## (solution) Can you help with exercise #2. Don't need help with the rest....

Can you help with exercise #2. Don't need help with the rest....
SYRACUSE UNIVERSITY

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.

Exercise 1

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

method.

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

non-operating income).

b. Does this value equal the estimated value using the FCFF method (which we

computed in class)? Why or why not?

Exercise 3

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

Total assets

Liabilities and Shareholders' Equity

Accounts payable \$ 2006

\$ 2007

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. &amp; O E \$ 2 Income Statement (\$ millions)

2007

Sales \$ Cost of goods sold 3250

1950 Selling &amp; 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

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