FSA3321 (Moore)
Exam 4
Summer 1 - 2005
Fourth Examination – Finance 3321
Summer 1 - 2005 (Moore)
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Clearly Circle the BEST response for each of the following questions (Multiple Choice @4):
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
Consider the following information for Questions 1 through 3:
You have just estimated β for XYZ Corp. using the Capital Asset Pricing Model. Your
regression results follow. In addition, you also have performed research on the 10-K to get
the balance sheet information below. Your goal is to estimate the relevant costs of capital for
XYZ Corp. Assume that last year’s market return was 4% and the 5-year Treasury had a yield
of 3.5%. Also, you found the market risk premium over the last 3-years to be 3.5% and that
interest rates are not expected to change in the next 4 years. The Market Cap is $80 million.
Balance Sheet (Millions)
Estimation
R
2
Period
β
5-Year
2.00
5.25%
3-Year
2-Year
1.50
1.30
28.45%
68.55%
Published β
1.90
2004
Average
Interest
Rate
Total Assets
120
Current Liabilities
Long Term Liabilities
Long-term Debt
Pension Liabilities
10
2.00%
30
40
8.00%
12.00%
Book Value of Equity
40
1. Based on your analysis, what is the appropriate estimate of the cost of equity?
a. 5.25%
b. 10.00%
c. 11.00%
d. 13.00%
e. 13.50%
2. Compute the appropriate weighted-average cost of debt of XYZ Corp.
a. 2.44%
b. 3.08%
c. 7.33%
d. 9.25%
e. 10.29%
3. Assume the weighted average cost of debt is 8% and the appropriate Ke is 14%, compute
WACCBT.
a. 8%
b. 10%
c. 11%
d. 12%
e. 14%
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
4. Which of the following will cause estimated before-tax WACC to be most severely biased
upwards?
a. P/B > 1 and using the book value of liabilities instead of market value of liabilities.
b. P/B < 1 and using the book value of liabilities instead of market value of liabilities.
c. P/B > 1 and using the book value of equity instead of market value of equity.
d. P/B < 1 and using the book value of equity instead of market value of equity.
e. P/B > 1 and using the market value of equity instead of book value of equity.
5. Which of the following is true regarding the Residual Income Valuation Model.
a. It is devoid of financial theory
b. It has the least explanatory and predictive power of the models we have considered
c. It links accounting valuations of equity to market valuations of equity
d. Normalized earnings are based upon the equity investment and DRIP income
e. It has limited interpretations since it cannot be decomposed into value drivers
6. Assume you had just performed a valuation using the residual income model. You found
that 65% of the value was supported by the current book value; that 25% of the value was
supported by residual income forecast annual for the next 7 years and the remainder was
associated with terminal value computations. What type of firm are you valuing?
a. A manufacturer within a stable, mature industry
b. A new restaurant chain
c. A high tech company in a growing industry
d. A major retailer such as Wal-Mart
e. A University such as Texas Tech
7. Which of the following types of market return measures would be most appropriate for
estimating Beta for a large firm (greater than $4 billion market capitalization)?
a. S&P 500 monthly return
b. New York Stock Exchange Monthly Return
c. Dow Jones Industrial Average’s monthly return
d. A broad-based market composite return with representation of small, medium and large
cap firms
e. The 3-month treasury yield
8. What is the main disadvantage of using daily returns to compute the firm’s Beta?
a. The data is not available to the public
b. Daily returns are inconsistent with the theoretical model
c. Daily returns are computed only on a Monday through Friday basis, and weekends
(when markets are closed) renders the model useless
d. Daily returns are “noisy” and provide less explanatory power than longer-term
measures.
e. The true value of a firm’s Beta changes on a daily basis.
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
9. Which is correct regarding the Abnormal Earnings Growth valuation model?
a. Since the model incorporates cumulative dividend earnings, it is not appropriate for
valuing firms that don’t pay dividends
b. A firm that, on average, is forecast to have increasing ROE has negative AEG
c. A firm that, on average, is forecast to have decreasing ROE has negative AEG
d. A firm that increases dividends will increase the intrinsic value of the firm through AEG
e. A firm that decreases dividends will decrease the intrinsic value of the firm through AEG
10. The intrinsic P/B (Price to Book) multiple would be computed using:
a. Trailing EPS
b. The Current market price you observe
c. The Forecast Book value per share you prepare
d. The Intrinsic Market Price you estimate
e. The AEG you estimate
11. You are comparing the published P/E multiple with the intrinsic P/E multiple based on your
valuation of a company and they differ. Both ratios use the same earnings denominator.
