BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE, PILANI - K. K.

BIRLA GOA CAMPUS

First Semester 2019-20, Comprehensive Examination December 2019
Business Analysis and Valuation (ECON F355)
(Answer all questions)
1h
Examination Date: 11 December, 2019. Duration: 3 HOURS Max Marks: 50
A. Each question carries 1 mark. (1* 6 = 6 Marks)
1. Historically, P/E ratios have tended to be -lower------ when inflation has been high.
(higher/lower)
2. Suppose that the average P/E multiple in the oil industry is 16. Shell Oil is expected to have an
EPS of $4.50 in the coming year. The intrinsic value of Shell Oil stock should be ---72.00---.

3. The required rate of return on equity is the most appropriate discount rate to use when
applying a _FCFE_____ valuation model.
4. You are reading an equity research report on Informix, and the analyst claims that the stock is
undervalued because its PE ratio is 9.71 while the average of the sector PE ratio is 35.51. Would
you agree? State the reasons.
5. Netting ----Cash-----out from firm value yields enterprise value, which can be considered to be
the market value of just the operating assets of the firm.
6. Other things remaining equal, firms that derive a greater portion of their EBITDA from
depreciation and amortization should trade at -----lower------multiples of EBITDA than otherwise
similar firms. (lower/higher)
7. Assume that Bolton Company will pay a $2.00 dividend per share next year, an increase from
the current dividend of $1.50 per share that was just paid. After that, the dividend is expected
to increase at a constant rate of 5%. If you require a 12% return on the stock, the value of the
stock is ___28.57____.

Solution: P1 = 2 (1.05)/(.12 − .05) = $30.00; PV of P1 = $30/1.12 = $26.78; PV of D1 = 2/1.12 = 1.79; PO =

$26.78 + $1.79 = $28.57.

B. Each question carries 4 marks. (4* 7 = 28 Marks)

1. Suppose Goodyear Tire and Rubber Company has an equity cost of capital 8.5%, a debt cost of
capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. Suppose
Goodyear maintains a constant debt-equity ratio.
a. What is Goodyear’s WACC?
b. What is Goodyear’s unlevered cost of capital?
c. Explain, intuitively, why Goodyear’s unlevered cost of capital is less than its equity cost of
capital and higher than its WACC.
Solution:

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2. Trying to estimate the beta of a private company…this is called pure play…Other home appliance
manufacturing companies that are public have the following beta, debt, and equity…

Company Beta Debt Equity

Black and Decker 1.40 $2,500 $3,000
Fedders 1.20 $5 $200
Maytag 1.20 $540 $2,250
National Presto 0.70 $8 $300
Whirlpool 1.50 $2,900 $4,000

a. Estimate the beta of a private company with a debt-equity ratio of 25% and a tax rate of
40%. These firms also have a tax rate of 40%.
b. What are your concerns on using this approach?

Solution:
a. One way is to compute the unlevered betas of each of the five firms and then average these
unlevered betas and substitute it as the unlevered beta of the private company…
Unlevered Beta = Beta / (1 + (1 –Tax Rate) (D/E))

Black & Decker = 1.4 / (1+ (1-0.40) (2,500/3,000) = 0.9333

Fedders = 1.2 / (1+ (1-0.40) (5/200) = 1.1823

Maytag = 1.2 / (1+ (1-0.40) (540/2,250) = 1.0490

National Presto = 0.7 / (1+ (1-0.40) (8/300) = 0.6890

Whirlpool = 1.5 / (1+ (1-0.40) (2,900/4,000) = 1.0453

Average Unlevered Beta = (0.9333 + 1.1823 + 1.0490 + 0.6890 + 1.0453) / 5

Average Unlevered Beta = 4.8989 / 5 = 0.9798

Levered beta of private firm = 0.9798 (1+ (1 – 0.40) (1/4)) = 1.1268

b. What are your concerns on using this approach?

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 First, the wide range of betas in the industry makes it hard to justify a point estimate of the beta
of the private firm. Second, the debt/equity ratios and size of these vary and it would probably be better
to find a firm similar in size and debt/equity funding for the private firm and just use that beta.

