1.

Which of the following are likely to result in higher profitability for a firm in a competitive industry?

A. High barriers to entry, low barriers to exit, and high switching costs.
B. Product differentiation, low switching costs, and high barriers to exit.
C. Low supplier concentration, low buyer concentration, and commoditization of the industry's
products.
Explanation: ANSWER A
All else equal, high barriers to entry, low barriers to exit, and high switching costs will tend to result in higher
profitability for a firm in a competitive industry.

2. Strawline, Inc. manufactures straws using a new technology which allows straws to be made with
an 11% reduction in costs. According to Porter's model, which of the following is most likely?
A. Strawline's increased profit margins will allow it to decrease financial leverage.
B. Any initial advantage will eventually be eliminated as competitors adopt the same technology.
C. Strawline's increased profit margins will allow it to increase financial leverage.
Explanation: ANSWER B
New technology does not offer a lasting advantage since the technology is available to all of Strawline's
current and potential competitors.
3.

An industry that manufactures and sells a commodity like product will face increased competition
primarily because of greater:
A. threat of new entrants.
B. bargaining power of buyers.
C. threat of substitute products.
Explanation: ANSWER C
Substitute products limit the profit potential of an industry. Why? They limit the prices firms can charge.
There will be higher levels of competition and lower profit margins for more commodity like products.
4.
A.
B.
C.

Automation can help a firm improve its competitive position by affecting:

new entrants to the industry.
suppliers' bargaining power.
the threat of substitutes.

Explanation: ANSWER A
Automating production can make it more expensive for rivals to enter the market, increasing the width of a
company's economic moat. Automation on its own will not affect the threat of substitutes or increase
suppliers' bargaining power.
5.

Karla Hanover, CEO of Marshall Computers, is gloating during a board meeting. "It's been a
wonderful year, people. First, we received a tax break from the state that allows us to reduce our
manufacturing costs. Second, we drove our long time competitor, Roseland Technology, out of
business. Third, we patented a new processor 30% faster than those of our rivals."

Which of the three victories Hanover cited is least likely to give the firm a lasting advantage over its
competitors?
A. The new, faster processor.
B. The tax break.
C. The demise of a competitor.
Explanation: ANSWER C
Government action and technological advancements don't generally have a lasting effect on an industry.
However, such Company specific factors as a state tax break and a patented new technology can
strengthen one company at the expense of others. However, the elimination of a rival could result in new
competitors entering the market. As such, it is least likely to provide a lasting competitive advantage.

6.

Laura's Chocolates, is a maker of nut based toffees. The company holds shares in one of its
suppliers, and wants to know what the holding period return was last year.

INFORMATION:

January 1 (purchase date) $40

December 31 $45
Dividend paid (December 31) $5
Cost of equity 11%
Cost of debt 8%
Debt : equity 1:3
What is the holding period return (ignore taxes)?
A. 25.00%.
B. 12.50%.
C. 22.50%.
Explanation: ANSWER B
((45-40)+5)/40 = 12.5%
7.

Currently the market index stands at 1,190.45. Firms in the index are expected to pay cumulative
dividends of 35.71 over the coming year. The consensus 5 year earnings growth forecast for these
firms is expected to increase to 6.2% up from last year's forecast of 4.5%. The long term
government bond is yielding 5.0%. According to the Gordon growth model, what is the equity risk
premium?
A. 1.2%.
B. 4.2%.
C. 2.5%.

Explanation: ANSWER B
Equity risk premium = (35.71 / 1,190.45) + (6.2%) 5.0%
= 4.2%

8. Liquidation value is the:

A. cash generated by terminating a business, selling its assets, and repaying liabilities.
B. market value of the total assets less the market value of the total liabilities.
C. present value of future cash flow less the possible liquidation cost.
Explanation: ANSWER A
Liquidation value is the cash generated by terminating a business, selling all of its assets, and repaying
liabilities.

No 9 No 11
Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants to
value the company so as to be able to make a decision on the fair price to pay for the investment.
9.
A.
B.
C.

List the steps in the top down valuation approach as it is applicable for Gold Star investment. Forecast
the growth of:
Gold Star, the growth of each firm in the industry, and then the growth of the oil industry.
each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy.
the overall economy, growth of the industry, and the growth rate of Gold Star.

