Seminar 10 N1591

Seminar 10 N1591
Valuation of Companies and Cash Flow Generating Assets (N1591)

Autumn Term 2019/20
Seminar 10: Flexibility (McK Chap 35)

and
Revisions
Flexibility (McK Chap 35)
1. We have a company which has developed a new drug which is about to start clinical
tests.
R&D expenses have been paid, but the drug requires an $ 210 investment for
production and distribution one year from now.
Following the outcome of these clinical tests next year, the product will be sold onto
the market. The tests have two outcomes with equal probability:
 Successful: $ 25/year in after-tax cash flows forever.

 Unsuccessful: $ 5/year in after-tax cash flows forever.
The risk-free rate is 5% and the WACC of the company is 10%.
 What is the standard NPV of the project?

 What is the contingent NPV if you can delay the $ 210 investment until the
outcome of the tests next year?
 Which NPV is higher, could that result have been anticipated?
 What is the value of the option to defer?
 What happens if the probability of success increases to 60%? Explain the result.
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Seminar 10 N1591
Essay Questions
2. Why can it be argued that the Enterprise Value/EBITA multiple is a better multiple
than the Enterprise Value/EBITDA multiple and the Price/Earnings multiple?
3. When performing a valuation, the forecast is spilt up between an Explicit Forecast

period and a Continuing Value. Why is this done? Discuss the difference between both
periods.
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Seminar 10 N1591
Multiple Choice Questions
4. Low ROIC companies typically create more value by _______ while higher ROIC
companies create more value by _________.
A. Focusing on growth/Increasing investments

B. Managing NOPLAT/Increasing ROIC
C. Stabilising growth/Increasing WACC
D. Increasing ROIC/Focusing on growth
5. If the growth of a company is 2% and the ROIC is 10%, what is the investment rate?
A. 25%
B. 50%
C. 60%
D. 20%
6. For a given company, next year’s NOPLAT is $ 600. For the foreseeable future,
the growth rate will be 5%, the ROIC will be 10%, and the WACC will be 20%. Using
the Key Driver Formula, calculate the value of the company.
A. $ 1,666
B. $ 2,000
C. $ 2,500
D. $ 2,750
7. Given that a company charges $ 3.40 per unit, has a cost per unit of $ 1.80, a tax
rate of 32%, and requires $ 16 of invested capital per unit, what is ROIC?
A. 6.8%
B. 10.2%
C. 15.6%
D. 30.3%
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Seminar 10 N1591
8. Which of the following explains the reasons that growth-rate rankings change among
industries so much over time?
I. The business cycle.

II. Changing regulations.
III. Fluctuating exchange rates.
IV. Product life cycles.
A. I and II only.
B. I and IV only.
C. II and III only.
D. III and IV only.
9. How will an increase in invested capital affect FCF and ROIC if all other things are
kept equal?
A. It will decrease both FCF and ROIC.

B. It will increase both FCF and ROIC.
C. It will increase FCF but decrease ROIC.
D. It will decrease FCF but increase ROIC.
10. In calculating FCF, which of the following are not an investment which should be
subtracted from gross cash flow?
A. Changes in operating working capital.

B. Changes in debt outstanding.
C. Net capital expenditures.
D. Investments in acquired intangibles.
11. Which of the following is most accurate?
A. Analysing ROIC excluding goodwill is the best measure for determining value
created for shareholders.
B. Analysing ROIC excluding goodwill serves no purpose.
C. Analysing ROIC excluding goodwill is the preferred method for most analysts.
D. None of these statements are true.
12. Other things being constant, if EBITA and revenue both increase by 10%, then it is
likely that:
A. ROIC will decrease.

B. ROIC will remain the same.
C. ROIC will increase.
D. ROIC will change, but the direction is not certain.
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Seminar 10 N1591
13. If a company forecasts that its capital expenditures will be smooth, then which is
the better method to use for forecasting depreciation?
(i) Using a percentage of revenues; or

(ii) Using a percentage of PP&E.
A. Percentage of revenues only.

Percentage of PP&E only.
C. Either method is appropriate because the choice does not matter if expenditures
are smooth.
D. Neither method is appropriate when expenditures are smooth.
14. The value of a steady state company:
A. Can be estimated by estimating FCF and using the growth perpetuity model.
B. Can be estimated using the quadratic formula.
C. Can be estimated using the PP&E method.
D. Cannot be estimated because at zero growth, the solution involves division by zero.
15. Which of the following is not one of the steps in the forecast of individual line items
reacted to the income statement?
A. Determine the economic relationships that drive the model.

