**Chapter 09 TestBank**

- Acquisitions create shareholder value on average.

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__TRUE__

- When an acquirer purchases all of a target firm’s equity, it must assume the target’s liabilities.

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__TRUE__

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- An acquirer should be willing to pay a higher control premium for a poorly managed company than for a well-managed company.

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__TRUE__

- When an acquirer values a potential target, it should discount the target’s cash flows at the target’s cost of capital.

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__TRUE__

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- Rational investors would never value a company’s stock below its liquidation value.

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__FALSE__

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- In business valuation, a typical discount for lack of marketability is about 10 percent.

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__FALSE__

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- Terminal value estimates based on book value tend to understate a company’s terminal value.

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__TRUE__

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- All else equal, a terminal value based on a no-growth perpetuity would be higher than a terminal value based on a perpetuity with 2-percent growth.

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__FALSE__

- An acquirer should never consider a target that would reduce the acquirer’s earnings per share.

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__FALSE__

- In venture-capital valuation, the post-money valuation is equal to the pre-money valuation plus the amount of the venture capitalist’s investment.

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__TRUE__

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- Which of the following statements are correct?
- Liquidation value of a firm is equal to the present worth of expected future cash flows from operating activities.
- When an acquiring firm purchases a target firm’s equity, the acquirer must assume the target’s liabilities.

III. The market value of a public company reflects the worth of the business to minority investors.

- The fair market value of a business is usually the lower of its liquidation value and its going-concern value.

- I and III only
- II and IV only
**II and III only**- I, II, and III only
- II, III, and IV only
- None of the options are correct.

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- Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Co. was $1.46 billion. What was the cost of this acquisition to the shareholders of Ginormous Oil?

- $1.46 billion
- $3.46 billion
- $4.92 billion
- $6.38 billion
- $8.38 billion
- None of the options are correct.

The value of the bid to Ginormous’s shareholders is the value of the assets acquired in the merger. This would include the value of the equity acquired and the liabilities that accompany the equity. Therefore, the cost of the acquisition was ($60 × 82 million shares) + $1.46 billion = 6.38 billion.

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- Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Co. was $1.46 billion. Immediately prior to the Ginormous Oil bid, the shares of Slick Co. traded at $33 per share. What value did Ginormous Oil place on the control of Slick Co.?

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- $2.21 billion
- $2.71 billion
- $4.17 billion
- $6.38 billion
- None of the options are correct.

Ginormous paid $60 per share for a firm that minority shareholders valued at $33 per share, so they placed a value of 60 – 33 = $27 per share on control of Slick. $27 × 82 million = $2.21 billion.

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- Which of the following statements is/are correct?
- Going-concern value of a firm is equal to the present value of expected net income.
- When a buyer values a target firm, the appropriate discount rate is the buyer’s weighted-average cost of capital.

III. The liquidation value estimate of terminal value usually vastly understates a healthy company’s terminal value.

- The value of a firm’s equity equals the discounted cash flow value of the firm minus all liabilities.

- II only
- III only
- I and II only
- II and III only
- II, III, and IV only
- None of the options are correct.

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- Which of the following statements are correct?

- Going-concern value of a firm is equal to the present value of expected future cash flows to owners and creditors.
- When an acquiring firm purchases a target firm’s equity, the acquirer need not assume the target’s liabilities.

III. The market value of a public company reflects the worth of the business to minority investors.

- The fair market value of a business is usually the lower of its liquidation value and its going-concern value.

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- I and III only
- II and IV only
- II and III only
- I, II, and III only
- II, III, and IV only
- None of the options are correct.

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- The following table presents forecasted financial and other information for Havasham Industries:

2015 | 2016 | 2017 | |

Projected EBIT | $ 317 | $ 339 | $ 363 |

Earnings after tax | 197 | 210 | 225 |

Free cash flow | 135 | 144 | 155 |

Havasham’s WACC | 8.2% | ||

Expected growth rate in FCFs after 2017 | 4.0% | ||

Warranted MV firm/FCF in 2017 | 19.4 | ||

Warranted P/E in 2017 | 18.7 |

What is an appropriate estimate of Havasham’s terminal value as of the end of 2017 using the perpetual-growth equation as your estimate?

- $161 million
- $363 million
- $3,690 million
- $3,888 million
- $5,357 million
**None of the options are correct.**

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FCF2018 = 155 × (1 + 0.04) = $161 million.

Terminal value2017 = FCF2018/(KW − g ) = $161 million/(0.082 − 0.04) = $3,833 million.

