Equity Level II 2019 Practice

Miranda Mendosa Case Scenario
Miranda Mendosa, equity analyst at San Antonio Investment Research Group (SIRG),
begins valuing Premier Riverboats, Inc. (PRBI), a thinly and infrequently traded stock on
a regional stock exchange.
For estimating PRBI’s required return on equity, Mendosa uses the capital asset pricing
model (CAPM) approach; however, she thinks its own equity beta of 1.20 is not very
reliable because of the stock’s extremely thin trading volume. Therefore, she obtains the
beta and other pertinent data for Supreme River Navigators Co. (SRNC) (see Exhibit 1),
a midsized company in the same industry with high market liquidity trading on the
NASDAQ, and re-levers it to reflect PRBI’s financial leverage.
EXHIBIT 1
COMPARATIVE DATA FOR VALUATION
PBRI Data SRNC Data
Equity beta 1.20 1.60
Debt ratio (Debt/Total assets) 0.20 0.60

Because of the recent expansion and beautification of the San Antonio Riverwalk along
with a substantial growth in tourism, PRBI has been experiencing double-digit growth
rates in revenues and cash flows and high growth is expected to persist for 10 more
years. Considering these facts, Mendosa decides to first determine PRBI’s present
value of growth opportunities (PVGO). Next, she estimates the value of its stock using
the H-Model. The data and estimates she has compiled for this purpose are in Exhibit 2.
EXHIBIT 2
PRBI’S DATA AND ESTIMATES FOR PVGO AND H-MODELS
Required return on equity 12.40%
Weighted average cost of capital (WACC) 10.60%
Dividend payout ratio 60%
Most recent earnings per share $5.33
Dividends and earnings growth rate over next 10 years (i.e., Years 1 to 10) 15.00%
Dividends and earnings growth rate after Year 10 4.00%
Current stock price $70.00

Venkat Raman, chief investment strategist at SIRG, reviews Mendosa’s use of the
CAPM, PVGO, and H-model in her work and makes the following three comments:
1. The PVGO correctly reflects the value of PRBI’s options or future opportunities to
invest, but it ignores the value of its real options (i.e., options for modifying or
abandoning its current projects).
2. The CAPM is a widely accepted approach for estimating the required return on
equity. However, for individual securities such as PRBI the idiosyncratic risk can
overwhelm the market risk, thereby making beta a poor predictor of the stock’s
future average return.
3. Although the H-model is appropriate for PRBI, the high-growth remains constant
throughout the supernormal growth period and then the low-growth period begins
abruptly.
Next, Mendosa and Raman have a discussion about other approaches that might be
appropriate for valuing PRBI’s stock. They make the following statements:
Statement 1: Raman: As PRBI’s management is actively seeking opportunities to be
acquired, the guideline public company method (GPCM) would be most appropriate
because it establishes a value estimate based on pricing multiples derived from the
acquisition of control of entire public or private companies that were acquired.
Specifically, it uses a multiple that specifically relates to sales of entire companies.
Statement 2: Mendosa: We could also value PRBI using the free cash flow to equity
(FCFE) model. In order to support its rapid growth, however, the company is expected
to significantly increase its net borrowing every year for the next three to five years, and
during those years it could have a significant dampening effect on the company’s FCFE
and thus a lower value for its equity.
Statement 3: Raman: I agree. The residual income (RI) model, also called the excess
earnings method, does not have the same weakness as the FCFE approach because
residual income is an estimate of the profit of the company after deducting the cost of all
capital: debt and equity. Furthermore, it makes no assumptions about future earnings,
and the justified P/B is directly related to expected future residual income.
Raman collects additional data for valuing PBRI using the multistage RI model. For this
model, he assumes an annual growth rate of residual income of 15% during the forecast
horizon of 5 years (Years 1 to 5) and discounts the terminal year’s residual income as a
perpetuity. Other inputs are found in Exhibit 3.
EXHIBIT 3
DATA FOR RESIDUAL INCOME MODEL
Current year net income $8.0 million
Interest expense $1.2 million
Equity capital book value, beginning of year $20.97 million
Cost of equity capital 12.4%

Current year net income $8.0 million
WACC 10.60%
Tax rate 40%
Q. Using the data in Exhibit 1, Mendosa's estimate of PBRI's beta is closest to:
A. 1.20.
B. 0.96.
C. 0.80.
Solution
C is correct. First, use SRNC’s data to find its unlevered equity beta. Next, use SRNC’s
unlevered beta and PRBI's debt ratio to find PRBI's equity beta. The formulas are as
follows:
Unleveredbeta:βu= 11+(DE) βEUnleveredbeta:βu=[11+(DE)]βE
Re leveredbeta:β′ E=[1+(D′ E′ )]βuRe leveredbeta:β'E=[1+(D'E')]βu

SRNC’s debt ratio of 0.60 means (D/E) = (0.60/0.40)
Unleveredbeta:βu= 11+(0.600.40)
1.60=0.64Unleveredbeta:βu=[11+(0.600.40)]1.60=0.64
PRBI’s debt ratio of 0.20 means (D'/E') = (0.20/0.80)
Re leveredbeta:β′
E=[1+(0.200.80)]0.64=0.80Re leveredbeta:β'E=[1+(0.200.80)]0.64=0.80
B is incorrect because it does not go beyond the computation of unlevered beta
Using PRBI’s data:Unlevered beta:βu= 11+(0.200.80) 1.20=0.96Using PRBI’s

data:Unlevered beta:βu=[11+(0.200.80)]1.20=0.96
A is incorrect because it uses debt ratios instead of debt to equity ratios:
Unlevered beta= (1/1.60) × 1.60 = 1.00
Re-levered beta = 1.20 × 1.00 = 1.20
Return Concepts Learning Outcome
d. Explain beta estimation for public companies, thinly traded public companies, and
nonpublic companies
Q. Using the data in Exhibit 2, the estimate of PRBI’s present value of growth
opportunities (PVGO) is closest to:
1. $20.57.
2. $27.02.
3. $40.34.
Solution
A is correct. Using the PVGO and assuming that the company has no positive NPV
projects:
PVGO Model:
E1/r+PVGO=$70=[($5.33×
V0V0 =
1.15)/0.124]+PVGOE1/r+PVGO=$70=[($5.33×1.15)/0.124]+PVGO
$70$70 = $49.43+PVGO$49.43+PVGO
PVGOPVGO = $70 $49.43=$20.57$70 $49.43=$20.57
B is incorrect because it uses E0 instead of E1: $70 = ($5.33/0.124) + PVGO = $42.98;
PVGO = $27.02
C is incorrect because it uses dividends instead of earnings.
$70$70 = [(5.33×0.60×1.15)/0.124]+PVGO[(5.33×0.60×1.15)/0.124]+PVGO
$70$70 = $29.65+PVGO$29.65+PVGO
PVGOPVGO = $70 $29.65$70 $29.65
= $40.35$40.35
Discounted Dividend Valuation Learning Outcome

e. Calculate and interpret the present value of growth opportunities (PVGO) and the
component of the leading price-to- earnings ratio (P/E) related to PVGO
Q. Using the data in Exhibit 2, the estimate of PRBI’s stock according to the H-model
is closest to:
1. $64.76.
2. $77.12.
3. $60.60.
Solution
C is correct. Using the H-model:
V0=D0(1+gL)+D0H(gS gL)r gLV0=D0(1+gL)+D0H(gS gL)r gL
D0 = $5.33 × 0.60 = $3.20
H = half of the life of high-growth period = 10/2 = 5 years
($3.20×1.04)+[$3.20×5×(0.15 0.04)]0.124
V0V0 =
0.04($3.20×1.04)+[$3.20×5×(0.15 0.04)]0.124 0.04
= $3.33+$1.760.084$3.33+$1.760.084
= $60.60$60.60
A is incorrect because it starts with D1 instead of D0.
($3.20×1.15)+[$3.20×5×(0.15 0.04)]0.124
V0V0 =
0.04($3.20×1.15)+[$3.20×5×(0.15 0.04)]0.124 0.04
= $3.68+$1.760.084$3.68+$1.760.084
= $64.76$64.76
B is incorrect because it uses WACC instead of the required return on equity.
($3.20×1.04)+[$3.20×5×(0.15 0.04)]0.106
V0V0 =
0.04($3.20×1.04)+[$3.20×5×(0.15 0.04)]0.106 0.04
= $3.33+$1.760.066$3.33+$1.760.066
= $77.12$77.12

i. Explain the assumptions and justify the selection of the two-stage DDM, the H-model,
the three-stage DDM, or spreadsheet modeling to value a company’s common shares
Q. In regard to the comments by Raman, he is most accurate with respect to the:
A. H-model.
B. CAPM.
C. PVGO.
Solution
B is correct. Raman is most accurate with respect to his comments on the CAPM. In
portfolios, the idiosyncratic risk of individual securities tends to offset against each other
leaving largely beta (market) risk. For individual securities, idiosyncratic risk can
overwhelm market risk and, in that case, beta may be a poor predictor of future average
return. Thus the analyst needs to have multiple tools available.
A is incorrect because it is a variant of the two-stage model in which growth begins at a
high rate and declines linearly throughout the supernormal growth period until it reaches
a normal rate at the end.
C is incorrect because PVGO reflects not only the value of a company’s options to
invest, captured by the word “opportunities,” but also the value of the company’s options
to time the start, adjust the scale, or even abandon future projects. This element is the
value of the company’s real options (options to modify projects, in this context).
Return Concepts Learning Outcomes

nonpublic companies
e. Describe strengths and weaknesses of methods used to estimate the required return
on an equity investment
Discounted Dividend Valuation Learning Outcomes

Q. In regard to the discussion on other approaches between Mendosa and Raman,

which of the following statements that they make is most accurate? Statement:
A. 1.
B. 3.
C. 2.
Solution
B is correct. Statement 3 by Raman is most accurate. The residual income model, also
called the excess earnings method, does not have the same weakness as the FCFE
approach, because it is an estimate of the profit of the company after deducting the cost
of all capital: debt and equity. Further, it makes no assumptions about future earnings
and dividend growth.
A is incorrect because raman’s statement is incorrect because it is the guideline
transactions method (GTM), not GPCM.
C is incorrect because changing leverage (changing the amount of debt financing in the
company’s capital structure), does have some effects on FCFE. An increase in leverage
will not affect FCFF (although it might affect the calculations used to arrive at FCFF). An
increase in leverage affects FCFE in two ways. In the year the debt is issued, it
increases the FCFE by the amount of debt issued. After the debt is issued, FCFE is
then reduced by the after-tax interest expense.
Free Cash Flow Valuation Learning Outcome

g. Explain how dividends, share repurchases, share issues, and changes in leverage
may affect future FCFF and FCFE
Residual Income Valuation Learning Outcome

d. Explain fundamental determinants of residual income
Private Company Valuation Learning Outcome

i. Calculate the value of a private company based on market approach methods and
describe advantages and disadvantages of each method
Q. Using the data in Exhibit 3, Raman’s estimate of the contribution that the terminal
value of the residual income stream in 5 years will contribute to the current value of
equity (in $ millions) is closest to:
A. $48.82.
B. $61.91.
C. $42.25.
Solution
A is correct. Using a multi-stage residual income model and the data in Exhibit 3:
Equity chargeEquity Equity capital×Cost of equity capitalEquity capital×Cost of

=
charge equity capital
= 20.97×0.12420.97×0.124
= $2.60 million$2.60 million
Residual income of the most recent yearResidual Net income Equity chargeNet
=
income of the most recent year income Equity charge
= 8.00 2.608.00 2.60
= $5.40 million$5.40 million
Raman’s assumed growth rate during the forecast period of five years = 15%
Annual residual income during the no growth period (after Year 5) = 5.40 × (1.15)5 =
$10.86
PV of the residual income from perpetual period, as at T = 5 = ($10.86/0.124) =
$87.58
PV of the perpetual period residual income at T = 0 = 87.58/(1.124)5 = $48.82
C is incorrect because It uses WACC as the discount rate instead of the required return
on equity.
Year RIs PVs
1 $5.40 $4.80
2 $6.21 $4.92
3 $7.14 $5.03
4 $8.21 $5.15
5 $9.44 $5.26
$25.16
TV
$9.44 $42.45
$67.61
B is incorrect because it uses the Year 0 residual income as Year 1---one year timing
difference.
Incorrect with WACC
Year PVs
Incorrect with WACC
1 $5.61
2 $5.84
3 $6.07
4 $6.31
5 $6.56
$30.40
TV
$61.91
V0 $92.31
Residual Income Valuation Learning Outcomes

a. Calculate and interpret residual income, economic value added, and market
value added
6. Calculate and interpret the intrinsic value of a common stock using single-stage
(constant-growth) and multistage residual income models
Thomas Wolff Case Scenario

Thomas Wolff is a new analyst working at Relnick and Silver (RS), a private equity firm.
In addition to managing its own portfolio, RS also consults with firms that want to make
private equity investments. Wolff was hired by Blair Silver to help with RS’s appraisal
consulting work.
Wolff is asked to value two private firms, Amalthia Inc. and Callisto Inc., for Randome
Investments LLC (Randome), a diversified holding company. Silver hands Wolff files
that other appraisers at RS had previously compiled with miscellaneous information on
the two companies, and Silver discusses Randome’s objectives for each firm.
Wolff consolidates the information for each of the two firms, shown in Exhibit 1 and
Exhibit 2, and begins to analyze them sequentially.
EXHIBIT 1
AMALTHEA INC.
This file is incomplete. It includes future cash flow projections and lists, prepared when
the company was at risk of bankruptcy in the prior fiscal year, of both tangible assets
and financial assets, including their costs and market values, but it contains no resultant
valuation or notes on the standard used for any prior valuation. Amalthea is a REIT,
similar to other holdings in Randome’s portfolio.
Updated Information
Company Stage: Development
Randome’s Investment Objective: Acquisition to complement other holdings and
generate potential cost savings and revenue enhancements arising from operational
control.
Silver has made a note on the cover sheet of Amalthea’s file that Wolff’s prior
experience as a bankruptcy analyst should be particularly relevant for this appraisal.
Wolff reviews the information and considers whether Amalthea is worth more in
liquidation or as a going concern.
 First, for its liquidation appraisal, Wolff updates the fair values of the assets and
liabilities. He records the difference (assets less liabilities) as the equity value. He
makes three footnotes to his appraisal indicating that the asset-based approach:
1. reflects the value of the assets to a potential buyer, not the value to the company
itself;
2. is inappropriate for real estate investment trusts (e.g., REITs); and
3. is applied frequently to early stage companies with limited tangible value.
 Second, for its going-concern appraisal, Wolff uses an income approach. His
approach applies a premium based on earnings from the perspective of a financial
buyer with a majority position. His results indicate that this appraisal value is less
than the liquidation appraisal value, and so Wolff concludes that the higher
liquidation value should be applied instead.
Wolff reviews the data in the Callisto Inc. file. Silver made a note on cover sheet of this
file reminding Wolff that considering the change in investment objective, he will need to
adjust the prior valuation to reflect a discount for lack of control and a discount for lack
of marketability.
EXHIBIT 2
CALLISTO INC.
This file includes comprehensive data and the results of a valuation done in the prior
fiscal year for a different client who had been considering a synergistic acquisition of
Callisto.
Updated Information
Company Stage: Mature
Randome’s Investment Objective: Minority investment
The following day, Silver and Wolff meet to discuss his appraisals of both firms. Wolff
cautions that he applied different definitions of value in each of the appraisals and
stresses that these different standards are not interchangeable, which leads to a
broader discussion of the evolving role of valuation standards and regulation thereof.
Silver notes that this overview would be useful to have available for the meeting with
Randome in case the topics arise. They immediately work up a brief outline, and Wolff
suggests the following major details:
 Common uses of equity valuation can be classified as transaction-related,
compliance-related, and litigation-related. Of the three, litigation-related valuation
has higher importance in private company valuation than in public company
valuation.
 Compliance-related valuation has grown as a result of the increasing role of fair
value estimates in financial reporting under the International Financial Reporting
Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).
 Since the creation of the Uniform Standards of Professional Appraisal Practice
(USPAP), business valuations, including valuations used for financial reporting, are
required by law to adhere to these standards.
Q. Silver’s note about the relevance of Wolff’s prior experience when valuing Amalthea
for acquisition most likely arises because his prior appraisals:
A. also required applying both types of comparative valuations.
B. only required an appraisal of a company’s value in liquidation.
C. led to greater familiarity with appraising firms in their development stage.
Solution
A is correct. Wolff has prior experience as a bankruptcy analyst. For companies
operating under bankruptcy protection, valuations of the business and its underlying
assets may help assess whether a company is more valuable as a going concern or in
liquidation. Similarly, when the valuation is applied for the purposes of acquisition,
companies in the development phase may best be valued using an asset-based
approach or the going-concern premise of value. Therefore, Wolff’s prior experience
should give him the knowledge to carry out both types of valuations that are required.
B is incorrect because for companies operating under bankruptcy protection, valuations
of the business and its underlying assets may help assess whether a company is more
valuable as a going concern or in liquidation. Both valuation standards may be required
for this application.
C is incorrect because companies in bankruptcy include both those in their development
phase and mature businesses.

b. Describe uses of private business valuation and explain applications of greatest
concern to financial analysts
Q. In Wolff’s liquidation appraisal of Amalthea, the most accurate footnote is number:
1. 1.
2. 2.
3. 3.
Solution
A is correct. Footnote 1 is the most accurate. The value of a company in liquidation
reflects the assumption that the assets might be redeployed by buyers to higher valued
uses. This is one reason why its value as a going concern might be less than its value in
liquidation.
B is incorrect because the asset-based approach may be appropriate for the valuation
of investment companies, such as real estate investment trusts (REITs). For these
entities, the underlying assets typically consist of real estate holdings that were valued
using the market and/or income approaches.
C is incorrect because companies with limited tangible value would be less
appropriately valued by an asset-based method. This approach may also be appropriate
for very small businesses with limited intangible value or early stage companies.

j. Describe the asset-based approach to private company valuation
Q. Wolff’s second appraisal of Amalthea is most likely flawed because:

1. it ignores the premium related to potential synergies arising from a strategic
acquisition.
2. it fails to reflect the premium available to an investor with controlling interest.
3. an income approach is inappropriate when the company is in the development
stage.
Solution
A is correct. Wolff’s valuation reflects the control premium for a financial buyer with a
majority position but disregards the premium for a strategic buyer. Per Exhibit 1,
Randome expects to generate cost savings and revenue enhancements arising from
operational control; therefore, it is a strategic buyer, not a financial buyer.
B is incorrect because wolff did apply a control premium by basing his valuation on
earnings from the perspective of a financial buyer with a majority shareholder position.
C is incorrect because the income approach is an appropriate method for a going
concern, even in the development stage, because it converts future economic benefits
into a present value equivalent.

k. Explain and evaluate the effects on private company valuations of discounts and
premiums based on control and marketability
Q. Silver’s note concerning the adjustments required for the new valuation of Callisto
is best described as:
1. correct.
2. incorrect with respect to the discount for the lack of marketability.
3. incorrect with respect to the discount for the lack of control.
Solution
B is correct. Silver is incorrect with respect to the discount for the lack of marketability.
The change in the investment objective is from a control perspective (given the
expected synergies) to a minority interest. It is thus appropriate to adjust the original
valuation for a discount for lack of control. Under both circumstances, however, there
would be a discount for lack of marketability because the company is private.
A is incorrect because silver is incorrect with respect to the discount for the lack of
marketability. The change in the investment objective is from a control perspective
(given the expected synergies) to a minority interest. It is thus appropriate to adjust the
original valuation for a discount for lack of control. However, under both circumstances
there would be a discount for lack of marketability because the company is private.
C is incorrect because silver is correct with respect to the discount for the lack of
control. The change in the investment objective is from a control perspective (given the
expected synergies) to a minority interest. It is thus appropriate to adjust the original
valuation for a discount for lack of control.

k. Explain and evaluate the effects on private company valuations of discounts and
premiums based on control and marketability
Q. Given the information provided in Exhibit 2, the standard of value most likely used in
Callisto’s prior valuation was:
1. investment value.
2. intrinsic value.
3. market value.
Solution
A is correct. The prior valuation with the objective of a synergistic acquisition would
most likely have been done with an investment valuation standard. Investment value
differs from other value definitions in its greater focus on a specific buyer rather than
value in a “market” context and includes potential synergies of the acquisition with other
assets owned by a prospective buyer. Both market value and intrinsic value ignore the
control premium and the value of specific synergies for an acquisition.
B is incorrect because the intrinsic value is a possible standard of value used for a block
of shares. It is not the most appropriate standard of value for the acquisition of a
company because it ignores both the control premium and the value of specific
synergies for an acquisition.
C is incorrect because the market value is a possible standard of value used for a block
of shares. It is not the most appropriate standard of value for the acquisition of a
company because it ignores both the control premium and the value of specific
synergies for an acquisition. In addition, the market value may be less persistent
because it is subject to short-term pricing aberrations.

