Can you help with exercise #2. Don’t need help with the rest….
MARTIN J. WHITMAN SCHOOL OF MANAGEMENT
Investments Professor David Weinbaum
Problem Set 2 This is an optional problem set. The solutions are posted on Blackboard but you should
not look at them until you have had a chance to work on the problems. While you are
not expected to hand anything in, solving the problems will help you keep up with the
material. Also, the questions on the problem sets are representative of the kinds of
questions that will be asked in the tests.
You have been asked to value a firm with expected annual after-tax cash flows, before
debt payments, of $100 million a year in perpetuity (FCFF). The firm has a cost of equity
of 10%, a market value of equity of $750 million and a market value of debt of $500
million (this is also the book value). The debt is perpetual and the after-tax interest rate
on debt is 5%. The company has no non-operating activities.
a. Estimate the value of the firm and the value of the equity based upon this value (i.e.,
do an FCFF valuation of the equity).
b. Estimate the value of equity, by discounting the cash flows to equity at the cost of
equity (i.e., do an FCFE valuation of the equity).
c. Now assume that you had been told that the market value of equity was $850 million
and that all of the other information remained unchanged. Answer parts a and b, using
these new values.
d. In practice, what needs to happen for the two valuation approaches (FCFF and FCFE)
to give the same estimate of the value of the equity? (Hint: Valuations are circular!) 1 Exercise 2
a. Using the financial statements and other information that you have for MPR, and
assuming a 5% perpetual growth rate in the FCFE, value the equity using the FCFE
HINT: The valuation we did in class used the FCFF approach. Here you are asked to use
the FCFE approach. The first step is to compute the FCFE for the most recent year. Since
we computed the FCFF in class (23.96334), use the formula that links FCFF and FCFE
(from page 6 of handout II. B., FCFE + net paym?t debt principal + AT interest = FCFF + AT
b. Does this value equal the estimated value using the FCFF method (which we
computed in class)? Why or why not?
Below are the balance sheet and income statement of Levco Corp. Assume that the
entire cash balance is operating.
Balance Sheet ($ millions)
ASSETS 2006 Cash $ 2007
240 $ 300 Accounts receivable 200 220 Inventory 350 330 790 850 Gross PPE 600 750 Accumulated depreciation 125 150 475 600 1,265 1450 Total current assets Net PPE
Liabilities and Shareholders' Equity
Accounts payable $ 2006
70 Short-term debt $ 65 175 195 5 10 250 270 Long-term debt 405 500 Common stock 210 240 Retained earnings 400 440 610 680 1,265 1450 Accrued expenses
Total current liabilities Total common equity
Total Liab. & O E $ 2 Income Statement ($ millions)
Sales $ Cost of goods sold 3250
1950 Selling & admin. expense 900 Depreciation 25 Operating profit 375 Interest expense 35 Earnings before taxes 340 Taxes @ 40% 136 Net income 204 a. Compute the 2007 FCFF for Levco Corp using the top down approach, from the above
balance sheet and income statement.
b. Compute the 2007 FCFF for Levco Corp using the bottom up approach, from the above
balance sheet and income statement. 3