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Problem 1

Business

Sector Averages
Revenues (in $ millions)
Enterprise Value/Sales

Computer hardware
Computer services

Country
United States
China

$1,000
$600

0.80
2.00

Risk free rate In local


currency
3.00%
4.00%

Equity Risk Premium


5.00%
7.00%

Risk free rate =

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%

20.00% ! Debt raised/Old value


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

Three years ago

Two years ago

$1,000
$100
$40
$50

$1,100
$110
$45
$60

Total Working capital


Total Debt

$10
$10

$30
$15

0%

Dividend Payout ratio

40%

Three years ago


Net Income
+ Depreciation
- Cap Ex
- Change in Working capital
+ Increase in debt
FCFE
Dividends paid
Change in cash balance
Cash Balance

Two years ago


$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

Expected growth rate =


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

Marginal tax rate


40%
25%

Total Revenues
$800.00
$800.00
1. Wrong risk free rate: -1/2 point

Unlevered Beta
1.25
0.9
1.04

2. Used revenue weights on beta: -1/2 point


3. Wrong ERP: -1/2 point
4. Math errors: -1/2 point

Weights
0.5
0.5

1.
2.
3.
4.

Wrong risk free rate: -1/2 point


Wrong levered beta: -1 to 1.5 points
ERP weighted incorrectly: -1 to 1.5 points
Math errors: -1/2 point each

lue/ EV to Sales of sector

Unlevered Beta
1.25
0.9
0.9583

ginal tax rate, since borrowing is in US.


are also in US.
Weghts
20%
80%

inesses in US (600) and China (1800).

Salvage Value
250000
750000
Incremental
$2,500,000.00
$600,000.00

1.
2.
3.
4.
5.

Initial investment in WC incorrect: -1 point


After-tax cash flow incorrect: -1 point
Salvage value incorrect: -1 point
PV incorrect: -1/2 point
Math error: -1/2 point

1. Annuity not based on initial investment: -1 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.

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


2. Wrong weights: -1/2 point
3. Math error: -1/2 point

t to subtract debt

1.
2.
3.
4.

Did not unlever & relever beta: -1 point


Did not after-tax cost of debt: -1/2 point
Wrong weights: -1/2 point
Math error: -1/2 point

1.
2.
3.
4.

Incorrect estimate of increase in value: -1 point


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)

Most recent year


$1,200
$120
$50
$70

1. Did not compute change in non-cash WC: -1 point


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

1. Did not compute change in non-cash WC: -1 point


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

1.
2.
3.
4.
5.

ROC incorrect: -1 point


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 add cash: -1/2 point


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

1. Betas weighted incorrectly: -1 point


2. ERP weighted incorrectly: -1 point
3. Math errors: -1/2 point

4. Used Brazilian rate as risk free rate: -1/2 poin


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%

NOTES: You cannot use the Braz


because it is not a risk free rate

10.200% ! 3% + 1.02857 (7.00%)

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

Cost of capital for company


Debt =

2700
44.44%

New unlevered beta

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

New D/E ratio wrong: -1 point


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

NOTES: Both the business and t


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.

Did not treat depreciation correctly: -1 point


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

1. Did not compute annuity: -1 point


2. Error in getting back to revenues from annuit
3. Wrong discount rate: -1/2 point

New
$2,000.00

1. Did not compute tax benefit from depreciaton

Depreciation

$500.00

$800.00
$600.00

2. Did not compute tax benefit from expensing:


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

NOTE: You don't have to redo al


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

Value = 5000 = 250/(.084-g)


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

1. Did not compute savings per year: -1 point

2. Used wrong debt ratio in computation: -1 poi


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

NOTE: When a dividend is paid,

$34.16

New value per

by roughly the amount of the di

Part c
$5,415.94
$2,000.00
- Debt
Value of equit $3,415.94
New firm valu

1. Did not set up for shares correctly: -1 point


Check your answer

2. Did not adjust number of shares: -1 point

If buyback price =

$60.57 3. Other errors: -1/2 point each

Let the stock buyback price Number of share bought

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

NOTE: Many of you treated the g


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

$274.40 1. Error on treating dividends: -1 point


$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

1. Net income wrong: -1/2 point


2. Change in non-cash WC wrong: -1 point
3. Other errors: -1/2 point

Part a

4. Error in getting to cash balance: -1 point


Base

Part b

Problem 5
After-tax oper

10

Cost of capital (high growth) =

12.00%

Book value of

45

Cost of capital (stable growth) =

Book value of

15

Cash

10

1. Did not compute expected growth: -1 point

Invested capit

50

2. Error on ROC: -1/2 point

Return on capi

20%

10%

3. Error on reinvestment rate: -1 point

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

Note: Since you have FCFF, you


You then have to add cash (sinc
debt.

