Suggested answer sheet for mock exam paper – BEAM038BEFM016-mock2023
Question 1.
(a). TLime: Market price = 1.95; Intrinsic Value = 2.2
SRose: Market price=3.2; Beta = 1.3
Risk-free rate = 2.50%
Expected market return= 6.50%
The CAPM gives: cost of equity = 7.70% (3 marks)
year0 1 2 3 4
dividends 0.11 0.119 0.128 0.139 0.143
earnings growth 8% 8% 8% 3%
(4*3=12 marks)
(b). constant div payout means divs grow at the same rate as earnings
year0 1 2 3 4
PV of divs 1-stage 0.44 0.11 0.11 0.11 0.11
PV of divs 2-stage 2.32
DDM v 2.76 (25 marks)
3.04 (15 marks)
Alternatively, using backward approach,
year0 1 2 3
DDM 2.76 2.86 2.95 3.04
(c). Compare each company’s intrinsic value with its current market price.
TLime: V > p, buy. Make sure you find out why the analysts are so confident about its
valuation.
SPotato: V < p, sell. (20 marks)
(4) FCFE = net dividends + excess cash, where net dividends = Cash dividends + share
repurchases - new share issuances. Net dividends can be negative. Explain excess cash.
Repurchases are a part of net dividends. You may mention that corporate stock buyback hits a
record high in recent years. (10 marks)
(5) in DDM, dividends are net dividends, see above. Note also net dividends =
comprehensive earnings - changes in book equity capital by CSR. In practice, difficult to
forecasts net dividends. Share repurchases and new issuances are difficult to forecast. Even
more difficult for a company without dividend history or without a constant payout policy. If
dividend policy is not stable, g is difficult to estimate. In theory, we can still use the DDM
since dividends in the DDM are future dividends. Just because a firm does not pay dividends
in the past, it does not mean it will not pay dividends in the future.
(15 marks)
Question 2.
(1) the levered cost of equity1 = 2.5% + 1.5*(7.5% - 2.5%) = 10% (5 marks)
Cost of debt1 = 2.5% + 0.3*(7.5% - 2.5%) = 4% (5 marks)
WACC1 = 40%*10% + 60%*4%*(1-25%) = 5.8% (5 marks)
Under Ruback ADMP, ru = 40%*10% + 60%*4% = 6.4%. (7 marks)
After year 2, cost of debt3 = 2.5% + 0.2*(7.5% - 2.5%) = 3.5% (6 marks)
The levered cost of equity3 = 6.4% + (6.4% - 3.5%)*(0.3/0.7) = 7.643% (6 marks)
WACC3 = 70%*7.643% + 30%*3.5%*(1-25%) = 6.138% (6 marks)
(2). FCFF3 = 16*(1+3%) = 16.48.
Vf = 16.48/(6.138% - 3%) = 525.26 (10 marks)
(3) at flotation, debt = 30%*525.18 = 157.554
Interest tax shield = 157.554*3.5%*25% = 1.379
Capital cash flow = 17.859
Vf = 17.859/(6.4% - 3%) =525.2 or V_u + V_tx = 484.71 + 40.55= 525.2
same as that in (2) (round error is acceptable) (25 marks)
(4) explain the passive and active debt management policies. discuss the values of tax shields from the
positive debt management policy and active debt management policy. see lecture handouts for details.
(25 marks)
Question 3.
(a). Risk free rate = 2.50%; market risk premium MRP= 4%; Beta = 1.2
The CAPM implies that cost of equity = 7.30%
yr1 yr2 yr3 yr4
OBV 300 322.5 348 365.4
earnings 25 30 31.5 33.075
divs 2.5 4.5 14.1 14.805
CBV 322.5 348 365.4 383.67
growth rate 5%
(3+6*2= 15 marks)
(b). residual income and abnormal earnings growth:
yr1 yr2 yr3 yr4
RI 3.1 6.4575 6.096 6.4008
AEG 3.3575 -0.3615 0.3048
Round errors are acceptable (6*2.5=15 marks)
(c.) Valuation
yr1 yr2 yr3
DDM, year start 538.70 575.53 613.04
(5*2=10 marks)
PV of RI 238.70 253.03 265.04
RIVM, year start 538.70 575.53 613.04
(5*2=15 marks)
PV of AEG2- 13.35 14.33 12.01
AEG, year start 538.70 575.53 613.04
(5*2=15 marks)
(d.) P/E approach
retention ratio, q 0.9 0.85 0.552
P/E 19.46 (5 marks)
equity value 613.04 (5 marks)
(e.) Compare and contrast the above models and their results. Discuss the detail assumptions
that make them resulting in the identical value. (20 marks)
Question 4.
(1).
Year 1
Operating profits 157.50
operating tax 39.38
NOPLAT 118.13 (7 marks)
gross cash flow 170.63
chg in WC -4.385
capitalX -79.9
FCFF 86.34 (9marks)
FCFE 87.84 (9marks)
(2). discount FCFE, direct approach
FCFE growth rate 5.00%, re=10%
equity value 1756.80
nos. of shares 60.00
price ps 29.28 (10 marks)
(3). WACC & RIF
market value cost of capital tax rate=25%
Debt v 300.0 6%
equity v 1756.80 10%
enterprise v 2,056.80 9.20% (10 marks)
RIF 59.65 (5 marks)
(4). DCF growth 5%
enterprise v 2056.80 (10 marks)
(5). RIV g 5%
PV of RIF 1421.10
enterprise v 2056.80 (round error is acceptable) (15 marks)
the value here is the same as that in (3)
(6). equity, indirect approach
devt v 300.00
Equity v 1756.80 (round error is acceptable)
price ps 29.28 the value here is the same as that in (2) (10 marks)
(7). Discuss the main difference between direct and indirect approaches in equity valuation.
indirect approach estimate enterprise value @ WACC on FCFF first, then subtracted by market value
of debt. Some analysts prefer to use indirect approach. It is useful to use unlevered cost of capital in
valuation.
direct approach estimate equity value by using FCFE or dividends @cost of equity. For some
industries, like banks, relative easy to use direct approach.
(15 marks)

