FINM 2416 Asset Pricing Topic 4: Stock Evaluation (2)

FINM2416 ASSET PRICING

TUTORIAL QUESTIONS

Textbook Questions (CH18)

1. In what circumstances would you choose to use a dividend discount model rather than a
free cash flow model to value a firm?

10. The market consensus is that Analog Electronic Corporation has an ROE = 9%, has a beta
of 1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3. This year's
earnings were $3 per share. The annual dividend was just paid. The consensus estimate of
the coming year's market return is 14%, and T-bills currently offer a 6% return.
a. Find the price at which Analog stock should sell.
b. Calculate the P/E ratio.
c. Calculate the present value of growth opportunities.
d. Suppose your research convinces you Analog will announce momentarily that it will
immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. The
market is still unaware of this decision. Explain why V0 no longer equals P0 and why
V0 is greater or less than P0.

13. FinCorp's free cash flow to the firm is reported as $205 million. The firm's interest expense
is $22 million. Assume the corporate tax rate is 21% and the net debt of the firm increases
by $3 million. What is the market value of equity if the FCFE is projected to grow 3%
indefinitely and the cost of equity is 12% ?

14. The FI Corporation's dividends per share are expected to grow indefinitely by 5% per year.
a. If this year's year-end dividend is $8 and the market capitalization rate is 10% per year,
what must the current stock price be according to the DDM?
b. If the expected earnings per share are $12, what is the implied value of the ROE on
future investment opportunities?
c. How much is the market paying per share for growth opportunities (i.e., for an ROE on
future investments that exceeds the market capitalization rate) ?

22. The MoMi Corporation's cash flow from operations before interest and taxes was $2
million in the year just ended, and it expects that this will grow by 5% per year forever. To
make this happen, the firm will have to invest an amount equal to 20% of pretax cash flow
each year. The tax rate is 21%. Depreciation was $ 200,000 in the year just ended and is
expected to grow at the same rate as the operating cash flow. The appropriate market
capitalization rate for the unleveraged cash flow is 12% per year, and the firm currently has
debt of $4 million outstanding. Use the free cash flow approach to value the firm's equity.

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FINM 2416 Asset Pricing Topic 4: Stock Evaluation (2)

CFA PROBLEMS

3. Abbey Naylor, CFA, has been directed to determine the value of Sundanci's stock using the
Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundanci's FCFE will grow
at 27% for 2 years and 13% thereafter. Capital expenditures, depreciation, and working
capital are all expected to increase proportionately with FCFE.
a. Calculate the amount of FCFE per share for the year 2018, using the data from Table
18A.

Table 18A
Sundanci actual 2017 and
2018 financial statements
for fiscal years ending May
31($ million, except per-
share data)

Table 18B
Selected financial
information

b. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE
model.
c. i. Describe one limitation of the two-stage DDM model that is addressed by using the
two-stage FCFE model.
ii. Describe one limitation of the two-stage DDM model that is not addressed by using
the two-stage FCFE model.

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FINM 2416 Asset Pricing Topic 4: Stock Evaluation (2)

7. Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones,

a. Compute the price-to-earnings (P0/E1) ratio for the industry based on this fundamental data.
b. Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathered
the following economic and market data:

Determine whether each of these fundamental factors would cause P/E ratios to be generally
higher for Country A or higher for Country B.

Non-textbook Questions
Problem 1

You are advising a firm in a potential acquisition and need to perform a discounted cash flow
valuation using the free cash flow to the firm (FCFF) approach. You have compiled the
following first year forecast information for the target firm.

Forecast
Income statement data
Sales 1337
Earnings before interest, tax, depreciation and amortisation (EBITDA) 368
Earnings before interest and tax (EBIT) 329
Pre-tax profit 214
Net profit after tax (NPAT) 150

You estimate the cost of equity capital at 15% and the cost of debt capital at 8%. For initial
valuation purposes, you decide to assume the acquisition is funded with 1/3 debt and 2/3 equity.
Depreciation is a reasonable estimate of sustaining capital expenditure, and an additional $30
million of capital expenditure will be spent on expansion each year. The corporate tax rate is
30%.

a) Estimate the weighted average cost of capital, incorporating the tax benefits of debt finance
into your cost of funds.

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FINM 2416 Asset Pricing Topic 4: Stock Evaluation (2)

b) Estimate the free cash flow to the firm (FCFF) in forecast year one which is consistent with
the cost of capital estimate for valuation purposes.
c) The difference between sales and EBITDA can be classified as cash operating costs.
Assume that half of these costs are fixed and half increase in direct proportion to sales. If
you forecast sales growth of 8% in the next forecast year, what is your expected EBITDA
in that year?
d) Your valuation of equity is $2 billion. Estimate the Value/EBITDA multiple.
e) Another analyst estimates an equity value of $3 billion. What is the P/E multiple implicit
in their valuation?

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