Question #1:
If you were working as an analyst and you were asked to value Porter Inc, would you consider Porter's accounting earnings or cash flow?
A) Discuss the positive and negatives aspects of using discounted cash flow to value Porter Inc.
B) Discuss the positive and negatives aspects of using accounting earnings. Discuss the following comment. "I don't know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows."
C) Explain why terminal values in accounting-based valuation are significantly lower than those for discounted cash flow valuation.
Question #2:
Define free cash flows (FCF) used in discounted cash flow valuations, from both a debt and equity perspective together and from only an equity perspective. Provide the full formula and explain it.
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash flows to equity alone? Explain why and how.
All answers assume a tax rate > 0.
A) An increase in accounts receivable
b) A decrease in gross margins
C) An increase in property, plant, and equipment
D) An increase in inventory
E) Interest expense
F) An increase in prepaid expenses
G) An increase in notes payable to the bank
Question #3:
A) What will Porter's cost of equity be if the equity market risk premium is 5 percent, common equity beta is 0.8 and risk free rate is 3.4%?
B) Assume that Porter changes its capital structure so that its market value weight of debt to capital increases to 30%, and its after-tax interest rate on debt at this new leverage level is 3.5%. Assume that the equity market risk premium is 6.7%. What will be the cost of equity at the new debt level? What will be the new weighted average cost of capital?
Note that the beta of Porter's assets will not change, since its assets are unchanged. Will the equity beta increase to reflect the increased financial risk faced by shareholders.Explain your answer. Under the prior capital structure, where the pre-tax cost of debt was 4.4%, the risk premium was 6.7% and the risk free rate was 3.41%, Porter's debt beta was (4.4%-3.41%)/6.7% or 0.15. Given its equity beta of 0.8 and its debt weighting of 20%, what is the asset beta for the company?
Under the new capital structure, the debt beta will increase. If the after-tax cost of debt is 3.5%, and the tax rate is 38%, the pre-tax cost of debt is 5.65%, the debt beta will be (5.65%-3.41%)/6.7% or 0.33. What is the adjusted equity beta?
Explain the affect of making changes in capital structure on the firm's cost of equity or WACC.
Question #4:
Consider capital market efficiency.
A) Do you think that capital markets are efficient? Explain the different levels of efficiency.
B) If the capital markets are efficient. Some would argue that that they don't know why anyone would bother devoting their time to following individual stocks and doing fundamental analysis. The best approach is to buy and hold a well-diversified portfolio of stocks." Do you agree? Why or why not?
Question #5:
A) Explain the difference between fundamental and technical analysis? Can you think of any trading strategies that use technical analysis? What are the underlying assumptions made by these strategies?
B) Explain the value and usefulness of how ratio analysis and valuation help you do fundamental analysis. Also explain the value of doing strategy analysis.
Question #6:
Porter Inc.'s stock has a market price of $20 per share and a book value of $12 per share. Its cost of equity capital is 15% and its book value is expected to grow at 5% per year indefinitely,
A) What is the market's assessment of its steady state return on equity? Hint: Use the abnormal earnings formula.
B) If the stock price increases to $35 and the market does not expect the firm's growth rate to change, what is the revised steady state ROE?
Question #7:
A) Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Explain why the lender would want to include this type of restriction?
B) The CFO of Porter feels that he would never agree to a debt covenant that restricts his ability to pay dividends to his shareholders because it reduces shareholder wealth." Do you agree with this argument? Explain why or why not.
Question #8:
Porter Inc. is currently valued at $50 in the market. A potential acquirer believes that it can add value in two ways: $15 of value can be added through better working capital management, and an additional $10 of value can be generated by making available a unique technology to expand the target's new product offerings. In a competitive bidding contest, how much of this additional value will the acquirer have to pay out to the target's shareholders to emerge as the winner?
Question #9:
A leading gold mining company decides to acquire a technology company at a 50 percent premium. The acquirer argues that this move creates value for its own stockholders because it can use its excess cash flows from the gold mining business to help finance growth in the new technology segment. Evaluate the economic merits of this claim.
Question #10:
A) What are likely to be the long-term critical success factors for the following types of firms?
- A high-technology company, such as Microsoft
- For a large, low-cost retailer such as Walmart
B) How useful is financial accounting data for evaluating how well these two companies are managing their critical success factors? What other types of information would be useful in your evaluation? What are the costs and benefits to these companies from disclosing this type of information to investors?
Question #11:
Two years after a successful public offering, the CEO of a biotechnology company is concerned about stock market uncertainty surrounding the potential of new drugs in the development pipeline. In his discussion with you, the CEO notes that even though they have recently made significant progress in their internal R&D efforts, the stock has performed poorly.
A) What options does he have to help convince investors of the value of the new products? Which of these options are likely to be feasible?
B) Why might the CEO of the biotechnology firm be concerned about the firm being undervalued? Would the CEO be equally concerned if the stock were overvalued? Do you believe that the CEO would attempt to correct the market's perception in this overvaluation case? How would you react to company concern about market under- or overvaluation if you were the firm's auditor? Or if you were a member of the audit committee?