10408065

Problem Set I
1. Your business plan for your proposed start-up firm envisions first-year revenues of $120,000, fixed
costs of $30,000, and variable costs equal to one-third of revenue.
a. What are expected profits based on these expectations?

b. What is the degree of operating leverage based on the estimate of fixed costs and expected profits?
c. If sales are 10% below expectation, what will be the decrease in profits?
d. Show that the percentage decrease in profit s equals DOL times the 10% drop in sales.
e. Baled on the DOL, what is the largest percentage shortfall in sales relative to original expectations
that the firm can sustain before profits turn negative? What are break-even sales at this point?
f. Confirm your answer to ( e) is correct by calculating profits at the break-even level of sales.
2. The market consensus is that Analog Electronic Corporation has an ROE = 9%, a beta of 1.25, and it
plans to maintain indefinitely its traditional plowback ratio of 2/3. This year’s earnings were $3 per
share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is
14%, and T-bills currently offer a 6% return.
a. Find the price at which Analog stock should sell
b. Calculate the P/E ratio.
c. Calculate the present value of growth opportunities.
d. Suppose your research convinces you Analog will announce momentarily that it will immediately
reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. The market is still unaware of
this decision. Explain why V0 no longer equals P0 and why V0 is greater or less than P0.
3. The FI Corporation’s dividends per share are expected to grow indefinitely by 5% per year.
a. If this year’s year-end dividend is $8 and the market capitalization rate is 10% per year, what must
the current stock price be according to the DDM?
b. If the expected earnings per share are $12, what is the implied value of the ROE on future
investment opportunities?
c. How much is the market paying per share for growth opportunities (i.e., for an ROE on future
investments that exceeds the market capitalization rate)?
4. Imelda Emma, a financial analyst at Del Advisors, Inc. (DAI), has been asked to assess the impact that
construction of Disney’s new theme parks might have on its stock. DAL uses a dividend discount
valuation model that incorporates beta in the derivation of risk-adjusted required rates of return on
stocks.
Until now, Emma has been using a five-year earnings and dividends per share growth rate of 15%
and a beta estimate of 1.00 for Disney. Taking construction of the new theme parks into account,
however, she has raised her growth rate and beta estimates to 25% and 1.15, respectively. The
complete set of Emma’s current assumptions is:
Current stock price $37.75

Beta 1.15
Risk-free rate of return (T-bill) 4.0%
Required rate of return on the market 10.0%
Short-term growth rate (five years) for earnings and dividends 25.0%
Long-term growth rate (beyond five years) for earnings and dividends 9.3%
Dividend forecast for 2015 (per share) $.287
a. Calculate the risk-adjusted required rate of return on Disney stock using Emma’s current beta
assumption.
b. Using the results of part (a), Emma’s current assumptions, and DAI’s dividend discount model,
calculate the intrinsic, or fair, value of Disney stock at September 30, 2014.
c. After calculating the intrinsic value of Disney stock using her new assumptions and DAT’s
1
dividend discount model, Emma finds that her recommendation for Disney should be changed
from a “buy” to a “sell.” Explain how the construction of the new theme parks could have such a
negative impact on the valuation of Disney stock, despite Emma’s assumption of sharply higher
growth rates (25%).
d. Discuss advantages and disadvantages of using a constant-growth DDM. Briefly discuss how the
two-stage DDM improves upon the constant-growth DDM.
5. Recalculate the intrinsic value of Honda in each of the following scenarios by using the three-stage
growth model ofSpreadsheet18.1（available at www.mhhe.com/bkm; link to Chapter 18 material）under
each of following assumptions. Treat each scenario independently.
a. ROE in the constant growth period will be 10%.
b. Honda’s actual beta is 1.0.
c. The market risk premium is 8.5%
6. Recalculate the intrinsic value of Honda shares using the free cash flow model of Spreadsheet 18.2
(available at www.mhhe.com/bkm: Link to Chapter 18 material) under each of following assumptions.
Treat each scenario independently.
a. Honda’s P/E ratio starting in 2013 will be 16.
b. Honda’s unlevered beta is 0.8
c. The market risk premium is 9%
7. Eastover Company (EO) is a large, diversified forest products company. Approximately 75% of its
sales are from paper and forest products, with the remainder from financial services and real estate.
The company owns 5.6 million acres of timberland, which is carried at very low historical cost on the
balance sheet.
Peggy Mulroney, CPA, is an analyst at the investment counseling firm of Centurion Investments.
She is assigned the task of assessing the outlook for Eastover, which is being considered for purchase,
and comparing it to another forest products company in Centurion's portfolios, Southampton
Corporation (SHC). SHC is a major producer of lumber products in the United States. Building
products, primarily lumber and plywood, account for 89% of SHC's sales, with pulp accounting for
the remainder SHC owns 1.4 million acres of timberland, which is also carried at historical cost on
the balance sheet. In SHC's case, however, that cost is not as far below current market as Eastover's.
Mulroney began her examination of Eastover and Southampton by looking at the five components
of return on equity (ROE) for each company. For her analysis, Mulroney elected to define equity as
total shareholders' equity, including preferred stock. She also elected to use year-end data rather than
averages for the balance sheet items.
a. Based on the data shown in Tables A and B, calculate each of the five ROE components for
Eastover and Southampton in 2014. Using the five components, calculate ROE for both
companies in 2014.
Table A: Eaastover Company ($ millions, except for shares outstanding)

