - 556.9 =

600.26

Weighted Duration of Debt = (12/1157)(0.5) + (545/1157)(3)+(600/1157)X = 6.5

Solve for X,

X=

9.80

Problem 4

Net Income

+ Depreciatio

+ Cex

+ Chg in WC

+ Net Debt i

FCFE

1996

212

149

-169

-152

608

648

Dividends

$

+ Buybacks $

Cash Returned $

45.70

131.00

176.70

Cash Returned

27.27%

1997

190

128

-170

34

-113

69

$

$

$

48.20

150.00 ! I did not net out stock issues. If you did, specify that you did so

198.20

287.25%

c.

Return on Capital = 307(0.6)/(109+558+1232) =

Net Cap Ex/Revenues = (170-128)/1861 =

Predicted Dividend Yield = 0.03 - 0.053(.097) - 0.15(.0226) =

Predicted Dividend = 0.0215 * $ 32 =

$

0.69

Problem 5

9.70%

2.26%

2.15%

EBIT (1-t)

+ Deprecn

- Cap Ex

- Chg in WC

FCFF

Base

$

184.20

$

128.00

$

170.00

$

$

$

$

$

1

202.62

140.80

187.00

50.30

106.12

$

$

$

$

$

2

222.88

154.88

205.70

55.33

116.73

$

$

$

$

$

3

245.17

170.37

226.27

60.86

128.41

Terminal Year

$

252.53

$

175.48

$

193.03 ! Used industry average cap ex/d

$

20.08

$

214.89

Revenues

$ 1,861.00 $ 2,047.10 $ 2,251.81 $ 2,476.99 $ 2,551.30

WC

$

503.00 $

553.30 $

608.63 $

669.49 $

689.58

% of Revenue

27.03%

27.03%

27.03%

27.03%

27.03%

b. Terminal Value Calculation

Cost of Equity in stable growth = 6% + 1(5.5%) =

Cost of Capital in Stable growth = 0.115(.6)+.07*.6*.4 =

Terminal Value = 215/(.0858-.03) =

$

0.115

8.58%

3,851

Value of the Firm = 106/1.0861+117/1.0861^2+(128+3851)/1.0861^3 =

$ 3,302.81

Value of Debt Outstanding =

$

556.90

Value of Equity =

$ 2,745.91

Value of Equity per Share =

$

37.62

EVA

$

8.67

$

(20.83)

0.80749421

8.61%

tio at optimal)

8.61%

Spring 1997

Problem 1

Cost of Equity for the project = 7% + 1.5 (5.5%) =

Cost of Capital = 15.25% (.6) + 10% (1-.4) (.4) =

NPVof project = -40 + 10 (1-.4)/.1155 =

11.55%

11.95

Problem 2

Business

Unlevered Bet Weight

Beta *Weight

Tech

1.51

33.33% 0.503144654

Auto Parts

1.02

26.67% 0.271186441

Financial Services

0.72

40.00%

0.2875

1.06

Levered Beta = 1.06 (1+ (1-.4) (40/60)) =

1.49 ! Use debt to equity, not debt to capital

Problem 3

Firm Value before change =

Firm Value after change =

2000

2200 ! I have assumed investors are rational and that they sold their stock ba

If you assume that the stock buyback was at $ 40, you will get a smaller

200

Cost of Capital before the buyback =

11.40%

(.114 - New Cost of Capital) (2000) /New Cost of Capital = 200

New cost of Capital = 228/2200 =

10.36%

Levered beta after transaction = 0.8 (1 + (1-.4) (500/1500)) =

Cost of Equity after the transaction =

12.28%

Let X be the pre-tax cost of new debt =

12.28% (.75) + X (1-.4) (.25) =10.36%

Solving for X,

Pre-tax cost of borrowing on new debt =

7.67%

Problem 4

a. FCFE during year = Dividends

FCFE = Net Income - Net Cap Ex

750 = 2000 - Net Cap Ex (1-.3)

