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Investments

At Home Mid-Term Exam 2

Fall 2022

36 Questions; 18 points

Part I: [Multiple Choice and Calculated Answers] [1/2 point each]

1. The common stock of Siegfried, Inc, a metal refining company, currently trades at $72 per share.  The firm is expected to earn $5.92 per share this year and is forecast to pay a dividend of $3.42 in one year.  The company is thought to be in a mature industry and is expected to have constant growth in the future.  If investors require an 8.5% return, what is the consensus growth rate for the firm?

a. 3.75%

b. 4.75%

c. 9.50%

d. 12.25%

e. 13.25%

2. You work for the CEO of a newly incorporated company that plans to acquire long-forgotten songs, like “Let’s Do Something Cheap and Superficial”, “Take This Job and Shove It”, and the “Mother-in-Law Song” and promote them to increase their popularity to earn royalties. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is the ROE when using financial leverage minus the ROE when using no financial leverage?

	0% Debt	60% Debt
Operating income (EBIT)	$400,000	$400,000
Required investment	$2,500,000	$2,500,000
% Debt Financing	0.0%	60.0%
$ of Debt Financing	$0.00	$1,500,000
$ of Common Equity Financing	$2,500,000	$1,000,000
Interest rate	NA	8.00%
Tax rate	25%	25%

  a.  5.85%

  b.  6.14%

  c.  7.45%

  d.  8.77%

  e.  9.00%

3. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks prices are in equilibrium – i.e. – prices are equal to their intrinsic value, which of the following statements is CORRECT?

a.  The two stocks should have the same expected dividend.

b.  The two stocks could not be in equilibrium with the numbers given in the question.

c.  A's expected dividend is $0.50.

d.  B's expected dividend is $0.75.

e.  A's expected dividend is $0.75 and B's expected dividend is $1.20.

4. Recall the Value of the Firm₀ = Ʃ  FCF_t / [1 + WACC]^t with t from 1 to ∞. The owners of Martial Arts Inc. [the owner/operator of a chain of karate dojos] are considering selling their business to a private equity firm.  Next year’s end-of-year free cash flow (FCF₁) is expected to be $1.25 million, lower than recent years due to a major expansion.  Free Cash Flow is expected to grow at the rates shown in the table below thereafter.  Beginning in year 7 a constant growth rate of 4% is forecast.  The company's WACC is 6.50%.  What is the estimated intrinsic value of the firm in millions of dollars? Round to two decimals.

a.  $54.57

b.  $68.15

c. $70.31

d.  $83.63

e.  $98.28

5. Refer to the previous question about Martial Arts Inc. The company has $27 million of long-term debt plus preferred stock outstanding and there are 2.1 million shares of common stock outstanding.  The $27 million is the combined market value of the debt and preferred stock. The firm does not hold excess cash.  Some believe, with some justification, the book value should be used but that is not consistent with the WACC calculation so theoretically market values should be used.  What is the firm's estimated intrinsic value per share of common stock? Round to one cent.

a.  $17.57

b.  $18.25

c.  $18.86

d.  $20.63

e.  $21.47

6. TPP Inc., which owns and operates a chain of tattoo and piercing parlors, was founded 10 years ago. It has been profitable for the last 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated it plans to pay $0.40 dividend 2 years from today, then to increase it at a relatively rapid rate for several years and then to increase it at a constant rate of 3.0% thereafter, as shown in the table below.  Management’s credibility with investors is high and it is believed the current price of the stock, $19, represents fair value – i.e. - the market price is equal to its intrinsic value, or is in equilibrium.   What is the expected rate of return on the common stock?

a. 5.00%

b.  6.16%

c. 6.34%

d. 6.27%

e. 7.54%

7. You must decide whether to produce “Straight Out of New Canaan”, a biographical film about four thugs who acquire fortune and fame as “gansta” rappers.  The budget, or initial investment, to produce the film and the cash flows it is forecast to generate are shown in the table below.  Beyond year 5, the film is expected to earn a cash flow of $200,000 perpetually.  What is the “Internal Rate of Return” or return that would be earned if the forecast is accurate?  This can only be answered by “trial and error”.  The process can be expedited by creating a program in SAS or SPSS or by using Excel to enter cash flows and test various rates of return.  Round the answer to one one-hundredth of a percent – i.e. - 1 basis point.