Question 5.
1. E/P, CF/P, B/P, D/P, sales/market capital, EBITDA/enterprise value, etc.
How does price multiples relate to the DCF valuation?
0
1
1P q
E r g
−
=
−
,
0
0 0

1
P PV of RI
B B
 
 

=

+ 0
0
(1 )P ROE q ROE g
B r g r g
− −
= =
− −
,
0 0
0 0
( / )(1 )(1 ) (1 )(1 )
/
E S q g PM q g
M S
r g r g
− + − +
= =
− −
,
Other multiples are similar.
Explain each of multiples. Explain key value drivers, ROE, q, g, discount rate, PM etc.
(4*10 = 40 marks)
2. We need to:
Identify comparable assets and obtain market values for these assets;
Convert these market values into standardized values, because the absolute values cannot be
compared. This process of standardizing creates price multiples.
Compare the multiple for the asset being analysed to the multiples for comparable assets to judge the
relative value of the asset;
Aggregate the multiples for comparable assets to obtain the value of the asset. Explain what the
aggregation means, say, mean/median. What is the potential drawbacks. (20 marks)
3. Explain the conventional P/e and its drawbacks, e.g. the conventional P/E can be very
volatile. So Shiller introduces the “long run average” P/E10 approach: calculate rolling 10-year real
earnings and relate to current price. The Cyclically Adjusted P/E Ratio (CAPE) is calculated by using
the S&P 500 index divided by the average inflation-adjusted earnings from the previous 10 years. It
takes into account the impact of economic cycles on a company's earnings. Discuss the adjustment
after 2018. Discuss the motivation and advantage of CAPE10. Shiller argues that CAPE10 is more
useful in predicting long-term return and evaluating whether the whole market is over or under
valued. (10 marks)
4. the P/E ratio is higher for a company with a higher growth rate. It may make high-growth
companies appear overvalued relative to others. Typically, a low P/E ratio may make a stock look
more attractive to investors. One may consider P/E on per unit of growth, this is why the PEG ratio
was introduced, i.e., PEG = (P/E)/expected EPS growth. Examples (FAANGs) are expected. It should
be noted that PEG does not explicitly consider risk, it doesn’t incorporate changes in growth rate and
the use of historical growth rates can be misleading. (10 marks)
5. Analysts have discretion in selecting peers. No clear rule.
Industries can be very widely based, including companies with differing financial health; a company
may operate in two or more different industries. But industry/peer comparison may ignore sector
“bubble effects”. Using groups implies averaging, which is more reliable in statistical term. Price
multiples and relative valuation are also susceptible to different accounting treatments, and one must
be careful to ensure consistency in practice.
But no rule exists regarding the aggregation of peers’ multiples (mean/median?) Most industry/market
P/Es are value-weighted means. But for smaller stocks medians can be more relevant.
(20 marks)