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6-Chp 13 & 14 & 15-Solution

Financial Analysis & Valuation (University of Southern California)

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Chapter 13 & 14 & 15 (Choosing the Right Model-Dividend Model /FCFE

model/ FCFF Models)

Scenario 1: Ameritech Corporation paid dividends per share of $3.56 in 1992, and dividends are
expected to grow 5.5% a year forever. The stock has a beta of 0.90, and the treasury bond rate is
6.25% and the equity risk premium is 5.5%.

1) Use Scenario 1: What is the value per share, using the Gordon Growth Model?
A) $78.55
B) $72.80
C) $65.89
D) $60.80
E) $55.47

Solution: C
Cost of Equity = 6.25% + 0.90 * 5.5% = 11.20%
Value Per Share = $3.56 * 1.055/(0.1120 - 0.055) = $65.89

2) Use Scenario 1: The stock is trading for $80 per share. What would the growth rate in
dividends have to be to justify this price?
A) 3.65%
B) 6.46%
C) 5.84%
D) 4.86%
E) 5.19%

Solution: B
$3.56 (1 + g)/(.1120 - g) = $80
Solving for g,
g = (80 * .112 - 3.56)/(80 + 3.56) = 6.46%

3) Church & Dwight, a large producer of sodium bicarbonate, reported earnings per share of
$1.50 in 1993 and paid dividends per share of $0.42. In 1993, the firm also reported the
following:
Net Income = $30 million
Interest Expense = $0.8 million
Book Value of Debt = $7.6 million
Book Value of Equity = $160 million

The firm faced a corporate tax rate of 38.5%. The market value debt-to -equity ratio is 5%. The
Treasury bond rate is 7%. The equity risk premium is 5.5%.

The firm expects to maintain these financial fundamentals from 1994 to 1998, at which time it is
expected to become a stable firm, with an earnings growth rate of 6%. The firm's financial
characteristics will approach industry averages after 1998. The industry averages are as follows:
1

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Return on Assets = 12.5%

Debt/Equity Ratio = 25%
Interest Rate on Debt = 7%

Church & Dwight had a beta of 0.85 in 1993, and the unlevered beta is not expected to change
over time. What is the value of the stock in year 1993, using the two-stage dividend discount
model?
A) $14.62
B) $17.50
C) $16.74
D) $15.59
E) $18.47

Solution: E
Current (year 1993):
Retention Ratio = 1 - Payout Ratio = 1-(Dividend per share/EPS) = 1 - 0.42/1.50 = 72%
ROE = NI/Equity = 30/160 = 0.1875 = 18.75%

Given: Beta in 1993 = 0.85; MV Debt / MV Equity = 5%; and tax rate = 38.5% and rf =7%
and Equity risk premium = 5.5%
Unlevered Beta = 0.85/(1 + (1 - 0.385) * 0.05) = 0.8246

High growth period (between 1994-1998):

Since firm is expected to maintain the fundamentals from 1994 to 1998, we can assume the
below.
Expected retention ratio = Current retention ratio = 72%
Expected payout ratio = 1-0.72= 28%
Expected ROE = current ROE = 18.75%
Expected Growth Rate = expected Retention ratio * expected ROE = 0.72 * .1875 = 13.5%

Given beta is constant from the current year, we can assume beta = 0.85.
Cost of Equity in 1999 = 7% + 0.85 * 5.5% = 11.68%

Stable growth period (in 1999 and after):

Given: g = 6% and unlevered beta is constant from prior years.
Given: ROC =12.5 ; D/E = 25%; rd = 7%; and tax rate = 38.5%. These are at the industry
averages.
𝒈 𝒈
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒑𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = 𝟏 − 𝒓𝒆𝒕𝒆𝒏𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒊𝒐 = 𝟏 − =𝟏−
𝑹𝑶𝑬 𝑫
[𝑹𝑶𝑪 + 𝑬 (𝑹𝑶𝑪 − 𝒊(𝟏 − 𝒕))]
𝟎. 𝟎𝟔
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒑𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = 𝟏 − = 𝟓𝟖. 𝟕𝟔%
[𝟎. 𝟏𝟐𝟓 + 𝟎. 𝟐𝟓(𝟎. 𝟏𝟐𝟓 − 𝟎. 𝟎𝟕(𝟏 − 𝟎. 𝟑𝟖𝟓))]

Beta = 0.8246 * (1 + (1 - 0.385) * 0.25) = 0.95

Cost of Equity = 7% + 0.95 * 5.5% = 12.23%

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PV of Cash Flows:
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝟏𝟗𝟗𝟗
𝑻𝑽𝟏𝟗𝟗𝟖 =
𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚𝒔𝒕𝒂𝒃𝒍𝒆 − 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆𝒔𝒕𝒂𝒃𝒍𝒆
𝑬𝑷𝑺𝟏𝟗𝟗𝟗 ∗ 𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐𝒔𝒕𝒂𝒃𝒍𝒆
=
𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚𝒔𝒕𝒂𝒃𝒍𝒆 − 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆𝒔𝒕𝒂𝒃𝒍𝒆
(𝟏. 𝟓𝟎 ∗ 𝟏. 𝟏𝟑𝟓𝟓 ∗ 𝟏. 𝟎𝟔) ∗ 𝟎. 𝟓𝟖𝟕𝟔
𝑻𝑽𝟏𝟗𝟗𝟖 = = $𝟐𝟖. 𝟐𝟓
𝟎. 𝟏𝟐𝟐𝟑 − 𝟎. 𝟎𝟔

YEAR EPS DPS

Current $1.50
1994 $1.70 $1.50*1.135 $0.48 $1.70*0.28
1995 $1.93 $1.70*1.135 $0.54 $1.93*0.28
1996 $2.19 $1.93*1.135 $0.61 $2.19*0.28
1997 $2.49 $2.19*1.135 $0.70 $2.49*0.28
1998 $2.83 $2.49*1.135 $0.79 $2.83*0.28 TV = $28.25

We will discount all the cash flows using high growth period cost of equity 11.68%.
CF0=0 CF1 =0.48 CF2=0.54 CF3=0.61 CF4=0.70 CF5=0.79+28.25=29.04 I/Y = 11.68
COMPUTE NPV=? = $18.47 = PV in 1993

OR you can use growing annuity formula to compute the PV.

