fin 3716 chapter 10

) If you want to value a firm but do not want to explicitly forecast its dividends, the simplest model for you to use is ________. A) the discounted free cash flow model B) the dividend-discount model C) the enterprise value model D) None of the above models can be used if you do not want to forecast dividends or use of debt.

A

Which of the following statements is FALSE? A) As the enterprise value represents the entire value of a firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are made. B) We can compute a firmʹs price-earnings ratio by using either trailing earnings or forward earnings with the resulting ratio called the trailing price-earnings or forward price-earnings. C) It is common practice to use valuation multiples based on a firmʹs enterprise value. D) Using a valuation multiple based on comparables is best viewed as a shortcut to the discounted cash flow method of valuation.

Answer: A Explanation: A) As the enterprise value represents the entire value of a firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest payments are made.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Another newspaper publishing firm (not shown) had sales of $640 million, EBITDA of $84 million, excess cash of $67 million, $14 million of debt, and 120 million shares outstanding. If the average enterprise value to sales for comparable businesses is used, which of the following is the range of reasonable share price estimates? A) $6.27 to $8.86 B) $4.59 to $12.23 C) $1.15 to $1.53 D) $6.19 to $9.32

Answer: A Explanation: A) Enterprise Value =1.35 × $640 =$864 million; P0 = ($864 million + $67 million - $14 million) / 120 = $7.64 Range is from 82% to 116% of estimate. $7.64 × 0.82 = $6.27; $7.64 × 1.16 = $8.86

Gonzales Corporation generated free cash flow of $88 million this year. For the next two years, the companyʹs free cash flow is expected to grow at a rate of 10%. After that time, the companyʹs free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 12% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Gonzales Corporationʹs expected terminal enterprise value in year 2? A) $1384.24 B) $1245.82 C) $1107.39 D) $968.97

Answer: A Explanation: A) FCF1 = $88 million × (1 + 0.1) = $96.8 million; FCF2 = $88 million × (1 + 0.1)2 = $106.48 million; V2 = ($106.48 million × 1.04) / (0.12 - 0.04) = $1384.24 million

Year 1 2 3 4 Free Cash Flow $12 million $18 million $22 million $26 million Conundrum Mining is expected to generate the above free cash flows over the next four years, after which they are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 11% and Conundrum has cash of $85 million, debt of $65 million, and 30 million shares outstanding, what is Conundrumʹs expected current share price? A) $12.61 B) $16.40 C) $20.18 D) $20.81

Answer: A Explanation: A) FCF5 = $26 million × (1 + 0.05) = $27.3 million; V4 = $27.3 million / (0.11 - 0.05) = $455.00 million; using a financial calculator, V0 = $358.36 million; P0 = (358.36 + 85 - 65) / 30 = $12.61

On a particular date, FedEx has a stock price of $89.27 and an EPS of $7.11. Its competitor, UPS, had an EPS of $0.38. What would be the expected price of UPS stock on this date, if estimated using the method of comparables? A) $4.77 B) $7.16 C) $9.54 D) $10.50

Answer: A Explanation: A) FedEx P/E = $89.27 / 7.11 =$12.5556; UPS stock price =$12.5556 × 0.38 = $4.77

Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for the clean-up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free cash flow by $11 million per year for ten years. If it is not liable, there will be no effect. On the close of trading the day before the announcement of the verdict, Advanced Chemicals was trading at $20 per share. Most investors calculate that there is a 100% chance that Advanced Chemicals will have a verdict returned against them. One investor, Jo, has performed extensive research into the outcome of the trial and estimates that there is no chance Advanced Chemicals will have a verdict returned against them. Given that Advanced Chemicals has 40 million shares outstanding and an equity cost of capital of 6% with no debt, Joʹs estimate of the value of a share of Advanced Chemicals would be how much more than the market price? A) $2.02 B) $20.81 C) $21.01 D) $21.62

Answer: A Explanation: A) Using a financial calculator, PV of 11 million for 10 years at 6% = $80.961 million; per share effect = $80.961 million / 40 million = $2.02

Which of the following statements is FALSE? A) The more cash a firm uses to repurchase shares, the less it has available to pay dividends. B) Free cash flow measures the cash generated by a firm after payments to debt or equity holders are considered. C) We estimate a firmʹs current enterprise value by computing the present value (PV) of the firmʹs free cash flow. D) We can interpret the enterprise value of a firm as the net cost of acquiring the firmʹs equity, taking its cash, and paying off all debts.