c. Explain various definitions of value and demonstrate how different definitions can lead
to different estimates of value
Q. In the list dealing with valuation standards and regulations prepared for the upcoming
meeting with Randome, Wolff most likely made an error in the detail pertaining to:
1. the litigation-related valuation of public versus private companies.
2. valuation as a component of financial reporting.
3. the binding nature of USPAP regulations.
Solution
C is correct. Randome made an error in the point related to the USPAP. Valuations
used for financial reporting do not involve mandatory compliance with USPAP or other
professional standards. More generally, business appraisers are typically not required
by law to adhere to these standards.
A is incorrect because the statement is correct: of the three key uses of valuation listed,
acquisition-related valuation issues and financial reporting valuation issues are of the
greatest importance. Litigation-related valuation has the least importance of the three
and is of lesser importance for a public firm than for a private firm valuation.
B is incorrect because the statement is correct: it is a valid description of the growing
role of compliance valuation.

l. Describe the role of valuation standards in valuing private companies
Gregory Armishaw Case Scenario
Gregory Armishaw is an equity analyst specializing in the food and beverage industry at
Fulsom-Wagner Investment Counsel in Minneapolis, Minnesota. In late January 2014,
he became aware of a new salt substitute, SansSalt, that was developed by a local
company, Vitality FoodGroup, Inc. (VFG).
With the continuing concern over health matters arising from excessive salt use,
Armishaw believes that the addition of this product line could be quite beneficial to VFG.
He uses the data in Exhibit 1 to calculate the value of VFG using (1) the residual income
model and (2) the H-model version of the dividend discount model.
EXHIBIT 1
VITALITY FOODGROUP SELECTED INFORMATION FOR VALUATION, 31
DECEMBER 2013
Net income $422 million
Common stock (par plus paid-in-excess of par) $1,075 million
Retained earnings $1,078 million
Weighted average cost of capital 11.9%
Cost of debt, before tax 7.0%
Cost of equity capital 15%
Expected dividend growth behavior:
Expected for 2014 14%
After 2014, dividend growth rate declines linearly over a 6 year period
The final and perpetual growth rate: 5%
Estimated earnings per share (EPS) in 2019 $5.04
Shares outstanding 150 million

Armishaw shows his report to Anthony Stack, Fulsom-Wagner’s senior portfolio
manager and Armishaw’s reporting official. In the H-model calculation, Stack notices
that Armishaw assumes a sustainable growth rate of 5% following the period of high
growth. Stack asks Armishaw if it is true that the sustainable growth model assumes the
company will require
1. external debt financing,
2. external equity financing, and
3. improving return on equity.
Still concerned with the estimate of growth after 2019, Stack asks Armishaw what the
present value of growth opportunities (PVGO) will be in 2019 when the perpetual growth
period begins.
Armishaw next presents Exhibit 2, which contains the basis for his estimates for the
share price (as of 15 January 2014) if he assumes a terminal value in 2023 arising from
treating 2023’s residual income as a perpetuity.
EXHIBIT 2
VITALITY FOODGROUP BASIS FOR TERMINAL VALUE AND REVISED PRICE
ESTIMATE, 15 JANUARY 2014
Forecasted residual income (RI) per share at end of 2023 $5.32
Estimated return on equity (ROE) in 2023 20%
Nature of stream beyond 2023 Perpetuity
Growth rate beyond 2023 0%
Cost of equity 15%
Dividend payout 40%

Stack questions Armishaw’s assumption in his 2014 valuation (Exhibit 2) that a
perpetuity would best describe the terminal value of the stream and suggests that
residual income should fade over time. Stack further suggests that a persistence factor
of 0.50 might be appropriate.
Stack tells Armishaw that he prefers the use of a residual income model to value the
company over other available methods. He provides three justifications for his
preference:
1. The model explicitly incorporates the cost of debt capital.
2. The model can be used when cash flows are unpredictable.
3. There is less of an impact arising from the uncertainty in forecasting terminal value.
Q. Based on the information in Exhibit 1, Armishaw’s estimate of VFG’s residual income
per share for 2015 is closest to:
A. $1.17.
B. $0.84.
C. $0.28.
Solution
A is correct. Residual income for 2015 = Net income (2015) – Equity charge at the
beginning of 2015
(all amounts millions except per share 2014 2015

data)
Growth rate 14% 12.5% 2015 growth:

14% (14% 5%)/6 years
Net income: $422 in 2013 $481.08 $541.22 Prior year × (1 + g):

g = 14% and 12.5%,
respectively
Less Dividends 192.43 216.49 40% × Net income
Increase in retained earnings $288.65 $324.73
Starting equity $2,153.00 $2,441.65 Start of 2014: $1,075 + $1,078
Increase in retained earnings 288.65 324.73
Ending equity $2,441.65 $2,766.38
Net income $541.22 From above
Less equity charge 366.24 Starting equity (2,441.65) ×

15%
Residual income $174.98
Residual income per share $1.17 Divide by 150 (million shares)

B is incorrect because it grows earnings but determines the equity charge based on end
of year equity.
Net Income = 541.22 (from table above)
Equity charge = 414.96 (0.15 × 2,766.38 end equity from table above)
Residual income = 126.26/150 million shares = $0.84/share
C is incorrect because it uses increase in retained earnings less equity charge (values
from table above):
[324.73 366.24]/150 million shares = $0.28/share

value added
Q. Based on the information in Exhibit 1, the H-model per share valuation of VFG’s
common shares is closest to:
1. $17.89.
2. $15.86.
3. $14.85.
Solution
C is correct. The value using the H Model is:
V0V0 =
D0(1+gL)+D0H(gS gL)r gLD0(1+gL)+D0H(gS gL)r gL
1.125×(1+0.05)+1.125×3×(0.14 0.05)0.15
=
0.051.125×(1+0.05)+1.125×3×(0.14 0.05)0.15 0.05
=
$14.85 per share$14.85 per share
where
V0 = value per share at t = 0
D0 = current dividend = $1.125 [$422 × 0.40/150 = Net income × (Payout/Number of
shares)]
r = required return on equity = 0.15 [= Cost of equity capital]
H = Half-life in years of high growth = 3 [0.5 × 6 years of high growth]
gS = initial short-term dividend growth rate = 14%
gL = long-term growth rate after Year 2H = 5%
A is incorrect because it uses 2H rather than H.
1.125×(1+0.05)+1.125×6×(0.14 0.05)0.15
0.05=17.891.125×(1+0.05)+1.125×6×(0.14 0.05)0.15 0.05=17.89
H is the half-life, whereas 2H is the entire growth period.
B is incorrect because it uses gS in the first term.
1.125×(1+0.14)+1.125×3×(0.14 0.05)0.15
0.05=15.861.125×(1+0.14)+1.125×3×(0.14 0.05)0.15 0.05=15.86

l. Calculate and interpret the value of common shares using the two-stage DDM, the H-
model, and the three-stage DDM
Q. Which of Stack’s three assumptions regarding the sustainable growth rate model
is most accurate?
1. 1
2. 2
3. 3
Solution
A is correct. The sustainable growth rate model assumes that the growth will be
financed with the issuance of debt and only internally generated equity will be used to
maintain a target capital structure. No additional common equity will be issued. The
ROE is assumed to be a constant during this period.
B is incorrect because it is assumed in the sustainable growth model that all additional
equity comes from internally generated funds, not new issues.
C is incorrect because the ROE is constant during this period.

o. Calculate and interpret the sustainable growth rate of a company and demonstrate the
use of DuPont analysis to estimate a company’s sustainable growth rate
Q. The most appropriate answer to Stack’s question about the PVGO is:
1. $14.11.
2. $12.43.
3. $19.32.
Solution
A is correct.
Value of no-growth level V0 = (5.04 × 1.05)/0.15 = $35.28 all EPS paid
perpetuity in 2019 out as
dividends
Value as a perpetual growing D1 = EPS1 ×

V0V0 = D1r gD1r g Payout ratio
stream (i.e., using the constant
growth Gordon model) Perpetual
5.04×(1+0.05)×0.400.15 growth at 5%
=
0.055.04×(1+0.05)×0.400.15 0.05
= $21.17$21.17
PVGO = $21.17 $35.28 = $14.11 PVGrowth

PVNoGrowth
B is incorrect because it uses the earnings as the dividend in the growth period:
Value of perpetual growth stream = [5.04 × (1 + 0.05)]/(0.15 0.05) = $52.92
PVGO = $52.02 $33.60 = $19.32
C is incorrect because it does not grow the dividend beyond the current value:
Value of perpetual growth stream = (5.04 × 0.40)/(0.15 0.05)= 20.16
PVGO = $20.16 $33.60= $13.44

Q. Using the information in Exhibit 2, comparing Armishaw’s approach to terminal value

to Stack’s approach, Stack’s assumption leads to a 2024 value that is approximately:
1. $6.50 lower than Armishaw’s approach.
2. $6.74 lower than Armishaw’s approach.
3. $26.30 higher than Armishaw’s approach.
Solution
A is correct.
Armishaw’s assumption VT = 5.32/0.15 = $35.47 Perpetuity of $5.32 per year starting in
2024
Stack’s assumption
Estimated 2024 growth 0.20 × 0.60 = 0.12 ROE2023 × Retention ratio

rate
Residual income in 2024 5.32 × 1.12 = 5.96 RI2024 = RI2023 × (1 + 0.12)
Terminal value 2024 5.96/(1 + 0.15 – 0.50) = VT = RI2024/(1 + r – w)

$9.17
Difference in VT 9.17 – 35.47 = –26.30 Stack’s vs. Armishaw’s assumptions
Difference in PV(VT) –26.30/(1.1510) = –$6.50 Stack’s estimate will be $6.50 lower

Where r = required return on equity; w = persistence factor for residual income; VT =
terminal value at forecast horizon.
B is incorrect because it does not grow Stack’s RI in 2023 by 12%:
Stack’s terminal value = 5.32/(1 + 0.15 – 0.50) = $8.18
PV Difference = (8.18 – 35.47)/(1.1510) = –6.74
C is incorrect because it ignores PV to time 0 and reverses effect (misunderstanding
persistence factor):
35.47 – 9.17 = +26.30

f. Calculate and interpret the intrinsic value of a common stock using single-stage
Q. The least appropriate justification that Stack makes in support of the use of the
residual income model is Statement:
A. 3.
B. 1.
C. 2.
Solution
B is correct. The residual income model uses accounting income estimates and
assumes that the cost of debt capital is properly reflected by interest expense, but
because of changing market conditions interest expense may not be a good proxy for
the company’s cost of debt capital.
A and C are incorrect because this is a strength of the residual income model.

i. Compare residual income models to dividend discount and free cash flow models
j. Explain strengths and weaknesses of residual income models and justify the selection
of a residual income model to value a company’s common stock
Bryan Yee Case Scenario

Bryan Yee is a junior analyst at HK Partners, a leading asset manager in Hong Kong.
His boss, Brittany Chen, has asked Yee to assist her in analyzing eLeisure, a leading
firm in the travel and leisure industry. eLeisure operates an online travel agency in Asia
that provides travel products and services to travelers and travel agents. Chen provides
Yee with a list of questions to help her finalize her analysis of discount rates as they
pertain to the valuation of eLeisure, compare the firm with its industry, and determine
intrinsic value estimates for eLeisure’s common stock.
Chen first asks Yee to estimate eLeisure’s sustainable growth rate, which he does using
the using the information in Exhibits 1 and 2.
EXHIBIT 1
SELECTED ELEISURE INCOME STATEMENT DATA
(HK$ millions, except shares outstanding) 2014
Sales 3,110.56
Pretax income 551.22
Income taxes 135.48
Net income 415.74
Dividends 103.87
Common shares outstanding (millions) 89.54

EXHIBIT 2
SELECTED ELEISURE BALANCE SHEET DATA
2014 Cost (HK$ millions) 2014 Market Value (HK$ millions)
Cash 490
Total assets 4,235.58
Total debt 1,051.96 997
Common shareholders’ equity 2,119.41
Non-controlling interest 580
Total equity 2,699.41

The current share price of eLeisure’s common equity is HK$31.28. Chen mentions to
Yee that historically, the company has had a ratio of enterprise value (EV) to sales of
1.25×. She asks Yee to use the information in Exhibits 1 and 2 along with this metric to
determine whether eLeisure’s common shares are appropriately priced.
Chen asks Yee to refine his analysis of the dividend growth rate and discount rates to
value eLeisure’s equity. Yee looks at eLeisure in more detail and concludes that its
expansion potential will likely follow three distinct stages of growth, provided in Exhibit
3. He also determines the long-term return on equity (ROE) for the stock and its
required rate of return, which are also presented in Exhibit 3.
EXHIBIT 3
YEE’S ESTIMATES FOR ELEISURE
1. Estimated growth rates for eLeisure’s dividends
2015–2017 2018–2021 Beyond 2021
19% 10% 5%
2. Other estimates for eLeisure
Long-term ROE 15%
Required rate of return on the stock 11%

With these estimates, Yee determines the intrinsic value of eLeisure common stock
using the dividend discount model (DDM).
Chen next instructs Yee to minimize the uncertainty in making assumptions about
eLeisure’s future earnings and long-term dividend growth by using the residual income
model. Yee uses the data in Exhibits 1, 2, and 3 to calculate eLeisure's intrinsic value
per common share.
Yee discusses with Chen the best reasons for using the residual income model and
provides the following explanation:
“The residual income model’s strengths include the fact that it uses readily available
accounting data and focuses on economic profitability. Weaknesses include the fact
that accounting data can be manipulated by management, the cost of debt capital is
assumed to be reflected by interest expense, and terminal values make up a large
portion of the value of a firm’s equity.”
Several firms in the leisure industry in Asia are privately held. Chen asks Yee to provide
three key differences between valuing private and public companies. He cites the
following differences:
 Private firms are generally smaller than public firms. Being smaller, they can have
enhanced growth prospects because of easier access to growth capital.
 Agency issues are usually greater at private companies.
 Small companies might decide to remain privately held because higher compliance
costs may outweigh any other benefits of being public.
Q. Using the information in Exhibits 1 and 2, Yee’s estimate of eLeisure’s sustainable

growth rate is closest to:
A. 7.4%.
B. 4.9%.
C. 14.7%.
Solution
C is correct. There are two ways to calculate sustainable growth rate (g). The first way
is to use the PRAT model (profit margin, retention ratio, asset turnover, and financial
leverage, T) (amounts in HK$ millions):
g=
Retentionratio × Profitmargin × Assetturnover × Financialleverage
g
(Net income Dividends)Net income×Net incomeSales×SalesTotal assets×
=Total assetsCommon shareholders' equity(Net
income Dividends)Net income×Net incomeSales×SalesTotal assets×Total assetsC
ommon shareholders' equity
(415.74 103.87)415.74×415.743,110.56×3,110.564,235.58×
=
4,235.582,119.41(415.74 103.87)415.74×415.743,110.56×3,110.564,235.58×4,235.5
82,119.41
=
0.750×0.134×0.734×2.000.750×0.134×0.734×2.00
=
14.7%14.7%
An alternative approach is to determine g by multiplying the retention ratio by ROE:
g
= Retentionratio×ROERetentionratio×ROE
g
(Net income Dividends)Net income×
= Net incomeCommon shareholders' equity(Net income Dividends)Net income×Net inco
meCommon shareholders' equity
= (415.74 103.87)415.74×415.742,119.41(415.74 103.87)415.74×415.742,119.41
= 0.750×0.1960.750×0.196
= 14.7%14.7%
B is incorrect because it uses 0.25 (dividend rate) in the first part of the equation instead
of 0.75 (retention rate). Equation incorrectly becomes:
g = [1 (415.74 103.87415.74)]×415.743,110.56×3,110.564,235.58×
g 4,235.582,119.41[1 (415.74 103.87415.74)]×415.743,110.56×3,110.564,235.58×4,2
35.582,119.41
=
4.9%4.9%
A is incorrect because it uses ROA × b. Equation becomes:
gg = (415.74 103.87)415.74×415.744,235.58(415.74 103.87)415.74×415.744,235.58
= 0.75×0.0980.75×0.098
= 7.4%7.4%

Q. Using the EV-to-sales ratio approach, Yee discovers that compared with this metric,
eLeisure’s common shares are most likely currently:
A. properly valued.
B. overvalued by 17.5%.
C. undervalued by 20.7%.
Solution
A is correct.
1. The company’s EV/sales multiple is 1.25.
With eLeisure’s sales of HK$3,110.56 million, EV = 1.25 × HK$3,110.56 = HK$3,888.20
million
2. eLeisure’s enterprise value = Market value (MV) of common equity + MV of debt
+ Non-controlling interest Cash and investments
= (HK$X × 89.54 million) + HK$997.00 million + HK$580.00 million HK$490.00 million
= HK$3,888.20 million
Solving for X = HK$31.28
3. With a current share price of HK$31.28, eLeisure’s shares are currently properly
valued according to this metric.
B is incorrect because cash is not subtracted in the EV calculation. The calculation
becomes:
+ Non-controlling interest = ($X × 89.54) + 997.00 + 580.00 = 3,888.20
X = $25.81
3. With a current share price of $31.28, eLeisure’s shares are currently overvalued
according to this metric by (31.28 25.81)/31.28 = 17.5%.
If price falls 17.5%, it equals model price: (1 0.175) × 31.28 = 25.81
C is incorrect because it doesn’t include the value of non-controlling interest. The
calculation becomes:
Cash and investments = ($X × 89.54) + $997.00 490.00 = 3,888.20
X = $37.76
3. With a current share price of $31.28, eLeisure’s shares are currently undervalued
according to this this metric by (31.28 37.76)/31.28 = 20.7%.
If price rises 20.7% it equals model price: 1.2075 × 31.28 = 37.77.
Market-Based Valuation: Price and Enterprise Value Multiples

Learning Outcome
n. Calculate and interpret EV multiples and evaluate the use of EV/EBITDA
Q. Based on Yee’s growth estimates and the information in Exhibits 1 and 3, the
amount that the terminal value component of its intrinsic value contributes to eLeisure’s
stock price at the end of 2014 is closest to:
A. HK$21.73.
B. HK$20.30.
C. HK$24.12.
Solution
C is correct. Using the DDM approach and Yee’s three-stage growth estimates, the
contribution that the terminal value provides to eLeisure’s stock price at the end of 2014
is calculated as follows:
1. Determine the current dividend by taking the 2014 dividend of HK$103.87 million
divided by the shares outstanding of 89.54 million = HK$103.87 million/89.54 million
shares = HK$1.16/share.
2. Then determine the value of the dividend when it enters its terminal growth stage.
Dividend Behavior during the Three Growth Periods
Period of growth Formula Value
First 1.16 × (1.19)3 1.954
Second 1.954 × (1.10)4 2.862
Third All future growth at 5%

3. The present value of all future dividends as of 2021 can be determined using the
constant growth perpetuity formula.
VTVT =
DT+1r g=DT×(1+g)r gDT+1r g=DT×(1+g)r g
V2021V2021 =
2.862×(1+0.05)0.11 0.052.862×(1+0.05)0.11 0.05
= HK$50.08HK$50.08
4. The present value as of 2014 of this terminal value is:
V2014V2014 =
50.08(1+0.11)750.08(1+0.11)7
= HK$24.12HK$24.12
A is incorrect because it discounts the correct terminal value by 8 years.
V2014V2014 =
50.08(1+0.11)850.08(1+0.11)8
= HK$21.70HK$21.70
The full valuation of the stock is not required, but is included here anyway.
Calculation
Time Value Dt 1 × (1 + g) Dt or Vt PV Calculation Present Value
2015 D1 1.16 × (1.19) 1.38 $1.38/(1.11)1 1.24
2016 D2 1.38 × (1.19) 1.64 $1.64/(1.11)2 1.33
2017 D3 1.64 × (1.19) 1.95 $1.95/(1.11)3 1.43
2018 D4 1.95 × (1.10) 2.15 $2.15/(1.11)4 1.42
2019 D5 2.15 × (1.10) 2.37 $2.37/(1.11)5 1.41
2020 D6 2.37 × (1.10) 2.61 $2.61/(1.11)6 1.40
2021 D7 2.61 × (1.10) 2.87 $2.87/(1.11)7 1.38
2021 V7 (2.87 × 1.05)/(0.11 0.05) 50.23 $50.23/(1.11)7 24.19
Total $33.79
B is incorrect because this alternative simply takes the current dividend and treats it as
a growing perpetuity:
V2014V2014 =
1.16×(1+0.05)0.11 0.051.16×(1+0.05)0.11 0.05
= HK$20.30HK$20.30

b. Calculate and interpret the value of a common stock using the dividend discount
model (DDM) for single and multiple holding periods
Q. Using the residual income model and Exhibits 1, 2, and 3, Yee’s estimate of
eLeisure’s intrinsic value per share is closest to:
A. HK$32.27.
B. HK$23.67.
C. HK$39.45.
Solution
C is correct. The residual income model is:
Vn=B0+ROE rr gB0Vn=B0+ROE rr gB0
where
B0 = Book value per common share at end of 2014 (beginning of 2015)
ROE = Long-term return on equity
r = Cost of equity
g = Long-term dividend growth rate
The book value per common share is calculated by dividing the common shareholders’
equity in Exhibit 2 by the common shares outstanding in Exhibit 1:
Common shareholders’ equity HK$2,119.41 million
÷ Common shares outstanding 89.54 million
= Book value per common share HK$23.67

The intrinsic value for eLeisure’s common shares is:
Vn=HK$23.67+0.15 0.110.11
0.0523.67=39.45Vn=HK$23.67+0.15 0.110.11 0.0523.67=39.45
B is incorrect because it uses the 11% for both ROE and r. The equation incorrectly
becomes:
Vn=HK$23.67+0.11 0.110.11
0.0523.67=23.67,Vn=HK$23.67+0.11 0.110.11 0.0523.67=23.67,which is simply the
book value per share.
A is incorrect because the denominator uses r instead of r g. The equation incorrectly
becomes:
Vn=HK$23.67+0.15 0.110.1123.67=32.27Vn=HK$23.67+0.15 0.110.1123.67=32.27

value added
c. Calculate the intrinsic value of a common stock using the residual income model and
compare value recognition in residual income and other present value models
Q. Which of Yee’s explanations of the strengths and weaknesses of the residual income
model is leastaccurate?
1. The explanation about terminal values
2. The explanation about accounting data
3. The explanation about debt capital
Solution
A is correct. Terminal values do not make up a large portion of the total present value
of a firm’s equity. Current book value often captures a large portion of total value.
Therefore, terminal value may not be a large component of total value.
B is incorrect because accounting data are both readily available and open to
manipulation by management. Also, the models have an appealing focus on economic
profitability.
C is incorrect because the cost of debt capital is assumed to be reflected by interest
expense.

Q. Which of the differences cited by Yee about private and public companies
is most accurate?
A. The differences in enhanced growth prospects
B. The differences in compliance costs
C. The differences in agency issues
Solution
B is correct. For small companies, the cost of operating as a public company and its
related compliance costs may outweigh enhanced access to capital that comes with
being a public company.
A is incorrect because a private firm’s small size may reduce growth prospects because
they have reduced access to capital to fund the growth in their operations.
C is incorrect because agency issues arise in a corporation when managers act in their
own interests instead of the interests of shareholders (for whom they are acting as
agents). The agency issues are mitigated at a private company because top
management has a controlling/significant ownership interest, so there is less of a
discrepancy of interests between management and shareholders

a. Compare public and private company valuation
Dividends and Share Repurchases: Analysis Learning Outcome

c. Describe types of information (signals) that dividend initiations, increases, decreases,
and omissions may convey
Valuation Strategies Case Scenario

Valuation Strategies, LLC, is a US-based manager of equity funds driven by a strict
valuation methodology. Internal analysts determine an intrinsic value target price for
each stock in their respective industry groups using the valuation method assigned by
the company’s director of research, Sara Filo.
Filo judges the integrity and quality of the valuation work and trains the recently hired
analysts. She meets with three such analysts—Pierce Tinker, Frances Evers, and
Jonathan Chance—to discuss residual income valuation. The analysts make the
following statements:
Tinker: Residual income (RI) valuation lacks a focus on economic profitability.
Evers: In a high-growth company, the RI method is more sensitive to the terminal value
estimate than other methods, such as the multi-stage discounted free cash flow model.
Chance: The RI method may be most appropriate when near-term forecasted free cash
flows are negative.
Filo then instructs Evers to use the data in Exhibit 1 and the single-stage version of the
RI model to determine the intrinsic value per share of Thompson Automation, Inc.
(THA).
EXHIBIT 1
INPUTS FOR SINGLE-STAGE RESIDUAL INCOME MODEL, THOMPSON
AUTOMATION, INC.
Cost of equity 0.105
Return on equity 0.120
Book value per share $49.00
Expected dividend in one year $3.00

Long-term growth rate of residual income 0.055
Filo informs Evers that the current market price of THA is $91 per share. She asks her
to use the data in Exhibit 1 and the single-stage Gordon growth model to determine
THA’s implied sustainable growth rate at that price.
Tinker’s assignment covers an industry with a wide range of company sizes and types,
although the industry average is similar to the market as a whole. Filo instructs him to
calculate the required return using the Fama–French model for RSTU, one of the firms
in the industry.
EXHIBIT 2
SELECTED DATA FROM TINKER’S INDUSTRY COVERAGE
Factor Sensitivities Risk Premiums (%)
Market Size Value Liquidity Market Size Value Liquidity
RSTU 0.9 –0.44 0.7 0.2 4.1 2.0 2.3 0.2
Industry ETF 1.1 0 0 0 4.1 2.0 2.3 0.2

Note: The risk-free rate is 2.1%.
Chance notes that RSTU, several other firms in the industry, and the industry average
could have different growth rates. He suggests that a P/E-to-growth (also known as the
PEG ratio) comparison could help determine relative values. Filo notes that caution
must be taken in applying a PEG ratio analysis correctly. Her analysts respond:
Tinker: The PEG ratio accounts for different rates of growth between two companies but
not for different levels of risk.
Evers: Further study of the dividend discount model shows that the relationship between
P/E and growth rates is linear.
Chance: Because PEG ratios can be affected by differences in the duration of growth,
shorter-term forecasts are preferred because such forecasts are more reliable.
When reviewing PEG ratios in the industry assigned to him, Chance finds that
Dauvision, Inc. (DAUV) appears to be undervalued. He discusses the stock with Filo,
who notes that DAUV has new, yet-unproven management. If events unfold in
accordance with the company’s forecasts, Filo expects that the P/E will converge to the
industry average in two years. Using the data in Exhibit 3, Chance estimates the
forecasted annualized return for DAUV from the current market price assuming these
expectations hold true.
EXHIBIT 3
SELECTED DATA FOR DAUVISION, INC. (DAUV)
Per Share Data
Current EPS $2.69
Current trailing P/E 15.1
Expected EPS sustainable growth rate 0.077
Dividends 0
Forecasted industry average forward P/E 17.4
Q. In the discussion of residual income valuation, which analyst makes

the most accurate statement?
1. Tinker
2. Chance
3. Evers
Solution
B is correct. Chance’s statement is the most accurate. When cash flows are negative
in the analyst’s comfortable forecast time horizon, the RI model is most appropriate.
Residual income is sometimes called economic profit because it estimates the
company’s profit after deducting the cost of all capital. The RI model is less sensitive to
estimates of terminal value than discounted dividend or cash flow models.
A is incorrect because Tinker is incorrect: Residual income is sometimes called
economic profit because it is an estimate of the profit of the company after deducting
the cost of all capital.
C is incorrect because Evers is incorrect: The residual income model is less sensitive to
estimates of terminal value than discounted dividend or cash flow models.

Q. Using the data in Exhibit 1 and the single-stage residual income model, the intrinsic
value per share for THA is closest to:
1. $49.00.
2. $60.00.
3. $63.70.
Solution
C is correct. Calculate the value of THA using the single-stage residual income
valuation formula:
V0=B0+ROE rr gB0V0=B0+ROE rr gB0
where
V0 = intrinsic value
B0 = book value
ROE = return on equity
r = cost of equity (i.e., required return on equity)
g = long-term growth rate of residual income
V0=49+0.12 0.1050.105 0.055 × 49=$63.70V0=49+0.12 0.1050.105 0.055 × 49=$6
3.70
A is incorrect because this is the book value. Also, this may be the result if one errs by
using g in the numerator instead of r and ROE in the denominator instead of r.
B is incorrect because it is the value using the single-stage Gordon growth model, which
is not appropriate given the instructions.
V0 = D1/(r g) = 3.00/(0.105 0.055) = 60.00

Q. Based on Exhibit 1 and the Gordon growth model, THA’s sustainable dividend
growth rate is closest to:
1. 0.072.
2. 0.087.
3. 0.084.
Solution
A is correct. Use the single-stage Gordon growth model, P0 = D1/(r g), and apply the
current market price provided by Filo and the information in Exhibit 1 to solve for g as
shown:
P0 = current price
D1 = expected dividend in one year
r = cost of equity (i.e., required rate of return on equity)
g = sustainable dividend growth rate
P0 = D1/(r g), solving for g: g = r (D1/P0) = 0.105 (3/91) = 0.084
B is incorrect because the error is in using the ROE of 0.12 in the denominator instead
of r of 0.105.
P0 = D1/(r g), solving for g: g = r (D1/P0) = 0.12 (3/91) = 0.087
C is incorrect because it uses the model with D1 as the current dividend D0:
P0 = [D0(1 + g)]/(k g), solving for g: g = (P0k D0)/(D0 + P0) = (91 × 0.12 3)/(3 + 91)
= 0.084, where k = ROE

d. Calculate and interpret the implied growth rate of dividends using the Gordon growth
model and current stock price
Q. Based on Exhibit 2 and the Fama–French model, the required return for RSTU
is closest to:
1. 4.42%.
2. 6.56%.
3. 6.52%.
Solution
C is correct. RSTU’s required return using the Fama–French model is 6.52%, as
shown in the following table:
Required Return = Sum of
Factor Sensitivity Risk Premium (Sensitivity × Premium) + Rf
Mkt Size Value Mkt Size Value FS ×RP FS ×RP FS ×RP Sub Rf Total
Mkt Size Value Total
RSTU 0.90 (0.44) 0.70 4.10 2.00 2.30 3.69 (0.88) 1.61 4.42 2.10 6.52
Note: Rf is the risk-free rate.
A is incorrect because it omits adding the risk-free rate.
B is incorrect because it includes the liquidity factor, which is not used in Fama–French:
(0.02 × 0.02) + 6.52 = 6.56.

c. Estimate the required return on an equity investment using the capital asset pricing
model, the Fama–French model, the Pastor–Stambaugh model, macroeconomic
multifactor models, and the build-up method (e.g., bond yield plus risk premium)
Q. Following Filo’s cautionary remark about the PEG ratio, the analyst who makes
the most accurate statement about it is:
1. Evers.
2. Tinker.
3. Chance.
Solution
B is correct. Tinker’s response is most accurate. Although the PEG ratio does reflect
differences in growth between companies, it does not factor in differences in risk. Risk is
an important determinant of P/E. The relationship between P/E and growth rate is not
linear. Because duration of growth is not reflected in the PEG ratio, longer-term growth
forecasts, not shorter-term ones, are recommended.
A is incorrect because Evers is incorrect: the relationship between P/E and growth rate
is not linear.
C is incorrect because chance is incorrect: because duration of growth is not reflected in
the PEG, longer-, not shorter-, term growth forecasts are recommended.

Learning Outcome
k. Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative
valuation
Q. Based on Exhibit 3 and Filo’s expectations for DAUV, the annualized percentage
return for DAUV is closest to:
A. 20.0.
B. 15.6.
C. 22.0.
Solution
A is correct. The forecasted annualized percentage return is 20.0, calculated as
follows:
Determine current price: Current P/E = 15.1, and EPS = 2.69
P/E × EPS = 15.1 × 2.69 = 40.62: current price
Forecast forward EPS (EPS3) in two years: EPS0 = 2.69, and g = 0.077
EPS3 = EPS0 × (1 + g)3 = 3.36: EPS3
Converge to industry P/E: Forward P/E = 17.4, and EPS3 = 3.36
P/E × EPS3 = 17.4 × 3.36 = 58.46: price in 2 years
Return calculation:
(Ph/P0)0.5 1 = (58.46/40.62)0.5 1 = (1.4392)0.5 1 = 0.1997 or 19.97%
B is incorrect because it uses the forecasted trailing EPS (or EPS2), thus calculating the
wrong future price of $66.99.
Determine current price: Current P/E = 15.1, and EPS = 2.69
P/E × EPS = 15.1 × 2.69 = 40.62: current price
Forecast trailing EPS (EPS2) in two years: EPS0 = 2.69, and g = 0.077
EPS2 = EPS0 × (1 + g)2 = 3.12: EPS2
Converge to Industry P/E: Forward P/E = 17.4, and EPS2 = 3.12
P/E × EPS2 = 17.4 × 3.12 = 54.29: price in 2 years
Return Calculation:
(Ph/P0)0.5 1 = (54.29/40.62)0.5 1 = (1.3365)0.5 1 = 0.1561 or 15.61%
C is incorrect because it finds the correct holding period return for two years of 0.4392
then divides by two to get 21.96 instead of discounting properly: [(58.46/40.62) 1]/2

a. Distinguish among realized holding period return, expected holding period return,
required return, return from convergence of price to intrinsic value, discount rate, and
internal rate of return

Learning Outcome
j. Evaluate a stock by the method of comparables and explain the importance of
fundamentals in using the method of comparables
Ellen Chau Case Scenario

Ellen Chau, an analyst with a regional investment broker, is researching Strongsville
Metal & Glass Industries (SMGI). The company specializes in preparing scrap metal
and glass for recycling. It buys surplus metal and glass from equipment manufacturers,
construction companies, and a local network of individual suppliers. The company sorts
and shreds the metals and crushes the glass and then packages the materials for
resale.
Chau presents the following company analysis (Exhibit 1) to Robert Simms, her
immediate supervisor. Chau is bullish on SMGI, but Simms is not convinced and asks
her to do some additional work on the report.
EXHIBIT 1
EXCERPTS FROM DRAFT REPORT ON SMGI
Chau’s Industry Structure Analysis
The scrap materials industry is capital intensive and is characterized by a steep cost
curve, high exit costs, and large supply-side economies of scale. Companies in the
industry face intense rivalry in competing for scrap metal from the limited number of
suppliers, and they lack attractive opportunities to integrate backward. Buyers consist of
large companies making high-volume purchases, and they can integrate backward
should they choose to do so.
Chau’s Operational Analysis of SMGI
Following more than a decade of mediocre financial results, SMGI has benefited from
the improved economic environment in recent years. Scrap metal and glass is, well,
scrap metal and glass. There is nothing particularly unique about it. Therefore, rather
than emphasizing marketing, the company has taken strong preemptive steps to contain
its costs of operations, introducing fuel hedging as well as the acquisition of more
efficient machinery, both of which are improving its profitability. These actions should
allow SMGI to price its products at or near the industry averages.
Exhibits 2 and 3 detail selected financial and market information for SMGI and its
industry.
EXHIBIT 2
SMGI AND INDUSTRY AVERAGE SELECTED FINANCIAL INFORMATION FOR THE
FISCAL YEAR ENDED 30 JUNE 2014
SMGI Industry Average
Return on assets 10.60% 11.00%
Return on equity 18.40% 16.00%
Net profit margin 4.30% 4.10%
Earnings per share (EPS) 2014 $2.45 n/a*
Forecast EPS for fiscal year ended June 2015 $2.84 n/a*
* n/a indicates not applicable
EXHIBIT 3
MARKET DATA FOR SMGI AND INDUSTRY AVERAGE, 30 JUNE 2014
Market price $29.64 n/a*
Beta (relative to S&P 500) 1.35 1.1
Required return on equity (CAPM) 14.60% 12.1%

Risk-free rate 5.00%

* n/a = not applicable
Chau sums up her case for recommending a “Buy” rating on SMGI shares by noting
three of the company’s strengths:
1. SMGI uses less financial leverage than the average company in its industry.
2. SMGI uses assets more efficiently than the average company in its industry.
3. SMGI’s return on equity (ROE) exceeds the required return on equity calculated
using the capital asset pricing model (CAPM).
Simms is not convinced and prepares some alternate assumptions relating SMGI’s
valuation. He believes that SMGI’s current price builds in overly optimistic expectations
regarding its growth prospects. He agrees with Chau’s 2014 EPS number (see Exhibit
2) but disagrees with her earnings forecast for 2015 and later years. Simms believes
that earnings growth in 2015 and 2016 will be 20% each year and then will drop sharply
as a result of intense industry rivalry. Simms expects earnings growth beyond 2016 to
be only 2% per year. Simms also assumes that SMGI will have a dividend payout ratio
of 40% for the foreseeable future. Finally, using a different determination of beta than
Chau, he estimates that the required rate of return on the company’s equity is 16.0%.
Q. Based on Chau’s industry structure analysis in Exhibit 1, SMGI’s competitive

advantage and ability to capture the value it creates for shareholders are most likely due
to:
A. lack of a threat of new entrants.
B. rivalry among existing competitors.
C. bargaining power of suppliers.
Solution
A is correct. According to Chau’s industry structure analysis, the scrap materials
industry is capital intensive and has large supply-side economies of scale, which create
high barriers to entry and make it less attractive to new entrants. Thus, companies
already established in this industry have a competitive advantage and greater ability to
capture the value created for shareholders.
B is incorrect because the firms in the industry maintain an intense rivalry in competing
for scrap metal supply. Thus, the firms in this industry will have a diminished competitive
advantage and ability to capture the value created for shareholders.
C is incorrect because the suppliers in the industry have relatively high bargaining
power because there are only a limited number of suppliers and the firms in the industry
lack attractive opportunities to integrate backward. Thus, in regards to bargaining power
of suppliers, the firms in this industry will have a diminished competitive advantage and
ability to capture the value created for shareholders
Industry and Company Analysis Learning Outcomes
g. Explain how competitive factors affect prices and costs
h. Judge the competitive position of a company based on a Porter’s five forces analysis
Q. Chau’s operational analysis of SMGI indicates that the company’s competitive

strategy is bestdescribed as:
1. differentiation.
2. cost leadership.
3. focus.
Solution
B is correct. SMGI’s competitive strategy is best described as cost leadership. A
successfully executed cost leadership strategy will lower costs and raise profit margins
while allowing products to be priced at or near the industry average. Differentiation is
not feasible in the scrap glass and metal industry. SMGI has not adopted a focus, such
as a particular type of glass or metal.
A is incorrect because the recycling business does not offer unique products or
services.
C is incorrect because SMGI does not pursue a “target segment” approach.
Equity Valuation: Applications and Processes Learning Outcome

e. Describe questions that should be addressed in conducting an industry and
competitive analysis
Q. Based on the information in Exhibits 2 and 3, SMGI’s present value of growth

opportunities (PVGO) as of 30 June 2014 is closest to:
1. $12.86.
2. $10.19.
3. $14.20.
Solution
B is correct. PVGO is calculated as
V0 = (E1/r) + PVGO
In this instance, V0 = $29.64, E1 = $2.84, and r, the required rate of return on the
company’s equity, is given as 0.146.
PVGO = $29.64 ($2.84/0.146) = $10.19
A is incorrect because it is based on 2014 earnings.
PVGO is calculated as V0 = (E1/r) + PVGO. In this instance, V0 = $29.64, E1 = $2.45
and r = 14.6%. Thus, PVGO = $29.64 ($2.45/0.146) = $12.86.
C is incorrect because it uses ROE instead of CAPM discount rate.
PVGO is calculated as V0 = (E1/r) + PVGO. In this instance, V0 = $29.64, E1 = $2.84, and
ROE = 18.4%. Thus, PVGO = $29.64 ($2.84/0.184) = $14.20.

Q. Using the information in Exhibits 2 and 3, which of the three strengths that Chau
identified in support of the “Buy” rating on SMGI’s stock is most accurate?
A. 2
B. 1
C. 3
Solution
C is correct. Using the data, financial leverage, total asset turnover, and CAPM, the
required return can be computed as follows:
Ratio SMGI Industry Average
Financial Leverage = ROE/ROA = 18.4/10.6 = 1.7 = 16.0/11.0 = 1.5
Total Asset Turnover = ROA/NPM = 10.6/4.3 = 2.5 = 11.0/4.1 = 2.7
Required return provided in Exhibit 3 14.58

From the above computations, it can be seen that SMGI uses higher financial leverage
than the average firm in the industry, thereby making Strength 1 incorrect. On the other
hand, efficiency in the use of assets, as indicated by the asset turnover ratio, is smaller
for SMGI compared to the average firm in the industry, making Strength 2 incorrect.
Strength 3 is correct because the rate of return on equity reported in Exhibit 1 (18.4%)
exceeds the required return of 14.6%.


Q. Based on the information in Exhibit 2 and Simms’s alternate assumptions, the per
share value of SMGI’s common shares is closest to:
1. $12.35.
2. $8.65.
3. $9.70.
Solution
C is correct. Using Simms’s assumptions and the two-stage dividend discount model:
2015 2016 2017
Earnings $2.45 × 1.20 = $2.94 × 1.20 = $3.53 $3.53× 1.02 =

$2.94 $3.60
Dividends $2.94 × 0.40 = $3.53 × 0.40 = $1.41 $3.60×0.40 =

$1.18 $1.44
Terminal value at 2016 $ 1.44/(0.16 0.02) =

10.28
Values to be discounted to $1.18 $10.28 + 1.41 = $11.69

2014
Value at 2014 = (1.18/1.16) + (11.69/1.162) = $9.70

A is incorrect because the dividend in 2016 is discounted, but the collapsed value of
future growth is not.
P = 1.18/1.16 + 1.41/1.162 + 10.28 = 12.35
B is incorrect because the collapsed value of future growth is discounted for three
years, not two.
P = 1.18/1.16 + 1.41/1.162 + 10.28/1.163 = 8.65

l. Calculate and interpret the value of common shares using the two-stage DDM, the H-
model, and the three-stage DDM
Q. Simms’s approach to valuing SMGI is best described as finding:
1. intrinsic value.
2. fair market value.
3. investment value.
Solution
A is correct. Simms’s approach is an example of finding intrinsic value because he is
attempting to gain a complete understanding of SMGI’s investment characteristics.
Investment value conceptualizes a specific buyer taking into account potential
synergies. Fair market value concerns the value at which an asset would change hands
between a willing buyer and seller. Neither of these concepts is discussed by Simms.
B is incorrect because Simms’s approach is an example of finding intrinsic value. Fair
market value concerns the value at which an asset would change hands between a
willing buyer and seller.
C is incorrect because Simms’s approach is an example of finding intrinsic value.
Investment value conceptualizes a specific buyer taking into account potential synergies
from a purchase.

c. Describe definitions of value and justify which definition of value is most relevant to
public company valuation
Mary Barton Case Scenario

Mary Barton is a junior equity analyst for an investment company. She is currently
working on two of the company’s funds: a large US-based equity fund and a smaller
private equity fund.
The large US-based fund uses discount models to estimate the value of stock prices.
For this fund, a difference in price of $1 or more between the market and estimated
prices indicates that the shares are mispriced for the fund’s investment purposes. The
fund is allowed to take either long or short positions in shares identified as misvalued.
Barton’s manager, George Eckhart, asks her to evaluate the stocks of two companies
for possible inclusion in that fund: XRail Company (XRL) and Z-Tarp Limited (ZTL).
Selected data for the stocks are shown in Exhibit 1.
EXHIBIT 1
SELECTED STOCK DATA FOR XRL AND ZTL AND ADDITIONAL MARKET
INFORMATION
XRL ZTL
EPS ($) DPS ($) EPS ($) DPS ($)
2015 3.15 1.77 5.62 2.53
2014 3.08 1.52 4.98 2.24
2013 2.99 1.36 4.73 2.13
2012 2.77 1.21 4.5 2.02
2011 2.52 0.9 4.2 1.89
Current market price $77.23 $93.05
Return on assets 27.40% 25.80%
Return on common equity 31.60% 32.80%
Beta 0.94 1.2
Required rate of return on common equity 8.84% 10.48%
Additional information
Equity risk premium for common shares 6.28%
US economy real growth rate 3.70%
US inflation rate 2.00%

Note: DPS is dividends per share, and EPS is earnings per share.
Barton begins her analysis by looking at XRL. After doing some research, she
concludes that a reasonable growth estimate for the company is the sustainable growth
rate using the most recent year’s retention ratio and calculates a price for XRL using
this information. She makes the following note:
 It will not be possible to use the Gordon growth model for the analysis of XRL.
Barton and Eckhart discuss the impact of a company’s growth rate on its future stock
price. Barton determines XRL’s growth rate of earnings for the period from 2011 to 2015
and compares it with the current nominal growth rate of the US economy. She
concludes that XRL is likely to be in the transition stage of growth.
Next, Eckhart asks Barton to calculate the intrinsic value of ZTL shares using the
Gordon growth model to determine whether it meets the fund’s investment objectives.
He suggests that rather than using the sustainable growth rate, she should use the
growth rate of dividends over the past five years.
Eckhart tells Barton that he has heard rumors that ZTL is contemplating selling one of
its major manufacturing facilities. If that should happen, he believes that the company
would pay a series of special dividends in each of the three years following the sale.
Barton asks him how she could best incorporate such a possibility into the valuation of
the shares.
Turning to the private equity fund, Eckhart informs Barton that the fund is considering
buying a controlling interest in a closely held company, H-Tron (HTR), which pays
infrequent dividends that are well below the free cash flow from equity. HTR has healthy
cash flows with significant growth potential and holds patents on a key innovation in
electronics technology. Eckhart believes the value of these patents is not fully reflected
in HTR’s balance sheet. He asks Barton how HTR’s common equity should be valued
given these circumstances. Barton states that she will assess which valuation method
will be the most suitable.
Finally, Eckhart asks Barton to value HTR’s noncallable perpetual preferred stock as a
potential investment for the fund. The stock, currently privately held, pays a fixed annual
dividend of $7.50. After performing some industry analysis, Barton decides to use an
equity risk premium of 6% in valuing the stock.
Q. Using the data in Exhibit 1, Barton’s note about the use of the Gordon growth model
to value XRL is most likely:
A. correct because the required return on equity is less than the expected growth
rate.
B. incorrect because the sustainable growth rate is greater than the US economy’s
growth rate.
C. incorrect because the required return on equity is greater than the US economy’s
growth rate.
Solution
A is correct. The Gordon growth model cannot be used when r < g. In this case, r =
8.84%, and g = 13.84%. The calculations are as follows:
Gordon growth model: P0 = D1/(r g)
where
P0 = current price
D1 = next period’s dividend
r = required return on equity
g = growth rate of dividends.
The calculated expected growth rate of dividends is based on the sustainable growth
rate model:
g = b ×ROE, where b = 1 (DPS/EPS)
= [1 (1.77/3.15)] × 0.316
= 0.1384
where
g = sustainable growth rate
b = retention ratio
DPS = dividends per share
EPS = earnings per share
The required return on equity is RF + bi[E(RM) RF] = 0.0294 + (0.94 × 0.0628) = 0.0884
= 8.84%.
B is incorrect because the sustainable growth must be less than the economy’s growth
rate (3.7%) for the Gordon growth model to be appropriate.
C is incorrect because although r must be greater than g, the appropriate growth rate is
the company’s growth rate in dividends rather than the economy’s growth rate (3.7%).

h. Describe strengths and limitations of the Gordon growth model and justify its selection
to value a company’s common shares
m. Estimate a required return based on any DDM, including the Gordon growth model
and the H-model
o. calculate and interpret the sustainable growth rate of a company and demonstrate the
Q. Barton’s conclusion that XRL is in the transition phase is best described as:
A. correct.
B. incorrect because the company is in the supernormal growth phase.
C. incorrect because the company is in the mature phase.
Solution
C is correct. Barton’s statement is incorrect because the company is in the mature
phase. The economy’s nominal growth rate, from Exhibit 1, is Real growth rate +
Inflation rate = 3.7% + 2% = 5.7%.
XRL’s compound growth rate over the four-year period is 5.7%, which is approximately
equal to the economy’s growth rate and calculated as follows:
g=(EPS2015EPS2011)1/4=(3.152.52)1/4=5.7%g=(EPS2015EPS2011)1/4=(3.152.52)1/4=5.7
%
where g is the compound growth rate in earnings, and EPS is earnings per share.
A company in the mature phase typically has earnings growth at a rate comparable with
the economy’s growth rate.
A is incorrect because a company in the transition phase is characterized by earnings
growth rates above the average nominal growth for the economy but with the growth
rate declining. The growth rate is not above the economy’s nominal growth rate, so the
fact that it is declining (2.7% for 2015 vs. 2014) is not relevant.
B is incorrect because a company in the supernormal growth phase has growth higher
than the economy’s nominal growth rate.

j. Explain the growth phase, transitional phase, and maturity phase of a business
Q. Using the data in Exhibit 1 and following Eckhart’s suggestions regarding the
valuation of ZTL, the most appropriate conclusion that Barton should make about the
ZTL shares is that the fund should:
A. take a long position in ZTL.
B. not add ZTL to the portfolio.
C. take a short position in ZTL.
Solution
B is correct. The growth rate of dividends over the past five years is calculated as
follows:
(D5D1)1/n 1=(2.531.89)1/4 1=7.56%(D5D1)1/n 1=(2.531.89)1/4 1=7.56%

where
D5 = 2015 dividend
D1 = 2011 dividend
n = number of years between the first and last dividends
Using the Gordon growth model, the intrinsic value is
D0×(1+g)r g=2.53×1.0756(0.1048
0.0756)=$93.19D0×(1+g)r g=2.53×1.0756(0.1048 0.0756)=$93.19
where
D0 = dividend just paid (in 2015)
g = compound growth rate in dividends
r = required return on the stock, given in Exhibit 1
With a current market price of $93.05, the stock is fairly valued according to the fund’s
definition of mispricing (i.e., mispriced by less than $1). It should not be added to the
portfolio as either a short or long position.
Note that the answer is calculated without rounding intermediate steps. If rounding is
used, the calculated answer may differ slightly.
A and C are incorrect because the stock’s intrinsic value differs by less than $1 from the
market price, so it should not be added to the portfolio.

c. Calculate the value of a common stock using the Gordon growth model and explain
the model’s underlying assumptions
p. Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market
based on a DDM estimate of value
Q. Eckhart’s best response to Barton’s question about the valuation of ZTL considering
the potential sale of its manufacturing facility would be to use:
A. the H-model to reflect the change in dividends.
B. the Gordon growth model to incorporate the decrease in firm value after the sale.
C. a spreadsheet model that incorporates the special dividends.
Solution
C is correct. Dividend discount models assume stylized patterns of dividend growth,
but a spreadsheet allows any assumed dividend pattern. Therefore, a spreadsheet
model would be best suited for these anticipated special dividends.
A and B are incorrect because dividend discount models assume stylized patterns of
dividend growth, but a spreadsheet allows any assumed dividend pattern.

n. Explain the use of spreadsheet modeling to forecast dividends and to value common
shares
Q. Based on the information Eckhart provides to Barton about HTR, the most suitable
method for her to use in determining the fair value of its common equity is to discount
future:
A. forecasted future dividends.
B. free cash flow to equity.
C. residual income.
Solution
B is correct. Free cash flow to equity is appropriate for investors who want to take a
control perspective and for companies that are not currently paying regular dividends.
A is incorrect because dividends are the most appropriate return measure when the
analyst has a dividend record to analyze and the investor takes a noncontrol
perspective. Here, the dividends are infrequent and hence would not produce a reliable
valuation.
C is incorrect because residual income is appropriate when the company’s expected
free cash flows are negative within the analyst’s comfortable forecast horizon.

a. Compare dividends, free cash flow, and residual income as inputs to discounted
cash flow models and identify investment situations for which each measure is suitable
Q. Barton’s estimate of the fair value for HTR’s preferred stock is closest to:
A. $125.
B. $84.
C. $81.
Solution
B is correct. Fair value for a noncallable fixed-rate perpetual preferred stock can be
calculated using the Gordon growth model with g = 0.
V0 = D/r = 7.50/(0.0294 + 0.06) = $83.89 = $84
where
D = dividend
r = required rate of return, defined as r = Rf + Equity risk premium = 0.0294 + 0.06 =
0.0894
The risk-free rate is given in Exhibit 1. The equity risk premium is determined by Barton.
A is incorrect because it uses the risk premium instead of the capitalization
rate: V0 = D/r = 7.50/0.06 = $125.
C is incorrect because it uses the market equity required return instead of the preferred
stock capitalization rate: V0 = D/r = 7.50/(0.0294 + 0.0628) = $81.34 = $81.
g. Calculate the value of noncallable fixed-rate perpetual preferred stock

Wadgett Manufacturing Case Scenario

Tom Baker, director of equity investments at Private Wealth Fund, instructs his recently
hired junior equity analysts Ida Paschel and Lyle Covey to review and evaluate
opportunities in the automotive parts industry for a possible addition to the equity
portfolio. Baker encourages Paschel to consider the onboard information systems
subsegment, which is growing rapidly as new mobile technologies are developed.
Baker mentions that he has heard that Wadgett Manufacturing Inc. projects rapid
growth of what it calls “smart mirrors.” Baker states that Wadgett’s stock price had been
decreasing recently and that he was not certain of an appropriate valuation for Wadgett.
The analysts make the following statements:
Covey: The decline in price was the result of a recent failed acquisition of Wadgett;
Wadgett’s price is moving back to an appropriate value as it no longer appears to be a
takeover target.
Paschel: We could compare the value to that of the value of a subsidiary of a large
technology conglomerate that also works on “smart mirrors.” However, the value of a
subsidiary tends to be higher than if it were a stand-alone entity.
Baker: Pairs trading analysis would help determine whether Wadgett’s market price
seemed to be below its intrinsic value
Since Wadgett has no plan to begin paying a dividend, Baker asks the analysts to
calculate the free cash flow to the firm (FCFF). The two analysts discuss how to go
about it, and they make the following comments:
Paschel: If we begin with cash flow from operations (CFO), we do not have to make
adjustments for working capital.
Covey: We should begin with earnings before interest, taxes, depreciation, and
amortization (EBITDA) but will have to add in all the non-cash charges on the income
statement.
Paschel: Regardless of whether we start with net income, CFO, or EBITDA, we will
have to add in net borrowing.
Wadgett’s ambitious growth projections will likely require a substantial investment in
manufacturing facilities. In order to finance the project, Wadgett expects to borrow
substantially more than it has in the past and intends to retire the debt within the next 10
years. During a discussion of how this debt may influence the valuation, the analysts
make the following statements:
Statement 1: Because the capital structure seems very likely to change significantly, it
would be best to use free cash flow to equity (FCFE) because the value to equity is
more direct.
Statement 2: I would select FCFF over FCFE. When we look forward, the required
return on equity may be more sensitive to changes in financial leverage than just the
changes in weighted average cost of capital (WACC).
Statement 3: With either model, we should discount future cash flows by the required
return on equity because we are considering buying the stock.
Baker asks his team to determine how sensitive the value of Wadgett’s common shares
is to model parameters by using the single-stage FCFE growth model for valuation.
Baker instructs Paschel to calculate the current intrinsic value of the shares using the
base case information. The valuation is shown in Exhibit 1.
EXHIBIT 1
VALUATION OF WADGETT’S COMMON SHARES
Normalized FCFE $1.38
FCFE growth rate 0.08
Equity risk premium 0.075
Beta 1.40
Risk-free rate 1.2%

Baker informs Covey that the highest and lowest reasonable alternative estimates of the
valuation model parameters are as follows: 15% for beta, 20% for equity risk premium,
and 25% for growth rate. He asks Covey to perform a sensitivity analysis for each of
these parameters while keeping all other inputs at the base case level. Covey’s results
are shown in Exhibit 2.
EXHIBIT 2
SENSITIVITY ANALYSIS TO MODEL PARAMETERS IN VALUATION OF
WADGETT’S COMMON SHARES
Parameter Per-Share Valuation Per-Share Valuation
with Low Estimate with High Estimate
FCFE growth rate $25.67 $89.29
Equity risk premium $93.15 $25.70
Beta $70.14 $28.25

Note: The risk-free rate is 1.2% in all cases.
Covey mentions that another auto parts competitor, Daklan PLC, always seems to trade
at a significant discount to its peers. Baker and his analysts meet to discuss Daklan's
valuation and make the following statements:
Covey: The current market price is $28 per share, which is well below the value
calculated using a two-stage dividend discount model.
Paschel: We should use both the method of comparables and the method of forecasted
fundamentals to evaluate whether Daklan truly trades at a P/E well below the market
multiple.
Baker: If Daklan spins off its unrelated paper products division, the valuation discount
will decline.
Q. Who makes the most accurate statement in regard to Wadgett’s current valuation?
A. Baker
B. Paschel
C. Covey
Solution
C is correct. Covey’s statement is based on the idea that a firm’s stock price increases
if it is the target of an acquisition (i.e., a control premium). Consequently, when the
acquisition failed with no apparent future threat of a takeover, the stock price decreases
as the control premium vanishes.
B is incorrect because the subsidiary of a conglomerate generally has a value that is
below its stand-alone value due to a conglomerate discount.
A is incorrect because pairs trading is a relative value strategy that does not consider
the actual intrinsic value of a given firm.

a. Define valuation and intrinsic value and explain sources of perceived mispricing
Q. In regard to calculating Wadgett’s FCFF, the comment that is most appropriate is the
one dealing with:
1. working capital adjustments.
2. treatment of all non-cash charges.
3. treatment of net borrowing.
Solution
A is correct. Cash flow from operations (CFO) already reflects changes in working
capital items, therefore Paschel’s first comment is correct. EBITDA has the non-cash
charges of depreciation and amortization added back, so Covey’s statement is
incorrect, not all non-cash charges will need to be added back. Net borrowing is added
back for FCFE not FCFF, so Paschel’s second statement is incorrect.
B is incorrect because depreciation has already been added back to EBITDA, though
there may be other items that still need to be added back.
C is incorrect because adjusting for net borrowing is not necessary for FCFF (just
FCFE).

c. Explain the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and
cash flow from operations (CFO) to calculate FCFF and FCFE
Q. In discussing Wadgett’s growth projections and the influence they may have on the
FCFE and FCFF valuation process, which of the analysts’ statements is most accurate?
A. Statement 1
B. Statement 3
C. Statement 2
Solution
C is correct. FCFF is preferred over FCFE when a company is leveraged and
expecting a change in capital structure. FCFF growth will reflect fundamentals more
clearly because FCFE growth will reflect fluctuating amounts of net borrowing. Second,
in a forward-looking context, the required return on equity might be expected to be more
sensitive to changes in financial leverage than changes in the WACC.
A is incorrect because statement 1 suggests that FCFE should be used, but this choice
is inappropriate given the already levered balance sheet and coming increase in debt
capital.
B is incorrect because statement 3 suggests that the required return to equity should
apply to both FCFE and FCFF, yet WACC is the proper discount rate to use in the
FCFF method.
a. Compare the free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE) approaches to valuation
Q. Using only the data for the base case in Exhibit 1, the intrinsic value that Paschel
calculates is closestto:
1. $37.30.
2. $73.78.
3. $40.28.
Solution
C is correct. First, use the CAPM to determine the required rate of return, r, then use
the single-stage FCFE discount model to calculate the intrinsic value per share as
follows:
r = E(Ri) = Rf + β[E(Rm) – Rf] = 0.012 + 1.4(0.075) = 0.117

where r is the required return, Rf is the risk-free rate, and [E(Rm) Rf] is the equity risk
premium.
V0=FCFE0(1+g)r g=$1.38(1.08)0.117
0.08=$40.28V0=FCFE0(1+g)r g=$1.38(1.08)0.117 0.08=$40.28

where V0 is intrinsic value, g is the long-term growth in FCFE, and r is the required
return.
A is incorrect because the error is in omitting incrementing FCFE0 by 1 + g.
V0=FCFE0r g=$1.380.117 0.08=$37.30V0=FCFE0r g=$1.380.117 0.08=$37.30

B is incorrect because the error is in deducting Rf from the market risk premium.
r = E(Ri) = Rf + β[E(Rm) Rf] = 0.012 + 1.4(0.075 0.012) = 0.1002
V0=FCFE0(1+g)r g=$1.38(1.08)0.1002
0.08=$73.78V0=FCFE0(1+g)r g=$1.38(1.08)0.1002 0.08=$73.78

j. Estimate a company’s value using the appropriate free cash flow model(s)
Q. Using the data in Exhibit 2, the parameter that causes the greatest sensitivity in
valuing Wadgett’s common shares is the:
1. beta.
2. growth rate.
3. equity risk premium.
Solution
C is correct. When the low/high measure of each variable is tested singly for sensitivity
in predicting a range of intrinsic value while holding the other variables at the base case,
the equity risk premium variable produces the largest stock price range, as shown in the
following table.
Valuation with Low Valuation with High Valuation

Variable Estimate Estimate Range
Equity risk $93.15 $25.70 $67.45

premium
FCFE growth rate $25.67 $89.29 $63.63
Beta $70.14 $28.25 $41.88

Note: The risk-free rate is 1.2% in all cases.
A and B are incorrect because per the calculations shown above.

k. Explain the use of sensitivity analysis in FCFF and FCFE valuations
Q. In the discussion of Daklan’s valuation, whose statement best describes a sum-of-

the-parts approach?
1. Paschel’s
2. Baker’s
3. Covey’s
Solution
B is correct. A sum-of-the-parts valuation sums the estimated values of each of the
company’s businesses as if each business were an independent going concern. Baker’s
statement describes such a valuation approach. Baker noticed that a division is
unrelated and mentions the value that might be unlocked via a spin-off. Covey suggests
an absolute valuation approach by comparing intrinsic and market values. Paschel
suggests two methods: comparables and justified price multiples.
A is incorrect because paschel has used comparables and justified price multiple
methods.
C is incorrect because covey has used an absolute value approach by comparing
intrinsic and market values.

g. Describe sum-of-the-parts valuation and conglomerate discounts
Daniel Bourne Case Scenario

Telco Cross Company (TCC) is a leading producer of fiber optic equipment used for
broadband communication through Central and South America. TCC’s headquarters are
located in Panama, where, in addition to the Panamanian balboa, the US dollar is an
official currency. On 31 December 2016, the company’s board of directors met and
determined it will look to grow its market share by acquiring a rival firm, SA Telecom.
TCC hires Daniel Bourne to determine an appropriate fair value range for SA Telecom
as well as the firm value of TCC should it decide to issue its own shares to complete the
acquisition. Bourne plans to use three valuation techniques and notes the following:
Market-based method: Yields a market-estimated fair stock price for the target
company. To estimate a fair takeover price, analysts must additionally estimate a fair
takeover premium and use that information to adjust the estimated stock price.
Discounted cash flow (DCF) method: A potential disadvantage is that estimates of
discount rates can change over time because of capital market developments, which
can also significantly affect acquisition estimates.
Comparable transactions method: An analyst uses details from recent takeover
transactions for comparable companies to make direct estimates of a target company’s
takeover value. Similar to the market-based observation, it is necessary to separately
estimate a takeover premium.
Bourne starts by researching the fiber optics industry and the forces that affect its
competitive dynamics. He highlights the following items from a recent industry trade
journal:
 The industry is dominated by a small number of companies that deal with one
another and with outside customers. The manufactured products use advanced
technology and require a high degree of product reliability.
 Products are designed to meet specific customer requirements and usually include
extensive set-up and training costs.
 The main customers for the industry are module manufacturers. These module
manufacturers have experienced high demand for optical components with the move
to replace voice-based with optical networking equipment. Module fiber optic
manufacturing is noted for smaller production amounts and rapidly evolving product
cycles that keep profit levels low.
Next, Bourne considers a price-to-sales ratio (P/S) approach to analyze SA Telecom.
He plans to calculate the firm’s justified P/S using the information in Exhibit 1.
EXHIBIT 1
SA TELECOM DATA
Required rate of return on equity 16.0%
Long-term profit margin 8.0%
Projected dividend payout ratio 70.0%
Expected long-run earnings growth rate 4.8%

Bourne analyzes SA Telecom in greater detail and determines that its home market
experiences high, unpredictable, and volatile rates of inflation. To help calculate the
company’s required rate of return, he uses the Exhibit 2.
EXHIBIT 2
BASIS FOR CALCULATING SA TELECOM’S RETURN
Real country return 8.60%
Rate of inflation 4.45%
Industry 1.60%
Size 1.45%
Leverage –0.85%
Bourne purchases an outside research report that concludes that a real required rate of
return on equity of 11.5% is appropriate for SA Telecom. He uses this rate of return and
the data in Exhibit 3 to calculate the value of the firm’s equity.
EXHIBIT 3
SA TELECOM DATA, CURRENT YEAR DATA
Normalized free cash flow to the firm (FCFF) $84 million
Interest expense $36 million
Tax rate 40.0%
Net borrowing $52 million
Long-term real growth rate 3.0%

Comfortable with the state of his work based on market comparables, Bourne finally
turns his attention to valuing TCC using a DCF analysis based on the company
information in Exhibit 4.
EXHIBIT 4
TCC DATA
Current FCFF $467.25 million
Growth rate of FCFF estimates
Years 1 and 2 15.0%
Years 3 and 4 10.0%
Year 5 and thereafter. 3.0%
Q. Which of the notes made by Bourne regarding the valuation methods

is least accurate? The note about the:
A. Discounted cash flow method.
B. Comparable transactions method.
C. Market-based method.
Solution
B is correct. The comparable transactions method uses details from recent takeover
transactions for comparable companies to make direct estimates of the target
company’s takeover value. It is not necessary, however, to separately estimate a
takeover premium because this is already included in the multiples determined from the
comparable transactions.
A is incorrect because the statement is accurate. Estimating a company’s free cash
flows begins with the creation of pro forma financial statements. This includes selecting
an appropriate time horizon and terminal value of the company. A potential
disadvantage is that estimates of discount rates can change over time because of
capital market developments, which can also significantly affect acquisition estimates.
C is incorrect because the statement is accurate. This approach includes defining a set
of comparable companies and calculating various relative value measures based on the
current market prices of the comparable companies in the sample. Using this approach
yields a market-estimated fair stock price for the target company. In order to estimate a
fair takeover price, analysts must additionally estimate a fair takeover premium and use
that information to adjust the estimated stock price.
Mergers and Acquisitions Learning Outcome

h. Compare the discounted cash flow, comparable company, and comparable
transaction analyses for valuing a target company, including the advantages and
disadvantages of each
© 2019 CFA Insti
Q. From his review of the industry trade journal, the most appropriate conclusion that
Bourne can make is that:
A. fiber optic customers have high bargaining power.
B. an opportunity for the industry is to forward integrate into module manufacturing.
C. there is limited threat of substitutes.
Solution
C is correct. The fact that the products are designed to meet specific customer
requirements and require extensive set-up and trainings costs would make customer
switching costs high, which reduces the threat of substitutes. Due to the advanced
technology and high degree of product reliability required, customers would have low
bargaining power. Module manufacturing involves small production runs and low profit
margins and should not be attractive to this high profit margin specialized industry.
A is incorrect because due to the advanced technology and high degree of product
reliability required, customers would have low bargaining power.
B is incorrect because module manufacturing involves small production runs and low
profit margins and should not be attractive to this high profit margin specialized industry.

g. Explain how competitive factors affect prices and costs
Q. Based on the data in Exhibit 1, Bourne’s estimate of the justified price-to-sales ratio
for SA Telecom is closest to:
1. 0.50.
2. 0.52.
3. 0.72.
Solution
B is correct.
P0S0=(E0/S0)(1 b)(1+g)r gP0S0=(E0/S0)(1 b)(1+g)r g
E0/S0 = the business’s long-term profit margin = 8.0%
b = retention ratio = 0.30
(1 b) = the projected payout ratio = 0.70
g = the long-run earnings growth rate = 4.8%
r = required rate of return = 16%
P0S0P0S0 = (0.08)(1 0.030)(1+0.048)0.16 0.048(0.08)(1 0.030)(1+0.048)0.16 0.048
= 0.05870.1120.05870.112
= 0.520.52
A is incorrect because it leaves out (1 + g) in the numerator. The equation becomes:
P0S0P0S0 = (0.08)(1 0.30)0.16 0.048(0.08)(1 0.30)0.16 0.048
= 0.500.50
C is incorrect because it uses WACC as discount rate (not required rate of return on
equity).
P0S0P0S0 = 0.05870.13 0.0480.05870.13 0.048
= 0.720.72

Learning Outcome
h. Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio
(P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals
Q. Using the data in Exhibit 2, SA Telecom’s real required rate of return is closest to:
A. 10.80%.
B. 15.25%.
C. 11.65%
Solution
A is correct.
Real required rate of return = Country return ± Industry adjustment ± Size adjustment ±
Leverage adjustment
Real country return 8.60%
± Industry 1.60%
± Size 1.45%
± Leverage 0.85%
Required rate of return 10.80%

C is incorrect because it ignores leverage, thinking it is a company concept: 8.6 + 1.6 +
1.45 = 11.65.
B is incorrect because the calculation incorrectly begins with the nominal country return
of 13.05%, not the correct 8.60%: 8.6 + 4.45 + 1.6 + 1.45 0.85 = 15.25.

f. Explain international considerations in required return estimation
Free Cash Flow Valuation

i. Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models and select and justify the appropriate model given a company’s characteristics
Using the real required rate of return Bourne obtains from the outside analyst’s report
and the data in Exhibit 3, SA Telecom’s firm's equity value ($ millions) is closest to:
A. 1,386.
B. 1,212.
C. 1,025.
Solution
A is correct.
V0=FCFE0(1+greal)rreal grealV0=FCFE0(1+greal)rreal greal
Real required rate of return as given = 11.50%
FCFE0FCFE0 =
FCFF Int(1 Taxrate)+NetborrowingFCFF Int(1 Taxrate)+Netborrowing
=
84 36(1 0.40)+5284 36(1 0.40)+52
= 114.4114.4
B is incorrect because it forgets 1 t in the FCFE calculation.
FCFEFCFE =
FCFF Int(1 Taxrate)+NetborrowingFCFF Int(1 Taxrate)+Netborrowing
= 84 36+5284 36+52
= 100100
C is incorrect because it forgets to subtract the long-term real growth rate in the
denominator.
Free Cash Flow Valuation learning Outcomes

d. Calculate FCFF and FCFE
Q. Using the data in Exhibit 4, Bourne’s calculation of TCC’s firm value ($ millions)
is closest to:
A. 9,639.
B. 10,127.
C. 9,892.
Solution
B is correct. Because of the three different growth periods, it is necessary to use the
three-stage FCFF model and calculate the FCFF for each of Years 1 to 4 and a terminal
value at the end of Year 4.
1 2 3 4 5
Growth rate 15% 15% 10% 10% 3% thereafter

1 2 3 4 5
FCFF 467.25 × 1.15= 537 618 680 748
PV @ WACC 537/1.096 = 490 514 516 518
Terminal value at T = 4 11,673
PV of Terminal value 8,089

PV0 = 490 + 514 + 516 + 518 + 8,089 = 10,127
C is incorrect because it forgets to grow FCFF another year for TV calculation:
748/(0.069 0.03)748/(0.069 0.03) = 11,33311,333

PVofTVPVofTV = 7,8547,854
Total value of equity (PV Years 1 through 4 + TV) = 490 + 514 + 516 + 518 + 7,854 =
9,892
A is incorrect because it forgets to add Year 5 PV to the total:
Total value of equity (PV Years 1 through 4 + TV) = 490 + 514 + 516 + 518 + 7,600 =
9,639
Free Cash Flow Valuation learning outcomes

William Valentine Case Scenario

William Valentine is a junior analyst for Morganfield Trust, a regional brokerage firm
based in Toronto, Canada. Valentine has recently been assigned to initiate coverage on
Laboutin Group, a publicly-traded company on the Toronto Stock Exchange. Laboutin
owns two businesses that include a property & casualty (P&C) insurer and an energy
firm that owns a fleet of deep-sea drilling rigs.
Before starting his analysis, Valentine discusses some features of different equity
valuation and security selection approaches with his boss, Sarah Norman, Chief Equity
Analyst. Based on his understanding of the discussion, he makes the following
conclusions:
1. A company’s sustainable growth rate assumes growth through internally generated
funds and approximates the average rate at which dividends can grow over a long
horizon.
2. Both free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are
impacted by changes in the firm’s financial leverage.
3. For an active security selection to consistently achieve positive alphas, the analyst
must combine accurate forecasts with an appropriate valuation model. Further, the
expectations must differ from consensus expectations and be, on average, correct.
Valentine compiles the data in Exhibit 1 to conduct a justified (fundamental) P/E
analysis to assess Laboutin’s stock.
EXHIBIT 1
SELECTED VALUATION INFORMATION
Laboutin
Expected long run dividend growth rate 3.50%
Laboutin’s stock’s beta 0.9
Laboutin’s current EPS $28.71
Required return on equity 7.26%
Market data
Expected market return 7.80%

Valentine decides to compare the stock’s justified forward P/E to what would be
predicted from a cross-sectional regression that was estimated for a group of stocks
with characteristics similar to Laboutin. The estimated regression is as follows:
Predicted P/E = 5.65 + (6.25× DPR) – (0.37 v Beta) + (15.48× DGR)
where DPR is the dividend payout ratio and DGR is the expected dividend growth rate.
Upon reviewing Valentine’s P/E analysis, Norman makes the following suggestions to
Valentine:
1. The P/E analysis by itself is incomplete, and you should consider the free cash flow
to equity (FCFE) model to evaluate Laboutin’s stock. The company fits the constant
growth assumptions, and you should use the firm’s sustainable growth rate as proxy
for the constant growth rate.
2. I have recalculated the beta for Laboutin’s common stock using some additional
fundamental factors and revised the estimate of the investor’s required return on
equity of 10%. From comments made at the annual meeting, I believe that the
payout ratio can be expected to rise to 32%.
EXHIBIT 2
ADDITIONAL DATA FOR LABOUTIN (CDN$ MILLIONS)
Net income $500
Depreciation $100
Tax rate 30%
Investment in fixed capital $90
Investment in working capital $25
Net borrowing $80
Number of outstanding shares 75 million
Norman’s Revised Estimates
Laboutin’s ROE 8.33%

Valentine finishes his analysis and makes the following comments about FCFE and
FCFF:
1. Of the three sections of the cash flow statement, I can rely solely on the cash flow
from operations section when determining FCFE.
2. Additionally, using FCFE to value equity is preferred and simpler than relying on
FCFF when a firm’s capital structure is relatively stable.
3. FCFE is not preferred over FCFF when a firm has significant debt and positive
FCFE.
After completing his analysis, Valentine finds out that Laboutin’s management is
considering the acquisition of a rival firm, privately-held Frontier Energy Co. The energy
operations business is not performing as well as the P&C business, and management
believes the acquisition will improve its competitive edge in that sector. Laboutin is
attracted to Frontier because they believe it is a developing company entering into a
high growth stage.
Unfamiliar with valuing private companies Valentine asks Norman which valuation
method he should use to value Frontier.
Q. Which of Valentine’s conclusions regarding valuation approaches and security
selection is leastaccurate? Conclusion:
A. 2.
B. 1.
C. 3.
Solution
A is correct. The conclusion about the impact of financial leverage on FCFF and FCFE
is inaccurate. Changes in financial leverage (the amount of debt financing in the
company’s capital structure) affects FCFE but not FCFF.
B is incorrect because the statement is correct as written: a company’s sustainable
growth rate assumes growth through internally generated funds and approximates the
average rate at which dividends can grow over a long horizon.
C is incorrect because the statement is correct as written: for an active security
selection to be consistently successful and achieve positive alphas, the analyst must
combine accurate forecasts with an appropriate valuation model. Further, the analyst’s
expectations must differ from consensus expectations.

a. Define valuation and intrinsic value and explain sources of perceived mispricing


Q. Using Valentine’s data in Exhibit 1, Laboutin’s justified trailing P/E is closest to:
1. 7.7.
2. 7.4.
3. 19.8.
Solution
A is correct. The justified (fundamental) trailing P/E is:
P0/E0 = [(1 b)× (1 + g)]/(r g)
where
(1 b) = dividend payout ratio = 28%
r = the required rate of return on Laboutin’s equity = 7.26%
g = the long run expected dividend growth rate = 3.5%
P0/E0 = (0.28 × 1.035)/(0.0726 0.035) = 0.2898/0.0376 = 7.71
B is incorrect because it determines the forward P/E, i.e., P0/E1.
P0/E1 = (0.28)/(0.0726 0.035) = 0.28/0.0376 = 7.44
C is incorrect because it took the dividend payout ratio as 0.72 (not 0.28).
P0/E0 = (0.72 ×1.035)/(0.0726 0.035) = 0.7452/0.0376 = 19.82

f. Calculate and interpret the justified leading and trailing P/Es using the Gordon growth
model
Q. Compared to the justified forward P/E for Laboutin, Valentine’s predicted P/E
regression analysis will produce a P/E multiplier that is:
1. higher.
2. lower.
3. the same.
Solution
A is correct. The justified forward P/E ratio can be determined from Exhibit 1, as
follows:
P0/E1 = (1 b)/(r g) = 0.28/(0.0726 0.035) = 7.45
The predicted P/E according to the estimated regression is:
5.65+(6.25×DPR) (0.37×Beta)+(15.48×
PredictedP/EPredictedP/E =
DGR)5.65+(6.25×DPR) (0.37×Beta)+(15.48×DGR)
5.65+(6.25×0.28) (0.37×0.90)+(15.48×
=
0.035)5.65+(6.25×0.28) (0.37×0.90)+(15.48×0.035)
= 7.617.61
The forward P/E under the regression method is higher than the justified forward P/E
ratio.
B is incorrect because if Rm is used instead of R for Laboutin in the justified P/E, it would
be lower (0.28)/(0.078 0.035) = 6.5.
C is incorrect.
Market-based Valuation: Price and Enterprise Value Multiples

Learning Outcome
i. Calculate and interpret a predicted P/E, given a cross-sectional regression on
fundamentals, and explain limitations to the cross-sectional regression methodology
Q. Using Norman’s suggested valuation methodology, estimates, and the data in Exhibit
2, Laboutin’s intrinsic value per share (in CDN$) is closest to:
A. $181.
B. $155.
C. $171.
Solution
A is correct. Norman suggests using FCFE and a required return on equity of 10% to
value Laboutin. Using Exhibit 2 to calculate FCFE:
Net Income+Depreciation FCInv WCInv+Net borrowingNet

FCFEFCFE =
Income+Depreciation FCInv WCInv+Net borrowing
= 500+100 90 25+80500+100 90 25+80
= $565 million$565 million
Sustainable growth rate: g = b × ROE
b = Retention ratio = (1 Dividend payout ratio)
g = (1 0.32) × 8.33 = 5.6%
r = 10%
Equity value = FCFE1(r g)=(565×1.056)(0.10
0.056)FCFE1(r g)=(565×1.056)(0.10 0.056) = 596.640.044596.640.044 = $13,560
million
Value per share = 13,5607513,56075 = $180.80
B is incorrect because it ignores net borrowing in calculating FCFE.
FCFE = 500 + 100 90 25 = 485
Equity value = (485 × 1.056)(0.10 0.056)=512.160.044(485 × 1.056)(0.10

0.056)=512.160.044 = 11,640
Value per share = 11,6407511,64075 = $155
C is incorrect because it forgets to grow the FCFE.
FCFE = 500 + 100 90 25 + 80 = $565 million
Equity value = 565(0.10 0.056)=5650.044565(0.10 0.056)=5650.044 = 12,841

Value per share = 12,8407512,84075 = $171

Free Cash Flow Valuation Learning Outcomes

Q. Which of Valentine’s comments about FCFE is most accurate?

A. 2
B. 1
C. 3
Solution
A is correct. If a company’s capital structure is relatively stable, using FCFE to value
equity is more direct and simpler than using FCFF. All three sections of the cash flow
statement are important in determining FCFE because one must integrate the cash
flows from the company’s operations with those from its investing and financing
activities to calculate a free cash flow figure. Working with FCFF is likely to be easiest
when a company is levered and has negative FCFE.
B is incorrect because all three sections of the cash flow statement are important in
determining FCFE because Valentine must integrate the cash flows from the company’s
operations with those from its investing and financing activities to calculate a free cash
flow figure.
C is incorrect because working with FCFF is likely to be easiest when a company is
levered and has negative FCFE.

a. Compare the free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE) approaches to valuation
e. Describe approaches for forecasting FCFF and FCFE
Q. The best answer to Valentine’s question about the valuation method for Frontier is
that he should use a(n):
1. income approach.
2. asset-based approach.
3. market approach.
Solution
A is correct. The best way to value private companies in a high growth stage is to use
a free cash flow method, which in private business appraisal is known as an income
approach.
B is incorrect because Asset-based approaches are best for start-ups.
C is incorrect because Market-based approaches are best for mature companies.

d. Explain the income, market, and asset-based approaches to private company
valuation and factors relevant to the selection of each approach
Ri Lin Case Scenario

Pacific Wind Capital Management (PWCM) is a global equity manager based in
Singapore. During a weekly investment call, managers of its Alpha fund express an
interest in exploring basic materials stocks in Canada and in the emerging market
country of South Africa. Ri Lin, PWCM’s senior materials analyst, assigns performing
initial research on South Africa materials stocks to Ji-min Kim, a junior research analyst
at the firm.
Before reviewing specific stocks, Lin provides Kim with the data in Exhibit 1 and asks
her to estimate the forward-looking risk premium for South African equities.
EXHIBIT 1
MARKET DATA
South Africa
Current equity market dividend yield 2.70%
Dividend yield based on year-ahead aggregate forecasts 3.00%
Consensus long-term earnings growth rate 5.90%

South Africa
Risk-free rate (90-day government bill) 5.00%
20-year government bond yield 8.50%
United States
20-year government bond yield 3.50%

Initial screening of selected South African stocks identifies Jacobs Brands LTD and
Krantz Group LTD as the most attractive candidates for further analysis. Lin directs Kim
to estimate the market betas of these stocks. Krantz Group is thinly traded, making it
difficult to run a return regression to estimate beta. As an alternative, Kim decides to
use the South Africa Basic Materials Index as a proxy to estimate the beta of Krantz
relative to the MSCI World Index.
EXHIBIT 2
MARKET BETA AND DEBT RATIOS
South Africa Basic Materials Equity Market Index (SABMI)
Estimated SABMI beta to MSCI World Index 0.9
Estimated SABMI beta to MSCI South Africa Index 0.8
Average SABMI debt-to-total capital-ratio 0.4
Krantz Group
Debt-to-equity ratio 0.75

Lin then asks Kim to calculate the justified price-to-sales (P/S) and EV/EBITDA
multiples for these South African stocks, starting with Jacobs Brands, using the data in
Exhibits 3 and 4.
EXHIBIT 3
JACOBS BRANDS LTD SELECTED FINANCIAL STATEMENT ITEMS (ZAR
MILLIONS)
Cash and cash equivalents 1,260
Short-term investments 486

Cash and cash equivalents 1,260
Accounts receivable, net 480
Inventories 1,657
Total sales 4,821
Interest 161
Taxes 964
Depreciation and amortization 171
Net income 446
Capital investment 121

EXHIBIT 4
ADDITIONAL FINANCIAL METRICS (ZAR MILLIONS)
Jacobs Brands Krantz Group
Market value of common equity 5,284 868
Market value of debt 2,687 651
Market value of preferred stock 1,210 0
Estimated dividend payout ratio 25.00% 5.00%
Estimated earnings growth rate 5.00% 6.00%
Estimated required rate of return 9.50% 10.00%

Before making recommendations, Kim and Lin discuss the comparability of a number of
metrics they have compiled for South African stocks with stocks Lin has identified in
Canada through separate analysis.
“In regard to estimating the required rate of return for the South African and Canadian
equity markets,” Kim says, “I believe the most important adjustments will be:
 accounting for differences in GDP growth rates,
 incorporating exchange rate forecasts into the calculations, and
 including a country premium for stocks in South Africa.”
When concluding their discussion, they make the following observations regarding
comparison of valuation multiples for companies across two different countries:
1. EV/EBITDA is less likely to be impacted by differences in international accounting
standards than P/E or price to free cash flow to equity (P/FCFE).
2. When the inflation rates in two countries are the same, the justified P/E multiple
should be lower for companies with a higher inflation pass-through rate, all else
being equal.
3. Assuming all else is equal, a company in a country with high inflation will have lower
justified P/E multiples than a company in a country with lower rates of inflation.
Q. Based on the data provided in Exhibit 1, Kim’s forward-looking estimate for the South
Africa equity risk premium is closest to:
A. 3.9%.
B. 5.4%.
C. 0.4%.
Solution
C is correct. Using the constant growth dividend discount model (Gordon growth
model), the equity risk premium can be presented as:
Dividend yield on the index based on year-ahead aggregate forecasts 3.0%
plus consensus long-term earnings growth rate + 5.9%
minus current long-term government bond yield. 8.5%
Equity risk premium = = 0.4%

A is incorrect because it incorrectly uses the South African risk-free rate: 3.0% + 5.9%
5.0% = 3.9%.
B is incorrect because it incorrectly uses the US long-term government bond yield: 3.0%
+ 5.9% 3.5% = 5.4%.

b. Calculate and interpret an equity risk premium using historical and forward-looking
estimation approaches
Q. Using Exhibit 2, Kim’s estimated beta of Krantz Group is closest to:
1. 0.84.
2. 0.95.
3. 1.13.
Solution
B is correct.
The four steps that occur when doing beta estimation are shown in the table below:
Step 1: Select proxy for Krantz Kim decided to use the SABMI
Group
Step 2: Estimate the beta of the Given as 0.90

proxy
Step 3: Unlever the benchmark’s

beta βu=(11 + D/E)βiβu=(11 + D/E)βi
D/E for the index is not given, but if debt is 40% of total capital,
then debt to equity would be 40/60 = 0.6667.
βu = (1/1.6667) × 0.9 = 0.6 ×0.9 = 0.54
Step 4: Relever beta to reflect βc = [1 + (D′/E′)]βu = (1 + 0.75) × 0.54 = 0.95

the company’s D/E
βu = beta unlevered;βi = beta index; βc = estimated company beta.
A is incorrect because this answer incorrectly uses the beta to the MSCI South Africa
Index, not the MSCI World Index (beta of 0.8 instead of 0.9 in Step 2): βu = (1/1.6667) ×
0.8 = 0.6 ×0.8 = 0.48; βc = [1 + (D′/E′)] βu = (1 + 0.75)×0.54 = 0.84.
C is incorrect because this answer incorrectly uses the debt to capital ratio of the index
instead of debt to equity (0.40 instead of 0.6667 in Step 3):βu = (1/1.4) ×0.9 = 0.71 × 0.9
= 0.643; βc = [1 + (D′/E′)]βu = (1+ 0.75)× 0.64 = 1.125.

nonpublic companies
Q. Using the data in Exhibits 3 and 4, the justified P/S ratio that Kim calculates for
Jacob Brands is closest to:
1. 1.62.
2. 1.10.
3. 0.54.
Solution
C is correct.
Justified P/S ratio = (E0/S0)(1 b)(1 + g)r g(E0/S0)(1 b)(1 + g)r g
Step 1: Calculate E0/S0 (446/4,821) = 0.0925
Step 2: (1 b) Given in Exhibit 4 0.25
Step 3: (1 + g) g = 5% (given in Exhibit 4) 1.05
Step 4: Calculate (r g) 0.095 0.050 = 0.045
Step 5: Apply formula (0.0925 × 0.25) × (1.05/0.045) = 0.540

b = earnings retention rate; g = earnings growth rate; r = required rate of return
B is incorrect because it represents current P/S ratio not justified P/S ratio.
P/S = Equity market capitalization/Total sales = 5,284/4,821= 1.10
Alternatively, 0.0925 × (0.25)/(0.45), i.e., P/S = (E/S)(1 b)/(r g)
A is incorrect because it represents a payout ratio that is too high. The middle term in
the numerator reflects 1 minus the payout ratio instead of 1 minus the retention rate.
P/S = (E/S)(1 b)(1 + g)/(r g) = (.0925)(0.75)(1.05)/(.045) = 1.62

Learning Outcome
Q. Using the data in Exhibits 3 and 4, the EV/EBITDA ratio Kim calculates for Jacobs
Brands is closestto:
1. 4.3.
2. 4.6.
3. 3.6.
Solution
A is correct.
Step 1: Calculate Enterprise Value Step 2: Calculate EBITDA
Enterprise value = EV = EBITDA =
MV of common equity 5,284 Net income 446
+ MV of preferred stock + 1,210 + Interest expense + 161
+ MV of debt + 2,687 + Taxes + 964
Cash and cash equivalents 1,260 + Depreciation and amortization + 171
Short term investments 486 EBITDA = = 1,742
Enterprise value = = 7,435
Step 3: Calculate EV/EBITDA = 7,435/1,742 = 4.27

B is incorrect because the short-term investments are not subtracted from the EV
calculation: 7,435 + 486 = 7,921/1,742 = 4.55.
C is incorrect because the market value of the preferred stock is ignored in the EV
calculation: 7,435 1,210 = 6,225/1,742 = 3.57.

Learning Outcome
Q. Which of Kim’s suggested adjustments when comparing the required rates of return
for South African and Canadian stocks is least relevant? The adjustment related to:
1. the country premium.
2. exchange rate forecasts.
3. GDP growth rates.
Solution
C is correct. Differences in GDP growth rates between countries may exist, but this is
not an important consideration specific to estimating required rate of return between the
two countries. Both exchange rates and model issues in emerging markets are
important considerations that concern analysts estimating required returns in a global
context.
A is incorrect because investing in emerging markets such as South Africa is typically
associated with greater expected risk, and analysts may want to consider incorporating
a country spread model or a country risk rating model.
B is incorrect because equity risk premium estimates in home currency terms can be
higher or lower than estimates in local currency terms.

f. Explain international considerations in required return estimation
Q. Which of the observations regarding comparison of cross-border valuation multiples

is the mostaccurate?
1. Observation 3
2. Observation 1
3. Observation 2
Solution
A is correct. All else being equal, companies operating in a country with higher inflation
will have a lower justified P/E than those operating in a country with lower inflation.
B is incorrect because international accounting differences affect the comparability of all
price multiples. However, cash based multiples such as P/FCFE will generally be the
least impacted by accounting differences.
C is incorrect because if the inflation rates are equal but pass-through rates differ, the
justified P/E should be lower for the company with the lower pass-through rate.

Learning Outcome
o. Explain sources of differences in cross-border valuation comparisons
Peter Tanner Case Scenario

Peter Tanner recently accepted a position as a domestic equity analyst with a large US
pension fund. The fund uses a bottom-up team approach to stock selection. The fund’s
equity manager, Cindy Bradley, is responsible for the results of the domestic equity
portfolio.
Tanner’s first assignment is to evaluate a packaged foods company, GreenSnacks, Inc.
(GNSK), which trades on the NASDAQ at a current price of $21.875 per share. His
analysis is to include a long-term outlook for the company in the context of the well-
established packaged foods industry, which is dominated by several large companies in
the United States.
The major players compete vigorously for market share. The industry has been growing
at a rate very similar to that of GDP for many years. GNSK competes in the rapidly
growing health food category, which has been gaining about 1%–2% of relative share
per year within the broader packaged foods industry because of external factors, such
as changes in social preference and an aging population.
Originally a spin-off from one of the industry’s key players, GNSK has shown promising
growth for the past few years because of a new and bold new patented process it
developed to enhance the preservation, packaging, and distribution of fruity snacks.
GNSK expects to face little competition for the next few years. The combination of its
efforts has allowed GNSK to create products that maintain a fresh taste without
preservatives and with a shelf-life much longer than the established products of the
leading brands.
Although the healthy snack category has been gaining market share rapidly because of
social changes, GNSK was not able to break through the established shelf-space
barrier controlled by the large competitors until its new process was perfected. As
national chains begin to pick up the product line, GNSK is experiencing substantial
market share gains and accelerating sales, although prices are lower than desired due
to the size of the aggressive buying practices of supermarkets. The outlook for the
company’s future sales growth exceeds 17%, and profit margins are increasing well
beyond the levels of competitors.
Tanner expects short-term rapid earnings growth of 20% in 2018 for GNSK, with the
rate of growth linearly diminishing over the next five years to match industry conditions
thereafter. He assumes that starting in Year 6, GNSK’s long-term dividend growth rate
will be equal to the current level of sustainable growth rate for the industry. Given these
assumptions and the data in Exhibit 1, Tanner decides to use the H-model for valuing
GNSK’s stock.
EXHIBIT 1
SELECTED FINANCIAL INFORMATION FOR THE FISCAL YEAR ENDING 31
DECEMBER 2017
GNSK Industry Average
Return on equity (%) 23.1 12.8
Earnings per share (EPS) 2017 ($) 2.45 n/a
Dividend payout ratio 2017 (%) 25 65
Required return (%) n/a 11

GNSK Industry Average
Trailing dividend yield (%) 2.8 3.7

Note: n/a indicates not available.
Tanner meets with Bradley for her advice. Bradley states that the industry growth rate
may be slower than that of GNSK because the packaged foods industry is mature and
stable. She suggests that Tanner calculate the implied long-term dividend growth rate
for GNSK using the Gordon growth model. Furthermore, Bradley believes that the
required return and dividend yield for the industry are the most stable indicators and
should be used in the valuation computations.
Bradley suggests that Tanner also analyze the investment appeal of industry peer Star
Cakes (STCK). She provides the following data and assumptions for STCK:
 The company paid a dividend of $2.48 last year.
 Its earnings are dropping about 2% every year permanently.
 I assign a required return of 7.4% for this company due to its low beta.
As they continued their discussion, the following additional points were made about
alternative dividend valuation methods:
 “Free cash flow valuation is especially appropriate for investors who want to take a
control perspective in takeovers. Also, free cash flow to equity is the cash flow
available to be distributed to shareholders without impairing the company’s value.”
 “Remember that the Gordon growth model is based on indefinitely extending future
dividends, and the intrinsic value derived by the model is very sensitive to small
changes in the assumed growth rate and required rate of return.”
 “You can use the residual income approach as well, a simpler model that does not
require holding of clean surplus relation, and the valuation is not impacted by book
values.”
Tanner prepares a list of issues he needs to consider and begins his analysis for his
report.
Q. GNSK can best be described as being in which of the following growth stages?
A. Growth
B. Transition
C. Mature
Solution
A is correct. GNSK is in the growth stage because it is expanding rapidly and enjoying
the benefits of the health food market, which is also growing rapidly. GNSK is also
experiencing high and growing profit margins as well as abnormally high earnings per
share growth, which are all indicative of a company in its growth phase.
B is incorrect because GNSK’s earnings are growing rapidly, and profits are increasing.
A company in the transition phase will experience slowing earnings growth or price and
profit margin pressure.
C is incorrect because mature companies have average investment opportunities.
GNSK is gaining market share and therefore able to grow at a faster rate than
competitors in what is otherwise a mature industry.

Q. The factor that is most consistent with GreenSnack’s current competitive position is:
A. barriers to entry.
B. weak buyer power.
C. availability of substitutes.
Solution
A is correct. Barriers to entry are high—it took a long time for GreenSnacks to break
into the supermarkets and the patents should prevent new entrants from duplicating
their results for quite some time.
B is incorrect because supermarkets have strong buyer power.
C is incorrect because patent protection should prevent robust substitutes.
Industry and Company Analysis Learning Outcome


e. Describe questions that should be addressed in conducting an industry and
competitive analysis
Q. According to the valuation approach that Tanner decides to use and data from
Exhibit 1, the expected rate of return for GNSK is closest to:
A. 9.6%.
B. 12.2%.
C. 8.5%.
Solution
C is correct. The H-model that Tanner decides to use is a variant of the two-stage
dividend discount model. It assumes that growth begins at a high rate and declines
linearly throughout the super-normal growth period until it reaches a normal rate at the
end. In the case of GNSK, the H-model is appropriate for estimating the required return
because Tanner expects extraordinary earnings growth of 20% next year with the rate
of growth diminishing over time to match industry conditions in Year 6.
r=(D0P0)[(1+gL)+H(gS gL)]+gLr=(D0P0)[(1+gL)+H(gS gL)]+gL

H = Half-life in years of the supernormal growth rate = 5 × 0.5 = 2.5
D0 = 2.45 × 0.25 = $0.6125
gL = Sustainable growth rate for the industry
= ROE × (1 payout) = 0.128 × (1 0.65)
= 0.0448 or 4.48%
gS = Short-term growth rate of GNSK = 0.20
(0.617521.875)[(1+0.0448)+2.5(0.20
0.0448)]+0.0448(0.617521.875)[(1+0.0448)+2.5(0.20 0.0448)]+0.0448
= (0.028)(1.0448 + 0.388) +0.0448
=0.08492 or 8.5%
A is incorrect because it uses 5 for H instead of 2.5.
r = 0.028 × [(1 + 0.0448) + 5(0.20 0.0448)] + 0.0448 = 0.09578 or 9.6%
B is incorrect because the answer used the payout ratio (rather than the retention ratio)
to determine GL.
GL = 0.128 × 0.65 = 0.0832
r = 0.028 × [(1 + 0.0832) + 2.5(0.20 0.0832)] + 0.0832 = 0.1217 or 12.2%

m. Estimate a required return based on any DDM, including the Gordon growth model
and the H-model
Q. Using Bradley’s assumptions regarding GNSK and the data from Exhibit 1, GNSK’s
implied long-term dividend growth rate is closest to:
A. 8.0%.
B. 7.0%.
C. 7.3%.
Solution
B is correct.
V0=D0(1 + g)r gV0=D0(1 + g)r g
Rearranging:
D0/V0 = (r g)/(1 + g)
Let D0/V0 = d, and rewrite the equation:
g = (r g)/(1 + d)
Using the industry data in Exhibit 1:
g = (0.11 0.037)/(1 + 0.037) = 0.0704 or 7.0%
Alternatively:
0.037 = (0.11 g)/(1 + g)
0.037(1 + g) + g = 0.11
0.037 + 0.037g + g = 0.11
1.037g = 0.11 0.037
g = 0.073/1.037 = 0.0704 = ~7.0%
A is incorrect because it uses the company dividend yield of 0.028 instead of the
industry yield of 0.037.
g = [(0.11 0.028)/(1 + 0.028)] = 0.08 or 8.0%
C is incorrect because it omits the last division: 0.11 0.037 = 0.073 or 7.3%.

d. Calculate and interpret the implied growth rate of dividends using the Gordon growth
model and current stock price

Learning Outcomes
d. Calculate and interpret alternative price multiples and dividend yield
g. Describe fundamental factors that influence alternative price multiples and dividend
yield
Q. Given Bradley’s suggestions and assumptions, STCK’s intrinsic value is closest to:
1. $26.38.
2. $32.84
3. $25.85.
Solution
C is correct.
V0V0 = D1/(r – g),whereD1=D0(1 + g)D1/(r – g),whereD1=D0(1 + g)

V0V0 = 2.48(1 0.02)0.074 (0.02)2.48(1 0.02)0.074 (0.02)
= 2.43/0.0942.43/0.094
= $25.85$25.85
A is incorrect because it uses trailing dividend of 2.48 in the numerator: V = 2.48/0.094
= $26.38.
B is incorrect because it adjusted the dividend for negative growth but not the discount
rate: 2.48(1 0.02)/0.074 = $32.84.

c. Calculate the value of a common stock using the Gordon growth model and explain
the model’s underlying assumptions
Q. In their continued discussion of the alternative dividend valuation methods, the

statement that is leastaccurate is the one concerning:
A. the Gordon model.
B. the residual income model.
C. free cash flows.
Solution
B is correct. The statement regarding residual income is least accurate. The residual
income approach uses the book value of equity and it requires that the clean surplus
relation holds. The other statements are accurate.
A and C are incorrect because the statement regarding residual income is least
accurate. The residual income approach uses the book value of equity and it requires
that the clean surplus relation holds. The other statements are accurate.

a. Compare dividends, free cash flow, and residual income as inputs to discounted
cash flow models and identify investment situations for which each measure is
suitable

b. Describe the uses of residual income models
d. Explain fundamental determinants of residual income
McKinley Investment Partners Case Scenario
McKinley Investment Partners (MIP), a diversified investment firm based in Salt Lake
City, USA, is considering increasing its investment in the North American transportation
sector. Douglas Gast, portfolio manager at MIP, states that although the railroad
industry is quite cyclical, it is a good time to invest in this sector because improved
economic activity in the United States will have a positive impact on the railroad
industry’s profitability relative to the S&P 500. Gast has assigned Gary Hughes, an
associate analyst, the task of analyzing rail companies and presenting his
recommendation the following week.
Hughes is initially interested in determining the required return on equity for the rail
company of interest. He considers several methods that can be utilized for this purpose
and makes the following notes:
 The capital asset pricing model (CAPM) captures company specific and market risk.
 The Fama–French model includes factors that measure size and value.
 The bond yield plus risk premium method incorporates the yield to maturity of a
company’s debt.
After considering these alternative methods, Hughes selects the Fama–French model
as his preferred method. His first determination is for Western Plains Rail (WPR), using
the data presented in Exhibit 1.
EXHIBIT 1
SELECTED MARKET DATA FOR WESTERN PLAINS RAIL
Factor Risk Premium (%)
Market factor 1.3 5.2
Size factor –0.2 2
Value factor –0.3 4.3
Liquidity factor 0.1 3.7
Current short-term government bill yield 1.2%
Current long-term government bond yield 4.1%

Gast asks Hughes to calculate the trailing and forward price/earnings multiples based
on core earnings. Hughes uses the data in Exhibit 2 for his calculations for WPR.
EXHIBIT 2
SELECTED FINANCIAL DATA FOR WESTERN PLAINS RAIL
Current year earnings per share $3.60
Expected restructuring charge next year as a % of EPS 2%
Expected EPS growth next year vs. S&P 500 1.15×
Most recent year annual dividend $1.01
Current share price $57.00
S&P 500 expected EPS growth rate 8%

Gast then makes the following comment: “As you review the financial statements in
preparation for calculating the price multiples please make note of the following three
items:
 The impact of the business cycle for this industry should be minimal, so adjustments
should not be necessary.
 The accounting methods used by these rail companies will have to be compared,
and adjustments may be necessary.
 The rail companies that provide core EPS have already made all the necessary
adjustments for nonrecurring items.”
Based on the forward P/E ratios and a five-year estimated growth rate, Hughes finds
that the industry’s P/E-to-growth (PEG) ratio is comparable to that of the company. He
mentions to Gast that this implies that the company is fairly valued relative to the
industry. Gast states that one must be careful in utilizing PEG because it:
 assumes a non-linear relationship between P/E and growth.
 ignores any risk differential between the industry and the company.
 adjusts for differences in the duration of growth between the industry and the
company.
As confirmation of the P/E results, Gast instructs Hughes to consider EV/EBITDA as an
alternative method of valuation. Hughes asks Gast whether there are any drawbacks to
this method.
Q. Which of Hughes’ notes regarding the various methods of estimating the required
return on equity is least accurate?
A. The note related to the Fama–French model
B. The note related to the CAPM
C. The note related to the bond yield plus risk premium method
Solution
B is correct. Hughes’ note about the CAPM is not accurate. CAPM only incorporates a
single risk premium for market risk (beta); it does not incorporate company-specific
(idiosyncratic) risk.
A is incorrect because the statement is correct. FFM expands on the CAPM model with
two additional risk factors: (1) SMB (small minus big), a size (market capitalization)
factor, and (2) HML (high minus low), a value return premium factor.
C is incorrect because the statement is correct. The bond yield plus risk premium
method is a build-up method used to estimate the equity risk premium. Bond yield plus
risk premium cost of equity = Yield to maturity on the company’s long-term debt + Risk
premium.

