A capital investment’s internal rate of return:

LIVING WITH THE EARTH
11/09/2019
Earnings Quality Analysis and Equity Valuation Richard G. Sloan Professor of Accounting Ross School of Business, University of Michigan Ann Arbor, Michigan
11/09/2019

A capital investment’s internal rate of return:

PART I: MULTIPLE CHOICE / SHORT ANSWER QUESTIONS (50 points; 2 ½ points each)

1. A capital investment’s internal rate of return:

a. Changes when the cost of capital changes.

b. Must exceed the cost of capital in order for the firm to accept the investment.

c. Is similar to the yield to maturity on a bond.

d. Is equal to annual net CF divided by one half of the project’s cost when the cash flows are an

annuity.

e. Statements b and c are correct.

2. Risk in a revenue-producing project can best be adjusted for by

a. Ignoring it.

b. Adjusting the discount rate upward for increasing risk.

c. Adjusting the discount rate downward for increasing risk.

d. Picking a risk factor equal to the average discount rate.

e. Reducing the NPV by 10 percent for risky projects

3. The primary goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize expected total corporate profit.

b. Maximize expected EPS.

c. Minimize the chances of losses.

d. Maximize expected net income.

e. Maximize the shareholder equity.

4. A tender offer in M&A deal is

a. a goodwill gesture by a “white knight.”

b. a would-be acquirer’s friendly takeover attempt.

c. a would-be acquirer’s offer to buy stock directly from shareholders.

d. viewed as sexual harassment when it occurs in the workplace.

5. Insight Corporation’s return on equity is 15% and its dividend payout ratio is 60%. The

sustainable growth rate of the firm’s earning and dividends should be:

A). 8%

B). 9%

C). 7%

D). 6%

E). 5%

6. Recent M&A-related accounting changes in the United States:

a. eliminated the purchase method, allowing only the pooling-of-interests method for M&A.

b. eliminated the pooling-of-interests method, allowing only the purchase method for M&A.

c. allow for both the purchase method and the pooling-of-interests method for M&A.

d. outlawed the recording of goodwill for any merger or acquisition.

e. none of above

7. What’s the future value of $1,500 after 5 years if the appropriate interest rate is 6%,

compounded semiannually?

a. $1,819

b. $1,915

c. $2,016

d. $2,117

e. $2,223

8. An investor plans to buy a common stock and hold it for two years. The investor expects to

receive $1.5 in dividend a year and $26 from the sales of the stock at the end of year 2. If the

investor wants a 15% return (compound annually), the maximum price the investor should pay for

the stock today is roughly:

A). $24

B). $28

C). $22

D). $32

E). $26

9. Amador Corporation has a stock price of $24 a share. The stock’s year-end dividend is expected

to be $2 a share. The stock’s required rate of return is 12 percent and the stock’s dividend is

expected to grow at the same constant rate forever. What is the expected price of the stock six

years from now?

a. $35

b. $40

c. $25

d. $15

e. $30

State if flowing statements are True [T] or False [F]. Briefly justify your answers.

10. Intrinsic value and market price of equity shares are always equal.

True [T] False [F]

Justification:

11. Under DCF method, in general, higher the risk level, higher will be the discount rete.

True [T] False [F]

Justification:

12. Market value per share is expected to be lower than the book value per share in case of

profitable and growing firms.

True [T] False [F]

Justification:

13. Firms tend to be more profitable when there is higher real growth in the underlying market than

when there is lower real growth.

True [T] False [F]

Justification:

14. A lower discount would be applied to the cash flows of the government bond.

True [T] False [F]

Justification:

Questions 15-16 are related to an investment’s time value of money (TVM)

15. How much would $6,000 due in 25 years be worth today if the discount rate were 6%? Show your calculations.

16. At a rate of 6%, what is the future value of the following cash flow stream? Show your calculations.

Years: 0 1 2 3 4

| | | | |

CFs: $0 $75 $225 $10 $350

17.

a. The company’s net income in 2008 was higher than in 2007.

b. The firm issued common stock in 2008.

c. The market price of the firm’s stock doubled in 2008.

d. The firm had positive net income in both 2007 and 2008, but its net income in 2008 was

lower than it was in 2007.

e. The company has more equity than debt on its balance sheet.

18. Stratigent Company is not a growing company and has earnings before interests and taxes of

$20,000, interest payments to a local bank of $3,500 and pay tax at 38% rate. Investors require a 9%

return on the stock and the firm has a cost of debt of 4.5%. What’s the approximante value of the

company’s equity? Show your calculations.

19. A bond has a $1000 par value, 10 years to maturity, 7% coupon payments (annual), and currently

sells for $985. What’s the yield to maturity (YTM)? Please show your calculations.

20. Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business

into a corporation. Which of the following statements is CORRECT?

a. The company will probably be subject to fewer regulations and required disclosures.

b. Assuming the firm is profitable, none of its income will be subject to federal income taxes.

c. Relaxant’s shareholders (the ex-partners) will now be exposed to less liability.

d. The firm’s investors will be exposed to less liability, but they will find it more difficult to

transfer their ownership.

e. The firm will find it more difficult to raise additional capital to support its growth.

PART II: MINI-CASE QUESTIONS

Question 1 Define each of the following M&A terms. Give a real world example of each. For

Example: vertical integration

“In a vertical merger, a company acquires another firm that is “upstream” or “downstream”; for

example, in 2005, the Detroit-based automobile manufacturer acquires a steel producer based in

Dayton (Ohio) for $xxx in an effort to create a vertical integration…” (6 points)

▪ Business synergy ▪ Horizontal merger ▪ White knight ▪ Poison pill ▪ Leveraged buyout (LBO) ▪ Purchasing accounting and pooling of interest

Question 2 Lucent Technology is considering seller-finance for an existing customer with the

following information. The net income is $95MM. The depreciation cost is $15MM. What is the subject

firm’s cash flow from operations (CFO)? (6 points)

Decrease in accounts receivable $30 MM

Issuance of new stocks 18

Proceeds from the sale of fixed assets 8

Increase in inventory 17

Increase in accounts payable 10

Dividends paid out 35

Decrease in wages payable 5

Question 3: Elaine Case, CFA, is an equity analyst with Prudential Securities. She has gathered

the following information about Lone Star Plastics: (6 points)

▪ Assets: $100,000; ▪ Net profit margin: 6.5%; ▪ Tax rate: 35%; ▪ Debt ratio: 40.0%; ▪ Interest rate: 7.5 %; ▪ Total assets turnover: 3.0.

What is Lone Star’s EBT (earning before tax)? Show your calculations.

Question 4: A price-linked investment pays $300 if the oil price over the next year increases by more

than 5%, an event that can happen with a 55% probability. Otherwise, it pays $60. If the expected

return on the security is 12%, how much does the security cost? Show your calculations. (4 points)

(Demo for your reference purpose):

Question 5 DuPont model for profitability & ROE analysis. Use the following information on

Dylan Enterprises for questions. (8 points)

1). What are the firm’s gross and net profit margin (in %) for the current year? Show your calculations.

2). Calculate current year’s ROE (using De Pont model) by showing the value of each individual

component. Show your calculations.

Income Statement

Revenues $320,000,000

Less: Cost of Goods Sold $162,000,000

Gross Profit $158,000,000

Less: Operating Expenses $120,000,000

Less: Depreciation $11,000,000

Operating Profit $27,000,000

Less: Interest Expense $8,500,000

Net Profit Before Taxes $18,500,000

Less: Taxes $6,290,000

Net Income $12,210,000

Earnings Available to Common $12,210,000

Dividends Paid (60% of EAC) $7,326,000

Addition to Retained Earnings $4,884,000

Balance Sheet

Assets Current Year Prior Year Change

Cash $1,500,000 $3,000,000 ($1,500,000)

Marketable Securities $1,500,000 $3,200,000 ($1,700,000)

Accounts Receivable $57,000,000 $44,000,000 $13,000,000

Inventory $106,000,000 $99,000,000 $7,000,000

Pre-Paid Expenses $8,400,000 $11,000,000 ($2,600,000)

Total Current Assets $174,400,000 $160,200,000 $14,200,000

Long-Term Assets $148,000,000 $154,000,000 ($6,000,000)

Total Assets $322,400,000 $314,200,000 $8,200,000

Liabilities Current Year Prior Year Change

Accounts Payable $8,716,000 $6,400,000 $2,316,000

Short-Term Debt $102,000,000 $105,000,000 ($3,000,000)

Total Current Liabilities $110,716,000 $111,400,000 ($684,000)

Long-Term Debt (8%) $115,000,000 $111,000,000 $4,000,000

Total Liabilities $225,716,000 $222,400,000 $3,316,000

Common Stock ($1 par value) $2,000,000 $2,000,000 $0

Paid-In Capital $65,000,000 $65,000,000 $0

Retained Earnings $24,800,000 $4,884,000

Total Equity $96,684,000 $91,800,000 $4,884,000

Total Liabilities and Equity $322,400,000 $314,200,000 $8,200,000

Question 6 (6 points)

Cumberland Industries December 31 Balance Sheets

(in thousands of dollars)

2003 2002

Assets

Cash and cash equivalents $91,450 $74,625

Short-term investments $11,400 $15,100

Accounts Receivable $103,365 $85,527

Inventories $38,444 $34,982

Total current assets $244,659 $210,234

Fixed assets $67,165 $42,436

Total assets $311,824 $252,670

Liabilities and equity

Accounts payable $30,761 $23,109

Accruals $30,477 $22,656

Notes payable $16,717 $14,217

Total current liabilities $77,955 $59,982

Long-term debt $76,264 $63,914

Total liabilities $154,219 $123,896

Common stock $100,000 $90,000

Retained Earnings $57,605 $38,774

Total common equity $157,605 $128,774

Total liabilities and equity $311,824 $252,670

Cumberland Industries December 31 Income Statements

(in thousands of dollars)

2003 2002

Sales $455,150 $364,120

Expenses excluding depr. and amort. $386,878 $321,109

EBITDA $68,272 $43,011

Depreciation and Amortization $7,388 $6,752

EBIT $60,884 $36,259

Interest Expense $8,575 $7,829

EBT $52,309 $28,430

Taxes (40%) $20,924 $11,372

Net Income $31,385 $17,058

Common dividends $12,554 $6,823

Addition to retained earnings $18,831 $10,235

Other Data 2003 2002

Year-end Stock Price $17.25 $14.75

# of shares (in thousands) 10,000 9,000

Lease payment $75,000 $75,000

Sinking fund payment $0 $0

Tax rate 40% 40%

Ratio Analysis 2003 2002

Liquidity Ratios

Current Ratio 3.14 3.50

Quick Ratio 2.65 2.92

Asset Management Ratios

Inventory Turnover 11.84 10.41

Days Sales Outstanding 82.89 85.73

Fixed Assets Turnover 6.78 8.58

Total Assets Turnover 1.46 1.44

Debt Management Ratios

Debt Ratio 49.46% 49.03%

Times-interest-earned ratio 7.10 4.63

EBITDA coverage ratio 1.71 1.42

Profitability Ratios

Profit Margin 6.90% 4.68%

Basic Earning Power 19.53% 14.35%

Return on Assets 10.06% 6.75%

Return on Equity 19.91% 13.25%

Market Value Ratios

Earnings per share $3.14 $1.90

Price-to-earnings ratio 5.50 7.78

Cash flow per share $3.88 $2.65

Price-to-cash flow ratio 4.45 5.58

Book Value per share $15.76 $14.31

Market-to-book ratio 1.09 1.03

a. Has Cumberland’s liquidity position improved or worsened? Briefly explain with supporting

financial ratios. Show your calculations.

b. Has Cumberland’s ability to manage its assets improved or worsened? Briefly explain with

supporting financial ratios. Show your calculations.

c. Has Cumberland’s ability to manage its debts improved or worsened? Briefly explain with

supporting financial ratios. Show your calculations.

d. How has firm’s profitability changed during the last year? Briefly explain with supporting financial

ratios. Show your calculations.

e. How has firm’s market value ratios changed during the last year? Briefly explain with supporting

financial ratios. Show your calculations.

Question 8. Review the file attachment from the CFA Institute. Prepare a short memo (< = three

pages) summarizing the key points and key take-away. Add charts / analytics / graphics if deemed

appropriate. (10 points)

The Readings Earning Quality & Equity Valuation.pdf

BONUS QUESTIONS FOR EXTRA CREDITS (CHALLENGING)

1. Swann Systems is forecasting the following income statement for the upcoming year:

Sales $5,000,000

Operating costs (excluding depreciation) $3,000,000

Gross margin $2,000,000

Depreciation $500,000

EBIT $1,500,000

Interest $500,000

EBT $1,000,000

Taxes (40%) $400,000

Net income $ 600,000

The company’s president is disappointed with the forecast and would like to see Swann generate

higher sales and a forecasted net income of $2,000,000. Assume that operating costs (excluding

depreciation) are always 60 percent of sales. Also, assume that depreciation, interest expense, and

the company’s tax rate, which is 40 percent, will remain the same even if sales change. What level of

sales would Swann have to obtain to generate $2,000,000 in net income? (6 points)

2. American Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern

Hardware. American’s analysts project that the merger will result in incremental free flows and

interest tax savings with a combined present value of $72.52 million, and they have determined that

the appropriate discount rate for valuing Eastern is 16 percent. Eastern has 4 million shares

outstanding and no debt. Eastern’s current price is $16.25. What is the maximum price per share that

American should offer? Show your calculations. (6 points)

3. Blazer Breaks, Inc. is considering an acquisition of Laker Showtime Company. Blazer expects

Laker’s NOPAT to be $9 million the first year with zero net investment in operating capital and zero

interest expense. For the second year, Laker is expected to have NOPAT of $25 million and interest

expense of $5 million. Also, in the second year only, Laker will require net investment in operating

capital of $10 million to finance future growth. Laker’s applicable marginal tax rate is 40 percent.

After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at a

constant rate of 4 percent. The firm has determined that Laker’s cost of equity is 17.5 percent. Laker

currently has no debt outstanding. Assume that all cash flows are end-of-year and that the Laker

acquisition will cost Blazer $45 million. Calculate the value to Blazer of Laker’s equity and determine

the NPV of the proposed acquisition to Blazer? Show your calculations. (8 points)

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