Explanation: ANSWER C
The top down model for valuation would begin with analysis of the overall economy and the expectation of the
growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry
needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates.
That involves the determination of the competitive forces in the industry and the future threats and opportunities
faced by the industry. It also determines the variables that determine the future profitability of the entire oil
industry. The analyst then forms future expectations of these variables given the expectations about the overall
economy. The expectations of variables determining the growth and profitability of the oil industry are then used
to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the
quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the
company. The analyst then selects an appropriate model to value the company. Assumptions used in the
valuation must be clearly spelled out and updated to reflect new information.

10.
A.
B.
C.

Which of the following models would be most suitable to value Gold Star?
Relative valuation.
Liquidation value.
Absolute valuation.

Explanation: ANSWER C
Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash
flow model value a company independent of peer valuation. The valuation is based on the present value of cash
flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that
of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E
ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be
undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the
valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is
not available.
11. Which discounts must be taken into account while valuing the investment opportunity? Joe should take
into account the:
A. marketability, liquidity, and control premium in the valuation.
B. marketability, liquidity, and majority discounts in the valuation.
C. marketability, liquidity, and minority discounts in the valuation.

Explanation: ANSWER C
Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the fact that the
investment cannot be easily liquidated and the cost of selling the investment needs to be discounted from the
value. Finally, since only 5% of the stock is being invested in, the control of the operations of the company still
remains with the majority shareholders. This lack of control needs to be quantified and discounted from Gold
Star's valuation.
12.
A.
B.
C.

A valuation of a firm based on the current market price of its assets liabilities is referred to as the firm's:
liquidation value.
operating value.
Going concern value.

Explanation: ANSWER A
The liquidation value is based on the assumption that the firm will cease to operate and all of its assets will be
sold to repay liabilities.
13. Which of the following two ratios are likely to be used for determining value as a function of company
peer benchmarks?
A. Price to sales and debt/equity.
B. Return on equity and net profit margin.
C. Price to earnings and price to book.

Explanation: ANSWER C
Relative valuation looks at market based ratios of comparable companies in the industry. Price to sales, price to
book, price to earnings, and price to cash flow are examples of ratios used in relative valuation analysis.

14.
A.
B.
C.

Cash flows to the firm should be discounted at the:

firm's weighted average cost of capital.
rate determined by the capital asset pricing model.
market's estimated rate of return.

Explanation: ANSWER A
The weighted average cost of capital is the preferred discount rate for cash flows to the firm, as it reflects
the cost of both debt and equity.
15. Equity analyst Yasmine Cordova of Substantial Securities is trying to determine the investment
appeal of shares of Maxwell Mincemeat, a small food company. Cordova has assembled the
following data about the company:
Internal rate of return: 9.4%.
Maxwell's 20year bond yield to maturity: 7.9%.
Maxwell's two year bond yield to maturity: 6.1%.
Treasury bill yield: 3.4%.
Maxwell's estimated beta: 2.1.
Maxwell's 20year bonds are priced at $102.65.

Maxwell's two year bonds are priced at $101.47.

Estimated return of Russell 2000 Index: 12.3%.
Substantial's credit analyst estimates that Maxwell's equity warrants a premium of 4.9% over its bonds.
Cordova wants to make sure her estimates are accurate, so she decides to calculate the estimated
required return in two ways. She opts for the bond yield plus risk premium method and the capital asset
pricing model. To check her work, she wants to compare the estimates derived under each method. The
difference between the required returns is closest to:
A. 5.30%.
B. 5.89%.
C. 9.29%.
Explanation: ANSWER C
The capital asset pricing model uses the following equation:

Required return = risk free rate + beta equity risk premium

To calculate the required return under CAPM, use the Russell 2000 index return, the beta, and the risk free
rate.

Required return = 3.4% + 2.1 (12.3% 3.4%) = 22.09%.

The bond yield model uses the following equation:

Required return = yield to maturity on long term bonds + risk premium.

Required return = 7.9% + 4.9% = 12.8%.
The difference between the two estimated required returns is 9.29%.
16. An analyst for a small European investment bank is interested in valuing stocks by calculating the
present value of its future dividends. He has compiled the following financial data for Ski, Inc.:

Earnings per Share

(EPS)
Year 0 $4.00
Year 1 $6.00
Year 2 $9.00
Year 3 $13.50
Note: Shareholders of Ski, Inc., require a 20% return on their investment in the high growth stage
compared to 12% in the stable growth stage. The dividend payout ratio of Ski, Inc., is expected to be 40%
for the next three years. After year 3, the dividend payout ratio is expected to increase to 80% and the
expected earnings growth will be 2%. Using the information contained in the table, what is the value of Ski,
Inc.'s, stock?
A.
B.
C.

