Page 1 Printable Exams 15/12/2006 21:39:51 http://www.schweser.com/online_program/test_engine/printable_answers.php Schweser Printable Answers - Session Analysis of Equity Investments: Valuation Models Test ID#: 1360693 Back to Test Review Hide Questions Print this Page Question 1 - #23519 Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies were builders of mid-scale and luxury homes in their respective markets. In 2004, because of tax considerations and the need to segment the businesses between mid-scale and luxury homes, Beachwood decided to spin-off Country Point, its luxury home subsidiary, to its common shareholders. Beachwood retained Bernheim Securities to value the spin-off of Country Point as of December 31, 2004. When the books closed on 2004, Beachwood had $140 million in debt outstanding due in 2012 at a coupon rate of 8 percent, a spread of 2 percent above the current risk free rate. Beachwood also had 5 million common shares outstanding. It pays no dividends, has no preferred shareholders, and faces a tax rate of 30 percent. When valuing common stock, Bernhiem’s valuation models utilize a market risk premium of 11 percent. The common equity allocated to Country Point for the spin-off was $55.6 million as of December 31, 2004. There was no long-term debt allocated from Beachwood. The Managing Director in charge of Bernheim’s construction group, Denzel Johnson, is prepping for the valuation presentation for Beachwood’s board with Cara Nguyen, one of the firm’s associates. Nguyen tells Johnson that Bernheim estimated Country Point’s net income at $10 million in 2004, growing $5 million per year through 2008. Based on Nguyen’s calculations, Country Point will be worth $223.7 million in 2008. Nguyen decided to use a cost of equity for Country Point in the valuation equal to its return on equity at the end of 2004 (rounded to the nearest percentage point). Nguyen also gives Johnson the table she obtained from Beachwood projecting depreciation (the only non-cash charge) and capital expenditures: $(in millions) 2004 2005 2006 2007 2008 Depreciation 5 6 5 6 5 Capital Expenditures 7 8 9 10 12 Looking at the numbers, Johnson tells Nguyen, “Country Point’s free cash flow will be $25 million in 2006.” Nguyen adds, “That’s Free Cash Flow to the Firm (FCFF). Free Cash Flow to Equity (FCFE) will be lower.” Part 1) Regarding the statements by Johnson and Nguyen about free cash flow in 2006: A) Johnson's statement is incorrect and Nguyen's statement is correct. B) Johnson's statement is incorrect and Nguyen's statement is incorrect. C) Johnson's statement is correct and Nguyen's statement is correct. D) Johnson's statement is correct and Nguyen's statement is incorrect. Your answer: A was incorrect. The correct answer was B) Johnson's statement is incorrect and Nguyen's statement is incorrect.
Schweser Printable Answers - Session Analysis of Equity Investments: ValuationModels
Test ID#: 1360693Back to Test Review Hide Questions Print this Page
Question 1 - #23519
Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies werebuilders of mid-scale and luxury homes in their respective markets. In 2004, because of taxconsiderations and the need to segment the businesses between mid-scale and luxury homes,Beachwood decided to spin-off Country Point, its luxury home subsidiary, to its common shareholders.Beachwood retained Bernheim Securities to value the spin-off of Country Point as of December 31, 2004.
When the books closed on 2004, Beachwood had $140 million in debt outstanding due in 2012 at acoupon rate of 8 percent, a spread of 2 percent above the current risk free rate. Beachwood also had 5million common shares outstanding. It pays no dividends, has no preferred shareholders, and faces a taxrate of 30 percent. When valuing common stock, Bernhiem’s valuation models utilize a market riskpremium of 11 percent.
The common equity allocated to Country Point for the spin-off was $55.6 million as of December 31,2004. There was no long-term debt allocated from Beachwood.
The Managing Director in charge of Bernheim’s construction group, Denzel Johnson, is prepping for thevaluation presentation for Beachwood’s board with Cara Nguyen, one of the firm’s associates. Nguyentells Johnson that Bernheim estimated Country Point’s net income at $10 million in 2004, growing $5million per year through 2008. Based on Nguyen’s calculations, Country Point will be worth $223.7 millionin 2008. Nguyen decided to use a cost of equity for Country Point in the valuation equal to its return onequity at the end of 2004 (rounded to the nearest percentage point).
Nguyen also gives Johnson the table she obtained from Beachwood projecting depreciation (the onlynon-cash charge) and capital expenditures:
Looking at the numbers, Johnson tells Nguyen, “Country Point’s free cash flow will be $25 million in2006.” Nguyen adds, “That’s Free Cash Flow to the Firm (FCFF). Free Cash Flow to Equity (FCFE) willbe lower.”
Part 1)Regarding the statements by Johnson and Nguyen about free cash flow in 2006:
A) Johnson's statement is incorrect and Nguyen's statement is correct.B) Johnson's statement is incorrect and Nguyen's statement is incorrect.C) Johnson's statement is correct and Nguyen's statement is correct.D) Johnson's statement is correct and Nguyen's statement is incorrect.
Your answer: A was incorrect. The correct answer was B) Johnson's statement is incorrect and Nguyen'sstatement is incorrect.
The estimated free cash flow for 2006 is $16 million. Johnson's statement is incorrect. Since none ofBeachwood's debt is allocated to Country Point, all the financing is in the form of equity, so FCFF andFCFE are equal. Nguyen's statement is also incorrect.
Part 2)If FCInv equals Fixed Capital Investment and WCInv equals Working Capital Investment, which statementabout free cash flow and its components is FALSE?
A) WCInv is the change in the working capital accounts, excluding cash and short-termborrowings.
B) FCFE = (EBIT x (1-tax rate)) + Depreciation – FCInv – WCInv.C) FCFF = (EBITDA x (1-tax rate)) + (Depreciation x tax rate) – FCInv – WCInv.D) FCFE = FCFF – (Interest expense x (1-tax rate)) + Net borrowing.
