FSA3321 (Moore)
Exam 3
Fall 2006
Third Examination – Finance 3321
Fall - 2006 (Moore)
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Clearly Circle the BEST response for each of the following questions (Multiple Choice @3):
1. Assume the market return and risk-free rate 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 WACC of the firm decreases
d. The value of the equity increases
e. The cost of equity increases
2. You have just computed the Beta of a stock to be 1.25 and the estimate of the relevant
risk-free rate is 4%. The expected market return next period is 8% and your estimate of
Ke is 16%. What is the appropriate long-run market risk premium?
a. 4.0%
b. 7.0%
c. 7.5%
d. 8.0%
e. 9.6%
3. Assume next period’s dividend is forecast to be $2.00 per share; that WACC = .18; the cost
of equity is 20%; the cost of debt is 14%; the risk-free rate is 5% and the long-run
dividend growth rate is expected to be 4% . The best estimate the today’s share value
using the discounted dividends method is:
a. $6.00
b. $6.24
c. $10.00
d. $12.50
e. $14.29
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FSA3321 (Moore)
Exam 3
Fall 2006
Consider the following information for Questions 4 through 6:
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
4. 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%
5. 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%
6. 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 3
Fall 2006
7. 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
8. 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. An internet search engine and advertising company such as Google
e. A University such as Texas Tech
9. Which of the following types of market return measure 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
10. 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.
11. 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
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FSA3321 (Moore)
Exam 3
Fall 2006
12. 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
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
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. 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%
16. Which of the following is correct regarding the use of Altman’s Z-Score?
a. A company with a score of 2.6 is twice as likely to get credit as a company with a 1.3
b. A company with a score of 1.0 is more credit worthy than a company with a 5.0
c. A company with a 3.3 is considered to be a high credit risk (in terms of bankruptcy)
d. A company with a 2.3 is considered to be a high credit risk (in terms of bankruptcy)
e. A company with a 1.3 is considered to be a high credit risk (in terms of potential for
bankruptcy)
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FSA3321 (Moore)
Exam 3
Fall 2006
Computation of Valuation Models Section (Problems – 2@26)
Use the following summary financial statement information and forecasts provided by TTU
Value-Metrics to value Hi-Flyer Corp. at 31 November 2006
All Per Share
EPS
DPS
BVE (year end)
CFFO
CFFI
CFFF
BV Liabilities
Ke
Kd
WACC
Actual
31 Nov 2006
2.00
0.20
20.00
5.00
-3.00
-2.00
40.00
0.15
0.08
0.10
Estimated
31 Nov 2007
2.25
0.20
Estimated
31 Nov 2008
2.20
0.30
Estimated
31 Nov 2009
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
Problem 1 – 26 Points
Value Hi-Flyer Using the Free Cash Flow Method (Show all Work)
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FSA3321 (Moore)
Exam 3
Fall 2006
Problem 2 – 26 Points
Value Hi-Flyer Using the Residual Income Method (Show all Work)
All Per Share
EPS
DPS
BVE (year end)
CFFO
CFFI
CFFF
BV Liabilities
Ke
Kd
WACC
Actual
31 Nov 2006
2.00
0.20
20.00
5.00
-3.00
-2.00
40.00
0.15
0.08
0.10
Estimated
31 Nov 2007
2.25
0.20
Estimated
31 Nov 2008
2.20
0.30
Estimated
31 Nov 2009
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
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