ed incorrectly: -1 point
incorrectly: -1 point

n rate as risk free rate: -1/2 point

u cannot use the Brazilian $ government bond rate,


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

th the business and the country weights changes as the


estructures. So, both numbers have to be resestimated.

depreciation correctly: -1 point


taxes: -1 point
nt rate: -1 point
1/2 point each

ute annuity: -1 point


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

ute tax benefit from depreciaton: -1 point

ute tax benefit from expensing: -1 point


1/2 point each

don't have to redo all of the cash flows, since


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.

ute savings per year: -1 point

ebt ratio in computation: -1 point

beta: -1 point

at 80 million

en a dividend is paid, the stock price will drop

the amount of the dividend (about $20/share)

p for shares correctly: -1 point

t number of shares: -1 point

-1/2 point each

y of you treated the given price as the buyback price.


is the price of the remaining shares.

rong: -1/2 point


n-cash WC wrong: -1 point

g to cash balance: -1 point

ing dividends: -1 point


debt: -1 point
balance: -1 point

ute expected growth: -1 point

estment rate: -1 point

NOTE: The acquisitons are a wild card. The problem states th


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

and growth for this firm.

mpute reinvestment rate: -1/2 point


iscount rate: -1/2 point
1/2 point each

iscount rate: -1/2 point


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

ent rate = 3%/20% = 15%

e you have FCFF, you have to discount at the cost of capital.


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

The problem states that


s and gives you the amount
amount and add it to your
estment rate and growth

s clearly part of the company's


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

$6.07 ! Tax savings each year = 4 (0.4) = 1.6


$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

If the operating income is only 60 million


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

Value per shar

$13.19

! Used revenue weights: -1 point


! Wrong D/E ratio: -1 point

! Wrong weights on businesses: -1 point


! Wrong D/E ratio: -1 point

! Wrong weights on businesses: -1 point


! Wrong D/E ratio: -1 point

!
!
!
!

Used total revenue instead of incremental: -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

! If you revert back to old revenue, WC in year 5 = 20


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

! Did not compute savings from expensing: -0.5 points

! 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

! Cost of equity incorrect: -0.5 point


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

! Did not unlever & relever beta: -1 point


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

! Change in firm value not computed: -1 point


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

! Mostly all or nothing


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

! Working capital change shown as a cash outflow (instead of inflow): -1 point


! Paying down debt shown as cash inflow instead of outflow: -1 point
! Forgot depreciation add back: -1 point

! Payout ratio incorrect for any reason: -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.

! Wrong growth rate: -1 point


! FCFF not consistent with growth: -1 point

! Did not compute reinvestment rate in year 6: -1 point


! Wrong discount rate on termnal value: -0.5 point

! Discounted terminal value at wrong discount rate: -0.5 point


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

ead of inflow): -1 point


flow: -1 point

e. You don't want


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.

Did not capitalize leases: -1 point


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.

Ignored working capital initial investme


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

compute unlevered beta: -1 poi


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

! If you choose not to salvage working cap


you will get in year 10 because you will be
tax benefit will be 0.4(10) = 4

9.042450851

b. If project continues in perpetuity


Initial investment
Terminal value
Revenues
EBITDA
- Depreciation
EBIT
EBIT (1-t)
+ Depreciaton
- Cap maintainence exp
Cash flow
NPV =

Year 10

-70 Forever

! Note that if the project is to continue fore


will deplete your assets' earning power an
100
15
5
10
6
5
5
6

-3.33333333 ! -70 + 6/.09

! Used cash flow from part a in perpetuity:


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 =

28.25111514 ! 5 million @12%

! Used wrong discount rate: -0.5 point


! 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

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


2. Error on weights: 0.5 point

1.
2.
3.
4.