Your answer: A was incorrect. The correct answer was B) FCFE = (EBIT x (1-tax rate)) + Depreciation –FCInv – WCInv.
The correct version of this equation is:FCFF = (EBIT x (1-tax rate)) + Depreciation – FCInv – WCInv
Part 3)What is the cost of capital that Nguyen used for her valuation of Country Point?
A) 17%.B) 15%.C) 20%.D) 18%.
Your answer: A was incorrect. The correct answer was D) 18%.
Since there is no debt allocated to Country Point, the cost of capital will equal the cost of equity. Nguyensaid that she used a cost of equity equal to Country Point’s Return on Equity (ROE) at year-end, roundedto the nearest percentage point. Since the net income at the end of 2004 was $10 million and theallocated common equity was $55.6 million, the return of equity is (10 million / 55.6 million =) 18%.
Part 4)Given Nguyen’s estimate of Country Point’s terminal value in 2008, what is the growth assumption shemust have used for free cash flow after 2008?
Your answer: A was incorrect. The correct answer was A) 7%.
We know the terminal value in 2008 is $223.7 million. We can calculate the free cash flow in 2008 to be($30 million net income + $5 million depreciation - $12 million capital expenditures =) $23 million (see thetable in question 1). Thus, we can solve for the estimated growth rate:
Terminal value = [CF@2008 x (growth rate plus one)] / (discount rate – growth rate) 223.7 million = ($23 million x (growth rate plus one)) / (0.18 – growth rate) 223.7 million x (0.18 – growth rate) = 23 million x (growth rate plus one)40.266 – (223.7 x (growth rate)) = 23 million + (23 x growth rate)17.266 = 246.7 x (growth rate)0.07 = growth rate
Nguyen’s growth rate assumption is 7% per year.
Part 5)The value of beta for Country Point is:
A) 1.09.B) 1.27.C) 1.00.D) 0.80.
Your answer: A was incorrect. The correct answer was A) 1.09.
The risk free rate is (8%- 2%) = 6%. We are told that the market risk premium is 11%, and we calculatedthe cost of equity (required return) to be (10 million / 55.6 million =) 18%. Since we know the risk-free rate,the market risk premium, and the discount rate, we can use the capital asset pricing model to solve forbeta:
Required rate of return = 0.18 = 0.06 + (b × 0.11)0.18 – 0.06 = b × 0.110.12 = b × 0.11b = 1.09
Part 6)What is the estimated value of Country Point in a proposed spin-off?
A) $178.3 million.B) $147.5 million.C) $144.5 million.D) $162.6 million.
Your answer: A was incorrect. The correct answer was D) $162.6 million.
Using the discounted cash flow approach on the levels of cash flow we calculated (see the table inquestion 1):
Flyaweight Foods is a vertically integrated producer and distributor of low-calorie food products operatingon a consumer club model. They have enjoyed rapid growth in the southwest United States during their 5-
year history and are planning rapid expansion throughout the rest of the country. In order to fund theirexpansion, they are soliciting investments from a variety of venture capital groups.
One of the groups considering a bid for Flyaweight is Angelcap Investors, a private equity fund run byHarry Moskowitz. Moskowitz’ partner, Bill Sharpless, runs the group doing due diligence on Flyaweight.He provides Moskowitz with financial data on the firm:
Moskowitz suggests that a Dividend Discount Model (DDM) would be an appropriate means for valuingFlyaweight because Angelcap would be a minority shareholder. Sharpless points out that the primaryadvantage of using a DDM is that dividends are more stable than earnings or cash flow.
They ask Merle Muller, an analyst at the firm, to calculate an appropriate required return on Flyaweight.Muller collects the following market consensus information:
Table 2: Current Market Conditions
(Consensus estimates)
Expected 5-year EPS growth 8.0%
Expected 1-year Dividend yield 2.2%
Current Treasury yield (10-year note) 4.8%
Food industry beta (specialtysegment)
0.95
Muller says, “If we assume that the beta for Flyaweight should equal the beta of the specialty foodindustry, then our required rate of return in less than 10%.” Moskowitz disagrees strongly with using adiscount rate that low and insists on using a multi-factor model such as the Arbitrage Pricing Theory(APT) instead. Sharpless disagrees that the APT will solve the estimation problem, pointing out, “Aprincipal limitation of both the Capital Asset Pricing Model (CAPM) and the APT is uncertainty about thecorrect measurement of the market and factor risk premiums.”
Sharpless argues in favor of using the Gordon Growth Model (GGM). “We know what the companygrowth rate is, we know what the dividend is, and we can decide what our required rate of return is. TheGGM will give us the most accurate valuation because it uses the inputs we can measure mostaccurately.” Moskowitz points out, “An H-model would be more appropriate because it assumes a linearslowdown in growth to a constant rate in perpetuity.”
While Sharpless and Moskowitz debate the appropriate valuation approach, Muller prepares forecasts forFlyaweight.
Table 3: Forecast Values for Flyaweight
Forecast
Average totalliabilities pershare $14.40Average owners’equity per share $12.70Profit margin 29%Sales per share $10.70Dividend payoutratio 10%
Part 1)Judging by the data in Table 1, the most appropriate method for valuing Flyaweight would be:
A) the DDM because the firm has a history of dividend growth.B) free cash flow to equity because the dividend payout ratio is unstable.
C) residual income because the firm is likely to have high capital demands and negative cash flowfor the foreseeable future.
D) justified P/E because it is a high-growth company.
Your answer: A was incorrect. The correct answer was C) residual income because the firm is likely tohave high capital demands and negative cash flow for the foreseeable future.
A residual income model is appropriate for firms with long term negative free cash flow due to high capitaldemands. A DDM would not be appropriate since the dividend payout ratio is fluctuating widely. Free cashflow to equity is not appropriate because the firm needs its cash for reinvestment. Justified P/E is not apreferred valuation method for high-growth companies because it assumes a constant growth rate inperpetuity.
