University of Tunis

Tunis Business School

Corporate Finance
Tutorial n°5: Corporate Valuation,
Value-Based Management & Corporate Governance
Professor: Dr. Ridha ESGHAIER

(Fall 2021)

Multiple Choice Questions:

Q1. Which of the following statements about Corporate Governance is correct?
A. The fundamental objective of corporate governance is essentially the enhancement of long term
shareholder value.
B. Corporate governance can be defined as the economic, legal, and institutional framework in which
corporate control and cash flow rights are distributed among shareholders, managers and other
stakeholders of the company.
C. Corporate governance is the government-imposed rules and regulations affecting corporate management
D. none of the above

Q2. The central issue of corporate governance is

A. how to protect creditors from managers and controlling shareholders
B. how to protect outside investors from the controlling insiders.
C. how to alleviate the conflicts of interest between managers and shareholders
D. how to alleviate the conflicts of interest between shareholders and bondholders
Q3. All of the following describe agency problems and costs except:
A. The agency problem exists when the desires of management and shareholders are not in accord.
B. Agency costs arise where there is “information asymmetry” between management and shareholders.
C. Agency problems can be solved and agency costs can be eliminated.
D. The agency problem exists when the company’s board of directors fails to fulfill their assigned
oversight role.
Q4. The board of directors may grant stock options to managers in order to
A. save executive compensation costs
B. to dissuade them from taking excessive risks or falsifying financial statements
C. align the interest of managers with that of shareholders.
D. none of the above
Q5. Suppose the managers of a company have driven the stock price down because they have spent the
investors' money on lavish perquisites like golf club memberships.
A. This situation may prompt a corporate raider to buy up the shares of the firm in a hostile
takeover.
B. If the hostile takeover is successful, the managers will probably lose their jobs in the ensuing
restructuring.
C. If the restructuring is successful, the corporate raider can sell his shares at a profit.
D. none of the above
Q6. The market value added (MVA) of a firm will always improve if:
A. the WACC is reduced.
B. the operating profitability increases.
C. the capital requirement decreases.
D. the expected return on invested capital (EROIC) exceeds the WACC.
E. the sales growth rate improves
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 Exercise n°1: Multistage DDM with H-Model

A Firm expects above average growth for the next five years. it establishes the
following facts and forecasts (as of the beginning of August 2013):
- The current market price is $56.18.
- The current dividend is $0.56.
- It forecasts an initial 5-year period of 11% per year earnings and dividend growth.
- It anticipates it can grow 6.5% per year as a mature company, and allows 10
years for the transition to the mature growth period.
- To estimate the required return on equity using the CAPM, it uses an adjusted
beta of 1.2 based on 2 years of weekly observations, an estimated equity risk
premium of 4.2%, and a risk-free rate based on the 20-year Treasury bond yield of
3%.
- It considers any security trading within a band of ±20 percent of her estimate of
intrinsic value to be within a “fair value range.”
1. Estimate the required return on the firm’s stocks using the CAPM. (Use only one
decimal place in stating the result.)
2. Estimate the value of the firm’s stock using a three-stage dividend discount
model with a linearly declining dividend growth rate in Stage 2.
3. Calculate the percentages of the total value represented by the first stage and
by the second and third stages considered as one group.
4. Based on the estimation Judge whether the firm is undervalued or overvalued

Solution 1:
1. The required return on equity is rs = RRF + β.RPM = 3% + 1.2 x 4.2% = 8%.
2.
The first step is to compute the five dividends in Stage 1 and find their present
values at 8%.
The dividends in Stages 2 and 3 can be valued with the H-model, which estimates
their value at the beginning of Stage 2. This value is then discounted back to find the
dividends’ present value at t=0.

