Principles of Finance

HEC Lausanne Solution 6 December 2, 2019

Problem 1
Shake Shack currently has 1 million outstanding shares and expects earnings of $6 million in
the coming year.

a) Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings
as a dividend. With these expectations of no growth, Shake Shacks current share price is
$60. Compute the equity cost of capital of Shake Shack in the no growth scenario.

b) Suppose the company will pay a dividend of $5 per share in the coming year. Its equity
cost of capital is 10% and you expect its dividend to grow at a rate of about 4% per
year, though you are somewhat unsure of the precise growth rate. If Shake Shack’s stock
is currently trading for $71.43 per share, what is the market expectation about Shake
Shack’s dividend growth rate?

c) Suppose Shake Shack could cut its dividend payout rate to 75% for the foreseeable future
and use the retained earnings to open new stores. The return on its investment in these
stores is expected to be 12%. Assuming its equity cost of capital is unchanged, what effect
would this new policy have on Shake Shacks stock price?

d) The management believes that the Shake Shack’s stock price is trading for a discount to
its intrinsic value and decides to use 30% of its earnings to repurchase shares and another
10% to pay a dividend. If the company’s earnings are expected to grow by 5% per year
and these payout rates remain constant, determine Shake Shack’s share price assuming
its equity cost of capital is unchanged.

Solution
a) The EPS of Shake Shack is: $6 million / 1 million shares = $6. The firm plans to pay a
dividend equal to its earnings of $6 per share. From the constant dividend growth model:

Div1
P0 =
rE − g
Rearranging terms, we have:

Div1 6
rE = +g = + 0 = 10%
P0 60
b) If we apply the constant dividend growth model based on a 4% growth rate, we would
estimate a stock price of
Div1 5
P0 = = = $83.33.
rE − g 0.1 − 0.04

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 Principles of Finance
HEC Lausanne Solution 6 December 2, 2019

The market price of $71.43, however implies that most investors expect dividends to grow
at a somewhat slower rate. If we continue to assume a constant growth rate, we can solve
for the growth rate consistent with the current market price as follows:
Div1 5
g = rE − = 10% − = 3%
P0 71.43
Thus, the market expects a dividend growth rate of 3% for Shake Shack.

c) If Shake Shack reduces its dividend payout rate to 75%, then its dividend this coming
year will fall to:

Div1 = EP S1 · Dividend Payout Rate1 = 6 · 75% = $4.5

At the same time, because the firm will now retain 25% of its earnings to invest in new
stores, its growth rate will increase to:

g = Retention Rate · Return on New Investments = 25% · 12% = 3%

Assuming Shake Shack can continue to grow at this rate, we can compute its share price
under the new policy using the constant dividend growth model:

Div1 $4.5
P0 = = = $64.29.
rE − g 10% − 3%

Thus, Shake Shacks share price should rise from $60 to $64.29 if the company cuts its
dividend to invest in projects that offer a return greater than their cost of capital.

d) Shake Shack’s total payouts will be:

Tot. Payouts = 40% · $6 million = $2.4 million

Based on the equity cost of capital of 10% and an expected growth rate of 5%, the present
value of Shake Shack’s future payouts can be computed as a constant growth perpetuity:

$2.4 million
P V (Future Tot. Payouts) = = $48 million.
0.1 − 0.05
This present value represents the total value of Shake Shack’s equity. To compute the
share price, we divide it by the current number of outstanding shares:

P V (Future Tot. Payouts) $48 million

P0 = = = $48.
# Shares Outstanding 1 million

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 Principles of Finance
HEC Lausanne Solution 6 December 2, 2019

Problem 2
Under Armour (UAA) had sales of $518 million in 2005. Suppose you expect its sales to
grow at a 9% rate in 2006, but that this growth rate will slow by 1% per year to a long-
run growth rate for the apparel industry of 4% by 2011. Based on UAA’s past profitability
and investments needs, you expect EBIT to be 9% of sales, increases in net working capital
requirements to be 10% of any increase in sales, and net investments (capex in excess of
depreciation) to be 8% of any increase in sales. KCP also has $100 million in cash, $3 million
in debt, 21 million shares outstanding, a tax rate of 37%, and a weighted average cost of
capital of 11%.

a) What is your estimate of the value of UAA’s stock in early 2006?

b) How would your estimate of the stock’s value change if you expected revenue growth of
4% from 2006 on? How would it change if in addition you expected EBIT to be 7% of
sales, rather than 9%?