Net Cap Ex =

$ 1,785.71

b. Drop in the stock price =

Dividend Paid =

Number of shares = 500/2.40 =

0.96

(1- Debt Ratio) - Change in Working Capital (1- debt ratio)

$

$

750

1.80

2.40 ! Change in stock price = Dividends (1- ord tax rate)/ (1- capital gains ra

208.33 ! Divide total dividends paid by dividends per share

Problem 5

a. Expected growth rate in perpetuity = ROE * Retention Ratio = .15 * .4 =

6.00% ! Cannot just assume a grow

Value per share = EPS (Payout ratio) (1+g)/(r-g) =

$

19.57 ! Used 5.5% risk premium and beta of 1

b. New growth rate with higher retention ratio = 14% *.5 =

Value per share = EPS (Payout ratio) (1+g)/(r-g) =

7%

$

19.45

Problem 6

a. False

b. False. Firms may pay out more in dividends than they have available in FCFE.

c. True

d. True. It may be the same for an unlevered firm, but it cannot be lower.

$ 40, you will get a smaller number (2150)

premium and beta of 1

Spring 1996

Problem 1

a. Unlevered Beta for Samson = 0.90/(1+(1-0.4)(.05)) =

0.873786408 ! Used the average debt/equity r

New Levered Beta = 0.87(1+(1-.4)(.25)) =

1.0005

New Cost of Equity = 8% + 1(5.5%) =

13.50%

b. Cost of Capital = 13.50%(.8) + 10%(1-.4)(.2) =

12.00%

c. The debt ratio currently is 20%. Doubling the debt ratio will increase it to 40%.

New Levered Beta = 0.87(1+(1-.4)(.40/60)) =

1.218

New Cost of Equity = 8% + 1.22(5.5%) =

14.71%

New Cost of Capital = 14.71%(0.6)+11.5%(1-.4)(0.4) =

11.59%

d. Value of Firm today = 240+60 =

300

Dollar Debt at 40% debt ratio = 0.4*300 =

120

Additional Debt needed = 120 - 60 =

60

e. Value of Equity in 3 years = 240(1.135)^3 =

$

351 ! This is probably understated. The beta will rise

Dollar Debt in 3 years = (0.4/0.6) ($ 351) =

$

234.00

f. Return on Capital in most recent year = 40(1-.4)/100 =

24.00% ! I used the book value at the beg

The firm is making a return on capital that is higher than the cost of capital. If it can continue to do so, I would suggest

Problem 2

a. FCFE in 1995 = Net Income + Deprecn - Cap Ex - Chg in Non-cash WC -(Principal Repaid + new Debt issued)

=150+20-70-10+15 =

105

Cash Balance increased by $ 50 million

Dividends paid must have been $ 55 million

b. Capital Expenditures = Change in Fixed Assets + depreciation = 50 + 20 = 70

Cash Balance increased by $ 50 million

c.

Net Income

165

- Net Cap (1-DR)

21 ! See below for calculation of net cap ex.

- Chg in WC (1-DR)

4.5

FCFE

$

139.50

Project

ROC

Beta

Cost of Equity Cost

A

13.34%

1.2

13.60%

B

9.99%

1

12.50%

C

12.51%

1.1

13.05%

D

14.28%

2

18.00%

Accept projects A and C; total cap ex = $ 50 million

Depreciation next year = 20*1.1 = 22

Net Cap Ex = 50-22 =

28

of Capital

11.40% ! Use firm's debt ratio of 25% and firm's after ta

10.58%

10.99%

14.70%

Problem 3

a. Return on Capital =

25%

Debt/Equity Ratio =

25%

Interest rate on debt =

8%

Expected Growth = .67(25% + .25(25%-8% (1-.4))) =

20.13%

b.

