CHAPTER 11

Problem 1:

You have been asked to estimate the expected growth in earnings in MNL Bank, a regional bank
that reported $ 2 in earnings per share in the most recent year on a book value of equity, per
share, of $10. The firm paid out $0.50 in dividends per share.

a. Assuming that the firm can maintain the return on equity and payout ratio from last year for
the next 5 years, estimate the expected growth rate in earnings for the next 5 years.

b. Now assume that the banking crisis will create the following changes: the firm will be
required to raise its equity capital by 50% immediately by regulatory authorities, to set aside
20% of earnings each period to cover bad loans and to suspend dividend payments for the next 5
years. Estimate the new expected growth rate in earnings per share.

Solution:

a- g (EPS) = ROE × Retention ratio

= ROE× (1- )

= × (1- )

= × (1- )

= 0.15

g (EPS) = 15 %

b. The company decided to suspend dividend payments →DPS = 0 → Retention ratio = 1

New EPS = Old EPS (1- 0.2) = 2 x 0.8 = 1.6

New BV (E) = Old BV (E) (1.5) = 10 ×1.5 = 15

g (EPS) = ROE × Retention ratio = (1.6 / 15) x 1 = 10.667%

Problem 2:

Softcom Inc. is a firm that manufactures entertainment software. The firm reported net income of
$ 25 million for the most recent financial year. It raised no new equity during the course of the
year, and the book value of equity increased from $ 125 million at the beginning of the year to
$145 million at the end of the year. Based on these fundamentals, estimate the expected growth
rate in earnings per share for Softcom.
Solution:

ROE = = = 0.2

The $20 million increase of BV (E) represents retained earnings.

Retention ratio = = 0.8

g (EPS) = ROE× Retention ratio = 0.8×0.2 = 0.16 or 16

Problem 3:

You are trying to estimate an expected growth rate in operating earnings for Zordon Corporation,
a chemical company for the next 5 years. In the most recent year, the firm reported after-tax
operating income of $ 100 million on a book value of capital of $ 1billion. The firm also had
capital expenditures of $ 150 million and depreciation of $ 80 million during the year. The firm
expects to maintain this reinvestment rate for the next 5 years and earn 15% on its new
investments starting immediately and to gradually improve its return on capital on existing assets
to 15% over the next 5 years.

a. Estimate the annual expected growth in operating income for the next 5 years?

b. How much of the annual growth rate (estimated in part a) can be attributed to more efficient
utilization of existing assets.

Solution:

a- g = ROC new * reinvestment rate + [1 + (ROC new – ROC old)/ROC old] 1/5 – 1

Reinvestment rate = reinvestments / EBIT0 (1-t) = (CAPEX – depreciation)/ EBIT0 (1-t) = (150–
80)/100 = 0.7

ROC old = EBIT0(1-t) / BV(Capital) = (100 x 106) / 109 = 10%

g= 15%*0.7 + [1 + (15% – 10%)/10%] 1/5 – 1 = 18.95%

b. New Investment growth = 15% *0.7 = 10.5%

Growth due to improved efficiency = 18.95% - 10.5% = 8.45%

OR

Growth due to improved efficiency = [1 + (ROC new – ROC old)/ROC old] 1/5 – 1] =
[1 + (15% – 10%)/10%] 1/5 – 1 = 8.45%
Problem 4:

Yuvan Chemicals reported $ 400 million in after-tax operating income on capital invested of $ 5
billion in the most recent year. In the same period, capital expenditures amounted to $ 250
million, depreciation was $ 100 million and noncash working capital increased by $ 50 million.
The company would like to maintain its existing reinvestment rate, but wants operating income
to grow 30% next year. What return on capital will the firm have to generate to achieve this
growth rate? (The return on capital will have to be the same on both new and existing
investments).

Solution:

Reinvestments = (CAPEX – depreciation) + ∆non cash working capital = 250–100+50 = 200

Reinvestment rate = reinvestments/EBIT (1-t) = 200/400 = 50%

Current ROC = EBIT (1-t)/BV (capital) = 400/5000 = 8%

g = ROC new * reinvestment rate + = ROC new * 0.5 +

Solving for ROCnew, we obtain ROCnew = 10%

CHAPTER 12

Problem 1:

The following are projected free cash flows to equity for a company that is expected to be in high
growth for the next 3 years. The firm's beta is also expected to change over the 3-year period:

Assume that after year 3, the beta will stay at 1.00, and that the growth rate will remain 6%
forever. The risk free rate is 5%, and you can assume a risk premium of 5.5%.

a. Estimate the price at the end of the third year.

b. Estimate the value per share today.

a- Terminal value = P3 = FCFE4 / (re –g)

Re= Rf+ B (risk premium mature) = 5% + 1 x 5.5% = 10.5%

Therefore, the terminal value is equal to $2.13 / (0.105 – 0.06) = $47.34

b-

The Present value today of the terminal value at yr 3 =

= =33.56

Value/share = 33.56+0.87+1.086+1.25 = $36.766

Problem 2:

You have been asked to examine a valuation done of Loden Construction, a real estate and
construction company. You have been provided with the income statement for the last year:

Revenues $ 1000 million

- Operating Expenses $ 700 million

- Depreciation & Amortization $ 100 million

= EBIT $ 200 million

In the valuation, the analyst has assumed a growth rate of 5% forever in revenues, operating
income and depreciation, and assumed capital expenditures of $ 160 million (for next year). In
addition, the analyst has assumed that non-cash working capital will be 26% of the change in
revenues. (Tax rate = 20%)

a. Estimate the expected free cash flows to the firm next year, based upon the assumptions listed
above.
b. What is the return on capital being assumed in perpetuity by the analyst?

c. You believe that this firm is in a competitive business and will earn a return on capital equal to
its cost of capital (which is 10%). What is the correct value of the firm assuming that the stable
growth rate of 5% remains unchanged?

Solution:

a- EBIT1 (1-t) = EBIT0 (1+g) (1-t) = 200*1.05*(1-0.2) = 168

Dep1 = Dep0 * (1+g) = 100*1.05 = 105

Change in non-cash NWC = 0.26 * [1000*1.05 – 1000] = 0.26*50 = 13

CAPEX = 160

Reinvestments = CAPEX – depreciation + change in NWC = 160 – 105 + 13 = 68

FCFF1 = EBIT1 (1-t) – reinvestments

FCFF1 = 168 – 68 = 100 million

b- g = reinvestment rate * ROC

Reinvestment rate = reinvestments / EBIT1 (1-t) = 68/168 = 40.48%

ROC = g/reinvestment rate = 5%/40.48% = 12.35%

c- ROC = WACC = 10%

Reinvestment rate = g/ROC = 5%/10% = 50%

FCFF1= EBIT1 (1-t) * (1-reinvestment rate) = 168 * (1-0.5) = 84 million

Present Value of operating assets = FCFF1/ (r-g) = 84/ (10% - 5%) = 1,680 million

Problem 3:

You have been asked to review the terminal value calculation in a valuation done by another
analyst. The analyst has the following estimates for net income and FCFE for the next 3 years:
To estimate the terminal value, the analyst has taken the FCFE in year 3 and grown it by 3% (the
stable growth rate) and used a cost of equity of 8%. If the firm’s return on equity will remain
unchanged at current levels in perpetuity and the analyst’s estimates of the FCFE for the high
growth period are correct, estimate the correct terminal value of equity, using the perpetual
growth rate of 3% and the cost of equity of 8%.

Solution:

FCFE4 = NI3 * (1+ g NI) * (1-reinvestment rate) = NI3*(1+ g) * (1 – g/ROE)

= 181.5*1.03 *(1 – 0.03/ROE) = 186.945*(1 – 0.03/ROE)

Growth in net income = (165 – 150)/150 = 10%

Reinvestment rate = 1 - =1- = 66.67%

ROE = = 10% / 66.67% = 15%

FCFE4 = 186.945*(1 – 0.03/ROE) = 186.945*(1 – 0.03/0.15) = 149.556

Terminal value = = = 2991.12

Problem 4:

Cool Springs Inc. is a privately owned business that owns a number of small restaurants. The
owner of the firm is considering an offer to buy the firm and has asked for your help in
evaluating the offer. The income statement for the firm for the most recent year is reported below
(in ‘000s):

