Homework and Suggested Example Problems Investment Valuation Damodaran. Lecture 1 Introduction to Valuation

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1 Homework and Suggested Example Problems Investment Valuation Damodaran Lecture 1 Introduction to Valuation Lecture 1 is an introduction to valuation. This lecture is intended to give you an overview of alternative valuation models. We will discuss the properties as well as the advantages and disadvantages of three alternative valuation frameworks: discounted cash flow analysis, relative valuation, and contingent claim valuation. We will also discuss basic accounting statements and financial statement analysis. Discussion Problems: Complete the problems on the attached pages and be prepared to discuss your solutions in class. Additional Suggested Problems: The following suggested problems will serve as additional examples related to our class material and should give you a basic idea of the topics that I want to emphasize from the text. The solutions to these problems are available on the class web site. You may not know the answers to all of the financial statement questions in chapter 3. Use the solutions as a way to review this information. We will discuss specific financial statement items in more detail throughout the semester. Note: The balance sheet listed for Coca Cola on page 55 contains an error. The marketable securities listed as 1049 should be listed separately as marketable securities of 159 and inventories of 890. Chapter Topic Suggested Problems 1 Introduction to valuation None 2 Approaches to valuation 1, 2, 3 3 Financial Statements 1 through 10

2 Discussion Problems - Lecture 1 1. You are analyzing a company with the expected future cash flows shown below. Based on current market prices, the market value of the firm s equity is $1, The outstanding debt has both a market and book value of $800. The firm's cost of equity (k e ) is 11.0%, the firm s past and future cost of debt is 10%, and the firm's tax rate is t=50%. Use this information to answer the questions below. Year FCF to Firm Int Exp (1-t) FCF to Equity 1 $ $ 40 $ $ $ 40 $ $ $ 40 $ $ $ 40 $ $ $ 40 $ Terminal Value $ $ a. Calculate the value of the firm's equity by discounting the listed Free Cash Flows to Equity. b. Calculate the value of the overall firm by discounting the listed Free Cash Flows to the Firm. Use your solution to calculate the value of the firm's equity. c. Are the equity values you obtained using the two methods the same? What real world firm characteristics might cause you to get different values for equity in the FCFE and FCFF models?

3 2. Consider a firm with the financial characteristics described below. Use this information to answer the following valuation questions: WACC = 8.015% Financial Forecast for Year t+1: Book value of Equity = $60.0 mil EBIT $40.00 mil Book value of Debt = $100 mil - Taxes (at 40%) Mkt value of Debt = $100 mil = EBIT(1-T) Cost of equity = 10.0% - Reinvestment (at 20%) Cost of debt = 4.0% = FCFF $19.20 mil a. Assuming cash flows grow at a stable rate of 3% per year, use discounted cash flows to estimate the value of the firm and the value of the firm s equity. b. Use the Economic Profit (or EVA) formula to estimate the value of the firm and the value of the firm s equity. As in the previous problem, assume that the economic profit generated by the firm grows at a stable rate of 3% per year. c. How do your answers based on the two valuation methods compare?

4 3. In the most recent fiscal year, General Mills had total revenues of $17,774.1 million, operating income $2,851.8 million, and net income of $1, The balance sheet for General Mills is provided on the next page. Use this information to answer the following questions. a. Assuming a tax rate of 29.2%, calculate the Return on Capital (ROC) for General Mills in the most recent fiscal year. b. General Mills expects the increasing costs of employee health benefits and other labor costs to result in decreased profit margins. Assuming all other financial ratios and firm characteristics stay the same, what is your revised estimate of the firm s ROC if the aftertax operating margin drops by 10%?

5 Consolidated Balance Sheet, General Mills, Inc. Fiscal Year t Fiscal Year t-1 Assets Cash & Short-Term Investments Receivables 1, ,323.6 Inventories 1, ,478.8 Current Tax Assets Prepaid Expenses and Other Current Assets Total Current Assets 4, ,691.4 Net Property Plant & Equip 3, ,652.7 Goodwill 8, ,182.5 Other Intangible Assets 5, ,704.9 Other Assets Total Assets 22, ,096.8 Liabilities & Stockholders Equity Accounts Payable 1, ,148.9 Current Portion of Long-Term Debt 1, Notes Payable Other Current Liabilities 1, ,426.6 Total Current Liabilities 5, ,843.2 Long-Term Debt 5, ,161.9 Deferred Income Taxes 1, ,171.4 Other Liabilities 1, ,189.8 Total Liabilities 14, ,366.3 Minority Interest Common Stock Additional Paid-In Capital 1, ,308.4 Retained Earnings 11, ,419.5 Accum Other Comprehensive Income -1, ,743.7 Treasury Stock -3, ,177.0 Total Equity 7, ,882.7 Total Liabilities & Equity 22, ,096.8