EXAM 1 SOLUTIONS. Finance Security Analysis. Mendoza College of Business Professor Shane A. Corwin Fall Semester 2008

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1 EXAM SOLUTIONS Finance 4060 Security Analysis Mendoza College o Business Proessor Shane A. Corwin Fall Semester 2008 Monday, September 29, 2008 INSTRUCTIONS:. You have 75 minutes to complete the exam. 2. The exam is worth a total o 00 points. 3. Allocate your time wisely. Use the number o points assigned to each problem as your guide. 4. In order to get ull credit on the problems, you must show ALL your work! 5. You may use a calculator and a ormula sheet. Please put your name on your ormula sheet and hand it in with your exam.

2 Multiple Choice (20 points) Choose the best answer or each o the ollowing questions. The questions are worth 4 points each.. Annual returns on the S&P 500 index or the past ive years are listed below, along with the associated index levels. Based on this inormation, what is the geometric average return on the S&P 500 over the past ive years? Year S&P 500 Index S&P 500 Return , % 2004, % 2005, % 2006, % 2007, % a).0% b) 8.9% c) 0.79% d) 5.72% R G (.2638)(.0899)(.03)(.362)(.0353) % 5 2. Which o the ollowing statements related to discounted cash low analysis is true? a) Holding all else constant, the value o an asset decreases as the lie o the asset increases b) Holding all else constant, the value o an asset increases as the discount rate decreases c) Holding all else constant, an investment in R&D will always lead to a decrease in irm value d) A DCF analysis cannot be perormed or irms with negative earnings 3. The Bloomberg description page reports a Beta or Microsot o.2. What is the regression Beta or this irm? a).30 b).3 c).20 d).4 Bloomberg regression () 3 2 ( 3 3 (.2 ) regression ) 4. Consider two all-equity irms with identical businesses, products, etc. The only dierence between the two irms is related to their cost structure. Firm A s costs include 25% ixed costs and 75% variable costs. Firm B s costs include 60% ixed costs and 40% variable costs. Which o these irms will have a higher equity Beta? a) Firm A b) Firm B c) The irms will have the same equity Beta 5. Which o the ollowing is NOT an advantage o relative valuation as compared to discounted cash low valuation? a) Relative valuation is unaected by assumptions such as growth and ROE b) Relative valuation can be used even when cash lows are negative c) Relative valuation will incorporate current market perceptions d) Relative valuation will always identiy some securities as under and over-valued Finance 4060 Exam September 29, 2008

3 Short Answer (2 points) Provide a brie answer (one or two sentences) to each o the questions below. 6. (6 points) Microsot stock is currently trading at $26.60 per share. When you value the irm using a Free Cash Flow to the Firm (FCFF) model, you estimate the intrinsic value to be $24.50 per share. However, when you instead value the irm using a Free Cash Flow to Equity (FCFE) model, you arrive at an intrinsic value o $27.0 per share. List one o the reasons we discussed in class that the FCFE and FCFF models may not give identical valuations. Theoretically, the FCFF and FCFE valuations should give the same equity value. However, we discussed three reasons in class why the two might give dierent results : () interest expense is not equal to the cost o debt (book value o debt market value o debt). (2) the market value o equity used in the WACC calculation is not the same as the equity value calculated rom the valuation model (i.e., the market price is not correct). (3) there are non-operating sources o income included in FCFE that are not included in FCFF. 7. (6 points) You are analyzing a irm that has recently had signiicant trouble meeting the interest payments on its very high debt levels. The irm had negative net income in the most recent iscal year and is currently trading or just $0.60 per share. Last night, the irm announced that it would take on an extremely risky strategic partnership. Ater staying up analyzing the cash low implications o this partnership, you determine that it leads to a negative value or the equity o the irm based on a DCF model. Ater taking a short nap, however, you wake up to ind that the stock price has jumped by 5% at the start o trading. Assuming you estimated the DCF model correctly, what could explain the dierence between your valuation conclusions and the market price reaction? The value o the irm's equity appears to relect some option value. This option value will not be picked up in a DCF analysis and leads to an increase in equity value as risk increases. Finance 4060 Exam 2 September 29, 2008

4 Problems (66 points) Answer each o the questions below completely. You must show ALL your work to get ull credit. 8. Implied Equity Premium (0 points): The current level o the Russell 3000 Index is and the long-term Treasury yield is 3.85%. The average ROE across all stocks is.0% and the average P/E ratio is Dividends paid last year on the Russell 3000 stocks amounted to approximately 2.05% o the current index level. You expect dividends to grow steadily at a rate o 6%. Based on this inormation, what is the implied equity risk premium or the U.S. market? Div R g P 703.7(.0205)(.06) % R R 8.73% 3.85% 4.32% OR E R g P g ROE % R R 8.93% 3.85% 5.08% 9. Beta and Leverage (0 points) You are valuing a private irm in the pharmaceutical industry. Across similar public irms in the industry, the average equity Beta is.3, the average debt-to-equity ratio is 30%, and the average marginal tax rate is 35%. Your irm s debt-to-equity ratio is similar to other irms in the industry at 30%. However, due to substantial tax subsidies, the marginal tax rate or your irm is only 5%. Use this inormation to calculate the appropriate equity Beta or your irm. u (.35) L (.5) Finance 4060 Exam 3 September 29, 2008

5 0. Discounted Cash Flow Analysis (30 points): You are valuing XYZ corporation using a DCF model. The Free Cash Flow to the Firm (FCFF) or the most recent iscal year was $20 million. You expect these cash lows to grow at a rate o 8% or the next six years. Ater the six years, the irm s patent expires and you expect cash lows to remain lat (zero growth) in perpetuity. The irm has 2 million shares outstanding and a current stock price o $25 per share. The irm s equity has a book value o $300 million. The irm s balance sheet debt has a book value o $200 million and a market value o $240 million. The irm also reports operating leases with a debt value o $30 million. The irm s cost o equity is 0.0%, its cost o debt is 6.5%, and its tax rate is 35%. a) Calculate the value o this irm based on the discounted value o FCFF. Debt MV Equity m MV 252m 500m WACC % (6.5%)(.35) 8.45% FCFF 20(.08) 29.6 PV HighGrowth m FCFF (.08) ( 0) TV m PV TV (.0845) 385.3m FirmValue $ m b) Based on your answer to part (a) and the other inormation provided, what is your estimate o the stock price per share? Does your analysis lead to a buy recommendation or a sell recommendation on this stock? EquityValue m m P $ m BUY (because your estimated price is higher than the current market price, or ) Finance 4060 Exam 4 September 29, 2008

6 . Cost o Capital (8 points): You are valuing the equity o a irm rom Dubai using the Free Cash Flow to Equity (FCFE) method, where the cash lows are denominated in nominal local currency (dirham). Long-term governmentissued debt in Dubai (denominated in dirham) has a BB+ rating and a yield o 6.5% (average yield spreads or various bond rating categories are provided on the next page). The comparable yield on long-term U.S. Treasury bonds is 3.85%. Inlation orecasts are.85% or the U.S. and 0.0% or Dubai. In addition, you estimate that the standard deviation o equity market returns is 22% in the U.S. and 38% in Dubai, and the standard deviation o Dubai debt markets is 26%. a) Assuming a U.S. market risk premium o 4.5% and an equity Beta o.50, calculate the cost o equity or this irm excluding country risk. Explain any assumptions necessary to arrive at your answer. The risk - reeratemust be currency matched. You can calculatethe risk - reeratein oneo two ways. Either start with thedubaigovernmentbond yieldo 6.5%andsubtract the deault spread,or start withthe U.S.governmentbond yieldand adjust or inlation. These methodsgive: R 6.5%- 4.76% 2.324% OR R 3.85% (0.0%-.85%) 2.0% Usingone o theserisk - reeratesand the U.S.equity premiumgivesa cost o equity equal to: K 2.324%.5(4.5%) 9.074% e OR K 2.0%.5(4.5%) 8.75% e b) Recalculate the cost o equity or this irm incorporating terms to account or country risk. Again, explain any assumptions necessary to arrive at your answer. To incorporate country risk,wemultiply hecountry t risk premiumby thesensitivtytocountry risk and add thissum to thecost o equity deinedabove. Thecountry risk premiumcan be deinedin oneo threeways: % 3.273% %(deault spread) % 6.03%.26 Thesensitivity tocountry risk can beestimateddirectly basedon thecharacteristicso theirm. Absent this inormation, wecan makeoneo twoassumptions. First,wecouldassumethat allirmswithin Dubaihavethesamesensitivity to country risk (λ market risk (λ 9.074%.5 ). β). Second,wecan assumethat theirm's sensitivity tocountry risk equalstheirm's sensitivity toequity Though there aremultiplepossiblesolutions,oneexampleis as ollows: 4.5% % % Finance 4060 Exam 5 September 29, 2008

7 Yield Spreads on Government-Issued Debt by Ratings Category: Debt Rating Yield Spread AAA.83% AA.396% A+.753% A.828% A- 2.33% BBB+ 2.54% BBB 2.53% BBB % BB+ 4.76% BB 5.427% BB % B % B 5.825% B % Finance 4060 Exam 6 September 29, 2008

MIDTERM EXAM SOLUTIONS

MIDTERM EXAM SOLUTIONS Finance 40610 Security Analysis Mendoza College of Business Professor Shane A. Corwin Fall Semester 2007 Monday, October 15, 2007 INSTRUCTIONS: 1. You have 75 minutes to complete