Analysis for Financial Management, 10e
SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS
CHAPTER 9
2. The value of the bid to Newscorp’s shareholders is the value of the assets acquired in
the merger. This includes the value of the equity acquired plus the liabilities
assumed by the buyer. The estimat4ed cost of the acquisition was thus ($60 x 82
million shares) + $1.46 billion = 6.38 billion. This is an estimate because the book
value of Dow Jones’s debt only approximates the preferred market value, although
the approximation is probably reasonably close.
4. a. The terminal value = 700*(1+.04)/(.08-.04) = $18,200. Discounting the annual
free cash flows plus the terminal value at 8 percent, the MAP = $11,926.
b. The terminal value = 700*(1+.05)/(.07-.05) = $36,750. Discounting the annual
free cash flow plus the terminal value at 7 percent, the MAP = $25,757.
c. The MAP increases 116 percent when the discount rate falls one percentage point
and the perpetual growth rate rises by the same amount. Plausible changes in
the discount rate and the perpetual growth rate can cause large changes in
estimated firm value. This is especially true when the initial rates are similar.
6. a. EBIT = $50 million. As a stand-alone company, typical debt would be .40 x $250
million = $100 million. At a 10% interest rate, interest expense would be $10
million. Therefore, profit before tax = $50 – 10 = $40 million. Profit after tax =
$40(1-.34) = $26.4 million. Therefore the value of the division's equity relative to
comparable firms is $26.4 x 12 = $316.8 million. Adding liabilities, Value of
division = $316.8 + $100 = $416.8 million. This should be the owner's minimum
acceptable price.
b. From the acquirer's perspective, this is essentially a "make-or-buy" decision.
Because the acquirer can "make" a like operation for a present value cost of $450
million, he should not pay more than this to "buy" the division. (This assumes the
opportunity costs of being slower to market are included in the $450 million price.)
c. An acquisition appears feasible; the owner's minimum price is less than the buyer's
maximum.
d. Redoing the answer to (a) at a 15 price-to-earnings ratio, the value of the division's
equity = $26.4 x 15 = $396, and adding liabilities, the value of the division is now
$396 + 100 = $496. Because the owner's minimum price is now more than the
buyer's maximum, an acquisition does not make economic sense.
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e. The answer to (d) suggests that acquisition activity will decrease when market
value rises above replacement value. In this situation, companies find it more
expensive to "buy" assets than to "make" them. This is why economists are
interested in James Tobin's q-ratio, defined as the market value of a
company/replacement value of its assets. When q rises, acquisition activity should
fall, and vice versa.
8. a. Negative free cash flow simply means that the company will not be able to fund all
worthwhile activities in that year out of operating cash flows and needs to raise
capital from outside sources. Negative free cash flows are usually associated with
growing companies.
b. Negative free cash flows do not compromise or invalidate the notion that the value
of the firm equals the present value of free cash flows, provided the securities sold
to make up the shortfall are fairly priced. They do mean that existing capital
suppliers will have to inject added capital into the business or share future free
cash flows with new investors. In the latter case, this does not change the value of
the business to existing capital suppliers provided the present value of the free cash
flows sacrificed equals the value of the capital raised from new investors.
c. The going-concern value of a company with negative expected free cash flows in
all future periods is negative. Nonetheless, an equity investor might buy shares in
such a company for at least two reasons: the expected liquidation value of equity
might be positive, and there might be a small but positive chance the present value
of future free cash flows will be positive. (Remember, negative expected free cash
flows does not rule out the chance that actual cash flows might be positive.) In
this latter case, the stock can be viewed as an out-of-the-money option, which is
valuable. Here’s a numerical example. An all-equity, one-period company has a
90% chance of generating a FCF next year of -$100 and a 10% chance of
generating +$50. The expected FCF is -$85, but due to limited liability, the payoff
to shareholders is a 90% chance at $0 and a 10% chance at $50, which has an
expected value of $5.
