PROBLEM 112 Equity Valuation

Ace Co. is to be taken over by Beta Ltd. at the end of year 2007. Beta agrees to pay the shareholders of Ace the book value per
share at the time of the takeover. A reliable analyst makes the following projections for Ace (assume cost of capital is 10% per
annum):

1 2 3 4 5 6
($ per share) 2002 2003 2004 2005 2006 2007
Dividends $ - $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Operating cash flows $ - $ 2.00 $ 1.50 $ 1.00 $ 0.75 $ 0.50
Capital expenditures $ - ### $ - $ 1.00 $ 1.00 $ -
Debt increase (decrease) $ - $ -1.00 $ -0.50 $ 1.00 $ 1.25 $ 0.50
Net income $ - $ 1.45 $ 1.10 $ 0.60 $ 0.25 $ -0.10
Book value $ 9.00 $ 9.45 $ 9.55 $ 9.15 $ 8.40 $ 7.30

a. Estimate Ace Co.s value per share at the end of year 2002 using the dividend discount model.

Solution

1 2 3 4 5
($ per share) 2003 2004 2005 2006 2007
Dividends $ 1.00 ### $ 1.00 $ 1.00 $ 1.00
Book value $ 9.45 $ 9.55 $ 9.15 $ 8.40 $ 7.30

Cost of capital 10%

$1/(1+10%)1+$1/(1+10%)2+$1/(1+10%)3+$1/(1+10%)4+$1/(1+10%)5+$7,30/(1+10%)5
Intrinsic value =

Intrinsic value = 8.32

c. Attempt to estimate the value of Ace Co. at the end of year 2002 using the free cash flow to equity model.

Solution

1 2 3 4 5
($ per share) 2003 2004 2005 2006 2007
Operating cash flows $ 2.00 $ 1.50 $ 1.00 $ 0.75 $ 0.50
Capital expenditures $ - ### $ 1.00 $ 1.00 $ -
+/- Debt increase (decrease) $ -1.00 $ -0.50 $ 1.00 $ 1.25 $ 0.50
Free Cash Flow to Equity $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Book value $ 9.45 $ 9.55 $ 9.15 $ 8.40 $ 7.30

Cost of capital 10%

$1/(1+10%)1+$1/(1+10%)2+$1/(1+10%)3+$1/(1+10%)4+$1/(1+10%)5+$7,30/(1+10%)5
Intrinsic value =

Intrinsic value = 8.32

 b. Estimate Ace Co.s value per share at the end of year 2002 using the residual income model.

Solution

0 1 2 3 4 5
($ per share) 2002 2003 2004 2005 2006 2007
Book Value $ 9.00 $ 9.45 $ 9.55 $ 9.15 $ 8.40 $ 7.30

Net income $ 1.45 $ 1.10 $ 0.60 $ 0.25 $ -0.10

- Capital charge
(10% k *Beginning BV) $ 0.90 $ 0.95 $ 0.96 $ 0.92 $ 0.84
Residual income $ 0.55 $ 0.16 $ -0.36 $ -0.67 $ -0.94
Gain on sale of equity to Pitbull (terminal value) $ -
because Beta agrees to pay the shareholders of Ace at the book value
$9+$0,55/(1+10%)1+$0,16/(1+10%)2+($(0,36))/(1+10%)3+($(0,67))/(1+10%)4+($(0,94))/(1+10%)5
Intrinsic value =

Intrinsic value = 8.32