CASS 2016



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Cass Undergraduate School

FR2203 Company Valuation

Part 2 Examination

| 21 May 2013 |10:00 – 12:15 |

Instructions to students:

Answer ALL questions from Section A, and ONE question from either Section B or

Section C.

Model Answers

External Examiner: Dr Chris Florackis

Internal Examiner: Dr Sonia Konstantinidi

Answer ALL questions from Section A, and ONE question from either Section B or Section C.

Section A - Multiple Choice Questions

Use the information below to answer questions 1 to 5.

Ramien Koshy is an active portfolio manager of Herkimer Investment Management, an equity portfolio management company. In a presentation, Koshy describes his active management approach using the Treynor Black model. He then proceeds to describe how to construct the optimal risky portfolio based on the TB model. Koshy uses three mispriced securities and shows the relevant data in Exhibits 1 and 2.

Exhibit 1: Herkimer TB Model Forecasts

|Security |E(r) |α |σ(e) |β |

|1 |31.2% |9.0% |50.0 |1.9 |

|2 |9.0% |-5.20 |35.0 |0.9 |

|3 |16.0% |5.80 |30.0 |0.4 |

Exhibit 2: Macro Forecasts

|Security |Expected return (%) |Standard Deviation (%) |

|Risk-free asset, rf |7.0 |NA |

|Market (Passive) Portfolio E(rM) |15.0 |20.0 |

1. Which of the following statements about the Treynor-Black model is incorrect?

A. The expected return, E(rM), and risk, σΜ, of the market portfolio can be forecasted.

B. The non-systematic components of returns for mispriced securities are not independent across securities.

C. Analysts can analyse in depth only a limited number of stocks out of the entire universe of securities and securities not analysed are assumed fairly priced.

D. Capital markets are not perfectly efficient.

The answer is B

2. Using the TB model and data in Exhibits 1 and 2, which security would have the greatest weight in the active portfolio?

A. Security 1

B. Security 2

C. Security 3

D. Both securities 1 and 2

C is correct

|Security |E(r) |α |

|2010 Earnings per share (EPS) |$3.44 |$1.77 |

|2011 estimated EPS |$3.50 |$1.99 |

|Book value per share end of year |$12.05 |$11.64 |

|Current share price |$65.50 |$37.23 |

|Sales (billion) |$32.13 |$67.44 |

|Shares outstanding end of year |2,322,034,000 |1,638,821,000 |

Cannan advises Ritter that he is considering three different multiples to value the shares of Delite and You Fix It.

Multiple 1: Price to Book ratio

Multiple 2: Price to Earnigns (P/E) ratio using trailing earnings

Multiple 3: Price to Earnings (P/E) ratio using forward earnings

Cannan tells Ritter that he has also calculated the price to sales ratio (P/S) for the two companies, but chose not to use it in the valuation of the companies’ shares. Cannan states to Ritter that it is more appropriate to use the P/E ratio rather than the P/S ratio for the following reasons.

Reason 1: The P/E ratio reflects financial leverage whereas the P/S ratio does not

Reason 2: Earnings are less easily manipulated than sales

Reason 3: Earnings are more stable than sales

Reason 4: Sales of the comparable firms will often be negative, resulting in P/S ratios that are not meaningful

Ritter provides Cannan with financial data on three close competitors of Delite and on the beverage sector which does not include the three close competitors. This information is presented in Exhibit 2. Ritter asks Cannan to determine, based on the forward P/E ratio, whether Delite shares are overvalued, fairly valued, or undervalued.

Exhibit 2 Beverage Sector Data

| |Forward P/E |

|Fresh Iced Tea Company |10.00 |

|Nonutter Soda |9.00 |

|Tasty Root Beer |11.00 |

|Beverage sector average (10 companies) |16.90 |

3. Based upon the information in Exhibit 1, the price-to-sales ratio for You Fix It is closest to

A. 4.73

B. 0.55

C. 0.90

D. 2.04

C is correct. The price to sales ratio is calculated as price per share divided by sales per share.

Sales per share = $67.44billion/1.638821 billion shares = $41.15

Price/sales per share = 0.90

4. Cannan’s preference to use the P/E ratio over the P/S is best supported by

A. Reason 1

B. Reason 2

C. Reason 3

D. Reason 4

A is correct. The price to sales ratio fails to consider differences in cost structures. While price reflects the effect of debt financing, sales is a pre-financing income measure.

5. Based upon the information in Exhibits 1 and 2, what is value estimate for Delite’s shares, based on the forward P/E valuation approach? In calculating the benchmark forward P/E ratio, use the mean of the P/E ratios of all Delite’s competitors.

A. 53.6

B. 59.2

C. 41

D. 12.6

The correct answer is A

Sum (PE1 + … +PE10) = 10 *16.9 = 169

Sum (PE1 + … +PE10 + PE11 + PE12 + PE13) = 169 + 10 + 9 + 11 = 199

Benchmark multiple = 199 / 13 = 15.31

Value estimate for Delite = 15.31*3.5 = 53.6

6. Assuming an intrinsic value of 23 billion for the total equity of You Fix It, calculate the present value of the company’s future residual earnings (in billion).

A. 11.36

B. 3.92

C. 11.64

D. 4.53

The correct answer is B

BV = Bps * shares = 11.64 * 1.638821 = 19.075 in billion

PV of future RE = 23 – 19.075 = 3.92 billlion

7. Assuming an intrinsic value of 23 billion for the total equity of You Fix It and a constant growth in residual earnings of 2% after year 1, calculate the implied required rate of return for You Fix It.

A. 15%

B. 20%

C. 82%

D. 85%

Correct answer is D.

Intrinsic value per share = 23/1.638821 = 14.03

14.03 = 11.64 + 1.99/(r – 0.02)

2.39 = 1.99 /(r – 0.02)

r – 0.02 = 0.83

r = 0.85

8. In 2007, Sony reported net income from continuing operations of $4,000 million, equal to EPS of $4. The company’s depreciation and amortization was $1,050 million and other non-cash expenses related to continuing operations were in total $1,500 million. The price of Sony as of early March 2008 was $25. Calculate the price-to-operating cash flow for Sony.

A. 3.8

B. 0.9

C. 17.2

D. 10

The correct answer is A

OCF = Income + depreciation + other non - cash expenses = 4 + 1.05 + 1.5 = 6.55

P/OCF = 25/6.55 = 3.8

9. Identify, within the context of the dividend discount model, which of the following fundamental factors would increase a firm’s P/E.

A. The risk (beta) of the company increases

B. The estimated long-term growth of the company decreases

C. The retention ratio of the company decreases

D. The equity risk premium decreases

The correct answer is D

10. Toyota Motor Corporation is one of the world’s largest vehicle manufacturers. Art Kisa, an analyst, forecasts a long-term earnings retention ratio for Toyota of 10% and a long-term growth rate of 3%. Art also calculates a required rate of return of 7%. Based on Art’s forecasts of fundamentals and the Gordon Growth constant model, what is Toyota’s justified forward P/E?

A. 1.43

B. 22.5

C. 2.5

D. 12.9

The correct answer is B

V/E1 = (1 – b)/(r-g) = 0.90/0.04 = 22.5

11. Two equivalent companies, A and B, have the same stock price and the same amount of tangible assets. The two companies have also the same amount of R&D expenditures. For Company A, R&D is at the research phase and therefore expensed, whereas for Company B, R&D is at the development stage and therefore capitalized. Which of the following statements is correct?

A. Under market efficiency, the P/B ratio of the two companies will be the same.

B. The P/B of Company A will be lower than the P/B of Company B

C. The P/E of Company A will be lower than the P/E of Company B

D. The P/E valuation approach will underestimate the intrinsic value of Company A.

Correct answer is D. The P/E of A will appear higher, so A will appear overvalued – expensive (intrinsic value is underestimated).

A is wrong. Prices will be the same, but P/B will be different because of the accounting (lack of comparability). B and C are the other way around.

12. Based on the following information, discuss the valuation of A relative to B or C.

|Firm |P/B |Forecasted ROE |Beta |

|A |2 |10% |3 |

|B |2 |12% |2 |

|C |1 |9% |4 |

A. Company A is undervalued relative to Company B

B. Company A is overvalued relative to Company B

C. Company A is overvalued relative to Company C

D. Company B is overvalued relative to Company C

Correct answer is B. Companies A and B have same P/B but A has lower forecasted ROE and higher risk, therefore it is overvalued.

