FINC 3630: Advanced Business Finance Additional Practice Problems

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1 FINC 3630: Advanced Business Finance Additional Practice Problems Accounting For Financial Management 1. Calculate free cash flow for Home Depot for the fiscal year-ended January 28, 2018 (the 2017 fiscal year). 2. Calculate MVA and EVA for Home Depot. Use the information given in class for market value data. Financial Statement Analysis 1. Use the DuPont equation to calculate return on equity for Home Depot for the fiscal years-end January 28, 2018 and January 29, Did it increase or decrease? Was the change in return on equity driven by changes in profitability, changes in how efficiently the firm used its assets, or changes in the extent to which the firm uses debt financing? Cost of Capital 1. Your boss has assigned you and your assistant the task of estimating the cost of common equity for your firm. Your assistant has gathered the following information. The company has $1,000 face value bonds outstanding with 9 years to maturity, a 7 percent coupon rate, paid semiannually, and currently selling for $ Analysts have estimated a 10 percent growth rate for your firm for the foreseeable future. The company s common stock currently has a dividend yield of 2 percent. Your assistant has estimated the beta of the stock to be 1.5. Using reasonable estimates for the risk-free rate and market risk premium, if necessary, what do you recommend as a reasonable estimate of the cost of common equity? Be sure to be able to justify your answer to your boss and the board of directors. 2. In addition to the information in the above problem, you know your company has 1,000 bonds outstanding, 20,000 shares of common stock, currently trading at $60, and a 40% marginal tax rate. You also know the firm has 12,000 shares of preferred stock, currently selling for $85 and paying a $8.50 annual dividend. What is your estimate of the firm s cost of capital? 3. Assume all of the same information from the previous 2 problems, except now your boss tells you that your firm has a target debt-equity ratio of 1, where equity is equally divided between common and preferred stock. What is your estimate of the firm s cost of capital now? 1

2 Corporate Value 1. Yost Rocks, Inc. is evaluating ON Corp. for a possible acquisition (to be known, of course, as Yost Rocks ON). You believe free cash flows will grow at 8 percent for the foreseeable future. ON Corp. has $100 million in marketable securities that you believe is not necessary for the firm s operations. The current book value of ON Corp. s common equity is $360 million. For the fiscal year that just ended, ON Corp. had total operating capital of $500 million, which is $91.5 million more than total operating capital at the end of the previous fiscal year-end. From the firm s income statement, ON Corp. had $200 million in earnings before interest and taxes. Both ON Corp. and Yost Rocks, Inc. are in the 40% tax bracket. ON s stock currently has a beta of 1.75, the firm s bonds yield 9 percent, and the dividend yield on preferred stock is 11 percent. The firm has 24 million shares of common stock outstanding, currently selling for $25 per share, 300,000 bonds outstanding, currently selling at par, and 1 million shares of preferred stock outstanding, currently selling for $100. Based on this information and reasonable estimates of any other inputs, what is the most Yost Rocks would be willing to pay per share of common stock for ON Corp.? What is EVA and MVA for ON Corp.? 2. Common shares of Yostmeister, Inc. are currently selling for $65. The firm had free cash flow for the fiscal year that just ended of $125 million and has a weighted average cost of capital of 10 percent. The firm also has $2.5 billion in debt and 75 million shares outstanding. You expect free cash flows to increase by 14 percent per year for the next two years and 8 percent per year thereafter. Based on this information, do you recommend your clients to buy, sell, or hold Yostmeister, Inc. stock? 2

3 SOLUTIONS Accounting For Financial Management 1. Information given in class for tax rate (from note 5 on pg. 48 of Annual Report/10-K) = 37% To calculate free cash flow, we need EBIT, the tax rate, and the net change in operating capital. To get the change in operating capital, we need total operating capital in each year fiscal year: Net operating working capital = operating current assets operating current liabilities *Note: Assume that Other Current Assets are necessary for the firm s operations. For current liabilities, the interest-bearing ones need to be eliminated (Short-Term Debt and Current Installments of Long-Term Debt). Net operating working capital = ($18,933 $0) ($16,194 $1,559 $1,202) = $18,933 $13,433 = $5,500 Operating long-term assets: *Note: Assume that Other Assets are necessary for the firms operations. We want the amount of fixed assets net of depreciation. Operating long-term assets = $22,075 + $2,275 + $1,246 = $25,596 Total Operating Capital = $5,500 + $25,596 = $31, fiscal year: Net operating working capital = ($17,724 $0) ($14,133 $710 $542) = $17,724 $12,881 = $4,843 Operating long-term assets = $21,914 + $2,093 + $1,235 = $25,242 Total Operating Capital = $4,843 + $25,242 = $30,085 Net change in total operating capital = $31,096 $30,085 = $1,011 Free cash flow = $14,681 (1 0.37) $1,011 = $8, million 3

4 2. Information given in class for market value data: Number of shares on 1/28/18 = billion Price per share on 1/26/18 = $ Tax rate from note 5 on pg. 48 of Annual Report/10-K) = 37% WACC = 8.4% MVA = (1.158 billion x $207.23) $1,454 million = $ billion EVA = $14,681 (1 0.37) $31,096 (0.084) = $6, million Financial Statement Analysis 1. ROE = Profit Margin TATO Equity Multiplier Net Income Net Income Sales Assets = Equity Sales Assets Equity ,630 = 8, ,904 44,529 1, ,904 44,529 1, ,957 = 7,957 94,595 42,966 4,333 94,595 42,966 4, Return on equity increased from 2016 to 2017 and it was driven by increased profitability (profit margin), increased asset use efficiency (total asset turnover), and especially increased leverage (equity multiplier). 4

5 Cost of Capital 1. There are three ways to estimate the cost of equity: CAPM: r = (0.06) = 0.12 using 3% for risk-free rate and 6% for market risk premium as reasonable estimates Bond Yield Plus Risk Premium: Need to calculate YTM: N = 18; PV = ; PMT = 35; FV = 1000 I/Y = 4 YTM = 8% r = = 0.12 Dividend Yield Plus Growth Rate: using 4% as risk premium (3% - 5% is reasonable, so 11% - 13% is reasonable range for r) r = = 0.12 Conclusion: 12% is a consistent estimate of the cost of common equity, and 11% to 13% is a reasonable range. 2. First, one needs the cost of preferred stock (the rest of the information is in #1). Cost of Preferred = $8.50 / $85 = 10% WACC = (1.2 M / M) x (0.12) + (1.02 M / M) x (0.10) + ( M / M) x (0.08) x (1-0.4) = % 3. If the target debt-equity ratio is 1, that means 50% of the firm is financed with debt and 50% with equity (25% from common stock and 25% from preferred stock). WACC = (0.5 / 2) x (0.12) + (0.5 / 2) x (0.10) + (1 / 2) x (0.08) x (1-0.4) = 7.9% 5

6 Corporate Value 1. To get price per share, we need to get value of equity, value of the firm, and therefore the value of the operating assets. In order to get the value of operations, we need to know free cash flow and the cost of capital. Cost of Capital: Cost of Common Equity = (0.06) = using 3% for risk-free rate and 6% for market risk premium as reasonable estimates WACC = (600 M / 1 B) x (0.135) + (100 M / 1 B) x (0.11) + (300 M / 1 B) x (0.09) x (1-0.4) = 10.82% Free Cash Flow (for fiscal year that just ended): = $200 million (1 0.40) - $91.5 million = $28.5 million Value of Operating Assets: = ($28.5 million x 1.08) / ( ) = $1, million Value of the Firm = $1, million + $100 million in non-operating assets = $1, million Value of the firm s common equity = $1, million $100 million (preferred stock) $300 million (debt) $ million Value per share = $ million / 24 million shares = $ per share. *Note: The value we estimate per share is equal to the intrinsic value. Based on this, we would not be willing to pay more than the estimated value of $32.98 per share, significantly more than the current market price. EVA = $200 million (1 0.40) - $500 million (0.1082) = $65.9 million MVA = $600 million - $360 million = $240 million 6

7 2. To get price per share, we need to get value of equity, value of the firm, and therefore the value of the operating assets. Value of Operating Assets: (1) Draw a timeline and (2) deal with the right-hand side PV1 = CF2 / (r-g) = $ million / ( ) = $8, million *Note: You could calculate PV2 (3) Bring it all back to today PV0 = ($142.5 million + $8, million) / (1.10) 1 = $7, million Value of the Firm = $7, million because there are no non-operating assets Value of the firm s common equity = $7, million $2,500 million (debt) $5, million Value per share = $5, million / 75 million shares = $66.85 per share. Recommend they buy. They are currently selling for $65, but you believe they are worth $

FINC 3630: Advanced Business Finance Additional Practice Problems

FINC 3630: Advanced Business Finance Additional Practice Problems Accounting For Financial Management 1. Calculate free cash flow for Home Depot for the fiscal year-ended January 27, 2017 (the 2016 fiscal