EXAM QUESTION PAPER
|Department||Economics & Finance|
|Module Code||EC560 4|
|Module Title||Investment Valuation Models|
|Duration||• 1.5 Hours exam writing time.
• 30 minutes to allow for upload of your work and hand in.
Uploads need to be COMPLETED before the end of the upload time. Students are responsible for completing the entire submission process, including clicking HANDIN; this will not be done for you if you forget or run out of time. Late work will not be accepted. If you have any problems uploading work you must notify us that you are experiencing difficulties in uploading and/or submitting your work, using the contact details you have been given (in exam “Live Chat” or phone 01895 268860). Please do not contact academic staff directly. Work sent via email will not be marked.
|Number of questions||4 questions|
|Question Instructions||Choose any 2 questions to answer
|Can students include drawings/ diagrams?||No|
|Any permitted reference materials (inc external websites)||Formula sheet (already attached at the end of question)|
|Hand in instructions||upload one PDF, students must upload and click hand-in to finish|
|Contact for Academic Queries:||Use the chat tool that is embedded in WISEflow|
|Contact for technical issues:||Use the chat tool that is embedded in WISEflow or phone the helpline 01895 268860 (9-5:30pm GMT)|
By continuing beyond this point, you confirm that you have read the information and instructions above, and understand the conditions of this examination.
(1) Britech Inc., a UK-based corporation, is in the food and biotechnology businesses, with UK and Eastern European operations (composed of Poland and Hungary). The company has provided you
information on the revenues (in millions of GBP) in the most recent year from different businesses and regions (with the unlevered beta of the businesses in the last column):
You have collected information on government bond rates in the UK, Poland and Hungary and they are reported below:
|In GBP (UK)||2.75%||4%||8.75%|
|In local currency||2.75%||11%||20%|
You can also assume that equities are 1.5 times more risky than government bonds in both Poland and Hungary and that their local currency ratings match their foreign currency ratings. You can assume an equity risk premium for mature markets (like the UK) of 5.75% and that Britech is all equity funded. a. What is the total equity risk premium for Eastern European operations in GBP (£)? (30 marks)
- What levered beta (in GBP £) would you use for the Eastern European operations? (20 marks)
- What is your estimate of the cost of equity (in GBP £) for the Eastern European operations of Britech? (10 marks)
(2) The chief financial officer of BitSoftware, a growing software manufacturing firm, has approached you for some advice regarding the beta of his company. He subscribes to a service that estimates have gone down every year since 2016 – from 2.35 in 2010 to 1.4 in 2019. He would like the answers to the following questions:
- Is this decline in beta unusual for a growing firm? Why would the beta decline over time? (20 marks)
- Is the beta likely to keep decreasing over time? (20 marks)
(1) You are trying to estimate the free cash flow to the firm on 1st January 2021, for a software company and have been provided with the following information for 2020 (all numbers in millions):
- Depreciation & Amortization £100
- R & D expenses £200
- Other operating expenses £200
Operating income £300
- Interest expenses £50
Taxable income £250
- Taxes paid £100 Net Income £150
You are also given the following information:
The firm invested £ 180 million in property, plant and equipment in 2020.
The firm’s R&D generally takes an average of 4 years to pay off; its R&D expenses were £40 million in 2016, £80 million in 2017, £120 million in 2018 and £160 million in 2019.
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 value of the research asset of the firm. (20 marks)
- Estimate the operating income adjusted for R&D expenditures. (20 marks)
- Estimate the free cash flows to the firm in 2020. (20 marks)
- Discuss reasons why firms do not pay out their free cash flows to equity (FCFE) as dividends? (20 marks)
- Suppose you are valuing a company in the UK. Would you include cash in your definition of working capital in order to compute cash flows? Explain your answer. (20 marks)
(1) Wayne Housing is a construction supplies company that has been hit by the slowing down of the housing market. The company has been losing money for a while and has accumulated a net operating loss carry forward of £40 million (including the most recent year’s loss). In the most recent year, the company reported EBITDA of £12.5 million on revenues of £500 million and had a depreciation charge of £40 million.
Over the next 3 years, the company expects the following:
- Sales will increase 5% a year for the next 3 years
- The EBITDA margin (EBITDA/Sales) will double each year for the next 3 years.
- The company has excess capacity and will not make any capital expenditures for the next 3 years and depreciation is expected to remain £40 million each year for this period.
- The company currently has inventory of £50 million (and no other working capital). This inventory will decrease £10 million each year for the next 3 years.
- The marginal tax rate that the company will face when it has taxable income is 40%.
- Estimate the free cash flows to the firm each year for the next 3 years. (20 marks)
- Now assume that at the end of 3 years, the company will be mature and that its operating income will grow 2% a year in perpetuity, while earning its cost of capital. If the cost of capital in stable growth is 8%, estimate the terminal value. (20 marks)
- Assume that the cost of capital for the next 3 years is 12%. How much value would you attach to having the net operating loss carry forward of £40 million? (20 marks)
(2) There are two approaches to valuation. The first approach is to value the equity in the firm. The second approach is to value the entire firm.
