BEAM038 / BEFM016 Turn over
Section A: Answer any TWO out of FOUR questions.
Question 1.
Hi-Invest is a small investment company. It requires all its analysts to use the
dividend discount model (DDM) and the capital asset pricing model (CAPM) to value
equity shares. Recently, they have estimated the expected market return of 6.5% per
annum. They also think that the risk-free rate of interest is 2.5% per annum.
Suppose that TLime and SPotato are two leading companies in the same industry.
Since TLime has steady growth in the last ten years, analysts in Hi-Invest are
relatively confident about the intrinsic value estimation of this company: £2.2 per
share, though TLime has no cash dividend history. The stock is currently traded at
£1.95 per share.
In order to value SPotato, analysts have collected the following information:
(a) the company has a constant dividend payout policy and the most recent net
dividends per share were £0.11. They also estimate the following earnings per share
(EPS) growth rates for SPotato:
First 3 years 8% per year
Years thereafter 3% per year
Other relevant information includes: the CAPM beta of SPotato is 1.3 and SPotato is
currently traded at £3.2 per share.
REQUIRED
(a) Calculate the required rate of return for SPotato and expected dividends for the
next four years.
(15 marks)
(b) Estimate the current intrinsic value of SPotato by using the two-stage
DDM, and the intrinsic value at the end of year 3.
(40 marks)
(c) Would Hi-Invest analysts recommend investors to buy, sell or hold TLime
and SPotato shares? Explain your recommendations.
(20 marks)
(d) Explain the difference between cash dividends and free cash flows to equity
holders (FCFE).
(10 marks)
(e) One analyst argues that the DDM does not apply to TLime since it has
never paid dividends to shareholders. Comment on this statement.
(15 marks)
[Total 100 Marks]
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BEAM038 / BEFM016 Turn over
Question 2
A private equity firm called DMAN Ltd purchased an IT company at the beginning of
2018. It paid £450m, financed with mixture of 40% equity and 60% debt (i.e., £270m
of debt).
Assume its levered equity beta is 1.5, its debt beta is 0.3 and the corporation tax rate
(Tc), is 25%. The constant risk free-rate is 2.5% and the constant expected return
on the market is 7.5%. You may assume that the cost of debt and the cost of equity
are given by the CAPM.
The company has projected free cash flows at the end of 2018 of £8m. These will
rise to £16m at the end of 2019 (year 2) and are projected to increase in perpetuity
at 3%. All free cash flow will be used to pay interest expenses (net of tax relief), and
the rest will be used to reduce the debt levels.
Assume at the end of year 2 the firm will be floated on the stock market at fair value.
It will issue new equity to achieve the planned long term financing mix of 70% equity
and 30% debt. This reduction in leverage will lower the debt beta to 0.2.
Assume the business risk is independent of the leverage and the management will
apply the Ruback (2002) active debt management policy.
REQUIRED:
(a) Estimate the levered cost of equity, the weighted average cost of capital, and
the unlevered cost of equity for year 1 and their long term values. (40 marks)
(b) Calculate the value of the firm at flotation (end of year 2) using the weighted
average cost of capital. (10 marks)
(c) Calculate the capital cash flow and the value of the firm at flotation using the
Ruback (2002) capital cash flow version of the Adjusted Present Value (APV) model.
(25 marks)
(d) The APV model has attracted attention as a model of corporate valuation as
an alternative to the discounted cash flow models based on the weighted average
cost of capital (WACC). Discuss the different implications on the value of tax shields
between the active debt management policy and passive debt management policy.
(25 marks)
[Total 100 marks]
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BEAM038 / BEFM016 Turn over
Question 3.
You wish to value the equity of MacD Co. using the residual income valuation model
(RIVM). In order to check your estimation results, you also apply the dividend
discount model (DDM), the abnormal earnings growth model (AEG) and P/E
multiple.