Answer: B Explanation: B) FCF is cash generated by a firm before payments to debt and equity holders.

Year 1 2 3 4 Free Cash Flow $12 million $18 million $22 million $26 million Conundrum Mining is expected to generate the above free cash flows over the next four years, after which they are expected to grow at a rate of 6% per year. If the weighted average cost of capital is 12% and Conundrum has cash of $80 million, debt of $60 million, and 30 million shares outstanding, what is Conundrumʹs expected terminal enterprise value? A) $413.4 million B) $459.3 million C) $505.3 million D) $528.2 million

Answer: B Explanation: B) FCF5 = $26 million × (1 + 0.06) =27.6 million; V4 =$27.6 million / (0.12 - 0.06) = $459.3 million

Which of the following statements is FALSE? A) We can estimate the value of a firmʹs shares by multiplying its current earnings per share by the average price-earnings ratio of comparable firms. B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is based on actual not expected earnings. C) Forward earnings are the expected earnings over the coming 12 months. D) Trailing earnings are the earnings over the previous 12 months.

Answer: B Explanation: B) For valuation purposes, the forward price-earnings ratio is generally preferred, since it is based on the expected earnings

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Another newspaper publishing firm (not shown) had sales of $620 million, EBITDA of $81 million, excess cash of $62 million, $11 million of debt, and 120 million shares outstanding. If the firm had an EPS of $0.41, what is the difference between the estimated share price of this firm if the average price-earnings ratio is used and the estimated share price if the average enterprise value/EBITDA ratio is used? A) -$0.08 B) -$0.13 C) -$1.27 D) -$1.39

Answer: B Explanation: B) Price using price-earnings ratio =11.33 × $0.41 = $4.6453; using enterprise value / EBITDA ratio = 6.44 × $81 million = $521.64 million; P0 = ($521.64 million + $62 million - $11 million) / 120 million = $4.77; difference = $-0.13

Which of the following statements is FALSE? A) The most common valuation multiple is the price-earnings ratio. B) You should be willing to pay proportionally more for a stock with lower current earnings. C) A firmʹs price-earnings ratio is equal to the share price divided by its earnings per share. D) The intuition behind the use of the price-earnings ratio is that when you buy a stock, you are in a sense buying the rights to the firmʹs future earnings, and differences in the scale of firmsʹ earnings are likely to persist.

Answer: B Explanation: B) You should be willing to pay proportionally more for a stock with higher current earnings.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Which of the following ratios would most likely be the most reliable in determining the stock price of a comparable firm? A) P/E B) Price/Book C) Enterprise Value/Sales D) Enterprise Value/EBITDA

Answer: C

Gonzales Corporation generated free cash flow of $86 million this year. For the next two years, the companyʹs free cash flow is expected to grow at a rate of 10%. After that time, the companyʹs free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $275 million, and 100 million shares outstanding, what is Gonzales Corporationʹs expected current share price? A) $14.37 B) $11.87 C) $12.49 D) $16.24

Answer: C Explanation: C) FCF1 = $86 million × (1 + 0.1) =$94.6 million; FCF2 = $86 million × (1 + 0.1)2 = $104.06 million; FCF3 = 104.06 million × (1 + 0.04) = $108.2224 million V2 = $108.2224 million / (0.11 - 0.04) = $1546.03 million using a financial calculator, V0 = $1424.48 million P0 = (1424.48 million - 275 million + 100 million) / 100 million = $12.49

Which of the following statements is FALSE? A) The long-run growth rate gFCFis typically based on the expected long-run growth rate of a firmʹs revenues. B) Since a firmʹs free cash flow is equal to the sum of the free cash flows from the firmʹs current and future investments, we can interpret the firmʹs enterprise value as the total net present value (NPV) that the firm will earn from continuing its existing projects and initiating new ones. C) If a firm has no debt, then rwacc equals the risk-free rate of return. D) When using the discounted free cash flow model, we forecast a firmʹs free cash flow up to some horizon, together with some terminal (continuation) value of the enterprise.

