11
CORPORATE CHAPTER 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 doesnt
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 firms 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 boards ability to fire the CEO and (2)the rules that cover
the CEOs 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 companys 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
6
.
A poison pill is also known as a corporate restructuring.
Diff: M
a. True
b. False
(11.5) Stock options
Answer: b Diff: M
7
.
The CEO of DAmico Motors has been granted some stock options that have
provisions similar to most other executive stock options. If DAmicos
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
9
.
Which of the following statements is NOT CORRECT?
Answer: b
Diff: M
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 firms 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 companys market
value?
a.
b.
c.
d.
e.
Page 2
Increasing
Increasing
Decreasing
Decreasing
Increasing
the
the
the
the
the
expected growth rate of sales.
expected operating profitability (NOPAT/Sales).
capital requirements (Capital/Sales).
weighted average cost of capital.
expected rate of return on invested capital.
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.
b.
c.
d.
e.
Abnormally high executive compensation.
Targeted share repurchases.
Shareholder rights provisions.
Restricted voting rights.
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.
b.
c.
d.
e.
To
To
To
To
To
increase worker productivity.
enable the firm to borrow at a below-market interest rate.
make it easier to grant stock options to employees.
help prevent a hostile takeover.
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.
b.
c.
d.
e.
$719
$757
$797
$839
$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.
b.
c.
d.
e.
$840
$882
$926
$972
$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 Corporations 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 firms value of operations, in millions?
a.
b.
c.
d.
e.
$948
$998
$1,050
$1,103
$1,158
(11.2) Corporate valuation model, value of operations
Answer: d Diff: E
16
.
Suppose Leonard, Nixon, & Shull Corporations projected free cash flow
for next year is $100,000, and FCF is expected to grow at a constant
rate of 6%. If the companys weighted average cost of capital is 11%,
what is the value of its operations?
a.
b.
c.
d.
e.
$1,714,750
$1,805,000
$1,900,000
$2,000,000
$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
firms value of operations, in millions?
a.
b.
c.
d.
e.
$158
$167
$175
$184
$193
(11.2) Corporate valuation model, value of operations
18
.
Diff: M
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:
Free cash flow:
a.
b.
c.
d.
e.
Page 4
Answer: a
1
-$50
2
$100
$1,456
$1,529
$1,606
$1,686
$1,770
Chapter 11: Corporate Valuation and Value-Based Management
(11.2) Corporate valuation model, value of operations
19
.
Answer: e
Diff: M
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:
Free cash flow:
a.
b.
c.
d.
e.
1
-$15
2
$10
3
$40
$315
$331
$348
$367
$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 firms value of equity, in millions?
a.
b.
c.
d.
e.
$429
$451
$475
$500
$525
(11.2) Corporate valuation model, P0
21
.
Answer: b
Diff: M
Based on the corporate valuation model, the value of a companys
operations is $1,200 million. The companys 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 30 has million shares of stock
outstanding, what is the best estimate of the stocks price per share?
a.
b.
c.
d.
e.
$24.90
$27.67
$30.43
$33.48
$36.82
Chapter 11: Corporate Valuation and Value-Based Management
Page 5
(11.2) Corporate valuation model, P0
22
.
Answer: c
Diff: M
Based on the corporate valuation model, the value of a companys
operations is $900 million. Its balance sheet shows $70 million in
accounts receivable, $50 million in inventory, $30 million in shortterm investments that are unrelated to operations, $20 million in
accounts payable, $110 million in notes payable, $90 million in longterm 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
stocks price per share?
a.
b.
c.
d.
e.
$23.00
$25.56
$28.40
$31.24
$34.36
(11.2) Corporate valuation model, P0
Answer: d Diff: M
23
.
Based on the corporate valuation model, Hunsaders 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 stocks price per share?
a.
b.
c.
d.
e.
$13.72
$14.44
$15.20
$16.00
$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:
Free cash flow:
a.
b.
c.
d.
e.
Page 6
1
-$20
2
$42
3
$45
$586
$617
$648
$680
$714
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
Answer: a
Diff: E
(11.2) Corporate valuation model, value of operations Answer: c
Diff: E
FCF5:
g:
WACC:
$50
6%
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
FCF3:
g:
WACC:
$40
5%
10%
HV3 = FCF4/(WACC g) = FCF3(1 + g)/(WACC g)
= $40(1 + 0.05)/(0.10 0.05) = $42/0.05 = $840
15.
FCF0:
g:
WACC:
$100
5%
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
FCF1: $100,000
g:
6%
WACC:
11%
Value Ops = FCF1/(WACC g) = FCF0(1 + g)/(WACC g)
Diff: E
= $100,000/(0.11 0.06) = $100,000/0.05 = $2,000,000
17.
(11.2) Corporate valuation model, value of operations Answer: b
FCF1:
FCF2:
g:
WACC:
Diff: M
-$10
$20
4%
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
FCF1:
FCF2:
g:
WACC:
Diff: M
-$50
$100
5%
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
Year:
FCF:
g:
WACC:
1
-$15
2
$10
Diff: M
3
$40
5%
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
Value of operations:
Short-term investments:
Notes payable:
Long-term debt:
Answer: d
Diff: M
$750
$50
$100
$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
Value of operations:
$1,200
Answer: b
Diff: M
Short-term investments:
Notes payable:
Long-term debt:
Preferred stock
Shares outstanding:
$100
$120
$300
$50
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
Value of operations:
Short-term investments:
Notes payable:
Long-term debt:
Preferred stock
Shares outstanding:
Answer: c
Diff: M
$900
$30
$110
$90
$20
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
Value of operations:
Short-term investments:
Notes payable:
Long-term debt:
Preferred stock
Shares outstanding:
Answer: d
Diff: M
$300
$20
$90
$30
$40
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
Year:
Free cash flow:
1
-$20
2
$42
3
$45
Diff: T
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