V/B = (ROE1 - g)/(r-g)

Return Concepts

13. An analyst has collected the following information for Dell and Sony. Based on the following information, calculate the required rate of return for the two firms based on the Fama and French model.

| |Dell |Sony |

|Market beta |0.74 |1.5 |

|Size beta |0.70 |0.80 |

|Value beta |1.20 |0.90 |

|Equity Risk Premium |4.5% |6.0% |

|SMB |3.0% |2.0% |

|HML |5.0% |4.0% |

|Risk-free Rate |4.9% |5.0% |

A. 16.33% for Dell and 19.20% for Sony

B. 16.33% for Dell and 19.60% for Sony

C. 12.50% for Dell and 19.20% for Sony

D. 12.50% for Dell and 19.60% for Sony

Solution

The correct answer is A

Dell: 4.9% + 0.74(4.5%) + 0.70 (3.0%) + 1.2 (5.0%) = 16.33%

Sony: 5.0% + 1.5 (6.0%) + 0.80 (2.0%) + 0.90 (4.0%) = 19.20%

14. The estimated factor sensitivities for a hypothetical company are given in the following table. Describe the expected style characteristics of the company based on its factor sensitivities.

| |Factor sensitivity |

|Market factor |1.20 |

|Size (SMB) factor |-0.40 |

|Value (HML) factor |-0.65 |

The company’s stock is

A. A large cap (high MV), high growth (low B/M) stock with above-average market risk

B. A low cap (low MV), high growth (low B/M) stock with above-average market risk

C. A large cap (high MV), low growth (low B/M) stock with below-average market risk

D. A large cap (low MV), low growth (high B/M) stock with above-average market risk

The correct answer is A

15. You are given the following information for a company for three years in the future. You estimate the company’s cost of capital to be 10%. Calculate the intrinsic value of the company in year 0, based on the Residual Income Valuation Model and assuming a 3-year period for the company (the company liquidates in year 3). In doing so, you will need to fill the gaps in the following table.

|Year |Opening book value |NI |DIV |Closing book value |RI |

|1 |100 |20 |5 | | |

|2 | |-10 |10 | | |

|3 | |30 |125 | | |

A. 101

B. 102

C. 107

D. 110

The correct answer is C

RIVM estimate: 100 + 10/1.10 + (-21.5)/1.102 + 20.5/1.103 = 106.72

|Year |Opening book value |NI |DIV |Closing book value |RI |

|1 |100 |20 |5 |115 |10 |

|2 |115 |-10 |10 |95 |-21.5 |

|3 |95 |30 |125 |0 |20.5 |

16. An analyst is analysing a company whose shares are currently selling for €30 and have paid a dividend of €2 per share for the most recent year. The following information is given:

- The risk-free rate is 3 percent

- The shares have an estimated beta of 1.5

- The equity risk premium is estimated at 4 percent

Based on the above information, determine the constant dividend growth rate that would be required to justify the market price of €30.

A. 2.19%

B. 9.5%

C. 3.20%

D. 5.00%

The correct answer is A.

Using the CAPM, the required rate of return for Maspeth Robotics is

Ri = RF + β[Ε(RM)- RF] = 3% + 1.5(4%) = 9%

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2.7 – 30g = 2 +2 g

32g = 0.7

G=0.02187 = 2.19%

17. A hypothetical company is expected to pay a $6 dividend next year. An analyst is expecting that dividends will decline forever at a rate of 5 percent. The required rate of return for the company is 15%. What is the value of the company’s shares?

A. $5.22

B. $60

C. $30

D. $50

Solution

The correct answer is C

The value of the stock is 6/(0.15 – (-0.05)) = $30

[Total: 64 Marks]

Part 2 (36 marks)

Answer All parts of this question.

Kostas Sakis is evaluating Dell, by using the residual income valuation model. He has accumulated the following information:

- Dell currently has total assets of $3,000,000 financed with twice as much debt capital as equity capital

- The cost of debt is 7% before taxes

- The cost of equity capital is 10%

- Next year, Dell has forecasted EBIT of $300,000

- Tax rate is equal to 40 percent and interest is tax deductible

- Dividend payout ratio is constant and equal to 50%

- Growth rate of earnings =

- 5 percent annually in years 2 and 3

- 4 percent in year 4

- 3 percent in years 5 and 6

Required:

i) Calculate residual income for year 1.