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- The following table presents forecasted financial and other information for Havasham Industries:

2015 | 2016 | 2017 | |

Projected EBIT | $ 317 | $ 339 | $ 363 |

Earnings after tax | 197 | 210 | 225 |

Free cash flow | 135 | 144 | 155 |

Havasham’s WACC | 8.2% | ||

Expected growth rate in FCFs after 2017 | 4.0% | ||

Warranted MV firm/FCF in 2017 | 19.4 | ||

Warranted P/E in 2017 | 18.7 |

What is an appropriate estimate of Havasham’s terminal value as of the end of 2017 using a warranted price-to-earnings multiple as your estimate?

- $225 million
- $3,833.0 million
- $4,207.5 million
- $4,365.0 million
- $6,788.1 million
- None of the options are correct.

Terminal value2017 = 18.7 × $225 million = $4,207.5 million.

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- The following table presents forecasted financial and other information for Havasham Industries:

2015 | 2016 | 2017 | |

Projected EBIT | $ 317 | $ 339 | $ 363 |

Earnings after tax | 197 | 210 | 225 |

Free cash flow | 135 | 144 | 155 |

Havasham’s WACC | 8.2% | ||

Expected growth rate in FCFs after 2017 | 4.0% | ||

Warranted MV firm/FCF in 2017 | 19.4 | ||

Warranted P/E in 2017 | 18.7 |

What is an appropriate estimate of Havasham’s terminal value as of the end of 2017 using a warranted multiple of free cash flow as your estimate?

- $155 million
- $2,898.5 million
- $3,007.0 million
- $4,365.0 million
- $7,042.2 million
- None of the options are correct.

Terminal value2017 = 19.4 × $155 million = $3,007.0 million.

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- Atmosphere, Inc. has offered $860 million cash for all of the common stock in ACE Corporation. Based on recent market information, ACE is worth $710 million as an independent operation. For the merger to make economic sense for Atmosphere, what would the minimum estimated present value of the enhancements from the merger have to be?

- $0
- $75 million
- $150 million
- $710 million
- $860 million
- None of the options are correct.

Minimum economic value in PV terms = $860 million − $710 million = $150 million

- Consider the following premerger information about a bidding firm (Buyitall Inc.) and a target firm (Tarjay Corp.). Assume that neither firm has any debt outstanding.

Buyitall | Tarjay | |

Shares outstanding | 1,500 | 1,100 |

Price per share | $32 | $26 |

Buyitall has estimated that the present value of any enhancements that Buyitall expects from acquiring Tarjay is $2,600. What is the NPV of the merger assuming that Tarjay is willing to be acquired for $28 per share in cash?

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- $400
- $600
- $1,800
- $2,200
- $2,600
- None of the options are correct.

The NPV of the merger is the market value of the target firm, plus the value of the enhancements, minus the acquisition costs: NPV = 1,100 ($26) + $2,600 − 1,100($28) = $400.

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*[The following information applies to the questions displayed below.]*

In March of 2011, Macklemore Corp. considered an acquisition of Blue Scholar Learning, Inc. (BSL), a privately held educational software firm. As a first step in deciding what price to bid for BSL, Macklemore’s CFO, Ryan Lewis, has prepared a five-year financial projection for the company assuming the acquisition takes place.

Blue Scholar Learning, Inc. (BSL) | |||||||||||||||

5-year Financial Projection | |||||||||||||||

($ millions) | |||||||||||||||

Actual | 2011 | 2012 | 2013 | 2014 | 2015 | ||||||||||

Income Statement | 2010 | ||||||||||||||

$ 1,996 | $ | 2,267 | $ | 2,508 | $ | 2,827 | $ | 3,138 | $ | 3,571 | |||||

Net sales | |||||||||||||||

Cost of sales | 644 | 742 | 830 | 959 | 1,087 | 1,241 | |||||||||

Gross income | 1,352 | 1,525 | 1,678 | 1,868 | 2,051 | 2,330 | |||||||||

Depreciation | 492 | 785 | 1,061 | 1,301 | 1,009 | 917 | |||||||||

Interest expense | 171 | 178 | 191 | 175 | 142 | 110 | |||||||||

Operating expenses | 212 | 239 | 270 | 306 | 334 | 374 | |||||||||

Net income before tax | 477 | 323 | 156 | 86 | 566 | 929 | |||||||||

Provision for taxes | 186 | 126 | 61 | 34 | 221 | 363 | |||||||||

Net income after tax | $ 291 | $ | 197 | $ | 95 | $ | 52 | $ | 345 | $ | 566 | ||||

Balance sheet | 1,121 | 1,234 | 1,412 | 1,650 | 1,923 | 2,179 | |||||||||

Total current assets | |||||||||||||||

Gross property and equipment | 4,180 | 5,149 | 6,410 | 7,449 | 8,200 | 9,016 | |||||||||

