Basic Financial Management Chapter 9

Gupta Corporation is undergoing a restructuring, and its free cash flows are expected to vary considerably during the next few years. However, the FCF is expected to be $65.00 million in Year 5, and the FCF growth rate is expected to be a constant 6.5% beyond that point. The weighted average cost of capital is 12.0%. What is the horizon (or continuing) value (in millions) at t = 5?

$1,025 $1,079 $1,136 $1,196 $1,259 Answer: e FCF6 = 65x1.065=69.22, V5 = 69.22/(.12-.065) =1258.54 This is the value of the whole firm at the end of year 5.

Mooradian Corporation's free cash flow during the just-ended year (t = 0) was $150 million, and its FCF is expected to grow at a constant rate of 5.0% in the future. If the weighted average cost of capital is 12.5%, what is the firm's total corporate value, in millions?

$1,895 $1,995 $2,100 $2,205 $2,315 Answer: c First grow FCF0 to FCF1 implies FCF1 = 150x1.05=157.5 then use the constant growth model: 157.5/(.125-.05) = 2,100

Molen Inc. has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, at what price should the stock sell?

$104.27 $106.95 $109.69 $112.50 $115.38 Answer: e 7.50/.065=115.38

Nachman Industries just paid a dividend of D0 = $1.32. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value?

$41.59 $42.65 $43.75 $44.87 $45.99 Answer: d First estimate the cashflows at the end of each period through the first year that growth is constant: D1 = 1.32x1.30=1.716; D2 = 1.716x1.10=1.888; D3 = 1.888x1.05=1.98. Now estimate the stock price at the end of period 2: P2 = 1.98/(.09-.05) = 49.50/share; now convert it into today's dollars, 49.50/1.092 = 41.66, this is the value today of all the cashflows from period 3 into the future. The stock is worth that plus the intervening dividends D1 and D2. The present value of D1 is PV(D1) = 1.716/1.09 = 1.57; the present value of D2 is PV(D2) = 1.888/1.092= 1.59. Now add the three PVs up: 41.66+1.57+1.59=44.82 (I'm off a nickel due to rounding). Thus, the value of a stock is the present value of all its cashflows.

You must estimate the intrinsic value of Noe Technologies' stock. The end-of-year free cash flow (FCF1) is expected to be $27.50 million, and it is expected to grow at a constant rate of 7.0% a year thereafter. The company's WACC is 10.0%, it has $125.0 million of long-term debt plus preferred stock outstanding, and there are 15.0 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock?

$48.64 $50.67 $52.78 $54.89 $57.08 Answer: c The value of the whole firm, debt plus equity today is V0 = 27.5/(.10-.07) = 916.67 The total equity value of the firm is 916.67-125=791.67 which translates into 791.67/15=52.78 per share.

If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year?

9.27%. Take P0=D1/(rs-g) and rearrange it so rs = D1/P0 + g. rs = [1.75x1.036]/32 + .036 =.0927

If markets are in equilibrium, which of the following conditions will exist?

A. Each stock's expected return should equal its realized return as seen by the marginal investor. B. Each stock's expected return should equal its required return as seen by the marginal investor. C. All stocks should have the same expected return as seen by the marginal investor. D. The expected and required returns on stocks and bonds should be equal. E. All stocks should have the same realized return during the coming year. Answer: b

Which of the following statements is CORRECT?

A. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. B. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. C. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. D. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. E. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. Answer: c

Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 $3.00 Current Price, P0 $50 Expected constant growth rate 6.0%

A. The stock's required return is 10%. B. The stock's expected dividend yield and growth rate are equal. C. The stock's expected dividend yield is 5%. D. The stock's expected capital gains yield is 5%. E. The stock's expected price 10 years from now is $100.00. Answer: b 50 = 3.00/(rs-.06) for this to work, Rs = 12% which implies g=DY as rs = g+DY

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9%

A. These two stocks should have the same price. B. These two stocks must have the same dividend yield. C. These two stocks should have the same expected return. D. These two stocks must have the same expected capital gains yield. E. These two stocks must have the same expected year-end dividend. Answer: b rs = CG+DY, For stock A: 10=7+DY implies DY =3%; for stock B: 12=9+DY implies DY =3%

Which of the following statements is CORRECT?

Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock. Corporations cannot buy the preferred stocks of other corporations. Preferred dividends are not generally cumulative. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation. Answer: b

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Beta 1.10 0.90 Constant growth rate 7.00% 7.00%

Stock A must have a higher stock price than Stock B. Stock A must have a higher dividend yield than Stock B. Stock B's dividend yield equals its expected dividend growth rate. Stock B must have the higher required return. Stock B could have the higher expected return. Answer: b First rs for A is 6.4+1.1(6)=13% and for B is 6.4+.9(6)=11.8%

Which of the following statements is CORRECT?

To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital. The corporate valuation model requires the assumption of a constant growth rate in all years. Answer: a

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True False True