10. The median and mean values for Scotts’s peers appear below.
5-year growth rate in sales (%)
5-year growth rate in eps (%)
Analysts’ projected growth (%)
Interest coverage ratio (X)
Total liabilities to assets (X)
Total assets ($ millions)
Price/earnings (X)
MV firm/EBIT(1-Tax rate (X)
Values excluding Scotts
Median
Mean
8.5
7.0
5.1
3.7
9.2
9.8
5.8
6.1
0.7
0.7
6,591
9,034
16.9
17.8
17.9
18.0
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distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
MV equity/sales (X)
MV firm/sales (X)
MV equity/BV equity (X)
MV firm/BV firm (X)
1.6
2.0
3.6
1.5
1.3
1.8
4.4
1.5
Here are my indicators of value for Scotts. In coming to these numbers, I believe
that Scotts’s somewhat higher historical and projected growth rates, combined with
dominant positions in its chosen markets,warrant numbers that are in the upper half
of the indicated valuation ranges. However, the company’s somewhat smaller size
suggests some caution. I have selected multiples for the first two ratios roughly 10
percent above the sample median and 5 percent above the mean. Scotts’s mediocre
gross margins, especially for a company that dominates its markets, suggest that
investors will pay less per dollar of sales for Scotts than for peers, resulting in lower
than average multiples for the next two ratios. I have chosen representative
multiples for the last two ratios.
Price/earnings (X)
MV firm/EBIT(1-Tax rate (X)
MV equity/sales (X)
MV firm/sales (X)
MV equity/BV equity (X)
MV firm/BV firm (X)
18.7
19.4
1.1
1.5
4.0
1.5
The implied value of Scotts’s common stock for each indicator is:
Price/earnings (X)
MV firm/EBIT(1-Tax rate) (X)
MV equity/sales (X)
MV firm/sales (X)
MV equity/BV equity (X)
MV firm/BV firm (X)
$ 33.19
$ 29.88
$ 49.44
$ 49.92
$ 30.00
$ 35.96
( = 18.7 X Net income / # shares)
( = [19.4 X EBIT(1 - Tax rate) - Debt] / # shares)
( = 1.1 X Sales / # shares)
( = [1.5 X Sales - Debt] / # shares)
( = 4.0 X BV equity / # shares)
( = [1.5 X BV firm -Debt] / # shares)
Looking at these numbers,my best guess of a fair price for Scotts’s shares on
November 1, 2007 is$33.00. I think $29.88 is the best single estimate, but because
all of the other estimated values are above this figure, I have raised my best guess by
about 10 percent. $33.00 compares to an actual price on the valuation date of
$38.69, so my estimate is about 17 percent low, within my notion of the tolerances
inherent in business valuation. Many other estimates are, of course, possible.
12. Price per share = $5 million/400,000 shares = $12.50 per share. Pre-money value =
1.6 million shares X $12.50 = $20 million. Post-money value = 2 million shares X
$12.50 = $25 million. Alternatively, post-money value = pre-money value +
$5million = $25 million.
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distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
14.
($ in millions)
Value of firm at year 6
$
Round 1
Investment
Time 0 PV @ 60%
% ownership at time 6
Round 2
Investment
Time 2 PV @ 40%
% ownership at time 6
Round 3
Investment
Time 4 PV @ 30%
% ownership at time 6
Employee bonus and option ownership
Round 3 retention ratio
Round 3 % ownership at time 4
Round 2 retention ratio
Round 2 % ownership at time 2
Round 1 retention ratio
a. Round 1 % ownership at time 0
240.00
6.00
14.31
41.9%
=240/(1+.60)^6
=6/14.31
8.00
62.47
12.8%
=240/(1+.40)^4
=8/62.47
12.00
142.01
8.5%
15.0%
85.0%
9.9%
0.77
16.7%
0.64
65.8%
b. Round 1 shares owned at time 0
=20*12
1,923,849
c. Price per share
$
3.12
d. Pre-money value of company
Post-money value of company
$ 3,118,748
$ 9,118,748
Alternatively,
=240/(1+.30)^2
=12/142.01
=(1-.15)
=8.5/.85
=(1-.15)*(1-.099))
=12.8/0.77
=(1-.15)*(1-.099)*(1-.167)
=41.9/.64
=.658*1 million/(1-.658)
=$6 million/1,923,849
=3.12*1 million shares
=3.12*(1 million+1,923,849)
= pre-money value +$6 million
16. See C9_Problem-16_Answer.xlsx on this Web site.
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.