Cases in Financial Management

MS A&F

Teacher: Dr. Zeeshan Ghafoor

Case 1 (25 Marks)

Mandy Herr, an investment analyst, at Crimson Investment Management (CIM) is currently

following technology stocks. Herr works with her supervisor, Jeremy Sparks, a portfolio
manager for institutional investors, to determine appropriate investments for their clients. Herr is
tracking the stock of Crown Technologies (CT), a well-known competitor in the industry. She
has compiled the following information about the stock.

Exhibit 1
Year EPS ($) DPS ($)
2003 3.75 1.5
2004 4.68 1.6
2005 4.70 1.4
2006 4.50 1.5
2007 4.43 1.5

While gathering information about Crown Technologies, Herr figured out that the company has
experienced a significant shift from equity to debt financing last year. This year the CEO plans to
issue a significant amount of equity to replace debt in its current capital structure. Herr found the
financial statements of the firm difficult to interpret because of the poor quality of accounting
disclosures. In addition, many items not presented in the financial statements were excluded
from the footnotes as well.

Herr is also evaluating the stock of Paper and Plastic Manufacturing Company Limited
(PPMCL). She has compiled the following information for her analysis:
 PPMCL’s EPS for the current year was $3.67.
 PPMCL’s dividend policy is to maintain the dividend payout ratio at 40%.
Based on the firm’s pro-forma financial statements, expected long-term growth rate in
earnings is going to be 6.5%.
 For the next three years, the company is expected to experience growth rates of 11%, 9%,
and 10% respectively, after which earnings are expected to grow at their long-term
estimated growth rate.
 The company’s beta relative to the local stock index is 1.2 and the market risk premium
is 5.5%.
 The U.S. Treasury rate is 3.75%.
 The current market price of the stock is $43.56.
Sparks is estimating the value of Petroleum Exploration Limited (PEL) stock. The company
earned an EPS of $5.12 and paid dividends of $2.34 over the past year. Based on his analysis,
Sparks estimates that the long-term earnings and dividend growth rate for the firm is 5.5%. The
current market price of the stock is $65.78. Sparks’ estimate of the required rate of return for the
stock is 12%.
Sparks has also been following a non-cyclical stock with a market price of $78.05. The stock has
earned an average EPS of $1.56 over the past five years, and is expected to earn a similar amount
in the foreseeable future. The stock’s beta is 1.13, the market risk premium is 5.5% and the risk
free rate is 4%.
During lunch hours, Herr and Sparks discussed the appropriateness of the dividend discount
valuation model for valuation purposes. Herr made the following comments:

Statement 1: “The Gordon Growth Model is appropriate to use when growth rate is less than
the required rate of return. The model also accommodates the possibility of
negative growth rates.”

Statement 2: “If the DDM model is correctly applied, it is an appropriate approach for common
stock valuation, even if the company being analyzed engages in share
repurchases.”

Questions
1) Given the information about Crown Technologies, which of the following valuation
models
is most appropriate to value CT’s stock?

 Dividend Discount Valuation Model.

 FCFF Valuation Model.
 Residual Income Valuation Model.
Also provide the reasoning.
2) Herr’s estimate of the value of PPMCL’s stock should be closest to?
3) The expected rate of return and dividend yield for PEL’s stock is closest to?
4) The no-growth P/E and the growth P/E for the non-cyclical stock are closest to?
5) Which statement of Herr is least accurate and why?
Case 2 (25 Marks)
Adam Frink is a senior financial analyst at the MultiVest Group, the largest privately held group
in the United States. The group is considering making a number of investments in various
projects in the near future. Details on each project are provided below.

Private Power Plant:

The idea of private power plant has been revoked by the board as expensive and unnecessary.
Nonetheless, the CEO directed the analyst division to draft a feasibility report of the project.
Exhibit 1 displays the NPV profile of a privately held wind operated power plant.

Y-axis: NPV values

X-axis: Discount rate

An increase in the agricultural budget and consequential increase in demand has motivated the
board to vote in favor of an expansion of the current fertilizer facility. The project has been
named Hexa and is projected over a four-year timeframe. The tax rate applicable to this division
is 28%. The summarized financial information related to the project is presented in Exhibit 2.
Automobile Division: (Parts 4-6 address the automobile division of the MultiVest Group. )

Most of the equipment in the automobile division is outdated and obsolete. The board recognizes
the serious need to invest in the latest technology to deliver an exceptional product. This
replacement has been named the Deca project and is due to commence from 1st January, 2011.
The tax rate applicable to this division is 28%. The summarized information available for this
project is presented in Exhibit 3.

With regards to the replacement projects, Adam made the following statements:

Statement 1: Cash flow analysis of replacement projects is comparatively less complicated than
the cashflow analysis of simpler expansion projects.
Statement 2: It is unnecessary to estimate incremental cash flows by comparing the cash flows
that occur with the new investment to the cash flows that would have occurred without the new
investment especially when new equipment has more capacity or is less costly.
Questions
1) The IRR of the power plant project is most likely?
2) The incremental after-tax operating cash flows from project Hexa are closest to?
3) The total termination year after-tax cash flow from the fertilizer division is closest to?
4) The initial outlay for project Deca is closest to?
5) The total after-tax operating cash flow from the automobile division, once project Deca is
initiated will be closest to?
6) Adam is least likely with respect to which of his statement?