CHAPTER 9

Problem 1:

a. Select Stores is a retail firm with no debt outstanding. However, the firm does have operating
lease commitments of $ 100 million a year for the next 3 years (years 1-3), and $ 80 million a
year for the following 3 years (years 4-6). The pre-tax cost of debt is 7%. Estimate the debt
outstanding, including operating lease commitments.

b. Assume that you decide to convert R&D expenses into capital assets for all firms. This will
generally have an impact on operating income. For which of the following firms will the increase
in operating income (resulting from this adjustment) be greatest?

A firm with a long amortizable life for R&D and stable R&D expenses over time.

A firm with a short amortizable life for R&D and growing R&D expenses over time.

A firm with a long amortizable life for R&D and growing R&D expenses over time.

A firm with a short amortizable life for R&D and stable R&D expenses over time.

Solution:

a.

Another way to calculate the PV (OL) is to get the PV of annuity 1 of 100 million for 3 years and
the PV of annuity 2 of 80 million at year 3 and get discount them back to year 0.

PV (OL) = PV annuity 1 + PV annuity 2

= 2.624×108 + = 2.624×108 + 1.71×108 = 4.33×108

b. Firms with long amortizable lives and growing R&D will have the biggest operating earnings
effect since the R&D will be large and the amortization will be low.

Problem 2:

Multiple choice questions (only one choice per problem):

a. If you capitalize operating leases and treat them as debt, which of the following will
always occur?

i. The cost of equity will increase because of the higher debt ratio.

ii. The operating income will increase because you will be adding back operating lease expenses.

iii. The debt ratio will increase.

iv. The return on capital will go up.

v. None of the above.

b. The primary reason for capitalizing R&D expenses is the following:

i. To reward companies that invest a lot in R&D.

ii. To punish companies that invest a lot in R&D.

iii. To measure the free cash flow to the firm more precisely.

iv. To get a higher return on capital.

v. To get a better sense of how much the company is reinvesting for future growth.

vi. None of the above.

c. For most companies, the effective tax rate is lower than the marginal tax rate. For such
companies, using the effective tax rate (instead of the marginal tax rate) in perpetuity to
compute the after tax operating income will result in which of the following?

i. We will overstate the value of the company.

ii. We will understate the value of the company.

iii. It should have no effect on the value of the company.

d. If a company grows primarily through acquisitions, and we are trying to estimate the
cash flows to the firm, which of the following estimation choices is likely to yield the best
estimate of value?

i. Ignore the growth from acquisitions when computing projected earnings and include
acquisitions in your forecasted capital expenditures.

ii. Count the growth from acquisitions when computing projected earnings and exclude
acquisitions in your forecasted capital expenditures.

iii. Ignore the growth from acquisitions when computing projected earnings and exclude
acquisitions in your forecasted capital expenditures

iv. Count the growth from acquisitions when computing projected earnings and include
acquisitions in your forecasted capital expenditures

v. None of the above

Solution:

a.iii. The debt ratio will increase.

b.v. To get a better sense of how much the company is reinvesting for future growth

c.i. We will overstate the value of the company

d.iv. Count the growth from acquisitions when computing projected earnings and include
acquisitions in your forecasted capital expenditures

Problem 3:

Leon Technology is a firm that specializes in advanced telecommunication software and has
been in existence for 4 years. For the current year, the firm reported $ 5 million in after-tax
operating income and a book value of equity of $ 25 million. However, the operating income was
computed after an R&D expense of $ 5 million. You believe that it will take approximately 5
years for R&D to commercially pay off in this business and have collected the R&D expenses
for the 3 prior years the firm has been in existence:

Year 3 Years -2 Year -1

R&D expense $ 2 million $ 3 million $ 4 million

a. Estimate the capitalized value of research at Leon Technology

b. Estimate the corrected after-tax operating income for Leon Technology

Solution:

a. 1/5 = 20% is the depreciation rate.

Value of R&D = = (5+3.2+1.8+0.8) ×106 = 10.8 x 106

b. Adjusted after tax operating income = EBIT (1-t) + current R&D expense –R&D Amortization

= (5 + 5 – 1.8) ×106

= 8.2 ×106

Problem 4:

You are analyzing the earnings/cash flows of a consulting firm that reported $ 5 million in net
income this year on a book value of equity of $ 15 million, yielding a return on equity of
33.33%. In computing these earnings, though, the firm subtracted out $ 5 million in recruiting
and training expenses spent during the course of the year on new consultants. Typically,
consultants hired by the firm stay with the firm approximately 4 years, and the recruiting and
training expenses for the last 4 years are as follows:

If you capitalized recruiting and training expenses, estimate the correct return on equity for the
firm.
Solution:

The depreciation rate is ¼ = 25%.

