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Cass Undergraduate School

FR2203 Company Valuation
Part 2 Examination

22 May 2009 14:30 - 16:45



Instructions to students:

Answer THREE questions from Section A, ONE question from Section B and TWO
questions from Section C.

SECTION A (45 marks), SECTION B (30 marks), SECTION C (25 marks)

The number of marks allocated is shown at the end of each question.

This examination paper consists of 12 printed pages including the title page.

Materials:

Number of answer books to be provided: 1
Only the Casio calculators FX-83 (MS or ES) or FX-85 (MS or ES) are permitted for use
in this exam
Dictionaries are not permitted.
Formulae sheets and Normal Distribution table are attached at the back of this exam
paper.
This examination paper may be removed from the examination room.



External Examiner: Dr George Alexandrou
Internal Examiner: Dr Peter Hahn
BSc (Hons) Degree in Banking and International Finance
BSc (Hons) Degree in Investment & Financial Risk Management
BSc (Hons) Degree in Investment Analysis & Insurance
BSc (Hons) Degree in Real Estate Finance & Investment

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Assume the CAPM unless instructed differently.

Section A - Answer all questions in this section.


Question 1

The market price of TOAD PLC is 20 per share. Investors expect a rate of
return of 12%. The risk free rate is 4% and the market risk premium is 6%.
Assume the company is expected to pay a constant dividend in perpetuity.

(a) The Bank of England, fearing greater economic recession, decreases
interest rates. All Gilt-Edged bond yields fall by 2% as do investors
expectations from equities. Assuming everything else remains constant
what will be the market price of a TOAD share?
(10 Marks)

Guidelines for Answer: Please show your calculations.

(b) In reality we do not expect everything to be constant. How would you
anticipate the expected rate of return to change in bad economic
times? Discuss the key variables that might be affected and what
influence they would have. Discuss the mechanism clearly and explain
in detail.
(10 marks)

Guidelines for Answer: Please provide at least 2 and no more than 4 bullet
points. Your answer does not need to be more than 6 sentences.






















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Question 2

Your preliminary analysis of two companies in different businesses, Southern
and Northern gives you the information below. The cost of capital for both
companies is 8%.
Southern Northern
Expected Return on Equity 10% 12%
Estimated earnings per share 1.50 2.00
Estimated dividends per share 1.00 1.20

(a) What are the expected dividend payout ratios for these two firms?
(5 marks)
(b) What are the expected dividend growth rates for these two firms?
(5 marks)
(c) What is the value of each of these firms?
(5 marks)
(d) Current Market price per share for both Southern and Northern is 28.
If you were to invest, which firm would you prefer to invest in? Explain
why.
(5 marks)

Guidelines for Answer: Please show your calculations (a,b,c) and provide at
least 1 and no more than 4 bullet points for (d).


























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Question 3

Circle the correct answers (5 marks)

(a) Price to Sales Ratios are considered to be most affected by
i. Beta
ii. Debt levels
iii. Profitability margins
iv. Interest rate levels

(b) Overall, market interest rates affect Price to Earnings Ratios
i. True
ii. False

(c) Time Series of Price to Earnings Ratios often expose opportunities for
portfolio managers to buy or sell
i. True
ii. False

(d) Managers can often influence short term share prices through minor
changes to their firms
i. Return on capital
ii. Reinvestment rate
iii. Capital structure
iv. i, ii and iii
v. ii and iii

(e) Analysts forecasts tend to be more accurate than time series in the
i. Short term
ii. Medium term
iii. Long term
iv. Never


















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Section B - Answer only one question in this section.



Question 4

Lasfer Bros., Hahn & Fong Bankers to the middle market always use at least
a two stage Dividend Discount model and the CAPM for valuation purposes.
Using these measures you have valued Eastern at 53 per share. Now you
must value Western. You estimate todays risk free rate to be 3.0% and the
market return as 12.0%.

(a) Use the following information to calculate the required rate of return for
Western:
(10 marks)
Eastern Western
Beta 1.00 1.40
Market Price 45 30
Value (Intrinsic) 53 ?


(b) You estimate that Westerns earnings per share will grow at 9% per
year for the first 2 years, and 7% for the next year, 6% for the following
year, and 5% per year thereafter. The last annual dividend per share
distributed was 2.00. Estimate the value of Western using a dividend
model.
(10 marks)

(c) Which company would you prefer to invest in? Explain why?
(5 marks)

(d) Describe and discuss at least one strength of the model used in
comparison with the constant growth model.
(5 marks)

Guidelines for Answer: Please show your calculations. For answer d please
use bullet points (do not use more than 3).













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Question 5

Bibendo Brands owns the clothing and gaming name rights to the 2010
release of Columbia Pictures film Business School Musical. Bibendo
estimates the cost of product development to be 100million and the expected
cash flows to be 110million. The rights will be forfeited in 8 months if no
investment is made. Based upon prior film rights deals Bibendo estimates the
standard deviation is 75% per year and interest rates are 5%.

(a) Use the Black-Scholes formula to find the value of this option.
(20 marks)

(b) Mattel Inc. has offered 25million for this option; the offer is for today
only. Explain how you decide.
(5 marks)

(c) What two factors are most likely to increase the value of this option
valuation?
(5 marks)

Guidelines for Answer: Please show your calculations.





























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Section C

Question 6

Answer all questions in this section

You are J ill Sharp, A.I. Goldman & Companys investment banker to the
branded consumer industry in London. Youve had many fruitless efforts at
industry gatherings and formal presentations trying to do business with Cyrus
MacFrump, the long time CEO, founder and 25% shareholder of Frump Plc
producer of the ubiquitous CyBrew energy drink (sold at all UK university
canteens). Suddenly, MacFrump sees you during the intermission at the
Royal Opera House. He offers you a drink and tells you confidentially that
hes considering selling the company and asks if you have a few moments
after the performance.

As the bell rings to return to seats, MacFrump says I have no children
interested in replacing me and Im tired, but is this the right time to sell? I just
dont understand why my P/E in todays FT is the same as the guys whove
just entered the market, have smaller market shares and less well known
brands. Finally, MacFrump says after all these years building up CyBrew,
you would think I deserve at least 20% premium over everyone else.

You cant do a DCF while the heroine dies in Act III, but you can think. What
will you tell MacFrump about his P/E questions? Why might it be lower than
he expects?
(20 Marks)


Guidelines: Please provide at least 3 but no more than 6 bullet points before
you briefly write about them. No more than 10-12 sentences are necessary.



Question 7

You are Simon Smarter, investment banker to the media industry. You and
your team value every major media property in Europe regularly.
Confidentially, Kate Tough, CEO of Mega, calls Simon to say that shes just
agreed to buy Mina Media and wants Simon to advise Mega including a
valuation for the price paid. Simon says yes. Simon recently valued Mina at
60 million and it is trading on the stock exchange for 80 million. Kate then
says the agreed price is 100 million. What should Simon do?
(5 Marks)

Guidelines: Provide 1-3 bullet points. No more than 5-6 sentences are
necessary.

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Formulae Sheet

n = t
1 = t
t
r) + (1
t
CF
= Value

E(R) = Rf + (Rm- Rf)

L = u (1+ ((1-t)D/E))

L = u (1+ ((1-t)D/E)) - debt (1-t) (D/E)

Cash Flow to the firm: = EBIT ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital

Cash Flow to equity = Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)

Retention Ratio = Retained Earnings/ Current Earnings

ROE = Net Income/Book Value of Equity

gEPS = Retention Ratio * ROE

ROC = EBITt (1 - tax rate) / Book value of Capitalt-1

Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t)

Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity)

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC





Call = Borrowing + Buying D of the Underlying Stock
Put = Selling Short D on Underlying Asset + Lending

Value of Call = Current Value of Underlying Asset*Option Delta
- Borrowing needed to replicate the option

Value of call = S N (d1) - Ke
-rt
N(d2)