Accumulated depreciation | 868 | 1,654 | 2,714 | 4,015 | 5,024 | 5,941 | |||||||||

Net property and equipment | 3,312 | 3,495 | 3,696 | 3,434 | 3,176 | 3,075 | |||||||||

Goodwill | 1,069 | 1,069 | 1,069 | 1,069 | 1,069 | 1,069 | |||||||||

Total assests | 5,502 | 5,798 | 6,177 | 6,153 | 6,168 | 6,323 | |||||||||

Accounts payable | 104 | 77 | 91 | 110 | 117 | 135 | |||||||||

Short-term debt | 335 | 482 | 842 | 814 | 585 | 393 | |||||||||

Current portion long-term debt | 41 | 140 | 165 | 200 | 223 | 267 | |||||||||

Accrued expenses | 86 | 97 | 120 | 134 | 174 | 168 | |||||||||

Total current liabilities | 566 | 796 | 1,218 | 1,258 | 1,099 | 963 | |||||||||

Long-term debt | 1,694 | 1,554 | 1,389 | 1,189 | 966 | 699 | |||||||||

Deferred taxes | 335 | 334 | 370 | 454 | 505 | 496 | |||||||||

Shareholders’ equity | 2,907 | 3,104 | 3,200 | 3,252 | 3,598 | 4,165 | |||||||||

Total liabilities and equity | $ 5,502 | $ | 5,798 | $ | 6,177 | $ | 6,153 | $ | 6,168 | $ | 6,323 | ||||

Free cash flows | $ | (130) | $ | 215 | $ | 464 | $ | 490 | |||||||

- Use BSL’s actual financial data for 2010 and its projections for 2011 as shown above. What is BSL’s projected free cash flow (in $ millions) for 2011?

- −$938
- −$792
- −$7
- $122
- $1,091
- None of the options are correct.

(NOTE to instructor: for this question, you might choose to remove the last row of the table above.) FCF = EBIT(1 − Tax rate) + Depreciation − Capital expenditures − Working capital investment. EBIT = Income before tax + Interest = 323 + 178 = $501.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Change in working capital: working capital is current assets less operating current liabilities (this excludes short-term debt and the current portion of long-term debt.) Hence, the working capital balance is 1,234 − (77 + 97) = 1,060 in 2011, and 931 in 2010. The change in working capital is 1,060 − 931 = 129; this increase is a cash outflow.

Thus, 2011 Free Cash Flow = 501(1 − 0.39) + 785 − 969 − 129 = −$7.

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Estimate the present value of BSL’s free cash flow (in $ millions) for the years 2011 to 2015. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent.

(NOTE to instructor: for this question, you might choose to include the FCF for 2011 of −$7 in the last row of the table above.)

- −$1.29
- $628.79
- $720.58
- $726.68
- $743.94
- None of the options are correct.

FCF = EBIT(1 − Tax rate) + Depreciation − Capital expenditures − Working capital investment. EBIT = Income before tax + Interest = 323 + 178 = $501.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Change in working capital: working capital is current assets less operating current liabilities (this excludes short-term debt and the current portion of long-term debt.) Hence, the working capital balance is 1,234 − (77 + 97) = 1,060 in 2011, and 931 in 2010. The change in working capital is 1,060 − 931 = 129; this increase is a cash outflow.

Thus, 2011 Free Cash Flow = 501(1 − 0.39) + 785 − 969 − 129 = −$7. PV@ 11.5% {FCFs, 2011-2015} = $628.79

The fundamental principle is that the discount rate should reflect the risks of the cash flows discounted. Here, the cash flows are BSL’s, so BSL’s WACC is the appropriate discount rate. Some argue incorrectly that because BSL will disappear in the merger, the cash flows will become Macklemore’s, so Macklemore’s WACC is the appropriate discount rate. However, the relevant criterion is the risk of the cash flows, not who owns them or what we call them.

- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Estimate BSL’s value (in $ millions) at the end of 2010 assuming it is worth the book value of its assets at the end of 2015. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent.

- $628.24
- $3,669.01
- $4,297.80
- $4,412.94
- $4,984.28
- $6,951.24
- None of the options are correct.

(NOTE to instructor: for this question, you might choose to include the FCF for 2011 of −$7 in the last row of the table above.)