(𝟏 + 𝒈𝒉 )𝒏
(𝟏 − )
(𝟏 + 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚)𝒏
𝑷𝑽𝟎 𝒈𝒓𝒐𝒘𝒊𝒏𝒈 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 = 𝑪𝑭𝟏
𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝒈𝒉

𝟏. 𝟏𝟑𝟓𝟓
(𝟏 −)
𝟏. 𝟏𝟏𝟔𝟖𝟓
𝑷𝑽 𝒐𝒇 𝒈𝒓𝒐𝒘𝒊𝒏𝒈 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 = 𝟎. 𝟒𝟖 = $𝟐. 𝟐𝟐𝟎𝟐
𝟎. 𝟏𝟏𝟔𝟖 − 𝟎. 𝟏𝟑𝟓

PV of terminal value = 28.25/(1.1168^5) = 16.2608

PV = 2.2202 + 16.2608 = $18.48

4) Medtronic Inc., the world's largest manufacturer of implantable biomedical devices, reported
earnings per share in 1993 of $3.95 and paid dividends per share of $0.68. Its earnings are
expected to grow 16% from 1994 to 1998, but the growth rate is expected to decline each year
after that to a stable growth rate of 6% in 2003. The payout ratio is expected to remain
unchanged from 1994 to 1998, after which it will increase each year to reach 60% in steady state.
The stock is expected to have a beta of 1.25 from 1994 to 1998, after which the beta will decline
each year to reach 1.00 by the time the firm becomes stable (the Treasury bond rate is 6.25%).
Assuming that the growth rate and beta declines linearly (and the payout ratio increases linearly)
from 1999 to 2003, estimate the value per share in 1993, using the three-stage dividend discount
model. Assume the equity risk premium is 5.5%.
A) $147.55
B) $155.80
C) $133.62

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D) $120.00
E) $115.53

Solution: A

High growth period (years 1 (1994) through 5 (1998)):

Growth in EPS = 16%
Payout ratio = Dividend per share / Earnings per share = 0.68 / 3.95 = 17.22%
Beta = 1.25

Cost of equity = 0.0625 + (1.25) (0.055) = 13.13%

Stable Period (after year 10 (2003)):

Growth rate = 6%
Payout ratio = 60%
Beta =1

Cost of equity = 0.0625 + (1) (0.055) = 11.75%

Transition Phase (years 1999 through 2003):

Linear decline per year for growth rate = (16 – 6) /5 =2%
Linear increase per year for payout ratio = (60 – 17.22) /5 =8.556%
Linear decline per year for beta = (1.25 - 1)/5=0.05

DPS = Cumulative
payout Cost of
Year EPS g (EPS*payout Beta discount PV
ratio equity
ratio) rates
Current $3.95 $0.68 17.2%
1994 $4.58 16% $0.79 17.2% 1.25 13.13% 1.13 $0.70
1995 $5.32 16% $0.92 17.2% 1.25 13.13% 1.28 $0.72
1996 $6.17 16% $1.06 17.2% 1.25 13.13% 1.45 $0.73
1997 $7.15 16% $1.23 17.2% 1.25 13.13% 1.64 $0.75
1998 $8.30 16% $1.43 17.2% 1.25 13.13% 1.85 $0.77
1999 $9.46 14% $2.44 25.8% 1.20 12.85% 2.09 $1.17
2000 $10.59 12% $3.64 34.3% 1.15 12.58% 2.35 $1.55
2001 $11.65 10% $5.00 42.9% 1.10 12.30% 2.64 $1.89
2002 $12.58 8% $6.47 51.4% 1.05 12.03% 2.96 $2.19
2003 $13.34 6% $8.00 60.0% 1.00 11.75% 3.31 $2.42
2003 TV $147.55 11.75% 3.31 $44.59
SUM $57.47

Year How did we calculate Cumulative Discount rate?

Current
1994 (1.1313)^1
1995 (1.1313)^2

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1996 (1.1313)^3
1997 (1.1313)^4
1998 (1.1313)^5
1999 (1.1313)^5 * (1.1285)
2000 (1.1313)^5 * (1.1285)*(1.1258)
2001 (1.1313)^5 * (1.1285)*(1.1258)*(1.1230)
2002 (1.1313)^5 * (1.1285)*(1.1258)*(1.1230)*(1.1203)
2003 (1.1313)^5 * (1.1285)*(1.1258)*(1.1230)*(1.1203)*(1.1175)

TV2003 = EPS2003 * (1+growth stable period) *(payout ratio stable period)/ (cost of capital stable period –
growth stable period) = ($13.34 * 1.06 * 0.60)/(.1175 - .06) = $147.55

5) Yuletide Inc. is a manufacturer of Christmas ornaments. The firm earned $100 million last
year and paid out 20% of its earnings as dividends. The firm has also bought back $180 million
of stock over the past 4 years in varying amounts in each year. The firm is in stable growth,
expects to grow 5% a year in perpetuity, and has a cost of equity of 12%. If the dividend payout
ratio is modified to include stock buybacks, what is the value of equity (stock price)? Use
dividend discount model.
A) $790 million
B) $847 million
C) $1250 million
D) $998 million
E) $975 million

Solution: E
Dividends = $ 20 million
Average annual stock buyback = 180/4 = $ 45 million
Modified dividends = $20 million + $45 million = $ 65 million
Value of equity = 65 (1.05)/(.12-.05) = $ 975 million

6) Newell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported

earnings per share of $2.10 in 1993, on which it paid dividends per share of $0.69. The current
return on equity is 22.34%. The return on equity and dividend payout ratio is expected to remain
unchanged from 1994 to 1998. After 1998, the earnings growth rate is expected to drop to a
stable 6%, and the ROE is expected to drop to 3.64%. The firm has a beta of 1.40 currently, and
it is expected to have a beta of 1.10 after 1998. The Treasury bond rate is 6.25% and the equity
risk premium is 5.5%. What is the value of the stock in 1993, using the two-stage dividend
discount model?
A) $55.00
B) $18.35
C) $46.68
D) $27.59
E) $35.47

Solution: D

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CURRENT:
Given: beta= 1.40, rf= 6.25%, ERP=5.5%, EPS= 2.10; DPS=0.69; ROE= 22.34% (expected
to stay constant over the high growth period), payout ratio is expected to stay constant over
the high growth period

Current Payout ratio = DPS/EPS= 0.69/2.10= 32.86%

Current Retention ratio= 1- payout ratio= 1-0.3286= 0.6714 =67.14%

HIGH GROWTH:
Expected retention ratio= current retention ratio= 67.14%
Expected ROE = current ROE 22.34%
Expected growth rate= expected ROE*expected retention ratio= 0.2234*0.6714 = 0.15 =
15%

Beta= 1.40 same as current beta

Cost of equity= rf+ (beta) (ERP)= 6.25% + (1.40)*(5.5%)= 13.95%

STABLE PERIOD GROWTH:

Given: Growth rate= 6% ; ROE declines to 3.64%, beta= 1.10

Payout ratio= 1- g/ROE = 1- (0.06/0.0364)= 0.65 = 65%

Cost of equity = 6.25% + (1.10)*(5.5%)= 12.30%

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝟏𝟗𝟗𝟗 𝑬𝑷𝑺𝟏𝟗𝟗𝟗 ∗ 𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐𝒔𝒕𝒂𝒃𝒍𝒆
𝑻𝑽𝟏𝟗𝟗𝟖 = =
𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚𝒔𝒕𝒂𝒃𝒍𝒆 − 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆𝒔𝒕𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚𝒔𝒕𝒂𝒃𝒍𝒆 − 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆𝒔𝒕𝒂𝒃𝒍𝒆

(𝟐. 𝟏𝟎 ∗ 𝟏. 𝟏𝟓𝟓 ∗ 𝟏. 𝟎𝟔) ∗ 𝟎. 𝟔𝟓

𝑻𝑽𝟏𝟗𝟗𝟖 = = $𝟒𝟔. 𝟏𝟗
𝟎. 𝟏𝟐𝟑𝟎 − 𝟎. 𝟎𝟔

growth in
YEAR EPS EPS DPS payout
Current $2.10 $0.69 $2.10*0.3286
1994 $2.42 $2.10*1.15 $0.79 $2.42*0.3286
1995 $2.78 $2.42*1.15 $0.91 $2.78*0.3286
1996 $3.19 $2.78*1.15 $1.05 $3.19*0.3286
1997 $3.67 $3.19*1.15 $1.21 $3.67*0.3286
1998 $4.22 $3.67*1.15 $1.39 $4.22*0.3286 TV = $46.19

We will discount all the cash flows using high growth period cost of equity 13.95%.
CF0=0 CF1 =0.79 CF2=0.91 CF3=1.05 CF4=1.21 CF5=1.39+46.19= I/Y = 13.95 COMPUTE
NPV=? = $27.59 = PV in year 1993

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(𝟏 + 𝒈𝒉 )𝒏
(𝟏 − )
(𝟏 + 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚)𝒏
𝑷𝑽𝟎 𝒈𝒓𝒐𝒘𝒊𝒏𝒈 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 = 𝑪𝑭𝟎 (𝟏 + 𝒈𝒉 )
𝒄𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝒈𝒉

𝟏. 𝟏𝟓𝟓
) (𝟏 −
𝟏. 𝟏𝟑𝟗𝟓𝟓
𝑷𝑽 𝒐𝒇 𝒈𝒓𝒐𝒘𝒊𝒏𝒈 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 = 𝟎. 𝟔𝟗(𝟏 + 𝟎. 𝟏𝟓) = $𝟑. 𝟓𝟓
𝟎. 𝟏𝟑𝟗𝟓 − 𝟎. 𝟏𝟓

PV of terminal value = 46.19/(1.1395^5) = 24.04

PV = 3.55 + 24.04 = $27.59

Scenario 2: Kimberly-Clark, a household product manufacturer, reported earnings per share of

$3.20 in 1993 and paid dividends per share of $1.70 in that year. The firm reported depreciation
of $315 million in 1993, and capital expenditures of $475 million (there were 160 million shares
outstanding, trading at $51 per share). This ratio of capital expenditures to depreciation is
expected to be maintained in the long term. The working capital needs are negligible. Kimberly-
Clark had debt outstanding of $1.6 billion and intends to maintain its current financing mix (of
debt and equity) to finance future investment needs. The firm is in a steady state, and earnings
are expected to grow 7% a year. The stock had a beta of 1.05, the Treasury bond rate is 6.25%,
and the equity risk premium is 5.5%.

7) Use Scenario 2: What is the value per share, using the Dividend Discount Model?
A) $36.20
B) $42.40
C) $48.95
D) $52.36
E) $65.90

Solution: A
Cost of Equity = 6.25% + 1.05 * 5.50% = 12.03%
Value Per Share = $1.70 * 1.07/(.1203 - .07) = $36.20

8) Use Scenario 2: Estimate the value per share, using the FCFE Model.
A) $17.50
B) $23.69
C) $50.20
D) $45.67
E) $34.00

Solution: C

MV of Equity = 160 million * $51 = $8160 million

Debt ratio = Debt / (Debt + Equity) = $1600 million / ($1600 million + $8160 million) =
16.39%

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Net Capex per share = (Capital Spending – Depreciation) / # of shares = ($475 mio - $315
mio)/160 mio = $1

The below values are based on per share.

Current Earnings per share = $3.20
- (1 – Debt ratio) * (Capital Spending - Depreciation) = 83.61%* $1.00 =$0.84
- (1 – Debt ratio) * Working Capital = 83.61% * $0.00 = $0.00
Free Cash Flow to Equity = $2.36

Cost of Equity = 6.25% + 1.05 * 5.5% = 12.03%

Value Per Share = $2.36 * 1.07/(.1203 - .07) = $50.20

Assumption: By growing the FCFE, we are assuming that current ratio of capital
expenditures to depreciation is maintained in perpetuity. Otherwise, FCFE does not
necessarily need to increase by 7% even though EPS is increasing by 7%.

9) Use Scenario 2: How would you explain the difference between the two models, and which
one would you use as your benchmark for comparison to the market price?

Solution: The FCFE is greater than the dividends paid. The higher value from the model
reflects the additional value from the cash accumulated in the firm. The FCFE value is
more likely to reflect the true value.