[12 marks]

Debt/Equity = 2/1

Debt = 2/3(3,000,000) = 2,000,000

Equity = 1,000,000

Interest Expense = 0.07(2,000,000) = 140,000

|Calculation of Net Income |

|EBIT |$300,000 |

|Less: Interest Expense |140,000 |

|Pre-tax Income |$160,000 |

|Less: Interest Tax Expense |0.4(160,000) = 64,000 |

|Net Income |$96,000 |

|Calculation of Residual Income |

|Net Income |96,000 |

|Less: Equity charge |$1,000,000×10% = 100,000 |

|Residual Income |-$4,000 |

ii) Forecast the firm’s residual earnings for years 2-6

[12 marks]

|Year |1 |2 |3 |4 |5 |6 |

|Growth | |5% |5% |4% |3% |3% |

|Op. BV |1,000,000 |1,048,000 |1,098,400 |1,151,320 |1,206,357 |1,263,045 |

|Earnings |96,000 |100,800 |105,840 |110,074 |113376 |116777 |

|Equity Charge |100,000 |104,800 |109,840 |115,132 |120,636 |126,304 |

|Residual income |-4,000 |-4,000 |-4,000 |-5,058 |-7,260 |-9,527 |

|Dividends |48,000 |50,400 |52,920 |55,037 |56,688 |58,389 |

|Ending BV |1,048,000 |1,098,400 |1,151,320 |1,206,357 |1,263,045 |1,321,433 |

iii) Estimate the value of the firm’s equity using the residual income valuation model, assuming that residual income remains constant after year 6.

[12 marks]

[Total: 36 Marks]

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Part 3 (36 marks)

Answer All parts of this question.

Paulo Alves is evaluating Microsoft Corporation, by using a three-stage growth model. He has accumulated the following information:

- Current operating cash flow is $900 million

- Current investing cash flow is -$200 million

- Current book value per share is $4

- Outstanding shares = 1,000 million

- Equity beta = 2, risk-free rate = 4 percent, equity risk premium = 5 percent

- Cost of debt is 8 percent

- Marginal tax rate = 30 percent

- Capital structure = 20 percent debt, 80 percent equity

- Market value of debt = $4,000 million

- Growth rate of FCFF =

- 8 percent annually in stage 1, years 1-3

- 6 percent in year 4, 4 percent in year 5

- 3 percent in year 6 thereafter

Required

i) Estimate the weighted average cost of capital. In your calculation, use the adjusted market beta introduced by Blume (1971): Adjusted beta = 2/3(Unadjustd beta) + 1/3(1.0)

[9 marks]

Adjusted beta = 2/3(Unadjustd beta) + 1/3(1.0) = 2/3(2) + 1/3(1.0) = 1.3 + 0.3 =1.67

The required rate of return for equity is

r = E(Ri) = RF + βi[E(RM – RF)] = 4 % + 1.67 × 5% = 12.35%

WACC = 0.2(8%)(1-0.30) + 0.8(12.35%) = 11%

ii) Forecast free cash flow for years 1-5

[9 marks]

Years |0 |1 |2 |3 |4 |5 | |Growth in FCFF | |8% |8% |8% |6% |4% | |FCFF |700 |756 |816 |882 |935 |972 | |

iii) Estimate the total value of the firm using the free cash flow valuation model.

[9 marks]

Years |0 |1 |2 |3 |4 |5 | |Growth in FCFF | |8% |8% |8% |6% |4% | |FCFF |700 |756 |816 |882 |935 |972 | |Discounted | |681 |662 |645 |616 |577 | |

The terminal value at the end of year 5 is

TV5 = FCFF6/(WACC – g) = 972(1.03)/(0.11 – 0.03) = 1,001/0.08 = $12,512.5 million

The present value of this amount discounted at 11% for 5 years is

PV of TV5 = $7,425.5 million

The total present value of the first five years of FCFF is 3,268.

The total value of the firm is 3,181 + 7,425.5= $10,606.5 million

iv) What is the present value of future residual income per share for Microsoft based on your value estimate in (iii)?

[9 marks]

Value of equity = $10,606.5 million – 4,000 million = $6,606.5 million

Value of equity per share = $6.607 per share

PV of RI = $6.607 – $4 = $2.607

Formulas

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BSc (Hons) Degree in Banking and International Finance

BSc (Hons) Degree in Investment & Financial Risk

BSc (Hons) Degree in Real Estate Finance & Investment

BSc (Hons) Degree in Accounting and Finance

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