Amortization Recruiting & Training = = (1+0.75+05+0.25) ×106 =

2.5×106

Unamortized Recruitment & Training = = (5+3+1.5+0.5) ×106 = 10×106

Adjusted NI = Old NI +Current Recruitment & Training expense – Amortization Recruitment &
Training

= (5+ 5 – 2.5) ×106 = 7.5 ×106

Correct BV (E) = OLD BV (E) + Value of recruitment & training asset

= 15×106 + 10×106 = 25 ×106

ROE = = = 0.3 = 30%

Problem 5:

FASB, the accounting standards board, is considering requiring that technology and
pharmaceutical firms capitalize R&D expenses and has approached you for advice on the
consequences for some widely used accounting and valuation numbers. Respond to each of the
following multiple-choice questions, with your response (only one choice).

a. Effect on earnings: If you capitalize R&D expenses at technology and pharmaceutical firms,
which of the following would you expect to happen to the adjusted earnings for these firms?
A. There will be no effect on earnings.

B. The reported earnings for all these firms will increase

C. The reported earnings for all these firms will decrease

D. The reported earnings will increase for firms that have seen R&D expenses increase over time

E. The reported earnings will increase for firms that have seen R&D expenses decrease over
time.

b. Effect on book value: If you capitalize R&D expenses at technology and pharmaceutical firms,
which of the following consequences would you expect for the adjusted book value for these
firms?

A. The book value of assets and the book value of debt will increase

B. The book value of assets and the book value of equity will increase

C. The book value of assets and the book value of debt will decrease

D. The book value of assets and the book value of equity will decrease

E. None of the above.

c. Effect on cost of capital: If you capitalize R&D expenses at technology and pharmaceutical
firms, which of the following consequences would you expect for the cost of capital for the
firms?

A. The cost of capital for the firms will increase

B. The cost of capital for the firms will decrease

C. The cost of capital for the firms will be unchanged

Solution:

D. The reported earnings will increase for firms that have seen R&D expenses increase over
time.

B. The book value of assets and equity will increase.

C. The cost of capital will be unaffected.

CHAPTER 10

Problem 1:

You are trying to estimate the free cash flow to the firm on January 1, 2010, for a software
company and have been provided with the following information for 2009

(All numbers in millions):

Net Income $ 150

You are also given the following information:

• The firm invested $ 180 million in property, plant and equipment in 2009.

• The firm’s R&D generally takes an average of 4 years to pay off; its R&D expenses were $40
million in 2005, $80 million in 2006, $ 120 million in 2007 and $ 160 million in 2008.

• Total working capital (including cash) increased by $ 10 million last year but the cash balance
decreased by $ 20 million. The firm has no short-term debt.

Estimate the free cash flow to the firm in 2009.

Solution:

∆ Noncash WC = ∆WC - ∆ Cash = 10 – (-20) = 30

FCFF = adjusted EBIT (1-t) – Reinvestments

= EBIT (1- t) + Current R&D’s expense – R&D’s amortization – Reinvestments

= EBIT (1- t) + Current R&D’s expense – R&D’s amortization –

(CAPEX - D&A + Current R&D’s expense – R&D’s amortization) - ∆ noncash WC

= EBIT (1-t) – CAPEX + D&A - ∆ noncash

= 300 (1-0.4) – 180 + 100 – 30

= 70

We obtained the tax rate by dividing the taxes paid by the taxable income.
Problem 2 :

Now assume that you have been asked to estimate the free cash flow to the firm last year for
Holton Holdings and have collected the following information.

• The firm reported earnings before interest, taxes, depreciation and amortization of $ 350
million on its revenues of $ 1600 million.

• Depreciation and amortization charges amounted to $ 100 million and capital expenditures
were $ 200 million.

• Holton spent $ 100 million last year on research and development in its software division,
following R&D expenditures of $ 60 million (3 years ago), $ 75 million (2 years ago) and $ 90
million (1 year ago) in the prior three years. You believe that research expenditures have an
amortizable life of 3 years.

• The working capital items for the last year and the previous year are reported below.

Last Year Year before last

a. Estimate the value of the research asset of the firm.

b. Estimate the operating income adjusted for R&D expenditures.

c. Estimate the free cash flows to the firm last year

Solution:

The value of the research asset is $185 million

b- EBIT = EBITDA – D&A = (350 – 100) 106 = 250 x 106

Adjusted EBIT (1- T) = old EBIT (1-T) + Current R&D’s expense – R&D’s amortization

= 250 106 (1-0.4) + 100 106 – 75 106

= (150 + 100 – 75) 106

= 175 106

c- ∆ Noncash WC = ∆ Current Assets - ∆ Current Liabilities

= ∆ (Accounts Receivables +Inventory) - ∆ (Accounts Payable)

= (80+150 -90- 100) 106 – (130 - 110) 106

= 40 106 - 20 106

= 20 106

FCFF = EBIT (1-T) – Reinvestments

= EBIT (1- T) – (CAPEX - D&A + Current R&D’s expense – R&D’s amortization) - ∆

noncash WC

=175 106 - (200 + 100 – 100 – 75) 106 - 20 106

= 30 106
Problem 3:

You are trying to estimate the free cash flows for Forman Distilleries, a brewer, based upon last
year’s financial statements which are reproduced below:

The firm’s effective tax rate last year is equal to its marginal tax rate.