Solution
a) We can estimate UAA’s future free cash flow based on the estimates above as follows:

FCF Forecast ($ millions) 2005 2006 2007 2008 2009 2010 2011
Sales 518 564.6 609.8 652.5 691.6 726.2 755.3
Growth vs Prior Year 9% 8% 7% 6% 5% 4%
EBIT (9% of sales) 50.8 54.9 58.7 62.2 65.4 68
Less: Income Tax (37% EBIT) -18.8 -20.3 -21.7 -23 -24.2 -25.1
Less: Net Investment (8% ∆sales) -3.7 -3.6 -3.4 -3.1 -2.8 -2.3
Less: ∆NWC (10% ∆sales) -4.7 -4.5 -4.3 -3.9 -3.5 -2.9
Free Cash Flow 23.6 26.4 29.3 32.2 35 37.6

Because we expect UAA’s free cash flow to grow at a constant rate after 2011, we can
compute a terminal enterprise value as follows:
 
1 + gF CF
V2011 = · F CF2011
rwacc − gF CF
 
1.04
= · 37.6 = $558.6 million.
0.11 − 0.04
UAA’s current enterprise value is the present value of its free cash flows plus the terminal
enterprise value:
23.6 26.4 29.3 32.2 35 37.6 + 558.6
V0 = + 2
+ 3
+ 4
+ 5
+
1.11 1.11 1.11 1.11 1.11 1.116
= $424.8 million.

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 Principles of Finance
HEC Lausanne Solution 6 December 2, 2019

We can now estimate the value of a share of UAA’s stock:

V0 + Cash0 − Debt0 424.8 + 100 − 3

P0 = = = $24.85.
# Shares Outstanding0 21

b) With 4% revenue growth and a 9% EBIT margin, UAA will have 2006 revenues of 518 ·
1.04 = $538.7 million, and EBIT of 9% · 538.7 = $48.5 million. Given the increase in sales
of 538.7 − 518 = $20.7 million, we expect net investment of 9% · 20.7 = $1.7 million and
additional net working capital of 10% · 20.7 = $2.1 million. Thus, UAA’s expected FCF
in 2006 is:
F CF06 = 48.5 · (1 − 0.37) − 1.7 − 2.1 = $26.8 million.
Because growth is expected to remain constant at 4%, we can estimate UAA’s enterprise
value as a growing perpetuity:

$26.8
V0 = = $383 million.
0.11 − 0.04
for an initial share value of P0 = (383 + 100 − 3)/21 = $22.86. Thus, we see that a higher
initial revenue growth of 9% versus 4% contributes about $2 to the value of UAA’s stock.

c) If, in addition, we expect UAA’s EBIT margin to be only 7%, our FCF estimate would
decline to:

F CF06 = (0.07 · 538.7) · (1 − 0.37) − 1.7 − 2.1 = $20 million.

for an enterprise value of of V0 = $20/(0.11 − 0.04) = $286 million and a share value of
P0 = (286+100−3)/21 = $18.24. Thus, a 2% drop in the EBIT margin causes a reduction
of $4.5 in the estimate of UAA’s stock value.

Problem 3
A firm can be worth $100 million (with 20% probability), $200 million (with 60% probability),
or $300 million (with 20% probability). The firm has one senior bond outstanding, promising
to pay $80 million. It also has one junior bond outstanding, promising to pay $70 million.
The senior bond promises an interest rate of 5%. The junior bond promises an interest rate
of 26%. If the firms projects require an appropriate cost of capital of 10%, then what is the
firms levered equity cost of capital?

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 Principles of Finance
HEC Lausanne Solution 6 December 2, 2019