FCF = EBIT(1 − Tax rate) + Depreciation − Capital expenditures − Working capital investment. EBIT = Income before tax + Interest = 323 + 178 = $501.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Change in working capital: working capital is current assets less operating current liabilities (this excludes short-term debt and the current portion of long-term debt.) Hence, the working capital balance is 1,234 − (77 + 97) = 1,060 in 2011, and 931 in 2010. The change in working capital is 1,060 − 931 = 129; this increase is a cash outflow.

Thus, 2011 Free Cash Flow = 501(1 − 0.39) + 785 − 969 − 129 = −$7. PV@ 11.5% {FCFs, 2011-2015} = $628.79

Terminal value in 2015 = $6,323.

PV = 6,323/1.115^{5} = 3,669.01.

Estimated firm value = $628.79 + 3,669.01 = $4,297.80

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Assume BSL is worth the book value of its assets at the end of 2015. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL’s equity?

- $1,702.80
- $2,227.80
- $2,342.94
- $2,383.94
- $2,603.80
- $4,297.80
- None of the options are correct.

(NOTE to instructor: for this question, you might choose to include the FCF for 2011 of −$7 in the last row of the table above.)

FCF = EBIT(1 − Tax rate) + Depreciation − Capital expenditures − Working capital investment. EBIT = Income before tax + Interest = 323 + 178 = $501.

Tax rate = 126/323 = 0.390 or 39.0% Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Thus, 2011 Free Cash Flow = 501(1 − 0.39) + 785 − 969 − 129 = −$7. PV@ 11.5% {FCFs, 2011-2015} = $628.79

Terminal value in 2015 = $6,323

PV of terminal value = 6,323/1.115^{5} = 3,669.01 Estimated firm value = $628.79 + 3,669.01 = $4,297.80

Equity value = firm value − existing interest-bearing debt = $4,297.80 − (335 + 41 + 1,694) = $2,227.80

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Estimate BSL’s value (in $ millions) at the end of 2010 assuming that in the years after 2015, the company’s free cash flow grows 4 percent per year in perpetuity. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent.

- $4,297.25
- $4,571.49
- $4,686.78
- $6,181.49
- $5,351.19
- $7,423.16
- None of the options are correct.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Terminal value in 2015 = (490 × (1 + 0.04))/(0.115 − 0.04) = $6,794.67

PV of terminal value = 6,794.67/1.115^{5} = 3,942.70. Estimated firm value = $628.79 + 3,942.70 = $4,571.49

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Assume that in the years after 2015, the company’s free cash flow grows 4 percent per year in perpetuity. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL’s equity at the end of 2010?

- $1,976.49
- $2,501.49
- $2,877.49
- $4,195.49
- $4,571.49
- None of the options are correct.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Terminal value in 2015 = (490 × (1 + 0.04))/(0.115 − 0.04) = $6,794.67

PV of terminal value = 6,794.67/1.115^{5} = 3,942.70 Estimated firm value = $628.79 + 3,942.70 = $4,571.49

Equity value = firm value − existing interest-bearing debt = $4,571.49 − (335 + 41 + 1,694) = $2,501.49

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Estimate BSL’s value (in $ millions) at the end of 2010 assuming that at year-end 2015, the company’s equity is worth 15 times earnings after tax, and its debt is worth book value. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent.

- $628.24
- $3,669.01
- $7,429.74
- $6,343.81
- $6,755.83
- $7,008.06
- None of the options are correct.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Terminal value in 2015 = value of equity + value of debt = 15 × 566 + (393 + 267 + 699) = 8,490 + 1,359 = $9,849

PV of terminal value = 9,849/1.115^{5} = $5,715.02 Estimated firm value = $628.79 + $5,715.02 = $6,343.81

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- Use BSL’s actual financial data for 2010 and its projections for 2011 to 2015 as shown above. Assume that at year-end 2015, the company’s equity is worth 15 times earnings after tax, and its debt is worth book value. The WACC of the acquiring firm (Macklemore) is 8.0 percent, BSL’s WACC is 11.5 percent, and the average of the two companies’ WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL’s equity at the end of 2010?

- $3,484.68
- $4,723.81
- $4,938.06
- $5,554.68
- $6,343.81
- None of the options are correct.

FCF = EBIT(1 −Tax rate) + Depreciation − Capital expenditures − Working capital investment. EBIT = Income before tax + Interest = 323 + 178 = $501.

Tax rate = 126/323 = 0.390 or 39.0%

Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969

Terminal value in 2015 = value of equity + value of debt = 15 × 566 + (393 + 267 + 699) = 8,490 + 1,359 = $9,849

PV of terminal value = 9,849/1.115^{5} = $5,715.02 Estimated firm value = $628.79 + $5,715.02 = $6,343.81

Equity value = firm value − existing interest-bearing debt = $6,343.81 − (335 + 41 + 1,694) = $4,723.81

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- A recent annual income statement for Stone Creek Roofing is shown below.