Rate of Return:

8. Suppose research has shown that "common stocks", as measured by the Standard & Poor's 500, have had an average cash flow payout ratio of 35%.  We forecast the average cash flow payout ratio will continue at 35% and that cash flows will grow by an average of 3.50% annually over the long term.  With long-term Treasury bond rates yielding 1.70%, we decide a "fair" rate of return on equities is 5.50%.  The PE Ratio on the S&P 500 should be approximately:

a.  3.89. d. 17.50.

b.  5.00. e. 23.72.

c. 11.86. f. 40.00.

9. With reference to question #8, assume inflationary expectations rise by 1%.  As a result, interest rates rise by 1%, but, suppose now that our forecast of nominal dividend growth also rises by 1% to 4.50%.  In this scenario, the "market" PE Ratio should be expected to:

a. Increase.

b. Decrease.

c. Remain unchanged.

d. all of the above.

e. none of the above.

10. Your answer to question #9 should lead you to conclude that:

a. Over the long term, equities are not a good hedge against inflation.

b. Over the long term, equities could be a good hedge against inflation.

c. Over the long term, the return on equities and inflation are not related.

d. all of the above are true.

e. none of the above are true.

11. 
To determine the Intrinsic Value of a common stock, you forecast the cash distributions per share shown below for the next four years.  The cash distributions are growing at a rate above the company’s long-term growth rate because the next four years are expected to be exceptionally profitable.  The most recent cash flow was $1.20 for fiscal year 2022, which ended September 30 - i.e. - CD₀ = $1.20].  It is the beginning of fiscal year 2023.  Beyond 2026, you forecast that the cash flow will grow at a constant rate of 3.50%.  You select a rate of return of 7.75% for this stock based on current interest rates and what you believe is a “reasonable” risk premium.  What is the Intrinsic Value of the stock as of time zero? Round to one cent.

Year	1	2	3	4
	2023	2024	2025	2026
	CD1	CD2	CD3	CD4
Cash Flow Distribution Forecast	$1.45	$1.65	$1.90	$2.20

Intrinsic Value:

Questions 12 and 13 are based on the information below.

An older article in The Wall Street Journal included the following paragraph: “Based on the S&P 500’s current multiple of 16.8 times earnings over the past 12 months, according to Thomson Reuters, investors are anticipating modest inflation.  Since 1950, in periods when inflation ran between 2% and 4% [as it has through much of this decade], stocks traded at an average price/earnings ratio of 17.4, according to Strategas Research Partners.  But in a 4% to 6% inflation environment, the average P/E ratio dropped to 14.7.

12. Use the data to calculate the Rate of Return based on the Earnings Yield model for time periods when inflation ranged from 2% to 4%.  Use the mid-point of the inflation range to derive the numbers and enter your answer as a percentage rounded to 2 decimals.

Rate of Return:

13. Use the data to calculate the Rate of Return based on the Earnings Yield model for time periods when inflation ranged from 4% to 6%.  Use the mid-point of the inflation range to derive the numbers and enter your answer as a percentage.

Rate of Return:

Questions 14 through 20 use the information given below.

The common stock of Permanent Assurance Corporation currently trades at $40.00 per share, which is approximates its intrinsic value. The company has announced plans to maintain its dividend next year at $1.20 per share.  Your research indicates that historically, the firm's dividend payout ratio has averaged 50% while its return on equity averaged 9.0%.  The book value of the shares is $25.00 and research shows there is relatively low variation in the firm's operations.  You believe the firm's payout ratio and ROE should continue at their historic levels in the future over the long term.  Enter your answers on the spreadsheet.

14. Calculate the dividend yield of the firm's shares based on the announced dividend and rounded to 2 decimals:

Dividend Yield:

15. Estimate the long-term dividend yield based on the firm’s financial and operational performance based on the absolute approach and round to 2 decimals.

Long-term dividend yield:

16. Estimate the long-term growth rate for the firm’s EPS, cash flow, and dividends based on the absolute approach and round to 2 decimals.

Long-term growth rate:

17. Estimate the expected annual rate of return on the common over the long term based on the absolute approach and round to 2 decimals.

Expected annual rate of return:

18. Estimate the firm's PE multiple over the long term based on the absolute approach and round to 2 decimals.

PE multiple:

19. If the firm's ROE is forecast to decline to 8% in the future due a change in industry conditions, the firm's growth would be expected to:

a. Increase.

b. Decrease.

c. Remain unchanged.

d. There is not enough information to answer the question.

e. None of the above answers is correct.

20. If the firm's ROE is forecast to decline to 8% in the future due a change in industry conditions, the firm's long term PE multiple would be expected to:

a. Increase.

b. Decrease.

c. Remain unchanged.

d. There is not enough information to answer the question.

e. None of the above answers is correct.