$43.04.
$39.50.
$71.38.

Explanation: ANSWER C
The dividends in the next four years are:
Year 1: 6 0.4 = 2.4
Year 2: 9 0.4 = 3.6
Year 3: 13.5 0.4 = 5.4
Year 4: (13.5 1.02) 0.8 = 11.016
The terminal value of the firm (in year 3) is 11.016 / (0.12 0.02) = 110.16. Value per share = 2.4 / (1.2) + 3.6 /
(1.2) + 5.4 / (1.2) +
110.16 / (1.2) = $71.38.

17. The value per share for Burton, Inc. is $32.00 using the Gordon Growth model. The company paid
a dividend of $2.00 last year. The estimates used to calculate the value have changed. If the new
required rate of return is 12.00% and expected growth rate in dividends is 6%, the value per share
will increase by:
A. 4.17%.
B. 9.51%.
C. 10.42%.
Explanation: ANSWER C
The value per share using the new estimates is $35.33 = [$2.0(1.06) / 0.12 0.06)] and the percentage
increase in the value per share will be 10.42% = [(35.33 32.00) / 32.00] 100%.

18. If the value of an 8%, fixed rate, perpetual preferred share is $134, and the par value is $100, what is
the required rate of return?
A. 6%.
B. 8%.
C. 7%.

Explanation: ANSWER A
The required rate of return is 6%: V = ($100par 8%) / r = $134, r = 5.97%
19. Which of the following models would be most appropriate for a firm that is expected to grow at an initial
rate of 10%, declining steadily to 6% over a period of five years, and to remain steady at 6% thereafter?
A. A two stage model.
B. The Gordon growth model.
C. The H model.

Explanation: ANSWER C
The H model is the best answer, as it avoids an immediate drop to 6% like a two stage would. The Gordon
growth model would not be appropriate.

20. Suppose the equity required rate of return is 10%, the dividend just paid is $1.00 and dividends are
expected to grow at an annual rate of 6% forever. What is the expected price at the end of year 2?
A. $29.78.
B. $27.07.
C. $28.09.
Explanation: ANSWER A
The terminal value is $29.78, and that is the price an investor should be willing to pay at the end of year 2.
The correct answer is shown below.
Year Dividend
1 $1.0600
2 $1.1236
3 $1.1910
V : $1.191/(0.10 0.06)
= $29.78
21. Which of the following models would be most appropriate for a firm that is expected to grow at 8% for
the next three years, and at 6% thereafter?
A. The H model.
B. The Gordon growth model.
C. A two stage model.

Explanation: ANSWER C
A firm that is expected to experience two growth stages with a fixed rate of growth for each stage should be
evaluated with a two stage dividend discount model.
22. A company's stock beta is 0.76, the market return is 10%, and the risk free rate is 4%. The stock

will pay no dividends for the first two years, followed by a $1 dividend and $2 dividend,
respectively. An investor expects to sell the stock for $10 at the end of four years. What price is an
investor willing to pay for this stock?
A.
B.
C.

$9.42.
$10.16.
$11.03.

Explanation: ANSWER A
The first step is to determine the required rate of return as 4% + [(10% 4%)
0.76] or 8.56% per year. The second step is to determine the present value of all future expected cash
flows, including the terminal $10 stock price, discounted back four years to today. The solution is shown
below.
Year CF
1
0
2
0
3
1
4
2

4
10
0/1.0856 + 0/(1.0856) + 1/(1.0856) + (2 + 10)/(1.0856) = $9.42
23. If a firm has a return on equity of 15%, a current dividend of $1.00, and a sustainable growth rate of 9%,
what are the firm's current earnings?
A. $1.50.
B. $2.50.
C. $1.75.

Explanation: ANSWER B
The earnings can be determined by solving for earnings in the sustainable growth formula:
9% = [1 ($1 / $Earnings)] 0.15 or $1 / 0.4 = $Earnings = $2.50
24. Given that a firm's current dividend is $2.00, the forecasted growth is 7% for the next two years and 5%
thereafter, and the current value of the firm's shares is $54.50, what is the required rate of return?
A. Can't be determined.
B. 10%.
C. 9%.

