Finance Problem Set #1 - Valuation Concepts

Problem Set #1 - Solution

• Problem 1: Investor valuing Asian stocks; two-year stock market growth of 60% per year and government borrowing rate of 15% creating a 45% historical premium. Should the investor use this historical premium to value future risk? No, and future risk premium should be based on other factors impacting the market, not just historical returns. Valuation relies on discounting cash flows at the cost of equity to determine the present value of the equity stake.
• Problem 1: Valuation distinctions; mismatching cash flows and discount rates, or misinterpreting the calculated present value of cash flows, can cause significant valuation errors.
• Problem 2: Eastman Kodak beta (1.10); six-month treasury bill rate (3.25%) and thirty-year bond rate (6.25%).
  • Part a): Cost of equity using treasury bill rate; CAPM formula. Using the treasury bill rate as the risk-free rate in the Capital Asset Pricing Model.
  • Part b): Cost of equity using treasury bond rate; CAPM formula using the treasury bond rate as the risk-free rate..
  • Determining which estimate to use: Long-term bond rate (risk-free rate) is more suitable for valuation on long-term investment horizons since it reflects long-term potential returns.
• Problem 3: Valuing BMW; beta of 0.90 relative to the Frankfurt Stock Exchange (DAX). Use of an international index for beta calculation is preferred since it provides a more relevant comparison for an international portfolio.
• Problem 4: High-technology firm with three divisions; personal computers (beta 1.60, market value $100 million), software (beta 2.00, market value $150 million), and computer mainframes (beta 1.20, market value $250 million).
  • Part a): Weighted average beta of the firm's equity portfolio.
  • Part b): Change in beta if the firm divested its software division.
  • Part c): Beta to use for valuing the software division; the beta for the software division (2.00) should be used in valuation.
• Problem 5: Four forestry/paper product companies' equity betas and debt/equity ratios; Weyerhaeuser, Champion International, International Paper, and Kimberly-Clark.
  • Part a): Calculation and interpretation of unlevered betas for each firm; measure business and operating leverage risk.
  • Part b): Kimberly-Clark's new beta with a 30% debt/equity ratio; calculation using the unlevered beta.
  • Part c): Beta for an initial public offering in the paper products market should use the average unlevered beta of comparable firms and relever it using the projected 40% debt/equity ratio.
• Problem 6: Five food production companies; CPC International, Ralston Purina, Quaker Oats, Chiquita, and Kellogg's; details about their cost structures (fixed vs. variable costs) and betas.
  • Part a): High and low operating leverage betas; CPC will have the highest and Kellogg's the lowest.
  • Part b): New estimate of Chiquita's beta due to increased financial leverage; calculation using the average leverage ratio from period of beta calculation.
• Problem 7: Company stock prices, dividends per share, and expected dividend growth rates for Merck, Ogden Co., Honda, and Microsoft; use of dividend growth model & CAPM
  • Part a): DDM cost of equity calculations and reasonable DDM candidates; candidates and why they're appropriate for DDM.
  • Part b): CAPM cost of equity calculation.
  • Part c): Estimate choice for valuation calculations & reasons; CAPM estimate is used for valuations unless dividend growth model cannot be calculated.
• Problem 8: Merck & Company's market and book values for debt and equity; cost of equity calculation, after-tax cost of debt, and cost of capital.
• Problem 9: General Motors cost of capital calculation; Equity, preferred stock cost calculation; and cost of debt.