21. Stellar Aeronautics, Inc. is trading at a trailing PE of 13.6.  Analysts forecast Stellar’s dividends will continue to grow at its recent rate of 4.50% annually into the indefinite future.  The dividend paid in 2022 was $0.60 per share while EPS were $1.50.  You select a rate of return of 8%.  Stellar’s stock is:

a. Undervalued.

b. Overvalued.

c. Fairly valued.

d. Cannot be determined from the information given.

e. None of the above answers is correct.

22. Using the financial data at the top of the  Exhibit spreadsheet labeled Exhibit I for the Cigarette and Liquor Warehouse Stores, Inc., calculate fiscal 2022 EBITDA.  You estimate the firm holds $28 million of excess cash on September 30, 2022.  Answer in millions and round to one decimal.

EBITDA:

23. Using the financial data in Exhibit I for the Cigarette and Liquor Warehouse Stores, Inc., calculate fiscal 2022 Free Cash Flow of the Firm.  You estimate the firm holds $28 million of excess cash on September 30, 2022.  Answer in millions and round to one decimal.

Free Cash Flow to the Firm:

24. Using the financial data in Exhibit I for the Cigarette and Liquor Warehouse Stores, Inc., calculate fiscal 2022 Free Cash Flow of the Common Equity.  You estimate the firm holds $28 million of excess cash on September 30, 2022.  Answer in millions and round to one decimal.

Free Cash Flow to Common Equity:

25. For 2023, Volant Inc. is forecast to have Free Cash Flow to the Firm of $1.7 million and Free Cash Flow to Common Equity of $1.3 million.  You forecast Free Cash Flow to the Firm to grow at a constant rate of 3.50% while Free Cash Flow to Common Equity grows at 4.00%.  Volant’s tax rate is forecast to be 25%.  You also collect the data shown below.

Book Value Market Value

Debt $14.5 million $15.0 million YTM: 4.24%

Common Equity $21.0 million $45.0 million Rate of Return: 7.00%

Calculate Volant’s Weighted Average Cost of Capital and round to 1 basis point.

WACC:

26. Using the information in question 25, calculate the intrinsic value of Volant’s common equity using Free Cash Flow to the Firm.  Answer in millions and round to one decimal.

IV:

27. Using the information in question 25, calculate the intrinsic value of Volant’s common equity using Free Cash Flow to Common Equity.  Round to 2 decimals.

IV:

28. The data for questions 28 through 36 is at the bottom of the Exhibit spreadsheet labelled Exhibit II.  PACCAR is a manufacturer of trailer-truck cabs and demand for cabs is cyclical.  PACCAR shares are currently priced at $101.  Data for fiscal 2022, which ends on December 31, is forecast and you believe the 2012 to 2022 data reasonably reflects profitability over a business cycle [in reality it likely does not].  The Rate of Return required on PACCAR common is estimated at 8.50%.  Using the data from 2012 through 2022, calculate normalized EPS for PACCAR using the average EPS.  Round to 1 cent.

Normalized EPS:

29. Based on the normalized EPS, what is the PE Ratio? Round to 2 decimal places.

PE Ratio:

30. What is the average Return on Equity, or ROE, for PACCAR?  Round to 2 decimal places or 1 basis point.  Note the critical format for ROE is EPS_t / Book Value_t-1 or Net Income_t / Common Equity_t-1.

Average ROE:

31. Calculate a normalized EPS forecast for fiscal 2023 using the average ROE and round to 1 cent.

Normalized EPS based on ROE:

32. Based on the normalized EPS forecast for 2023 using average ROE, what is the PE Ratio? Round to 2 decimal places.

PE Ratio:

33. Calculate PACCAR’s Residual Income per share for 2021 and round to one cent.

2021 Residual Income per share:

34. Calculate PACCAR’s Residual Income per share for 2022 and round to one cent.

2022 Residual Income per share:

35. You forecast future Returns on Equity as shown on the Exhibit.  Beginning in 2023, ROE is expected to decline to 16% and then proceed through a cycle and reach a steady state, long-term ROE of 15% in 2028.  PACCAR’s payout ratio is forecast to remain at 50% in the future.  The consensus Rate of Return on PACCAR common is 8.50%.  At the end of the forecast horizon, the premium of intrinsic value over book value is forecast to be 40%.  Calculate the Intrinsic Value of a share of common and round to one cent.

IV₀:

36. Rather than forecast the premium of intrinsic value over book value, Book Value is forecast to grow at a constant 2.50% beginning in 2029.  Calculate the Intrinsic Value of a share of common and round to one cent.

IV₀: