Assignment I

1.​ Define free cash Flow? Why is it the most important measure of cash Flow?
Free cash flow (FCF) is the cash flow available for distribution to a company's
investors, including creditors and stockholders, after the company has made
investments to sustain ongoing operations.
A company's value depends on the amount of FCF it can generate. Managers
and investors can use FCF and its components to measure a company's
performance.

2.​ What is the implication of zero or negative free cash flow for firm valuation?
If FCF is negative, it likely indicates that the company only covering ongoing
investment with operating cash flow. However, many high-growth companies
have positive NOPAT but negative FCF because they are making large
investments in operating assets to support growth. High growth usually leads
to negative FCF due to capital investments, but this is acceptable if ROIC >
WACC. Short-term negative FCF resulting from growth investments may not
harm valuation if the company is expected to generate future cash flows.
However, persistent negative FCF due to weak business performance signals
financial trouble, leading to a lower valuation.

3.​ Explain if equity is riskier than debt.

Equity is riskier than debt. When a company goes bankrupt, debt holders are
paid first, while equity holders receive payment only after all debts and
liabilities have been settled. As an equity investor, you may lose your entire
investment. Debt owners receive fixed interest payments, whereas equity
investors earn returns based on the company's performance, with no
guarantees.

4.​ What should be the goal of firm management? Explain.

The primary goal of firm management is to maximize stockholder wealth. This
implies maximizing value of the company or maximizing stock price for
publicly listed company.

5.​ Hale Corporation has zero net operating working capital (NOWC) and very
little fixed asset. What is the implication for Hale’s valuation?

A company with zero NOWC and very few fixed assets is deploying minimum
capital. The firm may command a high valuation given good growth potential
and competitive strength.
6.​ Define EVA and MVA. Why is EVA a better measure of economic profit?
What can we conclude from MVA?

EVA measures a company's true economic profit by accounting for the cost of
capital. MVA represents the difference between the market value of the firm’s
stock and the cumulative amount of equity capital supplied by shareholders.

EVA = NOPAT- (WACC)(Capital)

MVA = Market Value of the Firm - Book Value of the Firm

EVA differs substantially from accounting profit because accounting profit

does not include a charge for the use of equity capital. EVA focuses on
managerial effectiveness in a given year, measures the extent to which the firm
has increased shareholder value, and can be applied to individual divisions or
units within a large corporation. For these reasons, EVA is a better measure of
economic profit.
A high MVA indicates that the company has successfully generated long-term
shareholder value, reflecting investor confidence in its future growth.
Conversely, a low or negative MVA suggests that the firm is either destroying
value or that investors have low expectations for its future performance.

7.​ A startup secures $5m funding while providing 30% stake to the investor.
What is the estimated value of the startup?

Value=5/0.3 = 16.67
The estimated value of the startup is 16.67m.

8.​ Define P/E ratio. What are the factors that may influence P/E ratio of a firm?

The price/earnings (P/E) ratio shows how much investors are willing to pay
per dollar of reported profits. Price/earnings ratios are higher for firms with
strong growth prospects, other things held constant, but they are lower for
riskier firms.
Price/earnings (P/E) ratio = Price per share /Earnings per share (EPS)

9.​ Miller Electric Vehicle (MEV) Company’s current EPS is $6. P/E ratio of
Electric Vehicle industry is 22. What is the estimated value of MEV?

Price/earnings (P/E) ratio = Price per share /Earnings per share (EPS)
22=Price per share/6
Price per share =22*6=132
Ans: 132
10.​ Carter Swimming Pools has $16 million in net operating profit after tax
(NOPAT) in the current year. Carter has $12 million total net operating assets in the
current year and had $10 million in the previous year. What is its free cash flow?

FCF=NOPAT-Net investment in operating capital

FCF=16m-(12m-10m)=16m-2m=14m
Ans: 14m
Problems:

1.​ Mr. Investor wants to have $1m when he retires in 20 years. If he can earn a
10% annual return, compounded annually, what is the lump-sum amount he
would need to invest today?

1,000,000 FV, 20 N, 10 I/Y, 0 PMT, CPT PV

PV=1m/6.72=0.1486m
Ans: 148,643.63

2.​ What is the maximum amount an investor would be prepared to pay for
$750,000 to be received in 5 years? The required rate of return is 5%
750,000 FV, 5 I/Y, 5 N, 0 PMT, CPT PV
Ans: 587,644

3.​ Beth Payne has $800,000 in her pension plan and wants to receive equal
year-end payments for the next 15 years before exhausting her pension. What
will be the annual pension amount If Beth continues to earn 9% on her
pension?

800,000 PV, 15 N, 9 I/Y, 0 FV, CPT PMT

Answer: 99,247.11

4.​ Des Roberts is buying a $500,000 house with a 30-year mortgage requiring
payments to be made at the end of each month. The interest rate is 6% and
requires a downpayment of 10 percent. Find the monthly payment amount.

