Final Exam (FINC3015) Sample Questions Semester 1, 2012

1) What is the difference between enterprise-based and price-based multiples? Give an example of each and explain why they are defined as belonging to each category 2) Describe the four steps involved in relative (multiples) valuation analysis. Outline one issue of concern associated with the potential for significant error in each of the steps. 3) Why are comparable firms with the same industry or sector normally used as a basis of comparison in relative valuation? Would using a firm in a different industry or sector expose the valuation exercise to significant error? 4) Tom is examining a fast-growing distribution company. The company has two-years of audited financial statements, but despite the high turnover is not yet profit positive. Tom favours relative valuation in trying to determine what this company is worth. What kind of ratios would you suggest to Tom are useful for his analysis? Explain. 5) Explain why an enterprise value multiple like EV/EBITDA is often described as being capital structure neutral. Are there any dangers in using this measure as opposed to an earnings based multiple? 6) The PGF Corporation has expected earnings per share (EPS1) of $5. It has a history of paying dividends equal to 20% of earnings. The expected cost of equity is 15% per year, and the expected ROE (return on equity) on the firms future investments is 17% per year. Using the constant growth rate DDM a) What is the expected growth rate of dividends? b) What is the models estimate of the PV of the stock? c) If the model is right, what is the expected price of a share a year from now? 7) The Digital Growth Corp. pays no cash dividends currently and is not expected to for the next 5 years. Its latest EPS was $10, all of which was reinvested in the company. The firms expected ROE for the next 5 years is 20% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting 6 years from now, the firms ROE on new investments is expected to fall to 15%, and the company is expected to start paying out 40% of its earnings in cash dividends, which it will continue to do forever after. DGs expected cost of equity is 15% per year. a) What is your estimate of DGs intrinsic value per share? b) Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? The year after? c) What effect would it have on your estimate of DGs intrinsic value if you expected DG to pay out only 20% of earnings starting in year 6?

8) The following are the betas of the equity of four companies in the same industry and their debt/equity ratios.

Company AFL VFL NRL ARU The corporate tax rate is 40%.

Beta 1.15 1.18 1.05 0.91

Debt/Equity Ratio 33.91% 54.14% 45.50% 11.29%

A. Estimate the un-levered beta of each firm. What do the unlevered betas tell you about these firms? B. Assume that ARU is planning to increase its debt/equity ratio to 30%. What will its new beta be?

9) Jon Stewart is a retail analyst performing a P/E based comparison of two art work stores as of early 2001. He has the following data for Store 1 (S1) and Store 2 (S2): S1 is priced at $44. S2 is priced at $22.50 S1 has a simple capital structure, earned $2 per share in 2000 and is expected to earn $2.20 in 2001. S2 also has a simple capital structure but has several unusual items that reduced its basic EPS in 2000 to $0.5 (versus the 0.75 earned in 1999). For 2001, Jon expects S2 to achieve net income of $30m. S2 has 30 million shares outstanding.

A. Which P/E (trailing or leading) should Stewart use to compare the two companies valuation? B. Which of the two stocks is relatively more attractively value of the basis of P/Es (assuming that all other factors are approximately the same for both stock)? What would change in our analysis if S2 had options outstanding?

10) Compano Inc. was founded in 1986 in Texas. The firm provides oil-field services to Texas Gulf Coast region, including the leasing of drilling barges. Its balance sheet for year-end 2006 describes a firm with $830,541,000 in assets (book values) and invested capital structure of more than $1.334 billion (based on market values): Given
Liabilities and Owner's Capital Current liabilities Accounts payable Notes payable Other current liabilities` Total current liabilities Long-term debt (8.5% interest paid semi-annually, due in 2015) Total liabilities Owners' capital Common stock ($1 par value per share) Paid-in-capital Accumulated earnings Total owners' capital Total liabilities and owners' capital $ 8,250,000 7,266,000 15,516,000 420,000,000 435,516,000 $ $ $ 434,091,171 434,091,171 December 31, 2006 Balance Sheet Invested Capital (Book Values) (Market Values)

$ $ $

40,000,000 100,025,000 255,000,000 395,025,000 830,541,000

$ $

$ $

900,000,000 1,334,091,171

Companos executive management team is concerned that its new investments be required to meet an appropriate cost of capital hurdle before capital is committed. Consequently, the firms CFO has initiated a cost of capital study by one of his senior financial analysts, Jim Tipolli. Jims first action was to contact the firm's investment banker to get input on current capital costs.
Capital Market Data Treasury Bond Yield Market Risk Premium Unlevered equity beta (SIC 4924) Stock price Market capitalization Yield on debt Bond beta Short-term interest bearing debt New long-term debt total Tax Rate 5.42% 5.00% 0.90 22.50 900,000,000 8.00% 0.30 40.00%

$ $

$ $

Jim learned that although the firms current debt capital required an 8.5% coupon rate of interest (with annual payments and no principal repayments until 2015), the current yield on similar debt had declined to 8% if the firm were to raise debt funds today. When he asked about the beta for Companos debt, Jim was told that it was standard practice to assume 0.30 for the corporate debt of firms such as Compano. a) What are Companos total invested capital and capital structre weights for debt and equity? b) Based on Companos corporate income tax rate of 40%, the firms current capital structure, and an ulevered beta estimate of 0.90, what is Companos levered equity beta?

c) Assuming a long-term U.S Treasury Bond yield of 5.42% and an estimated market risk premium of 5%, what should Jims estimate of equity be if he uses the CAPM? d) What is your estimate of Comapnos WACC? 11) Smaltz enterprises is currently involves in its annual review of firms cost of capital. Historically, the firm has relied on the CAPM to estimate its cost of equity capital. The firm estimates that its equity beta is 1.25 and the current yield on long-term U.S Treasury bonds in 4.28%. The firms CFO is currently in a debate with one of the firms advisors at its investment bank about the level of the equity risk premium. Historically, Smaltz has used 7% to approximate the equity risk premium. However, the investment banker argues that this premium has shrunk dramatically in recent years and is more likely in the 3-4% range. a) Estimate Smaltzs cost of equity capital using a market risk premium of 3.5%. b) Smaltzs capital structure is comprised of 75% equity (based on current market prices) and 25% debt on which the firm pays a yield of 5.125% before taxes at 25%. What is the firms WACC under each of the two assumptions about the market risk premium?

12) The following information provides the basis for performing a straightforward application of the APV model. Given
Unlevered Cost of Equity Borrowing Rate Tax Rate Current debt outstanding 12.00% 8.00% 30.00% 200.00 Year FFCFs Interest bearing debt Interest expense Interest tax savings $ 1 100.00 200.00 16.00 4.80 2 $120.00 150.00 12.00 3.60 3 $180.00 100.00 8.00 2.40 4 & Beyond $ 200.00 50.00 4.00 1.20

a) What is the value of the unlevered firm, assuming that its free cash flows for year 5 and beyond is equal to the year 4 cash flow? b) What is the value of the firms interest tax savings, assuming that they remain constant for Year 4 and beyond? c) What is the value of the levered firm? d) What is the value of the levered firms equity (assuming that firms debt is equal to its book value)?

13) Glentech Manufacturing is considering the purchases of an automated parts handler for the assembly and test area of its Phoenix, Arizona, plant. The handler will costs $250,000 to purchase plus $10,000 for installation and employee training. If the company undertakes the investment, it will automate a part of the semiconductor test area and reduce operating costs by $70,000 per year for the next 10 years. However, five years into the investments life, Glentech will have to spend an additional $100,000 to update and refurbish the handler. The investment in the handler will be depreciated using straight-line depreciation over 10-

a) b) c)

d)

e)

years, and the refurbishing costs will be depreciated over the remaining five-year life of the handler (also using straight-line depreciation). In 10 years, the handler is expected to be worth $5,000 although its book value will be zero. Glentechs tax rate is 30%, and its opportunity cost of capital is 12%. Is the project good for Glentech? Why or why not? What can we tell about the project from the NPV profile? If the project were partially financed by borrowing, how would this affect the investment cash flows? How would borrowing a portion of the investment outlay affect the value of the investment to the firm? The project calls for two investments: one immediately and one at the end of Year 5. How much would Glentech earn on its investment, and how should we account for the additional investment outlay in our calculations? What are the considerations that make this investment somewhat risky, and how would you investigate the potential risks of this investment?