lOMoARcPSD|32506979

Tutorial 5 Solution- Topic 4: Valuation

Tutorial Questions (TQs)

Which Unit Learning Outcomes (ULOs) are you achieving in this tute?

√
√

 In this topic (Valuation) you are introduced to GLO1-discipline specific knowledge and
techniques to demonstrate an understanding of advanced decision making steps followed
by a finance manager.

 Here you also learn GLO5- problem solving by applying various valuation model to
improve your decision making capacity as an investment manager.

All these learning outcomes are meant to improve your skills and efficiencies to make you a
competent finance manager. The flowing tutorial questions should contribute to achieve such
learning outcomes.

TQ 1 Calculate the weighted-average cost of capital (WACC) for Federated Junkyards of

America, using the following information:
• Debt: $75,000,000 book value outstanding. The debt is trading at 90% of book value. The
yield to maturity is 9%.
• Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of return on
Federated’s stock is 18%.
• Taxes: Federated’s marginal tax rate is Tc = .35.

Solution:
Market value of debt D = 0.9 × 75 = $67.5 million
Market value of equity E = 42 × 2.5 = $105 million
V = D + E = 67.5 + 105 = 172.5 million
D/V = 67.5/172.5 = 0.3913, E/V = 105/172.5 = 0.6087 (or E/V = 1 – D/V = 0.6087)
WACC = 0.09 × (1 - 0.35) × 0.3913 + 0.18 × 0.6087 = 0.13246 ≈ 0.1325, or 13.25%.

Page 1 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)

 lOMoARcPSD|32506979

TQ 2 What are the assumptions to make, while applying a company’s WACC for its projects?

Two major assumptions of using the WACC to evaluate projects:

1. The business risk of the project under evaluation needs to be the same as the business
risk of the company’s existing core business.

2. The project must be funded with the same capital structure of the company. That is,
the firm must fund any new project with the same proportions of debt and equity as
their current structure.

TQ 3 A project costs $1 million and has a base-case NPV of exactly zero (NPV = 0). What is
the project’s APV in the following cases?
a. If the firm invests, it has to raise $500,000 by a stock issue. Issue costs are 15% of net
proceeds.
b. If the firm invests, its debt capacity increases by $500,000. The present value of interest
tax shields on this debt is $76,000.

APV = base-case NPV ± PV financing side effects

a. APV = 0 - 0.15× 500,000 = -75,000

b. APV = 0 + 76,000 = +76,000

TQ 4 The current market condition is as such that the cash rate is 8%; commonwealth
government securities are paying 7% interest; the return in Australian stock exchange is 15%;
cost of debenture is 11%; and corporate tax rate is 30%

Financial analyst for your company has determined that as your company currently
maintaining a Debt: Equity ratio of 40:60, so company’s current market risk is 1.5. What is
your weighted average cost of capital for your company?

Solution: You need to apply Capital Asset Pricing Model (CAPM) to find out the cost of
equity rj = rf + (rm- rf) beta
Where rf = risk free rate =7%; rm= market return =15%; beta= systematic risk=1.5
Cost of equity = re = rf + (rm- rf) beta = 0.07 + (0.15 – 0.07) × 1.5 = 0.19, or 19.00%;
Cost of debt = 0.11, or 11%
WACC (1  0.30) 0.40 0.11  0.60 0.19
0.1448
14.48%
TQ 5 A company has made the following forecasting of its future free cash flows for year 1-
5. Few cells of the table are kept empty for you to fill out. The WACC for the company is
12% and the long-run growth rate in year 5 and onwards is 4%. The Company has $5 million
debt and 865,000 shares outstanding. What is the value per share?