10) Ecolab Inc. sells chemicals and systems for cleaning, sanitizing, and maintenance. It
reported earnings per share of $2.35 in 1993 and expected earnings growth of 15.5% a year from
1994 to 1998, and 6% a year after that. The capital expenditure per share was $2.25, and
depreciation was $1.125 per share in 1993. Both capital expenditure and depreciation are
expected to grow at the same rate as earnings from 1994 to 1998. However, the capital
expenditures continue to be 200% of depreciation after year 1998 (during the stable period).
Working capital is expected to remain at 5% of revenues, and revenues, which were $1,000
billion in 1993, were expected to increase 6% a year from 1994 to 1998 and a 4% a year after
that. The firm currently has a debt ratio [D/(D+E)] of 5% but plans to finance future investment
needs (including working capital investments) using a debt ratio of 20%. The stock is expected to
have a beta of 1.00 for the period of the analysis, and the Treasury bond rate is 6.50% and the
equity risk premium is 5.5%. There are 63 million shares outstanding. Estimate the value per
share in 1993 using the two stage FCFE approach.
A) $26.65
B) $47.38
C) $42.00
D) $37.41
E) $33.30

Solution: D

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Total
Growth Change in Change in Change in
Revenue
Year Time rate in Revenue (in WC (in mio) WC (per
(in mio)
Revenues mio) = (Change share)
in Rev*5%)
1993 Current $1,000 n/a n/a
1994 1 6% $1,060 $60 $3.00 $0.0476
1995 2 6% $1,124 $64 $3.18 $0.0505
1996 3 6% $1,191 $67 $3.37 $0.0535
1997 4 6% $1,262 $71 $3.57 $0.0567
1998 5 6% $1,338 $76 $3.79 $0.0601
1999 6 4% $1,392 $54 $2.68 $0.0425
2000 7 4% $1,447 $56 $2.78 $0.0442

Growth Capital Change in FCFE

Depreciation
Year Time rate in EPS Expenditure WC per per
per share
EPS per share share share
1993 Current $2.35 $2.25 $1.13 n/a n/a
1994 1 15.50% $2.71 $2.60 $1.30 $0.0476 $1.64
1995 2 15.50% $3.13 $3.00 $1.50 $0.0505 $1.89
1996 3 15.50% $3.62 $3.47 $1.73 $0.0535 $2.19
1997 4 15.50% $4.18 $4.00 $2.00 $0.0567 $2.54
1998 5 15.50% $4.83 $4.62 $2.31 $0.0601 $2.93
1999 6 6% $5.12 $4.90 $2.45 $0.0425 $3.13
2000 7 6% $5.43 $5.20 $2.60 $0.0442 $3.31

Note: The capex continues to be 200% of depreciation in the stable period.

FCFE = NI – (1-DR)*(Capex – Depreciation) – (1-DR)*(Change in WC)

Since the data is given as per share, we adjust the FCFE equation to per share basis.
Example: FCFE = $2.71 – ((1 - 0.20)* ($2.60 - $1.30)) – ((1 - 0.20) * $0.0476) = $1.64

Cost of Equity = 6.5% + 1 * 5.5% = 12%

Growth in earnings in stable period = 6% (also the growth in FCFE keeps up with this
growth rate in earnings)

Terminal Value Per Share in year 1998 = $3.13/(0.12 - 0.06) = $52.17

𝟏. 𝟔𝟒 𝟏. 𝟖𝟗 𝟐. 𝟏𝟗 𝟐. 𝟓𝟒 𝟐. 𝟗𝟑 + 𝟓𝟐. 𝟏𝟕
𝑷𝑽 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝒊𝒏 𝒚𝒆𝒂𝒓 𝟏𝟗𝟗𝟑 = 𝟏
+ 𝟐
+ 𝟑
+ + = $𝟑𝟕. 𝟐𝟏
𝟏. 𝟏𝟐 𝟏. 𝟏𝟐 𝟏. 𝟏𝟐 𝟏. 𝟏𝟐𝟒 𝟏. 𝟏𝟐𝟓
Or
CF0=0 CF1= 1.64 CF2=1.89 CF3=2.19 CF4=2.54 CF5=2.93+52.17=55.10 I/Y=12% compute
NPV = ? = $37.41

11) Dionex Corporation, a leader in the development and manufacture of ion chromography
systems (used to identify contaminants in electronic devices), reported net income of $14.14

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million in 1993 and paid no dividends. These earnings are expected to grow 14% a year for five
years (1994 to 1998) and 7% a year after that. The firm reported depreciation of $2 million in
1993 and capital spending of $4.20 million and had 7 million shares outstanding. Both the
depreciation and the capital expenditure are expected to grow at the same rate as earnings.
However, in the stable period (in 1999 and afterwards), the capital expenditures are 150% of
depreciation. The working capital is expected to remain at 50% of revenues, which were $106
million in 1993, and revenues are expected to grow 6% a year from 1994 to 1998 and 4% a year
after that. In 1999 and after, firm is expected to maintain working capital at 25% of revenues,
consistent with industry. The firm is expected to finance 10% of its capital expenditures and
working capital needs with debt. Dionex had a beta of 1.20 in 1993, and this beta is expected to
drop to 1.10 after 1998. The Treasury bond rate is 7% and the equity risk premium is 5.5%.
Estimate the value per share today (1993), based upon the two stage FCFE model.
A) $28.54
B) $39.65
C) $37.53
D) $33.25
E) $30.65

Solution: B

Total
Growth Change in
Revenue % of Change in
Year Time in Revenue (in
(in mio) Revenues WC (in
revenues mio)
mio)
1993 Current $106 n/a n/a
1994 1 6% $112.36 $6.36 50% $3.18
1995 2 6% $119.10 $6.74 50% $3.37
1996 3 6% $126.25 $7.15 50% $3.57
1997 4 6% $133.82 $7.57 50% $3.79
1998 5 6% $141.85 $8.03 50% $4.01
1999 6 4% $147.53 $5.67 25% $1.42
2000 7 4% $153.43 $5.90 25% $1.48

Capital Change in FCFE

Growth NI in Depreciation
Year Time Expenditure WC (in (in
in NI million in million
in million million) million)
1993 Current $14.14 $4.20 $2 n/a
1994 1 14% $16.12 $4.79 $2.28 $3.18 $11.00
1995 2 14% $18.38 $5.46 $2.60 $3.37 $12.77
1996 3 14% $20.95 $6.22 $2.96 $3.57 $14.80
1997 4 14% $23.88 $7.09 $3.38 $3.79 $17.13
1998 5 14% $27.23 $8.09 $3.85 $4.01 $19.80
1999 6 7% $29.13 $6.18 $4.12 $1.42 $26.00
2000 7 7% $31.17 $6.61 $4.41 $1.48 $27.86

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Note: The capex continues to be 150% of depreciation in the stable period.