Current

1

2

3 Term. Year

EPS

$

3.00 $

3.60 $

4.33 $

5.20 $

5.51 ! Use a stable growth rate; I used

DPS

$

1.00 $

1.20 $

1.44 $

1.73 $

3.63

Payout Ratio

33.33%

33.33%

33.33%

33.33%

65.81% ! Payout Ratio in stable growth=1

c. Terminal Value per share = 3.63/(.125-.06) =

$

55.85

d. Value per share today = 1.20/1.1415 + 1.44/1.1415^2+(1.73+55.85)/1.1415^3 =

Cost of Equity today = 7% + 1.3 (5.5%) =

0.1415

e. If there is no net cap ex or working capital investment, the expected growth after year 3 has to be zero

EPS

$

3.00 $

3.60 $

4.33 $

5.20 $

5.20

- Net Cap Ex(

1.2 $

1.44 $

1.73 $

2.08

0

- Chg in WC (

0

0

0

0

0

FCFE

$

2.16 $

2.60 $

3.12 $

5.20

Current debt ratio = 20% (D/E ratio of 25% translates into debt ratio of 20%)

Terminal Value per share = 5.20/.125 =

$

41.61

Value per share today = 2.16/1.1415+2.60/1.1415^2+(3.12+41.61)/1.1415^3 =

$

33.96

(If you had used a 6% growth rate forever in this case as well, the assumptions would have been inconsistent.)

6

Used the average debt/equity ratio over period)

used the book value at the beginning. If you decide to use averages, specify it here

ntinue to do so, I would suggest it take projects

$

r 3 has to be zero

40.87

Fall 1995

Problem 1

a. To estimate market interest rate,

Yield to maturity on the debt =

9.31% ! If you are short of time, you can use the short cut = Inte

Estimated market value of bank debt =

$

39.52 ! Assumed that it was balloon payment debt.

Total Market Value = 42.5+39.5 =

82

After-tax Cost of Debt = 9.31%(1-.4) =

5.59%

b. Average Beta for comparable firms =

1.04

Average D/E Ratio for comparable firms =

22%

Unlevered Beta for comparable firms =

0.918727915

Levered Beta for SDL = 0.92 (1+0.6*(82/400)) =

1.03

(See below for calculation of debt)

Cost of Equity = 6% + 1.03 (5.5%) =

11.68%

c. Cost of Capital = 11.68% (400/482) + 5.59% (82/482) =

10.76%

d. SDL's debt seems much too long term for its needs. (The debt duration is only 1.5 years)

I would convert the debt into shorter term debt. I would keep it dollar debt since it does not seem to be affected by the

e. Unlevered beta after acquisition = 0.92(482/632)+1.25(150/632) =

0.998322785

New Dollar Debt = 82 + 150 =

232

New Debt/Equity ratio = 232/400 =

0.58

New Levered Beta = 1.00 (1+0.6*0.58) =

1.348

New Cost of Equity = 6% + 1.348(5.5%) =

13.41%

New Cost of Capital = 13.41% (400/632) + 9.5%(1-.4) (232/632) =

10.58%

Problem 2

a.

Net Income

- Net Cap Ex

- Chg in WC

FCFE

150

75 ! No debt

20

55

If cash balance increased by $ 25 million, the dividend must have been $ 30 million.

b.

Project

ROE

A

B

C

D

Take projects A, C and D

COE

13%

16%

12%

15%

17.00%

10.40%

12.05%

Net Income

165

- Net Cap Ex (1-.2)

72

- Chg in WC (1-.2)

8 ! Working capital will increase by 10%, if revenues increase 10%

FCFE

85

The firm can afford to return $ 85 million to its equity investors

Problem 3

a. Expected growth during high growth period = 0.8 (20%) =

16% ! ROE = EPS/BV ofEquity = 2

b.

1

2

3 Terminal year

EPS

$

2.32 $

2.69 $

3.12 $

3.31

DPS

$

0.46 $

0.54 $

0.62 $

2.10

Payout ratio

20%

20%

20%

63.53% ! Payout ratio in stable phase=.06/(.14+.25

Cost of Equity

14.25%

14.25%

14.25%

11.06% ! Levered Stable beta = 0.8(1+0.6*.25) ); T

(I used a cost of debt of 7% after year 3. It has to be greater than 6%, which is the T.Bond rate)

Terminal Value = 2.10/(.1106-.06) =

$

41.50

29.06

payment debt.