P 0 =
DPSt
(1+r)
t

t=1
t=n
+
P n
(1+r)
n
-
DPS0*(1+gn)
(r-gn)
+
DPS0*(1+gn)
(r-gn)
-
DPS 0
r
+
DPS0
r
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t
t )
2
+ (r +
K
S
ln
= d
2
1

d2 = d1 - t

n
1
0
g r
DPS
P

=

n
n
0
0
-g r
) g (1 * Ratio Payout
= PE
EPS
P +
=

n
n
0
0
-g r
) g (1 * ings) (FCFE/Earn
= PE
EPS
P +
=

n
n
n
n
n 0
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout * EPS
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout * EPS
= P

n
n
n
n
n
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout
=
EPS
P

PEG = PE / Expected Growth Rate in Earnings


n
n
n
n
n
n
n
r) + )(1 g - g(r
) g + (1 * g) + (1 * Ratio Payout
+
g) - g(r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout
= PEG

Relative PE = PE of Firm / PE of Market


EV/FCFF = (Market Value of Equity + Market Value of Debt-Cash)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in Working Cap


n
WACC) + )(1
n
g - (WACC
)
n
g + (1
n
g) + (1
0
FCFF
+
g - WACC
n
WACC) + (1
n
g) + (1
- 1 g) + (1
0
FCFF
=
0
V

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n
n
n
n n
n
0
0
WACC) + )(1 g - (WACC
) g + (1 g) + (1
+
g - WACC
WACC) + (1
g) + (1
- 1 g) + (1
=
FCFF
V

on Depreciati and Taxes Interest, before Earnings
Debt of Value Market + Equity of Value Market
EBITDA
Value
=

on Depreciati and Taxes Interest, before Earnings
Cash - Debt of Value Market + Equity of Value Market
EBITDA
Value Enterprise
=

g - WACC
FCFF
= V
1
0


g - WACC
Capital Working - Cex - (t) Depr + t) - (1 EBITDA
= Value



g - WACC
ITDA Capital/EB Working
-
g - WACC
CEx/EBITDA
-
g - WACC
(t)/EBITDA Depr
+
g - WACC
t) - (1
=
EBITDA
Value


Price/Book Value = Market Value of Equity / Book Value of Equity

n
1
0
g r
DPS
P

=
n
n 0
0
-g r
) g (1 * Ratio Payout * ROE * BV
P
+
=

n
n
0
0
-g r
) g (1 * Ratio Payout * ROE
= PBV
BV
P +
=

n
0
0
-g r
Ratio Payout * ROE
= PBV
BV
P
=

n
n
0
0
-g r
g - ROE
= PBV
BV
P
=

n
n
n
n
n 0
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout * EPS
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout * EPS
= P

n
n
n
n
n n
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout * ROE
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout * ROE
=
BV
P

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g - WACC
/BV FCFF
=
BV
V
1 0


Value/Book Value = Market Value of Equity + Market Value of Debt
Book Value of Equity + Book Value of Debt

Price/ Sales= Market Value of Equity
Total Revenues

n
n
0
0
-g r
) g (1 * Ratio Payout * Margin Profit Net
= PS
Sales
P +
=

n
n
n
n
n 0
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout * EPS
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout * EPS
= P

n
n
n
n
n n
n
n
0
0
r) + )(1 g - (r
) g + (1 * g) + (1 * Ratio Payout * Margin Net
+
g - r
r) + (1
g) + (1
1 * g) + (1 * Ratio Payout * Margin Net
=
Sales
P


Value/ Sales= Market Value of Equity + Market Value of Debt-Cash
Total Revenues

n
n
n
n
stable
n
n
growth
0
WACC) + )(1 g - (WACC
) g + (1 * g) + )(1 RIR - (1
+
g - WACC
WACC) + (1
g) + (1
1 * g) + )(1 RIR - (1
* Margin Oper. tax - After =
Sales
Value





+
N = t
1 = t
r) + (1
Value Terminal
t
r) + (1
t
CF
= Value
N

= t
1 = t
t
r) + (1
t
CF
= Value

n = t
1 = t
t
e
t
) k + (1
Equity to CF
= Equity of Value

n = t
1 = t
t
t
WACC) + (1
Firm to CF
= Firm of Value
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Normal Distribution Table


Normal Distribution
d N(d) d N(d) d N(d)
-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
-2.65 0.0040 -0.65 0.2578 1.40 0.9192
-2.60 0.0047 -0.60 0.2743 1.45 0.9265
-2.55 0.0054 -0.55 0.2912 1.50 0.9332
-2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.40 0.9918
-1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413