Part 2)
Regarding their statements about calculating a required rate of return for Flyaweight?
Sharpless Muller
A) Correct Correct
B) Correct Incorrect
C) Incorrect Incorrect
D) Incorrect Correct
Your answer: A was incorrect. The correct answer was A)Correct Correct
Sharpless is correct that uncertainty surrounding estimates of inputs and risk premiums is a key limitationof both the CAPM and the APT. Muller is correct that the required rate of return on Flyaweight is less than
10% if the beta of the specialty foods industry is used: Equity risk premium: one-year dividend growth +long-term EPS growth – long-term risk free rate Equity risk premium = 2.2% + 8.0% – 4.8% = 5.4% Thusthe required rate of return is: Required rate of return = Risk free rate + (beta * market risk premium)Required rate of return = 4.8% + (0.95 x 5.4) Required rate of return = 9.9%
Part 3)
With respect to their statements about the use of the GGM and the H-model?
Moskowitz Sharpless
A) Correct Incorrect
B) Correct Correct
C) Incorrect Correct
D) Incorrect Incorrect
Your answer: A was incorrect. The correct answer was A)Correct Incorrect
Moskowitz is correct that an H-model assumes a linear slowdown in growth until a constant growth rate isachieved. Sharpless is incorrect that the GGM would be an appropriate technique for valuing Flyaweightbecause the GGM assumes a constant rate of growth in perpetuity and Flyaweight has not yet reached aconstant growth rate.
Part 4)Which of the following is least likely to be a characteristic of a company in the initial growth phase?
A) High profit margin.B) Negative free cash flow to equity.C) Low dividend payout ratio.D) Return on equity equal to the required rate of return.
Your answer: A was incorrect. The correct answer was D) Return on equity equal to the required rate ofreturn.
Companies in the initial growth phase tend to have a return on equity higher than the required rate ofreturn, along with high profit margins, negative free cash flow to equity and a low dividend payout.
Part 5)
With respect to their statements about the use of DDMs?
Moskowitz Sharpless
A) Correct Incorrect
B) Correct Correct
C) Incorrect Correct
D) Incorrect Incorrect
Your answer: A was incorrect. The correct answer was A)
Moskowitz’ statement is correct. A dividend discount approach is most appropriate when the perspectiveis that of a minority shareholder. Sharpless’ statement is incorrect because the primary advantage of aDDM is that it is theoretically justified. The stability of dividends is an additional advantage.
Part 6)
Based on the forecast data in Table 3, Flyaweight’s sustainable growth rate (SGR) is closest to whichvalue? If asset turnover were to rise from the forecast level, what would be the impact on SGR?
ROE Impact on SGR
A) 24% Increase
B) 22% Decline
C) 22% Increase
D) 24% Decline
Your answer: A was incorrect. The correct answer was C)22% Increase
Note that total assets for the firm must equal total liabilities plus owners’ equity, so assets are ($14.40 + $12.70 =) $27.10. Thus the Return on Equity (ROE) of the firm equals: ROE = profit margin x assetturnover x financial leverage ROE = (0.29) x ($10.70 / $27.10) x ($27.10 / $12.70) ROE = 0.244 = 24.4%ROE will rise as asset turnover rises. The SGR of the firm equals: SGR = retention rate x ROE SGR = (1– 0.10) x 0.244 SGR = 0.90 x 0.244 SGR = 0.22 The SGR of the firm is approximately 22%.
Question 3 - #10112
Bernadine Nutting has just completed several rounds of job interviews with the valuation group, AncisAssociates. The final hurdle before the firm makes her an offer is an interview with Greg Ancis, CFA, thefounder and senior partner of the group. He takes pride in interviewing all potential associates himselfonce they have made it through the earlier rounds of interviews, and puts candidates through a gruelingseries of tests. As soon as Nutting enters his office, Ancis tries to overwhelm her with financial informationon a variety of firms, including AlphaBetaHydroxy, Inc., Turbo Financial Services, Aultman Construction,and Reality Productions.
He begins with AlphaBetaHydroxy, Inc., which trades under the symbol AB and has an estimated beta of1.4. The firm currently pays $1.50 per year in dividends, but the historical dividend growth rate has variedsignificantly, as shown in the table below.
Ancis says that, given AB’s wildly varying historical dividend growth, he wants to value the firm using 3different scenarios. The Low-Growth scenario calls for 3 percent annual dividend growth in perpetuity.The Middle-Growth scenario calls for 12 percent dividend growth in years 1 through 3, and 3 percentannual growth thereafter. The High-Growth scenario specifies dividend growth year by year, as follows:
AlphaBetaHydroxy, Inc. High-Growth Scenario
Year Dividend GrowthRate (%)
1 202 183 164 95 86 7
7 and thereafter 4
Nutting suggests that the scenarios are incomplete, saying that she’d like to include some additionalassumptions for the various scenarios. For example, while she would estimate the return on the S&P 500to be 12 percent regardless of AB’s performance, she would want to vary the outlook for interest ratesdepending on the scenario. In specific, she’d use a long-term Treasury bond rate of 4 percent for the twolower-growth scenarios, but raise it to 5 percent for the two higher-growth scenarios.
Ancis then moves on to Turbo Financial Services. Ancis has been following Turbo for quite some timebecause of its impressive earnings growth. Earnings per share have grown at a compound annual rate of19 percent over the past six years, pushing earnings to $10 per share in the year just ended. Heconsiders this growth rate very high for a firm with a cost of equity of 14 percent, and a weighted averagecost of capital (WACC) of only 9 percent. He’s especially impressed that the firm can achieve thesegrowth rates while still maintaining a constant dividend payout ratio of 40 percent, which he expects thefirm to continue indefinitely. With a market value of $55.18 per share, Ancis considers Turbo a strong buy.