2010 2011 2012 2013 2014
Income Statement Summary
Sales $5,652 $6,990 $7,863 $8,281 $7,406
EBIT $568 $901 $1,037 $708 $795
Interest expense (net) -147 -188 -186 -194 -195
Income before taxes $421 $713 $851 $514 $600
Income taxes -144 -266 -286 -173 -206
2
Tax rate 34% 37% 33% 34% 34%
Net income $277 $447 $565 $341 $394
Preferred dividends -28 -17 -17 -17 0
Net income to common $249 $430 $548 $324 $394
Common shares outstanding
(millions) 196 204 204 205 201
Balance Sheet Summary

Current assets $1,235 $1,491 $1,702 $1,585 $1,367
Timberland assets 649 625 621 612 615
Property, plant, and equipment 4,370 4,571 5,056 5,430 5,854
Other assets 360 555 473 472 429
Total assets $6,614 $7,242 $7,852 $8,099 $8,265
Current liabilities $1,226 $1,186 $1,206 $1,606 $1,816

Long-term debt 1,120 1,340 1,585 1,346 1,585
Deferred taxes 1,000 1,000 1,016 1,000 1,000
Equity-preferred 364 350 350 400 0
Equity-common 2,904 3,366 3,695 3,747 3,864
Total liabilities and equity $6,614 $7,242 $7,852 $8,099 $8,265
Table B: Southampton Corporation ($ millions, except for shares outstanding)

2010 2011 2012 2013 2014
Income Statement Summary
Sales $1,306 $1,654 $1,799 $2,010 $1,793
EBIT $120 $230 $221 $304 $145
Interest expense (net) -13 -36 -7 -12 -8
Income before taxes $107 $194 $214 $292 $137
Income taxes -44 -75 -79 -99 -46
Tax rate 41% 39% 37% 34% 34%
Net income $63 $119 $135 $193 $91
Common shares outstanding (millions) 38 38 38 38 38
Balance Sheet Summary

Current assets $487 $504 $536 $654 $509
Timberland assets 512 513 508 513 518
Property, plant, and equipment 648 681 718 827 1,037
Other assets 141 151 34 38 40
Total assets $1,788 $1,849 $1,796 $2,032 $2,104
3
Current liabilities $185 $176 $162 $180 $1,962
Long-term debt 536 493 370 530 589
Deferred taxes 123 136 127 146 153
Equity 944 1,044 1137 1,176 1167
Total liabilities and equity $1,788 $1,849 $1,796 $2,032 $2,104
b. Referring to the components calculated in part (a), explain the difference in ROE for Eastover and
Southampton in 2014.

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Problem Set I

a. What are expected profits based on these expectations?

Current stock price $37.75

Table A: Eaastover Company ($ millions, except for shares outstanding)

Balance Sheet Summary

Current liabilities $1,226 $1,186 $1,206 $1,606 $1,816

Table B: Southampton Corporation ($ millions, except for shares outstanding)

Common shares outstanding (millions) 38 38 38 38 38

Balance Sheet Summary

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