Professional Documents
Culture Documents
Problem Sets
7-11. ABC Incorporated shares are currently trading for $32 per share.
The firm has 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%.
2001 2002
Revenues $600.0 $690.0
Operating expenses 520.0 600.0
Depreciation 16.0 18.0
Earnings before interest and 64.0 72.0
taxes
Less Interest Expense 5.0 5.0
Less: Taxes 23.6 26.8
Equals: Net income 35.4 40.2
Addendum:
Yearend working capital 150 200
Principal repayment 25.0 25.0
Capital expenditures 20 10
Yearend working capital in 2000 was $160 million and the firm’s marginal tax rate is 40% in both 2001 and 2002.
Estimate the following for 2001 and 2002:
a.Free cash flow to equity.
b.Free cash flow to the firm.
Answers:
a.$16.4 million in 2001 and $(26.8) million in 2002
b.$44.4 million in 2001 and $1.2 million in 2002
FCFE2001= NI + Dep – Capex – Chg WC – Principal Repayments
= 35.4 + 16 – 20 – (150-160) – 25 = 16.4
FCFE2002 = 40.2 + 18 – 10 – (200 –150) –25 = -26.8
FCFF2001 = EBIT (1-t) + Dep –Capex – Chg. WC = 64 (1-.4) + 16 – 20 – (150-160) = 44.4
FCFF2002 = 72 (1-.4) + 18 – 10 – (200-150) = 1.2
7-14. No Growth Incorporated had operating income before interest and taxes in 2002 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
2002. At the end of 2001 and 2002, 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 2002. No Growth’s target
debt-to-total capital ratio is 30%.
Company A Company B
Free cash flow per share at the $1.00 $5.00
end of year 1
Growth rate in cash flow per 8% 4%
share
Beta 1.3 .8
Risk-free return 7% 7%
Expected return on all stocks 13.5% 13.5%
Answer:
a. Company A: 7 + 1.3 (13.5-7) = 7+8.45=15.45%
Company B: 7 + .8 (13.5-7.) = 7 + 5.2 = 12.2%
b. Company A: P= $1.00 / (.154-.08) = $13.50
Company B: P=$5.00 / (.122-.04) = $5.00/.082 =$61
7-19. You have been asked to estimate the beta of a high-technology firm, which has three divisions
with the following characteristics.
Answer:
a. Beta = 1.6 x 100/500 + 2.00 x 150/500 + 1.2 x 250/500 =1.52
b. COE (software division) = .05 + 2.0 (.055) = 16%
c. COE (entire firm) = .05 + 1.52 (.055) = 13.4%
d, PV (total firm) = $7.4 (1.08) / (.134 - .08) = 7.99/.054 = $148
PV (software division) = $3.1 (1.08) / (.16 - .08) = $3.35 / .08 = $41.85
7-20. 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?
Answers:
(20 + 15) / 2 = 17.5
PV (based on P/E and incl. 30% premium) = 17.5 x $4 x 1.3 = $91
(10 + 8)/2 = 9
PV (based on EBITDA incl. 30% premium) = 9 x $8 x 1.3 = 93.6
8-12. LAFCO Industries believes that its two primary product lines,
automotive and commercial aircraft valves, are rapidly becoming
obsolete. Its free cash flow is rapidly diminishing as it loses market share
to new firms entering its industry. LAFCO has $200 million in debt
outstanding. Senior management expects the automotive and commercial
aircraft valve product lines to generate $25 million and $15 million,
respectively, in earnings before interest, taxes, depreciation, and
amortization next year. Senior management also believes that they will not
be able to upgrade these product lines due to declining cash flow and
excessive current leverage. A competitor to its automotive valve business
last year sold for 10 times EBITDA. Moreover, a company that is similar to
its commercial aircraft valve product line sold last month for 12 times
EBITDA. Estimate LAFCO’s breakup value before taxes.
Answers:
a. COE = .05 + 2.0 (.055) = .16
PV = (33.3(1-.4) x 1.05 / (.16-.05)) x 1.2 = $228.9
b. PV = 11 x 20 = $220
c. ($220 + $228.9) / 2 = $224.5
8-14. Titanic Corporation has reached agreement with its creditors to liquidate voluntarily its assets and
to use the proceeds to pay off as much of its liabilities as possible. The firm anticipates that it will be
able to sell off its assets in an orderly fashion, realizing as much as 70% of the book value of its
receivables, 40% of its inventory, and 25% of its net fixed assets (excluding land). However, the firm
believes that the land on which it is located can be sold for 120% of book value. The firm has legal and
professional expenses associated with the liquidation process of $2,900,000. The firm has only
common stock outstanding. Estimate the amount of cash that would remain for the firm’s common
shareholders once all assets have been liquidated.
Answer: If the market leader has a market value and market share of $800
million and 38%, respectively, the market is valuing each percentage point of
market share at $21.05 million (i.e., $800 million/38). If Delhi has a market
share of 25 percent, the IPO could have a potential value of $526.3 million
(i.e., 25 points of market share times $21.05 million).
8-17. Photon Inc. is considering acquiring one of its competitors. Photon’s
management wants to buy a firm it believes is most undervalued. The firm’s three
major competitors, AJAX, BABO, and COMET, have current market values of
$375 million, $310 million, and $265 million, respectively. AJAX’s FCFE is
expected to grow at 10 percent annually, while BABO’s and COMET’s FCFE are
projected to grow by 12 and 14 percent per year, respectively. AJAX, BABO, and
COMET’s current year FCFE are $24, $22, and $17 million, respectively. The
current industry average price-to-FCFE ratio and growth rate are 10 and 8%,
respectively. Estimate the market value of each of the three potential acquisition
targets based on the information provided? Which firm is the most undervalued?
Which firm is most overvalued?
Answer: The value of the option is $13.54 million. The investor group should buy the firm since the value of the
option more than offsets the $(10) million NPV of the firm if the call option were not exercised.
Value of the underlying asset (Expected value of the property) (S) = $55 million
Exercise price (Upfront investment to commercialize the property) (E) = $60 million:
Variance in underlying asset’s value (Measure of cash flow risk) (σ2): .05
Time to expiration (t): 5
Risk free interest rate (R): 4
Where C = Theoretical call option value = SN(d1) – Ee-RtN(d2) = $55 x N(.6844) - $60 x 2.7183.04x5x N(.4920)
= $37.64 – $24.1 = $13.54 million.
d1 = ln(S/E) + R + (1/2)2t = ln($55/$60) + [.04 + (1/2).05]5 = -.0870 + .3250 = .2380 = .4780
t .05 5 2236 x 2.2361 .50
d2 = d1 - t = .4760 - .5 = -.0240
S = Stock price or underlying asset price
E = Exercise price
R = Risk free interest rate corresponding to the life of the option
2 = Variance of the stock’s or underlying asset’s returns
t = Time to expiration of the option
N(d1) and N(d2) = Cumulative normal probability values of d1 and d2
e = 2.7183
8-20. Acquirer Company’s management believes that there is a 60 percent chance
that Target Company’s free cash flow to the firm will grow at 20 percent per year
during the next five years from this year’s level of $5 million. Sustainable growth
beyond the fifth year is estimated at 4 percent per year. However, they also believe
that there is a 40 percent chance that cash flow will grow at half that annual rate
during the next five years and then at a 4 percent rate thereafter. The discount rate
is estimated to be 15 percent during the high growth period and 12 percent during
the sustainable growth period for each scenario. What is the expected value (EV) of
Target Company?