Ancis believes that Turbo will have one more year of strong earnings growth, with EPS rising by 20percent in the coming year. He then expects EPS growth to fall 5 percentage points per year for each ofthe following two years, and achieve its long-term sustainable growth rate of 5 percent beginning in yearfour.
Finally, Ancis turns to Aultman Construction, trading at $22 per share (with current EPS of $2.50 and arequired return of 18 percent), and Reality Productions, which currently trades at $30 per share. RealityProduction’s current divided is the same as AB’s ($1.50), but the historical dividend growth rate has beena stable 10 percent. Dividend growth is expected to decline linearly over six years to 5 percent, and thenremain at 5 percent indefinitely.
Ancis begins the valuation test by asking Nutting to value AB with both the two-stage DDM model and theGordon Growth model, using the scenario most suited to each modeling technique. Nutting answers thatthe Gordon Growth model gives a valuation for AB that is $1.32 higher than the valuation using the DDMmodel. After reviewing her analysis, Ancis says that her valuation is incorrect because she should haveapplied the Gordon Growth model to the High-Growth scenario.
Unhappy with her misuse of the Gordon Growth Model, Ancis asks Nutting to explain the appropriateuses of two other valuation tools: the H-model and three-stage DDM. She says that the H-model is mostsuited to sustained high-growth companies while three-stage DDM is only appropriate to companieswhere the dividend growth rate is expected to decline in stages. Ancis says that three-stage DDM does
not require a company’s growth rate to decline – it could equally well apply when a company’s growth isexpected to be higher in the final stage than in the first. Nutting loses the job.
Part 1)Which of the following statements is FALSE? The two-stage DDM is most suited for analyzing firms that:
A) are in an industry with low barriers to entry.B) are expected to grow at a normalized rate after a fixed period of time.C) own patents for a very profitable product.D) have high growth and are expected to maintain that growth for a specific period.
Your answer: A was incorrect. The correct answer was A) are in an industry with low barriers to entry.
The two-stage DDM is well suited to firms that have high growth and are expected to maintain it for aspecific period. The assumption that the growth rate drops sharply from high-growth in the initial phase toa stable rate makes this model appropriate for firms that have a competitive advantage, such as a patent,that is expected to exist for a fixed period of time. The model is not useful in analyzing a firm that is in anindustry with low barriers to entry. Low barriers to entry are likely to result in increased competition.Therefore, the length of the initial phase of the growth period is indeterminate and probably uneven.
Part 2)Regarding the statements made by Ancis and Nutting about the correct valuation models and values forAB:
A) Ancis’s statement is correct; Nutting’s statement is incorrect.B) Ancis’s statement is correct; Nutting’s statement is correct.C) Ancis’s statement is incorrect; Nutting’s statement is correct.D) Ancis’s statement is incorrect; Nutting’s statement is incorrect.
Your answer: A was incorrect. The correct answer was D) Ancis’s statement is incorrect; Nutting’sstatement is incorrect.
Both Ancis’s and Nutting’s statements are incorrect.
The Gordon Growth Model assumes that dividends increase at a constant rate perpetually. That fits theLow-Growth scenario, not the Middle or High-Growth scenarios. Thus, Ancis’s statement is incorrect.
In the Low-Growth scenario:The required rate of return is (r) = 0.04 + 1.4(0.12 - 0.04) = 0.152.The value per share is DPS0(1 + gn)/(r - gn) = 1.50(1.03)/(0.152 - 0.03) = $12.66.
The two-stage DDM model is most suited to a company that has one dividend growth rate for a specifiedtime period and then shifts suddenly to a second dividend growth rate. That best fits the Middle-Growthscenario. In the Middle-Growth scenario,
The required rate of return is (r) = 0.05 + 1.4(0.12-0.05) = 0.148.The value per share is:
The two-stage DDM gives a value for AB that is ($16.44 - $12.66 =) $3.78 higher than the value given bythe Gordon Growth Model. Thus Nutting’s statement is also incorrect.
Part 3)What is the implied required rate of return for Reality Productions?
A) 11.75%.B) 11.00%.C) 6.00%.D) 12.50%.
Your answer: A was incorrect. The correct answer was B) 11.00%.
The H-model applies to firms where the dividend growth rate is expected to decline linearly over the high-growth stage until it reaches its long-run average growth rate. This most closely matches the anticipatedpattern of growth for Reality Productions.
The H-model can be rewritten in terms of r and used to solve for r given the other model inputs:
r = D0/P0 x {(1 + gL) x [H x (gS – gL)]} + gL
Here,
r = 1.5/30 x {(1+ 0.05) + [(6.0/2) x (0.10 – 0.05)]} + 0.05 = 0.11
Part 4)Regarding the statements made by Ancis and Nutting about the appropriate uses of the H-model andthree-stage DDM:
A) Ancis’s statement is correct; Nutting’s statement is correct.B) Ancis’s statement is correct; Nutting’s statement is incorrect.C) Ancis’s statement is incorrect; Nutting’s statement is correct.D) Ancis’s statement is incorrect; Nutting’s statement is incorrect.
Your answer: A was incorrect. The correct answer was B) Ancis’s statement is correct; Nutting’sstatement is incorrect.
Ancis’s statement is technically correct. Although three-stage DDM traditionally uses progressively lowergrowth rates in each stage, that is not necessary. Three-stage DDM applies when growth rates vary inany manner, as long as they do so in three distinct stages. Nutting’s statement is incorrect because the H-model is not appropriate for a company with sustained dividend growth at any level (high or not). The H-model assumes that the company’s dividend growth rate declines linearly.
Part 5)Based upon its current market value, what is the implied long-term sustainable growth rate of TurboFinancial Advisors?
A) 19.0%.B) 40.0%.C) 4.0%.D) 0.3%.
Your answer: A was incorrect. The correct answer was C) 4.0%.
