CHAPTER 1 - SOLUTIONS

INTRODUCTION TO VALUATION

Problem 1

e. All of the above

Problem 2
d. Value is determined by investor perceptions, but it is also determined by the
underlying earnings and cash flows. Perceptions must be based upon reality.

Problem 3
e. Either a,b, or c.
 CHAPTER 2- SOLUTIONS
INTRODUCTION TO VALUATION
Problem 1
A. False. The reverse is generally true.
B. True. The value of an asset is an increasing function of its cash flows.
C. True. The value of an asset is an increasing function of its life.
D. False. Generally, the greater the uncertainty, the lower is the value of an asset.
E. False. The present value effect will translate the value of an asset from infinite to finite
terms.

Problem 2
A. It might be difficult to estimate how much of the success of the private firm is due to the
owner's special skills and contacts.
B. Since the firm has no history of earnings and cash flow growth and, in fact, no potential
for either in the near future, estimating near term cash flows may be impossible.
C. The firm's current earnings and cash flows may be depressed due to the recession.
Other measures, such as debt-equity ratios and return on assets may also be affected.
D. Since discounted cash flow valuation requires positive cash flows some time in the near
term, valuing troubled firms, which are likely to have negative cash flows in the
foreseeable future, is likely to be difficult.
E. Restructuring alters the asset and liability mix of the firm, making it difficult to use
historical data on earnings growth and cash flows on the firm.
F. Unutilized assets do not produce cash flows and hence do not show up in discounted
cash flow valuation, unless they are considered separately.

Problem 3
a. Value of Equity = $ 3,224 (Discount cashflows to equity at the cost of equity – 12%)
b. Value of Firm = $ 5,149 (Discount cashflows to the firm at the cost of capital of 9.94%)

Problem 4
A. Average P/E Ratio = 31.98
B. No. Eliminate the outliers, because they are likely to skew the average. The average P/E
ratio without GET and King World is 25.16.
C. You are assuming that
(1) Paramount is similar to the average firm in the industry in terms of growth and risk.
(2) The marker is valuing communications firms correctly, on average.
 CHAPTER 6
MARKET EFFICIENCY – DEFINITION, TESTS AND EVIDENCE
Problem 1
(a) Resources are allocated among firms efficiently (i.e. put to best use)
(f) No group of investors will do better than the market consistently after adjusting for risk
and transactions costs.

Problem 2
No. The stock price should reflect this seasonal pattern in sales. If seasonal sales were
better or worse than expected, you would expect to see an effect on stock prices.

Problem 3
To test any market inefficiency, a model needs to be specified for expected returns. One
cannot therefore test market efficiency alone without jointly testing an asset pricing model

Problem 4
No. Demand and Supply are determined by real variables (including the intrinsic value).

Problem 5
You should have looked at the merger announcement date (in the WSJ) and not at the
effective date. Furthermore you should have started looking at days before the
announcement date. Finally, by focusing on only the twenty largest mergers, you may be
inducing sampling bias into your conclusions.

Problem 6
(d) market prices contain errors, but the errors are random and therefore cannot be
exploited by investors.

Problem 7
a. Decrease Efficiency
Reasoning: Increases transactions cost and allows inefficiencies to continue.
b. Decrease Efficiency
Reasoning: Removes an avenue that those with bad news could have used.
c. Increase Efficiency
Reasoning: Allows investors to trade on news more easily
d. Increase Efficiency
Reasoning: Allows more investors to come in and exploit inefficiencies.
 Dividend Discount Models 2

Problem 8
(a) There is some insider trading going on,, or at least information leaking out.
(b) Suggests that the announcement contains good news, and that some of the news at
least is a positive surprise to markets.
(c) Suggests that markets over reacted to the initial news and there is a price correction.

Problem 9
Small firms make a substantial premium over expected returns after adjusting for risk. Most
of this premium is earned in the first fifteend days of the year. This may be because (a) we
are measuring risk incorrectly (b) Transactions costs are higher (c) Information is much
more scanty. If your transacitons costs are low enough, you could construct a portfolio of
smaller stocks.

Problem 10
This suggests that markets do not react instantaneously to information events and that price
adjustments to new informaition do not happen immediately. I would expect to find this to
be much more of a problem with smaller, information-poor firms. I would exploit this
anomaly by buying these stocks right after a positive surprise and selling after a negative
surprise and holding for a very short time period. (The transactions costs and uncertainty
might be much higher)

Problem 11
(a) Investors sell stocks on which they have made losses towards the end of the year
(driving the price down) and buy them back after the turn of the year (causing prices go up)

(b) More information may come out in January than any other month of the year. Investors
may be more optimistic and have more cash in January.

