Exercise 5 (Berk DeMarzo Chapter 8 and 9) Solutions

8-6. Cellular Access, Inc. is a cellular telephone service provider that reported net income of $251
million for the most recent fiscal year. The firm had depreciation expenses of $90 million, capital
expenditures of $151 million, and no interest expenses. Working capital increased by $11 million.
Calculate the free cash flow for Cellular Access for the most recent fiscal year.
FCF = Unlevered Net Income + Depreciation – CapEx – Increase in NWC
= $251 million + $90 million – $151 million – $11 million = $179 million.

8-9. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term
cash flows are difficult to estimate, management has projected the following cash flows for the first
two years (in millions of dollars):
Year 1 Year 2
Revenues 108.2 156.1
Costs of goods sold and operating
expenses other than depreciation 36.6 36.6
Depreciation 24.2 38.6
Increase in net working capital 5.1 8.9
Capital expenditures 32.1 42.5
Marginal corporate tax rate 43% 43%

a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two years?

a.
Year 1 2

Unlevered Net Income Forecast ($000s)

1 Sales 108 156

COGS & Operating Expenses (other than

3 Depreciation -24.2 -38.6

4 EBIT 47.4 80.9

5 Income tax at 43% -20 -35

6 Unlevered Net Income 27.0 46.1

b.
Year 1 2

Free Cash Flow ($000s)

7 Add: Depreciation 24.2 38.6

8 Less: Capital Expenditures 32.1 42.5

9 Less: Increase in net working capital 5.1 8.9

10 Unlevered Net Income 14.0 33.3

8-19. Bay Properties is considering starting a commercial real estate division. It has prepared the
following four-year forecast of free cash flows for this division:
1. 2. Year 1 3. Year 2 4. Year 3 5. Year 4
Free Cash Flow
6. - $182,000 7. $12,000 8. $90,000 9. $151,000

Assume cash flows after year 4 will grow at 5% per year, forever. If the cost of capital for this
division is 11%, what is the continuation value in year 4 for cash flows after year 4? What is the
value today of this division?
$151,000(1.05)
−$182,000 $12,000 $90,000 $151,000 + (0.11 − 0.05)
𝑁𝑃𝑉 = + + +
1.11 1.112 1.113 1.114

𝑁𝑃𝑉 = −$163,963.964 + $9,739.469199 + $65,807.22432 + $1,840,164.976 = $1,751,747.71

9-1. Assume Evco, Inc., has a current price of $45 and will pay a $2.05 dividend in one year, and its
equity cost of capital is 16%. What price must you expect it to sell for right after paying the
dividend in one year in order to justify its current price?
Use Eq. (9.1) to solve for the price of the stock in one year given the current price of $45.00, the $2.05
dividend, and the 16% cost of capital.

𝐷𝑖𝑣1 + 𝑃1
𝑃0 =
1 + 𝑟𝐸
$2.05 + 𝑃1
$45 =
1 + 0.16
$2.05 + 𝑃1
$45 =
1.16
$45(1.16) = $2.05 + 𝑃1
$52.2 − $2.05 = 𝑃1
𝑃1 = $52.2 − $2.05 = $50.15

At a current price of $45.00, we can expect Evco stock to sell for $50.15 immediately after the firm pays
the dividend in one year.

9-2. Anle Corporation has a current price of $17, is expected to pay a dividend of $2 in one year, and
its expected price right after paying that dividend is $18.
 a. What is Anle’s expected dividend yield?
b. What is Anle’s expected capital gain rate?
c. What is Anle’s equity cost of capital?

𝐷𝑖𝑣1
a. 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝑃0

$2.00
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 = = 0.1176 = 11.76%
$17

𝑃1 −𝑃0
b. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 =
𝑃0
$18−$17
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 = = 0.0588 = 5.88%
$17

c. Equity cost of capital = 11.76% + 5.88% = 17.64%

9-5. NoGrowth Corporation currently pays a dividend of $1.36 per year, and it will continue to pay this
dividend forever. What is the price per share if its equity cost of capital is 15% per year?
With the simplifying assumption (as was made in the chapter) that dividends are paid at the end of the
year, then the stock pays a total of $1.36 in dividends per year. Valuing this dividend as a perpetuity, we
have,

𝐷𝑖𝑣1
𝑃0 =
𝑟𝐸

= $9.07.
$1.36
𝑃0 =
0.15

9-6. Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s dividend to grow
by 6% per year, what is its price per share if its equity cost of capital is 11%?
P = 1.50 / (11% – 6%) = $30

9-17. Maynard Steel plans to pay a dividend of $2.92 this year. The company has an expected earnings
growth rate of 3.8% per year and an equity cost of capital of 10.4%.
a. Assuming Maynard’s dividend payout rate and expected growth rate remains constant, and
Maynard does not issue or repurchase shares, estimate Maynard’s share price.
b. Suppose Maynard decides to pay a dividend of $0.97 this year and use the remaining $1.95 per
share to repurchase shares. If Maynard’s total payout rate remains constant, estimate
Maynard’s share price.
c. If Maynard maintains the same split between dividends and repurchases, and the same payout
rate, as in part (b), at what rate are Maynard's dividends, earnings per share, and share price
expected to grow in the future?
a. Earnings growth = EPS growth = dividend growth = 3.8%.
𝐷𝑖𝑣1 $2.92
Thus, 𝑃0 = = = $44.24.
𝑟−𝑔 0.104−0.038

b. Using the total payout model,

$0.97
𝑔 = 0.104 − = 0.087 = 8.2% [Note: The share price is expected to also grow at the
$44.24
same rate as dividends and earnings per share]

9-24. You notice that PepsiCo (PEP) has a stock price of $74.02 and EPS of $3.82. Its competitor, the
Coca-Cola Company (KO), has EPS of $2.36. Estimate the value of a share of Coca-Cola stock
using only this data.

𝑃𝑟𝑖𝑐𝑒
𝑃𝐸 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
$74.02
𝑃𝐸𝑃𝐸𝑃 = = 19.38 𝑡𝑖𝑚𝑒𝑠
$3.82
𝑃𝐾𝑂 = 19.38 × $2.36 = $45.73