- What is the distinction? (20 marks)
- Why does the distinction matter? (20 marks)
(1) Meet is a social media company that currently has 10 million users but reported an operating loss of £5 million on £10 million in revenues in the most recent year, mostly from advertising. The company expects revenues to grow 80% a year for the next 5 years and its pre-tax operating margin to improve to 20% of revenues by year 5. After year 5, you expect revenue growth to drop to 10% a year for the following 5 years and margins to stay stable. (The company has no debt and no cash balance.)
- You have run a regression across more established advertising companies to arrive at the following regression (with all percentage numbers entered as decimals, i.e., 20% will be entered as 0.20):
EV/Sales = 0.80 + 45.0 (Expected annual revenue growth in the next 5 years) + 25.0 (Pre-tax Operating Margin) – 1.5 (Earnings Loss Dummy) where the earnings loss dummy is set equal to one if the company is reporting an operating loss and zero if it is not. Using this regression and current numbers, estimate the value of Meet today. (20 marks)
- Using the same regression, estimate the enterprise value of Meet at the end of year 5, based upon your expectations for what the company will look like then. (20 marks)
- Now assume that the cost of equity for Meet is 15% for the next 5 years and 10% beyond. If there is no chance that the company will fail over the next 5 years and your estimates from parts a and b are both correct, estimate how much new equity (in PV terms) the company will have to issue over the next 5 years. (You can assume that the company will have a 20% debt to capital ratio at the end of year 5). (20 marks)
- What is the argument in favour of using sector-specific multiples? (10 marks)
- When do sector-specific multiples work best? (20 marks)
- Why do multiples generally have skewed distributions? (10 marks)
Risk Free Rate
Government Bond Rate – Country default spread
Equity Risk Premium
Mature Market Base Premium + Country Risk Premium
Country Risk Premium
- Default Spread of country’s bond
- Country bond default spread × (Sd. Dev. of country’s equity/Sd. Dev. of country’s bond)
Total Risk Premium
Risk Premium in Mature Market × (Sd. Dev. of country’s equity/Sd. Dev. of mature market equity)
Cost of Equity
Cost of Equity = Risk free Rate+ Beta × Risk Premium
Cost of Equity with country risk premium
- Cost of Equity = Risk free Rate+ Beta×(Mature market risk premium) + Country risk premium
- Cost of Equity = Risk free Rate+ Beta×(Mature market risk premium + Country risk premium)
- Cost of Equity = Risk free Rate+ Beta×(Mature market risk premium) + λ×(Country risk premium), where: λ = % of Domestic Revenues firm / % of Domestic Revenue avg firm
Cost of Debt
Cost of Debt = Risk free Rate+ Default Spread of Company+ Default Spread of Country (if in emerging market)
Unlevered beta business = Beta comparable firms /[1+(1-t)(D/E ratio comparable firm)]
Unlevered beta firm = ∑ (Unlevered beta𝑗 × Value weight𝑗)
BL = Bu [1 + (1-T)(D/E)]
Cost of Capital
Cost of equity × (Market Value of Equity/Capital) + Cost of debt × (Market Value of Debt/Capital) Free Cash Flows to Firm
EBIT (1-T) – (Capital Expenditure + Acquisition – Depreciation) – Change in non-cash Working
where, changes in non-cash working capital = ∆Accounts receivables + ∆Inventories –
or changes in non-cash working capital = ∆(current assets-cash) –∆(current liabilities-short term debts)
Free Cash Flows to Equity
Net Income – (Capital Expenditure – Depreciation + Acquisition) – Change in non-cash Working Capital – (Debt Repaid – New Debt Issues)
Expected Growth Rate
Expected Growth Rate of FCFE = Equity Reinvestment Rate × Return on Equity Expected Growth Rate of FCFF = Capital Reinvestment Rate × Return on Capital where,
Equity reinvestment rate = (Net Capital Expenditure + Change in Non-cash Working Capital – Net Debt)/Net Income
Capital reinvestment rate = (Net Capital Expenditure + Change in Non-cash Working Capital)/EBIT(1T)
Terminal Value of the Firm
𝐸𝐵𝐼𝑇𝑛+1(1 − 𝑇)(1 − 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 𝑖𝑛 𝑆𝑡𝑎𝑏𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑛+1 − 𝑆𝑡𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
where, Reinvestment rate = Stable Growth Rate/Return on Capital
𝑁𝐼𝑛+1(1 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 𝑖𝑛 𝑆𝑡𝑎𝑏𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑛+1 − 𝑆𝑡𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
where, Equity Reinvestment rate = Stable Growth Rate/Return on Equity