Explanation: ANSWER C
The equation to determine the required rate of return is solved through iteration.
$54.50 = $2(1.07) / (1 + r) + $2(1.07) / (1 + r) + {[$2(1.07) (1.05)] / (r 0.05)}
/ [(1 + r)
Through iteration, r = 9%
25. Heather Callaway, CFA, is concerned about the accuracy of her valuation of Crimson Gate, a fast
growing
Telecommunications equipment company that her firm rates as a top buy. Crimson currently trades at $134
per share, and Callaway has put together the following information about the stock:
Most recent dividend per share $0.55
Growth rate, next 2 years 30%
Growth rate, after 2 years 12%
Trailing P/E 25.6
Financial leverage 3.4
Sales $1198 per share
Asset turnover 11.2
Estimated market rate of return 13.2%
Callaway's employer, Bates Investments, likes to use a company's sustainable growth rate as a key input to
obtaining the required rate of return for the company's stock.
Crimson's sustainable growth rate is closest to:
A. 13.2%.
B. 16.6%.
C. 14.8%.
Explanation: ANSWER C
Sustainable growth rate = ROE retention rate
Earnings per share = price / (P/E) = $134 / 25.6 = $5.23
The retention rate represents the portion of earnings not paid out in dividends. = (5.23 0.55) / 5.23 = 0.89
or 89%
ROE = profit margin asset turnover financial leverage
ROE = 5.23 / 1198 11.2 3.4 = 16.6%
Sustainable growth rate = 89% 16.6% = 14.8%
No 26-30 (Case Study)
Harrisburg Tire Company (HTC) forecasts the following for 2013:
Earnings (net income) = $600M.
Dividends = $120M.
Interest expense = $400M.
Tax rate = 40.0%.
Depreciation = $500M.
Capital spending = $800M.
Total assets = $10B (book value and market value).

Debt = $4B (book value and market value).

Equity = $6B (book value and market value).
Target debt to asset ratio = 0.40.
Shares outstanding = 2.0 billion
The firm's working capital needs are negligible, and HTC plans to continue to operate with the current capital
structure. The tire industry demand is highly dependent on demand for new automobiles. Individual companies in
the industry don't have much influence on the design of automobiles and have very little ability to affect their
business environment. The demand for new automobiles is highly cyclical but demand forecast errors tend to be
low.
26. The firm's earnings growth rate is most accurately estimated as:
A. 6.4%.
B. 4.8%.
C. 8.0%.

Explanation: ANSWER C
The firm's estimated earnings growth rate is the product of its retention ratio and ROE:
g = RR (ROE) = [(600 120) / 600] (600 / 6000) = 0.08
27.
A.
B.
C.

The 2013 forecasted free cash flow to equity is:

$300M.
$420M.
$340M.

Explanation: ANSWER B
Since working capital needs are negligible, the free cash flow to equity is:
FCFE = Net income [1 DR)] [FCInv Depreciation] [(1 DR) WCInv]
FCFE = 600M [1 0.4] (800M 500M) = 420M
where: DR = target debt to asset ratio
28. If the total market value of equity is $6.0 billion and the growth rate is 8.0%, the cost of equity based on
the stable growth FCFE model is closest to:
A. 15.0%.
B. 7.6%.
C. 15.6%.

Explanation: ANSWER C
Value of equity = FCFE /(Cost of equity growth rate) so $6,000 = [$420 (1.08)]/(Cost of equity 0.08)
(Cost of equity 0.08) $6,000 = $453.6
Cost of equity - 0.08 = 0.0756
Cost of equity = 0.1556 = 15.56%
29. The beta for HTC is 1.056, the risk free rate is 5.0% and the market risk premium is 10.0%. The
weighted average cost of capital for HTC is closest to:
A. 11.74%.
B. 13.34%.
C. 15.56%.

Explanation: ANSWER A
Cost of equity = rf + (r(m) - rf ) = 0.05 + 1.056(0.10) = 0.05 + 0.1056 = 0.1556
The best approximation for cost of debt is the interest expense divided by the market value of the debt.
Cost of debt = Interest expense/market value of debt = $400 million/$4.0 billion = 0.10
WACC = w r (1-t) + we re = 0.40 0.10 (1-0.40) + 0.60 0.1556 = 0.1174

30. FCFE for 2013 is $400.0 million and HTC took on an additional debt of $40.0 million while
repaying existing debt of $60.0 million. The growth rate for FCFF is 5.0% and the WACC is 11.5%.
The value of the firm calculated using the stable growth model is most accurately described as:
A. less than the market value of the firm by $3.3 billion.
B. less than the market value of the firm by $7.5 billion.
C. greater than the market value of the firm by $0.7 billion.
Explanation: ANSWER C
FCFF = FCFE + Interest expense (1-t) - Net borrowing = $400 million + $400 million (1-0.40) - ($ 40
million - $ 60 million) = $660 million.