Problem 12
9% (1-.4) + 5% (1-x) = 12% (1-.4) + 1% (1-x)
Solve for x, x = 55%

Problem 13
a. False. Low PE stocks are not riskier.
b. False. The small stock effect is not created by outliers.
c. False. Stock prices are affected but the average investor cannot take advantage of
the price effect.
 Dividend Discount Models 3

Problem 14
Expected Return on AD Value Fund = 6% + 0.8 (16%-6%) = 14%
Expected Return on AD Growth Fund = 6% + 1.2 (16%-6%) = 18%
AD Value outperformed the market by 2%
AD Growth underperformed by the market by 2%
b. (0.95) (1.02)^n = 1.00
Solve for n,
n = 2.59 years
 CHAPTER 7
RISKLESS RATES AND RISK PREMIUMS

Problem 1
I would use the U.S. treasury bond rate. There is country risk but it is best shown as part
of the risk premium.

Problem 2
Because it exposes you to reinvestment risk – the rate will be different in 6 months. A more
appropriate rate would be a 5-year treasury (preferable a zero coupon).

Problem 3
Rupiah riskless rate = Government bond rate – Default spread = 17% - 5% = 12%

Problem 4
70 = 45 (1+ r India )10 /(1.05) 10
Solving for r, you get = 9.74%

Problem 5
You could use the 3% rate on inflation-index treasury bonds as your riskless rate, if you
assume that capital flows freely across countries. If this is the case, the real riskless rate has
to be the same across countries. However, the assumption about free capital flows may not
be appropriate in some countries. An alternative approach would be to set the real riskless
rate = expected real growth rate in the long term in Chile.

Problem 6
Annual standard deviation (assuming no serial correlation) = 30%/ 50 = 4.25%

Problem 7
You are assuming that
a. The risk preferences of investors have not changed systematically over time.
b. The average risk investment over time has remained constant
c. There is no selection bias associated with the period of history that you are looking
at.
If investors have become less risk averse, the average risk investment has less risk or if
there is a “survivor market” bias, the historical risk premium will be too high an
estimate of the future expected risk premium.
 Dividend Discount Models 2

Problem 8
a. Country risk premium as default spread = 7.6% - 5.1% = 2.5%
b. Country risk premium with relative market volatility = 2.5% (25%/15%) =
4.17%

Problem 9
a. Total risk premium using equity std deviation = 5.5% (48/20) = 13.2%
Country risk premium = 13.2% - 5.5% = 7.7%
b. Country risk premium = 3% (48/24) = 6%

Problem 10
Expected dividends next year = 5% of 1400 = 70
Value = 1400 = 70/ (r - .06)
Solving for r,
Required return on stocks = (70 + .06*1400)/1400 = 11%
Riskless rate = 5.5%
Implied equity risk premium = 11% - 5.5% = 5.5%

Problem 11
Last year 1 2 3 4 5 Term Year

Dividends 750.00 862.50 991.88 1140.66 1311.75 1508.52 1583.94

Estimating the present value of the cash flows in the first five years, and the terminal value
as
Terminal value = 1583.94/(r - .06)
The discount rate of 12.85% yields a present value of 15000 (which is the current level of
the index)
Implied equity risk premium = 12.85% - 6% = 6.85%

Problem 12
This statement is not true. If earnings go up more than the index goes up, if there is a
substantial increase in expected growth rates or a big drop in the riskless rate, you can see
risk premiums go down as the index goes up.
 CHAPTER 12
CLOSURE IN VALUATION: ESTIMATING TERMINAL VALUE
Problem 1
a. Operating income in year 5 = 100 million (1.1)5 = $ 161.05 million
Terminal value (year 5) = 161.05 * 8 = $1288.41 million
b. Value/ EBIT = (1- t) (1 – g/ ROC)/ (Cost of capital – g)
8 = (1.4) (1-.05/ROC)/ (.10 - .05)
Solving for ROC,
ROC = .15 or 15%

Problem 2
Expected EBIT in year 6 = 80 (1.20)5 (1.05) = $209.02 million
Expected EBIT (1-t) in year 6 = $209.02 (1 - .40) = $125.41 million
Reinvestment rate in year 6 = g/ ROC = 5/14 = 35.71%
Terminal value = $125.41 (1-.3571)/ (.10-.05) = $1612.43 million