Q. Using the data in Exhibit 1 and Hughes’ preferred method, the required return on
equity for Western Plains Rail is closest to:
1. 6.6%.
2. 6.3%.
3. 9.2%.
Solution
B is correct. The Fama–French model estimate for return on equity is calculated using
the formula
ri=RF+βmktiRMRF+βsizeiSMB+βvalueiHMLri=RF+βimktRMRF+βisizeSMB+βivalueHML
where
ri = Required return on share i
RF = Current expected risk-free return on the short-term government bill
βmktiβimkt, βsizeiβisize, and βvalueiβivalue = Factor sensitivities for the market, size, and
value factors, respectively
RMRF, SMB, and HML = Risk premiums for the market, size, and value factors,
respectively
FFM: ri = 1.2% + 1.3 × (5.2%) 0.2 × (2.0%) 0.3 × (4.3%)
= 1.2% + 6.76% 0.40% 1.29%
= 6.27% = 6.30%
A is incorrect because the calculation incorrectly includes the liquidity factor.
FFM: ri = 1.2% + 1.3 × (5.2%) 0.2 × (2.0%) 0.3 × (4.3%) + 0.1 × (3.7%)
= 1.2% + 6.76% 0.40% 1.29% + 0.37%
= 6.64% = 6.6%
C is incorrect because the calculation incorrectly used the long-term bond instead of the
short-term bill.
FFM: ri = 4.1% + 1.3 × (5.2%) 0.2 × (2.0%) 0.3 × (4.3%)
= 4.1% + 6.76% 0.40% 1.29%
= 9.17% = 9.2%

Q. Following Gast’s recommended approach, the forward P/E multiple that Hughes
calculates for Western Plains Rail is closest to:
1. 14.2×.
2. 15.5×.
3. 14.5×.
Solution
A is correct. Gast’s recommended approach is to calculate the forward P/E based on
core earnings.
First calculate next year’s EPS based on the Next year’s EPS growth: 8% × 1.15x 9.20%
relationship to S&P expected growth rate
Next calculate the company’s expected EPS Next year’s EPS: $3.60 × (1 + 0.092) $3.93
= $3.931
Add the expected restructuring charge to determine Add: expected restructuring charge = $0.08
the expected core EPS $3.93 × 2% = $0.079
Core EPS Equals Core EPS $4.01
Finally calculate the P/E multiple by dividing the P/E multiple = $57.00/$4.01 = 14.2×
expected core EPS by the share price 14.214×
B is incorrect because the calculation used current year EPS instead of next year’s
EPS.
Current year EPS: $3.60 $3.60
Add: expected restructuring charge = $3.60 × 2% = $0.072 $0.07
= Core EPS $3.67
P/E multiple = $57.00/$3.67 = 15.531x 15.5×

C is incorrect because next year’s EPS was not adjusted for structuring charge.
Next year’s EPS growth: 8% × 1.15× 9.2%
Next year’s EPS: $3.60 × (1 + 0.092) = $3.931 $3.93
P/E multiple = $57.00/$3.93 = 14.504× 14.5×

Learning Outcome
Q. Which of Gast’s comments regarding the calculation of price multiples

is most accurate?
1. His comment regarding the business cycle.
2. His comment regarding the accounting methods.
3. His comment regarding the nonrecurring items.
Solution
B is correct. Gast’s comments regarding the accounting methods is the most accurate.
Analysts need to adjust EPS for differences in accounting methods between companies
being compared so that P/Es will be comparable.
A is incorrect because of cyclicality (discussed in opening paragraph of vignette), the
most recent four quarters of earnings may not accurately reflect the average or long-
term earnings power of a company. An analyst deals with this issue by normalizing EPS
(i.e., estimating the EPS a company could be expected to achieve under mid-cycle
conditions).
C is incorrect because an analyst’s calculation of underlying earnings may differ from
the company’s. Company-reported core earnings may not be comparable among
companies because of differing bases of calculation. Analysts should carefully examine
the calculation and, generally, should not rely on company-reported core earnings.
Learning Outcome
c. Describe rationales for and possible drawbacks to using alternative price multi-ples
and dividend yield in valuation
Q. Which of Gast’s comments about the PEG ratio comparison is the most accurate?
1. The comment about risk differences.
2. The comment about growth durations.
3. The comment about non-linearity.
Solution
A is correct. Gast is correct about the risk differences. PEG does not factor in
differences in risk, an important determinant of P/E.
C is incorrect because PEG assumes a linear relationship between P/E and growth. The
model for P/E in terms of the DDM shows that, in theory, the relationship is not linear.
B is incorrect because PEG does not account for differences in the duration of growth.

Learning Outcome
valuation
Q. Gast’s best response to Hughes’ question about the EV/EBITDA method would be
that:
1. EBITDA is ineffective in capital intensive industries.
2. it can be used even when EBITDA is negative.
3. compared with the free cash flow to the firm method, EBITDA overestimates cash
flow from operations if the company’s working capital is growing.
Solution
C is correct. A possible drawback to EV/EBITDA is that EBITDA will overestimate cash
flow from operations if working capital is growing.
A is incorrect because it is not a drawback. EBITDA is effective in capital intensive
industries because it controls for differences in depreciation and amortization.
B is incorrect because if EBITDA is negative, a positive enterprise value cannot be
calculated.
Learning Outcome
m. Explain alternative definitions of cash flow used in price and enterprise value (EV)
multiples and describe limitations of each definition
Jose Rivera Case Scenario

Louisiana High Growth Investors (LHGI), a large hedge fund in New Orleans, Louisiana,
is considering the purchase of Black Tiger Prawns Inc. (BTP), a publicly traded
company headquartered in the same city, for $500 million. BTP’s revenues and
earnings are cyclical, from both seasonal and business cycle effects. It is a small-cap
firm, and its stock trades thinly in the OTC market.
As a part of the analysis, Jose Rivera, equity analyst at LHGI, compiles the data
presented in Exhibit 1, Panel A, and estimates the forward-looking equity risk premium
using the Gordon growth model (GGM). Rivera adds 1.50% to the risk premium he has
computed to account for the additional small firm risk premium associated with BTP.
Rivera shows his computations to Kamini Royappa, chief investment officer. Royappa
suggests that the macroeconomic model with supply-side analysis using the Ibbotson–
Chen format provides a better estimate for BTP’s risk premium. She also suggests that
BTP commands a 0.75% risk premium for its thin trading in addition to the small firm
risk premium that Rivera has already considered. Following the suggestions by
Royappa, Rivera collects additional data presented in Exhibit 1, Panel B.
EXHIBIT 1
DATA FOR FORWARD-LOOKING RISK PREMIUM ESTIMATES
Panel A: Data for the GGM
Current price level of the market index 1,480.00
Current year’s dividend on the market index $31.25
Year-ahead forecasted dividend on the market index $33.60
Long-term earnings growth rate for the market index 6.00%
Current long-term government bond yield 4.00%
Current short-term government bond yield 2.75%

Panel A: Data for the GGM
Panel B: Data for the macroeconomic model using the Ibbotson–Chen format
Expected growth rate in real earnings per share 3.00%
Expected growth rate in P/E 1.50%
Expected income component 2.50%
Expected TIPS yield 2.15%
Expected inflation 1.81%

TIPS = Treasury Inflation-Protected Securities
Furthermore, Royappa says, “In addition to the forward-looking estimates of the equity
risk premium for BTP, you should also compute historical estimates of the risk premium
for the stock. But note the following three caveats as you undertake computations,
especially when using the capital asset pricing model (CAPM) approach:
1. Compared with the geometric mean return, the arithmetic mean return is consistent
with the assumptions of single period models, such as the CAPM.
2. In almost all cases, the equity risk premiums based on long-term government bonds
tend to be smaller than those based on short-term government bonds.
3. Make sure to adjust the risk premium upward if the market index has experienced
survivorship bias as a result of removing poorly performing companies.”
Next, Rivera presents his assessment of a risk premium for BTP to the investment
committee and asks for the committee’s advice regarding approaches to valuing BTP.
Katrina Smirnoff, portfolio manager, prefers to use two multiples-based approaches: the
justified price-to-book ratio (P/B) and the ratio of enterprise value to earnings before
interest, taxes, depreciation, and amortization (EV/EBITDA). Furthermore, she makes
the following three statements regarding different relative valuation approaches:
1. In assessing BTP’s trailing P/E, be sure to adjust for its counter-cyclical property
called the Molodovsky effect.
2. The P/E-to-growth (PEG) measure is better than P/E because it correctly accounts
for differences in risk and the duration of growth between BTP and its peers.
3. Note that BTP’s return on equity (ROE) is much higher than its peers. Therefore, on
the basis of justified P/B, BTP will appear overvalued relative to its peers with the
same P/B.
Additionally, Smirnoff suggests that Rivera should adjust BTP’s multiples to reflect a
25% discount for additional risks because of its small size and thin trading. Rivera
agrees with Smirnoff and collects the data needed, which are shown in Exhibit 2.
EXHIBIT 2
BTP’S SELECTED FINANCIAL DATA ($ MILLIONS)
Net income 20
Interest 5
Taxes 10
Depreciation 80
Amortization 15
Earnings growth rate 5.50%
Book value of equity 100
Market value of equity 250
Long-term debt 150
Cash 50
Required return on stock 11.00%
Q. Using Exhibit 1 and Rivera’s adjustment, the risk premium for BTP stock according to
the Gordon growth model is closest to:
A. 5.77%.
B. 5.61%.
C. 7.02%.
Solution
A is correct. First compute the GGM equity risk premium and then add Rivera’s
adjustment for small firm risk premium. Computations are as follows:
GGM equity risk premium estimate = Dividend yield on the index based on year-
ahead aggregate forecasted dividends and aggregate market value + Consensus
long-term earnings growth rate – Current long-term government bond yield
Dividend yield: 33.60/1,480 = 2.27%
Plus: Consensus long-term earnings growth rate 6.00%
Minus: Current long-term government bond yield 4.00%

Dividend yield: 33.60/1,480 = 2.27%
Equals: Equity risk premium per GGM 4.27%
Plus: Rivera’s adjustment for small firm risk premium 1.50%
Equals: GGM equity risk premium including Rivera’s adjustment 5.77%

B is incorrect because the mistake is in the computation of dividend yield: using the
current year’s dividend, as opposed to the use of year ahead forecasted dividend.
Dividend yield (based on current dividend): 31.25/1,480 = 2.11%
Plus: Consensus long-term earnings growth rate 6.00%
Minus: Current long-term government bond yield 4.00%
Equals: Equity risk premium (incorrect) 4.11%
Plus: 1.50% small firm risk premium 5.61%

C is incorrect because it uses short-term government bond yield instead of long-term
government bond yield:
2.27 + 6.00 2.75 + 1.50 = 7.02%

Q. Using the appropriate data in Exhibit 1 for the macroeconomic model and the
adjustments considered by Rivera and Royappa, the risk premium for BTP stock
is closest to:
1. 5.62%.
2. 7.54%.
3. 7.19%.
Solution
C is correct. First, compute the equity risk premium according to the macroeconomic
model with four components. Next, add the small firm and thin trading risk premiums.
Equity risk premium according to the macroeconomic model:
[(1 + EINFL)(1 + EGREPS)(1 + EGPE) 1] + EINC Expected risk-free rate
where
EINFL= expected inflation
EGREPS= expected growth in real earnings per share
EGPE= expected growth in P/E
EINC= expected income component
Equity risk premium: [(1.0181)(1.03)(1.015) 1] + 0.025 0.04 4.94%
Plus: Risk premiums for small firm and thin trading: 1.50% + 0.75% 2.25%
Equals: Risk premium for BTP including premiums for small firm and thin trading 7.19%
A is incorrect because it ignores the expected growth rate in P/E ratio.
Equity risk premium: [(1.0181)(1.03) 1] + 0.025 0.04 3.37%
Plus: Risk premia for small firm and thin trading: 1.50% + 0.75% 2.25%
= Risk premium for BTP including premia for small firm and thin trading 5.62%
B is incorrect because it mistakenly uses TIPs yield for expected inflation
Equity risk premium: {[(1.0215)(1.03)(1.015) 1] + 0.025} 0.04 5.29%
Plus: Risk premia for small firm and thin trading: 1.50% + 0.75% 2.25%
= Risk premium for BTP including premia for small firm and thin trading 7.54%

Q. Which of the three caveats regarding the historical estimates of risk premium that
Royappa has stated is least accurate?
A. Caveat 2
B. Caveat 1
C. Caveat 3
Solution
C is correct. Caveat 3, the caveat concerning survivorship bias, is the least accurate.
Survivorship bias in equity market data series arises when poorly performing or defunct
companies are removed from membership in an index, so only relative winners remain.
Survivorship bias tends to inflate historical estimates of the equity risk premium. When
using a series that has such bias, however, the historical risk premium estimate should
be adjusted downward.
A is incorrect because it is an accurate statement. A bond-based equity risk premium
estimate in almost all cases is smaller than a bill-based estimate.
B is incorrect because it is an accurate statement. The arithmetic mean return as the
average one-period return best represents the mean return in a single period. The major
finance models for estimating required return—in particular the CAPM and multifactor
models—are single-period models, so the arithmetic mean, with its focus on single-
period returns, appears to be a model-consistent choice.

Q. Which of the three statements regarding relative valuation approaches that Smirnoff
has stated is most accurate? Her statement concerning the:
A. justified P/B.
B. P/E.
C. PEG measure.
Solution
B is correct. BTP is a cyclical company. Empirically, P/Es for cyclical companies are
often highly volatile over a cycle even without any change in business prospects. High
P/Es on depressed earnings per share (EPS) at the bottom of the cycle and low P/Es on
unusually high EPS at the top of the cycle reflect the countercyclical property of P/Es
known as the Molodovsky effect.
A is incorrect because the justified P/B computed suggests that if we are evaluating two
stocks with the same P/B, the one with the higher ROE is relatively undervalued, all else
equal. These relationships have been confirmed through cross-sectional regression
analyses.
C is incorrect because PEG does not factor in differences in risk, an important
determinant of P/E. PEG does not account for differences in the duration of growth.

Learning Outcomes
valuation
Q. Using the data in Exhibit 2 and the adjustment suggested by Smirnoff, BTP’s justified
P/B is closest to:
1. 1.98.
2. 3.11.
3. 3.30.
Solution
A is correct. ROE = Net income/Book value of equity = 20/100 = 20.0%
Justified P/B = P0/B0 = (ROE – g)/(r – g) = (0.20 – 0.055)/(0.11 – 0.055) = 2.64
Adjustment per Smirnoff’s suggestion: 2.64 × (1 – 0.25) = 1.98
B is incorrect because it uses WACC for r rather than the required return on stock.
P/B = (ROE – g)/(r – g) = (0.20 – 0.055)/(0.09 – 0.055) = 4.14
Adjustment per Smirnoff's suggestion: 4.14 ×(1 – 0.25) = 3.11
C is incorrect because it makes an incorrect adjustment for Smirnoff’s suggested
discount.
Adjustment per Smirnoff's suggestion: 2.64 ×(1 + 0.25) = 3.30

Learning Outcome
Q. Using the data in Exhibit 2 and the adjustment suggested by Smirnoff, BTP’s
EV/EBITDA multiple is closest to:
1. 3.36.
2. 2.31.
3. 2.02.
Solution
C is correct.
EV = Market value of equity + Debt – Cash = 250 + 150 – 50 = 350
EBITDA= Net Income + Interest + Taxes + Depreciation + Amortization = 20 + 5 + 10 +
80 + 15 = 130
EV/EBITDA = 2.69
Adjustment per Smirnoff’s suggestion: 2.69 × (1 – 0.25) = 2.02
A is incorrect because it incorrectly applies the 25% discount per Smirnoff’s suggestion.
Adjustment per Smirnoff’s suggestion: 2.69 × (1 + 0.25) = 3.36
B is incorrect because it ignores cash.
EV = Market value of equity + Debt (ignores cash): 250 + 150 = 400
EBITDA= Net income + Interest + Taxes + Depreciation + Amortization = 130
EV/EBITDA = 3.08
Adjustment per Smirnoff's suggestion: 3.08 × (1 – 0.25) = 2.31

Learning Outcome
DongSun Electronics Case Scenario

Kim Chung-hee is an equity analyst with Incheon Securities. Kim is writing a research
report on DongSun Electronics, a South Korean company that is dual-listed on a US
exchange and complies with US GAAP. As part of his analysis, Kim wants to determine
the intrinsic value of DongSun’s common shares under both residual income and
comparable valuation methods.
When examining DongSun’s financial data, Kim notices that the company is underusing
its debt capacity and its debt ratio is well below the optimal level. To support the
valuation process, Kim assembles in Exhibit 1 selected financial information from
DongSun’s 2013 and 2012 audited financial statements (values stated in South Korean
won [KRW]). Other financial data pertaining to the valuation of DongSun’s shares at 31
December 2013 are shown in Exhibit 2.
EXHIBIT 1
SELECTED INFORMATION FROM DONGSUN’S 2013 AND 2012 FINANCIAL
STATEMENTS (KRW MILLIONS, EXCEPT WHERE NOTED)
Year Ended 31 December 2013
Net income 105,000
Dividends 42,000
Number of common shares outstanding (actual) 30,000,000
KRW at 31 December,
2013 2012
Total stockholders’ equity 750,000 687,000

EXHIBIT 2
OTHER FINANCIAL DATA FOR DONGSUN ELECTRONICS
Pretax cost of long-term debt 6%
Required return on equity 12%
Market price per share at 31 December 2013 KRW62,000

At 31 December 2013, Kim provides the following forecasted fundamentals for
DongSun:
 projected earnings per share (EPS) for 2013 are KRW4,000;
 expected long-term return on equity (ROE) is 15%;
 DongSun will retain 60% of its earnings over the long term; and
 after 2014, earnings and dividends will grow at 9% per year.
Kim’s supervisor is concerned that the residual income model may not apply, and she
asks Kim to investigate possible clean surplus violations. Looking at DongSun’s
financial statement information, Kim considers three items with possible violations to
clean surplus accounting:
1. Marketable securities classified as available-for-sale
2. Non-domestic currency transactions with customers and suppliers
3. Non-domestic currency translation adjustments from the consolidation of any self-
sustaining subsidiary companies (for which the local currency is the functional
currency)
Upon completing the analysis, Kim concludes that the net effects are not material to the
financial statements and, accordingly, makes no adjustments to the information in
Exhibit 1.
Kim believes that analyst forecasts are too pessimistic with respect to DongSun’s
residual income prospects after 2014. In a recent conference call, DongSun’s
management presented its plan to improve future profitability, particularly the economic
value added (EVA), by focusing on the following three strategic company goals:
1. Adjust financial leverage to the optimal level.
2. Implement efficiencies in administrative functions.
3. Reduce research and development (R&D) expenses.
As a final question, Kim’s supervisor asks him why he prefers the residual income
model to other approaches.
Q. Using the information in Exhibits 1 and 2, DongSun’s residual income (in millions) in
2013 is closest to:
A. KRW63,000.
B. KRW15,000.
C. KRW22,560.
Solution
C is correct.
KRW millions
Net income 105,000
Minus equity charge* 0.12 × KRW687,000 82,440
Residual income 22,560

* Based on start-of-year equity×Cost of equity
A is incorrect because it ignores the equity charge and calculates RI as Net income
Dividends: 105,000 42,000 = 63,000.
B is incorrect because it calculates the equity charge based on end of year equity:
105,000 (0.12 × 750,000) = 15,000.

value added
Q. Using the information in Exhibit 2 and Kim’s forecasted fundamentals, the justified
forward P/E for DongSun common stock at 31 December 2013 is closest to:
1. 10.0.
2. 13.3.
3. 15.5.
Solution
B is correct.
Justified forward P/E = P0/E1 = Payout ratio/(r – g)
Payout ratio = 1 – b = 1 – 0.60 = 0.40
r = 12% (given in Exhibit 2)
g = sustainable growth rate = ROE × b = 0.15 × 0.60 = 0.09 (also given as part of Kim’s
forecasted fundamentals)
Justified P0/E1 = 0.40/(0.12 – 0.09) = 13.3
A is incorrect because it interchanges payout and retention ratio throughout the
calculation: g = 0.15 ×0.40 = 0.06, so that P/E = 0.60/(0.12 – 0.06) = 10.
C is incorrect because it is the market-based P/E, not the justified P/E; it is the
KRW62,000 market value per share/2013 consensus KRW4,000 earnings per share for
the stock: 62,000/4,000 = 15.5.

Learning Outcome
Q. Using the information in Exhibits 1 and 2, Kim’s forecasts, and the single-stage
(constant growth) residual income approach, the justified price-to-book ratio (P/B) at 31
December 2013 for DongSun common stock is closest to:
A. 1.66.
B. 2.00.
C. 2.48.
Solution
B is correct. The justified P/B using a single-stage (constant growth) residual income
approach is given by
P0/B0P0/B0 = (ROE–g)/(r–g)(ROE–g)/(r–g)
= (0.15–0.09)/(0.12–0.09)(0.15–0.09)/(0.12–0.09)
= 2.002.00
A is incorrect because it uses the historical 2013 ROE (Net income/Total stockholders’
equity) of 105,000/750,000 = 14%. Using this in the formula:
(0.14 – 0.09)/(0.12 – 0.09) = 1.66
C is incorrect because it is the 2013 year-end market price per share divided by BV per
share, where BV per share = Year-end shareholders’ equity/Number of shares =
KRW750,000/30 = KRW25,000, giving P/B = KRW62,000/KRW25,000 = 2.48.

