Problem Set

Pieter Cosemans, Maarten Driessens, Mats Van Gils and Kevin Verhagen

Stock Valuation

Problem 1
Suppose firm W has sales of $518 mill in 2018. Furthermore, suppose that the sales are
expected to grow at 9% in 2019 and that this growth rate then will gradually slows by 1%
per year to along- run growth rate for the the industry of 4% by 2024. Based on the W’s
past profitability and investment needs, you expect EBIT to be 9% of sales, increase in net
working capital to be 10% of any increase in sales, and net investment (capital expenditure
in excess of depreciation) to be 8% of any increase in sales. Finally, W has $25 mill in cash,
$72 mill in debt, faces a corporate tax rate of 25%, and its weighted average cost of
capital (WACC) is 11%. (do it in Excel)
a. What is your estimate of the value of W in 2018?

Year 2018 2019 2020 2021 2022 2023 2024

FCF Forecast in million $
Sales 518.00 564.62 609.79 652.47 691.62 726.20 755.25
Growth versus prior year 9.00% 8.00% 7.00% 6.00% 5.00% 4.00%
EBIT (9% of sales) 50.82 54.88 58.72 62.25 65.36 67.97
Increase in NWC (change in sales
10%) -4.66 -4.52 -4.27 -3.91 -3.46 -2.90
Net investment (change in sales 8%) -3.73 -3.61 -3.41 -3.13 -2.77 -2.32
Income tax (25% EBIT) -12.70 -13.72 -14.68 -15.56 -16.34 -16.99
Free Cash Flow 29.72 33.03 36.36 39.64 42.79 45.75

1.04
𝑉!"!# = $ * ∗ 45.75 = 679.71 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $
0.11 − 0.04

29.72 33.03 36.36 39.64 42.79 45.72 + 679.71

𝑉!"$% = + + + + + = 519.55 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $
1.11 1.11² 1.11³ 1.11# 1.11& 1.11'

𝑀. 𝑉. 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑉2018 + 𝑐𝑎𝑠ℎ − 𝑑𝑒𝑏𝑡 = 519.55 + 25 − 72  =  472.55 million $

b. Perform a sensitivity analysis of your estimate with respect to parameter values. A

sensitivity analysis is an examination of how the result of your valuation depends on
the value of underlying parameters. Re-compute the equity value of W under the
following alternative assumptions:

1
 b1. the cost of capital (WACC) is 9% (everything else as
in a.)

M. V. of equity = 686.74 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $

b2. EBIT is 7 % of sales (everything else as in a.)

M. V. of equity = 340.99 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $

b3. the corporate tax rate is expected to increase to 30% starting from 2024
(everything else as in a.)

M. V. of equity = 444.73 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $

Problem 2
You want to value the equity of firm NYX. You have collected some basic financial
data on NYX. For example, you know that NYX’s sales are $20, book equity value is $20,
and its dividends are $1.0. Furthermore, you have collected data on comparable firms Y1,
Y2, and Y3, which are all publicly traded companies and as such you know their equity
market values in. The data on the comparable firms are summarized below:

Y1 Y2 Y3
Market value, 250 320 179
$
Sales, $ 325 352 214.8
Book equity, $ 217. 304. 162.7
4 8 3
Dividends, $ 10 16 10.8

Using the method of comparables estimate NYX’s market value of equity.

Y1 Y2 Y3 Average
Market value, $ 250 320 179
Sales, $ 325 352 214,8
Book equity, $ 217,4 304,8 162,73
Dividends, $ 10 16 10,8

Market/sales 0,77 0,91 0,83 0,84

Market/book 1,15 1,05 1,10 1,10
Market/net income 25,00 20,00 16,57 20,52

2
 Recent data Average market Indicated value of
NYX ratio equity
Sales 20,00 0,84 16,74
Book value of
20,00 1,10 22,00
equity
Net income 1,00 20,52 20,52
Average 19,76
The estimated market value is $19,76.

Problem 3
ABC will pay a dividend of $1.46 per share this year. You expect ABC’s dividends to
grow at 5.1% a year. What is ABC’s price per share if its cost of equity is 11.2% per year?
What is the price per share if its cost of equity is 10% per year instead?

1,46
𝑃" = = $23,93
0,112 − 0,051
1,46
𝑃" = = $29,80
0,10 − 0,051
Price per share goes up as cost of equity goes down

Problem 4
In early 2018, Coca-Cola Company (KO) had a share price of $42.21, and had paid a
dividend of $1.49 for the prior year. Suppose you expect Coca-Cola to raise this dividend by
approximately 6.6% per year in perpetuity.
a. If Coca-Cola’s equity cost of capital is 8.1%, what share price would you expect
based on your estimate of the dividend growth rate?
1,066
𝑃 = 1,49 ∗ = $105,89
0,015
b. Given Coca-Cola’s share price, what would you conclude about your assessment
of Coca- Cola’s future dividend growth?
When dividend level goes up the next year, the price of the share goes up too. The price
per stock is equal to the present value of the expected future dividends it will pay. In this
case, the future dividend growth per year is probably too optimistic, it will be lower than
6,6%.

Investment Decision Rules

Problem 5
3
 You are considering opening a new plant. The plant will cost you $95.8mil. upfront. After
that, it is expected to produce profits of $31.5mil. at the end of every year. The cash flows
are expected to last forever. Calculate the NPV of this investment opportunity if your cost of
capital is 7.4%. Should you undertake this investment? Calculate this project’s IRR and use it
to determine the maximum deviation allowable in the cost of capital estimate to leave the
decision unchanged.

$31.5𝑚𝑖𝑙
𝑁𝑃𝑉 = −$95.8𝑚𝑖𝑙 + = $330𝑚𝑖𝑙
7.4%
IRR is when the NPV is 0:
$31.5𝑚𝑖𝑙
𝑁𝑃𝑉 = 0 → 𝐼𝑅𝑅 = = 32.9%
$95.8𝑚𝑖𝑙

𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑙𝑙𝑜𝑤𝑎𝑏𝑙𝑒 = 𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 32.9% − 7.4% = 25.5%

Problem 6
Innovation Company (IC) is thinking about marketing a new software product. Upfront
costs to market and develop the product are $5,100,000. The product is expected to
generate profits of $1,000,000 per year for 10 years. The company will have to provide
product support expected cost $97,000 per year in perpetuity. Assume that all income and
expenses occur at the end of the year.
a. What is the NPV of this investment if the cost of capital is 5.24%? Should the firm
undertake this project? Repeat the same analysis if the discount rate is 2.72% and
10.46%.
$97,000 $1,000,000 $1,000,000 $1,000,000
𝑁𝑃𝑉@5.24% = −$5,100,000 − + + !
+ ⋯+
1 + 5.24% 1 + 5.24% 1 + 5.24% 1 + 5.24%$"
= $681378,71

𝑁𝑃𝑉@2.72% = $ − 12774,39
𝑁𝑃𝑉@10.46% = $ − 2344,87
b. How many IRRs does this investment opportunity have?

4
 NPV
1000000
0

0.01
0.06
0.11
0.16
0.21
0.26
0.31
0.36
0.41
0.46
0.51
0.56
0.61
0.66
0.71
0.76
0.81
0.86
0.91
0.96
-1000000
-2000000
NPV

-3000000
-4000000
-5000000
-6000000
Cost of capital

This investment has 2 IRR’s

c. Can the IRR rule be used to evaluate this investment? Explain.

The traditional IRR rule can’t be used because it states that if the discount rate is
lower then the IRR, the project should start but this isn’t the case when we have 2
IRR’s. We can look at the graph and see that we should start the project when the
cost of capital is larger then the first IRR but lower then the second.

Capital Budgeting

Problem 7
Cellular Access, Inc. is a cellular telephone service provider that reported net income of
$241mil. for the most recent fiscal year. The firm had depreciation expenses of $128mil.,
capital expenditure of $159mil., and not interest expenses. Working capital increased by
$10mil. Calculate the free cash flow for Cellular Access for the most recent fiscal year.

FCF = $241mil+$128mil-$159mil-$10mil = $200mil

Problem 8
One year ago, your company purchased a machine used in manufacturing for
$95,000. You have learned that a new machine is available that offers many advantages;
you can purchase it for $140,000 today. It will be depreciated on a straight-line basis
over ten years, after which it has no salvage value You expect that the new machine will
contribute EBITDA (earnings before interest, taxes, depreciation, and amortization) of
$60,000 per year for the next ten years. The current machine is expected to produce
EBITDA of $21,000 per year. The current machine is being depreciated on a straight-line
basis over a useful life of 11 years, after which it will have no salvage value, so depreciation
5
expense for the current machine is $8,636 per year. All other expenses of the two machines
are identical. The market value today of the current machine is $50,000. Your company’s
tax rate is 20%, and the opportunity cost of capital for this type of equipment is 11%. Is
it profitable to replace the year-old machine?

6
New machine 0 1 2 3 4 5 6 7 8 9 10 (year)
EBITDA 60 60 60 60 60 60 60 60 60 60
Selling, General (90)
Depreciation (14) (14) (14) (14) (14) (14) (14) (14) (14) (14)
EBIT (90) 46 46 46 46 46 46 46 46 46 46
Income tax (20%) 18 (9,2) (9,2) (9,2) (9,2) (9,2) (9,2) (9,2) (9,2) (9,2) (9,2)
Unlevered Net Income (72) 36,8 36,8 36,8 36,8 36,8 36,8 36,8 36,8 36,8 36,8
Plus: Depreciation 14 14 14 14 14 14 14 14 14 14
Free Cash Flow (72) 50,8 50,8 50,8 50,8 50,8 50,8 50,8 50,8 50,8 50,8
Project Cost of Capital 11%
Discount Factor 1 0,9009 0,8116 0,7312 0,6587 0,5934 0,5346 0,4817 0,4339 0,3903 0,3522
PV of Free Cash Flow (72) 45,766 41,230 37,145 33,464 30,147 27,160 24,468 22,043 19,859 17,891
NPV 227,173

Old machine 0 1 2 3 4 5 6 7 8 9 10 (year)

EBITDA 21 21 21 21 21 21 21 21 21 21
Selling, General
Depreciation (8,636) (8,636) (8,636) (8,636) (8,636) (8,636) (8,636) (8,636) (8,636) (8,636)
EBIT 12,364 12,364 12,364 12,364 12,364 12,364 12,364 12,364 12,364 12,364
Income tax (20%) (2,473) (2,473) (2,473) (2,473) (2,473) (2,473) (2,473) (2,473) (2,473) (2,473)
Unlevered Net Income 9,891 9,891 9,891 9,891 9,891 9,891 9,891 9,891 9,891 9,891
Plus: Depreciation 8,636 8,636 8,636 8,636 8,636 8,636 8,636 8,636 8,636 8,636
Free Cash Flow 0 18,527 18,527 18,527 18,527 18,527 18,527 18,527 18,527 18,527 18,527
Project Cost of Capital 11%
Discount Factor 1 0,9009 0,8116 0,7312 0,6587 0,5934 0,5346 0,4817 0,4339 0,3903 0,3522
PV of Free Cash Flow 0 16,691 15,037 13,546 12,204 10,994 9,905 8,923 8,039 7,242 6,524
NPV 109,111

The best option is to buy the new machine because the NPV is higher.