Problem 3

a. Expected stable growth rate = ROC* Reinvestment rate

= 15% .30 = 4.5%
Expected high growth rate = .80 *.15 = 12%
EBIT (1-t) in year 5 = (.15*100) (1.12)4 (1.045) = $24.66 million
Terminal value = 24.66 (1-.30)/(.09-.045) = $383.60 million
a. If return on capital drops to 9%, you can re-estimate value by either changing the
reinvestment rate (keeping growth at 4.5%) or changing the growth rate (keeping
the reinvestment rate at 30%).
If growth rate is kept fixed,
Reinvestment rate = 4.5/9 = 50%
Terminal value = 24.66 (1-.50)/(.09- .045) = $274 million
If reinvestment rate is kept fixed,
Expected growth rate = 9% (.30) = 2.7%
EBIT (1-t) in year 5 = (.15*100) (1.12)4 (1.027) = $24.24 million
Terminal value = 24.24 (1-.30)/(.09-.027) = $269.33 million

Problem 4
a. Terminal value = 500 (1.03)10 = $671.96 million
 Dividend Discount Models 2

a. After-tax operating income in year 10 = 50 (1.08)10 = $107.95 million

Terminal Value/ After-tax operating income = 671.96/107.95 = 6.22
b. Value = EBIT (1-t) (1+g)/ (r –g)
Value/ EBIT (1-t) = (1+g)/ (r – g)
6.22 = 1.03/ (r - .03)
Solving for r, cost of capital = 13.55%

Problem 5
a. After-tax operating income in year 6 = 20 (1.1)5 (1.04) = $ 33.50 million
Net Cap ex in year 6 = (15-5) (1.1)5 (1.04) = $16.75 million
Free cashflow to the firm in year 6 = $16.75 million
Terminal value of firm in year 5 = 16.75/(.12 - .04) = $209.375 million
c. Reinvestment rate = 10/20 = 50% (in perpetuity)
Return on capital in perpetuity = g/ Reinvestment rate = .04/.5 = 8%
b. Terminal value if net cap ex is zero = 33.50/ (.12-.04) = $ 418.75 million
c. Return on capital in perpetuity has to be infinite to allow growth rate to be
positive while reinvestment rate is zero.

Problem 6
a. Expected after-tax operating income in year 4 = 40 (1.07)3 (1.03) = $50.96
Return on capital = 40/ 400 = 10%
Reinvestment rate in year 4 = g/ ROC = 3%/10% = 30%
Value at end of year 3 = 50.96 (1 - .30)/ (.10 - .03) = $ 509.60 million
b. If no growth after year 4
Value at end of year 3 = 50.96 (1- 0)/ (.10 – 0) = $ 509.60 million
c. If expected growth rate is –5%
Reinvestment rate = g/ ROC = -5/10 = -50%
Value at end of year 3 = 50.96 (1- (-.5))/ (.10 – (-.05)) = $ 509.60 million
There is a partial liquidation of the firm each year which adds to the cashflows.
Since the cost of capital = return on capital, the terminal value is not a function of
the expected growth rate.

Problem 7
a. Expected after-tax operating income in year 4 = 40 (1.07)3 (1.03) = $50.96
Return on capital = 40/ 400 = 10%
Reinvestment rate in year 4 = g/ ROC = 3%/10% = 30%
Value at end of year 3 = 50.96 (1 - .30)/ (.08 - .03) = $ 713.44 million
 Dividend Discount Models 3

b. If no growth after year 4

Value at end of year 3 = 50.96 (1- 0)/ (.08 – 0) = $ 637.0 million
c. If expected growth rate is –5%
Reinvestment rate = g/ ROC = -5/10 = -50%
Value at end of year 3 = 50.96 (1- (-.5))/ (.08 – (-.05)) = $ 588 million
Since the cost of capital < return on capital, higher stable growth rates increase
terminal value.
 CHAPTER 13
DIVIDEND DISCOUNT MODELS
Problem 1
A. False. The dividend discount model can still be used to value the dividends that the
company will pay after the high growth eases.
B. False. It depends upon the assumptions made about expected future growth and risk.
C. False. This will be true only if the stock market falls more than merited by changes in
the fundamentals (such as growth and cash flows).
D. True. Portfolios of stocks that are undervalued using the dividend discount model seem
to earn excess returns over long time periods.
E. True. The model is biased towards these stocks because of its emphasis on dividends.