The implied long-term rate is the rate that will cause the present value of expected dividends to equal itscurrent market value. Since Ancis provides specific growth rates for Turbo over the next three years, we
can use a multi-stage dividend discount model and solve for the long-term growth rate that makes thepresent value equal to the current market value.
First, we calculate Turbo’s expected dividends.
D0 = $10.00 current EPS times the dividend payout ratio of 40% (0.40)
D0 = $4.00 dividend per share in year 0.
Note that the 19% historical dividend growth rate is irrelevant to the current value of the firm. Since thedividend payout ratio is expected to remain constant at 40 percent, we can use the expected growth ratein earnings to estimate future dividends. EPS growth is forecast at 20% in year 1, 15% in year 2, and 10%in year 3.
Multiplying each year’s expected dividend times the relevant forecast growth rate, we calculate:
D1 = $4.00 dividend in year 0 times (1.20) = $4.80
D2 = $4.80 dividend in year 1 times (1.15) = $5.52
D3 = $5.52 dividend in year 2 times (1.10) = $6.07
Discounting these back to their present value in year 0 using the cost of equity (the WACC is irrelevant),we find:
Thus, we know that $12.56 of the current $55.18 market value represents the present value of theexpected dividends in years 1, 2 and 3. Therefore, the present value of the firm’s dividends for years 4and beyond must equal ($55.18 - $12.56) = $42.62.
Since the present value of the firm’s dividends beginning in year 4 equals $42.62, the future value in yearfour will equal ($42.62 times 1.143) = $63.14.
Now that we know the value in year 4 of the future stream of steady-growth dividends, we can solve forthe growth rate using the Gordon Growth Model:
P3 = $6.07(1+x)/(0.14 – x ) = $63.14
63.14 (0.14 – x) = 6.07 (1+x)
8.84 – 63.14x = 6.07 + 6.07x
2.77 = 69.21 x
0.04 = x
The long-term growth rate that makes Turbo fairly valued is 4% per year.
We can check our calculation by plugging the 4% growth rate we just solved for into the Gordon GrowthModel and then plugging that result into the basic multi-stage dividend discount model:
(Note that this value varies from the previous calculation by 0.01 because of rounding error.)
P0 = $4.80/1.141 + $5.52/1.142 + $6.07/1.143 + $63.13/1.143 = $55.18, which is the current market value.At a 4% growth rate, Turbo is fairly valued.
Note that on the exam, it may be faster to plug each growth rate into the Gordon Growth Model and thenplug each of those terminal values into the basic multi-stage formula than to solve for the growth rate.This trial and error method is especially effective if you start with the “middle” growth rate and then decidewhich value to test next depending on the results of the first calculation. For example, if the first growthrate gives a value for the firm that is too high, you can eliminate all the higher growth rates and try the nextlower one.
Part 6)What is the present value of Aultman’s future investment opportunities as a percentage of the marketprice?
A) 13.9%.B) 36.9%.C) 8.1%.D) 63.1%.
Your answer: A was incorrect. The correct answer was B) 36.9%.
The present value of the company’s future investment opportunities is also known as PVGO, which canbe calculated using the formula:
Value = (E / r) + PVGO, where:E = earnings per share, r = required return, and (E / r) is the value of the assets in place.
Here, $22 = ($2.5 / 0.18) + PVGOPVGO = $8.11The PVGO as a percentage of the market price equals ($8.11 / $22.00) = 36.9%.
Question 4 - #38542
Burcar-Eckhardt, a firm specializing in value investments, has been approached by the management ofOverhaul Trucking, Inc., to explore the possibility of taking the firm private via a management buyout.Overhaul’s stock has stumbled recently, in large part due to a sudden increase in oil prices. Managementconsiders this an opportune time to take the company private. Burcar would be a minority investor in agroup of friendly buyers.
Jaimie Carson, CFA, is a private equity portfolio manager with Burcar. He has been asked by ThelmaEckhardt, CFA, one of the firm’s founding partners, to take a look at Overhaul and come up with astrategy for valuing the firm. After analyzing Overhaul’s financial statements as of the most recent fiscalyear-end (presented below), he determines that a valuation using Free Cash Flow to Equity (FCFE) ismost appropriate.
Eckhardt agrees with Carson ’s choice of valuation method, but her concern is Overhaul’s debt ratio.Considerably higher than the industry average, Eckhardt worries that the firm’s heavy leverage poses arisk to equity investors. Overhaul Trucking uses a weighted average cost of capital of 12 percent forcapital budgeting, and Eckhardt wonders if that’s realistic.
Eckhardt asks Carson to do a valuation of Overstock in a high-growth scenario to see if optimisticestimates of the firm’s near-term growth rate can justify the required return to equity. For the high-growthscenario, she asks him to start with his 2006 estimate of FCFE, grow it at 30 percent per year for threeyears and then decrease the growth rate in FCFE in equal increments for another three years until it hitsthe long-run growth rate of 3 percent in 2012. Eckhardt tells Carson that the returns to equity Burcar-Eckhardt would require are 20 percent until the completion of the high-growth phase, 15 percent duringthe three years of declining growth, and 10 percent thereafter. Eckhardt wants to know what Burcar couldafford to pay for a 15 percent stake in Overhaul in this high-growth scenario.
Carson assembles a few spreadsheets and tells Eckhardt, “We could make a bid of just under $16 millionfor the stake in Overhaul if the high-growth scenario plays out.” Eckhardt worries, though, that the value oftheir bid is extremely sensitive to the assumption for terminal growth, since in that scenario, the terminalvalue of the firm accounts for slightly more than two-thirds of the total value.
Carson agrees, and proposes doing a valuation under a “sustained growth” scenario. His estimates showOverhaul growing FCFE by the following amounts:
In this scenario, he would project sustained growth of 6 percent per year in 2012 and beyond. With themore stable growth pattern in cash flow, Eckhardt and Carson agree that the required return to equitycould be cut to a more moderate 12 percent.