3. You are a consultant who was hired to evaluate a new product line for Markum Enterprises. The
upfront investment required to launch the product line is $10 million. The product will generate
free cash flow of $7, 50,000 the first year, and this free cash flow is expected to grow at a rate of
4% per year. Markum has an equity cost of capital of 11.3%, a debt cost of capital of 5%, and a
tax rate of 35%. Markum maintains a debt-equity ratio of 0.40.
a) What is the NPV of the new product line (including any tax shields from leverage)?
b) How much debt will Markum initially take on as a result of launching this product line?
c) How much of the product line’s value is attributable to the present value of interest tax shields?

Solution:

4. Amarindo, Inc (AMR) is a newly public firm with 10 million shares outstanding. You are doing a
valuation analysis of AMR. You estimate its free cash flow in the coming year to be $15 million,
and you expect the firm’s free cash flows to grow by 4% per year in subsequent years. Because
the firm has only been listed on the stock exchange for a short time, you do not have an
accurate assessment of AMR’s equity beta. However you do have beta data for UAL, another
firm in the same industry:
Equity Beta Debt Beta Debt-Equity Ratio
UAL 1.5 0.30 1
AMR has a much lower debt-equity ratio of 0.30 which is expected to remain stable, and its debt
is risk free. AMR’s corporate tax rate is 40%, the risk-free rate is 5%, and the expected return on
the market portfolio is 11%.

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 a) Estimate AMR’s equity cost of capital.
b) Estimate AMR’s share price.

Solution:
a) UAL Asset beta = (1/2)*1.5 +(1/2)*0.3 = 0.90
We can use this for AMR’s asset beta
Equity beta = asset beta *(1+(1-t)D/E)
0.90 *(1+(1-.40)0.30) = 0.90*(1+0.60*0.30)
= 0.90*1.18 = 1.062
From the SML , cost of capital = 5%+1.062(11%-5%) = 11.37
b) Since D/E ratio is stable, we can value AMR using the WACC approach,
WACC = (1/1.3)11.37% + (.3/1.3)5%(1-.40) = 8.75+0.6923 =9.44%
Levered value of AMR
= 15/(9.44%-4%) = 275.73 million
Equity value =(E/(D+E))*Levered value of firm
= 275.73/1.3 = $212.10 million
Share price = 212.10/10 = $21.21

5. Acort Industries has 10 million shares outstanding and a current share price of $40 per share. It
also has long-term debt outstanding of value $113.86 million. The risk-free interest rate is

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 constant at 6%. Acort has EBIT of $106 million, which is expected to remain constant each year
(no growth). The corporate tax rate is 40% and Acort is expected to keep its debt-equity ratio
constant in the future. Based on this information :
a) Estimate Acort’s WACC.
b) What is Acort’s equity cost of capital?
Solution:
a) Acort’s equity value = 10*40 = 400
Acort’s enterprise value is E+D = 400+ 113.86 = 513.86
FCF = 106 (1-.40) = 63.6
Because Acort is not expected to grow
Levered value of Acort = 513.86 = 63.6/(r(wacc)-g)
R(wacc)= 63.6/513.86 = 12.38%

b)

6. The growth in dividends of Music Doctors, Inc. is expected to be 8%/year for the next two years,
followed by a growth rate of 4%/year for three years; after this five year period, the growth in
dividends is expected to be 3%/year, indefinitely. The required rate of return on Music Doctors,
Inc. is 11%. Last year's dividends per share were $2.75. What should the stock sell for today?
Solution: Calculations are shown below

P5 = 3.7164/(.11 − .03) = $46.4544; PV of P5 = $46.4544/(1.11)5 = $27.5684; PO = $12.1449 +

$27.5684 = $39.71

7. On January 1, 2005 the S&P index was trading at 1,211.92. The dividend yield on the index was
only 1.81%, but including stock buybacks increased the modified dividend yield of 2.9%. Analysts