Value of the firm = [$660 million (1.05)]/(0.115 0.05) = $10.662 billion. This is a difference of $0.662 billion
compared to the $10.0 billion current market value.
31. A firm currently has sales per share of $10.00, and expects sales to grow by 25% next year. The net

A.
B.
C.

profit margin is expected to be 15%. Fixed capital investment net of depreciation is projected to be 65%
of the sales increase, and working capital requirements are 15% of the projected sales increase. Debt
will finance 45% of the investments in net capital and working capital. The company has an 11%
required rate of return on equity. What is the firm's expected free cash flow to equity (FCFE) per share
next year under these assumptions?
$0.38.
$1.88.
$0.77.

Explanation: ANSWER C
FCFE = net profit Net FC Inv WC Inv + DebtFin = $1.88 - $ 1.63 - 0.38 + 0.90 = 0.77

32. Valuation with free cash flow to equity and free cash flow to the firm:
A. use different discount rates.
B.
C.

both use the cost of equity.

both use the after tax cost of debt.

Explanation: ANSWER A
Free cash flow to the firm uses the weighted average cost of capital and free cash flow to equity uses the cost of
equity. The key is to use a discount rate that reflects the opportunity cost of the indicated investor group.
33. Which of the following statements about the three stage FCFE model is most accurate?

A. There is a final phase when growth rate starts to decline.

B. There is a transition period where the growth rate declines.
C. There is a transition period where the growth rate is stable.
Explanation: ANSWER B
In the three stage FCFE model, there is an initial phase of high growth, a transition period where the growth
rate declines, and a steady state period where growth is stable.
34. An analyst is performing an equity valuation for a minority equity position in a dividend paying
multinational. The appropriate model for this analysis is most likely:
A. FCFE approach.
B. The Dividend Discount approach.
C. FCFF approach.
Explanation: ANSWER B
The dividend discount model is most appropriate for valuing a minority equity position in a dividend paying
company. The free cash flow approach looks to the source of dividends from the perspective of an owner
that has control rather than directly at dividends.
35. In computing free cash flow, the most significant noncash expense is usually:
A.
B.
C.

depreciation.
capital expenditures.
deferred taxes.

Explanation: ANSWER A
Depreciation is usually the largest noncash expense.
36. Creative Gardening is expected to have a return on equity (ROE) of 13% for the next five years and
10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end
of year 0) is $7.50 per share and its required rate of return is 10%. The premium over book value at the
end of five years is expected to be 30%. All earnings are reinvested. The sum of the present values of
the residual income estimates over the next five years is $1.10. The projected ending book value in year
5 is $13.83. What is the value of Creative Gardening using these inputs?
A. $11.18.
B. $8.60.
C. $13.83.

Explanation: ANSWER A
Applying the finite horizon residual income valuation model:
V = B + sum of discounted RIs + discounted premium

= 7.50 + 1.10 + [(0.30)(13.83)/(1.10) ] = $11.18

37.
A.
B.
C.

Economic value added (EVA ) is calculated as net operating profit after taxes minus:
a charge for total capital.
a charge for equity capital.
capital expenditures.

Explanation: ANSWER A
EVA = NOPAT ( C% TC), where NOPAT is a firm's net operating profit after taxes, C% is the cost of capital, and
TC is total capital.

38. An analyst uses the financial statements of Advanced Instruments to generate the following
estimates:
Book Value per share = 4.00
Dividend retention ratio = 75%
ROE = 17%
If the required rate of return is 15%, and the current share price is $7.56 per share, the stock
(using a single stage Residual income model) is most likely:
A. correctly valued.
B. undervalued.
C. overvalued.
Explanation: ANSWER A
g = retention ratio ROE = (0.75) 0.17 = 0.1275 or 12.75%

39.
A.
B.
C.

The residual income approach is NOT appropriate when:

the clean surplus accounting relation is violated significantly.
a firm does not pay dividends or the stream of payments is too volatile to be sufficiently predictable.
expected free cash flows are negative for the foreseeable future.

