978-0133507676 Chapter 10 Part 1

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Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)

Chapter 10 Stock Valuation: A Second Look

10.1 The Discounted Free Cash Flow Model

1) The discounted free cash low model ignores interest income and expense but adjusts for

cash and debt directly, if free cash low is calculated based on EBIT.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

2) Year 1 2 3 4

Free Cash Flow$12 million $18 million $22 million $26 million

Conundrum Mining is expected to generate the above free cash lows over the next four

years, after which they are expected to grow at a rate of 6% per year. If the weighted

average cost of capital is 12% and Conundrum has cash of $80 million, debt of $60 million,

and 30 million shares outstanding, what is Conundrum’s expected terminal enterprise

value?

A) $413.4 million

B) $459.3 million

C) $505.3 million

D) $528.2 million

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

3) Year 1 2 3 4

Free Cash Flow $12 million $18 million $22 million $26 million

Conundrum Mining is expected to generate the above free cash lows over the next four

years, after which they are expected to grow at a rate of 5% per year. If the weighted

average cost of capital is 11% and Conundrum has cash of $85 million, debt of $65 million,

and 30 million shares outstanding, what is Conundrum’s expected current share price?

A) $12.61

B) $16.40

C) $20.18

D) $20.81

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

4) Year 1 2 3 4 5

Free Cash Flow$22 million $26 million $29 million $30 million

$32 million

General Industries is expected to generate the above free cash lows over the next ive

years, after which free cash lows are expected to grow at a rate of 5% per year. If the

weighted average cost of capital is 9% and General Industries has cash of $15 million, debt

of $45 million, and 80 million shares outstanding, what is General Industries’ expected

current share price?

A) $7.78

B) $8.17

C) $9.34

D) $11.67

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

5) Gonzales Corporation generated free cash low of $88 million this year. For the next two

years, the company’s free cash low is expected to grow at a rate of 10%. After that time,

the company’s free cash low is expected to level of to the industry long-term growth rate

of 4% per year. If the weighted average cost of capital is 12% and Gonzales Corporation

has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is

Gonzales Corporation’s expected terminal enterprise value in year 2?

A) $1384.24

B) $1245.82

C) $1107.39

D) $968.97

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

6) Gonzales Corporation generated free cash low of $81 million this year. For the next two

years, the company’s free cash low is expected to grow at a rate of 9%. After that time, the

company’s free cash low is expected to level of to the industry long-term growth rate of

4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation has

cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is

Gonzales Corporation’s expected free cash low in year 2?

A) $1429.79 million

B) $86.61 million

C) $1572.77 million

D) $96.24 million

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

7) Gonzales Corporation generated free cash low of $86 million this year. For the next two

years, the company’s free cash low is expected to grow at a rate of 10%. After that time,

the company’s free cash low is expected to level of to the industry long-term growth rate

of 4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation

has cash of $100 million, debt of $275 million, and 100 million shares outstanding, what is

Gonzales Corporation’s expected current share price?

A) $14.37

B) $11.87

C) $12.49

D) $16.24

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

8) Use the table for the question(s) below.

FCF Forecast ($ million)

Year 0 1 2 3 4

Sales 240 270 290 310 325.5

Growth versus Prior Year 12.5% 7.4% 6.9% 5.0%

EBIT (10% of Sales) 27.00 29.00 31.00 32.55

Less: Income Tax (37%) (9.99) 10.73 11.47 12.44

Less Increase in NWC (12% of Change in Sales 3.6 2.4 2.4 1.86

Free Cash Flow 13.41 15.87 17.13 18.65

Banco Industries expect sales to grow at a rapid rate over the next three years, but settle

to an industry growth rate of 5% in year 4. The spreadsheet above shows a simpliied pro

forma for Banco Industries. If Banco industries has a weighted average cost of capital of

11%, $50 million in cash, $80 million in debt, and 18 million shares outstanding, which of

the following is the best estimate of Banco‘s stock price at the start of year 1?

A) $6.52

B) $11.74

C) $13.04

D) $23.48

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

9) Use the table for the question(s) below.

FCF Forecast ($ million)

Year 0 1 2 3 4

Sales 240 270 290 310 325.5

Growth versus Prior Year 12.5% 7.4% 6.9% 5.0%

EBIT (10% of Sales) 27.00 29.00 31.00 32.55

Less: Income Tax (37%) (9.99) (10.73) (11.47) (12.44)

Less Increase in NWC (12% of Change in Sales 3.6 2.4 2.4 1.86

Free Cash Flow 13.41 15.87 17.13 18.65

Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an

industry growth rate of 5% in year 4. The spreadsheet above shows a simpliied pro forma

for Banco Industries. Banco industries has a weighted average cost of capital of 11%, $40

million in cash, $70 million in debt, and 18 million shares outstanding. If Banco Industries

can reduce its operating expenses so that EBIT becomes 12% of sales, by how much will its

stock price increase?

