FINC 3630: Advanced Business Finance Additional Practice Problems

FINC 3630: Advanced Business Finance Additional Practice Problems

Accounting For Financial Management

1. Calculate free cash flow for Home Depot for the fiscal year-ended February 1, 2015 (the 2014 fiscal year).

2. Calculate MVA and EVA for Home Depot. Use the information given in class for market value data.

Financial Statement Analysis

1. Use the DuPont equation to calculate return on equity for Home Depot for the fiscal years-end February 1, 2015 and February 2, 2014. Did it increase or decrease? Was the change in return on equity driven by changes in profitability, changes in how efficiently the firm used its assets, or changes in the extent to which the firm uses debt financing?

Cost of Capital

1. Your boss has assigned you and your assistant the task of estimating the cost of common equity for your firm. Your assistant has gathered the following information. The company has $1,000 face value bonds outstanding with 9 years to maturity, a 7 percent coupon rate, paid semiannually, and currently selling for $936.70. Analysts have estimated a 10 percent growth rate for your firm for the foreseeable future. The company’s common stock currently has a dividend yield of 2 percent. Your assistant has estimated the beta of the stock to be 1.5. Using reasonable estimates for the risk-free rate and market risk premium, if necessary, what do you recommend as a reasonable estimate of the cost of common equity? Be sure to be able to justify your answer to your boss and the board of directors.

2. In addition to the information in the above problem, you know your company has 1,000 bonds outstanding, 20,000 shares of common stock, currently trading at $60, and a 40% marginal tax rate. You also know the firm has 12,000 shares of preferred stock, currently selling for $85 and paying a $8.50 annual dividend. What is your estimate of the firm’s cost of capital?

3. Assume all of the same information from the previous 2 problems, except now your boss tells

you that your firm has a target debt-equity ratio of 1, where equity is equally divided between

Corporate Value

1. Your firm, GOP Enterprises, is evaluating Obama, Inc. for a possible acquisition. You believe free cash flows will grow at 8 percent for the foreseeable future. Obama, Inc. has $100 million in marketable securities that you believe is not necessary for the firm’s operations. The current book value of Obama, Inc.’s common equity is $360 million.

For the fiscal year that just ended, Obama, Inc. had total operating capital of $500 million, which is $91.5 million more than total operating capital at the end of the previous fiscal year- end. From the firm’s income statement, Obama, Inc. had $200 million in earnings before interest and taxes. Both Obama, Inc. and Clinton Enterprises are in the 40% tax bracket.

Obama’s stock currently has a beta of 1.75, the firm’s bonds yield 9 percent, and the dividend yield on preferred stock is 11 percent. The firm has 24 million shares of common stock outstanding, currently selling for $25, 300,000 bonds outstanding, currently selling at par, and 1 million shares of preferred stock outstanding, currently selling for $100.

Based on this information and reasonable estimates of any other inputs, what is the most GOP Enterprises would be willing to pay per share of common stock for Obama, Inc.? What is EVA and MVA for Obama, Inc.?

2. Common shares of Yostmeister, Inc. are currently selling for $65. The firm had free cash flow

for the fiscal year that just ended of $125 million and has a weighted average cost of capital of

10 percent. The firm also has $2.5 billion in debt and 75 million shares outstanding. You

expect free cash flows to increase by 14 percent per year for the next two years and 8 percent

per year thereafter. Based on this information, do you recommend your clients to buy, sell, or

hold Yostmeister, Inc. stock?

SOLUTIONS

Accounting For Financial Management

1. Information given in class for tax rate (from note 6 on pg. 46 of Annual Report/10-K)

= 36.4%

To calculate free cash flow, we need EBIT, the tax rate, and the net change in operating capital.

To get the change in operating capital, we need total operating capital in each year.

2014 fiscal year:

Net operating working capital = operating current assets – operating current liabilities

*Note: Assume that Other Current Assets are necessary for the firm’s operations.

For current liabilities, the interest-bearing ones need to be eliminated (Short-Term Debt and Current Installments of Long-Term Debt).

Net operating working capital = ($15,302 – $0) – ($11,269 – $290 - $38) = $15,302 –

$10,941 = $4,361

Operating long-term assets:

*Note: Assume that Other Assets are necessary for the firms operations. We want the amount of fixed assets net of depreciation.