• Capital spending last year amounted to $ 40 million but the firm did an acquisition towards the
end of the year, where it used 2 million shares (trading at $30 per share at the time) to buy
another publicly traded firm.

• While revenues last year were unchanged from the previous year, non-cash working capital as a
percent of revenues decreased from 4% of revenues to 2% of revenues.

• The ten-year Treasury bond rate is 4.25%.

a. Estimate the free cash flow to the firm last year.

b. How would your answer to (a) change if you were told that the operating expenses for last
year included an operating lease expense of $ 20 million and that Forman Distilleries has lease
commitments of $ 20 million every year for the next 10 years. Their lease commitments were the
same the previous year.
Solution:

a. FCFF = EBIT (1-T) – Reinvestments

Effective tax rate = Marginal tax rate = = = 30%

∆noncash WC = (2% - 4%) x 500 x 106 = - 10 x 106

FCFF = EBIT (1-T) – Reinvestments

= EBIT (1-T) – (CAPEX – Depreciation + M&A) - ∆noncash WC

= 100 (1-0.3) – (40 – 50 + 60) + 10 = 30 million

b. Synthetic rating = = (100+20) / (10+20) = 4

Rating: BBB →Default Spread = 1.75 %

Cost of Debt = Rf + Company default Spread

= 4.25% + 1.75% = 6 %

1st method:

PV (OL) (using the calculator for an annuity of 20 million for 10 yrs) = 1.47×108

Current OL’s amortization = = 1.47 × 107

Adjusted EBIT (1-T) = (Old EBIT + Current OL expense – Current OL’s amortization) (1-t)

= (100 + 20 – 14.7) (1-0.3)

= 73.71 x 106

FCFF = EBIT (1-T) – Reinvestments

= adjusted EBIT (1-T) – (CAPEX – Depreciation + current OL expense - OL Amortization

+ M&A) - ∆noncash

= 73.71 – (40 – 50 + 20 – 14.7 + 60) +10

= 28.41 x 106

2nd method:

In the second method we adjust EBIT by adding back the imputed interest expense on the debt
value of the operating lease expense

Adjusted EBIT (1-t) = [Old EBIT + Debt value of operating lease expense× Interest rate on debt]
(1- t)

= (100+ 147×0.06) (1-0.3)

= 76.174 x 106

FCFF = EBIT (1-t) – Reinvestments

= adjusted EBIT (1-t) – (CAPEX – Depreciation + imputed interest expense + M&A) -

∆noncash

= 76.174 – (40 – 50 + 147 x 0.06 + 60) +10

= 17.354 x 106
Problem 4:

You are trying to estimate the free cash flow to the firm for Lafayette Enterprises, a furniture-
manufacturing firm, from its most recent financial statements. The income statement for the firm
is provided below:

You can assume that the firm paid its marginal tax rate on taxable income and that capital
expenditures amounted to $225 million in the most recent financial year. Working capital
decreased by $ 40 million but the firm’s cash balance (which is included in working capital)
dropped by $ 60 million.

a. Estimate the free cash flow to the firm in the most recent financial year

b. Estimate the free cash flow to equity for this firm in the most recent financial year, assuming
that the firm’s total debt decreased during the course of the year from $ 800 million to $ 760
million.

c. Now that you have computed the free cash flow to equity and the free cash flow to the firm,
which of the following statements about the two cash flows is true.

i. The free cash flow to equity will always be higher than the free cash flow to the firm.
ii. The free cash flow to the firm will always be higher than the free cash flow to equity.
iii. Paying common dividends reduces the free cash flow to equity
iv. Paying off debt reduces the free cash flow to the firm
v. None of the above.
Solution:

a. Tax rate = = = 0.4 = 40 %

∆in noncash WC = ∆ WC - ∆ cash = - 40 – (-60) = 20

FCFF = EBIT (1-T) – Reinvestments

= EBIT (1-T) – (CAPEX – Depreciation) - ∆in noncash WC

= 250 (1-0.4) – (225 – 150) – 20

= 150 – 75 – 20

= 55 millions

b. FCFE = NI – (CAPEX – Depreciation) - ∆in noncash W – (debt repayment –new debt raised)

= 120 – (225 – 150) – 20 – (800 – 760)

= - 15 millions

c. None of the above. Paying dividends has no effect on FCFE, since dividends are paid out of
FCFE. FCFF is before debt payments.