Explanation: ANSWER A
The residual income approach is not appropriate when the clean surplus accounting relation is violated
significantly. Both remaining responses describe circumstances in which the approach is appropriate.

40. Midland Semiconductor has a book value of $10.50 per share. The company's return on equity is
20%, and its required return on equity is 17%. The dividend payout ratio is 30%. What is the value
of the shares using a single stage residual income model?
A. $21.00.
B. $10.50.
C. $31.50.
Explanation: ANSWER A
g = retention ratio ROE = (1 0.30) 0.20 = 0.14 or 14%

41. Professor Cliff Webley made the following statements in his asset valuation class:
Statement 1: "Residual income approaches generally model ROE as approaching zero over time."
Statement 2: "If actual return on equity equals required return on equity, the residual income model
sets the company's proper market value equal to its book value."
Statement 3: "Using consistent assumptions, the single stage residual income model should give you
the same valuation as the Gordon Growth Dividend discount model."
Which of Webley's statements is least accurate?
A. Statement 2.
B. Statement 3.
C. Statement 1.
Explanation: ANSWER C

In a competitive market, ROE has been found to decline over time not to zero but to the cost of equity.
Thus, residual income approaches often model ROE fading toward the cost of equity. As ROE approaches
the cost of equity, residual income approaches zero. The other two statements are accurate.
42. An investor is considering the purchase of Microscopics, which has a price to book value (P/B) ratio of
4.00. Return on equity (ROE) is expected to be 12%, current book value per share is $12.00, and the
cost of equity is 10%. What growth rate is implied by the current P/B rate?
A. 9.33%.
B. 10.00%.
C. 0.67%.

Explanation: ANSWER A
The P/B ratio of 4.00 and the current book value per share of $12.00 imply a current market price of
$48.00. This implies a growth rate of:
g = r [{ B (ROE - r)} / {V-B}] = 0.10 [{12.00(0.12 - 0.10)} / {48.00 - 12.00}] = 0.0933 = 9.33%.
Note that the reading in the curriculum does not provide this expression directly.
43.
A.
B.
C.

The residual income approach is appropriate when:

a firm pays high dividends that are quite stable.
the clean surplus accounting relation is violated significantly.
expected free cash flows are negative for the foreseeable future.

Explanation: ANSWER C
The residual income approach is appropriate when expected free cash flows are negative for the foreseeable
future. It is not appropriate when the clean surplus accounting relation is violated significantly. A firm that pays
high dividends that are quite stable is also a poor candidate for the approach.

44. Big Sky Ranches reported the following for the end of its fiscal year:
Revenues = $40.8 million.
Pretax income = $8.6 million.
Assets = $53.2 million.
Liabilities = $27.8 million.
Dividends per share = $0.35.
Shares outstanding = 8 million.
Tax rate = 35%.
The beta for Big Sky Ranches is 1.2, the current risk free rate is 4.5%, and the expected return on the
market is 12.5%. What is the value of the shares using a single stage residual income model?
A. $8.10.
B. $11.28.
C. $23.23.
Explanation: ANSWER B
After tax earnings = Pretax earnings (1 T) = 8.6 million (1 0.35) = $5.59 million
EPS = After tax earnings/shares outstanding = $5.59 million / 8 million = $0.70
Retention ratio = (0.70 0.35) / 0.70 = 0.50 or 50%
Equity = Assets liabilities = $53.2 million $27.8 million = $25.4 million
Book value per share = Total equity/shares outstanding = $25.4 million / 8 million = $3.18
ROE = $0.70 / $3.18 = 0.22 or 22%
g = retention ratio ROE = (0.50) 0.22 = 0.11 or 11.00%
Expected return = 0.045 + [0.125 0.045]1.2 = 0.1410 or 14.10 %

45.
A.
B.
C.

Continuing residual income is defined as the:

residual income that is expected beyond the initial forecast time horizon.
residual income that forces the net present value to zero.
permanent as opposed to the transitory part of residual income.

Explanation: ANSWER A
Continuing residual income is defined as the residual income that is expected beyond the initial forecast time
horizon. It comes into play when RI is forecast for a defined time horizon and a terminal value based on
continuing RI is estimated at the end of that time frame.

46. Using the following figures, calculate the value of the equity using the capitalized cash flow method

(CCM), assuming the firm will be acquired.

