Assignment #3, Solutions
FIN 503
Problem 1: Payout policy
Clearwater Inc. is going to pay a dividend of D1 = $5.00 per share next year and dividends will then
increase at a 5% annual rate forever (D2 = $5.25, D3 = $5.5125, etc.). The required rate of retu
Assignment #3
FIN 503
Due on March 25 Hand in only one solution per group
Problem 1: Payout policy
Clearwater Inc. is going to pay a dividend of D1 = $5.00 per share next year and dividends will then
increase at a 5% annual rate forever (D2 = $5.25, D3 =
In valuing Company X, the group used the WACC approach. Unlevered cost of capital was taken from the previous
assignment and adjusted WACC was derived. Adjusted WACC used the 10-year risk-free rate, since within that
period, a typical boom and bust cycle
FIN 503
Capital Structure in a Perfect
Market
Outline
Definitions
Does capital structure matter?
M&M Proposition I
Leverage and financial risk
M&M Proposition II
Levered and unlevered betas
2
Capital Structure
A firm can be financed by equity or by
FIN 503
Company Valuation: Free and
Residual Cash Flows
Outline
Overview of firm valuation approaches
Forecasting accounting statements
Body Shop case
Cash flow calculations
Free cash flows (FCF)
Free cash flows to equity or Residual cash flows
(RCF
FIN 503
Company Valuation: Estimating
Continuation Value
A Simplified Approach to Estimating
Continuation Value
Firm value =
PV(FCF) of forecast period
+ PV of Continuing value
FCF
Continuation value at time T = T 1
WACC g
(growing perpetuity)
2
A Simpl
FIN 503
Company Valuation: Multiples
Valuation using Multiples
This sounds like a fancy valuation method, but it is
actually just a short-cut (less accurate) valuation
method.
Idea: comparable firms should have similar
performance measures, which in thi
FIN 503
Real Options
Capital Budgeting with DCF
Using NPV rule in capital budgeting
Forecast projects expected future cash
flows
Discount cash flows at discount rate
reflecting
Time value of money
Riskiness of the cash flows
Add up discounted cash f
FIN 503
Company Valuation: WACC and
APV Method
Outline
Firm valuation under constant debt-equity
ratio
WACC method
APV method
FTE (flow-to-equity) method
Advanced topics
Project with different risk than firm
Other leverage policies
2
WACC Method (D
FIN 503
Company Valuation 4: An Example
Outline
Multiples approach
Business plan
Financial model
Cost of capital
Continuation value
Company valuation
2
Multiples Approach
Consider Ideko Corporation, a privately held firm.
The owner has decided to sell th
FIN 503
Estimating the Cost of Capital
Outline
Cost of debt
Debt value (D)
Cost of debt (rD)
Cost of equity
Equity value (E)
Cost of equity (rE)
Calculating cost of capital
2
Overview
Example firm: Barrick Gold Corporation
Traded on TSX (ABX.TO)
FIN 503
Capital Structure: Taxes, Financial
Distress, and Agency Costs
Outline
Capital structure matters
Debt and taxes
Costs of bankruptcy and financial
distress
Agency costs/benefits of leverage
Optimal capital structure
2
When Does Capital Structu
MV of Equity
MV of Debt
Debt Ratio
Cost of Equity
Cost of Debt
Unlevered Cost of Capital
Tax rate
After-tax WACC
Target Debt-to-Equity
Debt Ratio
In USD Mn
EBIT
Less: Income Tax
Unlevered Net Income
Add: Depreciation and Amortization
Less: Increase in NWC
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Income Statement
(numbers in $1,000; * indicates forecasted numbers)
Sales
Cost of Goods Sold
Gross Profit
Selling, General & Administrative Expense
EBITDA
Depreciation
EBIT
Interest Expense
Pretax income
Income Tax
Net Income
2008
2,591
-2,131
460
-184
2
FIN 503
Capital Structure in a Perfect
Market
Outline
Definitions
Does capital structure matter?
M&M Proposition I
Leverage and financial risk
M&M Proposition II
Levered and unlevered betas
2
Capital Structure
A firm can be financed by equity or by
Assignment #2
FIN 503
Due on February 11 Hand in only one solution per group
Today is January 1, 2015. You are interested in evaluating Slender, the maker of weight-loss yoghurt, as a
potential acquisition target. You collected the following information:
Assignment #2, Solutions
FIN 503
Today is January 1, 2015. You are interested in evaluating Slender, the maker of weight-loss yoghurt, as a
potential acquisition target. You collected the following information:
Net Income
+ After-tax Interest Expense
Unle
Assignment #4
FIN 503
Due on April 8 Hand in only one solution per group
Problem 1: Mergers and acquisitions
As CFO of Fashion Inc. you are investigating the possible acquisition of Style Inc. You have the
following basic data:
Expected earnings per share
Assignment #4, Solutions
FIN 503
Problem 1: Mergers and acquisitions
As CFO of Fashion Inc. you are investigating the possible acquisition of Style Inc. You have the
following basic data:
Expected earnings per share in one
year
Expected dividend per share
FIN 503
Practice Problem: Free Cash Flows and WACC
A friend of yours is a consultant specialized in performance-based compensation. The times in
the consulting business are currently pretty bleak, which is why he is trying to increase the scope
of his ser
Answers to Practice Problems in Capital Structure Slides
FIN 503
Problem 1
1. Market price is unaffected
2. $160 million / $10 = 16 million shares
3. E + D = 9 million shares $10 + $160 million = $250 million
4. D/(D+E) = 160/250 = 64%
5. No gains or loss
Assignment #1
FIN 503
Due on January 21 Hand in only one solution per group
Note: If not otherwise stated, WACC refers to the after-tax weighted average cost of capital.
Problem 1
Rockwood Enterprises is currently an all equity firm and has just announced
FIN 503
Capital Structure: Taxes, Financial
Distress, and Agency Costs
Outline
Capitalstructurematters
Debtandtaxes
Costsofbankruptcyandfinancialdistress
Agencycosts/benefitsofleverage
Optimalcapitalstructure
2
When Does Capital Structure Matter?
Conditio
Assignment #1, Solutions
FIN 503
Problem 1
Rockwood Enterprises is currently an all equity firm and has just announced plans to expand their current
business. In order to fund this expansion, Rockwood will need to raise $100 million in new capital. After
Body Shape
I+A3:E34nput Data
Sales
COGS/Sales
OP EX/sales
Interest rate
Tax Rate
Dividends
Curr Assets/Sales
Curr Liab/sales
Fixed Assets
Starting equity
Numbers in Thousands
Income Statement
Sales
COGS
Op Ex
Int Ex
Prof BT
Tax
Profit after tax
Dividends