Chapter 13 – Equity Valuation
CFA 5
Answer:
a. The value of a share of Rio National equity using the Gordon growth model and
k － g
0. 13 － 0. 12
b. The sustainable growth rate of Rio National is 9.97%, calculated as follows:
(
Beginning Equity
(
$30.16
)
$270.35
CFA 6
Answer:
i. Subtract investment in fixed capital: CFO does not take into
ii. Add net borrowing: CFO does not take into account the amount of
b. Note 1: Rio National had $75 million in capital expenditures during the year.
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Chapter 13 – Equity Valuation
In calculating FCFE, only cash flow investments in fixed capital should be
calculation is:
Note 3: The decrease in long-term debt represents an unscheduled principal
Note 4: On 1 January 2012, the company received cash from issuing 400,000
shares of common equity at a price of $25.00 per share.
respect to the issuance of new shares.
Note 5: A new appraisal during the year increased the estimated market
value of land held for investment by $2 million, which was not recognized
income is required.
c. Free cash flow to equity (FCFE) is calculated as follows:
FCFE = NI + NCC – FCINV – WCINV + Net borrowing
WCINV = investment in working capital
Million $ Explanation
NI = $30.16 From Table 13.6
NCC = +$67.17 $71.17 (depreciation and amortization from Table 13.6)
– $4.00* (gain on sale from Note 2)
FCINV = –$68.00 $75.00 (capital expenditures from Note 1)
– $7.00* (cash on sale from Note 2)
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Chapter 13 – Equity Valuation
WCINV = –$24.00 –$3.00 (increase in accounts receivable from Table 13.5) +
–$20.00 (increase in inventory from Table 13.5) +
–$1.00 (decrease in accounts payable from Table 13.5)
Net Borrowing = +(–$5.00) –$5.00 (decrease in long-term debt from Table 13.5)
FCFE = $0.33
*Supplemental Note 2 in Table 13.7 affects both NCC and FCINV.
CFA 7
Answer:
Rio National’s equity is relatively undervalued compared to the industry on a P/E-to-
Rio National
CFA 8
Answer:
Using a two-stage dividend discount model, the current value of a share of Sundanci is
calculated as follows:
V0=D1
(1+k)1+D2
(1+k)2+
D3
(k−g)
(1+k)2
=$0. 3770
1. 141+$0 . 4976
1 . 142+
$0 .5623
(0 .14−0 . 13)
1. 142=$43 . 98
where:
13-3
Chapter 13 – Equity Valuation
CFA 9
Answer:
a. Free cash flow to equity (FCFE) is defined as the cash flow remaining after
NWC
b. The FCFE model requires forecasts of FCFE for the high growth years (2014
The following table shows the process for estimating Sundanci’s current value
on a per share basis:
Free Cash Flow to Equity
Base Assumptions
Shares outstanding: 84 millions
Required return on equity (r): 14%
Actual
2013
Projected
2014
Projected
2015
Projected
2016
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Chapter 13 – Equity Valuation
Growth rate (g) 27% 27% 13%
Current value per share $40.7859****
c. i. The following limitations of the dividend discount model (DDM) are
addressed by the FCFE model. The DDM uses a strict definition of cash
flows to equity, i.e. the expected dividends on the common stock. In fact,
potential tax disadvantage of high dividends relative to the capital gains
achievable from retention of earnings.
ii. The following limitations of the DDM are not addressed by the FCFE model.
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Chapter 13 – Equity Valuation
period. For example, a longer period of high growth will lead to a higher
valuation, and there is the temptation to assume an unrealistically long period
of extraordinary growth. Second, the assumption of a sudden shift form high
growth to lower, stable growth is unrealistic. The transformation is more
likely to occur gradually, over a period of time. Given that the assumed total
horizon does not shift (i.e., is infinite), the timing of the shift form high to
stable growth is a critical determinant of the valuation estimate. Third,
because the value is quite sensitive to the steady-state growth assumption,
over- or under-estimating this rate can lead to large errors in value. The two
models share other limitations as well, notably difficulties inaccurately
forecasting required rates of return, in dealing with the distortions that result
from substantial and/or volatile debt ratios, and in accurately valuing assets
that do not generate any cash flows.
CFA 11
Answer:
a. The formula for calculating a price earnings ratio (P/E) for a stable growth firm
b. The P/E ratio is a decreasing function of riskiness; as risk increases the P/E ratio
13-6