Prof. Dr.

Jing Zeng Advanced Corporate Finance

Department of Economics University of Bonn

Problem Set 1

1. You expect CCM Corporation to generate the following free cash flows over the next five years:

Year 1 2 3 4 5
FCF ($ millions) 25 28 32 37 40

Following year five, you estimate that CCM's free cash flows will grow at 5% per year and that CCM's
weighted average cost of capital is 13%.

a) Estimate the enterprise value of CCM corporation.

b) If CCM has $200 million of debt and 8 million shares of stock outstanding, estimate the share price
for CCM.

2. Which of the following statements is FALSE?

A) Even two firms in the same industry selling the same types of products, while similar in
many respects, are likely to be of different size or scale.
B) In the method of comparables, we estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
C) Consider the case of a new firm that is identical to an existing publicly traded company. If
these firms will generate identical cash flows, the Law of One Price implies that we can use
the value of the existing company to determine the value of the new firm.
D) A valuation multiple is a ratio of some measure of the firm's scale to the value of the firm.

3. Which of the following statements is FALSE?

A) The most common valuation multiple is the price-earnings (P/E) ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
C) A firm's P/E ratio is equal to the share price divided by its earnings per share.
D) The intuition behind the use of the P/E ratio is that when you buy a stock, you are in a sense
buying the rights to the firm's future earnings and differences in the scale of the firms'
earnings are likely to persist.

4. Which of the following statements is FALSE?

A) We can estimate the value of a firm's shares by multiplying its current earnings per share by
the average P/E ratio of comparable firms.
B) For valuation purposes, the trailing P/E ratio is generally preferred, since it is based on actual
not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.
Prof. Dr. Jing Zeng Advanced Corporate Finance
Department of Economics University of Bonn

5. Which of the following statements is FALSE?

A) Because the enterprise value represents the entire value of the firm before the firm pays its
debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows
after interest payments are made.
B) We can compute a firm's P/E ratio by using either trailing earnings or forward earnings with
the resulting ratio called the trailing P/E or forward P/E.
C) It is common practice to use valuation multiples based on the firm's enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a "shortcut" to the
discounted cash flow method of valuation.

6. Which of the following statements is FALSE?

A) The fact that a firm has an exceptional management team, has developed an efficient
manufacturing process, or has just secured a patent on a new technology is ignored when we
apply a valuation multiple.
B) Valuation multiples have the advantage that they allow us to incorporate specific information
about the firm's cost of capital or future growth.
C) For firms with substantial tangible assets, the ratio of price to book value of equity per share
is sometimes used.
D) Using multiples will not help us determine if an entire industry is overvalued.

7. Which of the following statements is FALSE?

A) Because capital expenditures can vary substantially from period to period, most practitioners
rely on enterprise value to free cash flow multiples.
B) Common multiples to consider are enterprise value to EBIT, EBITDA, and free cash flow.
C) If two stocks have the same payout and EPS growth rates as well as equivalent risk, then they
should have the same P/E ratio.
D) Looking at enterprise value as a multiple of sales can be useful if it is reasonable to assume
that the firms will maintain similar margins in the future.

8. Suppose that Texas Trucking (TT) has earnings per share of $3.45 and EBITDA of $45 million. TT
also has 5 million shares outstanding and debt of $150 million (net of cash). You believe that
Oklahoma Logistics and Transport (OLT) is comparable to TT in terms of its underlying business,
but OLT has no debt. OLT has a P/E of 12.5 and an enterprise value to EBITDA multiple of 7.

a) Based upon the price earnings multiple, what is the value of a share of Texas Trucking?

b) Based upon the enterprise value to EBITDA ratio, what is the value of a share of Texas Trucking?

c) What are some common multiples used to value stocks?

Prof. Dr. Jing Zeng Advanced Corporate Finance
Department of Economics University of Bonn

9. Assume that this new project is of average risk for Omicron and that the firm wants to hold
constant its debt to equity ratio. Use the WACC method of valuation for the following questions.

Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital
Assets Liabilities Cost of Capital
Cash 0 Debt 200 Debt 6%
Other Assets 500 Equity 300 Equity 12%
τc 21%

Omicron Industries' New Project Free Cash Flows (Millions)

Year 0 1 2 3
Free Cash Flows ($100) $40 $50 $60

a) What is Omicron's weighted average cost of capital?

b) What is the NPV for Omicron's new project?

c) What is the debt capacity for Omicron's new project in year 0 under consistent capital structure
assumption?

d) What is the debt capacity for Omicron's new project in year 2 under consistent capital structure
assumption?

10. Which of the following statements regarding the adjusted present value method is FALSE?
A) The firm's unlevered cost of capital is equal to its pre-tax weighted average cost of capital—
that is, using the pre-tax cost of debt, rd, rather than its after-tax cost, rd (1 - τc ).
B) A firm's levered cost of capital is a weighted average of its equity and debt costs of capital.
C) When the firm maintains a target leverage ratio, its future interest tax shields have similar
risk to the project's cash flows, so they should be discounted at the project's unlevered cost of
capital.
D) The first step in the APV method is to calculate the value of free cash flows using the project's
cost of capital if it were financed without leverage.

11. Which of the following statements is FALSE?

A) To determine the project's debt capacity for the interest tax shield calculation, we need to
know the value of the project.
B) To compute the present value of the interest tax shield, we need to determine the appropriate
cost of capital.
C) Because we don't value the tax shield separately, with the APV method we need to include
the benefit of the tax shield in the discount rate as we do in the WACC method.
D) A target leverage ratio means that the firm adjusts its debt proportionally to the project's
value or its cash flows.
Prof. Dr. Jing Zeng Advanced Corporate Finance
Department of Economics University of Bonn

12. Which of the following statements is FALSE?

A) The APV approach explicitly values the market imperfections and therefore allows managers
to measure their contribution to value.
B) We need to know the debt level to compute the APV, but with a constant debt-equity ratio we
need to know the project's value to compute the debt level.
C) The WACC method is more complicated than the APV method because we must compute
two separate valuations: the unlevered project and the interest tax shield.
D) Implementing the APV approach with a constant debt-equity ratio requires solving for the
project's debt and value simultaneously.

13. Suppose Luther Industries is considering divesting one of its product lines. The product line is
expected to generate free cash flows of $2 million per year, growing at a rate of 3% per year.
Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a corporate tax rate of
21%, and a debt-equity ratio of 2. This product line is of average risk and Luther plans to maintain
a constant debt-equity ratio.

a) Luther's unlevered cost of capital is:

b) The unlevered value of Luther's product line is:

14. Alpha Beta Corporation maintains a constant debt-equity ratio of 0.5. The total value of the firm is
$30 million, and existing debt is riskless. Over the next three months, news will come out that will
either raise or lower Alpha Beta's value by 10%. How will Alpha Beta adjust its debt level in
response to keep its debt-equity ratio constant?
A) Either increase by $1 million or decrease by $1 million.
B) Either increase by $1.5 million or decrease by $1.5 million.
C) Either increase by $3 million or decrease by $3 million.
D) There will be no change—the debt-equity ratio will remain constant.

15. Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100
million. The acquisition is expected to increase Rose's free cash flow by $5 million the first year,
and this contribution is expected to grow at a rate of 3% every year thereafter. Rose currently
maintains a debt to equity ratio of 1, its corporate tax rate is 21%, its cost of debt rD is 6%, and its
cost of equity rE is 10%. Rose Industries will maintain a constant debt-equity ratio for the
acquisition. Given that Rose issues new debt of $50 million initially to fund the acquisition, the
total value of this acquisition using the APV method is equal to?
Prof. Dr. Jing Zeng Advanced Corporate Finance
Department of Economics University of Bonn

16. Nielson Motors (NM) is a newly public firm with 25 million shares outstanding. You are doing a
valuation analysis of Nielson and you estimate its free cash flow in the coming year to be $40
million. You expect the firm's free cash flows to grow by 4% per year in subsequent years.
Because the firm has only been listed on the stock exchange for a short time, you do not have an
accurate assessment of Nielson's equity beta. However, you do have the following data for
another firm in the same industry:

Equity Beta Debt Beta Debt-Equity Ratio

1.8 0.4 1.5

Nielson has a much lower debt-equity ratio of .5, which is expected to remain stable, and
Nielson's debt is risk free. Nielson's corporate tax rate is 21%, the risk-free rate is 5%, and the
expected return on the market portfolio is 10%.

a) Nielson's estimated equity beta is:

b) Nielson's equity cost of capital is:

c) Nielson's share price is:

17. The Aardvark Corporation is considering launching a new product and is trying to determine an
appropriate discount rate for evaluating this new product. Aardvark has identified the following
information for three single division firms that offer products similar to the one Aardvark is
interested in launching:

Equity Cost Debt Cost Debt-to-Value

Comparable Firm of Capital of Capital Ratio
Anteater Enterprises 12.50% 6.50% 50%
Armadillo Industries 13% 6.10% 40%
Antelope Inc. 14% 7.10% 60%

Based upon the three comparable firms, calculate that most appropriate unlevered cost of capital
for Aardvark to use on this new product.