House Price: $500,000

Down payment: 10%=50,000 (Borrowing=500,000-50,000=450,000)
Term: 30 years = 360 months
Interest rate: 6% (year) =0.5% (month)
450,000 PV, 360 N, 0.5 I/Y, 0 FV, CPT PMT
Ans: 2697.98

5.​ Donald Yam deposits $12,000 at the end of each of the next 30 years, into an
account paying 9% interest compounded annually. How much money will be
there in the account at the end of 30th year?
0 PV, 12,000 PMT, 30 N, 9 I/Y, CPT FV
Ans: 1,635,690.46

6.​ Anson Tung is creating a charitable trust to provide six annual payments of
$20,000 each, beginning today. How much money must Anson set aside now
at 10% interest (compounded annually) to meet the required disbursements?
Terms: 5 years
PMT: 20,000
Interest: 10%
20,000 PMT, 5 N, 10 I/Y, CPT PV
Ans: 75,815.74 +20,000 = 95,815.74

7.​ A loan of $50,000 is repayable by 18 monthly installments of $2,993, starting

1 month after the loan is advanced. What is the effective annual interest cost?
PV: 50,000
Terms: 18 month
PMT: 2,993 /month
Interest: ?
50,000 PV, 18 N, -2,993 PMT, 0 FV, CPT I/Y
I/Y= 0.7976/month
Effective annual interest: .8*12 =9.6
Ans: the effective annual interest= 9.6

8.​ Bob has just turned 32 years old and planning for his retirement at age 60. He
plans to save $8,000 per year at the end of next 10 years. Bob wants to have
retirement income of $65,000 per year for 25 years, with the first payment
starting one year from the date he retires. How much must Bob save at the end
of each year 11 to 28 to achieve his retirement goal? The interest rate is 7%.

Step 1: Total Fund needed at retirement:

PMT: 65,000
N: 25 years
Interest: 7%
Find PV
65000 PMT, 25N, 7 I/Y, 0 FV, CPT PV
PV: 757,482.91

Step 2: Savings at 42
N=10 years
PMT: 8000
Interest: 7%
8,000 PMT, 10 N, 7 I/Y, CPT FV
FV: 110,531.58

Step 3: Calculate remaining amount

110,531.58 will keep growing at 7% for 18 more years (42-60)
The value at 60:
110,531.58 PV,18 N, 7 I/Y CPT FV
FV: 373,609.53

Deficit at 60: 757,482.91-373,609.53 = 383,873.39

Step 4: Calculate savings per year over 18 years (42-60):

N=18 (11-28year)
383,873.39 FV, 7 I/Y, 18 N, CPT PMT
PMT: 11,291
Ans: 11,291

9.​ Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund
that contains the following stocks. The required rate of return on the market is
11.00% and the risk-free rate is 5.00%. What rate of return should investors
expect (and require) on this fund?​
Stock Amount Beta Proportion
A $1,075,000 1.20 0.35 0.42
B 675,000 0.50 0.23 0.115
C 750,000 1.40 0.25 0.35
D 500,000 0.75 0.17 0.1275
Total $3,000,000 1.0125

Market rate: 11.00%

Risk-free rate: 5.00%

Beta portfolio=
0.35*1.2+0.23*0.5+0.25*1.4+0.17*0.75=0.42+0.115+0.35+0.1275=1.0125
Rate of return = Risk-free rate+ (Market rate- Risk-free rate)*Beta
=5+(11-5)*1.0125=11.075
Ans:11.075

10.​Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of
1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. Hazel
expects to receive an additional $60 million, which she plans to invest in
additional stocks. After investing the additional funds, she wants the fund's
required and expected return to be 13.00%. What must the average beta of the new
stocks be to achieve the target required rate of return?

Risk-free rate is 4.25%

Market risk premium is 6.00%

Stock Amount Beta Proportion Beta portfolio

1 40m 1 0.4 0.4
2 60m x 0.6 0.6x
Total 100m
Return to Combined 100millio portfolio = 13 = 4.25+6(Beta) (CAPM model)
Thus, beta of total portfolio = 1.46

1.46 = (40/100) *1.0 + (60/100) (Beta New stocks)

Beta New Stocks = 1.76

11.​The P/E ratios of 6 pharmaceutical stocks are 15, 17, 18, 14 and 13. The total
earning of a startup in pharmaceutical industry is $20 million. What is a
reasonable estimate of the value of the startup?

Average: (15+17+18+14+13)/5=77/5=15.4
Estimated Value:15.4*20,000,000=308,000,000

Ans: 308,000,000

12.​A listed company’s stock is currently trading at $30. The company has 50
million outstanding shares and 500 million debts. What is the market cap?
What is the enterprise value of the company?

Market Cap=Price per Share*Shares Outstanding

Market Cap=30*50,000,000=1,500,000,000
The enterprise value of the company=Market Cap +Total Debt
Value=1,500,000,000+500,000,000=2,000,000,000

Ans: Market Cap= 1.5 Billion, Value of the company=2 Billion

13.​Suppose the risk-free rate is 5% and the market risk premium is 7%. What is
the required return on (1) the market, (2) a stock with beta of 1.0 and (3) a
stock with beta of 1.7?
Market risk premium= Market rate-Risk-free rate
Market rate = 7 + 5 = 12

Return= risk free rate+(market rate-risk free rate)*Beta=5+(12-5)*1=12

Return= risk free rate+(market rate-risk free rate)*Beta=5+(12-5)*1.7=16.9

Ans: (1)12% (2)12% (3)16.9%

14.​Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of
return on average stock is 13%, and the risk-free rate is 7% By how much does
the required return on the riskier stock exceed that on the less risky stock?

Return= Risk free rate+(Market rate-Risk free rate)*Beta

Stock R Return 7+(13-7)*1.5=16

Stock S Return 7+(13-7)*0.75=11.5
16-11.5=4.5

Ans: 4.5

15.​Find the present value of following cash flows: (interest rate is 8%)

Year​ ​ ​ Cash Flow

1​ ​ ​ ​ $250
2​ ​ ​ ​ $350
3​ ​ ​ ​ $500
CF01 100, CF02 350, CF03 500, NPV Interest 8, CPT

Ans: 928.47