Problem 5:

You have been asked to assess the value of a finite-life asset with an expected life of 5 years and
constant cash flows over that life (with no salvage value at the end). You have been given the
following income statement for the asset:

You can assume that the firm has no capital expenditures, depreciation or working capital needs;
in other words, earnings are cash flows. The effective tax rate is also the marginal tax rate. The
cost of capital for the asset is 10%.
a. Estimate the value of the asset.

b. How would your answer to (a) change if you were told that the cash flows were real cash
flows and that the cost of capital (of 10%) was a nominal cost of capital. (The expected inflation
rate is 2%)

Solution:

a. Marginal tax rate = = = 0.35 = 35 %

FCFF = EBIT (1- t) – Reinvestments

=EBIT (1-t) – (CAPEX – Depreciation) - ∆in noncash WC

= 400(1- 0.35) = 260

Value of the asset = PV of $260 million annuity for 5 years discounted at 10 % = 985,604,560

b. Method 1:
We convert real cash flows to nominal cash flows

1 2 3 4 5
Real Cash 260 260 260 260 260
flow
Nominal Cash 260 x 1.02 = 260 x 1.022 = 260 x 1.023 = 260 x 1.024 = 260 x 1.025 =
flow 265.20 270.50 275.91 281.43 287.06
PV at 10% 241.09 223.55 207.29 192.22 178.24
Value of asset = = 241.09+223.55+207.29+192.22+178.24 = 1,042,390,000

Method 2:

You can use a real cost of capital to discount the cash flows, using the Fisher equation:

Real cost of capital = (1.10/1.02)-1 = 7.84 %

PV of $260 million at real cost of capital = + + + +

= 1,042,497,069

Problem 6:

Cell Phone Inc. is a cellular firm that reported net income of - $50 million in the most recent
financial year. The firm had $ 1 billion in debt, on which it reported interest expenses of $ 100
million in the most recent financial year. The firm had depreciation of $ 100 million for the year,
and capital expenditures were 200% of depreciation. Assuming that there is no working capital
requirement, estimate the free cash flow to the firm in the most recent financial year.
Solution:

Since the firm is losing then its income is not taxed

EBIT = NI + Interest expense = (-50+100) ×106 = 50 ×106

CAPEX = 2× Depreciation = 2×100×106 = 200×106

FCFF = EBIT – Reinvestments = EBIT – (CAPEX + Depreciation)

= 50 ×106 – (200×106-100×106)

= - 50×106

Problem 7:

You have been asked to value Wythe Pharmaceuticals and have been supplied with the following
information:

- The firm reported earnings before interest and taxes of $ 1 billion on revenues of $ 15 billion
last year.

- These earnings were after research and development expenses of $ 1 billion last year. You have
capitalized research expenses, using a 5-year amortizable life, and estimated a value for the
research asset of $ 3 billion, and amortization of $ 600 million on this asset for last year.

- Last year, the firm had capital expenditures of $ 800 million and depreciation of $ 500 million.
There are no working capital requirements.

- The book value of equity at the beginning of the year was $ 5 billion and the book value of the
debt was $ 1 billion. The firm has operating lease commitments of $ 1 billion each year for the
next 5 years.

- The beta for the stock is 1.2. The pre-tax cost of debt is 7%, the risk-free rate is 6% and the
market risk premium is 4%. The current market value debt to capital ratio is 20%.

- The tax rate for the firm is 40%

a. Estimate the free cash flow to the firm.

b. Estimate the adjusted book value of capital at this firm.

Solution:

a. PV of operating leases = 1,000,000,000 (PVA, 7%, 5 years) = $4,100,197,436

Depreciation = 4,100,197,436/5 = 820,039,487.2

Adjusted EBIT (1-t) = (old EBIT + current OL expense – OL depreciation) (1-t) + current R&D
expense – R&D amortization = (109+109 – 820,039,487.2) (1-0.4) + 109 – 600 x 106 =
1,107,976,308

FCFF = adjusted EBIT(1-t) – reinvestments

= adjusted EBIT(1-t) – (CAPEX – depreciation + current OL expense – OL depreciation +

current R&D expense – R&D depreciation)

= 1,107,976,308 – (800 x 106 – 500 x 106 + 109 – 820,039,487.2 + 109 – 600 x 106)

= $228,015,795.2

b. BV (capital) = BV (initial debt + PV operating leases) + BV (equity + research asset) =

(109+4,100,197,436) + (5 x 109 +3 x 109) = $13.10 x 109