FCFE = NI – (1-DR)*(Capex – Depreciation) – (1-DR)*(Change in WC)

Example: FCFE = $16.12 mio – ((1 - 0.10)* ($4.79 mio - $2.28 mio)) – ((1 - 0.10) * $3.18
mio) = $11 mio

Cost of Equity in high growth period = 7% + 1.20 * 5.5% = 13.60%

Cost of equity in stable period = 7%+1.10*5.5%=13.05%

Growth in earnings in stable period =7% (also the growth in FCFE keeps up with this
growth rate in earnings)
Terminal Value1998 = $26 million/(0.1305 - 0.07) = $429.752 million

𝟏𝟏 𝒎𝒊𝒐 𝟏𝟐. 𝟕𝟕𝒎𝒊𝒐 𝟏𝟒. 𝟖𝟎𝒎𝒊𝒐 𝟏𝟕. 𝟏𝟑𝒎𝒊𝒐 𝟏𝟗. 𝟖𝟎𝒎𝒊𝒐 + 𝟒𝟐𝟗. 𝟕𝟓𝟐𝒎𝒊𝒐
𝑷𝑽 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝟏𝟗𝟗𝟑 = + + + +
𝟏. 𝟏𝟑𝟔𝟎𝟏 𝟏. 𝟏𝟑𝟔𝟎𝟐 𝟏. 𝟏𝟑𝟔𝟎𝟑 𝟏. 𝟏𝟑𝟔𝟎𝟒 𝟏. 𝟏𝟑𝟔𝟎𝟓
= $𝟐𝟕𝟕. 𝟓𝟖𝒎𝒊𝒐
Or
CF0=0 CF1= 11 CF2=12.77 CF3=14.80 CF4=17.13 CF5=19.80+429.752=449.552
I/Y=13.60% compute NPV = ? = $277.58 mio

#of shares outstanding = 7 mio

Price per share = 277.58 mio /7 mio = $39.65 per share

12) Luminos Corporation, a manufacturer of lightbulbs, is a firm in stable growth. The firm
reported net income of $100 million on a book value of equity of $1 billion. However, the firm
also had a cash balance of $200 million on which it earned after tax interest income of $10
million last year (this interest income is included in the net income, and the cash is part of the
BV of equity). The cost of equity for the firm is 9%. If you expect the cash flows from the
operating assets of Luminos to increase 3% a year in perpetuity, estimate the value of equity at
Luminos using the FCFE approach.
A) $1333 million
B) $1444 million
C) $1133 million
D) $1222 million
E) $1022 million

Solution: A
𝑵𝑰 𝒇𝒓𝒐𝒎 𝒏𝒐𝒏𝒄𝒂𝒔𝒉 𝒂𝒔𝒔𝒆𝒕𝒔
𝑵𝒐𝒏𝒄𝒂𝒔𝒉 𝑹𝑶𝑬 =
𝑩𝑽 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝑪𝒂𝒔𝒉
𝑵𝑰 − (𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒇𝒓𝒐𝒎 𝒄𝒂𝒔𝒉 &𝒎𝒂𝒓𝒌𝒕. 𝒔𝒆𝒄. (𝟏 − 𝒕))
=
𝑩𝑽 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝑪𝒂𝒔𝒉

𝟏𝟎𝟎𝒎𝒊𝒐 − (𝟏𝟎𝒎𝒊𝒐) 𝟗𝟎𝒎𝒊𝒐

𝑵𝒐𝒏𝒄𝒂𝒔𝒉 𝑹𝑶𝑬 = = = 𝟏𝟏. 𝟐𝟓%
𝟏𝟎𝟎𝟎𝒎𝒊𝒐 − 𝟐𝟎𝟎𝒎𝒊𝒐 𝟖𝟎𝟎𝒎𝒊𝒐
Equity reinvestment rate = g / ROE = 3% / 11.25% = 26.67%

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𝑵𝑰𝒕+𝟏 (𝟏 − 𝒆𝒒𝒖𝒊𝒕𝒚 𝒓𝒆𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕)

𝑷𝑽𝒕 =
𝑪𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝒈

𝟗𝟎 ∗ 𝟏. 𝟎𝟑 ∗ (𝟏 − 𝟎. 𝟐𝟔𝟔𝟕)
𝑷𝑽𝒕 =
𝟎. 𝟎𝟗 − 𝟎. 𝟎𝟑
= $𝟏, 𝟏𝟑𝟑 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 𝒃𝒖𝒕 𝒕𝒉𝒊𝒔 𝒊𝒔 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒏𝒐𝒏𝒄𝒂𝒔𝒉 𝒆𝒒𝒖𝒊𝒕𝒚

Value of equity = $1,133 million + $ 200 million = $1,333 million

(the PV of cash is added separately to the value of the non-cash equity).

13) Which of the following statements is true?

A) FCFE can never be negative.
B) FCFE will always be higher than net income.
C) For a firm that pays out more in dividends than potential dividends, the dividend discount
model will overstate the value of the firm compared to FCFE approach.
D) For a firm that pays out less in dividends than potential dividends, the dividend discount
model will yield the same value as the FCFE approach.
E) All of the statements are true.

Solution: C

14) Biomet Inc., designs, manufactures and markets reconstructive and trauma devices, and
reported earnings per share of $0.56 in 1993, on which it paid no dividends. (It had revenues per
share in 1993 of $2.91). It had capital expenditures of $0.13 per share in 1993 and depreciation
in the same year of $0.08 per share. The working capital was 60% of revenues in 1993 and will
remain at that level from 1994 to 1998, while earnings and revenues are expected to grow 17% a
year. The earnings and revenue growth rate is expected to decline linearly over the following five
years to a rate of 5% in 2003 and afterwards. During the high growth, transition, and stable
periods, capital spending and depreciation are expected to grow at the same rate as earnings.
Working capital is expected to drop linearly from 60% of revenues during the 1994-1998 period
to 30% of revenues in 2003 and afterwards. The firm has no debt currently, but plans to finance
10% of its net capital investment and working capital requirements with debt.
The stock is expected to have a beta of 1.45 for the high growth period (1994-1998), and it is
expected to decline linearly to 1.10 by the time the firm goes into steady state (in 2003). The
Treasury bond rate is 7% and the equity risk premium is 5.5%. Estimate the value per share,
using the three stage FCFE model.
A) $5.50
B) $6.10
C) $7.20
D) $9.25
E) $8.30

Solution: D

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Linear decline in EPS, Capex. Depr and Revenues. (17% - 5%)/5% = 12% / 5 = 2.4%
decline per year
Linear decline in WC /Revenue = (60%-30%)/5 = 6% per year
Stable period growth rate in earnings = 5% (also growth in FCFE keeps up with the 5%
growth in earnings)
Beta in high growth = 1.45
Beta in stable period = 1.10
Beta in transition declined by (1.45-1.10)/5 =0.07% per year

Cost of equity in high growth = 7% + (1.45)*(5.5%) = 14.98%

Cost of equity in stable period = 7% +(1.10)*(5.5%) = 13.05%
Cost of equity in transition period is provided in the below table.

Growth Revenu Change in Change in

Working
Year Time rate in e (per Revenue (per WC (per
Capital/Revenue
Revenue share) share) share)
Curren
1993 t $2.91 n/a
1994 1 17% $3.40 $0.49 60% $0.30
1995 2 17% $3.98 $0.58 60% $0.35
1996 3 17% $4.66 $0.68 60% $0.41
1997 4 17% $5.45 $0.79 60% $0.48
1998 5 17% $6.38 $0.93 60% $0.56
1999 6 14.6% $7.31 $0.93 54% $0.50
2000 7 12.2% $8.20 $0.89 48% $0.43
2001 8 9.8% $9.01 $0.80 42% $0.34
2002 9 7.4% $9.67 $0.67 36% $0.24
2003 10 5.0% $10.16 $0.48 30% $0.15
2004 11 5% $10.67 $0.51 30% $0.15

growth
rate in Capital Change in FCFE Cumulative
Depreciation Cost of
Year Time EPS, EPS Expenditure WC per per beta Discount
per share equity
Capex, per share share share rate
Depr
1993 Current $0.56 $0.13 $0.08 n/a n/a n/a n/a n/a
1994 1 17% $0.66 $0.15 $0.09 $0.30 $0.34 1.45 14.98% 1.1498
1995 2 17% $0.77 $0.18 $0.11 $0.35 $0.39 1.45 14.98% 1.3219
1996 3 17% $0.90 $0.21 $0.13 $0.41 $0.46 1.45 14.98% 1.5199
1997 4 17% $1.05 $0.24 $0.15 $0.48 $0.54 1.45 14.98% 1.7475
1998 5 17% $1.23 $0.29 $0.18 $0.56 $0.63 1.45 14.98% 2.0092
1999 6 14.6% $1.41 $0.33 $0.20 $0.50 $0.84 1.38 14.59% 2.3023
2000 7 12.2% $1.58 $0.37 $0.23 $0.43 $1.07 1.31 14.21% 2.6294
2001 8 9.8% $1.73 $0.40 $0.25 $0.34 $1.29 1.24 13.82% 2.9927
2002 9 7.4% $1.86 $0.43 $0.27 $0.24 $1.50 1.17 13.44% 3.3948
2003 10 5.0% $1.95 $0.45 $0.28 $0.15 $1.67 1.10 13.05% 3.8378

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2004 11 5.0% $2.05 $0.48 $0.29 $0.15 $1.75 1.10 13.05% 4.3387

TV2002 = FCFE2003 / (cost of equity stable – growth stable) = $1.67 /(0.1305 – 0.05) = $20.71
𝟎. 𝟑𝟒 𝟎. 𝟑𝟗 𝟎. 𝟒𝟔 𝟎. 𝟓𝟒 𝟎. 𝟔𝟑 𝟎. 𝟖𝟒 𝟏. 𝟎𝟕 𝟏. 𝟐𝟗 𝟏. 𝟓𝟎 + 𝟐𝟎. 𝟕𝟏
𝑷𝒓𝒊𝒄𝒆𝟏𝟗𝟗𝟑 = + + + + + + + + = $𝟗. 𝟐𝟓
𝟏. 𝟏𝟒𝟗𝟖 𝟏. 𝟑𝟐𝟏𝟗 𝟏. 𝟓𝟏𝟗𝟗 𝟏. 𝟕𝟕𝟕𝟓 𝟐. 𝟎𝟎𝟗𝟐 𝟐. 𝟑𝟎𝟐𝟑 𝟐. 𝟔𝟐𝟗𝟒 𝟐. 𝟗𝟗𝟐𝟕 𝟑. 𝟑𝟗𝟒𝟖

15) You have been asked to value Oneida steel, a midsize steel company. The firm reported $80
million in net income, $50 million in capital expenditures, and $20 million in depreciation in the
just-completed financial year. The firm reported that its noncash working capital increased by
$20 million during the year and that total debt outstanding increased by $10 million during the
year. The book value of equity at Oneida Steel at the beginning of last financial year was $400
million. The cost of equity is 10%. You can assume that the firm will continue to maintain the
same debt ratio that it used last year to finance its reinvestment needs.
Estimate the expected growth rate using the above fundamentals. If this growth rate is expected
to last five years and then drop to a 4% stable growth rate after that and the return on equity after
year 5 is expected to be 12%, estimate the value of equity today, using the two stage FCFE
approach.
A) $1600
B) $1124
C) $1328
D) $1078
E) $1467

Solution: B

Net Income Net income

- (capex - Depreciation) - (capex-depr)
- Changes in noncash WC - changes in noncash WC
- (Principal Repayments - New Debt Issues) +net debt issue
FCFE FCFE

Equity Reinvestment rate= (Cap Ex – Deprec’n + Chg in WC- Net Debt Issued)/ Net
Income = (50 –20 + 20 - 10)/ 80 = 50%
Return on Equity = Net Income/ Book value of equity = 80/ 400 = 20%

High growth period:

