Prepared for Jia Jia

4/5/2014

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Equity – Yee
Chan Mei Yee is valuing McLaughlin Corporation common shares using
a free cash flow approach. Yee gathered information about McLaughlin
from several sources. She begins her analysis by determining free cash
flow to the firm (FCFF) and free cash flow to equity (FCFE) for the 2012
fiscal year, using the financial statements in Exhibits 1 and 2.
McLaughlin’s fiscal year ends 31 December.

Exhibit 1
McLaughlin Corporation
Selected Financial Data
($ millions, except per share amounts)

For Year Ending 31 December 2012

Revenues $6,456
Earnings before interest, taxes, depreciation, and 1,349
amortization (EBITDA)
Depreciation expense 243
Operating income 1,106
Interest expense 186
Pretax income 920
Income tax (32%) 294
Net income $626

Number of outstanding shares (millions) 411

2012 earnings per share $1.52
2012 dividends paid (millions) 148
2012 dividends per share 0.36
2012 fixed capital investment (millions) 535

Cost of equity 12.0%

Weighted average cost of capital (WACC) 9.0%

Exhibit 2
McLaughlin Corporation
Consolidated Balance Sheets
($ millions)

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 as of 31 December

Assets 2012 2011

Cash and cash equivalents $32 $21

Accounts receivable 413 417

Inventories 709 638

Other current assets 136 123

Total current assets $1,290 $1,199

Current liabilities $2,783 $2,678

Long-term debt 2,249 2,449

Common stockholders’ equity 1,072 594

Total liabilities and stockholders’ equity $6,104 $5,721

Yee plans to perform two different valuations of McLaughlin, which she

calls the “base case” valuation and the “alternative” valuation. Critical
assumptions for each are given in the following lists.

Base case valuation

 2013 FCFF will be $600 million.
 Beyond 2013, FCFF will grow in perpetuity at 4% annually.
 The market value and book value of McLaughlin’s
long-term debt are approximately equal.
Alternative valuation
2013 earnings per share (EPS) will be $1.80.EPS will grow
forever at 6% annually.For 2013 and beyond:
 net capital expenditures (fixed capital expenditures minus
depreciation) will be 30% of EPS.
 Investments in working capital will be 10% of EPS.
 Of future investments, 60% will be financed with equity
and 40% will be financed with debt

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Yee is also concerned about the effects on McLaughlin’s 2013 FCFE of
the following three possible financial actions by McLaughlin during the
year 2013:
 Increasing common stock cash dividends by $110 million
 Repurchasing $60 million of common shares
 Reducing its outstanding long-term debt by $100 million

Melissa Nicosia, Yee’s supervisor, reviews McLaughlin’s valuations.

Specifically, Nicosia makes the following three statements:

1. The free cash flow valuation approach is superior to the discounted

dividend valuation approach because the company’s dividends have
been substantially different from its FCFE.
2. Because the company’s capital structure seems unstable, the FCFE
valuation approach is superior to the FCFF valuation approach.
3. If there is a change in control at McLaughlin, the discounted dividend
valuation approach would be superior to a free cash flow valuation
approach.

Question
1. McLaughlin’s FCFF ($ millions) for 2012 is closest to:
A.$485.
B.$418.
C.$460.

2.Assuming 2012 FCFF equals $500 million, McLaughlin’s FCFE

($ millions) for 2012 is closest to:
A.$174.
B.$574.
C.$114.

3.Using Yee’s base case valuation assumptions and the FCFF valuation
approach, the year-end 2012 value per share of McLaughlin common
stock is closest to:
A.$29.20.
B.$12.78.
C.$23.73.

4.Using Yee’s alternative valuation assumptions and the FCFE valuation

approach, the year-end 2012 value per share of McLaughlin’s common
stock is closest to:
A.$24.17.
B.$22.80.
C.$18.00.

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5.The most likely combined effect of the three possible financial actions
identified by Yee will reduce McLaughlin’s 2013 FCFE ($ millions) by:
A.$100.
B.$270.
C.$160.

6.Which of Nicosia’s three statements pertaining to McLaughlin’s

valuation is the most accurate? Statement:
A. 2
B. 3
C. 1

Equity – TCC
Telco Cross Company (TCC) is a leading producer of fiber optic
equipment used for broadband communication through Central and
South America. TCC’s headquarters are located in Panama, where, in
addition to the Panamanian balboa, the U.S. dollar is an official currency.
On 31 December 2012, the company’s board of directors met and
determined it will look to grow its market share by acquiring a rival firm,
Latino Telecom.

