Topic 4 - Solutions

1. Rome Corporation is expected have EBIT of $2.3M this year. Rome Corporation is in the 30% tax
bracket, will report $175,000 in depreciation, will make $175,000 in capital expenditures, and will have
no change in net working capital this year. What is Rome’s FCFF?
A. 2,300,000
B. 1,785,000
C. 1,960,000
D. 1,610,000
E. 1,435,000
Answer: D

2. The most appropriate discount rate to use when applying a FCFF valuation model is the
A. required rate of return on equity.
B. WACC.
C. risk-free rate.
D. required rate of return on equity or risk-free rate depending on the debt level of the firm.
E. None of the options
Answer: B

3. Smart Draw Company is expected to have per share FCFE in year 1 of $1.20, per share FCFE in year
2 of $1.50, and per share FCFE in year 3 of $2.00. After year 3, per share FCFE is expected to grow
at the rate of 10% per year. An appropriate required return for the stock is 14%. The stock should be
worth today.
A. $33.00
B. $40.68
C. $55.00
D. $66.00
E. $12.16
Answer: B

4. Goodie Corporation produces goods that are very mature in their product life cycles. Goodie Corpo-
ration is expected to have per share FCFE in year 1 of $2.00, per share FCFE of $1.50 in year 2, and
per share FCFE of $1.00 in year 3. After year 3, per share FCFE is expected to decline at a rate of
1% per year. An appropriate required rate of return for the stock is 10%. The stock should be worth
today.
A. $9.00
B. $101.57
C. $10.57
D. $22.22
E. $47.23
Answer: C
Topic 4 - Solutions Page 2 of 5

5. Historically, P/E ratios have tended to be .

A. higher when inflation has been high
B. lower when inflation has been high
C. uncorrelated with inflation rates but correlated with other macroeconomic variables
D. uncorrelated with any macroeconomic variables including inflation rates
E. none of these
Answer: B

6. A company whose stock is selling at a P/E ratio greater than the P/E ratio of a market index most
likely has .
A. an anticipated earnings growth rate which is less than that of the average firm
B. a dividend yield which is less than that of the average firm
C. less predictable earnings growth than that of the average firm
D. greater cyclicality of earnings growth than that of the average firm
E. none of these.
Answer: B

7. A firm’s earnings per share increased from $10 to $12, dividends increased from $4.00 to $4.80, and
the share price increased from $80 to $90. Given this information, it follows that .
A. the stock experienced a drop in the P/E ratio
B. the firm had a decrease in dividend payout ratio
C. the firm increased the number of shares outstanding
D. the required rate of return decreased
E. none of these
Answer: A

8. In the context of the constant growth model, P/E ratios and risk
A. will be directly related.
B. will have an inverse relationship.
C. will be unrelated.
D. will both increase as inflation increases.
E. none of these.
Answer: B

9. Which of the following combinations will produce the highest growth rate? Assume that the firm’s
projects offer a higher expected return than the market capitalization rate.
A. a high plowback ratio and a high P/E ratio
B. a high plowback ratio and a low P/E ratio
C. a low plowback ratio and a low P/E ratio
D. a low plowback ratio and a high P/E ratio

Cont.
Topic 4 - Solutions Page 3 of 5

E. Neither the plowback ratio nor the P/E ratio is related to a firm’s growth.
Answer: A

10. Which of the following are comparative valuation ratios?

I) the plowback ratio
II) the price-to-book ratio
III) the dividend payout ratio
IV) the price-to-sales ratio
V) the price-to-cash flow ratio

A. I, IV, and V
B. II and III
C. IV and V
D. II, IV, and V
E. I, II, III, IV, and V

Answer: D

11. 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 percent for
two years and 13 percent 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 2013, using the data from the table below.
b. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE model.
c. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage
FCFE model.
d. Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage
FCFE model.

Cont.
Topic 4 - Solutions Page 4 of 5

Solution:

a. Sundanci’s FCFE for the year 2013 = Earnings after tax + Depreciation expense - Capital ex-
penditures - Increase in NWC = $80 million + $23 million - $38 million - $41 million = $24 million.

FCFE per share = FCFE/number of shares outstanding = $24 million/84 million shares = $0.286
b. The FCFE model requires forecasts of FCFE for the high-growth years (2014 and 2015) plus a
forecast for the first year of stable growth (2016) in order to allow for an estimate of the terminal
value in 2015 based on perpetual growth. The following table shows the process for estimating
Sundanci’s current value on a per share basis.

c. The DDM uses the expected dividends on the common stock. The DDM cannot be used to
estimate the value of a stock that pays no dividends. The FCFE model expands the definition of
cash flows to include the balance of residual cash flows after all financial obligations and investment
needs have been met. Thus the FCFE model explicitly recognizes the firm’s investment and
financing policies as well as its dividend policy. In instances of a change of corporate control, and
therefore the possibility of changing dividend policy, the FCFE model provides a better estimate
of value.
d. Both two-stage valuation models allow for two distinct phases of growth, an initial finite pe-
riod where the growth rate is abnormal, followed by a stable growth period that is expected to
last indefinitely. These two-stage models share the same limitations with respect to the growth
assumptions. First, there is the difficulty of defining the duration of the extraordinary growth
period. For example, a longer period of high growth will lead to a higher valuation, and there
is the temptation to assume an unrealistically long period of extraordinary growth. Second, the
assumption of a sudden shift form high growth to lower, stable growth is unrealistic. The trans-
formation is more likely to occur gradually, over a period of time. Third, because the value is
quite sensitive to the steady-state-growth assumption, over- or underestimating this rate can lead
to large errors in value.

Cont.
Topic 4 - Solutions Page 5 of 5

12. Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA, head
of the research department, gathered the following fundamental industry and market data to help in
his analysis

Forecast industry earnings retention rate 40%

Forecast industry return on equity 25%
Industry beta 1.2
Risk-free rate 6%
Equity risk premium 5%

Compute the price-earnings (P0 /E1 ) ratio for the industry using these fundamental data.

Solution:

The industry’s estimated P/E can be computed using the following model:

P0 Payout ratio
=
E1 r−g

However, since r and g are not explicitly given, they must be computed using the following formulas:

gind = ROE × Retention rate = 0.25 × 0.40 = 0.10

rind = 0.06 + (1.2 × 0.05) = 0.12

Therefore:
P0 0.60
= = 30.0
E1 0.12 − 0.10

The End.