! Beta fpr XLNT is unlevered

stable phase=.06/(.14+.25(.14-.07*.6))

beta = 0.8(1+0.6*.25) ); Tax rate used =40%]

8.24%

Fall 1994

Problem 1

a. Market Value of debt = 5 (PVA,10%,10) + 60/1.1^10 =

b.

Business

Beta

D/E

Unlev Beta

Record/CD

1.15

50%

0.88

Concert

1.2

10%

1.13

Unlevered Beta for JP = 0.88 (.75) + 1.13 (0.25) =

0.9425

Levered Beta for JP = 0.9425 (1+(1-.4)(53.86/240)) =

1.07

Cost of Equity = 8% + 1.07 (5.5%) =

13.89%

c. Cost of Capital = 13.89% (240/293.86) + 10%(1-.4)(53.86/293.86) =

d. If the treasury bond rate rises to 9%,

New Market Value of Debt = 5 (PVA,11%,10) + 60/1.11^10 =

Cost of Equity = 9% + 1.07 (5.5%) =

14.89%

Cost of Debt =

11%

Cost of Capital = 14.89% (240/290.58) + 11% (1-.4) (50.58/290.58) =

53.86

12.44%

$

50.58

13.45%

Problem 2

Project

IRR to Equity Cost of Equity

A

16.00%

16.80%

B

15.00%

14.88%

C

12.50%

13.50%

D

11.50%

10.75%

Accept projects B and D

a.

Net Income

$

57.60

- (Cap Ex - Depr) (1-DR) $

28.10 ! (50 - 13(1.2))(1-(53.86/293.86))

! I would also have given you credit

- Chg in WC (1-DR)

$

4.90 ! Working capital is 20% of revenues

FCFE

$

24.60

b. Dividends next year = 0.25*(57.60) =

$

14.40

Expected increase in cash balance = (24.60-14.4) =

$

10.20

Problem 3

a. Expected growth rate = .75(.48) =

36%

! If you use current ROE = 48/100 = 48%

The expected growth rate will be slightly lower if the market value debt to equity ratio and interest rate is used to get t

Expected growth = .75 (.3188+ 53.86/240 (.3188-.06)) =

28.26%

If book value debt/equity ratio and book interest rate is used, the answer will be 35.55%

I am going to use the 27.46% growth rate because I think it is more sustainable.

b. Expected Dividends

Current

1

2

3

4

EPS

$

4.00 $

5.13 $

6.58 $

8.44 $

10.83

DPS

$

1.00 $

1.28 $

1.65 $

2.11 $

2.71

Payout Ratio

25.00%

25.00%

25.00%

25.00%

25.00%

c. Stable Payout Ratio = 1 - [.06/(.15+(53.86/240)(.15 - .06)] =

64.75%

d. Terminal Value

Cost of Equity in stable growth =

13.50%

Terminal Value = $ 9.53/(.135-.06) =

$

127.06

e. Value today (discounting at current cost of equity of 13.89%)

Cost of Equity during high growth =

13.89% ! See problem 1

DPS + Term Price

$

1.28 $

1.65 $

2.11 $

2.71

PV

$

1.13 $

1.27 $

1.43 $

1.61

Value per share =

$

73.55

Problem 4

a. New Fundamentals:

Return on Capital = (85-5)*(1-.4)/(160-50) =

Interest rate on debt is assumed to stay at

Retention Ratio =

new Expected Growth Rate = .85 (.4364 + .2835 (.4364-.06)) =

Proportion of the firm in record/CD business after sale =

New Levered Beta = 0.955 (1+0.6*(.2835)) =

10.00% ! Interest rate on debt is assumed no

15.00%

46.16%

69.87%

0.955

1.12

! Now it is = .75 * 293.86 million - 50

! New Proportion = (.75*293.86-50)/

1994

! I estimated the market value of the debt

given the current market interest rate of 10%

! You can even re-estimate the levered beta with this new debt

but it won't change by much.