Learning Outcome

e. Explain the relation between residual income valuation and the justified price-to-book
ratio based on forecasted fundamentals
Q. With respect to the three items that Kim examined, which item is least likely to result
in a clean surplus accounting violation?
A. Item 2
B. Item 1
C. Item 3
Solution
A is correct. There is no clean surplus violation if the ending book value of equity is
equal to the beginning book value plus earnings minus dividends, apart from ownership
transactions. In the ordinary course of business, non-domestic currency transactions
with customers and suppliers (resulting from import purchase or export sale) are
accounted for on both the income statement and balance sheet at fair value, and hence
they do not violate clean surplus accounting. The other two items examined would affect
other comprehensive income and hence violate the equity clean surplus relationship.
B is incorrect because although available for sale marketable securities are measured
at fair market value on the balance sheet, any unrealized gains and losses that arise
bypass the income statement and are reported in equity as a component of other
comprehensive income thereby violating the clean surplus relationship.
C is incorrect because financial statements of self-sustaining subsidiaries will be
translated using the current rate method and any foreign exchange gains and losses will
bypass the income statement and go into other comprehensive income, thus violating
the clean surplus relationship.
Intercorporate Investments Learning Outcome

b. Distinguish between IFRS and US GAAP in the classification, measurement, and
disclosure of investments in financial assets, investments in associates, joint
ventures, business combinations, and special purpose and variable interest entities
Multinational Operations Learning Outcome

c. Analyze how changes in exchange rates affect the translated sales of the subsidiary
and parent company

k. Describe accounting issues in applying residual income models
Q. Which of management’s three strategic goals will least likely result in a higher EVA
for DongSun?
A. Goal 1
B. Goal 2
C. Goal 3
Solution
C is correct. By definition, EVA = NOPAT – (C% × TC), where NOPAT is the net
operating profit after taxes, C% is the cost of capital, and TC is the total capital
employed. Efficiencies in the administrative functions will decrease operating expenses,
increase NOPAT, and thus increase EVA. Adjusting financial leverage to the optimal
level will decrease the cost of capital and thus increase EVA. R&D costs are added
back to NOPAT when calculating EVA. Therefore, decreasing R&D will serve to lower
NOPAT and thus lower EVA.
A is incorrect because adjusting financial leverage to the optimal level will decrease the
cost of capital and therefore increase EVA.
B is incorrect because efficiencies in the administrative functions will decrease
operating expenses, increase NOPAT, and thus increase EVA.

value added
Q. Which of the following is the most appropriate response Kim can make to his
supervisor’s final question?
A. The analyst need not adjust the book value of common equity for non-recurring
items.
B. The analyst need not adjust book value of common equity for off-balance-sheet
items.
C. The interest expense in the residual income model correctly captures the cost of
debt capital.
Solution
A is correct. Although it is important to adjust income for non-recurring items, these
adjustments do not need to be made to the book value because they are already
reflected in the value of the assets.
B is incorrect because it is necessary to adjust for off-balance sheet items.
C is incorrect because it is a weakness of residual income that interest expense may
not reflect the true cost of debt capital.

b. Describe the uses of residual income models
Darwin Industrial Case Scenario

Gabrielle Marchand and Cristiano Palmeiro are junior analysts recently hired by
Nordfjord Investment Management, an international investment firm. They have been
assigned by senior analyst Anniken Kristensen to work as a team to research Darwin
Industrial (Darwin), a major company in the paints and coatings industry.
Marchand and Palmeiro start by researching the industry. They discuss how the
competitive environment could impact profitability and make the following notes:
 The industry is fragmented, and there is a strong rivalry for market share, particularly
among the larger participants.
 Paints and coatings are the logical or only choice for many applications, but
alternatives, such as aluminum, vinyl, and wood, are available for some situations.
 There is some brand loyalty, although it is not pervasive. The essentially identical
product offerings from the various manufacturers enable customers to easily switch
brands.
In developing their sales and expense forecasts for 2016, Marchand and Palmeiro
review selected financial data on Darwin and selected economic factors, as shown in
Exhibit 1. Using 2015 as the base year, the analysts expect Darwin’s
 sales to grow 1% faster than projected nominal global GDP growth,
 cost of goods sold as a percent of sales to decline 0.5% annually,
 selling expenses to remain stable as a percentage of sales,
 general and administrative and depreciation and amortization expenses to be fixed,
and
 net debt to decline €100 million in 2016.
EXHIBIT 1
DARWIN INDUSTRIAL SELECTED FINANCIAL DATA
2014
2015
(€ millions)
(€ millions)
Income statement
Sales 8,838 9,280
Cost of goods sold (COGS) 5,183 5,401
Gross profit 3,655 3,879
Selling expenses 1,836 1,940
General and administrative expenses (G&A) 485 485
Depreciation and amortization expenses (D&A) 294 294
Operating profit 1,040 1,160
Interest expense 96 92
Earnings before taxes (EBT) 944 1,068
Income taxes (30%) 283 320
Net profit 661 748
Average balance sheet items
Total assets 7,730
Net debt 1,533

2014
2015
(€ millions)
(€ millions)
Total liabilities 4,279
Total equity 3,451
Selected Economic Data
2016 global GDP growth rate 4.50%

Marchand and Palmeiro use a five-year forecast horizon when building their long-term
model for Darwin after considering the following factors:
Factor 1: Nordjford has historically experienced a 25% annual turnover in its equity
portfolio.
Factor 2: The paint and coatings industry’s performance is closely tied to the business
cycle.
Factor 3: Darwin recently announced a corporate restructuring, and the benefits are
expected to be fully realized by the end of 2017.
After completing their forecast of the income statement, Marchand and Palmeiro
discuss approaches to forecasting balance sheet accounts. Marchand asks Palmeiro
which accounts on the balance sheet can be most reliably forecasted from the income
statement.
Kristensen and her team then move on to a discussion of the various ways of
comparing Darwin’s profitability with other firms in the industry, and they make the
following comments:
Kristensen: I prefer return on invested capital (ROIC) because it is not affected by the
amount of debt on Darwin’s balance sheet.
Palmeiro: Return on equity (ROE) is the most common measure of shareholder return,
although Darwin’s share repurchase program will affect the relevance of the ratio.
Marchand: We could use return on capital employed (ROCE), but its significance will be
limited if we compare Darwin with companies based in other countries.
Q. Based on Marchand and Palmeiro’s notes, the industry’s competitive strength

is most likely related to the:
A. threat of substitutes.
B. rivalry among the firms.
C. bargaining power of buyers.
Solution
A is correct. Marchand and Palmeiro’s analysis indicates that although there are
alternative products available for some situations, paints and coatings are the logical or
only choice for many applications. Thus, the threat of substitutes would be considered
low to medium, which would improve the competitive position and profitability of firms in
the industry.
B is incorrect because the industry is fragmented with no dominant market leader, and
there is a strong rivalry for market share, which limits pricing power. This would reduce
competitive strength and profit opportunities.
C is incorrect because Brand loyalty is not of great importance to customers. Many
products are basically identical, and switching costs for customers is low. This would
reduce competitive strength and profit opportunities.

Q. Marchand and Palmeiro’s modeling approach can be best described as:

A. bottom-up.
B. hybrid.
C. top-down.
Solution
B is correct. The analysts base their sales forecasts on economic factors, including
GDP growth, which is a top-down approach. They also base their projections on an
analysis of the company’s historical sales and expense data, which is a bottom-up
approach. Thus, by using a combination of top-down and bottom-up approaches,
Marchand and Palmeiro are using a hybrid approach.
A and C are incorrect because the analysts base their sales forecasts on economic
factors, including GDP growth, which is a top-down approach. They also base their
projections on an analysis of the company’s historical sales and expense data, which is
a bottom-up approach. Thus, by using a combination of top-down and bottom-up
approaches, Marchand and Palmeiro are using a hybrid approach.

a. Compare top-down, bottom-up, and hybrid approaches for developing inputs to
equity valuation models
b. Compare “growth relative to GDP growth” and “market growth and market share”
approaches to forecasting revenue
Q. Based on the analysts’ sales and expense forecasts and the data in Exhibit 1, their
forecasted net profit for Darwin in 2016 will be closest to:
A. €861 million.
B. €853 million.
C. €827 million.
Solution
A is correct.
2015 2016
(€ millions) 2016 vs. 2015 Calculation (€ millions)
Sales 9,280 GDP + 1% = 5.5% increase 9,280 × 1.055 9,791
COGS 5,401 Percentage of sales, expected to [(5,401/9,280) 5,649

decline 0.5% in 2016 0.005)] ×9,790
Selling 1,940 Stable percentage of sales (1,940/9,280)× 9,790 2,047

expenses
G&A 485 No change 485

expenses
D&A 294 No change 294

expenses
Operating 1,160 1,316

profit
Interest 92 Rate on 2015 net debt 1,433× 0.06 86

expense = 92/1,533 = 6%
Debt to decline by €100 million
EBT 1,068 1,230
Income 320 30% tax rate 1,230×0.3 369

taxes
Net profit 748 861

B is incorrect because the candidate incorrectly calculates interest expense as a
percentage of sales instead of debt.
2015 2016
COGS 5,401 Percentage of sales, expected to [(5,401/9,280) 5,649

decline 0.5% in 2016 0.005)] ×9,790

expenses

expenses

expenses

profit
Interest 92 Rate on 2015 net debt Cost of 2016 net 97

expense = 92/9,280 (sales) = 0.99% debt
= 9,790 × 0.99% =
97
EBT 1,068 1,219
Income 320 30% tax rate 1,219 × 0.3 366

taxes
Net profit 748 853

C is incorrect because the candidate did not reduce the COGS by 0.5% in 2016.
2015 2016

2015 2016
COGS 5,401 COGS did not decline by [(5,401/9,280) 5,698

0.5% as % of sales 0.005)] ×9,790

expenses

expenses

expenses

profit
Interest 92 Rate on 2015 net debt 1,433× 0.06 86

expense = 92/1,533 = 6%
Debt to decline by 100
EBT 1,068 1,181
Income 320 30% tax rate 1,181 × 0.3 354

taxes
Net profit 748 827

d. Forecast the following costs: cost of goods sold, selling general and administrative
costs, financing costs, and income taxes
m. Demonstrate the development of a sales-based pro forma company model
Q. Which factor considered by Marchand and Palmeiro best justifies the use of the five-
year forecast horizon in the Darwin model?
1. Factor 2
2. Factor 1
3. Factor 3
Solution
A is correct. Industry cyclicality can influence the analyst’s choice of timeframe
because the forecast period should be long enough to allow the business to reach an
expected mid-cycle level of sales and profitability. Factor 2 best justifies the use of a
five-year forecast horizon given that the industry’s performance is closely tied to the
business cycle.
B is incorrect because Nordjford’s 25% annual turnover would be more consistent with a
four-year forecast horizon.
C is incorrect because given that the benefits of the corporate restructuring are
expected to be fully realized within two years, a five-year forecast horizon is more than
sufficient to see the impact in Darwin’s financial statements.

k. Explain considerations in the choice of an explicit forecast horizon
Q. The best answer to Marchand’s question about forecasting balance sheet accounts
is:
1. operating loans.
2. property, plant, and equipment.
3. inventory.
Solution
C is correct. The income statement can be the starting point for balance sheet
modeling. A common way to forecast working capital accounts (i.e., inventory) would be
by using efficiency ratios, such as inventory turnover. Projections for long-term assets,
such as property, plant, and equipment, are less directly tied to the income statement.
The operating loan balance would depend on the working capital needs and cash flow
forecasts, so it is two steps removed from the income statement.
B is incorrect because projections for long-term assets such as PP&E are less directly
tied to the income statement and more to capital expenditure plans.
A is incorrect because the operating loan balance would depend on the working capital
needs and cash flow forecasts so it is two steps removed from the income statement.
e. Describe approaches to balance sheet modeling
Q. Which of the three analysts’ comments about the methods used to compare Darwin’s
profitability with other firms in the industry is the least accurate?
1. Kristensen’s
2. Marchand’s
3. Palmeiro’s
Solution
B is correct. Marchand’s comment is the least accurate. ROCE is essentially ROIC
before tax and is defined as operating profit divided by capital employed. As a pre-tax
measure, ROCE is useful when comparing peer companies in different countries
because the comparison of underlying profitability would not favor companies benefiting
from low tax rate systems.
A is incorrect because Kristensen’s statement is accurate. ROIC is a better measure of
profitability than ROE because it is not affected by a company’s financial leverage.
C is incorrect because Palmeiro’s statement is accurate. A disadvantage of using ROE
is that it is affected by financial leverage. A company could reduce equity by
repurchasing shares and have a higher ROE even if earnings were unchanged from
year to year.

f. Describe the relationship between return on invested capital and competitive
advantage
McLaughlin Corporation Case Scenario

Chan Mei Yee is valuing McLaughlin Corporation common shares using a free cash
flow approach. Yee gathered information about McLaughlin from several sources. She
begins her analysis by determining free cash flow to the firm (FCFF) and free cash flow
to equity (FCFE) for the 2012 fiscal year, using the financial statements in Exhibits 1
and 2. McLaughlin’s fiscal year ends 31 December.
EXHIBIT 1
MCLAUGHLIN CORPORATION SELECTED FINANCIAL DATA ($ MILLIONS,
EXCEPT PER SHARE AMOUNTS)
For Year Ending 31 December 2012
Revenues $6,456
Earnings before interest, taxes, depreciation, and amortization (EBITDA) 1,349
Depreciation expense 243
Operating income 1,106
Interest expense 186
Pretax income 920
Income tax (32%) 294
Net income $626
Number of outstanding shares (millions) 411
2012 earnings per share $1.52
2012 dividends paid (millions) 148
2012 dividends per share 0.36
2012 fixed capital investment (millions) 535
Cost of equity 12.0%

EXHIBIT 2
MCLAUGHLIN CORPORATION CONSOLIDATED BALANCE SHEETS ($ MILLIONS)
as of 31 December
2012 2011
Assets
Cash and cash equivalents $32 $21

as of 31 December
Accounts receivable 413 417
Inventories 709 638
Other current assets 136 123
Total current assets $1,290 $1,199
Current liabilities $2,783 $2,678
Long-term debt 2,249 2,449
Common stockholders’ equity 1,072 594
Total liabilities and stockholders’ equity $6,104 $5,721

Yee plans to perform two different valuations of McLaughlin, which she calls the “base
case” valuation and the “alternative” valuation. Critical assumptions for each are given
in the following lists.
Base case valuation
 2013 FCFF will be $600 million.
 Beyond 2013, FCFF will grow in perpetuity at 4% annually.
 The market value and book value of McLaughlin’s long-term debt are approximately
equal.
Alternative valuation
 2013 earnings per share (EPS) will be $1.80.
 EPS will grow forever at 6% annually.
 For 2013 and beyond:
o Net capital expenditures (fixed capital expenditures minus depreciation) will be
30% of EPS.
o Investments in working capital will be 10% of EPS.
o Of future investments, 60% will be financed with equity and 40% will be financed
with debt.
Yee is also concerned about the effects on McLaughlin’s 2013 FCFE of the following
three possible financial actions by McLaughlin during the year 2013:
 Increasing common stock cash dividends by $110 million
 Repurchasing $60 million of common shares
 Reducing its outstanding long-term debt by $100 million
Melissa Nicosia, Yee’s supervisor, reviews McLaughlin’s valuations. Specifically,
Nicosia makes the following three statements:
1. The free cash flow valuation approach is superior to the discounted dividend
valuation approach because the company’s dividends have been substantially
different from its FCFE.
2. Because the company’s capital structure seems unstable, the FCFE valuation
approach is superior to the FCFF valuation approach.
3. If there is a change in control at McLaughlin, the discounted dividend valuation
approach would be superior to a free cash flow valuation approach.
Q. McLaughlin’s FCFF ($ millions) for 2012 is closest to:

A. $418.
B. $485.
C. $460.
Solution
B is correct.
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
Net income (given) = $626; Non-cash charges (depreciation, given) = $243; Interest
expense (given) = $186; Tax rate = 294/920 = 32%; Fixed capital investment (given) =
$535
2012 2011 Net increase

Working Capital Investment ($ millions) ($ millions) ($ millions)
Current assets excluding cash 1,290 32 = 1,258 1,199 21 =1,178
Current liabilities 2,783 2,678
Working capital 1,525 1,500 25

FCFF = 626 + 243 + 186(1 0.32) 535 ( 25) = 485.48 = $485 million
A is incorrect because it uses t not (1 t).
FCFF = 626 + 243 + 186(0.32) 535 ( 25) = 418.2 = $418 million
C is incorrect because it ignores working capital investment
FCFF = 626 + 243 + 186(1 0.32) 535 = 460.48 = $460 million

Q. Assuming 2012 FCFF equals $500 million, McLaughlin’s FCFE ($ millions) for 2012
is closest to:
A. $574.
B. $174.
C. $114.
Solution
B is correct.
FCFE = FCFF Interest(1 T) + Net borrowing
Given: 2012 FCFF base case estimate = $500; Interest expense = $186; Tax rate =
32%
2012 2011 Net increase
Long-term debt ($) 2,249 2,449 200

FCFE = 500 186 × (1 0.32) + ( 200) = $174 million
A is incorrect because it switches the sign for net borrowing
FCFE = 500 186× (1 0.32) + 200 = $574 million
C is incorrect because it ignores tax adjustment for interest expense.
FCFE = 500 186 + ( 200) = $114 million

Q. Using Yee’s base case valuation assumptions and the FCFF valuation approach, the
year-end 2012 value per share of McLaughlin common stock is closest to:
A. $29.20.
B. $12.78.
C. $23.73.
Solution
C is correct. In the base case, the growth rate is stable, thus using the constant-
growth FCFF model the value of the firm is
Firm value=FCFF1WACC g=6000.09 0.04=$12,000 millionFirm
value=FCFF1WACC g=6000.09 0.04=$12,000 million
Equity valueEquity Firm value Market value of debt=12,000–2,249=$9,751 million.Firm

=
value value Market value of debt=12,000–2,249=$9,751 million.
Value per
shareValue per = Equity valueNumber of sharesEquity valueNumber of shares
share
=
9,751 million411 million9,751 million411 million
= 23.7251=$23.73 per share23.7251=$23.73 per share

A is incorrect because it does not deduct the market value of debt: $12 million/411
million shares = $29.20.
B is incorrect because it uses cost of equity, not WACC: [600/(0.12 – 0.04) – 2249]/411
= 12.78.

Q. Using Yee’s alternative valuation assumptions and the FCFE valuation approach, the
year-end 2012 value per share of McLaughlin’s common stock is closest to:
A. $24.17.
B. $18.00.
C. $22.80.
Solution
C is correct. First, it is necessary to estimate FCFE2013.
FCFE = Net income – (1 – DR) × (FCInv – Depreciation) – (1 – DR) ×(WCInv)
where
DR = debt ratio, which is 40%
FCInv = investment in fixed capital, which is 30% of EPS
WCInv = investment in working capital, which is 10% of EPS
On a per-share basis:
1.80 (1 0.40)×(0.30×1.80) (1 0.40)×(0.10×

FCFE1(2013)FCFE1(2013) =
1.80)1.80 (1 0.40)×(0.30×1.80) (1 0.40)×(0.10×1.80)
= 1.80 0.324 0.1081.80 0.324 0.108

= 1.368.1.368.
FCFE will grow at the same rate as net income, 6% annually.
Equity value=FCFE1r g=1.3680.12

0.06=$22.80Equity value=FCFE1r g=1.3680.12 0.06=$22.80
The value per share is $22.80.
A is incorrect because it uses FCFE1 ×(1 + g) = 1.368 × (1.06)/(0.12 – 0.06) = 24.17.
B is incorrect because it uses FCFF: (1.80 – 0.54 – 0.18 )/(0.12 – 0.06) = 18.00

Q. The most likely combined effect of the three possible financial actions identified by
Yee will reduce McLaughlin’s 2013 FCFE ($ millions) by:
A. $100.
B. $270.
C. $160.
Solution
A is correct. The three possible actions are:
1. Increasing common dividends = $110 million, which is a use of FCFE—no effect on
FCFE.
2. Share repurchase = $60 million, which is a use of FCFE—no effect on FCFE.
3. Debt repayment = $100 million, which will reduce FCFE by the full amount.
Therefore, FCFE will decrease by $100 million. Reducing debt by $100 million reduces
FCFE (the amount of cash available to equity holders) by that amount. The cash
dividend and the share repurchase are uses of FCFE and do not change the amount of
cash available to equity holders.
B is incorrect because it adds all three amounts.
C is incorrect because it adds long-term debt of $100 million and $60 million share
repurchases.

Q. Which of Nicosia’s three statements pertaining to McLaughlin’s valuation is

the most accurate? Statement:
A. 2
B. 3
C. 1
Solution
C is correct. Nicosia’s first statement is correct. Analysts should use a FCFE valuation
whenever dividends differ significantly from the company’s capacity to pay dividends or
when a change of control is anticipated. A FCFF valuation is preferred over a FCFE
valuation whenever the capital structure is unstable or ever-changing. So, Nicosia’s first
statement is correct, and her second and third statements are incorrect.
A is incorrect because analysts should use free cash flow to equity valuation whenever
dividends differ significantly from the company’s capacity to pay dividends. FCFF
valuation is preferred over FCFE valuation whenever the capital structure is unstable or
ever-changing.
B is incorrect because with control comes discretion over the uses of free cash flow, as
does the capacity to change dividend levels. As such, a free cash flow valuation
approach is likely to be superior to a discounted dividend valuation approach.

f. Compare the FCFE model and dividend discount models

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PBRI Data SRNC Data

Equity beta 1.20 1.60

Debt ratio (Debt/Total assets) 0.20 0.60

Required return on equity 12.40%

Weighted average cost of capital (WACC) 10.60%

Dividend payout ratio 60%

Most recent earnings per share $5.33

Dividends and earnings growth rate after Year 10 4.00%

Current stock price $70.00

Current year net income $8.0 million

Interest expense $1.2 million

Equity capital book value, beginning of year $20.97 million

Cost of equity capital 12.4%

Tax rate 40%

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Net income $422 million

Common stock (par plus paid-in-excess of par) $1,075 million

Retained earnings $1,078 million

Weighted average cost of capital 11.9%

Cost of debt, before tax 7.0%

Cost of equity capital 15%

Expected dividend growth behavior:

Expected for 2014 14%

The final and perpetual growth rate: 5%

Estimated earnings per share (EPS) in 2019 $5.04

Dividend payout ratio 40%

Shares outstanding 150 million

Forecasted residual income (RI) per share at end of 2023 $5.32

Estimated return on equity (ROE) in 2023 20%

Nature of stream beyond 2023 Perpetuity

Growth rate beyond 2023 0%

Cost of equity 15%

Dividend payout 40%