The calculation of the five dividends in Stage 1 :

D1 = 0.56(1.11)1 = $0.6216
D2 = 0.56(1.11)2 = $0.6900
D3 = 0.56(1.11)3 = $0.7659
D4 = 0.56(1.11)4 = $0.8501
D5 = 0.56(1.11)5 = $0.9436

The H-model for calculating the value of the Stage 2 and Stage 3 dividends at the
beginning of Stage 2 (t = 5) would be:

D (1 + g L ) D 5 H (g S − g L )
Pˆ 5 = 5 +
rs - g L rs - g L
Here:
gS= 11% ; gL= 6.5% ; rS= 8% and H = 5 (the second stage lasts 2H = 10 years)
D5 = D0 (1+gS)5= 0.56(1.11)5 = $0.9436

Substituting these values into the equation for the H-model gives P5 as:

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 0.9436 × 1.065 0.9436 × 5 × (0.11 - 0.065)
Pˆ 5 = +
0.08 - 0.065 0.08 - 0.065
= 66.9979 + 14.1545 = $81.1524

P0 = D1/(1+rs) + D2/(1+rs)2 + … + D5/(1+rs)5 + P5/(1+rs)5

P0 = $0.6216/(1.08) + $0.06900/(1.08)2 + … + $0.9436/(1.08)5 + $81.1524/(1.08)5

= $58.2731

According to the three- stage DDM model, the total firm’s value is $58.27

3.
The present value of the 5 next dividends (D1, D2, D3, D4 and D5) is :
$0.6216/(1.08) + $0.06900/(1.08)2 + … + $0.9436/(1.08)5 = $3.0422. Thus, the first
stage represents $3.0422/$58.2731 = 5.2% of total value.
The second and third stages together represent 100% - 5.2% = 94.8% of total value
(check: $81.1524/(1.08)5 = $55.2310 thus, $55.2310/$58.2731 = 94.8%).
4.
The band the firm is looking at is $58.27 ± 0.20($58.27), which runs from $58.27 +
$11.65 = $69.92 on the upside to $58.27 - $11.65 = $46.62 on the downside.

Because the current price of $56.18 is between $46.62 and $69.92, we would
consider the company to be fairly valued.

Exercise n°2: Total Payout model

BMI, an all-equity financed firm, just reported EPS of $5.00 per share for 2017. Despite the
economic downturn, BMI is confident regarding its current investment opportunities. But
due to the financial crisis, BMI does not wish to fund these investments externally. The
Board has therefore decided to suspend its stock repurchase plan and cut its dividend to
$1per share (vs. almost $2 per share in 2016), and retain these funds instead. The firm has
just paid the 2017 dividend, and BMI plans to keep its dividend at $1 per share in 2018 as
well. In subsequent years, it expects its growth opportunities to slow, and it will still be able
to fund its growth internally with a target 40% dividend payout ratio, and reinitiating its
stock repurchase plan for a total payout rate of 60%. (All dividends and repurchases
occur at the end of each year.)
Suppose BMI’s existing operations will continue to generate the current level of earnings
per share in the future. Assume further that the return on new investment is 15%, and that
reinvestments will account for all future earnings growth (if any). Finally, assume BMI’s
equity cost of capital is 10%.
A. Estimate BMI’s EPS in 2018 and 2019 (before any share repurchases).
B. What is the value of a share of BMI at the start of 2018?

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Solution
A. To calculate earnings growth, we can use the formula:
g = (retention rate) × Return On New Investments.
In 2017, BMI retains $4 of its $5 in EPS (since Div2017=$1), for a retention rate of 80% (=4/5), and an
earnings growth rate g2017 of : g2017 = 80% × 15% = 12%.
Thus, EPS2018 = EPS2017 x (1+g2017) = $5.00 × (1.12) = $5.60.

In 2018, BMI retains $4.60 of its $5.60 in EPS (since Div2018=$1), for a retention rate of 82.14% (=4.6/5.6)
and an earnings growth rate g2018 = 82.14% × 15% = 12.32%.
So, EPS2019 = EPS2018 x (1+g2018) = $5.60 × (1.1232) = $6.29.