Did not adjust beta: -1 point


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

!
!
!
!

Price per share in buyback =


11
Number of shares bought back = 45.45454545 ! 500/11
Portion of value to bought back s 45.45454545 ! 45.45 (11-10)

Did not compute change in


Error in computing change
Did not net out portion of
Did not adjust number of s

Remaining value increase=


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

Most recent y Next 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 =

0.2 0.683333333 ! 10.25/15

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

(1-t)/ (BV of debt

4
$29.28
$11.71
$17.57
$11.17

alize leases: -1 point


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

ute unlevered beta: -1 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

ng capital initial investment: -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

e project is to continue forever, the cap ex = depreciaation. Otherwise, you


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

from part a in perpetuity: -1 point (This is mathematically impossible.


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

scount rate: -0.5 point

tax cost of debt: -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

Did not compute change in firm value: -1 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

! All or nothing: -1 point

ng with change in working capital: -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 working capital correctly: -1 point


ute change in debt correctly: -1 point
-0.5 point each
end by revenues or some other variable: -0.5 point

T (1-t)/ (BV of debt + BV of equPart a


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

Market Value Unlevered beta of business


$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%

After-tax operating income


Book value
$75
$500
25
$500

ROC
15.00%
5.00%

Levered Beta Cost of equity


1.17
9.8500%
1.56
11.8000%

Problem 2
Life Products
Pfizer

Pre-tax cost ofAfter-tax


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%

a. Invest and produce


Initial investment =

$750.00

After-tax Cash flow


After-tax Operating inc
+ Depreciation =
Cash flow to firm=

90.00
$50.00
$140.00

Discount rate =
PV of cash flows =
NPV =

12.50% ! Pre-debt cash flows


$928.61
$178.61

! Did not comptue after-tax cash flow right: -1 point


! 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

! Did not compute pre-change cost of capital correctly: -0.5 to -1 point


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

Part b: Buyback price to make value change zero


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

FCFE without cap ex


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

! Used 3 years instead of 2 years t


! Working capital change not dalt
1 Forgot dividends: -1 point
! Did not deal with change in cash

Change in cash balance = FCFE - Dividends - Stock buybacks


(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

!
!
!
!

Debt change computed incorrectly or ignored: -1 point


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

Change in cash balance = FCFE - Dividends - Stock buybacks


(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

Book value of equity


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%

! Did not compute FCFE in year 6 correctly: -1 point


! 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%

! Computed return on capital using market value: -1 point


! 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

scount rate: -1 point


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

correctly: -0.5 to -1 point

nge to buyback shares: -1 point

Used 3 years instead of 2 years to get to cash flows: - 0.5 point


Working capital change not dalt with correctluy: - 0.5 point
Forgot dividends: -1 point
Did not deal with change in cash correctly: -1 point

rectly or ignored: -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 compute change in regulatory capital: -1 point


! 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 add PV of FCFE in years 1-5: -0.5 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 very fact that


e remainign shares.

quivalent of net cap ex and working

ulatory capital has to be taken out


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

! You cannot keep equity value fixed while you so


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 =

$470.44 ! -650+169.73(PV of annuity, 8.8%,10) + 50/1.088^10

PV of tax benefits from 5-yr depr


PV of tax benefits from 10-yr depr
Change in NPV from shift
New NPV =

$187.68 ! Deprcn=120; Tax savings=48; n=5 years


$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

! Already next year's cashflow. No growth needed in numerator


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%

b. Effect of using 40% debt ratio for reinvestment


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

Change in cash balance


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

c. Value of equity per share today


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

! Used book value instead of market: -1 point


Wrong weights on companies: -1 point
Math errors: -0.5 point

! Kept equity value fixed; -1 point


Math errors: -0.5 point each

ep equity value fixed while you solve for debt.


ve to estimate th value of the combined firm
portion that is debt.

! Math error: -0.5 point

! Did not set up annuity: -1 point


! Used 8.8% rate: -1 point
! I gave full credit, if you misread the problem and subtracted
depreciation from this number

! Forgot WC initial investment: -0.5 point


! 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

! Math error: -0.

! Used equity value: -0.5 to -1 point


Did not set up equation: -2 points

No growth needed in numerator.