Suppose you are planning to use the CAPM to estimate the cost of capital. You
estimate that the firm has a beta of 1.2 and the market risk premium is 4%. Assume
the risk free rate is 2.5%.
Current book value of MacD is 300 pence per share and you forecast earnings and
dividends to be as follows:
Earnings per share: 25 pence in year 1 and 30 pence in year 2
Dividends per share: 2.5 pence in year 1 and 4.5 pence in year 2
For year 3 and beyond, you forecast a growth rate in book values and earnings to be
5%.
REQUIRED:
(a) Calculate earnings, dividends and book values for years 3 and 4.
(15 marks)
(b) Calculate residual income and abnormal earnings growth for years 2-4.
(15 marks)
(c) Calculate the current value of MacD Co. using the DDM, RIVM and AEG
models. Also, calculate the value at the beginning of year 3 by using these
three models. You need to present your workings for each model.
(40 marks)
(d) Calculate the value of the company using the P/E approach at the beginning
of year 3.
(10 marks)
(e) Compare and contrast the DDM, RIVM, AEG and P/E models.
(20 marks)
[Total 100 marks]
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BEAM038 / BEFM016 Turn over
Question 4. The income statement and reorganized balance sheet for ExE Plc. are
given below.
Income Statement (in millions) Reorganized balance sheet (in millions)
Today Year 1 Today Year 1
Revenues 1000.0 1050.0 Operating working capital 87.7 92.085
Operating costs (800.0) (840.0) Property and equipment 548.0 575.400
Depreciation (50.0) (52.5) Invested capital 635.7 667.485
Operating profits 150.0 157.5
Debt 300.0 315.000
Interest expenses (16.0) (18.0) Shareholders' equity 335.7 352.485
Earnings before
taxes
134.0 139.5 Invested capital 635.7 667.485
Taxes (33.5) (34.875
)
Net Income 100.5 104.625
Assume the cost of equity is 10% and cost of debt before tax is 6%. The operating
tax rate (also marginal tax rate) is 25 percent. Revenues are expected to grow at a
rate of 5 percent forever. Assume the market value of debt equals today’s book
value of debt.
REQUIRED:
(a). Determine the following values for year 1: net operating profit after tax
(NOPLAT), the free cash flow to firm (FCFF), and free cash flow to equity holders
(FCFE). (25 Marks)
(b). Assume ExE Plc. currently has 60 million shares outstanding. Compute ExE’s
equity value and price per share by using the free cash flow to equity holders (FCFE)
model. Assume FCFE are growing at 5 percent. (10 Marks)
(c). Calculate the weighted average cost of capital and the enterprise economic profit
(RIF). (15 Marks)
(d). Estimate ExE’s enterprise value using the DCF model and the growing-
perpetuity formula. Assume free cash flow grows at 5 percent. (10 Marks)
(e). Estimate the enterprise value using the economic profit model and compare it
with the result in (d). Assume economic profit grows at 5 percent. (15 Marks)
(f). Calculate the intrinsic equity value for ExE Plc using indirect approach. Does the
intrinsic value per share differ from the share price in (b) above? (10 Marks)
(g). Discuss the main difference between direct and indirect approaches in equity
valuation using the DCF. (15 Marks)
[Total 100 Marks]
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BEAM038 / BEFM016 End of Paper
Section B: This is a compulsory question.
Question 5
Markets seem to make extensive use of price multiples in equity (and firm) valuation.
REQUIRED:
(a) List three commonly used valuation multiples and explain how they are related to
the DCF (RIVM) valuation.
(40 marks)
(b) Explain the normal procedure to do a relative valuation.
(20 marks)
(c) Discuss the difference between conventional P/E and Shiller’s CAPE10 ratio.
(10 marks)
(d) Explain the rationale to introduce the price-earnings growth ratio (PEG).
(10 marks)
(e) Discuss the potential problems in applying valuation multiples in practice.
(20 marks)
(Total 100 marks)