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23 Dec 2018

F1 Q6-Q10

Please show all workings/give explanations

Note: Questions 6 – 10 are based on the same mega problem. For convenience

we have included the entire set of information in every question. For purposes

of the questions that follow, assume that changes in working capital are

negligible and capex and depreciation are of the same magnitude and therefore

cancel each other. This is the assumption we made in most of the videos to

focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

XYZ, Inc.’s revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

year’s earnings have just been paid out. If the appropriate discount rate for XYZ,

Inc. is 7.50%, For this question, assume taxes are zero. (Enter the number with up to two decimals but without any $ or comma sign.)

Q6 What is the price per share of XYZ, Inc.?

Q7 What is the price-to-earnings ratio?

XYZ, Inc.’s revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

year’s earnings have just been paid out. The appropriate discount rate for XYZ,

Inc. is 7.50%. The CEO of XYZ, Inc. has a very exciting plan to make her company

look more attractive to investors. She suggests to her CFO that if the firm issues

$2.50M debt in perpetuity with a return of 5%, and uses this debt to repurchase

some of the shares of the company, it will make the firm more attractive to

acquirers. The CFO is skeptical of the CEO’s plan and argues with her about the

logic behind it. Frustrated with her CFO’s argumentative stance, the CEO finally

simply states: “I do not have to convince you, Gautam, especially since my plan

is fool proof. My debt-based strategy will make our company attractive to any

acquirer because it will lower our price-earnings ratio and, consequently, make

them offer us a lot more money for our assets than they would otherwise.” Is

the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

For this question, assume taxes are zero.

Q8 Is the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

Yes

No

It depends

Q9 What will be the new price-earnings ratio of XYZ?

Q10 What will the value of the firm be?

3,000,000

2,333,333

3,333,333

None of the above

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Keith Leannon
Keith LeannonLv2
25 Dec 2018

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Related questions

V3 F2 Q18

For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

You are working on a big new idea for your firm. You have projected an EBIT of $5 million starting next year (t = 1) with a growth rate of 3.50% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. Your firm will consider all types of financing options, but the first critical step in your analysis is figuring out the present value of the cash flows of the new business. Your research has revealed the following information: similar businesses have a beta asset of 2.00, the risk-free rate is 2.00% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 3.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You are tasked to figure out the value of the business under various financing alternatives, including long-term loan/debt. You have considered a loan of $25 million in perpetuity at an interest rate of 4%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $25 million of debt in perpetuity. The return on equity from t = 0 to t = 1 will be (Enter the number in percentage terms with up to two decimals but no % sign.):

V2 A7 Q11-20


Note: Questions 11 - 20 relate to the same "mega" problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.


Q11


You are an analyst at Goldman Sachs tasked with valuing a company, Incline, Inc., a private company. You estimate that the earnings of Incline (or EBIT) will be $100,000 next year (at t = 1) and then grow at 2% for the foreseeable future. Specifically, $100,000 at t = 1 and $102,000 at t = 2, etc. Your due diligence and analysis of comparable firms in the same industry have revealed that the beta

asset in the business of Incline, Inc. is 1.50. The risk free rate is 2.50% and the expected market risk premium (the premium that the market is expected to earn over the risk free rate) is 5.00%. The balance sheet of Incline shows that it has $250,000 of debt that it plans to maintain for the foreseeable future and the interest on the debt is 5%. The corporate tax rate is 35%, interest payments on debt are tax deductible and it is reasonable to assume that the riskiness of the

tax shield is the same as the debt. You estimate that the chances that Incline, Inc. will go bankrupt in the future are negligible. Given the above information which method is the most applicable (and easiest) to use to calculate the value of Incline, Inc.?

a) Equity Valuation Method

b) Adjusted Present Value Method

c) Enterprise Value (WACC) Method

d) Multiples Method


Q12


Use the method you chose above to obtain an estimate of the value is??


Q13


The growth rate in the cash flows to equity holders for the foreseeable future will be:

a) Less than 2%

b) Greater than 2%

c) 2%


Q14


What capital structure (debt-to-equity ratio) does the valuation in Q. 12 imply for Incline, Inc. today (t=0)?


Q15


What capital structure (debt-to-equity ratio) will exist at t = 1?

a) A lower D/E ratio than t = 0.

b) Cannot evaluate given the information.

c) A higher D/E ratio than t = 0.

d) The same as t = 0.

Q16


The Enterprise Valuation method cannot be applied to this situation unless:

a) The debt to equity ratio is gxed upfront and never changed.

b) The WACC is adjusted each year for the change in capital structure.

c) The return on asset is adjusted every year for the change in capital structure.



Q17


What will be the value of Incline, Inc. one year from now (at t = 1)??


Q18


What is the return on equity to shareholders of Incline, Inc. from t = 0 to t = 1???


Q19



What is the weighted average cost of capital (WACC) of Incline, Inc. from t = 0 to t = 1 ???

Enter answer here


Q20


What will be the weighted average cost of capital (WACC) of Incline, Inc. one year from from t = 1 to t = 2?


a) 8.90%

b) 9.05%

c) 9.00%

d) 8.95%


F1 Q19-Q20

Please show workings/give explanations

Note: Questions 11 – 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q19) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity. Given this decision, you want to consider the Multiples Approach to Valuation as a double-check for your detailed Discounted Cash Flow (DCF) based analyses. Fortunately, there have been several market transactions in this business environment, but you want to choose the most optimal multiple to use given your decision to use a capital structure that is different from the competition where virtually no debt is used. The best multiple to use will be:

a) Either P/E or EBITDA multiple is suitable for your situation.

b) Neither P/E nor EBITDA multiple is suitable for your situation.

c) EBITDA multiple.

d) P/E multiple.

Q20) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity.The government however is seriously contemplating removing the tax subsidy to debt, that is, the deductibility of interest but not dividends from earnings before taxes are calculated. Given this information, and assuming that costs of bankruptcy are likely to be negligible, you should:

a) Change your capital structure and lower your debt.

b) Not worry about your capital structure and focus on the value drivers of your business.

c) Keep your capital structure unchanged because all your previous analysis will remain valid.

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