! Bought back shares at today's price: -1 point


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

!
!
!
!

Counted all of WC: -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

Did not count cash flow from debt properly: -1 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.

Error on weighting or used levere


Used book value of equity: -1
Used effective tax rate: -.5
Math error: -0.5

1. Did not recompute unlevered bet


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

b. Annual incremental cashflow - Yrs 1-5


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 =

1. Reported total annual cash flow:


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

$3.69 ! -7.5 + PV of 1.4 million from yrs 1-5


+PV of 2.5 million from yrs 6-10

1. Did not estimate higher cashflow


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

1. Weights on debt and equity wron


2. Wrong cost of equity: -0.5 point
3. Forgot after-tax cost of debt: -0.5

1. Did not recompute beta: -1 point


2. Errors on weights: -0.5 to -1 poin
3. Forgot to after-tax cost of debt: -

1.
2.
3.
4.

Used equity value instead of firm


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

I gave full credit for both net and gr


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

1 Used total working capital instead


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%

If you got the dollar debt used (84.1


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%

Stable growth rate =


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

1. Did not compute Reinvestment r


2. Did not compute growth rate righ
3. Error on ROC formula = -0.5 to -1

1. Did not recompute reinvestment


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 cashflows from years 1-3:


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

Did not recompute unlevered beta: -1.5


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)

Computed PV of future cash flows : -0.5 point


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

Reported total annual cash flow: -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

Used equity value instead of firm value in computing savings


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.

Used total working capital instead of change: -1 point


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 Reinvestment rate right: -0.5 to -1 point


Did not compute growth rate right: -1 point
Error on ROC formula = -0.5 to -1 point

Did not recompute reinvestment rate: -1 point


Used wrong cost of capital (12% instead of 10%) -0.5 point
Grew operating income twice: -0.5 point

Forgot cashflows from years 1-3: -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

Unlevered beta corrected for cash =

Firm value =
Cash =
Operating ass

250
25
225

1.2

Unlevered beta for Vaudeville =


Levered beta for Vaudeville =

1.08 ! 1.2(225/250)+ 0 (25/250)


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

b. New debt =
Equity =
New Debt/Equity ratio =

150 ! Old debt + New debt issue


200 ! Stays unchanged
0.75
Firm value =
1.486
Movie =
2.154
Software =

New unlevered beta =


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 =

$3.03 ! Annual tax benefit = $0.8 million: PV over 5 years


Year
1
2
3
4
5

NPV will increase by


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

! Debt increases by $25 million; Equity decreases


! Unlevered beta (1+(1-t)(D/E))
! Cost of debt =7% (1-.4)
! (Change in cost of capital * 100)/(.0912-.03)

! Debt increases by $25 million; Equity does not change


(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=

3yearsago 2yearsagoMostrecentyearNext year


$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=

$215.00 ! FCFE - Change in cash balance

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

b. Reinvestment rate in first 3 years =


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

! (Net cap ex + Chg in WC)/ EBIT (1-t)

c. Value of firm today =


+ Cash
- Debt
Value of equity today =
Value per share today =

$316.04 ! PV of cash flows in first 3 years + Terminal value/1.12^3


$25.00 (Terminal value gets discounted back at today's cost of ca
$80.00
$261.04
$26.10

! Growth rate in high growth period/ Reinvestment Rate


!
!
!
!

Growth rate/ ROC


EBIT (1-t) in year 3 (1.04)
Net of reinvestment
FCFF in year 4 / (New cost of capital -g)

lion: PV over 5 years

n; Equity decreases

a. Weights on cash incorrect: -0.5 points


b. Did not consider cash: -1 point
c. Debt to Equity ratio wrong; -0.5 point

a. Wrong weights on new beusinesses: -0.5 point


b. Wrong debt to equity ratio: -0.5 point

a. Computed break-even cashflow incorrectly: -1 point


b. Did not consider depreciation: -1 point
c. Added back depreciation: -0.5 point

a. Tried to adjust cashflows for new depreciation: -1 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

a. Computed ROC incorrectly: -0.5 points


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

a. Used old cost of equity in computation: -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

a. Computed FCFE incorrectly: -1 point


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

a. FCFF computed incorrectly: -0.5 to -1 point

a. Did not compute new reinvestment rate: -1 point


b. Mechanical errors; -0.5 point each

eriod/ Reinvestment Rate

a. Discounted terminal value at wrong rate or for 4 years: -0.5 points


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

ue which was invested at the old cost of capital.