A) $3.27

B) $3.92

C) $5.72

D) $9.80

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

10) Which of the following is the appropriate way to calculate the price of a share of a

given company using the free cash low valuation model?

A) P0 = Div1/(rE – g)

B) P0 = PV(Future Free Cash Flow of Firm) / (Shares Outstanding0)

C) P0 = [Div1 / (rE – g)] / (Shares Outstanding0)

D) P0 = (V0 + Cash0 – Debt0) / (Shares Outstanding0)

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

11) If you want to value a irm that consistently pays out its earnings as dividends, the

simplest model for you to use is the ________.

A) enterprise value model

B) method of comparables

C) dividend-discount model

D) discounted free cash low model

AACSB Objective: Analytic Skills

Author: JN

Question Status: Revised

12) If you want to value a irm but do not want to explicitly forecast its dividends, the

simplest model for you to use is ________.

A) the discounted free cash low model

B) the dividend-discount model

C) the enterprise value model

D) None of the above models can be used if you do not want to forecast dividends or use of

debt.

AACSB Objective: Analytic Skills

Author: JN

Question Status: Revised

13) Which of the following statements is FALSE?

A) The more cash a irm uses to repurchase shares, the less it has available to pay

dividends.

B) Free cash low measures the cash generated by a irm after payments to debt or equity

holders are considered.

C) We estimate a irm’s current enterprise value by computing the present value (PV) of the

irm’s free cash low.

D) We can interpret the enterprise value of a irm as the net cost of acquiring the irm’s

equity, taking its cash, and paying of all debts.

AACSB Objective: Analytic Skills

Author: JN

Question Status: Revised

14) Which of the following statements is FALSE?

A) A irm’s weighted average cost of capital, denoted rwacc, is the cost of capital that

relects the risk of the overall business, which is the combined risk of the irm’s equity and

debt.

B) Intuitively, the diference between the discounted free cash low model and the dividend-

discount model is that in the divided-discount model, a irm’s cash and debt are included

indirectly through the efect of interest income and expenses on earnings in the dividend-

discount model.

C) We interpret rwacc as the expected return a irm must pay to investors to compensate

them for the risk of holding the irm’s debt and equity together.

D) When using the discounted free cash low model, we should use a irm’s equity cost of

capital.

AACSB Objective: Analytic Skills

Author: JN

Question Status: Revised

15) Which of the following statements is FALSE?

A) The long-run growth rate gFCF is typically based on the expected long-run growth rate

of a irm’s revenues.

B) Since a irm’s free cash low is equal to the sum of the free cash lows from the irm’s

current and future investments, we can interpret the irm’s enterprise value as the total net

present value (NPV) that the irm will earn from continuing its existing projects and

initiating new ones.

C) If a irm has no debt, then rwacc equals the risk-free rate of return.

D) When using the discounted free cash low model, we forecast a irm’s free cash low up

to some horizon, together with some terminal (continuation) value of the enterprise.

AACSB Objective: Analytic Skills

Author: JN

Question Status: Revised

16) What additional adjustments are required to ind the share price, in case we are using

the discounted cash low model?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Revised

10.2 Valuation Based on Comparable Firms

1) In the method of comparables, the known values of a irm’s cash lows are used to

estimate the unknown cash lows of a similar irm.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

2) Several methods should be used to provide an estimate of a stock’s value since no single

method provides a deinitive value.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

3) On a particular date, FedEx has a stock price of $89.27 and an EPS of $7.11. Its

competitor, UPS, had an EPS of $0.38. What would be the expected price of UPS stock on

this date, if estimated using the method of comparables?

A) $4.77

B) $7.16

C) $9.54

D) $10.50

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

4) Which of the following statements concerning the valuation of irms using the method of

comparables is FALSE?

A) If two diferent irms generate identical cash lows, the Law of One Price will imply that

both irms have the same value.

B) Comparables adjust for scale diferences when valuing similar irms.

C) Valuation multiples take into account diferences in the risk and future growth between

the irms being compared.

D) Two irms that sell very similar products or ofer very similar services will have diferent

values if they are of diferent sizes.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

Use the igure for the question(s) below:

5) On a particular date, the above information concerning Oice Depot, Incorporated, was

given on Google Finance. Its competitor, Staples Incorporated, had a stock price of $24.33.

Which of the following is closest to the EPS of Staples Incorporated if it is estimated using

valuation multiples based on price-earnings ratios?

A) $1.58

B) $1.84

C) $2.63

D) $14.15

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised