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FIN 534A

Advanced Corporate Finance I - Valuation

PRACTICE EXAM

I. Cost of Capital (20 points)

Open Seasme! (OPSM) is a large e-commerce company that provides a variety of consumer and business services via web portals.  It just went public with a recent IPO.  As a valuation consultant hired by the company, you need to estimate OPSM’s weighted average cost of capital (WACC).  OPSM has 10,000 shares outstanding, and its current market price is $40 per share.  The company also has $200,000 debt outstanding, selling at 95% of its par value with a yield of 3.1%.  Its current excess cash balance is at $350,000.  You know OPSM plans to keep its debt-to-value ratio constant at the current level.  Further you know that the risk-free rate is 2.8%, and the equity market risk premium is 5.5%.  However, because the company has only been listed on the stock exchange for a short time, you do not have an accurate assessment of its equity beta.  Thus, you have found BABA, a comparable firm in the same industry, and estimated the following data for BABA:

Suppose that BABA will keep its level of debt constant in dollar amount (i.e., permanent debt) regardless of how the market value of its equity changes.  Both companies have an effective corporate tax rate of 35%.  Compute OPSM’s WACC.

II. DCF & Relative Valuation (30 points)

Upon graduation, you become a junior equity analyst at Morgan Stanley covering the Retail sector.  Your first assignment is to value Walmart stock.  So excited to apply what you learned at Olin, you studied Walmart’s financial statements and calculated its free cash flow to be $12.895 billion for fiscal year 2017 (i.e., year 0).  The biggest challenge you see Walmart currently faces is the fierce competition over the Internet channel.  To transition from its traditional store strategy to one that focuses on e-commerce, Walmart has undertaken a few new initiatives such as developing a fully functional online division, competing with companies like Amazon and Alibaba through a possible price war, and starting a series of marketing and promotion campaigns.  Thus, you anticipate huge expenses related to these strategies, which will cause Walmart’s free cash flow to first decline, then gradually recover, and finally reach a steady state with constant growth.  More specifically, you project that Walmart’s free cash flow will drop by 3% next year (i.e., year 1), then drop again by 1% the following year (i.e., year 2), but grow by 1% during the third year (i.e., year 3).  Thereafter Walmart’s growth rate will stabilize at 3% perpetually.

The weighted cost of capital (WACC) for Walmart is 6.50%.  It currently holds (i) outstanding debt in the amount of $54.16 billion and (ii) excess cash in the amount of $15.84 billion.  There are 2.93 billion shares outstanding of Walmart stock.

a. (10 points)  Value Walmart stock using the Discounted Cash Flow (DCF) model.

To complement the DCF model you built in part a, you collected more information about Walmart and two comparable firms, Target and Walgreen, in the following table.

b. (4 points)  Value Walmart stock based on comparable firms’ PE ratio.

c. (8 points)  Value Walmart stock based on comparable firms’ Enterprise Value / EBITDA multiple.

d. (5 points)  Suppose that Walmart has a current stock price of $95.81 per share, a payout ratio of 57.71%, an expected EPS and dividend growth rate of 4.27%, and an equity cost of capital of 6.86%.  Calculate Walmart’s market-based PE ratio and fundamental-based PE ratio.  Based on the two PE ratios, is Walmart stock overvalued or undervalued?  Briefly explain why.

e. (3 points)  Calculate the market-based PEG ratio for Walmart.  Based on the PEG ratio, is Walmart stock overvalued or undervalued?  Briefly explain why.

III. Capital Budgeting (25 points)

July is the annual budgeting season at PTG Corporation, a global sports apparel and footwear company.  Each department submits budgeting proposals to the corporate finance department around this time in order to receive funding on projects for the next year.  The Outdoor & Action division proposes a new line of insulated winter jackets using a synthetic alternative to down that achieves phenomenal warmth in cold and wet weather.  This new project requires an initial investment (i.e., t=0) in fixed assets (machines, etc.) of $3,500,000, which will be depreciated straight-line to zero over seven years.  The division paid a marketing research company $750,000 last year and found that the potential sales volume for such a product will be 30,000 units in the first year (i.e., t=1), then grow by 25% to 37,500 units in the second year (i.e., t=2), but decline by 30% to 26,250 units in the third year (i.e., t=3), and become obsolete afterward.  To reach such sales volume, PTG needs to spend $1,000,000 as marketing expenses in the first year (i.e., t=1) to introduce this new line.  The proposed unit price is $280 per jacket.  Research also showed that 25% of the new jacket sales will come from PTG’s existing down jacket sales, which, however, will decline by $750,000 in annual sales due to competition outside PTG even if PTG does not introduce this new line of jackets.  In the meantime, the new jackets will boost the annual sales of insulated pants using the same synthetic material by $100,000.  Variable costs are estimated to be $150 per jacket, and fixed costs amount to $500,000 per year.  This new jacket will be produced on an existing production line that was purchased three years ago for $1,200,000, has a remaining book value of $480,000, and is currently idle.  A small apparel company has offered PTG, though, to rent this production line for $200,000 a year for the next three years.  The project requires an investment in net working capital of $800,000 at the beginning of the project (i.e., t=0) and then 20% of the sales revenue in each of the subsequent years (i.e., t=1, 2, 3).  At the end of the project (i.e., t=3), the fixed assets can be sold for $1,850,000, and 90% of the net working capital will be recovered (with the remaining 10% considered as a loss to the company).  The effective corporate tax rate is 40%, and the project cost of capital is 15%.

Compute the NPV of the project and decide whether the company should approve this budgeting proposal (i.e., whether to go ahead with the project).

Space to answer Question III:

IV. FCF & Change in Cash (25 points)

Given below are Microsoft’s financial statements for fiscal years 2015 and 2016.

Assume the following based on a 360-day year:

· Days in Inventory (DI) = 25

· Days Sales Outstanding (DSO) = 77

· Days Payables Outstanding (DPO) = 75

a. (6 points)  Calculate the six missing items on the Balance Sheet.

1. Accounts Receivable

2. Inventory

3. Net Fixed Assets

4. Accounts Payable

5. Long-term Debt

6. Total Liabilities and Shareholders’ Equity

b. (10 points)  Calculate Microsoft’s Free Cash Flow (FCF) in fiscal year 2016.

c. (9 points)  Using your calculation of FCF in part b, show what the company did with its free cash flow to result in the change in cash on its balance sheet between fiscal years 2015 and 2016.  That is, reconcile the change in cash.