0.0034

io and interest rate is used to get the growth rate

ROC =

31.88%

{85*0.6/(100+60))

$

$

5

13.88

3.47

25.00%

$

$

130.53

68.12

! I am assuming that there was no cash at the start of the year. If there

had been, I would have netted it out.

Term Year

$

14.72

$

9.53

64.75%

Book Value of capital drops $ 50 mil after buyback: I am adjusting the beginning of the year book capital by this.

nterest rate on debt is assumed not to change

Now it is = .75 * 293.86 million - 50 million

New Proportion = (.75*293.86-50)/(293.86-50)

Fall 1993

Problem 1

KentuckyFriedChicken

Hardee's

Popeye'sFriedChicken

RoyRogers

UnleveredBeta=

1.05

1.2

0.9

1.35

1.125

0.9183673

0.2

50%

10%

70%

0.375

1a.Firstcalculatethebetabaseduponcomparablefirms:

AverageBeta=

1.125

AverageD/ERatio=

0.375

Unleveredbeta=

0.91836735

BetaforBostonTurkey= 1.2627551

Usethisbetatocalculatethecostofequity

CostofEquity=6.25%+1.26*5.5%=

13.18%

(Alternativelythelongbondratecouldhavebeenusedastheriskfreerate,witha5.5%premium)

1b.AftertaxCostofDebt:

Firstcomputetheinterestcoverageratio=EBIT/InterestExpense=

ThisyieldsabondratingofA,andapretaxrateof7.50%=6.25%+1.25%

Aftertaxcostofdebt=7.5%(10.4)=

4.50%

1c.MarketValueofEquity=20*100000=

$2,000,000

MarketValueofDebt=1.25*1000000=

$1,250,000

1c.CostofCapital=13.18%(2/3.25)+4.5%(1.25/3.25)=

1d.NewDebtEquityratioafterrepurchase=

Newbetaafterrepurchase=

Newcostofequity=6.25%+1.56*5.5%=

9.84%

1.1666666667

1.5612244898

14.83%

1e.Newaftertaxcostofdebt=7.75%(10.4)=

4.65%

Newcostofcapital=14.83%(1.5/3.25)+4.65%(1.75/3.25)=

9.35%

ChangeinFirmValue= 3,250,000(.0984.0935)/.0935=

$171,419

Changeinstockpricepershare=

$1.71 !Dividebythetotalnumb

2a.Firstdecidewhichprojectsyouwillaccept

Project

ROE

CostofEquity

A

12.50%

11.75% Accept

B

14.00%

14.50% Reject

C

16.00%

16.15% Reject

D

24.00%

17.25% Accept

Nextcalculateworkingcapitalas%ofRevenues

WorkingCapital=CurrentAssetsCurrentLiabilitie

WorkingCapitalas%ofRevenues=50%

IncomeStatementNextyear

Revenues

Expenses

Depreciation

=EBIT

InterestExp

=TaxableInc.

Tax

=NetIncome

(CapExDeprec)(1)

WC(1)

=FCFE

$500,000

1100000

440000

100000

560000

100000

460000

184000

276000

30000 (150000100000)(10.4)

30000 (50%ofincreaseinrevenues($100000))*(10.4)

216000

2b.CashBalancenextyear=CurrentBalance+FCFEDividends=150000+216000100000=266000

2c.Ordinarytaxrate=40%

CapitalGainstaxrate=28%

(PricebeforePriceafter)/Dividend=(10.4)/(10.28)=0.833

Changeinprice=$0.833

3a.RetentionRatio=1(1/2.4)=

58.333%

ROC=(EBIT(1t))/(BVofDebt+BVofEquity)=

12.00% ! You can estimate ROE directly by dividing

Debt/EquityRatio=1.25/2=

0.625 !Ifyoudecidetousebookvaluedebttoequityratio,speci

Interestrate=Marketinterestrateondebt=

7.50%

ExpectedGrowthRate=0.5833(0.12+0.625(0.120.045)=

9.73%

3b.Terminalprice=Priceattheendofyear3

CostofEquity=6.25%+1(5.5%)=

PayoutRatioattheendofyear3=1(0.06/(0.12+0.625(0.120.045)))=

Terminalprice=($2.40*1.0973^3*1.06*0.6404)/(0.11750.06)=

3c.

