MIDTERM EXAM SOLUTIONS Finance 70610 Equity Valuation Mendoza College of Business Professor Shane A. Corwin Fall Semester 011 Wednesday, November 16, 011 INSTRUCTIONS: 1. You have 110 minutes to complete the exam.. The exam is worth a total of 100 points. 3. Allocate your time wisely. Use the number of points assigned to each problem as your guide. 4. In order to get full credit on the problems, you must show ALL your work! 5. You may use a calculator and a formula sheet. Please put your name on your formula sheet and hand it in with your exam.
Multiple Choice (3 points) Choose the best answer for each of the following questions. The questions are worth 4 points each. 1. The current level of the S&P 500 index is 118.0 and the long-term Treasury yield is 1.8%. The average ROE across all stocks is 17.0% and the average P/E ratio is 19.0. You expect both dividends and earnings to grow steadily at a rate of 3.5% per year. Based on this information, estimate the implied equity risk premium for the U.S. market. a) 5.88% b) 5.6% c) 4.50% d) 7.68% R E1 g 1.035 g 1 =.035 1 = 7.68% P ROE 19.17 R R = f = 7.68% 1.8% = 5.88%. True or False: As we discussed in class, the residual income valuation model uses the book value of equity as a base value for the market value of equity. In this model, the market value of equity will equal the book value of equity whenever the return on equity (ROE) is greater than the cost of equity (K e ). a) True b) False 3. Using two years worth of weekly data, you find that the regression Beta for Boeing is 1.36. The standard error on this estimate is 0.30 and the cross-sectional standard deviation of Beta estimates across all companies is 0.60. Based on this information and the methodology that utilizes standard errors, what is the adjusted Beta for your firm? a) 1.38 b) 1.40 c) 1.88 d) 0.965.3.60 1.0 1.36 = 1.88.3.60.3.60 4. An analyst at your firm comes to you with the historical estimates of equity market risk premiums shown below. He wants to know which estimate is most appropriate to use in his cost of equity calculation for firm valuation. Which of the following market risk premium estimates would be most appropriate for this purpose? Equity Premium Relative to 10-year Treasury Bonds Equity Premium relative to 6-month T-Bills Arithmetic Average 198-010 6.03% 7.6% Geometric Average 198-010 4.31% 5.67% a) 6.03% b) 7.6% c) 4.31% d) 5.67% Finance 70610 Midterm Exam 1 November 16, 011
5. Consider two all-equity firms with identical businesses, products, etc. The only difference between the two firms is related to their cost structure. Firm A s costs include 5% fixed costs and 75% variable costs. Firm B s costs include 60% fixed costs and 40% variable costs. Which of these firms will have a higher equity Beta? a) Firm A b) Firm B c) The firms will have the same equity Beta 6. During fiscal year 010, your firm completed an acquisition for a total price of $80 million. The net value of the acquired firm s assets equals $15 million. Which of the following statements best describes the GAAP accounting rules for recording the goodwill associated with this acquisition? a) Your firm will record goodwill of $65 million and test it annually for impairment b) Your firm will record $80 million in goodwill and amortize it over 15 years c) Your firm will record goodwill of $65 million and amortize it over 40 years d) Your firm can use either purchase or pooling accounting to determine goodwill e) None of the above, your firm will not record any goodwill 7. You are valuing a firm that generates 58% of its revenues from the retail industry and the remaining 4% from the entertainment industry. The unlevered Betas for these industries are 0.9 and 1.5, respectively. Calculate the fundamental Beta for this firm based on the fraction of revenues derived from each industry. Assume a debt/equity ratio for the firm of 0.5 and a tax rate of 40%. a) 0.8875 b) 1.0586 c) 1.376 d) 0.9963 ( 0.58) 0.9 ( 0.4) 1.5 = 1.0586 = 1.0586( 1 0.5(1.4) ) = 1. 376 β e 8. You are calculating the weighted average cost of capital (WACC) for a firm that has a single convertible bond and no other debt. The bond is a 10% coupon bond (annual coupon payments), with two years to maturity, and a face value of $900 million. The firm s cost of debt equals 4% and the convertible bond is currently trading for a market value of $1,130 million. What debt value should be used to calculate the weight in the debt component of the WACC formula? a) $1,001.85 million b) $18.15 million c) $1,130.0 million d) $83.10 million DebtValue = 90 90 900 (1.04) (1.04) 1 = 1,001.85 Finance 70610 Midterm Exam November 16, 011
Problems (68 points) Answer each of the questions below completely. You must show ALL your work to get full credit. 9. Adjustments for Operating Lease Debt (0 points): You are valuing Walgreen Co. and have decided to treat operating leases as debt. Future operating lease commitments for Walgreens are listed below. Based on the firm s debt rating, you estimate that the firm s pre-tax cost of debt is 5.0%. The firm s operating lease expense in the most recent year was $,18 million. Use this information to answer the questions below. Year Operating Lease Commitments ($ millions) 011,301 01,39 013,96 014,48 015,188 >015 5,48 Total 36,790 a) Based on the operating lease commitments described above, estimate the debt value of operating leases at Walgreens. To determine the present value of future operating lease obligations, we must first make an assumption about how the payments after year five are spread out over time. I will assume that the $,188 million payment from year five is paid annually after year five. Based on this assumption, the obligations after year five are defined as an annuity of 188 per year for 11.6 years (548/488). This gives : 301 39 DebtValue = 96 48 188 1 188.05 5 11.6 = 1 3 4 5 $4,690.04 Damodaran often assumes that the average payment from the first five years continues after year five. Based on this assumption, the payments after year five are defined as an annuity of 11.19 years.this gives a debt value of $4,833. 7 per year for Finance 70610 Midterm Exam 3 November 16, 011
b) The most recent annual financial statements for Walgreens are provided at the end of the exam. Using these financial statements and any necessary information from your answer above, estimate the after-tax return on capital (ROC) for Walgreens in the most recent year after adjusting both the income statement and balance sheet for operating lease debt. For the purposes of this calculation, you can assume that Walgreen s operating lease debt has not changed over the last year and the firm s marginal tax rate is 37%. Adjusted EBIT(1 T ) = 3458(1.37) (18 4690 16.6 )(1.37) = 178.54 461.41 = $,639.95 Adjusted EBIT(1 T ) = 3458(1.37) (4690(.05)(1.37) = 178.54 777.74 = $,956.8 AdjustedDebt t 1 = 336 15 4690 = 7041 Equity t 1 = 14376 639.95 ROC = = 6.37% 7041 14376 956.8 ROC = = 7.14% 7041 14376 Note that I estimated ROC based on prior year debt and equity values. You could also calculate ROC using the average of beginning and ending year debt and equity values. 10. R&D Capitalization (10 points): You are performing a FCFE valuation of Boeing as of the end of fiscal year 010. The table below describes research and development expenditures at Boeing for each of the past six years. You have decided to capitalize R&D using a four-year life. The balance sheet for Boeing lists short-term debt of $948 million, long-term debt of $11,473 million, total shareholders equity of $,86 million, and total assets of $68,565 million. Using this information, calculate the adjusted values of total debt, equity, and total assets, after accounting for the capitalization of R&D expenses. Year R&D Expense ($ mil) Current Year Amortization Debt = 948 11473 = 1,41(no adjustment) Equity = 86 11938 = 14,800 Assets = 68565 11938 = 80,503 Unamortized Amount Remaining in Current Year 005,988.0 0.00 0% 0.00 006 3,57.0 814.5 0% 0.00 007 3,850.0 96.50 5% 96.50 008 3,768.0 94.00 50% 1884.00 009 6,506.0 166.50 75% 4879.50 010 4,1.0 0.00 100% 41.00 Total 4345.5 11938.00 Finance 70610 Midterm Exam 4 November 16, 011