Problem 2
A. Cost of Equity = 6.25% + 0.90 * 5.5% = 11.20%
Value Per Share = $3.56 * 1.055/(.1120 - .055) = $65.89

B. $3.56 (1 + g)/(.1120 - g) = $80

Solving for g,
g = (80 * .112 - 3.56)/(80 + 3.56) = 6.46%

Problem 3
A. Retention Ratio = 1 - Payout Ratio = 1 - 0.42/1.50 = 72%
Return on Capital
= (Net Income + Int Exp (1-t))/(BV of Debt + BV of Equity)
= (30 + 0.8 * (1 - 0.385))/(7.6 + 160) = 18.19%
Debt/Equity Ratio = 7.6/160 = .0475
Interest Rate on Debt = 0.8/7.6 = 10.53%
Expected Growth Rate
= 0.72 [.1819 + .0475 (.1819 - .1053 * (1 - 0.385))] = 13.5%
Alternatively, and much more simply,
Return on Equity = 30/160 = .1875
Expected Growth Rate = 0.72 * .1875 = 13.5%

B. Expected payout ratio after 1998:

= 1 - g/[ROC + D/E (ROC - i (1-t))]
= 1 - .06/(.125+.25(.125 - .07(1-.385))
 Dividend Discount Models 2

= 0.5876

C. Beta in 1993 = 0.85

Unlevered Beta = 0.85/(1 + (1 - 0.385) * 0.05) = 0.8246
Beta After 1998 = 0.8246 * (1 + (1 - 0.385) * 0.25) = 0.95

D. Cost of Equity in 1999 = 7% + 0.95 * 5.5% = 12.23%

Expected Dividend in 1999
= ( $1.50 * 1.1355 * 1.06) * 0.5876 = $1.76
Expected Price at End of 1998 = $1.76/(.1223 - .06) = $28.25

E.
Year EPS DPS
1994 $1.70 $0.48
1995 $1.93 $0.54
1996 $2.19 $0.61
1997 $2.49 $0.70
1998 $2.83 $0.79 $28.25
Cost of Equity = 7% + 0.85 * 5.5% = 11.68%
PV of Dividends and Terminal Price (@ 11.68%) = $18.47

F. Total Value per Share = $18.47

Value Per Share Using Gordon Growth Model
= $1.50 * 1.06 * 0.5876/(.1223 - .06) = $15.00
Value Per Share With No Growth = $1.50 * 0.5876/.1223 = $7.21
Value of Extraordinary Growth = $18.47 - $15.00 = $3.47
Value of Stable Growth = $15.00 - $7.21 = $7.79

Problem 4
A. Cost of Equity = 6.25% + 0.85 * 5.5% = 10.93%
Value of Stable Growth = $0.48 * 1.07/(.1093 - .07) = $13.07

B. Value of Extraordinary Growth

= $0.48 * (6/2) * (.25 - .07)/(.1093 - .07) = $6.60

C. The payout ratio is assumed to remain unchanged as the growth rate changes. The
payout ratio in this case is assumed to remain at 60% (0.48/0.80).
 Dividend Discount Models 3

Problem 5
A.
Period EPS DPS
1 $4.58 $0.79
2 $5.32 $0.92
3 $6.17 $1.07
4 $7.15 $1.21
5 $8.30 $1.43
6 $9.46 $2.35
7 $10.59 $3.56
8 $11.65 $4.94
9 $12.58 $6.44
10 $13.34 $8.00

B. Expected Price at End of 2003

= ($13.34 * 1.06 * 0.60)/(.1175 - .06) = $147.54
(Cost of Equity = 6.25% = 5.5% = 11.75%)

C.
PV of Dividends - High Growth = $3.67
PV of Dividends - Transition = $9.10
PV of Terminal Price = $44.59
Value Per Share = $57.36

Problem 6

a. Dividends = $ 20 million
Value of equity = 20 (1.05)/(.12-.05) = $ 300 million
b. Average annual stock buyback = 180/4 = $ 45 million
Modified dividends = $ 65 million
Value of equity = 65 (1.05)/(.12-.05) = $ 975 million
 CHAPTER 14
FREE CASH FLOW TO EQUITY DISCOUNT MODELS
Problem 1
A. True. Dividends are generally smoothed out. Free cash flows to equity reflect the
variability of the underlying earnings as well as the variability in capital expenditures.
B. False. Firms can have negative free cash flows to equity. Dividends cannot be less
than zero.
C. False. Firms with high capital expenditures, relative to depreciation, may have lower
FCFE than net income.
D. False. The free cash flow to equity can be negative for companies, which either have
negative net income and/or high capital expenditures, relative to depreciation. This
implies that new stock has to be issued.