Answer: C Explanation: C) If the firm has no debt, then rwacc = the cost of equity.

Carbondale Oil announces that a well that it has sunk in a new oil province has shown the existence of substantial oil reserves. The exploitation of these reserves is expected to increase Carbondaleʹs free cash flow by $100 million per year for eight years. If investors had not been expecting this news, what is the most likely effect on Carbondaleʹs stock price upon the announcement, given that Carbondale has 80 million shares outstanding, no debt, and an equity cost of capital of 11%? A) no effect B) rise by $5.15 C) rise by $6.43 D) rise by $7.72 Carbondale Oil announces that a well that it has sunk in a new oil province has shown the existence of substantial oil reserves. The exploitation of these reserves is expected to increase Carbondaleʹs free cash flow by $100 million per year for eight years. If investors had not been expecting this news, what is the most likely effect on Carbondaleʹs stock price upon the announcement, given that Carbondale has 80 million shares outstanding, no debt, and an equity cost of capital of 11%? A) no effect B) rise by $5.15 C) rise by $6.43 D) rise by $7.72

Answer: C Explanation: C) PV of 100 million for 8 years at 11% = $514.6123 million per share = $514.6123 million / 80 million = $6.43

Which of the following statements is FALSE? A) Even two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of different size or scale. B) In the method of comparables, we estimate the value of a firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. C) Consider the case of a new firm that is identical to an existing publicly traded company. If these firms will generate identical cash flows, the Law of One Price implies that we can use the value of the existing company to determine the value of the new firm. D) A valuation multiple is a ratio of some measure of a firmʹs scale to the value of the firm.

Answer: D Explanation: D) A valuation multiple is a ratio of the value of the firm to some measure of the firmʹs scale.

On a certain date, Kastbro has a stock price of $37.50, pays a dividend of $0.64, and has an equity cost of capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then sells all stocks that he owns in Kastbro. Given Kastbroʹs share price, was this a reasonable action? A) No, since the constant dividend growth rate gives a stock estimate of $37.50. B) No, since the constant dividend growth rate gives a stock estimate greater than $37.50. C) Yes, since the constant dividend growth rate gives a stock estimate greater than $37.50. D) No, since the difference between his calculated stock price and the actual stock price most likely indicates that his estimate of dividend growth rate was incorrect.

Answer: D Explanation: D) Calculated stock price =$0.64 / .06 = $10.67; actual stock price = $37.50. Difference = $26.83

) Gonzales Corporation generated free cash flow of $81 million this year. For the next two years, the companyʹs free cash flow is expected to grow at a rate of 9%. After that time, the companyʹs free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Gonzales Corporationʹs expected free cash flow in year 2? A) $1429.79 million B) $86.61 million C) $1572.77 million D) $96.24 million

Answer: D Explanation: D) FCF1 = 81 × (1 + 0.09) =88.29; FCF2 = $81 million × (1 + 0.09)2 = $96.2361 million

Which of the following statements is FALSE? A) A firmʹs weighted average cost of capital, denoted rwacc, is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firmʹs equity and debt. B) Intuitively, the difference between the discounted free cash flow model and the dividend-discount model is that in the divided-discount model, a firmʹs cash and debt are included indirectly through the effect of interest income and expenses on earnings in the dividend-discount model. C) We interpret rwacc as the expected return a firm must pay to investors to compensate them for the risk of holding the firmʹs debt and equity together. D) When using the discounted free cash flow model, we should use a firmʹs equity cost of capital.

