CHAPTER 11CORPORATE VALUATION AND VALUE-BASED MANAGEMENT (Difficulty: E = Easy, M = Medium, and T = Tough) True/False Easy: (11.1) Corporate valuation model Answer: b Diff: E 1 . The corporate valuation model cannot be used unless a company doesn’t pay dividends. a. True b. False (11.2) Free cash flows and valuation Answer: a Diff: E 2 . Free cash flows should be discounted at the firm’s weighted average cost of capital to find the value of its operations. a. True b. False (11.3) Value-based management Answer: b Diff: E 3 . Value-based management focuses on sales growth, profitability, capital requirements, the weighted average cost of capital, and the dividend growth rate. a. True b. False (11.5) Corporate governance Answer: b Diff: E 4 . Two important issues in corporate governance are (1) the rules that cover the board’s ability to fire the CEO and (2)the rules that cover the CEO’s ability to remove members of the board. a. True b. False Medium: (11.3) Return on invested capital and MVA Answer: b Diff: M 5 . If a company’s expected return on invested capital is less than its cost of equity, then the company must also have a negative market value added (MVA). a. True b. False Chapter 11: Valuation and Value-Based Management Page 1 (11.5) Corporate governance Answer: b Diff: M 6 . A poison pill is also known as a corporate restructuring. a. True b. False (11.5) Stock options Answer: b Diff: M 7 . The CEO of D’Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D’Amico’s stock underperforms the market, these options will necessarily be worthless. a. True b. False (11.6) ESOP Answer: a Diff: M 8 . ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers. a. True b. False Multiple Choice: Conceptual Medium: (11.2) Corporate valuation model Answer: b Diff: M 9 . Which of the following statements is NOT CORRECT? a. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. b. The corporate valuation model discounts free cash flows by the required return on equity. c. The corporate valuation model can be used to find the value of a division. d. An important step in applying the corporate valuation model is forecasting the firm’s pro forma financial statements. e. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. (11.3) Value-based management Answer: a Diff: M 10 . Which of the following does NOT always increase a company’s market value? a. Increasing the expected growth rate of sales. b. Increasing the expected operating profitability (NOPAT/Sales). c. Decreasing the capital requirements (Capital/Sales). d. Decreasing the weighted average cost of capital. e. Increasing the expected rate of return on invested capital. Page 2 Chapter 11: Corporate Valuation and Value-Based Management (11.5) Corporate governance Answer: a Diff: M 11 . Which of the following is NOT normally regarded as being a barrier to hostile takeovers? a. Abnormally high executive compensation. b. Targeted share repurchases. c. Shareholder rights provisions. d. Restricted voting rights. e. Poison pills. (11.6) ESOP Answer: c Diff: M 12 . Which of the following is NOT normally regarded as being a good reason to establish an ESOP? a. To increase worker productivity. b. To enable the firm to borrow at a below-market interest rate. c. To make it easier to grant stock options to employees. d. To help prevent a hostile takeover. e. To help retain valued employees. Multiple Choice: Problems Easy: (11.2) Corporate valuation model, horizon value Answer: e Diff: E 13 . Akyol Corporation is undergoing a restructuring, and its free cash flows are expected to be unstable during the next few years. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5? a. $719 b. $757 c. $797 d. $839 e. $883 (11.2) Corporate valuation model, horizon value Answer: a Diff: E 14 . Simonyan Inc. forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3? a. $840 b. $882 c. $926 d. $972 e. $1,021 Chapter 15: Valuation, Governance Conceptual Questions Page 3 (11.2) Corporate valuation model, value of operations Answer: c Diff: E 15 . Suppose Yon Sun Corporation’s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm’s value of operations, in millions? a. $948 b. $998 c. $1,050 d. $1,103 e. $1,158 (11.2) Corporate valuation model, value of operations Answer: d Diff: E 16 . Suppose Leonard, Nixon, & Shull Corporation’s projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company’s weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 Medium: (11.2) Corporate valuation model, value of operations Answer: b Diff: M 17 . Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm’s value of operations, in millions? a. $158 b. $167 c. $175 d. $184 e. $193 (11.2) Corporate valuation model, value of operations Answer: a Diff: M 18 . Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments). Year: 1 2 Free cash flow: -$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770 Page 4 Chapter 11: Corporate Valuation and Value-Based Management (11.2) Corporate valuation model, value of operations Answer: e Diff: M 19 . A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: -$15 $10 $40 a. $315 b. $331 c. $348 d. $367 e. $386 (11.2) Corporate valuation model, value of equity Answer: d Diff: M 20 . Based on the corporate valuation model, Bernile Inc.’s value of operations is $750 million. Its balance sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable, $100 million of notes payable, $200 million of long- term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm’s value of equity, in millions? a. $429 b. $451 c. $475 d. $500 e. $525 (11.2) Corporate valuation model, P0 Answer: b Diff: M 21 . Based on the corporate valuation model, the value of a company’s operations is $1,200 million. The company’s balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82 Chapter 11: Corporate Valuation and Value-Based Management Page 5 (11.2) Corporate valuation model, P0 Answer: c Diff: M 22 . Based on the corporate valuation model, the value of a company’s operations is $900 million. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36 (11.2) Corporate valuation model, P0 Answer: d Diff: M 23 . Based on the corporate valuation model, Hunsader’s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock’s price per share? a. $13.72 b. $14.44 c. $15.20 d. $16.00 e. $16.80 Tough: (11.2) Corporate valuation model, value of operations Answer: b Diff: T 24 . Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: -$20 $42 $45 a. $586 b. $617 c. $648 d. $680 e. $714 Page 6 Chapter 11: Corporate Valuation and Value-Based Management CHAPTER 11 ANSWERS AND SOLUTIONS Chapter 11: Corporate Valuation and Value-Based Management Page 7 1. (11.1) Corporate valuation model Answer: b Diff: E 2. (11.2) Free cash flows and valuation Answer: a Diff: E 3. (11.3) Value-based management Answer: b Diff: E 4. (11.5) Corporate governance Answer: b Diff: E 5. (11.3) Return on invested capital and MVA Answer: b Diff: M 6. (11.5) Corporate governance Answer: b Diff: M 7. (11.5) Stock options Answer: b Diff: M 8. (11.6) ESOP Answer: a Diff: M 9. (11.2) Corporate valuation model Answer: b Diff: M 10. (11.3) Value-based management Answer: a Diff: M Statement a is correct, because investors recognize that companies sometimes try to grow too fast, at the expense of maintaining profit margins. 11. (11.5) Corporate governance Answer: a Diff: M 12. (11.6) ESOP Answer: c Diff: M Statement c is the correct answer, because firms can easily grant stock options to employees without an ESOP. 13. (11.2) Corporate valuation model, horizon value Answer: e Diff: E FCF5: $50 g: 6% WACC: 12% HV5 = FCF6/(WACC – g) = FCF5(1 + g)/(WACC – g) = $50(1 + 0.06)/(0.12 – 0.06) = $53/0.06 = $883 14. (11.2) Corporate valuation model, horizon value Answer: a Diff: E FCF3: $40 g: 5% WACC: 10% HV3 = FCF4/(WACC – g) = FCF3(1 + g)/(WACC – g) = $40(1 + 0.05)/(0.10 – 0.05) = $42/0.05 = $840 15. (11.2) Corporate valuation model, value of operations Answer: c Diff: E FCF0: $100 g: 5% WACC: 15% Value Ops = FCF1/(WACC – g) = FCF0(1 + g)/(WACC – g) = $100(1 + 0.05)/(0.15 – 0.05) = $105/0.1 = $1,050 16. (11.2) Corporate valuation model, value of operations Answer: d Diff: E FCF1: $100,000 g: 6% WACC: 11% Value Ops = FCF1/(WACC – g) = FCF0(1 + g)/(WACC – g) = $100,000/(0.11 – 0.06) = $100,000/0.05 = $2,000,000 17. (11.2) Corporate valuation model, value of operations Answer: b Diff: M FCF1: -$10 FCF2: $20 g: 4% WACC: 14% First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC – g) = $20(1.04)/(0.14 – 0.04) = $20.8/0.10 = $208.00 Then find the PV of the free cash flows and the horizon value: Value of operations = -$10/(1.14)1 + ($20 + $208)/(1.14)2 = -$8.772 + $175.439 = $167 18. (11.2) Corporate valuation model, value of operations Answer: a Diff: M FCF1: -$50 FCF2: $100 g: 5% WACC: 11% First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC – g) = $100(1.05)/(0.11 – 0.05) = $1,750.00 Then find the PV of the free cash flows and the horizon value: Value of operations = -$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456 19. (11.2) Corporate valuation model, value of operations Answer: e Diff: M Year: 1 2 3 FCF: -$15 $10 $40 g: 5% WACC: 13% First, find the horizon, or terminal, value: HV4 = FCF3(1 + g)/(WACC – g) = $40(1.05)/(0.13 – 0.05) = $525 Then find the PV of the free cash flows and the horizon value: Value of operations = -$15/(1.13) + $10/(1.13)2 + ($40 + $525)/(1.13)3 = $386 20. (11.2) Corporate valuation model, value of equity Answer: d Diff: M Value of operations: $750 Short-term investments: $50 Notes payable: $100 Long-term debt: $200 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total Value of Value of market value = operations + non -operating assets = $750 + $50 = $800. Value of Equity = Total MV − Long- and Short-term debt = $500. The book value of equity figures are irrelevant for this problem. Also, the accounts payable are not relevant because they were netted out when the FCF was calculated. 21. (11.2) Corporate valuation model, P0 Answer: b Diff: M Value of operations: $1,200 Short-term investments: $100 Notes payable: $120 Long-term debt: $300 Preferred stock $50 Shares outstanding: 30 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total Value of Value of market value = operations + non -operating assets = $1,200 + $100 = $1,300. Value of Equity = Total MV − Long- and Short-term debt and preferred = $830 Stock price = Value of Equity/Shares outstanding = $27.67 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated. 22. (11.2) Corporate valuation model, P0 Answer: c Diff: M Value of operations: $900 Short-term investments: $30 Notes payable: $110 Long-term debt: $90 Preferred stock $20 Shares outstanding: 25 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total Value of Value of market value = operations + non -operating assets = $900 + $30 = $930. Value of Equity = Total MV − Long- and Short-term debt and preferred = $710 Stock price = Value of Equity/Shares outstanding = $28.40 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated. 23. (11.2) Corporate valuation model, P0 Answer: d Diff: M Value of operations: $300 Short-term investments: $20 Notes payable: $90 Long-term debt: $30 Preferred stock $40 Shares outstanding: 10 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total Value of Value of market value = operations + non -operating assets = $300 + $20 = $320. Value of Equity = Total MV − Long- and Short-term debt and preferred = $160 Stock price = Value of Equity/Shares outstanding = $16.00 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated. 24. (11.2) Corporate valuation model, value of operations Answer: b Diff: T Year: 1 2 3 Free cash flow: -$20 $42 $45 WACC: 13% First, find the growth rate: g = $45/$42 – 1.0 = 7.14% Second, find the horizon, or terminal, value, at Year 2 HV2 = FCF3/(WACC – g) = $45/(0.13 – 0.0714) = $768 Now find the PV of the FCFs and the horizon value: Value of operations = -$20/(1.13) + ($42 + $768)/(1.13)2 = $617