Net sales | $5,000 | |

Cost of sales | 3,200 | |

Gross profit | 1,800 | |

Operating expense | 800 | |

Depreciation expense | 200 | |

Operating income | 800 | |

Interest expense | 100 | |

Income before tax | 700 | |

Tax | 175 | |

Income after tax | $ | 525 |

Assume that during the year, Stone Creek spent $180 on new capital equipment and increased current assets net of non-interest-bearing current liabilities by $120. What was Stone Creek’s free cash flow in this year?

- $425
- $500
- $700
- $725
- $740
- None of the options are correct.

FCF = EBIT(1 − t) + Depreciation − Fixed investment − Working capital investment FCF = 800(1 − 0.25) + 200 − 180 − 120 = 500

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- STU Corporation has $3 million in earnings on $20 million in sales and has 1 million shares outstanding. Earnings per share of comparable firm 1 is $5, and earnings per share of comparable firm 2 is $2. Comparable firm 1’s stock is trading for $50, and comparable firm 2’s stock is trading for $28. What is the estimated stock price of STU using the method of comparables? (Use average multiples of the comparable firms when doing the calculations.)

- $33.43
- $36.00
- $39.00
- $40.00

Comp. 1 P/E = 10, Comp. 2 P/E = 14, Avg. P/E = 12 STU = 12 × $3.00 (EPS) = $36.00

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- Tutter Corporation is being valued using discounted cash flow methodology with terminal value calculated as a growing perpetuity. Not including the terminal value, the present value of projected free cash flows for years 1 through 5 is $200 million (total). In year 5, projections show free cash flow of $60 million. What is the estimated fair market value of Tutter Corporation? Assume a WACC of 10% and a growth rate of 2%.

- $666 million
- $675 million
- $950 million
- $965 million

FMV = PV{FCF, 1 − 5} + PV{Terminal value}.

Terminal value = FCF(1 + g)/(KW − g ) = $61.2/0.08 = $765 million. PV of Terminal value = $765 million/1.11^{5} = $475 million.

FMV = 200 million + 475 million = $675 million.

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- The following information is available about Chiantivino Corp. (CC):

Stock price per share | $ | 8.00 |

Common shares outstanding (millions) | 10 | |

Market value of interest-bearing debt (millions) | $ | 75 |

Weighted-average cost of capital | 14% |

An activist investor is confident that by terminating CC’s money-losing fortified wine division, she can increase free cash flow by $4 million annually for the next decade. In addition, she estimates that an immediate, special dividend of $10 million can be financed by the sale of the division.

- Assuming these actions do not affect CC’s cost of capital, what is the maximum price per share the investor would be justified in bidding for control of CC? What percentage premium does this represent?

- Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year.

- The maximum justifiable premium = the fair market value of CC under new management − the fair market value of CC under existing management. A plausible estimate of CC’s fair market value under existing management is its standalone value = current market value of firm = $8 × 10 million + 75 million = $155 million.

Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of the division.

Input: | 10 | 14 | ? | 4 | 0 |

n | i | PV | PMT | FV | |

Output: | −20.86 |

*In Excel:*

=PV(0.14,10,4)

=−20.86

Fair market value = 155 million + 20.86 million + 10 million = $185.86 million.

Fair market value of equity = $185.86 −75 = $110.86 million.

Fair market of equity per share = $110.86/10 = $11.09.

This is a 38.6% premium over the existing $8 share price.

- The fair market value of the firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 17.57 + 10 = $182.57 million.

Value of equity = 182.57 − 75 = 107.57.

Value per share = 107.57/10 = $10.76.

This is a 34.5% premium over the existing price.

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Input: | 10 | 15 | ? | 3.5 | 0 |

n | i | PV | PMT | FV | |

Output: | −17,57 |

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*In Excel:*

=PV(0.15,10,3.5)

=−17.57

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*Accessibility: Keyboard Navigation*

*Difficulty: 2 Medium*

*Gradable: manual*

- Below is a recent income statement for Gatlin Camera:

Net sales | $8,000 |

Cost of sales (including depreciation of $800) | 4,700 |

Gross profit | 3,300 |

Selling and admin. expenses (including interest expense of $570) | 1,500 |

Income before tax | 1,800 |

Tax | 612 |

Income after tax | $1,188 |

Calculate Gatlin’s free cash flow in this year assuming it spent $510 on new capital equipment and increased current assets net of noninterest-bearing current liabilities by $340.

Free cash flow = EBIT(1 − Tax rate) + Depreciation − Fixed investment − Working capital investment.