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%

Change in firm value =


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

! Since you are given next year's income, y


who did use it..

4%
40%
10.0%

c. New Return on equity =


New retention ratio =
Value of equity = 1500 = 100 (1-.3333)/(r - .04)
Solve for r
Cost of equity =
8.44%

12%
33.333%

! Don't forget to recompute the new payou

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.

x - Investment in old facility

from storage facility, since both


ave same book value)

! Only incremental revenues and operating income matter


! 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.

pon interest expenses and cost of borrowing

nancing would alter market value of existing debt.

plus given to those who sell their share back at 10.75/share

more in dividends over the entire period.


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.

is the same for

tal revenue (operating income)

ond effect will dominate.

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

a. One solution is to discount the pre-debt cashflows at 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 =

2 (in year 10)

Working capital (initial investment)=


Working capital salvage =
Correct Cashflows
Cashflow to firNet present value =

1.5 ! Negative cashflow in year 0


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

Debt = 30% of investment


3.5
-$3.45 (Debt creates cash inflow
when borrowed, and has
to be repaid at end)
$0.05

Market value of equity =


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

o set up a balance sheet.


structuring; D=10 and E = 60 after)

ty and discount at the cost

ebt = 30% of investment

Debt creates cash inflow


hen borrowed, and has
be repaid at end)

be the same as before.

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

! Any errors in the cashf

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 =

$2,787,301 ! - 20,000 + 5,000/1.09^10 + X(PVA


$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

Market value of equity =


Cost of equity =
Cost of capital =

$20.00
0.162
8.90%

1. Use wrong cost of deb


! Other math errors: -0

Cost of capital at optimal


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

! If you use the old cost

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

0.15 ! 60/400: : I also gave full credit if


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

! Since you began with o


! You have to add back c

ue of Business
If you use revenue weights: -1

Any errors in the cashfl

00 at end fo year 10 =
Forget salvage value: -1

,000/1.09^10 + X(PVA,

.50 (difference between

. Use wrong cost of debt


Other math errors: -0.

If you use the old cost o

Did you remember to tak

Did you switch to a 40%

Did you compute the cha


Did you show repayment

Did you consider the st

I did give you full cred

lso gave full credit if

Forget reinvestment (-1.


79.86 (1.03) ( 1 - 0.20

Since you began with op


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

b. Cost of equity for the firm =


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

On part a and b, the key question


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

I gave full credit even if you did c


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

$0.41 ! Depreciation * Tax rate


$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

The correct solution


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%

! Errors here mostly math

! If you forgot to reestimate the cost of equity, you lost a poin


! Wrong weights for debt and equity also cost a point

! With rational investors you have to multiply by the total num


! (.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

Most recent fi Previous year


110
100
44
40
100
78

Increase in cash balance =


Dividends paid by the firm =

22
44

Free Cashflows to Equity =


Net cap ex in most recent year =

66
44

! If you got net cap ex wrong, you lost a point

Estimates for the future


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

b. .85 = (1- ord tax rate)/ (1- cap gains rate)


.85 = (1- ord tax rate)/ (1-.2)
Ordinary tax rate =
32.00%

! Dividends are eliminated. If you continued to p


! Add the FCFE every year to the previous year'

! For some reason, if you inserted a dollar divide

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 =

! If you use average return on capital, you woul

10.00%

0.333333333
83.0544
1107.392

! A common error was not recomputing the rein


! 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

! I gave you full credit if you took your FCFF and


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.

net present value zero.

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

n tax benefit to the PV of EBIT. It is an approximate solution because the depreciation


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

enefit would be $0.04

e cost of equity, you lost a point


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.

cap ex wrong, you lost a point

eliminated. If you continued to project dividends, you lost a 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.

or was not recomputing the reinvestement rate = g/ ROC = 4/12 = 33.33%

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

hat the eventual beta


would be 10.2%. However
getting any tax benefits of

ve lost credit if you

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 unlevered bet


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%

b. New unlevered beta =


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

Firm value = 1500 = 100 (1- Reinvestment rate)/ (.10- .05)


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

Cost of debt = 10%

tire investment in computing NPV

nefit from depreciation to each year's cashflow

/ (Cost of capital after - Expected growth rate)

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

Debt for AT&T after merger =


Equity for AT&T after merger=

! =0.92/(1+(1-.4)(.12)) ! Use average D/E ratio duri


! =1.40/(1+(1-.4)(.25))
! Weighted average = 0.86 (300/400) + 1.22 (100/400)
125
275

New levered beta =

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 in firm value =


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

!
!
!
!