TCC hires Daniel Bourne to determine an appropriate fair value range

for Latino Telecom as well as the firm value of TCC should it decide to
issue its own shares to complete the acquisition. Bourne plans to use
three valuation techniques and notes the following:
Market-based method: Yields a market-estimated fair stock
price for the target company. To estimate a fair takeover price,
analysts must additionally estimate a fair takeover premium and
use that information to adjust the estimated stock price.
Discounted cash flow (DCF) method: A potential
disadvantage is that estimates of discount rates can change
over time because of capital market developments, which can
also significantly affect acquisition estimates.
Comparable transactions method: An analyst uses details
from recent takeover transactions for comparable companies to
make direct estimates of a target company’s takeover value.
Similar to the market-based observation, it is necessary to
separately estimate a takeover premium.

Bourne starts by researching the fiber optics industry and the forces that
affect its competitive dynamics. He highlights the following items from a
recent industry trade journal:
 The industry is dominated by a small number of companies
that deal with one another and with outside customers. The

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 manufactured products use advanced technology and require
a high degree of product reliability.
 Products are designed to meet specific customer
requirements and usually include extensive set-up and
training costs.
 The main customers for the industry are module
manufacturers. These module manufacturers have
experienced high demand for optical components with the
move to replace voice-based with optical networking
equipment. Module fiber optic manufacturing is noted for
smaller production amounts and rapidly evolving product
cycles that keep profit levels low.

Next, Bourne considers a price-to-sales ratio (P/S) approach to analyze

Latino Telecom. He plans to calculate the firm’s justified P/S using the
information in Exhibit 1.

Exhibit 1
Latino Telecom Data

Required rate of return on equity 13.0%

Weighted average cost of capital (WACC) 16.0%
Long-term profit margin 8.0%
Projected dividend payout ratio 80.0%
Expected long-run earnings growth rate 4.8%

Bourne analyzes Latino Telecom in greater detail and determines that its
home market experiences high, unpredictable, and volatile rates of
inflation. To help calculate the company’s required rate of return, he
uses the following:

Exhibit 2
Basis for Calculating Latino Telecom’s Return

Real country return 8.60%

Rate of inflation 4.45%
Industry 1.60%
Size 1.45%
Leverage –0.85%

Bourne purchases an outside research report that concludes a real

required rate of return on equity of 11.5% is appropriate for Latino
Telecom. He uses this rate of return and the data in Exhibit 3 to calculate
value of the firm’s equity.

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Exhibit 3
Latino Telecom Data
(Current Year)

Normalized free cash flow to the firm (FCFF) $84 million

Interest expense $36 million
Tax rate 40.0%
Net borrowing $52 million
Long-term real growth rate 3.0%

Comfortable with the state of his work based on market comparables,

Bourne finally turns his attention to valuing TCC using a DCF analysis
based on the company information in Exhibit 4.

Exhibit 4
TCC Data

Current FCFF $467.25 million

Weighted average cost of capital 9.6%
Growth rate of FCFF estimates
Years 1 and 2 15.0%
Years 3 and 4 10.0%
Year 5 and thereafter 3.0%

Question
1.Which of the notes made by Bourne regarding the valuation methods
is least accurate? The note about the:
A.Discounted cash flow method.
B.Comparable transactions method.
C.Market-based method.

2.From his review of the industry trade journal, the most appropriate
conclusion that Bourne can make is that:
A.customer switching costs reduce the threat of new entrants.
B.fiber optic customers have high bargaining power
C.an opportunity for the industry is to forward integrate into module
manufacturing.

3.Based on the data in Exhibit 1, Bourne's estimate of the justified

price-to-sales ratio for Latino Telecom is closest to:
A.0.82
B.0.78
C.0.60

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4.Using the data in Exhibit 2, Latino Telecom's real required rate of
return is closest to:
A.10.80%.
B.15.25%.
C.11.65%.

5.Using the real required rate of return Bourne obtains from the outside
analyst's report and the data in Exhibit 3, Latino Telecom's firm's equity
value ($ millions) is closest to:
A.1,212.
B.1,386.
C.1,025.

6.Using the data in Exhibit 4, Bourne's calculation of TCC's firm value

($ millions) is closest to:
A.10,127.
B. 9,892
C. 9,639

Equity – Mendosa
Miranda Mendosa, equity analyst at San Antonio Investment Research
Group (SIRG), begins valuing Premier Riverboats, Inc. (PRBI), a thinly
and infrequently traded stock on a regional stock exchange.

For estimating PRBI’s required return on equity, Mendosa uses the

capital asset pricing model (CAPM) approach; but she thinks its own
equity beta of 1.20 is not very reliable because of the stock’s extremely
thin trading volume. Therefore, she obtains the beta and other pertinent
data for Supreme River Navigators Co. (SRNC) (see Exhibit 1), a
midsized company in the same industry with high market liquidity trading
on the NASDAQ, and re-levers it to reflect PRBI’s financial leverage.

Exhibit 1
Comparative Data for Valuation

PBRI Data SRNC Data

Equity beta 1.20 1.60
Debt ratio (Debt/Total assets) 0.20 0.60

Because of the recent expansion and beautification of the San Antonio

Riverwalk along with a substantial growth in tourism, PRBI has been
experiencing double-digit growth rates in revenues and cash flows and
high growth is expected to persist for 10 more years. Considering these
facts, Mendosa decides to first determine PRBI’s present value of
growth opportunities (PVGO). Next, she estimates the value of its stock

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using the H-Model. The data and estimates she has compiled for this
purpose are in Exhibit 2.

Exhibit 2
PRBI’s Data and Estimates for PVGO and H-Models

Required return on equity 12.40%

Weighted average cost of capital (WACC) 10.60%
Dividend payout ratio 60%
Most recent earnings per share $5.33
Dividends and earnings growth rate over next 10 years (i.e., 15.00%
Years 1 to 10)
Dividends and earnings growth rate after Year 10 4.00%
Current stock price $70.00

Venkat Raman, chief investment strategist at SIRG, reviews Mendosa’s

use of the CAPM, PVGO, and H-model in her work and makes the
following three comments:

1. The PVGO correctly reflects the value of PRBI’s options or future

opportunities to invest, but it ignores the value of its real options (i.e.,
options for modifying or abandoning its current projects).

2. The CAPM is a widely accepted approach for estimating the required

return on equity. But for such individual securities as PRBI, the
idiosyncratic risk can overwhelm the market risk, thereby making beta a
poor predictor of the stock’s future average return.

3. Although the H-model is appropriate for PRBI, the high-growth

remains constant throughout the supernormal growth period and then
the low-growth period begins abruptly.

Next, Mendosa and Raman have a discussion about other approaches

that might be appropriate for valuing PRBI’s stock. They make the
following statements:

Statement 1—Raman: Because PRBI’s management is actively

seeking opportunities to be acquired, the guideline transactions method
(GPCM) would be most appropriate. It establishes a value estimate
based on pricing multiples derived from the acquisition of control of
entire public or private companies. Specifically, it uses a multiple that
relates to the sale of entire companies.

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Statement 2—Mendosa: We could also value PRBI using the free cash
flow to equity (FCFE) model. But in order to support its rapid growth, the
company is expected to significantly increase its net borrowing every
year for the next three to five years, and during those years, it could
have a significant dampening effect on the company’s FCFE and thus a
lower value for its equity.

Statement 3—Raman: I agree. The residual income (RI) model, also

called the “excess earnings method,” does not have the same weakness
as the FCFE approach because residual income is an estimate of the
profit of the company after deducting the cost of all capital: debt and
equity. Furthermore, it makes no assumptions about future earnings and
the justified P/B is directly related to expected future residual income.

Raman collects additional data for valuing PBRI using the multistage RI
model. For this model, he assumes an annual growth rate of 15% during
the forecast horizon of 5 years (Years 1 to 5) and discounts the terminal
year’s residual income as a perpetuity. Other inputs are found in Exhibit
3.

Exhibit 3

Data for Residual Income Model

Cost of
Current year net
$8.0 million equity 12.40%
income
capital

Interest expense $1.2 million WACC 10.60%

Equity capital book

$20.97
value, beginning of Tax rate 40%
million
year

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Question
1.Using the data in Exhibit 1, Mendosa's estimate of PBRI's beta is
closest to:
A. 0.96.
B.1.20.
C.0.80.

2.Using the data in Exhibit 2, the estimate of PRBI's present value of

growth opportunities (PVGO) is closest to:
A.$20.57.
B.$40.34.
C.$27.02.

3.Using the data in Exhibit 2, the estimate of PRBI's stock according to

the H-model is closest to:
A.$77.12.
B.$64.76.
C.$60.60.

4.In regard to the comments by Raman, he is most accurate with respect

to the:
A.H-model.
B.PVGO.
C. CAPM

5.In regard to the discussion on other approaches between Mendosa

and Raman, which of the following statements that they make is most
accurate? Statement:
A. 2
B. 3
C. 1

6.Using the data in Exhibit 3, Raman’s estimate of the contribution that

the terminal value of the residual income stream in 5 years will contribute
to the current value of equity (in $-millions) is closest to:
A.$61.91.
B.$42.25.
C.$48.82.

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