B. From 2019 on, the firm plans to retain 40% of EPS, for a growth rate of g2019 ∞ = 40% × 15% = 6%.
Total Payouts in 2019 are 60% of EPS2019, or Payouts 2019 = 60% × $6.29 = $3.774.
Thus, the value of the stock at the end of 2018 is, given the 6% future growth rate:
P2018 = Payouts2019/(rs-g) = $3.774/(10% – 6%) = $94.35.
Given the $1 dividend in 2018, and the end of 2018 price ($94.35) we get a share price in 2017 (at the
start of 2018) of :
P2017 = Div2018/(1+rs)1 + P2018/(1+rs)1
= ($1 + 94.35)/1.10 = $86.68

Non-constant growth Annual growth rate g2019 ∞ = 6% Constant forever

g2017=12% g2018=12.32% g2019=6% g2020=6%

2016 2017 2018 2019 2020 .… ∞
| | | | |
Payout2017=$1 Payout2018=$1 Payout2019=$3.774 Payout2020 ….
P2018

P2017

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 Exercise n°3: Comparables Valuation
Part1: EPS and M/B multiple
Suppose that in January 2016, Kenneth Cole Productions (KCP) had EPS of $1.65 and a book value of equity
of $12.05 per share.
a. Using the average P/E multiple in the Table below, estimate KCP’s share price.
b. What range of share prices do you estimate based on the highest and lowest P/E multiples?
c. Using the average price to book value multiple, estimate KCP’s share price.
d. What range of share prices do you estimate based on the highest and lowest price to book value multiples?
Part2: Entreprise value multiples
Suppose that in January 2016, Kenneth Cole Productions had sales of $518 million, EBITDA of $55.6 million,
excess cash of $100 million, $3 million of debt, and 21 million shares outstanding.
a. Using the average enterprise value to sales multiple in the table below, estimate KCP’s share price.
b. What range of share prices do you estimate based on the highest and lowest enterprise value to sales
multiples?
c. Using the average enterprise value to EBITDA multiple, estimate KCP’s share price.
d. What range of share prices do you estimate based on the highest and lowest enterprise value to EBITDA
multiples?
Stock Prices and Multiples for the Footwear Industry, January 2016

Solution:
Part1: EPS and M/B multiple
a. Share price = Average P/E × KCP EPS = 15.01 × $1.65 = $24.77
b. Minimum = 8.66 × $1.65 = $14.29, Maximum = 22.62 × $1.65 = $37.32
c. Share price = Average P/B × KCP Book value PS =2.84 × $12.05 = $34.22
d. Minimum = 1.12 × $12.05 = $13.50, Maximum = 8.11 × $12.05 = $97.73
Part2: Entreprise value multiples
a. Estimated enterprise value for KCP = Average EV/Sales × KCP Sales = 1.06 × $518 million = $549M.
Equity Value = EV – Debt + Cash = $549 – 3 + 100 = $646 million.
Share price = Equity Value / Shares = $646/ 21 = $30.77
b. Minimum : [(0.47 × $518M) – $3M + $100M ]/21M = $16.21
Maximum : [(2.19 × $518M) – $3M + $100M ]/21M = $58.64

c. Estimated enterprise value for KCP = Average EV/EBITDA × KCP EBITDA = 8.49 × $55.6million = $472M.
Share Price = ($472 – 3 + 100)/21 = $27.10
d. Minimum : [6.66 × $55.6M – $3M + $100M ]/21M = $22.25
Maximum : [10.75 × $55.6M) – $3M + $100M ]/21M = $33.08
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 Exercise n°4: FCFF Valuation model

A Corporation is a fast-growing supplier of office products. Analysts project the following free cash
flows to the firm (FCFFs) during the next 3 years, after which FCFF is expected to grow at a constant
7% rate. The company’s weighted average cost of capital is WACC = 12%.
Year
1 2 3
Free cash flow ($ millions) −$10 $25 $45

a. What is the company’s terminal, or horizon, value?

b. What is its current value of operations?
c. Suppose the company has $11.525 million in marketable securities, $140 million in debt, and 10
million shares of stock.
What is its intrinsic value per share?