Operating long-term assets = $22,720 + $1,353 + $571 = $24,644 Total Operating Capital = $4,361 + $24,644 = $29,005

2013 fiscal year:

Net operating working capital = ($15,279 – $0) – ($10,749 – $33) = $15,279 – $10,716 =

$4,563

Operating long-term assets = $23,348 + $1,289 + $602 = $25,239 Total Operating Capital = $4,563 + $25,239 = $29,802

Net change in total operating capital = $29,005 – $29,802 = -$797  negative number

2. Information given in class for market value data:

Number of shares on 2/1/15 = 1.307 billion Price per share on 1/30/15 = $104.42

Tax rate from note 6 on pg. 46 of Annual Report/10-K) = 36.4%

WACC = 7.12%

MVA = (1.307 billion x $104.42) – $9,322 million

= $127.1549 billion

EVA = $10,469 (1 – 0.364) – $29,005 (0.0712) = $4,593.1280 million

Financial Statement Analysis

1.

ROE  =  Profit Margin  X  TATO  X  Equity Multiplier 

Net Income 

=  Net Income 

X  Sales 

X  Assets 

Equity  Sales  Assets  Equity 

2014             

6,343  =  6,343  X  83,176  X  39,946 

9,322  83,176  39,946  9,322 

0.6804    0.0763    2.0822    4.2851 

2013             

5,385  =  5,385  X  78,812  X  40,518 

12,522  78,812  40,518  12,522 

0.4300    0.0683    1.9451    3.2357 

↑    ↑    ↑    ↑ 

Return on equity increased from 2013 to 2014 and it was driven by all three factors: increased

profitability (profit margin), increased asset use efficiency (total asset turnover), and increased

leverage (equity multiplier).

Cost of Capital

1. There are three ways to estimate the cost of equity:

CAPM: r = 0.02 + 1.5 (0.06) = 0.11  using 2% for risk-free rate and 6% for market risk premium as reasonable estimates

Bond Yield Plus Risk Premium:

Need to calculate YTM: N = 18; PV = -936.70; PMT = 35; FV = 1000

 I/Y = 4  YTM = 8%

r = 0.08 + 0.04 = 0.12  using 4% as risk premium (3% - 5% is reasonable, so 11% - 13% is reasonable range for r)

Dividend Yield Plus Growth Rate:

r = 0.02 + 0.10 = 0.12

Conclusion: 12% is a consistent estimate of the cost of common equity, and 11% to 13%

is a reasonable range.

2. First, one needs the cost of preferred stock (the rest of the information is in #1).

Cost of Preferred = $8.50 / $85 = 10%

WACC = (1.2 M / 3.1567 M) x (0.12) + (1.02 M / 3.1567 M) x (0.10) + (0.9367 M / 3.1567 M) x (0.08) x (1 - 0.4)

= 9.2173%

3. If the target debt-equity ratio is 1, that means 50% of the firm is financed with debt and 50%

with equity (25% from common stock and 25% from preferred stock).

WACC = (0.5 / 2) x (0.12) + (0.5 / 2) x (0.10) + (1 / 2) x (0.08) x (1 - 0.4)

= 7.9%

Corporate Value

1. To get price per share, we need to get value of equity, value of the firm, and therefore the value of the operating assets. In order to get the value of operations, we need to know free cash flow and the cost of capital.

Cost of Capital:

Cost of Common Equity = 0.04 + 1.75 (0.06) = 0.145  using 4% for risk-free rate and 6% for market risk premium as reasonable estimates

WACC = (600 M / 1 B) x (0.145) + (100 M / 1 B) x (0.11) + (300 M / 1 B) x (0.09) x (1 - 0.4)

= 11.42%

Free Cash Flow (for fiscal year that just ended):

= $200 million (1 – 0.40) - $91.5 million = $28.5 million

Value of Operating Assets:

= ($28.5 million x 1.08) / (0.1142 – 0.08) = $900 million

Value of the Firm = $900 million + $100 million in non-operating assets = $1 billion

Value of the firm’s common equity = $1 billion

– $100 million (preferred stock) – $300 million (debt)

$600 million

Value per share = $600 million / 24 million shares = $25 per share.

*Note: The value we estimate per share is equal to the current market price. Based on this, we would not be willing to pay more than the current market price of $25 per share.

EVA = $200 million (1 – 0.40) - $500 million (0.1142) = $62.9 million

MVA = $600 million - $360 million = $240 million

2. To get price per share, we need to get value of equity, value of the firm, and therefore the value of the operating assets.

Value of Operating Assets:

(1) Draw a timeline and (2) deal with the right-hand side

PV

= CF

/ (r-g) = $162.45 million / (0.10 – 0.08) = $8,122.50 million

*Note: You could calculate PV

(3) Bring it all back to today

PV

= ($142.5 million + $8,122.50 million) / (1.10)

= $7,513.6364 million Value of the Firm = $7,513.6364 million because there are no non-operating assets

Value of the firm’s common equity = $7,513.6364 million – $2,500 million (debt) $5,013.6364 million

Value per share = $5,013.6364 million / 75 million shares = $66.85 per share.

Recommend they buy. They are currently selling for $65, but you believe they are worth

$66.85.