1. ABC Incorporated shares are currently trading for $32 per share. The firm has 1.

1.13 billion shares

outstanding. In addition, the market value of the firm’s outstanding debt is $2 billion. The 10-year
Treasury bond rate is 6.25%. ABC has an outstanding credit record and has earned an AAA rating
from the major credit rating agencies. The current interest rate on AAA corporate bonds is 6.45%. The
historical risk premium for stocks over the risk-free rate of return is 5.5 percentage points. The firm’s
beta is estimated to be 1.1 and its marginal tax rate, including federal, state, and local taxes is 40%.

a. What is the cost of equity?

b. What is the after-tax cost of debt?
c. What is the cost of capital?

2. HiFlyer Corporation does not currently have any debt. Its tax rate is .4 and its unlevered beta is
estimated by examining comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25%
and the historical risk premium over the risk free rate is 5.5%. Next year, HiFlyer expects to borrow up
to 75% of its equity value to fund future growth.

a. Calculate the firm’s current cost of equity.

b. Estimate the firm’s cost of equity after it increases its leverage to 75% of equity?

3. Abbreviated financial statements are given for Fletcher Corporation in the following table:
2010 2011
Revenues $600.0 $690.0
Operating expenses 520.0 600.0
Depreciation 16.0 18.0
Earnings before 64.0 72.0
interest and taxes
Less Interest Expense 5.0 5.0
Less: Taxes 23.6 26.8
Equals: Net income 35.4 40.2
Addendum:
Yearend working 150 200
capital
Principal repayment 25.0 25.0
Capital expenditures 20 10

Yearend working capital in 2009 was $160 million and the firm’s marginal tax rate is 40% in both
2010 and 2011. Estimate the following for 2010 and 2011:
a. Free cash flow to equity.
b. Free cash flow to the firm.

4. No Growth Incorporated had operating income before interest and taxes in 2011 of $220 million. The
firm was expected to generate this level of operating income indefinitely. The firm had depreciation
expense of $10 million that same year. Capital spending totaled $20 million during 2011. At the end of
2010 and 2011, working capital totaled $70 and $80 million, respectively. The firm’s combined
marginal state, local, and federal tax rate was 40% and its debt outstanding had a market value of $1.2
billion. The 10-year Treasury bond rate is 5% and the borrowing rate for companies exhibiting levels
of creditworthiness similar to No Growth is 7%. The historical risk premium for stocks over the risk
free rate of return is 5.5%. No Growth’s beta was estimated to be 1.0. The firm had 2,500,000
common shares outstanding at the end of 2011. No Growth’s target debt to total capital ratio is 30%.

a. Estimate free cash flow to the firm in 2011.

b. Estimate the firm’s cost of capital.
c. Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011,
assuming that it will generate the value of free cash flow estimated in (a) indefinitely.
d. Estimate the value of the equity of the firm at the end of 2011.
e. Estimate the value per share at the end of 2011.

5. Carlisle Enterprises, a specialty pharmaceutical manufacturer, has been losing market share for three
years since several key patents have expired. The free cash flow to the firm in 2002 was $10 million.
 This figure is expected to decline rapidly as more competitive generic drugs enter the market.
Projected cash flows for the next five years are $8.5 million, $7.0 million, $5 million, $2.0 million, and
$.5 million. Cash flow after the fifth year is expected to be negligible. The firm’s board has decided to
sell the firm to a larger pharmaceutical company interested in using Carlisle’s product offering to fill
gaps in its own product offering until it can develop similar drugs. Carlisle’s cost of capital is 15%.
What purchase price must Carlisle obtain to earn its cost of capital?

6. Ergo Unlimited current year’s free cash flow is $10 million. It is projected to grow at 20% per year for
the next five years. It is expected to grow at a more modest 5% beyond the fifth year. The firm
estimates that its cost of capital is 12% during the next five years and then will drop to 10% beyond the
fifth year as the business matures. Estimate the firm’s current market value.

7. In the year in which it intends to go public, a firm has revenues of $20 million and net income after
taxes of $2 million. The firm has no debt, and revenue is expected to grow at 20% annually for the next
five years and 5% annually thereafter. Net profit margins are expected remain constant throughout.
Capital expenditures are expected to grow in line with depreciation and working capital requirements
are minimal. The average beta of a publicly traded company in this industry is 1.50 and the average
debt/equity ratio is 20%. The firm is managed very conservatively and does not intend to borrow
through the foreseeable future. The Treasury bond rate is 6% and the tax rate is 40%. The normal
spread between the return on stocks and the risk-free rate of return is believed to be 5.5%. Reflecting
the slower growth rate in the sixth year and beyond, the firm’s discount rate is expected to decline to
the industry average cost of capital of 10.4%. Estimate the value of the firm’s equity.

8. The following information is available for two different common stocks: company A and
Company B.

Company A Company B

Free cash flow per $1.00 $5.00

share in the current
year

Growth rate in cash 8% 4%

flow per share

Beta 1.3 .8

Risk-free return 7% 7%

Expected return on all 13.5% 13.5%

stocks

a. Estimate the cost of equity for each firm.

b. Assume that the companies’ growth rates will continue at the same rate indefinitely.
Estimate the per share value of each companies common stock.

9. You have been asked to estimate the beta of a high-technology firm, which has three
divisions with the following characteristics.

Division Beta Market Value

 Personal Computers 1.6 $100 million
Software 2.00 $150 million
Computer 1.2 $250 million
Mainframes

a. What is the beta of the equity of the firm?

b. If the risk-free return is 5% and the spread between the return on all stocks is 5.5%,
estimate the cost of equity for the software division?
c. What is the cost of equity for the entire firm?
d. Free cash flow to equity investors in the current year (FCFE) for the entire firm is
$7.4 million

and for the software division is $3.1 million. If the total firm and the software
division are

expected to grow at the same 8% rate into the foreseeable future, estimate the
market value of the

firm and of the software division.

10. Financial Corporation wants to acquire Great Western Inc. Financial has estimated the enterprise value
of Great Western at $104 million. The market value of Great Western’s long-term debt is $15 million,
and cash balances in excess of the firm’s normal working capital requirements are $3 million.
Financial estimates the present value of certain licenses that Great Western is not currently using to be
$4 million. Great Western is the defendant in several outstanding lawsuits. Financial Corporation’s
legal department estimates the potential future cost of this litigation to be $3 million, with an estimated
present value of $2.5 million. Great Western has 2 million common shares outstanding. What is the
value of Great Western per common share?