Which of the following is correct?
a. Intrinsic P/E > Published P/E implies you believe the firm is undervalued
b. Intrinsic P/E < Published P/E implies you believe the firm is undervalued
c. The published P/E must be wrong
d. The intrinsic P/E must be wrong
e. None of the above must be true
12. Assume the market return and risk-free rate (both positive) remain unchanged. Which of
the following must be true if the firm’s Beta suddenly changes from 0.75 to 1.50?
a. The firms cost of equity doubles
b. The firm’s cost of debt decreases in direct proportion to the increase in the cost of
equity because the WACC must remain constant
c. The cost of equity for the firm decreases
d. The value of the equity is reduced by half
e. The share price will decrease
13. Which is correct regarding the Abnormal Earnings Growth valuation model?
a. Although the model incorporates cumulative dividend earnings, it is not appropriate for
valuing firms that don’t pay dividends.
b. A firm that, on average, has increasing ROE has positive AEG.
c. During periods when Residual Income is growing, AEG is constant for those periods.
d. A firm with forecast earnings growth less than Ke will increase shareholder value by
decreasing dividends.
e. A decrease in the cost of sales percentage will increase the AEG
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
14. You have the following per share information available. Residual Income (RI) in 2002 is
$(0.42), RI in 2003 is $0.58 and Residual Income in 2004 is $1.08. Assume Ke is 10% and
that dividends in 2002, 2003 and 2004 are $0.40, $0.50 and $0.60, respectively. EPS in
2002 and 2003 are $4.00 and $5.00. Compute the Earnings per share for 2004.
a. $5.00
b. $5.50
c. $5.95
d. $6.00
e. $6.35
15. You used the AEG model to value a non-dividend paying company that has Ke of 8% and
assumed the AEG after year 10 would be equal to zero. In performing sensitivity analysis,
you want to see the effect including a constant AEG perpetuity from year 11 onward of
$0.12 per share. The incremental impact on your intrinsic valuation would be:
a. $0.12 increase in the price per share
b. $1.50 increase in the price per share
c. $5.79 increase in the price per share
d. $8.68 increase in the price per share
e. $18.75 increase in the price per share
16. Old Reliable Manufacturing Company's stock has a market price of $40 per share and a
book value of $10 per share. If its cost of equity capital is 15 percent and its book value is
expected to grow at 5 percent per year indefinitely, what is the market’s assessment of its
steady state return on equity?
a. 25%
b. 30%
c. 35%
d. 40%
e. 45%
17. EBAY is a publicly traded internet-based world-wide garage sale broker. It’s P/B = 6;
Trailing P/E = 56; and Leading P/E = 34. Assuming EBAY has a cost of equity capital of
15% and that its ROE has been consistently at 13% for the past 3 years. What growth
rate in book value (per year) must EBAY average in the long run in order to support its
current stock price?
a. 2.60%
b. 5.34%
c. 15.00%
d. 15.4%
e. 17.8%
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
Computation of Valuation Models Section (Questions 18-25)
Use the following summary financial statement information and forecasts provided by TTU
Value-Metrics to answer the valuation questions in this section about Hi-Flyer Corp.
All Per Share
EPS
DPS
BVE (year end)
CFFO
CFFI
CFFF
BV Liabilities
Ke
Kd
WACC
Actual
31 Dec 2004
2.00
0.20
20.00
5.00
-3.00
-2.00
40.00
0.15
0.08
0.10
Estimated
31 Dec 2005
2.25
0.20
Estimated
31 Dec 2006
2.20
0.30
Estimated
31 Dec 2007
2.50
0.30
6.00
-2.50
-4.00
4.00
-4.00
2.00
6.00
-5.00
2.00
CFFO = Cash Flow from operating activities
CFFI = Cash Flow from investing activities
CFFF = Cash Flow from financing activities
18. (Residual Income Valuation). Compute the book value of equity at the end of 2007.
a. $22.05
b. $23.95
c. $26.15
d. $28.52
e. $28.75
19. (Residual Income Valuation). Compute the normal income for 2006.
a. $2.0000
b. $3.0000
c. $3.3075
d. $3.5925
e. $3.9225
20. (Residual Income Valuation). Compute the intrinsic value of Hi-Flyer’s shares at the end of
2004. Assume residual income will be $1.50 in 2008 and no growth.
a. $24.37
b. $25.38
c. $27.59
d. $30.03
e. $34.41
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FSA3321 (Moore)
Exam 4
Summer 1 - 2005
21. (Residual Income Valuation - sensitivity). Assume the residual income perpetuity in the
previous problem was changed to $1.00 beginning in 2008 with a -20% growth rate. By
how much will this change the estimated share price computed in the previous problem?
a. $0.50 lower
b. $2.86 lower
c. $4.70 lower
d. $19.67 lower
e. Cannot be determined
22. (AEG Valuation). Compute the dividend reinvestment income (DRIP) for 2006.
a. $0.020
b. $0.030
c. $0.045
d. $0.200
e. $0.300
23. (AEG Valuation). Assume the dividend reinvestment income (DRIP) in 2007 is $0.045,
compute the AEG for 2007.
a. -$0.3100
b. -$0.3575
c. $0.0150
d. $0.2588
e. $0.2800
24. (AEG Valuation). Compute Cumulative Dividend Income (CDI) for 2006.
a. $2.20
b. $2.23
c. $2.25
d. $2.59
e. $2.86
25. (AEG Valuation). Assume that AEG is forecast to be $0.05 per year from 2008 onwards.
Estimate the intrinsic value of Hi-Flyer’s shares at the end of 2004.
a. $12.50
b. $14.75
c. $15.00
d. $15.25
e. $15.50
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