Year

11.75%

0.64044944

$37.44

DPS

1 $1.10

!Growingat9.73%estimatedabove

2 $1.20

3 $1.32

$37.44

CurrentCostofEquity(baseduponcurrentbeta)=

13.18% !Seeproblem1forcalculation

PresentValueofDividendsandTerminalPrice=

$28.65

Dividebythetotalnumberofsharesoutstanding.

00000=266000

e ROE directly by dividing net income by book equity, but your answer will be different.

debttoequityratio,specifyithere

forcalculation

Fall 1992

1a. Current Cost of Equity = 8% + 1.15 (5.5%) =

14.33%

Current after-tax Cost of Debt = 10% (1- 0.4) =

6.00%

Current Weighted Average Cost of Capital = 14.33% (0.8) + 6.00% (0.2) =

1b. New Debt Ratio = (200+200)/1000 =

40.00%

Unlevered Beta = 1.15/(1+0.6*.25) =

1.00

New levered beta = 1.00 (1+0.6*0.67) =

1.40

New Cost of Equity = 8%+1.40 (5.5%) =

15.70%

New Cost of Capital = 15.70% (0.6) + 6.60% (0.4) =

12.06%

1c. Change in Firm Value = 1000 (.1266-.1206)/.1206 =

$

49.75 millions

Increase in Stock Price = $49.75 million/ 40 million =

$

1.24

1d. Debt next year = $ 200 + $150 = $350 million

Expected Price Appreciation in Equity = Expected Return - Dividend Yield = 14.33%-10% = 4.33%

Expected Value of Equity = 800 (1.0433) =

$

834.64

Expected Debt/Equity Ratio at end of next year = $350/$835 =

41.92%

2a.

Net Income

+ Deprec'n

- Cap. Ex.

- Chg. WC

= FCFE

Dividends

(Assuming that net capital

Cash Balance

1

2

3

$

110.00 $

121.00 $

133.10

$

54.00 $

58.32 $

62.99

$

60.00 $

60.00 $

60.00

$

10.00 $

10.00 $

10.00

$

94.00 $

109.32 $

126.09

$

66.00 $

72.60 $

79.86

investment and working capital is financed with equity)

$50.00

$78.00

$114.72

$160.95

$

$

$

$

100.00

50.00

60.00

10.00

Net Income

$

100.00

- (CE-Dep) (1-)

$

8.00

- (Ch WC) (1-)

$

8.00

= FCFE

Dividends

Cash Balance

$

50.00

$

110.00 $

121.00 $

133.10

$

4.80 $

1.34 $

(2.39)

$

8.00 $

8.00 $

8.00

$

97.20 $

111.66 $

127.49

$

66.00 $

72.60 $

79.86

$

81.20 $

120.26 $

167.88

4.50%

Capital Gains Tax Rate =

20.00%

Dividends Per Share =

$2.00

Price Change per share on Ex-Dividend Day = [(1-.045)/(1-.20)]($2.00) =

2.39

Problem 3

4

1

2

3

3.31

EPS

$

2.40 $

2.78 $

3.12 $

61.54% ! Payout ratio = 1 - g/ROE, where RO

Payout Ratio

0.00%

25.65%

36.17%

2.03

DPS

$

$

0.71 $

1.13 $

Beta

1.4

1.25

1.1

1

Cost of Equity

0.142

0.13375

0.1255

0.12

Note: The alternative to estimating a levered beta in year 4 is to assume a beta of 1.

Terminal Price = $2.03/(.12 - .06) =

33.90

24.59

12.66%

%-10% = 4.33%

Payout ratio = 1 - g/ROE, where ROE = ROC + D/E (ROC - I (1-tax rate))

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