Carson also decides to try valuing the firm on Free Cash Flow to the Firm (FCFF) using this same 12percent required return. Using a single-stage model on the estimated 2006 figures presented in thefinancial statements above, he comes up with a valuation of $1.08 billion.
Part 1)One of the differences between FCFE and FCFF is that FCFF includes adjustments to revenue for all ofthe following EXCEPT:
A) operating expenses.B) interest payments to bondholders.C) fixed capital investment.D) working capital investment.
Your answer: A was incorrect. The correct answer was B) interest payments to bondholders.
FCFF includes the cash available to all of the firm’s investors, including bondholders. Therefore, interestpayments to bondholders are not removed from revenues to derive FCFF. FCFE is FCFF minus interestpayments to bondholders plus net borrowings from bondholders.
Part 2)Which of the following is the least likely reason for Carson’s decision to use FCFE in valuing Overstockrather than FCFF?
A) Overhaul’s capital structure is stable.B) FCFE is an easier and more straightforward calculation than FCFF.C) Overhaul’s debt ratio is significantly higher than the industry average.D) FCFE is positive.
Your answer: A was incorrect. The correct answer was C) Overhaul’s debt ratio is significantly higher thanthe industry average.
The difference between FCFF and FCFE is related to capital structure and resulting interest expense.When the company’s capital structure is relatively stable, FCFE is easier and more straightforward to use.FCFF is generally the best choice when FCFE is negative or the firm is highly leveraged. The fact thatOverhaul’s debt ratio is significantly higher than the industry average would argue against the use ofFCFE. Hence, this is the least likely reason to favor FCFE.
Part 3)Assuming that Carson is using May 1, 2005 as his date of valuation, what is the estimated value of thefirm’s equity under the scenario most suited to using the two-stage FCFE method?
A) $173.3 million.B) $129.5 million.C) $183.7 million.D) $125.2 million.
Your answer: A was incorrect. The correct answer was D) $125.2 million.
The “sustained-growth” scenario is the only scenario suitable for using the two-stage method, in partbecause the “high-growth” scenario uses three different required rates of return.
First, we need to calculate estimated FCFE in 2006.
1080 (0.12) – 1080 x = 54129.6 – 1080 x = 5475.6 = 1080 x0.07 = xThe expected growth rate in FCFF that Carson must have used is 7%.
Part 5)If Carson had estimated FCFE under the assumption that Overhaul Trucking maintains a target debt-to-asset ratio of 36 percent for new investments in fixed and working capital, what would be his forecast of2006 FCFE?
A) $16.9 million.B) $9.6 million.C) $26.5 million.D) $22.4 million.
Your answer: A was incorrect. The correct answer was C) $26.5 million.
Part 6)Regarding the statements made by Carson and Eckhardt about the value of Overhaul in the high-growthscenario:
A) Carson’s statement is incorrect; Eckhardt’s statement is correct.B) Carson’s statement is incorrect; Eckhardt’s statement is incorrect.C) Carson’s statement is correct; Eckhardt’s statement is incorrect.D) Carson’s statement is correct; Eckhardt’s statement is correct.
Your answer: A was incorrect. The correct answer was D) Carson’s statement is correct; Eckhardt’sstatement is correct.
This is a complex problem. It would help to create a table:
Total discount factor(calculated) 1.20 (1.20)2 (1.20)3 (1.20)4 (1.20)4
(1.15)(1.20)4
(1.15)2(1.20)4
(1.15)3
PV of FCFE 4.17 4.51 4.89 5.30 5.57 5.43 4.86
We begin with the forecast growth rates in FCFE in line 1. Since we have previously calculated that FCFEis $5 million in 2006, we can use the growth rates from line 1 to forecast FCFE in each year on line 2.
Line 3, required return to equity, is given. Using that, we can calculate discount factors in line 4.
Notice that the total discount factor is simply each year’s factor multiplied together. For example, the totaldiscount factor for year 4 is (1.20)4 so the total discount factor for year 5, when the year 5 required rate ofreturn drops from 20% to 15%, becomes (1.20)4(1.15).
Using the total discount factors from line 4, we can calculate the present value of each year’s cash flow inline 5. For example, the present value of year 2010 FCFE of $13.29 million will be $13.29/[(1.20)4(1.15)]or $5.57 million.
Once we have the discounted cash flows for each year, we need to calculate the terminal value. Terminalvalue will be:
TV = (15.33)(1.03) / (.10 - .03)
TV = 15.7899 / .07
TV = $225.57 million
Note that the required rate of return used for the terminal value is the rate for the steady-growth period,which is lower than that used in the high-growth phase (stage) or the declining growth phase (stage two).
We now need to discount terminal value back using the total discount factor for 2012:
PV of terminal value = $225.57 million / [(1.20)4(1.15)3]
PV of terminal value = $71.53 million
Adding together the discounted cash flows for each year with the discounted terminal value, we have:
Since the equity value of the firm is $106.26 million, Burcar should be willing to pay up to $106.26 x 0.15 =$15.94 million for a 15% stake in the firm. Since this is slightly less than $16 million, Carson ’s statementis correct. The terminal value represents ($71.53 / $106.26 = ) 67.3% of the firm’s present value, soEckhardt’s statement is also correct.
