17. Rob Lowe is valuing the equity of Vic Beverages. He estimates FCFE for 2016 by using a constant-growth model. The estimated value for FCFE for 2015 is $5. Lowe uses FCFE growth rate of 5% and required rate of return of 10%. With these variables the estimated value per share for 2016 is $105. Lowe then conducts a sensitivity analysis by taking the base values of FCFE growth rate and required rate of return and highest and lowest estimates of these variables based on economic and competitive environment. The following table shows the results:
17. C is correct. Economic income is the profit realized from an investment. For a given year economic income is the after-tax cash flows from an investment plus the change in market value: Economic income = Cashflow + (Ending market value – Beginning market value). Section 8.2.
12. C is correct. Secondary market sale of stake to strategic investors in the same market or business segment seems the most appropriate. The two main advantages are 1) the possibility to achieve the highest valuation multiples in the absence of an IPO, 2) specialized firms have the skill to bring their portfolio companies to the next level and sell to either a strategic investor or another PE firm having a different skill set. A & B are incorrect because IPOs are costly and MBOs use large amounts of debt. Section 2.6.
19. Crimson Corporation is considering the acquisition of Gamma Tech. The following data relates to Gamma Tech. The freecashflow is projected to grow at a constant rate of 6% per annum after four years. Using the discounted cashflow approach the value per share of Gamma Tech. is closest to:
8. B is correct. The pecking order theory, suggests that managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content (internally generated funds) and lowest preference to the form with the greatest potential information content (public equity offerings). Internal financing is first chosen, and if insufficient, managers next prefer debt, and finally equity. Section 2.6.
Absolute valuation models or intrinsic value models such as the dividend growth rate model and the freecashflow 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.
7. Jeremy Kabelo, a newly hired fixed income analyst at a securities firm, makes the following statements regarding valuation of option-free bonds, “My method will calculate the same values for option-free bonds as those produced by a binomial tree. Special programming skills are needed to properly calibrate a binomial tree to match benchmark risk-free bond prices, which makes the binomial approach quite costly to adopt.” Is Kabelo most likely correct when comparing his method to the binomial tree approach?
20. B is correct. The residual dividend policy is based on paying out dividends from internally generated funds after financing the current year’s capital expenditures. Liz’s current earnings = $100 million. Expected capital expenditure is $80 million. Internal financing from retained earnings according to target capital structure = 80% x 80 = $64 million. Residual cashflow = dividend = $100 - $64 = $36 million. Implied payout ratio = 36/100 = 36%. Section 4.1.3.
2. A is correct. Trader violated Standard VI (A) – Disclosure of Conflicts, by not reporting her directorship, stock ownership and cash compensation that she received on account of her position as a director of AMD to her employer and clients. This disclosure was important, as it would provide her employer and clients to assess her objectivity when making an investment decision or carrying out a trade.
4. B is correct. Using Equation 6: Equity risk premium = Div. yield on index based on next year aggregated forecasted dividends & aggregate market value + long-term earnings growth rate- current long-term government bond yield. . Section 3.2.
3. CRG is in the manufacturing industry. The company has found it difficult to pay dividends over the years due to debt financing requirements. Moreover, even though the company has been profitable over the last few years, its freecash flows have been negative owing to large capital investment requirements. The debt retirement over the years has made its capital structure quite volatile. Which of the following is least likely true with respect to identifying a model to value the company? A. A dividend discount model is unsuitable.
17. C is correct. Differences in market values of individual companies in the same industry but trading in different countries is a common factor and is unlikely to create difficulty in relative valuations. The differences in interest rates and risks as well as accounting methods across different countries for individual companies in the same industry makes relative valuation difficult. Section 5.
4. Firm A is a struggling company in the manufacturing industry . Demand for the company’s products has declined markedly over the last two years and is unlikely to pick up again. Firm B is an established company in the dairy industry with a steady and predictable cashflow. The best way to value these companies is:
8. Northern Airways has a current book value of $15 per share. The company's expected long- term ROE is 15% and its cost of equity is 11%. The company maintains a dividend payout ratio of 70% and has constant earnings growth. The intrinsic value of equity is closest to: A. $24.
86. Alex Karachanis, CFA, is an independent financial advisor with a roster of over 100 clients. Along with advisory services, he also facilitates in executing the trades for his clients and manages their portfolio. Adonia Papadakis signed up Alex in November 2013 to advise and manage her portfolio. After detailed discussions on Adonia‟s circumstances and return requirements, it was agreed that only large cap equity investments will be made. In mid-2013 Alex felt that large cap stocks were excessively overvalued and shifted 50% of the portfolio to small-cap stocks. Over the next six months, small-cap stocks significantly outperformed large cap stocks. It is now January 2014 and Adonia has just received her account statement for 2013. She is very happy with the performance of her portfolio. Which standard did Alex least likely violate?
Di Stefano asked Starshah's Director of Strategic Planning, Keisha Simmons, to make a presentation to Starshah's board at the end of 2004 about the future growth of the firm. The news was sobering. Simmons told the board members that Starshah could expect two more years of rapid growth, during which time earnings per share could be expected to rise 45% per year with 30% annual increases in capital spending and depreciation. During this high-growth period, Simmons estimates that the required return on equity for Starshah will be 25%. Starshah consistently maintains a target debt ratio of 0.25.
23. An investor buys one share of a stock at $85 at t = 0. He buys an additional share for $90 at t = 1. The stock pays a dividend of $5 per share at t = 1 and t = 2. The investor sells both the shares at t = 2 for $100 each. Which of the following is most likely the time weighted rate of return?
11. Lincoln Ltd issued a $20,000 200-day note at 10%, and used the cash to pay for salaries. It also issued long-term debt worth $90,000 at 10% annually and used the cash to purchase equipment for the new office. The combined effect of these transactions is least likely to be: A. a decrease in operating cashflow by $20,000.