Solution

Supernormal growth Normal growth gL= 7% Cst forever

0 1 2 3 4 .… ∞
| | | |
FCFF1= -$10 FCFF2=$25 FCFF3=$45 FCFF4=$48.15 …. FCFF∞
PV FCFF1
PV FCFF2
PV FCFF3
PV HV3 TV3=FCFF4 /(WACC – gL)
= Value of Operations
a- HV3=FCFF4 /(WACC – gL) = 45(1+7%)/(12%-7%) = $963
FCFF1 FCFF2 FCFF3 TV3
b- Value of Operations : VOP = + + +
(1 + WACC) (1 + WACC) 2
(1 + WACC) 3
(1 + WACC) 3

Vop= -10/1.12 + 25/1.122 + 45/1.123 + 963/1.123 = $728.475M

c- Total Value = VOp + VNon Op = $728.475M + $11.525M = $740M

Value of Equity = Total Value – Value of Debt

= $740M - $140M = $600M

Intrinsic price per share = $600M/10M = $60

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 Exercise n°5: DDM vs FCFE Model
ABC’s current FCFE is $31,450 million, its last total dividend paid was $22,470. Earnings and
FCFE are expected to grow 17 percent a year over the next three years before stabilizing at
an annual growth rate of 9 percent.
You decide to value ABC by using the DDM and FCFE models. After reviewing ABC’s
financial statements and forecasts related to the new production agreement, you
conclude the following:
ABC will maintain the current payout ratio. Number of shares outstanding is 13,000.
ABC’s beta is 1.25.
The government bond yield is 6 percent, and the market equity risk premium is 5 percent.
A Calculate the value of a share of ABC’s common stock by using the two-stage DDM.
B Calculate the value of a share of ABC’s common stock by using the two-stage FCFE
model.
C You are discussing with a corporate client the possibility of that client acquiring a
70 percent interest in ABC. Discuss whether the DDM or FCFE model is more appropriate for
this client’s valuation purposes.

Solution:

A.

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 C. The FCFE model is best for valuing companies for takeovers or in situations that
have a reasonable chance of a change in corporate control. Because controlling
stockholders can change the dividend policy, they are interested in estimating the
maximum residual cash flow after meeting all financial obligations and investment
needs. The DDM is based on the premise that the only cash flows received by
stockholders are dividends. FCFE uses a more expansive definition to measure what a
company can afford to pay out as dividends.

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Exercise n°6: DDM vs RI Model
A company is expected to earn $4.00, $5.00, and $8.00 for the next three years. It will pay annual
dividends of $2.00, $2.50, and $20.50 in each of these years. The last dividend includes a
liquidating payment to shareholders at the end of Year 3 when the trust terminates.
The company’s book value is $8 per share and its required return on equity is 10 percent.
A What is its current value per share according to the dividend discount model?
B Calculate its per-share book value and residual income for each of the next 3 years and use
those results to find the stock’s value using the residual income model.
C Calculate return on equity and use it as an input to the residual income model to calculate the
company’s value.

Solution:

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 Exercise n°7: DDM vs RI Model
An analyst is valuing a company and has made the following assumptions:
Book value per share is estimated at $9.62 on 31 December 2017.
EPS will be 22 percent of the beginning book value per share for the next eight years.
Cash dividends paid will be 30 percent of EPS.
At the end of the eight- year period, the market price per share will be three times the book
value per share.
The beta of the company is 0.60, the risk-free rate is 5.00%, and the equity risk premium is 5.50%.
Its current market price is $59.38, which indicates a current P/B of 6.2.
A Prepare a table that shows the beginning and ending book values, net income, and cash
dividends annually for the eight- year period.
B Estimate the residual income and the present value of residual income for the eight years.
C Estimate the value per share using the residual income model.
D Estimate the value per share using the dividend discount model. How does this value compare
with the estimate from the residual income model?

Solution:

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