Question 5 - #10308
Analysts and portfolio managers at Big Picture Investments are having their weekly investment meeting.CEO Bob Powell, CFA, believes the firm’s portfolios are too heavily weighted toward growth stocks. “Iexpect value to make a comeback over the next 12 months. We need to get more value stocks in the BigPicture portfolios." Four of Powell’s analysts, all of whom hold the CFA charter, were at the meeting –Laura Barnes, Chester Lincoln, Zelda Marks, and Thaddeus Bosley. Powell suggested Big Picture shouldstart selecting stocks with the lowest price/earnings (P/E) multiples. Here are the analysts’ comments:
Barnes said numerous academic studies have shown that low P/E stocks tend to outperform thosewith high P/Es. She uses the P/E ratio as the basis of most of her valuation analysis. “I prefer to usethe justified P/E ratio because it is inversely related to the required rate of return.”Lincoln warned against using P/E ratios to evaluate technology stocks. He suggests using price/book ratios instead, because they are useful for explaining long-term stock returns. “Book value is agood measure of value for companies with a lot of liquid assets, and it is easier to calculate thanthe P/E because you rarely have to adjust book value.”Bosley prefers the price/sales (P/S) ratio and the earnings yield. “The P/S ratio is particularly usefulfor valuing companies in cyclical industries because it isn’t affected by sharp changes in profitabilitycaused by economic cycles.”
Marks acknowledges that the P/E ratio is a useful valuation measurement. However, she prefersusing the price/free-cash-flow ratio. “Free cash flow is more difficult to manipulate than earnings,and it has proven value as a predictor of stock returns.”
Powell has provided Barnes with a group of small-cap stocks to analyze. The stocks come from a varietyof different sectors and have widely different financial structures and growth profiles. She has been askedto determine which of these stocks represent attractive values. She is considering four possible methodsfor the job:
The PEG ratio, because it corrects for risk if the stocks have similar expected returns.Comparing P/E ratios to the average stock in the S&P 500 Index, because the benchmark shouldserve as a good proxy for the average small-cap stock valuation.Comparing P/E ratios to the median stock in the S&P 500 Index, because outliers can skew theaverage P/E upward.The P/S ratio, because it works well for companies in different stages of the business cycle.
Part 1)Which analyst’s quote is INCORRECT?
A) Barnes’.B) Bosley’s.C) Lincoln’s.D) Marks’.
Your answer: A was incorrect. The correct answer was C) Lincoln’s.
Book value must be adjusted constantly, and it is generally more complicated to calculate than earnings.The other three statements are true.
Part 2)Barnes is contemplating the use of a price/earnings ratio to value a start-up medical technology firm.Which of the following is the most compelling reason not to use the P/E ratio?
A) Earnings per share are not a good determinant of investment value for medical-technologycompanies.
B) Clients who receive a report on the company may not understand what the P/E ratio means.C) P/E ratios for medical-technology firms with different specialties are not comparable.D) The company is likely to be unprofitable.
Your answer: A was incorrect. The correct answer was D) The company is likely to be unprofitable.
Earnings are the chief determinant of value for most companies, including med-tech. P/E is the mostcommon valuation method and the best known by lay investors. Comparability of P/E ratios acrossindustries is always problematic, but not as much so for within the med-tech industry. A start-up companyis very likely to have negative earnings, which renders the P/E ratio useless.
Part 3)Based on their responses to Powell, which of the analysts is most likely concerned about earningsvolatility?
A) Lincoln.B) Barnes.C) Bosley.D) Marks.
Your answer: A was incorrect. The correct answer was A) Lincoln.
Book value tends to be more stable than earnings. Therefore, Lincoln’s favorite valuation tool, the price tobook (P/B) ratio, is less volatile than the P/E. The P/S ratio tends to be less volatile than the P/E as well,but Bosley’s other favorite, earnings yield, is just as volatile. The methods preferred by the other analystsare likely to be more volatile than the P/B ratio.
Part 4)Based on their responses to Powell, which of the analysts has proposed a method that has the bestchance to work for determining the relative value start-up companies?
A) Lincoln.B) Barnes.C) Bosley.D) Marks.
Your answer: A was incorrect. The correct answer was C) Bosley.
Start-up companies tend to be unprofitable, and also often have negative free cash flow. Book value hassome predictive power for such companies, but this is also often negative for new and unprofitablecompanies. The price/sales ratio, one of Bosley’s favorites, is the only metric that will work even ifearnings, cash flows, and book value are negative.
Part 5)Barnes would be least likely to use EV/EBITDA ratio, rather than the price/earnings ratio, when analyzinga company that:
A) pays a dividend, and is likely to deliver little earnings growth.B) is unprofitable.C) reports a lot of depreciation expense.D) has a different capital structure than most of its peers.
Your answer: A was incorrect. The correct answer was A) pays a dividend, and is likely to deliver littleearnings growth.
For companies that are unprofitable, report a lot of depreciation expense, or must be compared tocompanies with different levels of financial leverage, the EV/EBITDA ratio may be more useful than the P/E. For companies that pay a dividend and have little profit growth, both should work fine. Given Barnes’stated preference for the P/E ratio, she is least likely to use the EV/EBITDA ratio with the dividend-payingfirm.
Part 6)Barnes is considering the four methods previously described to analyze the small-cap stocks provided toher by Powell. For which method does Barnes provide the weakest justification?
A) The mean P/E of S&P 500 companies.B) The PEG ratio.C) The median P/E of S&P 500 companies.D) The price/sales ratio.
Your answer: A was incorrect. The correct answer was B) The PEG ratio.
No valuation method will work dependably across all types of stocks. The four Barnes proposed areprobably as good as any. But the PEG ratio does not correct for risk – it works as a comparison tool only ifthe companies have similar expected risks and returns. The other justifications are reasonable.
Starshah Industries competes in a high-growth, emerging technology sector that is facing increasingcompetitive pressures. So far, the firm has been performing well, earning $4.55 per share in 2004.Investment requirements were high, with capital expenditures of $1.75 per share, depreciation expense of$1.05, and a net investment in working capital that year of $1.00 per share. However, despite Starshah’shigh growth rate and impressive profitability, Starshah’s Chairman, Lorenzo di Stefano, has becomeconcerned about the impact that a slowdown in expected growth may have on the firm’s valuation.