Expected equity reinvestment rate= current equity reinvestment rate=50%
Expected ROE= current ROE= 20%
Expected growth rate in net income = ROE * Equity Reinv. Rate = 20% * 0.5 = 10%
Cost of equity= 10%

Stable growth period:

Given: g= 4%, ROE=12%
Equity reinvestment rate after year 5 = g/ ROE = 4/12 = 33.33%
Cost of equity = 10%

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equity
Growth reinvestment
YEAR in NI Net income rate FCFE
Current n/a 80 n/a n/a
1 10% 88.00 50% 44.00
2 10% 96.80 50% 48.40
3 10% 106.48 50% 53.24
4 10% 117.13 50% 58.56
5 10% 128.84 50% 64.42
6 4% 133.99 33.33% 89.33
7 4% 139.35 33.33% 92.91

FCFE 6 = NI 6 (1- equity reinvestment rate 6)

TV5 = FCFE 6 / (cost of equity stable – growth rate stable) = 89.33 / (0.10 -0.04) = $1,488.83
In stable period, since equity reinvestment rate is constant and NI grows at 4%, FCFE also
grows by 4%.

𝟒𝟒 𝟒𝟖. 𝟒𝟎 𝟓𝟑. 𝟐𝟒 𝟓𝟖. 𝟓𝟔 𝟔𝟒. 𝟒𝟐 + 𝟏𝟒𝟖𝟖. 𝟖𝟑

𝑷𝑽 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝟎 = + + + + = $𝟏𝟏𝟐𝟒. 𝟒𝟒
𝟏. 𝟏𝟎𝟏 𝟏. 𝟏𝟎𝟐 𝟏. 𝟏𝟎𝟑 𝟏. 𝟏𝟎𝟒 𝟏. 𝟏𝟎𝟓

Or
CF0=0 CF1= 44 CF2=48.40 CF3=53.24 CF4=58.56 CF5=64.42+1488.83=1553.25 I/Y=10%
compute NPV = ? = $1124.44 mio

16) Union Pacific Railroad reported EBIT of $1523 million and net income of $770 million in
1993. The corporate tax rate was 36%. It reported depreciation of $960 million in that year, and
capital spending was $1.2 billion. Union Pacific paid 40% of its earnings as dividends and
working capital requirements are negligible.

The firm also had $4 billion in debt outstanding on the books, rated AA (carrying a yield to
maturity of 8%), trading at par (up from $3.8 billion at the end of 1992). The beta of the stock is
1.05, and there were 200 million shares outstanding (trading at $60 per share), with a book value
of $5 billion. The treasury bond rate is 7% and equity risk premium is 5.5%. What is the value of
the firm at the end of 1993, using the FCFF approach.
A) $9,920 million
B) $9,050 million
C) $9,210 million
D) $9,530 million
E) $9,780 million

Solution: C

Reinvestment rate = (Netcapex + Changes in noncash WC)/ EBIT (1-t) = (1,200 mio -960
mio + 0)/ (974.72 mio) = 24.62%

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Return on Capital = EBIT (1-t)/ (BV of Debt + BV of Equity) =

974.72mio/(4,000+5,000)mio = 10.83%
Growth = Reinvestment rate *ROC= 0.2462 * 10.83% = 2.67%

Cost of Equity = 7% + 1.05 * 5.5% = 12.775%

Before tax cost of debt = YTM = 8%
MV debt = BV debt = $4000 million since it trades at par.
MV equity = 200 million * $60 = $12000 million
Wd = MV debt/MV (D+E) = 4,000 mio/ (4,000 mio+12,000 mio) = 25%
We = MV equity / MV (D+E) = 12,000 mio / (4,000 mio + 12,000 mio) = 75%
Cost of capital =WACC = wd rd (1-t) + we re
Cost of Capital = 8% (1 - 0.36) (0.25) + (12.775%) (0.75) = 10.86%

Value of the Firm 1993 = EBIT(1-T) 1993 (1+g) (1- reinvestment rate) /(WACC-g)
= 974.72 * (1+0.0267) (1-0.2462) /(0.1086 - 0.0267) = $9,210 millions

Extra: If you would like to find the Value of Equity

Value of equity= Value of Firm - Market Value of Debt
= $9,210 million - $4,000 million = $5,210 millions
Value Per Share = $5,210 million/200 million = $26.05

17) Santa Fe Pacific, a major rail operator with diversified operations, had earnings before
interest, taxes and depreciation, of $637 million in 1993, with depreciation amounting to $235
million (offset by capital expenditure of an equivalent amount). The firm is in steady state and
earnings before interest and taxes are expected to grow 3% a year in perpetuity. Santa Fe Pacific
had a beta of 1.25 in 1993 and debt outstanding of $1.34 billion. The stock price was $18.25 at
the end of 1993, and there were 183.1 million shares outstanding. The expected ratings and the
costs of debt at different levels of debt for Santa Fe are shown in the following table The tax rate
is 40%, the Treasury bond rate is 7% and equity risk premium is 5.5%. Estimate the value of the
firm using the FCFF approach. Hint: Find the debt ratio for the firm and based on the below
rating table, find the cost of debt for the firm.

Cost of Debt
D/(D+E) Rating
(Pre-tax)
0% AAA 6.23%
10% AAA 6.23%
20% A+ 6.93%
30% A- 7.43%
40% BB 8.43%
50% B+ 8.93%
60% B- 10.93%
70% CCC 11.93%
80% CCC 11.93%
90% CC 13.43%

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A) $3,989 million
B) $3,714 million
C) $3,563 million
D) $3,326 million
E) $3,037 million

Solution: E
MV equity = $18.25 * 183.1 million = $3,342 million
Current Debt Ratio (wd) = D/ (D+E) = $1,340 million/($1,340 million + $3,342 million) =
28.63%
we = E/ (D+E) = $3,342 million / ($1,342 million + $3,342 million) = 71.37%

Cost of Equity = 7% + 1.25 * 5.5% = 13.88%

In the above table, the cost of debt for a debt ratio of 28.63% (around 30%) is 7.43%.

Cost of Capital = 13.88% (0.7137) + 7.43% (1 - 0.4) (0.2863) = 11.18%

Remember that EBIT = EBITDA-Depreciation

EBIT(1-t) = (637-235) (1-0.4)= 241.2 million
Reinvestment rate = ((Capital Expenditures –Depreciation) + Working Capital)/ EBIT
(1-t)
Reinvestment rate= 0 since depreciation is offset by capital expenditure, and there is no
change in WC
Value of the Firm 1993= EBIT(1-t)1993 (1+g) (1-reinvestment rate) / (WACC –g) = 241.2 mio*
1.03* (1-0) /(0.1118-0.03) = $3,037.11 million

Scenario 3: You have been asked to estimate the value of Cavanaugh Motels, a motel chain. The
firm reported earnings of $200 million before interest and taxes in the most recent year and paid
40% of its taxable income in taxes. The book value of capital at the firm is $1.2 billion, and the
firm expects to grow 4% a year in perpetuity. The firm has a beta of 1.2, a pretax cost of debt of
6%, equity with a market value of $1 billion, and debt with a market value of $500 million. (The
risk-free rate is 5%, and the market risk premium is 5.5%.) The probability of default at this firm
at its current debt level is 10% and that the cost of bankruptcy is 25% of unlevered firm value.

18) Use Scenario 3: Estimate the value of the firm, using the FCFF (cost of capital) approach.
A) $1,519 million
B) $1,392 million
C) $1,765 million
D) $1,841 million
E) $1,967 million

Solution: A
Cost of equity = 5% + 1.2 (5.5%) = 11.6%
Pre-tax cost of debt = 6%

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Cost of capital =WACC= wd rd (1-t) + we re

Cost of capital = (500/1500) (6%) (1-.4) + (1000/1500) (11.6%) = 8.93%

Return on capital = EBIT (1-t) /Invested capital = 200 (1 - 0.4)/ 1200 = 10%
Growth in perpetuity = 4%
Reinvestment rate = g/ ROC = 4%/10% = 40%

Value of firm = EBIT (1-t) (1- Reinvestment rate) (1+g)/ (Cost of capital – g)
= 200 (1-0.4) (1-0.4)(1.04)/ (0.0893 -0.04) = $1,519 million

19) Use Scenario 3: Estimate the value of the firm using the adjusted present value approach.
A) $1,591 million
B) $1,401 million
C) $1,471 million
D) $1,531 million
E) $1,571 million

Solution: B
Levered beta = Unlevered beta (1+ (1-t) D/E)) and solve for unlevered beta as below:
Unlevered beta = 1.20/ (1 + (1-.4)(500/1000)) = 0.9231
Use the unlevered beta to derive the unlevered cost of equity = 5% + 0.9231 (5.5%) =
10.08%

Value of firm = EBIT (1-t) (1- Reinvestment rate) (1+g)/ (Cost of capital – g)
When the firm has zero debt and all the capital is financed through equity, the cost of
capital equals to the cost of equity
Cost of capital =WACC= wd rd (1-t) + we re = 0 + (1) re = re
Unlevered firm value = 200 (1-0.4) (1-0.4)(1.04)/ (0.1008 - 0.04) = $1,232 million. We used
cost of equity to discount.
PV of tax benefits from debt = Tax rate * Debt= 0.40 * 500 = $ 200 million
Expected bankruptcy costs = Probability of bankruptcy * Unlevered firm value * Cost
of bankruptcy = 0.10 * 1232 * 0.25 = $30.8 million

Firm Value through APV method:

Firm Value = Unlevered firm value + PV of tax benefits from debt– Expected bankruptcy
cost
APV value of firm = $ 1,232 million + $200 million – $30.8 million= $ 1,401.2 million

20) In the face of disappointing earnings results and increasingly assertive institutional
stockholders, Eastman Kodak was considering a major restructuring in 1993. As part of this
restructuring, it was considering the sale of its health division, which earned $560 million in
earnings before interest and taxes in 1993, on revenues of $5.285 billion. The expected growth in
earnings was expected to moderate to 6% between 1994 and 1998, and to 4% after that. Capital
expenditures in the health division amounted to $420 million in 1993, while depreciation was

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$350 million. Both were expected to grow 4% a year in the long term. Working capital
requirements were negligible.

The average beta of firms competing with Eastman Kodak’s health division was 1.15. While
Eastman Kodak had a debt ratio [D/(D + E)] of 50%, the health division could sustain a debt
ratio [D/(D + E)] of only 20%, which was similar to the average debt ratio of firms competing in
the health sector. At this level of debt, the health division could expect to pay 7.5% on its debt,
before taxes. The tax rate is 40%, the Treasury bond rate is 7%, and the risk premium is 5.5%.
What is the value of the division? Use the two stage FCFF method.
A) $3,550 million
B) $3,610 million
C) $4,060 million
D) $4,150 million
E) $3,870 million

Solution: C

Growth in
Growth
EBIT Capital Capital Change
in EBIT Depreciation FCFF
(1-t) Expend & Expenditure in WC
earnings
Depreciation
1993 6% $560 $336 4% $420 $350 $0 $266
1994 6% $594 $356 4% $437 $364 $0 $283
1995 6% $629 $378 4% $454 $379 $0 $302
1996 6% $667 $400 4% $472 $394 $0 $321
1997 6% $707 $424 4% $491 $409 $0 $342
1998 6% $749 $450 4% $511 $426 $0 $364
1999 4% $779 $468 4% $531 $443 $0 $379

In both stages (high growth and stable growth periods),

Beta for the Health Division = 1.15
Cost of Equity = 7% + 1.15 * 5.5% = 13.33%
Before tax cost of debt = 7.5%
Debt/(D+E) = 20%
E/(D+E) = 80%
Cost of Capital for the division= 0.80 * 13.33% + 0.2 * (7.5% * (1-0.40)) = 11.56%

Growth rate in stable period = 4%

TV 1998 = FCFF1999 / (WACC-g) = 379 / (0.1156 – 0.04) = $5,013 million
Value of the Division in 1993 = 283 mio/1.1156 + 302 mio/(1.1156)2 + 321 mio/(1.1156)3 +
342 mio/(1.1156)4 + (364 mio+ 5,013 mio)/(1.1156)5 = $4,060 millions
OR
CF0 = 0 CF1=283 mio CF2= 302 mio CF3=321 mio CF4= 342 mio CF5 = 5377 mio
i/y = 11.56 Compute NPV=?= 4,060 million

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