Revenues $ 5,000

- Operating Expenses $ 3,500

EBIT $ 1,500

- Interest Expenses $ 300

- Taxes $ 480

Net Income $ 720

The owner did not pay herself a salary last year, but believes that $ 100,000 would be a
reasonable salary for a general manager. The firm is in stable growth, and is expected to grow
5% a year forever (with a 40% reinvestment rate). You estimate the unlevered beta of publicly
traded restaurants to be 0.80 and the correlation coefficient with the market to be 50%. The
average debt to capital ratio for these firms is 30%, and you believe that Cool Springs will have
to operate at close to this average. If the riskfree rate is 6%, the market risk premium is 4% and
the cost of debt is 7%, estimate the value of Cool Springs for sale in a private transaction (to an
individual who will not be diversified).

Solution:

Tax rate = = = = 40%

Total beta = 0.8/0.5 = 1.6

B levered = B unlevered [1+ (1- t)] = 1.6[1+ (1-0.4)] = 2.011

re = rf + BL*Rp = 6% + 2.011*4% = 14.044%

WACC = WD*RD (1-t) + WE * re = 0.3*7 %*( 1-0.4) + 0.7*14.044% = 11.09%

Adjusted EBIT0 = 1500 – 100 = 1400

FCFF1= adjusted EBIT0 (1-t) * (1+g) * (1 – reinvestment rate) = 1400(1-0.4)*1.05*(1-0.4) =

PV = = = 8689.65

Problem 5:

You are comparing two firms- BigName Inc. and NoName Inc., both of which are mature and
growing at a stable growth rate of 4%. Both firms are forecasting revenues of $ 5 billion, have a
book value of capital invested of $ 2.5 billion and a cost of capital of 9%. BigName Inc., though,
has an after-tax operating margin of 12%, whereas NoName Inc. has an after-tax operating
margin of 6%. Estimate the value of Big Name Inc.’s brand name.

Solution:

We need to compute the value of each firm, and then the difference between the two will be the
value of Big Name Inc’s brand name.

Big Name: EBIT1(1-t) = 5 x 109 x 0.12 = 0.6 x 109

ROC = EBIT1(1-t) / BV(Capital) = 0.6 / 2.5 = 24%

Reinvestment rate = g / ROC = 4% / 24% = 16.667%

= 0.6 x 109 x (1-0.16667) / (0.09 – 0.04)

= 9,999,960,000

No Name: EBIT1(1-t) = 5 x 109 x 0.06 = 0.3 x 109

ROC = EBIT1(1-t) / BV(Capital) = 0.3 / 2.5 = 12%

Reinvestment rate = g / ROC = 4% / 12% = 33.333%

Value of No Name = EBIT1(1-t)(1-reinvestment rate) / (rWACC – g)

= 0.3 x 109 x (1-0.33333) / (0.09 – 0.04)

= 4,000,020,000

Value of Big Name’s brand name = 9,999,960,000 – 4,000,020,000 = 5,999,940,000

Problem 6:

You have been asked to value a privately owned retail company for a sale transaction and have
collected the following information on the firm. The firm is expected to earn after-tax operating
income of $1.5 million on revenues of $ 10 million next year. It expects to earn a return on
capital of 10% and income will grow 4% in perpetuity. The firm has no debt outstanding and the
average unlevered beta of retail firms is 0.90; however, only 30% of the risk in this sector is
market risk. The risk-free rate is 5% and the risk premium is 4%.

a. Estimate the value of a 25% stake in this company in a private transaction (to an undiversified
individual).

b. Now assume that the company can double its return on capital on new investments, if run
efficiently, while maintaining the same growth rate. Estimate the value of a 51% stake in a
private transaction. (Existing assets will continue to earn a return on capital of 10%)

Solution:

a. B levered = B unlevered because there is no debt.

B levered = 0.9/0.3 =3

RWACC = Re = R f + B levered x R p = 5% + 3*4% = 17%

Reinvestment rate = g/ROC = 4%/10% = 40%

FCFF = EBIT(1-t)(1+g) (1- reinvestment rate) = 1.5 x 106 (1-0.4) = 0.9 x 106
PV = FCFF / (rwacc – g) = 0.9 x 106 / (0.17 – 0.04) = 6,923,076.923

Value of 25% stake in firm =0.25*6,923,076.923 = 1,730,769.231

b. Reinvestment rate = g/ROC = 4%/20% = 20%

FCFF = EBIT(1-t)(1+g)(1- reinvestment rate) = 1.5 x 106 (1-0.2) = 1.2 x 106

PV = FCFF / (rwacc – g) = 1.2 x 106 / (0.17 – 0.04) = 9,230,769.231

Value of 51% stake in the firm = 0.51*9,230,769.231 = 4,707,692.308

Problem 7:

Gloria Inc. is a publicly traded manufacturer of name brand perfumes that expects to report $ 150
million in after-tax operating income on $ 1 billion in revenues next year. Hong Kong Perfumes
Inc. makes generic perfumes and is expected to report the same revenues as Gloria Inc next year
but is expected to earn only $75 million in after-tax operating income. Both firms have the same
book value of capital of $600 million today, are in stable growth and expect operating earnings
to grow 5% a year in perpetuity. Both firms also have the same cost of capital of 10%.

Estimate the value of Gloria Inc.’s brand name.

Solution:

Gloria Inc: EBIT(1-t)(1+g) = 150 x 106 ; ROC = 150 x 106 / 600 x 106 = 25% ; reinvestment rate
= g / ROC = 0.05 / 0.25 = 20%

Value = FCFF / (rwacc – g) = (150 x 106 (1-0.20)) / (0.10 – 0.05) = 2.4 x 109

Hong Kong: EBIT(1-t)(1+g) = 75 x 106 ; ROC = 75 x 106 / 600 x 106 = 12.5% ; reinvestment
rate = g / ROC = 0.05 / 0.125 = 40%

Value = FCFF / (rwacc – g) = (75 x 106 (1-0.4)) / (0.10 – 0.05) = 900 x 106

Value of Gloria Inc’ brand name: 2.4 x 109 – 900 x 106 = 1.5 x 109

Problem 8:

You have been called in to value a dental practice by an old friend and have been provided with
the following information:

• The practice generated pre-tax income of $ 550,000 last year for the dentist, after meeting all
office expenses. The income is expected to grow at 2% in perpetuity, with no reinvestment
needed. The tax rate is 40%.
• The dentist currently spends about 20 hours a week doing the accounting and administrative
work. You estimate that hiring an external accounting service will cost you $25,000 annually. As
an alternative to private practice, the dentist could work at a dental hospital nearby at an annual
salary of $ 150,000. (Neither was considered when estimating the income above)

• The office is run out of a building owned by the dentist. While no charge was assessed for the
building in computing the income, you estimate that renting the space would have cost you
$75,000 a year.

• The unlevered beta of publicly traded medical service companies is 0.80 but only one-third of
the risk in these companies is market risk. The dental practice has no debt.

(You can use a risk free rate of 4.25% and a risk premium of 4%).

a. Estimate the cost of capital that you would use in valuing this practice.

b. Estimate the value of the practice for sale in a private transaction to another dentist who is not
diversified.

Solution:

a. BU = BL because there is no debt

BL = 0.8*3 = 2.4

Re = R f + B (risk premium) = 4.25% + 2.4*4% = 13.85%

b. Corrected income = EBIT – rent – accounting expenses – dental salary = 550 000 – 75 000 –
25 000 – 150 000 = 300 000

After-tax income= EBIT * (1-t) = 300 000 * (1-0.4) = 180 000

Value= = = 1,549,367.089

Problem 9:

You have been asked to value Tiddly Winks Toys, a privately held firm. In the most recent
financial year, Tiddly Winks Toys reported after-tax operating income of $ 12 million and
earned an after-tax return on capital of 12% on invested capital. Tiddly Winks has no debt, and
the unlevered beta for this private company is 3. The risk-free rate is 5%, the equity risk
premium is 4%.

Value Tiddly Winks Toys for sale as a private business, run as is. (You can assume that the
return on capital will remain unchanged and that the firm will grow 3% a year in perpetuity).
Solution:

Re= Rf + B (risk premium) = 0.05 + 3× 0.04 = 17%

Reinvestment rate = = = 25%

FCFF1 = EBIT (1-T) (1+g) (1- Reinvestment rate)

=12×106 (1.03) (1-0.25)

=9,270,000

Value = = 9,270,000 / (0.17 – 0.03) = 66,214,285.71

Problem 10:

You are considering buying Cervelli Plumbing, a privately owned plumbing business and have
collected the following information.