Di Stefano asked Starshah’s Director of Strategic Planning, Keisha Simmons, to make a presentation toStarshah’s board at the end of 2004 about the future growth of the firm. The news was sobering.Simmons told the board members that Starshah could expect two more years of rapid growth, duringwhich time earnings per share could be expected to rise 45 percent per year with 30 percent annualincreases in capital spending and depreciation. During this high-growth period, Simmons estimates thatthe required return on equity for Starshah will be 25 percent. Starshah consistently maintains a target debtratio of 0.25.
After the near-term spurt of high growth, however, she and her group expect Starshah to move eventuallyto a stable growth period. During the stable growth period, free cash flow to equity (FCFE) will rise only 5percent per year and the annual return to shareholders will decline to 10 percent.
The strategy group expects the transitional period between high-growth and mature growth to last fiveyears. During that time, capital expenditures will rise only 8 percent per year, with depreciation rising 13percent per year. The growth in earnings should drop by eight percentage points per year, hitting 5percent in the fifth year. During this transition, the expected return to shareholders will be 15 percent peryear.
Throughout the high-growth and transitional growth periods, Simmons expects Starshah to be able tolimit increases in the investment in working capital to 20 cents per year. In her analysis, the investment inworking capital will peak in 2010, declining a dime to $2.10 per share in 2011.
After Simmons’ presentation, the board debated what to do about the incipient slowdown in Starshah’sgrowth. A majority of the board argued in favor of moving to offset this slowdown in organic growththrough a new emphasis on growth by acquisition.
One potential target is TPX. TPX is expected to have fairly strong free cash flow to equity (FCFE) for thenext few years: $425,000 in 2004, $500,000 in 2005, $600,000 the following year, and $700,000 in 2007.After that, Starshah expects free cash flow to equity at TPX to grow 3 percent per year indefinitely.Starshah would require a return on its equity investment of 20 percent per year in the high-growth stageand 12 percent per year in the stable growth stage.
Di Stefano and Simmons had a somber meeting the day after the board presentation. But despite thebleak news about future years, di Stefano had convinced himself it was worth staying around through thehigh-growth and transitional periods. He pointed out to Simmons that, if Simmons’ projections werecorrect, the value of Starshah’s stock would be in excess of $450 per share by the time the company hitthe stable-growth phase. Di Stefano was very pleased with what that implied for the value of his stockoptions.
Simmons had done the same calculations herself, but she also realized that if required rates of return in2012 rose from the very modest 10 percent she used in her board projections to only 15 percent, thatwould cut the terminal value of Starshah’s stock in 2011 to only half the level di Stefano was counting on.She considered that valuation too small to make the wait worthwhile. Simmons said nothing to di Stefano,but planned to look for another job.
Part 1)Which of the following free cash flow to equity (FCFE) models is best suited to analyzing TPX?
Your answer: A was incorrect. The correct answer was B) Two-stage FCFE model.
The two-stage FCFE model is most suited to analyzing TPX because we have specific forecasts for thefirst several years and then a stable growth pattern into the indefinite future.
Part 2)The free cash flow to equity (FCFE) for Starshah at the end of the transition period in 2011 is closest to:
A) $20.62.B) $23.42.C) $27.52.D) $21.89.
Your answer: A was incorrect. The correct answer was D) $21.89.
In order to calculate FCFE for Starshah in 2011, we need to construct a table of the components of cashflow for Starshah.
We are given the 2004 values for net income, capital expenditures, depreciation, and change in workingcapital. We are also given growth rates for each of the three stages of Starshah’s growth: high-growth fortwo years followed by transitional growth for five years, culminating in stable growth for the followingyears. Using the original values and their related growth rates, plus the formula for FCFE (see below), wecan construct the following table:
FCFE = Earnings per share - (Capital Expenditures - Depreciation) x (1 - Debt Ratio) – (Change inworking capital x (1 - Debt Ratio)) = 24.27 – (4.35 – 3.27) x (1-0.25) – (2.10 x (1-0.25))= 24.27 – 0.81 – 1.57 = 21.89Free cash flow to equity equals $21.89 per share in 2011.
Part 3)Regarding di Stefano’s and Simmons’ statements about the terminal value of Starshah stock in 2011:
A) Di Stefano’s statement is correct and Simmons’ statement is incorrect.B) Di Stefano’s statement is incorrect and Simmons’ statement is incorrect.C) Di Stefano’s statement is incorrect and Simmons’ statement is correct.D) Di Stefano’s statement is correct and Simmons’ statement is correct.
Your answer: A was incorrect. The correct answer was D) Di Stefano’s statement is correct and Simmons’statement is correct.
Starshah hits the stable growth phase in 2012. At that point, Terminal Firm Value2011 = FCFE in year 2012 divided by (required rate of return – growth rate)= $21.89 (1.05) / (0.10 - 0.05) = $22.98 per share / 0.05= $460 per share. Di Stefano’s statement is correct.Terminal Firm Value2011 = FCFE in year 2012 divided by (required rate of return – growth rate) = $21.89
(1.05) / (0.15 - 0.05)= $22.98 per share / 0.10 = $230 per share. Simmons’ statement is also correct.
Part 4)Assuming Simmons is right that the required return on Starshah equity rises to 15% in 2012 and beyond,what is the value of Starshah stock at the end of 2004?
A) $63.71.B) $44.29.C) $111.35.D) $117.49.
Your answer: A was incorrect. The correct answer was D) $117.49.
In order to calculate the firm value, we need to know the discount rate that applies over each period.Since the discount rate changes, we can simplify the arithmetic by constructing a table of discount factorsusing 25% for each of the first two years and 15% for each of the following five years:
We can then calculate firm value in 2004 using the FCFE values we calculated in question 1 and thestock value in the year 2012 (that we calculated in question 3).
Your answer: A was incorrect. The correct answer was A) Three-stage FCFE model.
The three-stage FCFE model is most suited to analyze firms in high growth industries that will faceincreasing competitive pressures over time, since those competitive pressures will lead to a gradualdecline in the firm’s growth rate (second stage) to a stable level (third stage).
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