Problem 2
A. Value Per Share = $1.70 * 1.07/(.1203 - .07) = $36.20
(Cost of Equity = 6.25% + 1.05 * 5.50% = 12.03%)

B.
Current Earnings per share = $3.20
- (1 - Desired Debt Fraction)(Capital Spending - Depreciation) = 83.61%* $1.00 =$0.84
- (1 - Desired Debt Fraction) * ∆ Working Capital = 83.61% * $0.00 = $0.00
Free Cash Flow to Equity = $2.36
Cost of Equity = 6.25% + 1.05 * 5.5% = 12.03%
Value Per Share = $2.36 * 1.07/(.1203 - .07) = $50.20
This is based upon the assumption that the current ratio of capital expenditures to
depreciation is maintained in perpetuity.

C. The FCFE is greater than the dividends paid. The higher value from the model reflects
the additional value from the cash accumulated in the firm. The FCFE value is more likely
to reflect the true value.

Problem 3
A.
Year EPS Cap Exp Depr WC FCFE Term Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
 FCFE Discount Models 2

3 $3.62 $3.47 $1.73 $0.05 $2.19

4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $84.74
6 $5.12 $4.90 $4.90 $0.04 $5.08
The net capital expenditures (Cap Ex - Depreciation) and working capital change is offset
partially by debt (20%). The balance comes from equity. For instance, in year 1:
FCFE = $2.71 - ($2.60 - $1.30) * (1 - 0.20) - $0.05 * (1 - 0.20) = $1.64)
Cost of Equity = 6.5% + 1 * 5.5% = 12%
Terminal Value Per Share = $5.08/(.12 - .06) = $84.74
Present Value Per Share = 1.64/1.12 + 1.89/1.122 + 2.19/1.123 + 2.54/1.124 + (2.93 +
84.74)/1.125 = $55.89

B.
Year EPS Cap Exp Depr WC FCFE Term Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
3 $3.62 $3.47 $1.73 $0.05 $2.19
4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $52.09
6 $5.12 $4.90 $2.45 $0.04 $3.13
Terminal Value Per Share = $3.13/(.12 - .06) = $52.09
Present Value Per Share = 1.64/1.12 + 1.89/1.122 + 2.19/1.123 + 2.54/1.124 +
(2.93+52.09)/1.125 = $37.36

C.
Year EPS Cap Exp Depr WC FCFE Term Price
1 $2.71 $2.60 $1.30 $0.05 $1.43
2 $3.13 $3.00 $1.50 $0.05 $1.66
3 $3.62 $3.47 $1.73 $0.05 $1.92
4 $4.18 $4.00 $2.00 $0.06 $2.23
5 $4.83 $4.62 $2.31 $0.06 $2.58 $45.85
6 $5.12 $4.90 $2.45 $0.04 $2.75
Terminal Value Per Share = $2.75/(.12 - .06) = $45.85
 FCFE Discount Models 3

Present Value Per Share = 1.43/1.12 + 1.66/1.122 + 1.92/1.123 + 2.23/1.124 + (2.58 +

45.85)/1.125 = $32.87
The beta will probably be lower because of lower leverage.

Problem 4
A.
Year EPS Cap Ex Deprec WC FCFE Term.
1 $2.30 $0.68 $0.33 $0.45 $1.57 Price
2 $2.63 $0.78 $0.37 $0.48 $1.82
3 $2.99 $0.89 $0.42 $0.51 $2.11
4 $3.41 $1.01 $0.48 $0.54 $2.45
5 $3.89 $1.16 $0.55 $0.57 $2.83 $52.69
6 $4.16 $0.88 $0.59 $0.20 $3.71
The net capital expenditures (Cap Ex - Depreciation) and working capital change is funded
partially by debt (10%). The balance comes from equity. For instance, in year 1 -
FCFE = $2.30 - ($0.68 - $0.33) * (1 - 0.10) - $0.45 * (1 - 0.10) = $1.57)
B. Terminal Price = $3.71/ (.1305 - .07) = $52.69
C. Present Value Per Share = 1.57/1.136 + 1.82/1.1362 + 2.11/1.1363 + 2.45/1.1364 +
(2.83 + 52.69)/1.1365 = $35.05

Problem 5
A.
Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n) * (1- $0.05 $0.06 $0.07 $0.08 $0.10
∂)
∆ Working Capital * (1- $0.27 $0.31 $0.37 $0.43 $0.50
∂)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten

years)
Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 9.80% 7.40% 5.00%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
 FCFE Discount Models 4

