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Orca Share Media1518781277030
Orca Share Media1518781277030
Orca Share Media1518781277030
2013-05-02
Practice sets are handed out to help students master the material of the course and prepare for the final exam.
These sets contain worked-out problems in corporate finance and, investments and portfolio management, with a
bias toward quantitative problems. These sets are not graded, and there is no need to hand-in the solutions.
Students are strongly encouraged to solve them, discuss the solutions with other course participants, and discuss
any problems with their teacher. Some questions in the final exam might resemble the problems given here.
Question 1
ToT Malt (an all-equity firm) is reinvesting 65% of its earnings in projects that provide a ROE of 9%.
The expected return on similar risky projects is 14% on the stock market. Given the present policy of
the firm its year-end dividend is now €3 per share.
b) What is the present value of the growth opportunities for ToT Malt?
Question 2
In early 1999 an investor bought 1000 shares of Skandia for 127 SKr per share. During the year
dividends were received at 1.15 SKr per share, and finally the shares were sold for 235 SKr per share.
What is the investor’s
Question 3
HGUS Inc. has a book value of €21,500,000 (including expected retained earnings), expected earnings
of €2,640,000, the pay-out ratio is 0.65. The opportunity cost of capital for the company is 7.5%.
There are 1,100,000 outstanding shares.
a) What are the excepted growth rate, the price and the P/E ratio of this firm?
b) If the plow-back rate were to change to .45 what would be the expected dividend per share, the
growth rate, price and P/E ratio, given that all other values remain unchanged?
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Question 4
McManus Teaching Company is expected to pay a dividend of $2 in the upcoming year. The risk-free
rate of return is 4% and the expected return on the market portfolio is 14%. The beta of McManus
Teaching Company 1.25. Analysts expect the price of McManus Teaching Company shares to be $22 a
year from now.
c) If McManus Teaching Company’s intrinsic value is $21.00 today, what must be its growth rate?
Question 5
The following is given, there are two risky assets A and B with the following characteristics
The weights of the optimal risky portfolio are wA = 0.81 and wB = 0.19
c) What is the Capital Allocation Line associated with this risky portfolio? What is the slope of
the line? The slop is called reward to variability ratio. (Show a graph and try to calculate
numerically). Explain briefly why the slope can be called “reward to variability ratio?
Question 6
This year, AGL paid its shareholders an annual dividend of $3 a share. A major brokerage firm
recently put out a report on AGL stating that, in its opinion, the company’s annual dividends should
grow at the rate of 10 per cent per year for each of the next 5 years and then level off the grow at the
rate of 6 per cent a year thereafter.
a) Use the variable-growth dividends technique and a required rate or return of 12 per cent to
find the maximum price you should be willing to pay for this share.
b) Redo the AGL problem in part a), except this time assume that after year 5, dividends stop
growing altogether (for year 6 and beyond, g = 0). Use all the other information given to find
the share’s intrinsic value.
c) Contrast your two answers and comments on your findings. How important is growth to this
valuation model?
Question 7
MacKline Bank recently reported net profits after tax of $1,000 million. It has 2.5 million
shares outstanding and pays dividends on preference shares equal to $1 million per year.
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a. Calculate the firm’s earnings per share (EPS).
b. Assuming that the share currently trades at $75.80 per share, determine what the
firm’s dividend yield would be if it paid $10 per share to ordinary shareholders.
c. What would the firm’s dividend payout ratio be if it paid $10 a share in dividends
Question 8
You are looking at an asset with a beta value of 1.25. The risk premium on the market is
stable around 6% and the risk free rate is 4%. Over the past years the return on this stock has
been 10%.
b) Next, use an appropriate figure to illustrate the situation, explain the concepts in the figure.
In the context of the question explain what is meant by excess return, risk premium and
abnormal return.
Question 9
Moo and Boo's Moonshine Inc. has expected free cash flows of €1,950 forever. The interest on debt is
11%, the company's overall cost of capital is 15% and the market value of debt is €2,600.
a) Assume that there are no taxes or transaction cost and that all investors have the same information
as the management of the firm, what is the value of the firm?
b) What is the value of the firm’s equity, and the debt/equity ratio?
d) What would happen to the cost of be the cost of equity capital if the firm was all equity?
e) Answer question c) under the assumption of a corporate tax rate (tc) of 28%.
f) Discuss factors of relevance for deciding on the debt/equity ratio in the real world.
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Solutions #2
Solution 1
Given the policy of the management the growth rate can be estimated as,
The earning of the firm can solved from the figures given in the question. Dividends (D), Earnings (E)
and b is the plow-back ratio (reinvestment ratio). Thus D = E x (1-b). What is not reinvested is paid
out as dividends. Thus, earnings per share is, E = D/(1-b) = €3/0.35 = €8.57.
Suppose the price per share should is estimated according to the Gordon’s formula
If the firm was to pay out its earnings as dividends its value would be, E/r = €8.57/0.14 = €61.22.
Thus, PVGO is negative, since the firm has no growth opportunities that yield a return over or at least
in par with the market return for similar projects. The rate of return on ToT Malt is less than the
opportunity cost of capital. The reason for a takeover is that the firm can be bought today for a price of
€34.88 per share, lower than its price during a different management and investment policy. A new
management can change the dividend policy and pay out all earnings as dividends. The price of the
firm per share will then rise to €61.22. And €61.22 - €34.88 (-transaction costs) is profit for the new
owner.
Solution 2
b) The capital gain is (235-127)/127=0.85 and dividend yield is 1.15/127=0.009 and the total
return is 0.85+0.009=0.859.
Solution 3
a)
ROE = €2,640,000/€21,500,000 = 0.123 or 12.3%
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(Plow-back) Retention ratio = b = 1- pay-out ratio = 1 - 0.65 = 0.35
Expected Price
Expected P/E
b) Change b to 0.45,
P0 / E1 = €61.40 / €2.4 = 25.58 (Notice that the currency signs in the denominator and nominator will
cancel each other, the P/E ratio is not I any currency, is just a ratio)
Solution 4
a)
Apply CAPM o get the markets required rate of return McManus's stocks:
E( ri) = rf + Bi E(rm - rf)
b)
Again apply CAPM, solve for required, expected equilibrium return
0.165 = (22 – P + 2) / P
0.165P = 24 – P
1.165P = 24
P = 20.60
c)
a) Start with CAPM to get equilibrium expected return on this stock,
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k = 0.04 + 1.25 (0.14 - 0.04)
k = 0.165
b) Next apply dividend growth formula and solve for the growth rate,
0.165 = 2/21 + g
g = 0.07 or 7%
Solution 5
a)
E(rp) = wA E(rA) + wB E(rB) = 0.81 x 12 + 0.19 x 7 = 9.72 + 1.33 = 11.05
b)
He formula for the variance of a combination of two stochastic returns
c)
The reward to variability ratio is the slope of the capital allocation line. The straight line that
combines the risk-free rate with the points [E(rp), σp] = [11.05, 16.78]. The slope of this CAL is
given by [E(rp) - rf] / σp = (11.05 - 4) / 16.78 = 0.42
Reward to variability comes from the assumption of risk-averse investors. The higher the risk the
higher must the expected return be for the investor to be happy. To get max points you have to discuss
the meaning of the slope [E(rp) - rf] / σp, and not state the ratio.
Solution 6
Year Dividends
0 $3.00
1 3.30 (g = 10%)
2 3.63 (g = 10%)
3 3.99 (g = 10%)
4 4.39 (g = 10%)
5 4.83 (g = 10%)
6 5.31 (g = 6%)
6
3 3.99 .712 2.84
4 4.39 .636 2.79
5 4.83 .567 2.74
Total $14.21
Step 4:
Therefore, $62.59 is the maximum price you should be willing to pay for this
share.
b. Since g = 0 for year 6 and beyond, dividends for year 6 will be the same as the dividend for
year 5; i.e., $4.83. We just need to redo steps 2 and 3 to find the intrinsic value of the share:
P5 = D6 = $4.83 = $4.83=$40.25
k -g .12 - 0 .12
Since the present value of the first five years of dividends is the same as in (a), above, the
intrinsic value (=valuation based on estimated cash flows) of the share is:
c. The intrinsic value of the share in (a) is much higher than that calculated in (b). In (a),
dividends are growing at 6% per year beyond year 5, while in (b), the dividends do not grow
after year 5. The dividend valuation model is very sensitive to the growth rate in dividends; the
higher the rate of growth in dividends, the higher the intrinsic value of the share.
Solution 7
a. Earnings per share (EPS) = Net profits after taxes - Preference dividends
Number of ordinary shares outstanding
For Mackline Bank:
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EPS = $1,000,000,000 - $1,000,000 = $399.6
2,500,000
Solution 8
CAPM predicts that the present price is too high. If the stocks pay 10% and CAPM predicts 11.5% it
means that the return is lower than compensation for risk. Present holders are making abnormal
negative returns of 10 - 11.5 = -1.5%. If the price goes down the return will go up. The model
predicts that market forces will drive down the price, and bring up the return to the equilibrium return
of 11.5%. Thus, you should sell the stock before the price goes down in order to make a profit.
b) Answer: Set up the security market line (SML) and discuss of the stock is over priced or under
priced.
Solution 9
a) Under these assumptions M&M propositions I and II hold why the financing (debt/equity ratio) is
irrelevant, the value of the firm is €1,950/.15 = €13,000.
b) The total value is V = E + D = €13,000. D = € 2,600 and thus E = A – D = €13,000 – €2, 600
= €10, 400. Thus, the D/E ratio is 2,600/10,600 = 0.25.
c) The overall cost of capital is 15% and the cost of debt is 11%. The cost of capital can therefore be
written as
rs = 16% (check?)
d) According to MM prop I+II (without taxes) the cost of capital for an all-equity firm is the same as
for the whole firm with debt and that was given as 15%
e) If there is a company tax of 28% the formula for the weighted average cost of capital transforms to
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f) Develop from the lectures and the text book 1) M&M 2) the trade off-theory, 3) the pecking-order
theory and 4) the agency theory. If you start with M&M and their most restrictive assumptions the
other theories follows.