B. Model the business cycle.
C. Estimate the forecast ratios.
D. Forecast the drivers and multiply times the respective ratios.
16. As a firm begins to grow and faces increasing competition as it expands, which of
the following is the most likely to be the relationships among ROIC on base capital,
RONIC and ROIC on total capital?
A. ROIC on base capital < RONIC < ROIC on total capital.

B. ROIC on base capital > RONIC > ROIC on total capital.
C. ROIC on base capital > ROIC on total capital > RONIC.
D. ROIC on base capital < ROIC on total capital < RONIC.
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Seminar 10 N1591
17. In computing the cost of equity for a firm, which of the following are recommend
steps in estimating the CAPM beta using regression analysis?
I. Use sample size equal to or greater than 60.

II. Use daily returns.
III. Use a diversified value-weighted index.
IV. Watch for possible distortions from market bubbles.
A. I, II and III only.

B. I, III and IV only.
C. II and IV only.
D. II, III and IV only.
18. The weights in the WACC should reflect:
A. Current book values.

B. Current market values.
C. Target market based values.
D. Book values in case of bonds and market values in case of equity.
19. Company X controls Company Y so that Company Y’s financial statements are
fully consolidated in the group accounts. With respect to Company X’s financial
statements, third party stakes in Company Y:
A. Are mot of concern.

B. Are to be deducted and are called non-controlling interest.
C. Are to be added and are called non-controlling interest.
D. Are illegal.
20. Which of the following is not a question related to the economic consistency of a
model?
A. Are the patterns intended?

B. Are the patterns reasonable?
C. Are the patterns chartable?
D. Are the patterns consistent with industry dynamics?
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Seminar 10 N1591
21. Which of the following are reasons that the Value/EBITA ratio is superior to the
Price/Earnings ratio as a multiple to aid in valuation?
I. P/E is distorted by capital structure.

II. P/E is distorted by inflation.
III. P/E is distorted by non-operating gains and losses.
IV. P/E is distorted by dividend pay-outs.
A. I and III only.

B. II and III only.
C. II and IV only.
D. I, III and IV only.
22. Increasing growth while holding ROIC, the tax rate and WACC constant will:
A. Increase the Value/EBITA ratio.

B. Not affect the Value/EBITA ratio.
C. Decrease the Value/EBITA ratio.
D. Have an undetermined effect on the Value/EBITA ratio.
23. Appropriate adjustments for operating leases are:
A. Increase assets, liabilities and operating income.

B. Decrease assets, liabilities and operating income
C. Increase assets and liabilities, but decrease operating income.
D. Decrease assets and liabilities and but increase operating income.
24. The value of flexibility is lowest when:
A. Uncertainty is high and managers can react to new information.

B. Uncertainty is low and managers can react to new information.
C. Uncertainty is high and managers cannot react to new information.
D. Uncertainty is low and managers cannot react to new information.
25. The option to abandon (or sell) a project, such as the right to abandon a coal mine,
is most similar to:
A. A swap contract.
B. A put option on a stock.
C. A call option on a stock.
D. A futures contract on a bond.

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Valuation of Companies and Cash Flow Generating Assets (N1591)

Seminar 10: Flexibility (McK Chap 35)

Flexibility (McK Chap 35)

 Successful: $ 25/year in after-tax cash flows forever.

The risk-free rate is 5% and the WACC of the company is 10%.

 What is the standard NPV of the project?

3. When performing a valuation, the forecast is spilt up between an Explicit Forecast

Multiple Choice Questions

A. Focusing on growth/Increasing investments

I. The business cycle.

A. It will decrease both FCF and ROIC.

A. Changes in operating working capital.

11. Which of the following is most accurate?

A. ROIC will decrease.

(i) Using a percentage of revenues; or

A. Percentage of revenues only.

14. The value of a steady state company:

A. Determine the economic relationships that drive the model.

A. ROIC on base capital < RONIC < ROIC on total capital.

I. Use sample size equal to or greater than 60.

A. I, II and III only.

18. The weights in the WACC should reflect:

A. Current book values.

A. Are mot of concern.

A. Are the patterns intended?

I. P/E is distorted by capital structure.

A. I and III only.

A. Increase the Value/EBITA ratio.

23. Appropriate adjustments for operating leases are:

A. Increase assets, liabilities and operating income.

24. The value of flexibility is lowest when:

A. Uncertainty is high and managers can react to new information.

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