Earnings $1.41 $1.58 $1.73 $1.86 $1.95

(CapEx-Deprec'n) * (1- $0.11 $0.13 $0.14 $0.15 $0.16
∂)
∆ Working Capital * (1- $0.45 $0.39 $0.30 $0.22 $0.13
∂)
FCFE $0.84 $1.07 $1.29 $1.50 $1.67
Beta 1.38 1.31 1.24 1.17 1.10
Cost of Equity 14.59% 14.21% 13.82% 13.44% 13.05%
Present Value $0.37 $0.41 $0.43 $0.44 $0.43
End-of-Life Index 1
Stable Growth Phase
Growth Rate: Stable Phase = 5.00%
FCFE in Terminal Year = $1.95 (1.05)
Cost of Equity in Stable Phase = 13.05%
Price at the End of Growth Phase = $23.79
PV of FCFE in High Growth Phase = $1.51
Present Value of FCFE in Transition Phase =$2.08
Present Value of Terminal Price = $6.20
Value of the Stock = $9.79

B.
Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n)* (1-∂) $0.05 $0.06 $0.07 $0.08 $0.10
∆ Working Capital * (1- $0.27 $0.31 $0.37 $0.43 $0.50
∂)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten

years)
Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 7.40% 5.00%
9.80%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
Earnings $1.41 $1.58 $1.73 $1.86 $1.95
 FCFE Discount Models 5

(CapEx-Deprec'n)*(1-∂) $0.11 $0.13 $0.14 $0.15 $0.16

∆ Working Capital *(1-∂) $0.50 $0.48 $0.43 $0.36 $0.26
FCFE $0.79 $0.97 $1.16 $1.35 $1.54
Beta 1.38 1.31 1.24 1.17 1.10
Cost of Equity 14.59% 14.21% 13.82% 13.44% 13.05%
Present Value $0.34 $0.37 $0.39 $0.40 $0.40
End-of-Life Index 1
Stable Growth Phase
Growth Rate in Stable Phase = 5.00%
FCFE in Terminal Year = $1.78
Cost of Equity in Stable Phase = 13.05%
Price at the End of Growth Phase = $22.09
PV of FCFE in High Growth Phase = $1.51
Present Value of FCFE in Transition Phase = $1.90
Present Value of Terminal Price = $5.76
Value of the Stock = $9.17

C.
Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n) * (1- $0.05 $0.06 $0.07 $0.08 $0.10
∂)
∆ Working Capital * (1- $0.27 $0.31 $0.37 $0.43 $0.50
∂)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten

years)
Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 9.80% 7.40% 5.00%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
Earnings $1.41 $1.58 $1.73 $1.86 $1.95
(CapEx-Deprec'n) * (1- $0.11 $0.13 $0.14 $0.15 $0.16
∂)
 FCFE Discount Models 6

∆ Working Capital * (1- $0.45 $0.39 $0.30 $0.22 $0.13

∂)
FCFE $0.84 $1.07 $1.29 $1.50 $1.67
Beta 1.45 1.45 1.45 1.45 1.45
Cost of Equity 14.98% 14.98% 14.98% 14.98% 14.98%
Present Value $0.36 $0.40 $0.42 $0.43 $0.41
Stable Growth Phase
Growth Rate in Stable Phase = 5.00%
FCFE in Terminal Year = $1.92
Cost Of Equity in Stable Phase = 14.98%
Price at End of Growth Phase = $19.19

PV of FCFE In High Growth Phase = $1.51

Present Value of FCFE in Transition Phase =$2.03
Present Value of Terminal Price = $4.75
Value of the Stock = $8.29

Problem 6
A. Both models should have the same value, as long as a higher growth rate in earnings is
used in the dividend discount model to reflect the growth created by the interest earned, and
a lower beta to reflect the reduction in risk. The reality, however, is that most analysts will
not make this adjustment, and the dividend discount model value will be lower than the
FCFE model value.
B. The dividend discount model will overstate the true value per share, because it will not
reflect the dilution that is inherent in the issue of new stock.
C. Both models should provide the same value.
D. Since acquisition, with the intent of diversifying, implies that the firm is paying too
much (i.e., negative net present value), the dividend discount model will provide a lower
value than the FCFE model.
E. If the firm is over-levered to begin with, and borrows more money, there will be a loss
of value from the over-leverage. The FCFE model will reflect this lost value, and will thus
provide a lower estimate of value than the dividend discount model.

Problem 7

a. Equity Reinvestment rate

= (Cap Ex – Deprec’n + Chg in WC- Net Debt Issued)/ Net Income
 FCFE Discount Models 7

= (50 –20 + 20 - 10)/ 80 = 50%

Return on Equity = Net Income/ Book value of equity = 80/ 400 = 20%
Expected growth rate = ROE * Equity Reinv. Rate = 20% * .5 = 10%

b.
Equity reinvestment rate after year 5 = g/ ROE = 4/12 = 33.33%
Equity Terminal
Year Net Income Reinvestment FCFE value PV
1 $88.00 $44.00 $44.00 $40.00
2 $96.80 $48.40 $48.40 $40.00
3 $106.48 $53.24 $53.24 $40.00
4 $117.13 $58.56 $58.56 $40.00
5 $128.84 $64.42 $64.42 $1,488.83 $964.44
6 $133.99 $44.66 $89.33
$1,124.44
Value of Equity today = $1,124.44 million

Problem 8
a. Non-cash return on equity
= (Net Income – Interest income from cash (1-t))/ (BV of equity – Cash)
= (100 – 10)/ ( 1000 – 200) = 90 / 800 = 11.25%
b. Equity reinvestment rate = g / ROE = 3% / 11.25% = 26.67%
Value of non-cash equity = 90 (1.03) (1- .2667)/ (.09 - .03) = $ 1,133 million
Value of equity = $1,133 million + $ 200 million = $1,333 million
(I valued cash separately and added it to the value of the non-cash equity.
 CHAPTER 15
FIRM VALUATION: COST OF CAPITAL AND APV APPROACHES
Question 1
A. False. It can be equal to the FCFE if the firm has no debt.
B. True.
C. False. It is pre-debt, but after-tax.
D. False. It is after-tax, but pre-debt.
E. False. The free cash flow to firm can be estimated directly from the earnings before
interest and taxes.

Question 2
A. FCFF in 1993 = Net Income + Depreciation - Capital Expenditures - ∆ Working Capital
+ Interest Expenses (1 - tax rate)
= $770 + $960 - $1200 - 0 + $320 (1 - 0.36) = $734.80 million

B. EBIT = Net Income/(1 - tax rate) + Interest Expenses

= 770/0.64 + 320 = $1523.125 million
Return on Capital = EBIT (1-t)/ (BV of Debt + BV of Equity)
= 974.80/9000 = 10.83%
Expected Growth Rate in FCFF = Retention Ratio * ROC
= 0.6 * 10.83% = 6.50%
Cost of Equity = 7% + 1.05 * 5.5% = 12.775%
Cost of Capital = 8% (1 - 0.36) (4000/(4000 + 12000)) + 12.775%
(12000/(4000 + 12000)) = 10.86%
Value of the Firm = 734.80/(.1086 - .065) = $16,853 millions

C. Value of Equity = Value of Firm - Market Value of Debt

= $16,853 - $4,000 = $12,853 millions
Value Per Share = $12,853/200 = $64.27

Question 3
A.
Yr EBITDA Deprec'n EBIT EBIT Cap WC FCFF Term
(1-t) Exp. Value
0 $1,290 $400 $890 $534 $450 $82 $402
1 $1,413 $438 $975 $585 $493 $90 $440
 Price/Earnings Multiples 2

2 $1,547 $480 $1,067 $640 $540 $98 $482

3 $1,694 $525 $1,169 $701 $591 $108 $528
4 $1,855 $575 $1,280 $768 $647 $118 $578
5 $2,031 $630 $1,401 $841 $708 $129 $633 $14,941
'93-97 After 1998
Cost of Equity = 13.05% 11.89%
AT Cost of Debt = 4.80% 4.50%
Cost of Capital = 9.37% 9.45%
Terminal Value
= {EBIT (1-t)(1+g) - (Rev1998 - Rev1997) * WC as % of Rev}/(WACC-g)
= (841 * 1.04) - (13500 * 1.0955 * 1.04 - 13500 * 1.0955)
* 0.07 /(.0945-.04) = $14,941
Value of the Firm
= 440/1.0937 + 482/1.09372 + 528/1.0937 3 + 578/1.0937 4 + (633 + 14941)/1.09375
= $11,566

B. Value of Equity in the Firm = ($11566 - Market Value of Debt) = 11566 - 3200 = 8366
Value Per Share = $8366/62 = $134.94

Question 4
A. Beta for the Health Division = 1.15
Cost of Equity = 7% + 1.15 * 5.5% = 13.33%
Cost of Capital = 13.33% * 0.80 + (7.5% * 0.6) * 0.2 = 11.56%