Latest (figures in ‘000s)

Year Forecast
0 1 2 3 4 5
Page 2 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)

 lOMoARcPSD|32506979

1. Sales 40,123.0 36,351.0 30,155.0 28,345.0 29,982.0 30,450.0

2. Cost of Goods Sold 22,879.0 21,678.0 17,560.0 16,459.0 15,631.0 14,987.0
3. Other Costs 8,025.0 6,797.0 5,078.0 4,678.0 4,987.0 5,134.0
4. EBITDA 9,219.0
5. Depreciation and Amortization 5,678.0 5,890.0 5,670.0 5,908.0 6,107.0 5,908.0
6. EBIT (pretax profit) 3,541.0 1,986.0 1,847.0 1,300.0 3,257.0 4,421.0
7. Tax at 35% 1,239.4
8. Profit after Tax 2,301.7

9. Change in Working Capital 784.0 -54.0 -342.0 -245.0 127.0 235.0

10. Investment (change in gross PP&E) 6,547.0 7,345.0 5,398.0 5,470.0 6,420.0 6,598.0
11. Free Cash Flow 648.7

Solution: all dollar figures, except value per share, are rounded up to 1 decimal place.
Latest (figures in ‘000s)
Year Forecast
0 1 2 3 4 5
1. Sales 40,123.0 36,351.0 30,155.0 28,345.0 29,982.0 30,450.0
2. Cost of Goods Sold 22,879.0 21,678.0 17,560.0 16,459.0 15,631.0 14,987.0
3. Other Costs 8,025.0 6,797.0 5,078.0 4,678.0 4,987.0 5,134.0
4. EBITDA (1 – 2 – 3) 9,219.0 7,876.0 7,517.0 7,208.0 9,364.0 10,329.0
5. Depreciation and Amortization 5,678.0 5,890.0 5,670.0 5,908.0 6,107.0 5,908.0
6. EBIT (pretax profit) (4 – 5) 3,541.0 1,986.0 1,847.0 1,300.0 3,257.0 4,421.0
7. Tax at 35% 1,239.4 695.1 646.5 455.0 1,140.0 1,547.4
8. Profit after Tax (6 – 7) 2,301.6 1,290.9 1,200.5 845.0 2,117.0 2,873.6

9. Change in Working Capital 784.0 -54.0 -342.0 -245.0 127.0 235.0

10. Investment (change in gross PP&E) 6,547.0 7,345.0 5,398.0 5,470.0 6,420.0 6,598.0
11. Free Cash Flow (8 + 5 – 9 – 10) 648.6 -110.1 1,814.5 1,528.0 1,677.0 1,948.6

PV Free Cash Flow, Years 1–5 4,607.3 Horizon Value in Year 5

PV Horizon Value5 14,373.9 25,331.8
PV of Company 18,981.2
 110 .1 1,814.5 1,528.0 1,677.0 1,948.6
PV FCF (Year 1 - 5)      4,607.3
1.121 1.12 2 1.12 3 1.12 4 1.12 5
C (1  g ) 1,948.6 (1  0.04)
Horizon value5  5  25,331.8
r g 0.12  0.04
25,331.8
PV of Horizon value5  14,373.9
1.12 5
The total value of the equity is: $18,981.2 – $5,000.0 = $13,981.2
Value per share = $13,981.2/865 ≈ $16.16.

Additional Practice Questions

APQ 1 The following Table 19.3 shows a book balance sheet for the Wishing Well Motel
chain. The company’s long-term debt is secured by its real estate assets, but it also uses short-
term bank financing. It pays 10% interest on the bank debt and 9% interest on the secured
debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The
expected return on Wishing Well’s common stock is 18%. Tax rate is 35%.

Page 3 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)

 lOMoARcPSD|32506979

Calculate Wishing Well’s WACC. Assume that the book and market values of Wishing Well’s
debt are the same.

. If the bank debt is treated as permanent nancing, the capital structure proporons are:

Bank debt (rD = 10 percent) $280 9.4%

Long-term debt (rD = 9 percent) 1800 60.4
Equity (rE = 18 percent, 90 x 10 million shares) 900 30.2

$2980 100.0%
WACC* = [0.10(1 - 0.35)0.094] + [0.09(1 - 0.35)0.604] + [0.180.302]
= 0.096 = 9.6%

APQ 2 Table 19.4 shows a simplified balance sheet for Rensselaer Felt. Calculate this
company’s weighted-average cost of capital. The debt has just been refinanced at an interest
rate of 6% (short term) and 8% (long term). The expected rate of return on the company’s
shares is 15%. There are 7.46 million shares outstanding, and the shares are trading at $46.
The tax rate is 35%.