Normalized FCFE in current year $3,000,000
Reported FCFE in current year $2,400,000
Growth rate of FCFE 7.0%
Equity discount rate 16.0%
WACC 13.0%
Risk free rate 3.5%
Cost of debt 10.5%
Market value of debt $3,000,000
The value of the equity is:
A. $28,533,333.
B. $32,666,667.
C. $35,666,667.
Explanation: ANSWER C
To arrive at the value of the equity using the CCM, it can be estimated using the free cash flows to equity
and the required return on equity (r):

Note that we grow the FCFE at the growth rate because the current year FCFE is provided in the problem
(not next year"s FCFE). We use normalized earnings, not reported earnings, given that normalized
earnings are most relevant for the acquirers of the firm. The relevant required return for FCFE is the equity
discount rate, not the WACC. An alternative approach to calculate the value of the equity would be to
subtract the market value of the firm"s debt from total firm value. However, the FCFF are not provided so a
total firm value cannot be calculated.
47. An analyst is examining three companies. Given the information below, which of them is most

likely to be a private firm?

Firm

Number of Years in

Market Required Return for Common

Operation

Capitalization

Stock

12 years

$1,324.8 million

14.8%

4 years

$1,313.9 million

18.3%

19 years

$2,231.0 million

16.4%

A. Firm A.
B. Firm C.
C. Firm B.
Explanation: ANSWER C
The firm most likely to be a private firm is Firm B. Compared to public firms, private firms are less mature (4
years for Firm B), smaller (market cap of B is $1,313.9 million), and have higher required returns (required
return for B is 18.3%).
48. Using the following figures, calculate the value of the firm using the excess earnings method
(EEM).
Working capital $600,000
Fixed assets $2,300,000
Normalized earnings $340,000
Required return for working capital 5%
Required return for fixed assets 13%
Growth rate of residual income 4%
Discount rate for intangible assets 18%

A. $3,073,199.
B. $2,981,714.
C. $3,027,111.
Explanation: ANSWER B
The answer is calculated using the following steps.
Step 1: Calculate the required return for working capital and fixed assets.
Given the required returns in percent, the monetary returns are:
Working Capital: $600,000 5% = $30,000.
Fixed Assets: $2,300,000 13% = $299,000.
Step 2: Calculate the residual income.
After the monetary returns to assets are calculated, the residual income is that which is left over in the
normalized earnings:
Residual Income = $340,000 $30,000 $299,000 = $11,000.
Step 3: Value the intangible assets.
Using the formula for a growing perpetuity, the discount rate for intangible assets, and the growth rate for
residual income:
Value of Intangible Assets = ($11,000 1.04) / (0.18 0.04) = $81,714.
Step 4: Sum the asset values to arrive at the total firm value.
Firm Value = $600,000 + $2,300,000 + $81,714 = $2,981,714.
49.
A.
B.
C.

The capitalized cash flow method (CCM) used in private firm valuation is most appropriate when:
stable growth is expected.
there are many intangible assets to value.
earnings are growing quickly in an initial period.

Explanation: ANSWER A
The CCM is a growing perpetuity model that assumes stable growth and is in effect a single stage
free cash flow model. It may be suitable when no comparables or projections are available and when stable
growth is expected. The excess earnings method (EEM) is useful when there are intangible assets to value.
The free cash flow method assumes high growth in an initial period followed by constant growth thereafter.
50. An analyst is valuing a private firm on the behalf of a strategic buyer and deflates the average
public company multiple by 15% to account for the higher risk of the private firm. Given the
following figures, calculate the value of firm equity using the guideline public company method
(GPCM).
Market value of debt $4,100,000
Normalized EBITDA $42,800,000
Average MVIC/EBITDA multiple 8.5
Control premium from past transaction 25%
The value of the firm's equity is closest to:
A. $304,060,000.
B. $382,438,000.
C. $381,412,500.
Explanation: ANSWER C
The adjustment to the MVIC/EBITDA multiple for the higher risk of the private firm is: 8.5 (1 0.15) =
7.225. Given that the buyer is a strategic buyer, a control premium adjustment should be made on the
value of equity.
MVIC = 7.225 $42,800,000 = $309,230,000.
Subtracting out the debt results in the equity value (before control premium): $309,230,000 $4,100,000 =
$305,130,000.
Equity value after applying control premium = 305,130,000(1.25) = 381,412,500