MGFB10H3 Principles of Finance

Assignment 1
Valuation
Problem 1 Emma Li graduated from university five years ago with an undergraduate
degree in finance. Emma currently works as an investment analyst at a private equity firm.
Her annual salary at the firm is $70,000 per year, expected to increase at 2.5% per year until
retirement. She is currently 28 years old and expects to work for 40 more years. Her current
job includes a fully paid health insurance plan, and her current average tax rate is 26%.
Although Emma is satisfied with her current job, her goal is to advance to a more senior
management position. She feels that an MBA degree would allow her to achieve this goal.
Emma has a savings account with enough money to cover the entire cost of her MBA. After
examining schools, she has narrowed his choice to full-time MBA programs at the University
of Toronto and Queen’s University. Assume that other than internships, neither school will
allow its students to work while enrolled in the program.
University of Toronto is home to one of the top MBA programs in the country. The
MBA degree requires two years of full-time enrollment at the university. The annual tuition
is $46,270, payable at the beginning of each school year. Books and other supplies are
estimated to cost $3,000 per year. Emma expects that after graduation from University of
Toronto, she will receive a job offer for about $95,000 per year, with a $15,000 signing bonus
(lump sum of money paid upon joining the company). The salary at this job is expected
to increase at 4% per year. Because of the higher salary, her average income tax rate will
increase to 30%.
Queen’s University offers an accelerated, one-year program, with a tuition cost of $83,000
to be paid at the beginning of the school year. Books and other supplies for the program are
expected to cost $4,500. Emma thinks that she will receive an offer of $85,500 per year upon
graduation, with a $20,000 signing bonus. The salary at this job is expected to increase at
3.5% per year. Her average tax rate at this level of income will be 29%.
Emma also estimates that room and board expenses at both schools will cost $2,000 more
per year than her current living expenses, payable at the beginning of each year of studies.
Assume that the appropriate discount rate is 5%. Answer the following questions.

1. Emma has three choices: remain at the current job, pursue a University of Toronto
MBA, or pursue a Queen’s University MBA. Assuming all salaries are paid at the end
of each year, which is the best option for Emma – from a strictly financial standpoint?
(1.5 points)

2. Emma believes that the appropriate analysis is to calculate the future value of each
option. Do you agree with this statement? Explain. (0.5 points)

3. You were asked to assume a particular discount rate for your calculations. In your
opinion, what factors need to be considered when determining the proper discount
rate for financial planning decisions like the MBA decision? (1 point)

1
Problem 2 Emma Li successfully finished her MBA and now works as the CFO of the
Great Lake Industries, a manufacturer of snowmobiles, all-terrain vehicles (ATVs), and
neighborhood electric vehicles. To this point, the company has used outside suppliers for
various key components of the company’s vehicles, including engines. Emma has decided
that Great Lake Industries should consider the purchase of an engine manufacturer to allow
it to better integrate its supply chain and get more control over engine features. After
investigating several possible companies, Emma feels that the purchase of Polaris Engines
Inc. is a possibility. She has asked you to analyze Polaris’s value.
Polaris Engines Inc. was founded some years ago by a brother and sister, Richard and
Kelly Polaris, and has remained a privately owned company. The company manufactures
engines for a variety of applications. Polaris has experienced rapid growth because of a
proprietary technology that increases the fuel efficiency of its engines with very little sacrifice
in performance. The company is equally owned by Richard and Kelly. The original agreement
between the siblings gave each 75,000 shares of stock.
Emma asked you to value Polaris stock. To accomplish this, you have gathered the
following information about some of Polaris’s competitors that are publicly traded:
EPS DPS Price ROE r
Blue Motors Corp. $1.19 $0.19 $16.32 10.00% 12.00%
Continental Motors Inc. 1.26 0.55 13.94 12.00 17.00
Nautilus Engines -0.27 0.57 23.97 N/A 13.00
Industry average $0.73 $0.44 $18.08 11.00% 14.00%
Nautilus Engines’ negative EPS was the result of an accounting write-off last year. With-
out the write-off, EPS for the company would have been $2.07. Last year, Polaris had an
EPS of $5.35 and paid a dividend to Richard and Kelly of $160,000 each. The company also
had an ROE of 21%. Emma tells you that the required return for Polaris is 18%.
1. Assuming the company continues its current growth rate, what is the value per share
of the company’s stock? (0.5 points)
2. Although Polaris currently has a technological advantage, your research indicates that
Polaris’s competitors are investigating other methods to improve efficiency. Given this,
you believe that Polaris’s technological advantage will last only for the next five years.
After that period, the company’s growth will likely slow to the industry average. Addi-
tionally, you believe that the required return the company uses is too high. You believe
the industry average required return is more appropriate. Under these assumptions,
what is the estimated stock price? (1.5 points)
3. What is the industry average P/E ratio? What is Polaris’s P/E ratio? Comment on
any differences and explain why they may exist. (1 point)
4. Assume the company’s growth rate slows to the industry average after five years. What
future ROE does this imply? What percentage of the stock’s value is attributable to
growth opportunities? (1 point)