Francisco Cervelli, the owner, has provided you with the financial statements of the business that
indicate that it generated after-tax operating income of $200,000 last year on revenues of $
800,000. Mr. Cervelli did not pay himself a salary and does much of the accounting, advertising
and bill collection work. You believe that hiring an administrative service to do the same work
will cost you $ 50,000 a year (pre-tax). The tax rate is 40%. The risk-free rate is 4% and the
equity risk premium is 6%. The unlevered beta for the firm is 1.067. The firm is entirely equity
funded and is expected to generate its current after-tax operating income in perpetuity.

Estimate the value of the firm.

Solution:

New EBIT (1-t) = Old EBIT (1-t) – administrative expense (1-t)

= 200,000 – 50,000 (1-0.4)

= $170,000

There is no reinvestment because there is no growth (the current EBIT(1-t) will be generated in
perpetuity).

Re = Rf + B risk premium = 4% +1.067 x 6% = 10.402%

Value of business = = = $1,634,301.096

Cementics is a large manufacturing firm that reported earnings before interest and taxes of -$400
million on revenues of $ 8 billion in the current year. The firm expects its pre-tax operating
margin to improve next year to the industry average of 5%. The average cost of capital for the
industry is 10%, the average return on capital for the industry is 12.5% and the industry is
mature, with all firms in it expecting to report growth of 5% in revenue and operating income
over the long term. The marginal tax rate for all firms is 40%.

a. Estimate the value of Cementics as a firm. (You can assume that it will have the same cost of
capital and return on capital as the rest of the industry)

b. Now assume that Cementics will have $ 861 million in net operating losses to carry forward
after the current year. How will this affect the firm valuation that you did in part (a))?

Solution:

a- Revenues next year = Revenues at time 0 * (1+g) = 8000 * (1.05) = 8400 million

EBIT1 = Pre-tax operating margin * Revenues next year = 0.05 * 8400 = 420 million

EBIT1 (1-t) = 420 * (1-0.4) = 252 million

Reinvestment rate = g/ROC = 5%/12.5% = 40%

FCFF1 = EBIT1 (1-t) * (1 – reinvestment rate) = 252 * (1-0.4) = 151.2 million

Value = = = 3,024 million

b- Expected Tax Savings from the net operating loss

EBIT2 = EBIT1 * (1+g) = 420 * 1.05 = 441 million

Net operating loss carried forward for year 1 is 420 million and for year 2 is 441 million.

Taxes at year 1 = 0.4*420 = 168 million

Taxes at year 2 = 0.4 *441 = 176.4 million

PV of savings of year 1 = = 152.73 million

PV of savings of year 2 = = 145.78 million

Total PV of savings = $298.51 million. This amount needs to be added to the value of the firm.
Problem 12:

You have been asked to check the valuation of InfoSys, a software firm, done by an eminent
analyst. You note that the analyst has assumed earnings growth of 10% a year for the next 3
years, and 5% a year thereafter, and has arrived at a value for the firm of $ 400 million. While
you find yourself in agreement with most of the assumptions made by the analyst, you disagree
with the assumption she has made that capital expenditures will offset depreciation after year 3.
You believe, instead, that capital expenditures will be 150% of depreciation after year 3. If the
current depreciation is $10 million and the cost of capital is 11%, estimate the effect of this
change in assumption on the value of the firm. (There are no working capital requirements and
depreciation grows at the same rate as earnings)

Solution:

Expected Depreciation in year 4 = current depreciation * (1+g1)3 * (1+g2)

= 10 x 106 (1.10)3 (1.05) = 13.9755 x 106

Expected Capital Expenditures in year 4 = expected depreciation in year 4 * 1.5

= 13.9755 x 106 (1.50) = 20.96325 x 106

Expected Net CAPEX in year 4 = 20.96325 x 106 – 13.9755 x 106 = 6.98775 x 106

Expected present value of Net CAPEX in perpetuity = [6,987,750 / (0.11 – 0.05)] / 1.113

= $85,156,376.24

New Value = Previous Value of the firm – expected present value of Net CAPEX in perpetuity

= 400,000,000 – 85,156,376.24

= $314,843,623.8