11. Country Risk and the Cost of Capital (18 points): You are valuing a firm from Italy based on $U.S.-denominated cash flows. Long-term Eurodenominated government-issued debt in Italy has a yield of 4.6%. The comparable yield on long-term U.S. Treasury bonds is.0%. Inflation forecasts are 1.7% for the U.S. and.3% for Italy. In addition, you estimate that the standard deviation of equity market returns is 3% in the U.S. and 3% in Italy. a) Assuming an equity market risk premium of 4.5% and an equity Beta of.1, calculate the cost of equity for this firm including country risk. Assume that all firms in Italy have the same exposure to country risk and explain any additional assumptions necessary to arrive at your answer. The appropriate risk - free rate for $U.S. cash flows is the U.S. treasury yieldof.0%. To incorporate country risk, we multiply the country risk premium by the sensitivity to country risk and add this sum to the cost of equity based on the CAPM equation. Given the information provided, the country risk premium can be defined in one of two ways.based on relativeequity market risk, we get : Coutnry Risk Premium Italy.3.3 = 4.5% = 1.761%.3 The alternative is to assume the country risk premium equals the default spread on the Italian gonverment bond. To estimate this default spread, we first define a risk - free rate for Italy by starting with the U.S. rate and adjusting for the difference between Euro and $U.S. inflation. We then subtract this risk - free rate from the Italian government bond, giving : Coutnry Risk Premium Italy = Default Spread Italy = 4.6% (.0% 1.7%.3%) =.0% Based on our assumption that all firms in Italy have the same sensitivity to country risk, we get λ = 1. We can now solve for the cost of equity using the CAPM adjusted for country risk : K =.0%.1(4.5%) 1.0(1.761%) = 13.11% e K e =.0%.1(4.5%) 1.0(.0%) = 13.45% b) The firm described above has equity with a book value of $1.1 billion and a market value of $1.7 billion. The firm has long-term debt with a book value of $600 million and a market value of $750 million, along with short-term debt worth $50 million. Finally, the firm faces a marginal tax rate of 40% and has a cost of debt equal to 5.6%. Use this information along with your answer from part (1) to calculate the firm's weighted average cost of capital (WACC). Using market value weights and including both short-term and long-term debt, we get: Debt = 750 50 = $ 1000 Equity = $ 1700 K = 5.6% There are two alternative values for K described above. Using these values, we get: e d 1700 1000 WACC = (13.11%) (5.6%)(1.4) = 9.564% 1000 1700 1000 1700 1700 1000 WACC = (13.45%) (5.6%)(1.4) = 9.710% 1000 1700 1000 1700 Finance 70610 Midterm Exam 5 November 16, 011
1. Discounted Cash Flow Analysis (0 points): You are valuing a U.S. firm using a DCF model based on Free Cash Flow to the Firm (FCFF). The firm is currently losing money, but you expect its business to improve over the next several years. Your FCFF forecasts for the next four years are listed below. After year four, you expect cash flows to grow at a rate of 9% for 3 years and then stabilize at 4% thereafter. Year FCFF forecast 1 $118.0 mil $3.0 mil 3 $0.0 mil 4 $68.0 mil The firm has 65 million shares outstanding and a current stock price of $8.50 per share. The firm s equity has a book value of $1.5 billion. The firm also has total debt with a book value of $.5 billion and a market value of $1.8 billion. The firm s cost of debt (K d ) is 4.%, its cost of equity (K e ) is 8.6%, its weighted average cost of capital (WACC) is 5.6%, and its marginal tax rate is 40%. a) Calculate the value of this firm's equity based on the discounted value of FCFF. For FCFF, the appropriate discount rate is WACC = 5.6%. 118 3 PV1 = = 111.74 m PV 1 = = 0.63m (1.056) (1.056) 68 PV3 = 0 PV4 = = 54.68m 4 (1.056) FCFF = 68(1.09) = 74.1m PV 5 HighGrowth 3 1.09 1 1.056 4 = 74.1 / ( 1.056 ) = 174.84m.056.09 FCFF 8 = = 3 68(1.09) (1.04) 91.58 m 91.58 573.75 TV7 = = 573.75 m PVTV = = 3908.71m 7.056.04 (1.056) FirmValue = 111.74 0.63 0 54.68 174. 84 3908.71 = $4005.86m EquityValue = 4005.86 1800 = $05.86m b) Based on your answer to part (a) and the other information provided, what is your estimate of the stock price per share? Does your analysis lead to a buy recommendation or a sell recommendation on this stock? 05.86m EquityValue = 05.86 m P = = $33.94 65m BUY (because your estimated price is higher than the current market price, or 33.94>8.50) Finance 70610 Midterm Exam 6 November 16, 011