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Tutorial: Chapter 1

Drill Exercises
E1.1. Calculating Enterprise Value (Easy)
The shares of a firm trade on the stock market at a total of $1.2 billion and its debt trades at
$600 million. What is the value of the firm (its enterprise value)?
E1.2. Calculating Value per Share (Easy)
An analyst estimates that the enterprise value of a firm is $2.7 billion. It has $900 million
of debt outstanding. If there are 900 million shares outstanding. What is the analyst's esti-
mated value per share?
E1.3. Buy or Sell? (Easy)
A firm reports book value of shareholders' equity of $850 million with 25 million shares
outstanding. Those shares trade at $45 each in the stock market. An analyst values the
equity by following the scheme: Value = Book value + Extra value. She calculates extra
value of $675 million. Should she issue a buy or a sell recommendation to her clients?

Applications
E1.4. Finding Information on the Internet: Dell, Inc.
General Motors, and Ford (Easy)
This chapter compared Dell, Inc., and General Motors Corp., and Ford Motor Co. Go to the
Internet and find sources that will help research these firms. One site to start with is Yahoo!
Finance: http://quote.yahoo.com
Also find the firms' web pages. Look at the book's web page for links to further sources.
E1.5. Enterprise Market Value: General Mills and Hewlett-Packard (Medium)
a. General Mills, Inc., the large manufacturer of packaged foods, reported the following
in its annual report for the year ending May 30, 1999 (in millions):

Short-term borrowing $ 614.9


Long-term debt 1,702.4
Stockholders' equity 164.2

The short-term borrowing and long-term debt are carried on the balance sheet at their
market value. The firm's 150.0 million shares traded at $80 per share when the annual
report was released. From these numbers, calculate General Mills's enterprise market
value (the market value of the firm).
b. Hewlett-Packard, the computer equipment manufacturer and systems consultant, had
1,013 million shares outstanding in July 1999, trading at $100 per share. Its most
recent quarterly report listed the following (in millions):

Long-term investments in debt securities $ 5,800


Short-term borrowings 1,380
Long-term debt 1,730
Stockholders' equity 18,198
30 Chapter 1 Introduction to Investing and Valuation

Calculate the enterprise market value of Hewlett-Packard. The question requires you
to consider the treatment of the long-term debt investments. Are they part of the
enterprise?

E1.6. Identifying Operating, Investing, and Financing Transactions:


Microsoft (Easy)
Microsoft Corp. reported the following in its annual report to the Securities and Exchange
Commission for fiscal year 2004. Classify each item as involving anjoperating, investing,
or financing activity. Amounts are in millions.
a. Common stock dividends 1,729
b. General and administrative expenses 4,997
с Sales and marketing expenses 8,309
d. Common stock issues 2,748
e. Common stock repurchases 3,383
f. Sales revenue 36,835
g. Research and development expenditures 7,779
h. Income taxes 4,028
i. Additions to property and equipment 1,109
j. Accounts receivable 5,890
Real World Connection
Exercises E4.16, E10.10, and E17.10 also deal with Microsoft, as do Minicases M8.2 and
M12.1.
Chapter 1 Introduction to Investing and Valuation 31

Minicase M1.1
Critique of an Equity Analysis:
America Online Inc.
The so-called Internet Bubble gripped stock markets in 1998,1999, and 2000, as discussed in
the chapter. Internet stocks traded at multiples of earnings and sales rarely seen in stock mar-
kets. Start-ups, some with not much more than an idea, launched initial public offerings
(IPOs) that sold for very high prices (and made their founders and employees with stock op-
tions very rich). Established firms, like Disney, considered launching spinoffs with "dot.com"
in their names, just to receive the higher multiple that the market was giving to similar firms.
Commentators argued over whether the high valuations were justified. Many concluded
the phenomenon was just speculative mania. They maintained that the potential profits that
others were forecasting would be competed away by the low barriers to entry. But others
maintained that the ability to establish and protect recognized brand names—like AOL,
Netscape, Amazon, Yahoo!, and eBay—would support high profits. And, they argued, con-
sumers would migrate to these sites from more conventional forms of commerce.
America Online (AOL) was a particular focus in the discussion. One of the most well-
established Internet portals, AOL was actually reporting profits, in contrast to many Internet
firms that were reporting losses. AOL operated two worldwide Internet services, America
Online and CompuServe. It sold advertising and e-commerce services on the Web and, with
its acquisition of Netscape, had enhanced its Internet technology services. See Box 1.3.
For the fiscal year ending June 30, 1999, America Online reported total revenue of
S4.78 billion, of which $3.32 billion was from the subscriptions of 19.6 million AOL and
CompuServe subscribers, $ 1.00 billion from advertising and e-commerce, and the remain-
der from network services through its Netscape Enterprises Group. It also reported net in-
come of $762 million, or $0.73 per share.
AOL traded at $ 105 per share on this report and, with 1.10 billion shares outstanding, a
market capitalization of its equity of $115.50 billion. The multiple of revenues of 24.2 was
similar to the multiple of earnings for more seasoned firms at the time, so relatively, it was
very high. AOUs P/E ratio was 144.
In an article on the op-ed page of The Wall Street Journal on April 26, 1999, David D.
Alger of Fred Alger Management, a New York-based investment firm, argued that AOL's
stock price was justified. He made the following revenue forecasts for 2004, five years later
(in billions):
Subscriptions from 39 million subscribers $12,500
Advertising and other revenues 3.500
Total revenue 16.000
Profits margin on sales, after tax 26%
To answer parts (A) and (fi), forecast earnings for 2004

A. If AOL's forecasted price-earnings (P/E) ratio for 2004 was at the current level of that for
a seasoned firm, 24, what would AOL's shares be worth in 1999? AOL is not expected to
pay dividends. Hint: The current price should be the present value of the price expected
in the future.
B. Alger made his case by insisting that AOL could maintain a high P/E ratio of about 50
in 2004. What P/E ratio would be necessary in 2004 to justify a per-share price of $ 105
in 1999? If the P/E were to be 50 in 2004, would AOL be a good buy?
C. What is missing from these evaluations? Do you see a problem with Alger's analysis?

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