EBIT = Income before tax + Interest = 1,800 + 570 = $2,370.

Tax rate = 612/1,800 = 0.34

Free cash flow = 2,370(1 − 0.34) + 800 − 510 − 340 = $1,514.20.

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- Given the forecast below, estimate the fair market value of Kenmore Air at the end of 2017. Assume that after 2021, earnings before interest and tax will remain constant at $220 million, depreciation will equal capital expenditures in each year, and working capital will not change. Kenmore Air’s weighted-average cost of capital is 11 percent and its tax rate is 40 percent.

Forecast for Kenmore Air, Inc. | ||||

Year | 2018 | 2019 | 2020 | 2021 |

Free cash flow ($ millions) | −40 | 85 | 97 | 112 |

FMV = PV{FCF, 2018-2021} + PV{Terminal value}.

Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2018-2021} = $177.7 million.

Terminal value = EBIT(1 − Tax rate)/0.11 = $132/0.11 = $1,200 million.

PV{Terminal value} = $1,200 million/(1 + 0.11)^{4} = $790.5 million.

FMV = 177.7 million + 790.5 million = $968.2 million.

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- Given the forecast below, estimate the fair market value per share of Kenmore Air’s equity at the end of 2017 if the company has 50 million shares outstanding and the market value of its interest-bearing liabilities on the valuation date equals $300 million. Assume that after 2021, earnings before interest and tax will remain constant at $220 million, depreciation will equal capital expenditures in each year, and working capital will not change. Kenmore Air’s weighted-average cost of capital is 11 percent and its tax rate is 40 percent.

Forecast for Kenmore Air, Inc. | ||||

Year | 2018 | 2019 | 2020 | 2021 |

Free cash flow ($ millions) | −40 | 85 | 97 | 112 |

FMV = PV{FCF, 2018-2021} + PV{Terminal value}.

Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2018-2021} = $177.7 million.

Terminal value = EBIT(1 − Tax rate)/0.11 = $132/0.11 = $1,200 million.

PV{Terminal value} = $1,200 million/(1 + 0.11)^{4} = $790.5 million.

FMV = 177.7 million + 790.5 million = $968.2 million.

FMV of equity per share = ($968.2 − $300)/50 = $13.36.

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- Given the forecast below, estimate the fair market value of Kenmore Air’s equity per share at the end of 2017 under the following assumptions:

EBIT in year 2021 is $210 million and then grows at 4 percent per year forever.

To support the perpetual growth in EBIT, capital expenditures in year 2022 exceed depreciation by $25 million, and this difference grows 4 percent per year forever.

Similarly, working capital investments are $10 million in 2022, and this amount grows 4 percent per year forever.

Kenmore Air’s weighted-average cost of capital is 11 percent, and its tax rate is 40 percent.

Kenmore Air has 50 million shares outstanding, and the market value of its interest-bearing liabilities on the valuation date equals $300 million.

Forecast for Kenmore Air, Inc. | ||||

Year | 2018 | 2019 | 2020 | 2021 |

Free cash flow ($ millions) | −40 | 85 | 97 | 112 |

FMV = PV{FCF, 2018-2021} + PV{Terminal value}.

Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2018-2021} = $177.7 million.

Terminal value = FCF in 2022/(0.11 − 0.04).

FCF in 2022 = $210(1.04)(1 − 0.4) − 25 − 10 = $96.0 million.

So, terminal value = $96/(0.11 − 0.04) = $1,371.4 million.

PV{Terminal value} = $1,371.4/(1 + 0.11)^{4} = $903.4 million.

FMV of company = $177.7 + $903.4 = $1,081.1 million.

FMV of equity per share = ($1,081.1 − $300)/50 = $15.62.

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- Given the forecast below, estimate the fair market value of Kenmore Air’s equity per share at the end of 2017 under the following assumptions:

EBIT in year 2021 will be $210 million.

At year-end 2021, Kenmore Air has reached maturity, and analysts expect its equity will sell for 15 times year 2021 net income.

At year-end 2021, Kenmore Air has $300 million book value of interest-bearing liabilities outstanding at an average interest rate of 10 percent.

Kenmore Air’s weighted-average cost of capital is 11 percent, and its tax rate is 40 percent.

Kenmore Air has 50 million shares outstanding, and the market value of its interest-bearing liabilities on the valuation date equals $300 million.

Forecast for Kenmore Air, Inc. | ||||

Year | 2018 | 2019 | 2020 | 2021 |

Free cash flow ($ millions) | −40 | 85 | 97 | 112 |

FMV = PV{FCF, 2018−2021} + PV{Terminal value}.

Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2018−2021} = $177.7 million.

Terminal value = Value of equity + Value of interest-bearing liabilities.

Value of equity = 15 × Net income in 2021 = 15 × (210 − 0.10 × 300)(1 − 0.40) = $1,620 million.

Terminal value = $1,620 + $300 = $1,920 million.

PV{Terminal value} = $1,920/(1 + 0.11)^{4} = $1,264.8 million.

FMV of company on valuation date = $177.7 + $1,264.8 = $1,442.5 million.

FMV of equity per share = ($1,442.5 − $300)/50 = $22.85.

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- Ketema, Inc. is a manufacturer of electronic instruments. Use the following information on Ketema and five other similar companies to value Ketema, Inc. on December 31, 2017.

Ketema, Inc., 2017 ($ millions) | ||

Net income | $ | 66.10 |

Number of common share (millions) | 32.82 | |

Earnings before interest and tax | $ | 112.30 |

Tax rate | 22% | |

Book value of equity | $ | 335.10 |

Book value of interest-bearing debt | $ | 470.80 |

Comparison of Ketema, Inc. with Comparable Companies | ||||||

Aloha | Butler | Baker | National | |||

Ketema | Electric | Electric | AJ Smith | Modesto | Power | |

Growth Rates, Financial Risks, Size, Returns | ||||||

5-year growth rate in sales (%) | 3.3 | 6.8 | 1.4 | 8.1 | 10.2 | 15.2 |

5-year growth rate in eps (%) | 5.1 | 1.3 | 9.2 | (5.4) | 19.6 | 3.4 |

Interest coverage ratio (X) | 4.8 | 8.0 | 38.0 | 3.0 | 12.3 | * |

Total liabilities to assets (X) | 0.7 | 0.6 | 0.4 | 0.7 | 0.5 | 0.1 |

Total assets ($ millions) | 1,029 | 15,046 | 196 | 1,294 | 585 | 1,421 |

Indicators of Value | ||||||

Price/earnings (X) | 23.2 | 16.1 | 32.0 | 12.4 | 25.0 | |

MV firm/EBIT(1−Tax rate) (X) | 23.3 | 16.2 | 34.7 | 13.2 | 25.0 | |

MV equity/BV equity (X) | 3.9 | 3.5 | 1.0 | 2.1 | 2.3 | |

MV firm/BV firm (X) | 2.7 | 3.3 | 1.0 | 1.8 | 2.3 | |

Price/sales (X) | 1.5 | 1.4 | 0.4 | 1.0 | 2.0 | |

MV firm/sales (X) | 1.9 | 1.4 | 0.8 | 1.1 | 2.0 |

*National Power has no interest-bearing debt outstanding.

MV = Market value; BV = Book value. MV firm is estimated as book value of interest-bearing debt + market value of equity.

The median and mean values for Ketema’s peers are presented below:

(Excluding Ketema) | ||

Median | Mean | |

5-year growth rate in sales (%) | 8.1 | 8.3 |

5-year growth rate in eps (%) | 3.4 | 5.6 |

Interest coverage ratio (X) | 10.1 | 15.3 |

Total liabilities to assets (X) | 0.5 | 0.4 |

Total assets ($ millions) | 1,294 | 3,708 |

Price/earnings (X) | 23.2 | 21.7 |

MV firm/EBIT(1−Tax rate) (X) | 23.3 | 22.5 |

MV equity/BV equity (X) | 2.3 | 2.6 |

MV firm/BV firm (X) | 2.3 | 2.2 |

Price/sales (X) | 1.4 | 1.3 |

MV firm/sales (X) | 1.4 | 1.4 |

The following estimates require subjective reasoning. In coming to these estimates, Ketema, Inc. is judged as exhibiting representative earnings per share growth, but considerably higher financial leverage, and a below-average five-year growth rate in sales. The company’s higher-than-average leverage suggests that its firm value ratios will be particularly key, as equity value ratios can be distorted by Ketema’s higher leverage. Since the firm value ratios abstract from differences in financing, values for these ratios are selected that are closer to the sample averages. Turning to equity value ratios, Ketema’s modest growth and higher financial leverage suggest a 10 to 20 percent discount from the group average for its price/earnings and price/sales indicators.

Here are estimated indicators of value for Ketema, Inc.