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 were estimating that the earnings of the stocks in the index would increase 8.5% a year for the
next five years. Beyond year 5, the expected growth rate in earnings and dividends was
expected to be 4.22%, set equal to the Treasury bond rate on the assumption that the Treasury
bond rate is a reasonable proxy for nominal long-term growth in the economy. Use the risk
premium of 4% to estimate the cost of equity. Recommend with respect to the overvaluation
and undervaluation of index.
Solution:
• Cost of equity = 4.22% +4% = 8.22%
• The expected dividends (and stock buybacks) on the index for the next five years can be
estimated from the current dividends and expected growth of 8.5%.
• Current modified dividends = 2.90% of 1211.92 = 35.148
• Year 1 2 3 4 5
Expected dividends 38.13 41.37 44.89 48.71 52.85
PV 35.24 35.33 35.42 35.51 35.60
• To estimate the terminal value, we estimate modified dividends in year 6 on the index:
Expected dividends in year 6 = 52.85 (1.0422) = 55.08
Terminal value of index = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑠6/ (r-g)
= 55.08/(0.0822-0.0422 = 1376.93
PV of TV = 1376.93/ 1.08225 = 927.63
• The value of the index can now be computed:
= 35.24+35.33+35.42+35.51+35.60+927.63 = 1,104.73
Based upon this analysis, we would have concluded that the index was overvalued by about 10%
at 1,211.92.

C. Each question carries 15 marks. (15* 1 = 15 Marks)

1. In 2000, the Gap reported operating income $1,445 million on revenues of $13,673
million. The firm also reported capital expenditures of $1,859 million and depreciation of
$590 million for the year, and its non-cash working capital increased by $323 million
during the year. The operating lease expenses for the year were $705.8 million and Table
below reports the lease commitments for future years.

Table: Lease Commitments for future years: The Gap

Year Commitment
1 $774.60
2 $749.30
3 $696.50
4 $635.10
5 $529.70
6 and beyond $5,457.90

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Pre-tax cost of debt for the firm is based upon its rating of A. The default spread for A rated
firms is 1.80% and the risk free rate is 5.4%.Treating the commitment in year 6 and beyond as an
annuity of $682.24 million for 8 years, estimate a debt value for the operating leases.
The Gap’s market value of equity at the time of this valuation was $28,795 million and the debt
outstanding on the balance sheet of $1,809.90 million. Estimate the adjusted debt value, adjusted
operating income and adjusted after-tax operating income.
Dividing this value by the book value of debt (including capitalized operating leases) and the
book value of equity at the end of the previous year yields an adjusted return on capital of
13.61% in 2000 for the firm. We will assume that the firm will be able to maintain this return on
capital in perpetuity.
Cost of equity estimate for the Gap begins by using a bottom-up beta of 1.20 (based upon the
betas of specialty retailers) for the high growth period, a riskfree rate of 5.4% and a mature
market premium of 4%. In stable growth, we will lower the beta to 1.00, keeping the riskfree rate
and risk premium unchanged.
To estimate the cost of capital during the high growth and stable growth phases, we will assume
that the pre-tax cost of debt will remain at 7.2% in perpetuity and that the current market debt
ratio of 20.58% will remain the debt ratio.
To estimate the expected growth in operating earnings during the high growth period, we will
assume that the firm will continue to earn 13.61% as its return on capital and that its
reinvestment rate will equal its average reinvestment rate over the last 4 years, 93.53%. To
estimate the terminal value at the end of year 5, we assume that this cash flow will grow forever
at 5%.
Estimate the Gap’s equity value if the firm’s cash and marketable securities (estimated to be
$409 million at the end of 2000) and subtracting out the value of the debt yields a value for the
equity in the firm. Provide your recommendation if the prevailing market value of equity of
$27,615 million.

Solution:

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Table below summarizes the expected cash flows for the high growth period.
Table: Estimated FCFF: The Gap
Year EBIT(1-t) Reinvestment rate Reinvestment FCFF Present Value
Current $1,203
1 $1,356 93.53% $1,269 $88 $80
2 $1,529 93.53% $1,430 $99 $83
3 $1,732 93.53% $1,620 $112 $86
4 $1,952 93.53% $1,826 $126 $89
5 $2,190 93.53% $2,049 $142 $92
Sum of present values of cash flows = $430