Before you issue new debt, this debt is trading at bo


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

Many of you tried to solve the problem by reestimatin


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

3 Term. year (4)


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

Use average D/E ratio duri

(300/400) + 1.22 (100/400)

if you counted only the se


nd 100 in five years)

bly creative in trying to co


Given the information in t

tax benefits that matters.

t, this debt is trading at bo


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

erm. year (4)

! Reinvestment Rate = g / ROC

! Terminal value in year 3= CF in year 4/(.09-.05)


! 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

Unlevered Beta of the firm after divestiture = (1.13 - 1.35*(10/50))/(40/50) =


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%

Unlevered Beta = 0.9/(1+0.6*(1/9)) =


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 firm value = 10000 (.09963 - .09138)/(.09138 - .05) =


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

c. If you overpay on the acquisition,


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

Non-Cash Working Capital

$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

Cash available for stock buybacks =

$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

y the growth rate.

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

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


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

nning of the year book value of equity

EVA
$
8.67
$
(20.83)
0.80749421
8.61%

tio at optimal)

ecify that you did so

Used industry average cap ex/deprciation in year 4.

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 =

0.1525 ! Since I did not give a premium, use a reas


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

Change in firm value =


Cost of Capital before the buyback =

11.40%

! The cost of equity (using the 5.5% premiu

Since no growth is given, I have taken the simpler assumption of no growth:


(.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

paid + Increase in cash balance = 500 + 250 =


(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.

give a premium, use a reasonable number

hat they sold their stock back at $ 44


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

uity (using the 5.5% premium) is the cost of capital

ax rate)/ (1- capital gains rate)

Cannot just assume a growth rate


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)

y understated. The beta will rise over time.

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

aid + new Debt issued)

t ratio of 25% and firm's after tax cost of debt of 4.8%

Use a stable growth rate; I used 6%.

Payout Ratio in stable growth=1 - .06/(.15+.25(.15-.048))


$

r 3 has to be zero

40.87

ave been inconsistent.)

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%

11.50% ! Assuming that betas given are levered betas


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

c. Value per Share = 0.46/1.1425+0.54/1.1425^2+(0.62+41.50)/1.1425^3 =

29.06

can use the short cut = Interest exp/ MV of debt = 70/850 =


payment debt.

seem to be affected by the $/DM rate.


! Beta fpr XLNT is unlevered

ROE = EPS/BV ofEquity = 2/10 = 20%

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) =

43.64% : Book Value of capital drops $ 50 m

Debt/Equity Ratio after buyback = 53.86/190 =


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 Unlevered Beta = 0.88 (.70) + 1.13 (.30) =


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

28.35% ! Market value of equity drops $ 50 m


10.00% ! Interest rate on debt is assumed no
15.00%
46.16%
69.87%

0.955
1.12

! It used to be 75% of $ 293.86 millio


! 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.

would also have given you credit if debt=60

0.0034

ent ROE = 48/100 = 48%


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.

Market value of equity drops $ 50 mil after buyback


nterest rate on debt is assumed not to change

t used to be 75% of $ 293.86 million.


Now it is = .75 * 293.86 million - 50 million
New Proportion = (.75*293.86-50)/(293.86-50)

e start of the year. If there

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

b. If the firm had financed its net capital


Net Income
$
100.00
- (CE-Dep) (1-)
$
8.00
- (Ch WC) (1-)
$
8.00
= FCFE
Dividends
Cash Balance
$
50.00

investment and working capital with 20% debt


$
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

2b. Ordinary Tax Rate = (0.3)(0.15) =


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

DDM Value = $0.71/(1.142*1.13375)+(1.13+33.90)/(1.142*1.13375*1.1255) =

24.59

12.66%

%-10% = 4.33%

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