Estimated Indicators for Ketema, Inc. | |

Price/earnings (X) | 18.0 |

MV firm/EBIT(1−Tax rate) (X) | 20.0 |

Price/sales (X) | 1.1 |

MV firm/sales (X) | 1.3 |

MV equity/BV equity | 2.7 |

MV firm/BV firm | 2.1 |

And here are associated implied values of Ketema stock:

Implied Value of Ketema Stock | |||

Price/earnings (X) | $36.26 = 18 × Net income / # shares | ||

MV firm/EBIT(1−Tax rate) (X) | $39.26 = [20 | × EBIT(1 − Tax rate) − Debt] / # shares | |

Price/sales (X) | $34.35 | = 1.1 | × Sales / # shares |

MV firm/sales (X) | $26.25 | = (1.3 × Sales − Debt) / # shares | |

MV equity/BV equity | $27.57 | = 2.7 | × BV equity / # shares |

MV firm/BV firm | $37.23 | = (2.1 × BV firm – Debt) / # shares |

Based on these numbers, a reasonable estimate of a fair price for Ketema, Inc.’s shares at year-end 2017 is $36.00. Many other estimates are, of course, possible.

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- Rainy City Coffee’s (RCC) free cash flow next year will be $100 million, and it is expected to grow at a 4 percent annual rate indefinitely. The company’s weighted average cost of capital is 10 percent, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding.

- Estimate the price per share of RCC’s common stock.
- A hedge fund believes that by selling the company’s private jet and instituting other cost savings, it can increase RCC’s free cash flow next year to $110 million and can add a full percentage point to RCC’s growth rate without affecting its cost of capital. What is the maximum price per share the hedge fund can justify bidding for control of RCC?

- Price per share of RCC stock = (100/(0.10 − 0.04) − 1,000)/20 = $33.33.
- Fair market value of equity per share after change in ownership = (110/(0.10 − 0.05) − 1,000)/20 = $60.00.

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*Difficulty: 2 Medium*

*Gradable: manual*

- Empirical evidence indicates that the returns to shareholders of the target firm vary significantly from the returns to the shareholders of the acquiring firm. Identify the shareholders that tend to realize the smaller return. Does your answer depend on the way the acquisition is financed?

The empirical evidence strongly indicates that the shareholders of the target firm realize large wealth gains (premiums of 20 to 40 percent) as a result of a takeover bid but the shareholders in the acquiring firm gain little or nothing. While a definitive answer is elusive, the following have been offered as possible explanations for these low returns to acquiring shareholders: size differentials, competition in the takeover market, lack of achieving expected synergy gains, management goals other than the best interests of the shareholders, and early announcements of corporate acquisition intent.

The empirical evidence also suggests that leveraged buyouts lead to sizeable improvements in operating performance and attractive returns to buyers. Hence, financing policy does appear to change the outcome for buyers.

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- Estimate a current stock price for Montana Corporation using the following information. Projected free cash flows for the next three years are shown in the table below. Assume the growth rate in years 1 through 3 continues into the future. Calculate terminal value as a growing perpetuity. Montana’s WACC is 18%, the market value of its debt is $5 million, and it has 1.2 million shares of stock outstanding.

Year | 1 | 2 | 3 |

Free cash flow | $1,000,000 | $1,050,000 | $1,102,500 |

PV of cash flows, years 1 to 3 = 1,000,000/1.18 + 1,050,000/1.18^{2} + 1,102,500/1.18^{3} = $2,272,567

Terminal value = 1,102,500(1.05)/(0.18 − 0.05) = $8,904,808

PV(Terminal value) = 8,904,808/1.18^{3} = $5,419,741

Firm value = 2,272,567 + 5,419,741 = $7,692,308

Equity value = 7,692,308 − 5,000,000 = $2,692,308

Stock price = 2,692,308/1,200,000 = $2.24

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- A venture capital firm wants to invest $5 million in Artichoke Corp., a startup biotech firm. Artichoke is expected to go public in 4 years. Earnings will be negligible until year 4 but are projected to be $4 million in year 4. Comparable biotech firms are trading at P/E ratios of 18 on average. Artichoke has 3 million shares of stock outstanding. The VC firm will apply a discount rate of 40% to the investment. How many shares of stock should the VC firm be given for its $5 million investment?

Terminal value = $4 million × 18 = $72 million

PV(Terminal value) = $72 million/1.4^{4} = $18,742,191

Required ownership percentage = 5,000,000/18,742,191 = 26.7%

Number of new shares = (New owners% / existing owners%) × current shares

=(0.267/0.733) × 3,000,000

=1,092,769

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*Difficulty: 2 Medium*

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**Chapter 09 Test Bank Summary**

Category |
# of Questions |

Accessibility: Keyboard Navigation | 42 |

Difficulty: 1 Easy | 15 |

Difficulty: 2 Medium | 17 |

Difficulty: 3 Hard | 10 |

Gradable: automatic | 31 |

Gradable: manual | 11 |