B.
Year Deprec'n EBIT EBIT(1-t) Cap Ex FCFF Term Val
0 $350 $560 $336 $420 $266
1 $364 $594 $356 $437 $283
2 $379 $629 $378 $454 $302
3 $394 $667 $400 $472 $321
4 $409 $707 $424 $491 $342
5 $426 $749 $450 $511 $364 $5,014

Now After 5 years

Cost of Equity = 13.33% 13.33%
Cost of Debt = 4.50% 4.50%
 Price/Earnings Multiples 3

Cost of Capital 11.56% 11.56%

=
Value of the Division = 283/1.1156 + 302/1.11562 + 321/1.1156 3 + 342/1.1156 4 + (364
+ 5014)/1.1156 5 = $4,062 millions
C. There might be potential for synergy, with an acquirer with related businesses. The
health division at Kodak might also be mismanaged, creating the potential for additional
value from better management.

Question 5

Value = FCFF /(WACC-g)

750 = 30/(WACC-.05)

Solving for WACC,

WACC = .09

Given the cost of equity of 12% and the after-tax cost of debt of 6%,

Book Value weight for Equity = 0.50

The correct weights will be as follows:

Market Value Weight of Equity = (3*50)/(3*50+50) = 0.75

Correct Cost of Capital = 12% (.75) + 6% (.25) = 10.5%

Correct Value of Firm = 30/(.105-.05) = $545.45

Question 6
A. Cost of Equity = 7% + 1.25 * 5.5% = 13.88%
Current Debt Ratio = 1340/(1340 + 18.25 * 183.1) = 28.63%
After-tax Cost of Debt = 7.43% (1 - 0.4) = 4.46%
Cost of Capital = 13.88% (0.7137) + 4.46% (0.2863) = 11.18%

B. & C. See table below.

D/(D+E Cost of Beta Cost of AT Cost of Cost of Firm
)
Debt Equity Debt Capital Value
0% 6.23% 1.01 12.54% 3.74% 12.54% $2,604
10% 6.23% 1.07 12.91% 3.74% 11.99% $2,763
20% 6.93% 1.16 13.37% 4.16% 11.53% $2,912
 Price/Earnings Multiples 4

30% 7.43% 1.27 13.97% 4.46% 11.11% $3,063

40% 8.43% 1.41 14.76% 5.06% 10.88% $3,153
50% 8.93% 1.61 15.87% 5.36% 10.61% $3,265
60% 10.93% 1.91 17.53% 6.56% 10.95% $3,125
70% 11.93% 2.42 20.30% 7.16% 11.10% $3,067
80% 11.93% 3.43 25.84% 7.16% 10.89% $3,149
90% 13.43% 6.45 42.47% 8.06% 11.50% $2,923
Unlevered Beta = 1.25/(1 + 0.6 * (1340/(183.1 * 18.25)) = 1.01
Levered Beta at 10% D/(D+E) = 1.01 * (1 + 0.6 * (10/90)) = 1.07
FCFF to Firm Next Year = (637 - 235) * (1 - 0.4) * 1.03 = $248.43 million

Value of the Firm = 255.67 * 1.03/(WACC-.03)

Problem 7
a. Cost of capital approach
Return on capital = 200 (1 - .4)/ 1200 = 10%
Reinvestment rate = g/ ROC = 4%/10% = 40%
Cost of equity = 5% + 1.2 (5.5%) = 11.6%
Cost of capital = 11.6% (1000/1500) + 6% (1-.4)(500/1500) = 8.93%
Value of firm
= EBIT (1-t) (1- Reinvestment rate ) (1+g)/ (Cost of capital – g)
= 200 (1-.4) (1-.4)(1.04)/ (.0893 - .04) = $1,519 million
b. Unlevered beta = 1.20/ (1 + (1-.4)(500/1000)) = 0.9231
Unlevered cost of equity = 5% + 0.9231 (5.5%) = 10.08%
Unlevered firm value = = 200 (1-.4) (1-.4)(1.04)/ (.1008 - .04) = $1,232 million
+ PV of tax benefits from debt = Tax rate * Debt
= 0.40 * 500 = $ 200 million
- Expected bankruptcy costs = Probability of bankruptcy * Unlevered firm value * Cost
of bankruptcy = 0.10 * 1232 * .25 = $30.8 million
APV value of firm = $ 1232 + 200 – 30.8 = $ 1401.2 million
c. The APV approach considers only the tax benefits from existing debt, whereas the cost
of capital approach assumes that debt will increase over time (to keep the debt ratio stable as
the firm grows) and considers the potential tax benefits from future debt issues.