We make three adjustments to the balance sheet:

 Ignore deferred taxes; this is an accounting entry and represents neither a liability
nor a source of funds
 ‘Net out’ accounts payable against current assets
 Use the market value of equity (7.46 million x $46)

Now the right-hand side of the balance sheet (in thousands) is:
Short-term debt $75,600
Long-term debt 208,600
Shareholders’ equity (7.46 million x $46) 343,160
Total $627,360
The after-tax weighted-average cost of capital formula, with one element for each
source of funding, is:
WACC = [rD-ST(1 – Tc)(D-ST/V)]+[rD-LT(1 – Tc)(D-LT/V)]+[rE (E/V)]
Page 4 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)

 lOMoARcPSD|32506979

WACC = [0.06(1 – 0.35)(75,600/627,360)]+[0.08(1 – 0.35)(208,600/627,360)]

+ [0.15(343,160/627,360)]
= 0.004700 + 0.017290 + 0.082049 = 0.1040 = 10.40%

APQ 3. Consider a project lasting one year only. The initial outlay is $1,000 and the expected
inflow is $1,200. The opportunity cost of capital is r = .20. The borrowing rate is rD= .10,
and the tax shield per dollar of interest is Tc = .35.
a. What is the project’s base-case NPV?
b. What is its APV if the firm borrows 30% of the project’s required investment?

. a. Base-case NPV = -1,000 + 1200/1.20 = 0

b. PV tax shield = (0.35 × 0.1 × 0.3×1000)/1.1 = 9.55. APV = 0 + 9.55 = $9.55

APQ 4. The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is
contemplating a $1 million expansion of its existing business. This expansion is expected to
produce a cash inflow of $130,000 a year in perpetuity.
The company is uncertain whether to undertake this expansion and how to finance it.
The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt.
The flotation costs of a stock issue would be around 5% of the amount raised, and the
flotation costs of a debt issue would be around 1½%.
Bunsen’s financial manager, Ms. Polly Ethylene, estimates that the required return on
the company’s equity is 14%, but she argues that the flotation costs increase the cost of new
equity to 19%. On this basis, the project does not appear viable.
On the other hand, she points out that the company can raise new debt on a 7% yield,
which would make the cost of new debt 8½%. She therefore recommends that Bunsen should
go ahead with the project and finance it with an issue of long-term debt.
Is Ms. Ethylene right? How would you evaluate the project?

Solution. Note the following:

 The costs of debt and equity are not 8.5% and 19%, respectively. These figures
assume the issue costs are paid every year, not just at issue.
 The fact that Bunsen can finance the entire cost of the project with debt is
irrelevant. The cost of capital does not depend on the immediate source of
funds; what matters is the project’s contribution to the firm’s overall borrowing
power.
 The project is expected to support debt in perpetuity. The fact that the first debt
issue is for only 20 years is irrelevant.
Assume the project has the same business risk as the firm’s other assets. Because it is
a perpetuity, we can use the firm’s weighted-average cost of capital. If we ignore
issue costs:
WACC = [rD  (1 – TC)  (D/V)] + [rE  (E/V)]
WACC = [0.07  (1 – 0.35)  0.4] + [0.14  0.6] = 0.1022 = 10.22%
Using this discount rate:
$130,000
NPV   $1,000,000  $272,016
0.1022
Page 5 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)

 lOMoARcPSD|32506979

The issue costs are:

Stock issue: 0.050  $1,000,000 = $50,000
Bond issue: 0.015  $1,000,000 = $15,000

Debt is clearly less expensive. Project NPV net of issue costs is reduced to:
($272,016 – $15,000) = $257,016. However, if debt is used, the firm’s debt ratio will
be above the target ratio, and more equity will have to be raised later. If debt
financing can be obtained using retaining earnings, then there are no other issue costs
to consider. If stock will be issued to regain the target debt ratio, an additional issue
cost is incurred.
A careful estimate of the issue costs attributable to this project would require a
comparison of Bunsen’s financial plan ‘with’ as compared to ‘without’ this project.

Page 6 of 6

Downloaded by Diana Pereira (diana.p7reira@gmail.com)