Answer: D Explanation: D) You should use the firmʹs weighted average cost of capital.

In the method of comparables, the known values of a firmʹs cash flows are used to estimate the unknown cash flows of a similar firm. T/F

T

Several methods should be used to provide an estimate of a stockʹs value since no single method provides a definitive value. T/F

T

If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for you to use is the ________. A) enterprise value model B) method of comparables C) dividend-discount model D) discounted free cash flow model

C

Valuation models use the relationship between share value, future cash flows, and the cost of capital to estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we reliably use such models to determine? I. the firmʹs future cash flows II. the firmʹs cost of capital III. the firmʹs market price A) I only B) II only C) III only D) I and II

C

Which of the following is the best statement of the efficient markets hypothesis? A) Investors with information that a stock had a positive net present value (NPV) will buy it, while investors with information that a stock had a negative net present value (NPV) will sell it. B) Investorʹs decisions are dependent on complete current information of a firmʹs cash flows and accurate predictions of future cash flows. C) Competition between investors works to make the net present value (NPV) of all trading opportunities zero. D) A shareʹs price is the aggregate of the information of many investors.

C

Which of the following statements concerning the valuation of firms using the method of comparables is FALSE? A) If two different firms generate identical cash flows, the Law of One Price will imply that both firms have the same value. B) Comparables adjust for scale differences when valuing similar firms. C) Valuation multiples take into account differences in the risk and future growth between the firms being compared. D) Two firms that sell very similar products or offer very similar services will have different values if they are of different sizes.

C

The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt directly, if free cash flow is calculated based on EBIT. T/F

T

) Which of the following is the appropriate way to calculate the price of a share of a given company using the free cash flow valuation model? A) P0 = Div1/(rE - g) B) P0 = PV(Future Free Cash Flow of Firm) / (Shares Outstanding0) C) P0 = [Div1 / (rE - g)] / (Shares Outstanding0) D) P0 = (V0 + Cash0 - Debt0) / (Shares Outstanding0)

D

An investor estimates the value of a firm which manufactures cookware by examining the cash flows of similar firms. Which of the following is assumed to be the same for these firms? A) P/E B) annual growth rates C) payout rates D) all of the above

D

Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity cost of capital of 8%. Praetorianʹs stock is currently trading at $84 per share. By comparing Praetorian with similar firms, an investor expects that its dividends will grow by up to 5% per year. What is the best next step that the investor should take regarding Praetorianʹs stock? A) Sell any Praetorian stock that she owns. B) Short Praetorianʹs stock. C) Revise Praetorianʹs equity cost of capital. D) Revise her estimate of Praetorianʹs dividend growth.

D

Which of the following is NOT an advantage of the valuation multiple method as compared to the discounted cash flow method? A) calculations based upon widely available information B) based upon actual stock prices of real firms C) does not rely on estimates of future cash flows D) takes into account important differences between different firms

D

If you value a stock using a range of stock valuation methods and these valuations indicate a stock price that is greater than its actual market price, it is most likely that the stock is under-valued. T/F

F

In an efficient market, investors will only find positive-NPV trading opportunities if they have some form of competitive advantage over other investors. T/F

T

) Year 1 2 3 4 5 Free Cash Flow $22 million $26 million $29 million $30 million $32 million General Industries is expected to generate the above free cash flows over the next five years, after which free cash flows are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 9% and General Industries has cash of $15 million, debt of $45 million, and 80 million shares outstanding, what is General Industriesʹ expected current share price? A) $7.78 B) $8.17 C) $9.34 D) $11.67

answer: A Explanation: A) FCF6 = $32 million × (1 + 0.05) = $33.6 million; V5 = $33.6 million / (0.09 - 0.05) = $840 million; using a financial calculator, V0 = 652.45 million; P0 = $(652.45 + 15 - 45) million / 80 million = $7.78